401k Rollover Answers

Money is a strange creature. We need it to live but many people prefer not to think about it, even when life is going well and a steady paycheck is the norm. When things get stressful – moving, divorce, job loss – people want easy fixes and easy answers. They want money to solve their problems. If you’re in a bind like that, you might be tempted to cash out your 401(k) or, as a seemingly sound fiscal move, take a loan against your 401(k).

Both are usually bad moves and here’s why: if you cash out your 401(k), you can expect to get about 60% of your money. The rest will be eaten by taxes and penalties. If you take a loan against your 401(k), best case scenario is that you reset the clock on your retirement investing. Worst case, you end up owing every penny all at once if you lose your job for any reason.

Let me explain this scenario in detail. First, cashing out the 401(k): You think you need the money. Of course you think you need the money. Your life feels chaotic right now. Changing jobs, moving to a new city, getting a divorce, losing a job…. All of these are serious life situations. But cashing out your 401(k) to deal with the turmoil can be foolish in the long term. To keep the math simple, let’s say that you have $10,000 in the 401(k). First, you will owe Federal taxes on the money – let’s round that figure to 25%. So now your $10,000 is $7,500. Next you owe a 10% penalty for “early withdrawal.”  So now you have $6,750. And don’t forget state taxes. They’ll whittle another chunk off the original figure, too. In the end, you have a little over $6,000 to use for this emergency.

Next, taking a loan against your 401(k): First and foremost, you are incurring a huge risk. Is your job secure? Can anyone, especially these days, say that they will still be at this job in five years? That’s what you have to be able to say before you should consider a loan against your 401(k). It’s a stipulation that most people gloss over when considering a decision like this. If you lose or leave the job, the loan is due within 60 days. That’s how most 401(k) plans operate. If you default on the loan you pay taxes on the full amount. It doesn’t ding your credit score, but that is small comfort when you’re looking at that bill.

Bad things do happen and we all find ourselves strapped for cash sometimes, but I hope I’ve made a good case that your 401(k) should not be considered an ATM machine, even if it is your money. Best to leave the money alone and let it do its job. Let it grow and mature and when you are ready to retire, it will be there.