-- Younger generations change jobs more often than Baby Boomers do, and when they do, they're more likely than the population as a whole to cash out their 401(k) accounts, according to Hewitt Associates.
They're young enough, the thinking goes, to make up the savings later. What many don't realize is that cashing out a retirement account when you're young not only can trigger taxes and penalties, but it also imperils your financial future.
Noah Velthouse, 28, and his wife chose to cash out their 401(k)s when they moved last year from Charleston, S.C., for teaching jobs in Indianapolis, and used it for a down payment on a home. "We didn't get a lot of advice," Velthouse says. "But it was only a year's worth of 401(k), so I don't think it will affect our retirement that much."
"When there is not much in the retirement plan, many people just view it as found money," says Pamela Hess, director of retirement research at Hewitt. "But a little bit of money does make a big difference" in preparing for retirement, even when it's decades away.
Too much debt
Gen X and Gen Y consumers often recognize that they accumulate too much debt, according to a recent survey of adults ages 21 to 41 by Fidelity Investments. In that group, 51% said financial priorities, including mortgage bills and credit card debt, prevent them from saving for retirement. These young adults often face an ongoing struggle with debt management, says Pam Norley, executive vice president of Fidelity Consulting Group.
Of the group surveyed, 40% said they cashed out their workplace retirement plan when they switched jobs. Few had asked for guidance. And more than half said they are now unhappy with their decision.
When Frank DeFina, 27, changed jobs this year, he cashed out his 401(k) account to pay off debt.
"I just wanted to free up my assets and eliminate my debt so that I have more money for disposable income," says DeFina, a sales engineer in Boston. "It could be wrong, but this is my thinking."
Like DeFina, many young Americans feel justified in their decision to cash out their 401(k) if they use the proceeds to pay down credit card debt or school loans or to put down money for a home.
"Becoming debt-free is a huge goal," says Mary Lacey Gibson, a financial planner in San Juan Bautista, Calif. "That's good, but I'd like to see them do it in another way, rather than using their 401(k)."
Their deciding factor, Gibson says, is often their preferred lifestyle. But younger adults, she suggests, need to understand budgeting, retirement planning and the difference between needs and wants.
There's also concern among planners that once young workers cash out a 401(k) account, they may develop the habit of doing so each time they leave a job. That can be devastating to their retirement savings, given how often younger workers change employers and how few of them can depend on a traditional company pension plan. Even if it's only a small sum of money in the plan, it'll prove far more valuable, over time, than many realize.
"One of the things we hammer home to those under the age of 40 is that time is on their side," says Ken McDonnell, program director of the American Savings Education Council. "Even small amounts make a huge difference."
How a small sum adds up
Say a 25-year-old has just $5,000 in a retirement account. Even without adding any more money, if the account earns a 7% average annual rate of return, it will be worth $74,872 once the worker reaches 65, according to Hewitt.
Those thinking of tapping their retirement savings should also consider the taxes and a 10% early-withdrawal penalty that will generally result. If, for instance, you cash out $5,000 from your retirement account, you'll end up with about $2,900, according to Fidelity. (Fidelity assumed a 25% marginal federal tax rate and a 7% state tax rate.)
Those who don't cash out their account when they change jobs often just keep their retirement savings in the existing 401(k) plan, perhaps out of inertia. But if workers have $1,000 or less in a 401(k) plan, some companies will force them out of it. The company might then just send the former employee a check for the retirement savings, along with some information about the available options.
That's not mandatory, though, and not all companies will do that. And even if they do close the account and mail out a check, the employee will have 60 days to invest it in a retirement plan to avoid taxes and the 10% early-withdrawal penalty.
When an employee's 401(k) account contains $1,000.01 to $5,000, the employer must automatically roll it into an IRA if it doesn't want to keep it in the 401(k) plan, according to Hewitt. It's up to the employers to select an IRA; many of them designate a money market fund as the default option.
Among Gen X and Gen Y workers who left jobs in 2007, the biggest percentage cashed out their retirement funds, followed by those who left their money in the existing plan, Hewitt says. It found that 62% of Gen Y (ages 21 to 32) and 45% of Gen X (ages 33 to 41) cashed out, vs. 22% of Gen Y and 31% of Gen X who left their money in the plan. A smaller group rolled their money into an IRA.
For people who had worked for fairly sizable employers, the best option when they leave a job is often to leave the 401(k) money where it is. That's because the fees in 401(k) plans are generally lower than on most IRAs, Hess says.
But in addition to fees, participants also need to examine the plan investment options. "If you're in a 401(k) plan that only has stock and a couple of other options, you might want to transfer it to an IRA," Norley says. Even if the fees are higher, you should have more choices, and they may be much better.
McDonnell thinks the industry should consider developing a default option when a worker leaves a company. It would automatically roll over a 401(k) balance into an IRA for anyone — not just those with small balances — who leaves a company.
For now, better communication with participants is crucial. "Just getting them to understand the issue is important, and giving them real examples so they know what happens if they take out their retirement savings," Hess says.
When kids graduate from high school, parents can teach a vital lesson by helping them set up an IRA, Norley says. Later, when they leave a job, they'll already know the value of long-term savings.
John Garcia of Salt Lake City has learned the lesson the hard way. About 10 years ago, when he quit a job at age 25, he pulled the cash from his 401(k).
"Looking back, I totally regret it," says Garcia, who works in computer networking. "It was a nice chunk of change. I didn't even think about a penalty. I didn't think about holding on to it until I'm 65."
Now, as a father, he's much more focused on planning for retirement. "I'm in a 401(k), and I think that the savings could have been so much more."
READERS: Did you cash out a 401(k) when you changed jobs and not re-invest it?