Why do Employees Cash Out their 401(k)/403(b) When They Leave?
I was talking to a retirement plan participant the other day who had terminated employment with his employer and had a small amount in his 403(b) plan - not so small that it would be automatically cashed out (if the plan had a cash-put provision), but not a giant amount, either. The employee’s first thought was to withdraw his funds because he had some student loan debt to address. However, by the end of the call, it appeared that I had persuaded him not to take a distribution.
No, I am not some sort of asset retention magician! I simply explained the advantages and disadvantages of his options. For example, he was unaware of the 10% premature distribution penalty (in addition to the ordinary tax due) on retirement plan distributions, and the fact that the distribution, when added to his other income, might be taxed at a higher marginal tax rate. All of that would likely offset any benefit gained from using the distribution to pay off his student loan debt.
He was similarly unaware that he could roll over his distribution to his current employer’s plan without paying taxes on it. His new employer’s plan permitted loans, and by rolling over to his new plan, he would have more funds available to him via a plan loan than he would have if he took a withdrawal - with far fewer tax consequences. Of course, I also explained to him the downside of a loan as well (see our Top of Mind on Why Borrowing to Pay off Debt is a Bad Idea for more). By the end of the conversation, he had enough information to consider all of his options.
After our call, I thought to myself, “What about all the people who don’t take the time to ask questions when they are in a similar situation?” If this participant and I had not discussed his options, I believe he would have forged ahead with his distribution. In fact, I suspect that most people in this situation would have taken the taxed and penalized distribution simply because they could, without considering the tax consequences - especially since those consequences only become painfully apparent at tax filing time the following year.
As retirement plan sponsors and advisors, we need to enhance participants’ understanding of their options and consequences, because taking a distribution at the wrong time (i.e., early in one’s working career) is not only a tax disaster, but totally defeats the power of compounding. Just as saving at an early age is critical to retirement success, so is leaving the money in place!
Now, to be clear, I do not believe people should have to jump through hoops to withdraw money that is rightfully theirs, even if it is to their detriment. However, I also do not think that taking a withdrawal should be as easy as internet shopping. Whether it is via chat, telephone, messaging, etc., there should be a big flashing warning to participants considering this option: “DO YOU KNOW THERE ARE A LOT OF TAX/WEALTH ACCUMULATION CONSEQUENCES TO THIS WITHDRAWAL? ARE YOU CERTAIN YOU WISH TO PROCEED?” Otherwise, individuals who move from job to job have ample opportunity to cripple their retirement at each step along the way.
Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice. Opinions expressed are those of the author, and do not necessarily represent the opinions of Cammack Retirement Group.
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