The Consequences of Early 401(k) Withdrawals
Last Updated: April 05, 2023
Imagine this scenario:
You are a young working professional that has recently accepted an exciting and unexpected opportunity in a new city. This new opportunity will be a great move in furthering your career. However, with the excitement also comes a host of unexpected anxieties. You are leaving the company that gave you a shot, taught you a lot of what you know, and for better or for worse, has led you to the point you are at today.
With this move, you have an expansive to-do list – cleaning out your office, training your replacement, and preparing for this huge life change and leap in your career. And to top it all off, you are also thinking about the expenses that are about to incur from moving and taking two weeks off. Your new paycheck will help you once you are settled in the city, but between now and then, you are running short of funds. Where could you get the extra cash to help provide a little cushion before you start your new gig? You are only a few years into your career and haven’t built a nest egg to cover you during times like these. You are feeling the financial pinch of the next few weeks.
Then you remember that you have a 401(k) with your previous employer. You have been saving just enough to get the employer match, so it isn’t a huge amount of money, but it is just enough to be the cushion over the next few weeks. You may even have enough to replenish some of your emergency savings account. What would it hurt, it’s only a few thousand dollars, right?
Chances are you have seen a graph similar to this one on the right. It shows the difference between a person who starts saving a small amount at age 25 and then stops after 10 years, and a person who is 35 years old who starts saving the same amount for a longer time period.
If you have seen it, then you know that the person who started saving for retirement at age 25 is probably going to be better off in the long run. They made the proactive choice to start saving earlier, but they are at risk of landing back at square one if they pull their money out of the plan.
Unfortunately, this is a very common choice that individuals make when leaving their employers. Although younger people are more likely to cash out their balances, people of all ages make this detrimental mistake.
In a recent study done by Alight Solutions, “What do workers do with their retirement savings after they leave their employers,” branching from 2008-2017, they took a deep look at the post-termination decisions that participants made when it came to their retirement plans. Two of the most interesting areas the study covers are the likelihood of participants taking a cash distribution based on their balance and their age.
Alight first looked through a broad scope to see what decisions these participants made when leaving their employer. They found that roughly a quarter of the participants decided to keep their retirement savings in the plan. Making this decision allows them to continue tax-advantaged growth, as well as continue investing in funds that they are familiar with. Similarly, roughly a quarter of the participants decided to roll their retirement savings into an IRA or their new employer’s plan. This allows them to continue tax-advantaged growth and continue investing in that balance.
Conversely, they found that the largest portion of the participants decided to take full cash distribution of their retirement savings in that plan. When doing this, they stop all tax advantage savings that they previously had and start their balance at $0 again. They did find that some participants did a combination of these actions, but it was a minority.
Additionally, Alight found that the people who are cashing out their retirement savings are generally those who have a smaller balance in the plan. When looking at the total assets that leave the plan, almost half of the funds are rolled into a new plan, a slightly smaller amount of the funds are left in the plan, and a much smaller amount of the funds are taken as a cash distribution. This could be due to plan rules that force savings out if there is not a high enough balance, expenses that come when changing jobs, or people not wanting to do the work to roll the funds over.
They go on to break down the distributions by the balance in the account and it shows a clear truth – that those with low balances are much more likely to cash out their plans. In a culture, where the median employee tenure is around 4 years, someone who continues to cash out a small balance will likely continue that trend through their career, putting them far behind their retirement goals. *
If a participant switches jobs every four years and can accumulate between $5,000 – $9,999 during that time, the study shows that there is a 50% likelihood of them taking a cash distribution. However, if they roll that into their next plan and can double the balance in the next four years, the likelihood of a distribution drops by 14%. If they continue the trend of rolling their balance to the new plan, they are drastically less likely to take a cash distribution and are more likely to be able to meet their income needs within retirement.
Let’s look at the other interesting component of the study, age. At some point in most people’s lives, they have been told how important it is to save for their retirement and that you must start when you are young, but it isn’t always that simple. A lot of young professionals find themselves waiting to get their finances under control or find the right job to start their retirement contributions.
The study shows that even those who get an early start, don’t always make the right decisions with their balances when they transition jobs. There is roughly a 50% chance that participants under 30 will cash out their retirement when leaving a job. Those that keep their retirement in the plan or roll it over can continue growing their balance, making them much less likely to take a cash distribution.
The number of participants who cash out of their retirement plans is almost as important as those who are not saving in the plan at all. This sets participants back to square one every time that they take a distribution. There are a lot of tools that can help along the way, whether it is easier rollover procedures, no cash “force outs,” or completely automatic rollovers. All of these can make a huge difference in the future of the average American worker.
However, the most important and influential need is more education. If a participant is able to talk with an expert who can help guide them through the negatives of taking that cash out, many times, that participant will choose a different option. It would be very naïve to assume that all cash distributions would come to a stop, but if participants are better informed on the potential harm to their financial futures, it can go a long way.
If your employees need help making positive decisions about their retirement, reach out today! PCI’s unique Retirement Ready Model is designed to get participants on track toward their successful retirement!
Alight Solutions. “What do workers do with their retirement savings after they leave their employers? A deep dive into post-termination behavior, 2008–2017.” https://www.alight.com/thought-leadership/distributions-retirement-plans-after-employment.
*US Bureau Labor of Statistics. “Employee Tenure Summary.”22 September 2022. https://www.bls.gov/news.release/tenure.nr0.htm