The essence of a retirement nest egg is the concept of patient growth and compounding investments over time. Its purpose is to provide a plentiful reserve of funds when one bids farewell to the workforce, thereby ensuring a comfortable retirement. However, a disconcerting trend has emerged as a significant portion of young workers are succumbing to the temptation to break their nest eggs prematurely.
The result is a tax bill, fines for early withdrawals, lost contributions, and a diminished – or gone – account balance that may be insufficient at retirement. We will discuss the details.
A financial advisor can help you organize your retirement savings and ensure that you are able to meet your financial goals.
Workers cash in their 401(k) when they leave their jobs
According to a study by the UBC Sauder School of Business, more than 41% of workers who quit their jobs cashed in earlier on their employer-sponsored 401(k) retirement plans. That’s up from pre-pandemic levels, when about one in three departing workers withdrew money or emptied their accounts completely.
There are a number of financial issues with such a move. One of these being that contributions are tax-deferred, withdrawals are treated as ordinary income, subject to the worker’s marginal tax rate.
Additionally, the Internal Revenue Service (IRS) is taking a second cut, adding a 10% penalty for withdrawals made before age 59.5 (although there is an exception available for workers age 55 years and older).
If you’re ready to be matched with local advisors who can help you achieve your financial goals, start now.
Other financial consequences
Workers can also sacrifice some of their employer’s 401(k) match if their account isn’t fully vested, which can take up to four years. Moreover, the worker loses the precious long-term capitalization of all this untaxed money.
And workers who take out loans against their 401(k) balances must pay off the entire balance before the next federal tax filing deadline. If workers do not repay the balance by this date, the remaining loan balance is treated as a distribution and is treated as taxable income.
Collection according to the balance
There are also situations where employers may choose to cash out your account when you leave your job, depending on the balance:
Account balance less than $1,000
The employer can write you a check. But it won’t be for the full amount. The IRS requires the employer to withhold 20% to cover income taxes.
Between $1,000 and $5,000 in loan balance
Accounts can be involuntarily transferred to an Individual Retirement Account (IRA) in your name. This IRA is at least tax-deferred, so you don’t take the tax hit. The bad news is that so-called “force-placed” IRAs can incur significant fees that can drain your account over several years.
Balance over $5,000
The employer cannot kick you out of the plan. You are free to leave the money where it is.
Either way, your best bet as soon as you know you’re leaving is to contact your benefits department for instructions on moving your money into an IRA at an institution of your choice. Any financial institution that offers IRAs can handle the rollover for you.
You can also transfer your money directly into your new employer’s 401(k) plan, if permitted. If you received a check, you have 60 days to deposit that money into an IRA with enough money to cover the 20% of the balance that was withheld.
Workers who cash out their 401(k) balances when they leave a job will immediately be hit with taxes and penalties on the money. And they may not have enough long-term investments to cover their retirement needs.
Tips for preparing for retirement
Planning for retirement is complex and can be stressful. If you’re not sure what your vision looks like, consider talking to a financial advisor. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three financial advisors who serve your area, and you can interview your matching advisors for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.
Social security is another source of income you can expect in your old age. Although you shouldn’t depend on it, it can help cover small expenses during retirement. Find out how much you’ll receive with our free social security calculator.
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