The amount of funds you relinquish upon withdrawing from your 401(k) retirement plan can be quite substantial.
Generally, you have three choices when transferring from one job to another: Keep it as it is if the organization permits it. Switch it to a tax-deferred retirement account like an IRA or the 401(k) of your new employer. Or simply withdraw the funds.
A significant number of 401(k) participants opt for the first or second option, however, a considerable portion prefers the third, according to recent studies. The average number of people choosing to withdraw is approximately 33%, as per Vanguard Investments, based on data from over 1,500 401(k) and 403(b) plans that cater to nearly 5 million participants.
A study conducted by the Yale School of Management, on the other hand, analyzed a smaller pool of nine company 401(k)s, all of which included automatic enrollment and escalation features. In this sample, 40% of the participants withdrew their funds upon leaving.
The real costs of withdrawing
Vanguard found that individuals most likely to withdraw their 401(k) funds are younger workers and those with smaller account balances (less than $25,000).
The thought of using the funds may be tempting, especially in financial hardships, but it's advisable to hold off if possible. There are three main reasons for this: Taxes, penalties and the loss of long-term investment growth.
For instance, let's consider a 30-year-old employee living in a high-tax area such as New York City or Los Angeles. If she withdraws $15,000 from her account, she could lose thousands of dollars that year alone, and even more in the long term.
Taxes and penalties: Assuming her annual income is $85,000 and her combined federal, state, and local tax rate is approximately 30%, she will have to pay between $4,500 and $4,695 in taxes on the withdrawal, along with a 10% early withdrawal penalty of $1,500. In total, she will lose at least $6,000, leaving her with a net of $9,000 from her initial $15,000 savings.
If her income is $55,000, she will pay $5,250 in taxes and penalties, leaving her with a net of $9,750.
Lost growth: The most significant loss, however, may not be immediately apparent. It's the money she would have earned had she left that $15,000 invested in a tax-deferred account for the next few decades.
Assuming it would be invested in a low-cost S&P 500 index fund for 30 years, it could have grown to over $260,000, assuming an average 10% annual return. Or if you assume a more modest 7% average return, it would have grown to approximately $115,000.
In simple terms, "Withdrawing from the 401(k) before 59-1/2 is one of the most expensive things a person can do, both from a tax perspective and an investment perspective." It results in a permanent decrease in capital that can significantly impact their retirement income security in the future, said certified financial planner Paul Brahim, president-elect of the Financial Planning Association.
Other possible setbacks to your savings when you quit
A recent study by Vanguard also found that changing jobs can reduce your retirement savings in the long term, unless you are diligent.
"The typical U.S. worker has nine employers during their career. The median job switcher experiences a 10% increase in pay but a 0.7 percentage point decrease in their retirement saving rate when they switch employers," Vanguard noted in its report.
The reason lies in the differences between 401(k) plans from one employer to another. While many now automatically enroll employees in the plan, the default savings rate may vary. If your new employer sets a lower default rate than your old one, make sure to save at least the same rate, or more, at your new job. Otherwise, you may end up with less money in your future.
For a worker earning $60,000 at the start of their career who switches jobs eight times across employers (total of nine jobs), the estimated loss in potential retirement savings could be $300,000 — enough to fund an estimated six additional years of spending in retirement, stated Vanguard.
And when considering a new job offer, don't forget to compare the employer match you would get with the current one. This money forms a part of your total compensation package.
Additionally, check the vesting period at the new job. This is the length of time you need to stay at a company for the employer matches to be fully yours. If you join a new job before the vesting period ends, you could lose some or all of the matches.
After considering the potential financial consequences, it's wise for individuals to reconsider withdrawing their 401(k) funds upon job change. Instead, they could explore opportunities for investing this money in a tax-deferred account. For instance, one could opt for Rolling Over the 401(k) to an Individual Retirement Account (IRA), which allows for continued tax-deferred growth and potential diversification of investments.
Given the long-term benefits of investing, it's essential to careful weigh the pros and cons before opting for a withdrawal. The decision to invest rather than withdraw can significantly impact one's retirement income security, potentially offering a more financially secure future.
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