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It's generally not smart to cash out your 401(k) account when you switch jobs. Sure, it's easy to ask your former employer to just cut you a check -- but it'll cost you dearly.
To find out just how much cashing out can cost you, consider several factors:
- How old you are now.
- When you hope to retire.
- How much you expect to earn on your investments.
- How big your 401(k) is.
Unfortunately, the biggest hit for those who decide to cash out comes from tax -- 30% or more, depending on your bracket -- and penalties, which general amount to a whopping 10% of your entire account! You'll save all that money, and earn a lot more, by rolling over the account into an IRA and leaving it to grow.
See for yourself
Let's say I'm 45, plan to retire at 65, have $50,000 in my 401(k) plan, and expect to earn 8% over the long haul. If I cash in now, I'll face:
- $5,000 in penalties
- $15,000 in taxes
- Overall costs totaling 40% of what I've saved
- Only $30,000 left.
But if you roll that $50,000 into an IRA, that miserly $30,000 could eventually grow into $233,000. Sure, it'll take 20 years, but that's still a hefty difference. Even if you cash out now, take your $30,000, and invest it for the same 20 years at a higher 10% rate of return, you'll still end up with only $202,000 -- less than what you'd have if you'd just rolled the money over in the first place.
Maximize your odds
Fine, you say -- I'll just earn enough to turn my $30,000 into $233,000. Well, an average annual gain of 11% would do it, but that's easier said than done. You can invest in big names that you know well, and still get mixed results. Check out these numbers:
|
Company
|
20-year average annual return
|
|
Limited Brands (NYSE: LTD)
|
4.7%
|
|
Pitney Bowes (NYSE: PBI)
|
6.6%
|
|
American Express (NYSE: AXP)
|
6.7%
|
|
General Electric (NYSE: GE)
|
9.2%
|
|
Schlumberger (NYSE: SLB)
|
10.6%
|
|
General Mills (NYSE: GIS)
|
13.4%
|
|
EMC (NYSE: EMC)
|
24.5%
|
Source: Yahoo! Finance.
The overall stock market has averaged just 10% over many decades. In the last 10 years, it has actually lost ground. So why set yourself up to face a higher hurdle than you have to?
In perspective
If you're tempted to cash out your 401(k) today, stop and give a thought to tomorrow. You might reap enough today to buy a new car or help pay off some debt, but in exchange, you'll lose critical income in retirement. According to our Rule Your Retirement newsletter service, in order to make your nest egg last, you should conservatively plan to withdraw about 4% of it per year in retirement. In that light, 4% of $233,000 would be more than $9,000 per year -- for the entire span of your retirement.
If you're like to set yourself up for an unpainful retirement, try our Rule Your Retirement newsletter service for free, with full access to all past issues. It regularly offers recommendations of promising stocks and mutual funds, too.
"The most exciting development in my lifetime!" 15 years ago, Motley Fool founder David Gardner uncovered a secret that changed how he'd invest forever. It can make you money in up, down, and rollercoaster markets. To learn more, enter your email address now.
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