One-Third of Americans Cash Out 401(k) When Leaving Jobs

The Growing Trend of 401(k) Cashouts and Its Impact on Retirement Security

A significant number of individuals who have participated in 401(k) plans administered by Vanguard and left their jobs in 2023 opted to withdraw their entire balance in a lump sum rather than rolling it over into a new employer's plan or another retirement account. This trend raises concerns about the long-term financial stability of these individuals, as cashing out can lead to substantial penalties and tax liabilities.

According to research from Vanguard, those who choose to cash out their 401(k) accounts are more likely to take the full balance instead of just a portion. This decision is often made without considering the long-term consequences, such as the loss of potential investment growth and the impact of early withdrawal penalties.

The Consequences of Early Withdrawals

Withdrawing funds from a 401(k) before the age of 59 1/2 typically results in a 10% early withdrawal penalty, in addition to income taxes that must be paid on the amount withdrawn. These penalties can significantly reduce the amount of money available for retirement, making it harder for individuals to maintain their standard of living in their later years.

The report highlights that this issue is particularly prevalent among certain groups. For instance, hourly workers are more likely to cash out their 401(k) balances compared to salaried workers. Among those who leave their jobs, 42% of hourly workers opt for a lump sum withdrawal, while only 21% of salaried workers do the same. This disparity may be attributed to factors such as income volatility and limited access to alternative financial resources.

Income and Withdrawal Behavior

Lower-income workers tend to cash out their 401(k) balances more frequently than higher-income workers. However, even when comparing individuals with similar incomes, hourly workers were found to be 10 to 15 percentage points more likely to cash out. This suggests that financial instability and the need for immediate liquidity play a significant role in these decisions.

Vanguard’s findings also indicate that many individuals who cash out their retirement accounts do so entirely rather than taking a partial withdrawal. This behavior could be influenced by the perception that a lump sum provides an opportunity to access the full balance, unlike hardship withdrawals or 401(k) loans, which come with certain restrictions. However, there is no conclusive evidence to support this theory.

Common Reasons for Early Withdrawals

A survey conducted by the Transamerica Center for Retirement Studies in June revealed that 37% of workers reported taking a loan, early withdrawal, or hardship withdrawal from their 401(k), IRA, or similar retirement account. Financial emergencies are the most frequently cited reason for these actions, followed by debt repayment, everyday expenses, unplanned major costs, medical bills, and home improvements.

Experts emphasize the importance of having an emergency fund to reduce the likelihood of needing to tap into retirement savings. Individuals with at least $2,000 in emergency savings are less likely to take out loans or hardship withdrawals from their 401(k) accounts. Moreover, they are 43 percentage points less likely to cash out their retirement balances after changing jobs, according to Vanguard.

Strategies for Protecting Retirement Savings

To mitigate the risks associated with early withdrawals, individuals should consider building a robust emergency fund and exploring other financial options before accessing their retirement accounts. Rolling over funds into a new employer's plan or an individual retirement account (IRA) can help preserve the long-term growth potential of their savings.

By understanding the implications of cashing out and making informed decisions, individuals can better protect their financial future and ensure that their retirement savings last throughout their golden years.