Here's why an alarming number of workers cash out 401(k) plans

A 401(k) retirement account is supposed to be hands-off. It’s not your money, in theory, but savings for the future you.

And yet, when Americans leave jobs, one-third of them cash out their 401(k) accounts.

That’s called 401(k) “leakage,” and it costs workers untold billions of dollars in lost retirement savings.

In a recent paper, Vanguard ponders why so many Americans liquidate retirement accounts when they exit jobs – about 33%, by their estimate -- and what employers and employees can do about it.

The 401(k) was designed to help American workers build retirement savings, using tax breaks as an incentive.

Nearly $9 trillion sits in 401(k) accounts nationwide, according to the Investment Company Institute. Half of all private-sector workers now participate in the plans, a record high.

But 401(k) dollars don’t always end up funding someone’s retirement.

At least $1.7 trillion sits in lost or forgotten 401(k) accounts, according to research by Capitalize, a financial services firm.

A new Vanguard research note focuses on another problem: Workers cashing out retirement accounts when they leave jobs.One-third of workers cash out 401(k) plans when they leave jobs, Vanguard estimates.

Cashing out a 401(k) is often the worst option

When you depart a job, you have several options with a 401(k). You can do nothing, keeping the money in the account. You can execute a “rollover,” transferring the funds to another 401(k) or Individual Retirement Account.

Or, you can cash out. And if you’re exiting a job, a cashout might sound alluring. You may not have another job lined up. Perhaps you’re planning a move. Maybe a new child has arrived.

“It can be very tempting. You’re having this big decision in your life,” said Rob Williams, managing director of financial planning at Charles Schwab. “Especially if it’s not a large amount, your first instinct is to take the money.”

But cashing out a 401(k) is generally the worst option, at least in financial terms.

If you liquidate a 401(k) before age 59 ½, you generally pay income taxes on the amount, plus a 10% penalty for early withdrawal.

Moreover, you miss out on the chance to collect years of compounded returns on your 401(k) investments.

If you cash out a $7,000 retirement account at age 40, you may net as little as $4,270 in actual cash to spend, after penalties and taxes, Fidelity estimates.

But if you leave the same $7,000 invested for 20 more years, and the investments increase at an annual rate of 8%, the sum will grow to nearly $35,000, according to a NerdWallet calculator.

“You think it’s a small amount of money. You take it out. But if it stayed invested, it could have grown to a much larger sum,” said Anqi Chen, associate director of savings and household finance at the Center for Retirement Research at Boston College.Illustration on poor savings methods.

Why do departing workers cash out their 401(k)s?

Exiting workers cash out 401(k) accounts for several reasons, retirement experts say.

Vanguard researchers theorize that financial need, more than anything else, drives workers to liquidate retirement accounts.

Hourly workers are more likely than salaried employees to cash out 401(k)s. The reason, Vanguard says, may be that hourly workers have more income fluctuations. Those ups and downs can leave them short of cash.

Workers with lower incomes are more likely to cash out than those with higher incomes. That data point, too, suggests financial need.

“It’s really short-term cashflow liquidity challenges that are explaining a lot of these early withdrawals,” said Aaron Goodman, an economist at Vanguard.

Vanguard found that workers with emergency savings were much less likely to cash out a 401(k) when leaving a job.

Thus, Vanguard urges workers to save for emergencies. Even $2,000 in rainy-day funds, researchers found, allowed workers to leave jobs without raiding retirement funds.

Employees are also much more likely to cash out a 401(k) account with a small balance. The typical cashout involves “a few thousand dollars,” Goodman said.

Some workers, especially younger workers, cash out retirement accounts because the sum seems too small to bother with.

“It’s easy for them to fall into this mindset, ‘It’s not a lot of money,’” said Mike Shamrell, vice president of thought leadership at Fidelity Investments. “If you do that every other year in your 20s, that starts to add up.”

Rolling over a 401(k) can be 'incredibly hard'

Cashing out a 401(k) is relatively easy. Rolling it over into another retirement account, by contrast, can be “incredibly hard,” said Chen of Boston College.

That’s another reason why many workers cash out retirement plans.

In a rollover, you move your retirement savings to another 401(k) account at your new company, or into an IRA, a personal retirement savings account.

Rollovers can get complicated, especially when the funds are going into a new 401(k) account managed by a different firm.

Research by Capitalize, a retirement savings platform, found rollovers “outdated and painful”: Only 22% of savers managed to roll over an account without help, and 42% said the process took them at least two months to complete. In many cases, rollovers involve laborious forms and old-fashioned paper checks.

Some employers encourage departing workers to cash out low-balance retirement accounts, "just because it's easier for them," said David John, a senior strategic policy advisor at the AARP Public Policy Institute.

The ability to move a 401(k) from one employer to the next is called “portability,” and the lack of it has thwarted workers from preserving retirements savings, according to Chen and others.

When exiting employees contemplate rolling over a 401(k) account, “they’re just a little bit overwhelmed by the process,” said Shamrell of Fidelity. “They feel it’s going to be time-consuming and complex.”

A recent initiative in the retirement-savings industry aims to solve the portability problem. In 2022, a consortium of private retirement-plan providers announced a collaboration to boost the portability of small retirement accounts.

When someone leaves a job, the network of providers will make sure that retirement funds “move seamlessly from one job to another,” said John of AARP.

The auto-portability program applies to accounts valued at $7,000 or less, which are more likely to be cashed out or forgotten. Most big retirement-plan providers participate in the effort.

“I do think there’s an evolution, as there should be, in terms of making this more of a point-and-click exercise,” said Williams of Schwab.

This article originally appeared on USA TODAY: Workers cash out 401(k)s at an alarming rate. Why?

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