By Teresa McUsic
Although automatic features are taking fire in retirement plans these days, many in the younger half of the work force are taking the cash from their 401(k)s and running when they switch jobs, according to Fidelity.
Forty percent of workers age 20 to 40 cash out their 401(k)/403(c) plans when they changed jobs instead of rolling it into an IRA or their new company’s retirement plan, the survey said.
More than half said they later regretted the decision, according to the study.
Here’s why: Even just $5,000 in a retirement plan with a relatively modest growth rate of 7 percent in compounding interest will grow to $53,000 in 35 years, said Lauren Brouhard, vice president of rollover business management for Fidelity.
“Even a small contribution to a 401(k) or IRA can make a big difference in retirement,” she said. “Young people think they have their whole lives to save, but if you talk to a 50- or 60-year-old, they wish they had started earlier.”
Cashing out a retirement plan also has considerable upfront costs. That same $5,000 in a retirement plan will likely only net you about $3,300 once the penalty (10 percent if under age 59½) and federal taxes (if you are in the 25 percent tax bracket) are taken out in an early cash-out.
While that may still sound like a lot of money to a younger worker wanting a car or house or to pay off a student loan, the costs to their retirement savings are higher, Brouhard said.
Such practice is likely to increase as more workers enroll in 401(k) plans, said Jack VanderHei, research director at the Employee Benefits Research Institute.
More new employees, especially lower-income workers, are enrolling in their company’s retirement plans because of a relatively new automatic feature where employees actually must “opt out” of the plan to not be enrolled, VanderHei said.
“Now there’s a whole segment of the population only in these plans because their employer put them in,” he said. “When they change jobs, they are much more likely to grab the money.”
Enrollment in company retirement plans is surging two years after the Pension Protection Act removed barriers that prevented companies from automatically enrolling new employees in the plans.
A study by the Vanguard Center for Retirement Research of 50 Vanguard plans found that 86 percent of new hires enrolled in plans when it was automatic, double the number of employees who enrolled when the plans were voluntary.
More companies are adding the feature since the law was passed, and some are even expanding it to all employees, not just new hires, to be automatically enrolled, according to EBRI.
Once in, employees need to educate themselves about the plans, including knowing better options than cashing out when they need money, said Steve Blankenship, a certified financial planner with Heritage Financial Planning in Grapevine.
“Cashing out is a more common practice than it ought to be,” he said. “It’s often a symptom of not having a properly funded emergency fund.”
Most planners recommend having four to six months worth of spending in a money-market and checking account to cover emergencies from a job loss, death or other difficult financial period. Using your retirement fund to get you through tough times should only be a last resort, Blankenship said.
Getting a loan from your retirement account may be even worse than cashing it out, however, he warned. Employees with 401(k)s can take out a loan of $50,000, or 50 percent of the amount you’ve invested, whichever is smaller, without penalty.
The loans are attractive because of their low interest rates, usually just 1 or 2 percent above prime.
“But there are hidden dangers in 401(k) loans,” he said. “For example, the usual payout schedule is five years, but if you leave the company or get cash out, your loan becomes due almost immediately — within 30 to 60 days.”
In addition, a borrower must still pay that 10 percent penalty if under age, along with federal taxes to the IRS, Blankenship said.
“A loan on your 401(k) has a better interest rate than most credit cards, but it’s a dangerous place to go,” he said. “If you end up defaulting on a credit card, nobody’s going to take your house, but nothing can stop the IRS from getting what’s owed.”
Other options to cashing out a 401(k) are keeping the plan with the former employer, rolling it into an IRA or putting it in the plan of your next employer, Brouhard said.
Rollover IRAs are easy to find through your bank, brokerage house or insurance company, Blankenship said.
“Everyone has gotten into this business,” he said. “There’s no shortage of options.”
Often rollover IRAs don’t even require paperwork, Brouhard said.
“It’s quite easy to initiate a transaction,” she said. Most companies have toll-free numbers, and the transaction can be done over the phone with a customer-service representative, she said.
But it’s worthwhile to do some homework on the rollover fund before you commit to one company, Blankenship said.