Once you earn money, it’s normal to want to spend it. There’s nothing wrong with that, unless it sits in a tax-advantaged account.
Most employees who participate in a 401(k) or another defined contribution plan want to build a nest egg. They allocate a portion of every paycheck to it and leave it alone. If their employer matches their contribution, even better.
But when leaving their employer, they might treat their retirement account balance as a ready source of cash. Advisers often urge job switchers to resist that urge; instead, they suggest rolling over the funds into another tax-deferred vehicle so that it continues to grow.
Yet many people ignore that advice: About 41% of employees who leave their job cash out of their 401(k). Most of them drain their entire account.
The IRS imposes a 10% penalty for withdrawing these funds before age 59 ½. Some savers don’t realize this until it’s too late. Even if they’re aware of the penalty, they may withdraw the cash anyway. That’s especially true for younger individuals who tend to prioritize immediate spending needs over long-term growth.
“Sadly, when you’re younger, there can be a lack of long-term thinking,” said Bob Peterson, a financial adviser in Lake Forest, Ill. “It’s easier to just take the money, maybe to pay off credit card or school debt. They may think, ‘I’ll get a check for $10,000 now.’ They don’t realize they could wait and get a check for $100,000 later” thanks for the power of compound interest and investment gains.
For those under 59 1/2 and facing financial hardship, there are ways around the 10% penalty. Examples include withdrawing tax-deferred money to cover unreimbursed medical expenses above a certain level, some higher education expenses and buying a first home.
Yet in the majority of early-withdrawal cases, the penalty applies. Some individuals get caught off guard. “It feels good for a short period of time [to cash out],” Peterson said. But when filing federal tax returns, people might discover that their refund is smaller than they expected — or there’s even a balance due — because of the penalty.
“When you request a distribution, your 401(k) administrator may not tell you about the penalty,” Peterson said. “Or you may not read the disclosures” and face a nasty surprise at tax time.
As a rule, anyone under 59 ½ who is thinking of fiddling with the money in a tax-advantaged account should avoid online transactions. Instead, call your employer’s benefits administrator and talk through your options. “Many folks do a rollover online and there tends to be confusion,” said Tim Ralph, an adviser in Boca Raton, Fla.
A financial planner can help with that. If you don’t have one, some advisers, especially those looking to build their practice, might offer a free introductory consultation.
Some investors seek to redeploy their retirement savings to take risky bets. They may want to buy real estate, cryptocurrencies or pursue other alluring possibilities.
“We advise against that given the penalties and fees,” Ralph said. He adds that such high-risk investments can also jeopardize the kind of portfolio diversification that tends to generate higher long-term returns.
In some scenarios, however, it can make sense to pay the early withdrawal penalty.
“You can make a case for debt pay-down if you have high credit-card debt,” Ralph said. “A lot of folks don’t want to lose 10% of their money [by paying a penalty]. But if you pay 10% to get rid of 20% or 24% [credit card interest],” it may be worth it.
If you withdraw their 401(k) balance —and then regret it — you can salvage the situation if you act quickly. Job switchers who receive funds from an IRA or other type of retirement plan distribution have 60 days to roll the money over into another tax-advantaged account. Even after the deadline, the IRS may agree to waive the 60-day rule under certain circumstances.
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This story originally appeared on Marketwatch
