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Those who cash out 401(k) plans are at risk

Millions of workers take a huge chance with their retirement savings every year: They cash out their 401(k) accounts when they lose their jobs or move to new employers.
/ Source: The Associated Press

Millions of workers take a huge chance with their retirement savings every year: They cash out their 401(k) accounts when they lose their jobs or move to new employers.

When people cash out, a chunk of their money just disappears.

Employers and financial advisers have warned workers about the possibility of retiring poor, something that's more likely to happen when people cash out their accounts. The rhetoric to keep saving ratcheted higher over the past year as stock prices fell and the average retirement account balance fell by a third.

But a recent study shows that workers are ignoring the advice — the rate of cashing out has been stable since 2005.

Business consultant Hewitt Associates looked at the behavior of 170,000 401(k) participants who left jobs last year. The review shows that 46 percent of those changing or losing their jobs took the cash out of their accounts. A quarter of the workers either rolled over their money to individual retirement accounts or other retirement plans and about a third kept the money in their previous employers' 401(k) plans.

The fact that people are cashing out at such high rates does not bode well for future retirees, said Pamela Hess, Hewitt's director of retirement research.

"Millions of Americans who rely on defined contribution plans will find themselves unable to achieve a financially secure retirement," she said.

The trend is even worse among workers in their 20s. The problem with those workers taking out their money is that they miss out on decades of tax deferred growth and the benefit of compound interest on their investment.

An employee who cashes out a $5,000 retirement balance at age 25 would get a check for just $3,500 after taxes and penalties. Left in an account, that $5,000 may have grown over decades to $75,000 at retirement, Hewitt said.

Jeremy Caverly, 29, of Silver Springs, Md., learned the hard way that cashing out doesn't pay.

He took out his 401(k) money when he was in his early 20s. After receiving a job offer, he gave his employer four weeks notice. However, two weeks later the offer was rescinded and he was left without a job. He saw the thousands of dollars in his 401(k) as a way to get him by until he found work again.

He ended up with about $10,000 from the account. Some of it he spent on a planned trip with friends and some was used for expenses until he found a job about three months later. He had some left over and put it in a savings account.

He said he was horrified by the 30 percent in upfront taxes and a penalties that shaved thousands of dollars off the top of his savings. To make matters worse, he received a bill from the IRS for thousands of dollars in additional taxes due on the cash, which was considered income that year.

"It made me sick when I saw the amount of the check compared to how much was actually in the account, how much was taken out in fees and penalties," he said. "Then I was floored when I got that bill for thousands of dollars in extra taxes," he said.

He said many people, especially younger ones, consider the retirement account savings to tap into when needed.

"They see it as money I put away and I'll use it as a rainy day fund," he said.

That's no surprise to Jack VanDerhie, research director for the Employee Benefit Research Institute, a nonprofit group which studies retirement account trends. "Psychologically, if you're young and you only have a few hundred or a few thousand dollars, you think, I'll save for retirement at my next job," he said.

His concern is that workers will keep putting savings off and never amass enough money.

In its own research released in January, EBRI looked at cash-out trends. The study showed that more than 16 million people had reported taking some of the cash out of their retirement account when changing jobs. The average amount taken was $32,000, although most distributions were smaller with about a quarter of them $2,500 or less.

The EBRI study was based on U.S. Census Bureau survey information from 2006. Although it's a few years old, it does provide some insight into how the money was used. While some people said they simply spent the money, many more reported using it for home purchases, starting a business or paying down debt.

EBRI says that in 2006, nearly 17 percent of workers who changed jobs and took money out of their 401(k) said they spent it on items like cars or boats or on everyday expenses. More than a third used it to pay down debt, start a business or buy a home and about 7 percent put the money in a savings account. Most of the rest put the money in an IRA or another 401(k).

Some critics of the 401(k) may be quick to say it points to a weakness in current voluntary retirement savings system — many people simply don't have the discipline to save long-term.

The criticism of the 401(k) as the primary retirement savings method for a majority of workers has grown with the stock market crash and account losses. Some critics want the voluntary savings plans to be replaced by a government-run retirement system. Others suggest adjustments to the 401(k) that make them less susceptible to market losses.

The 401(k) itself shouldn't be blamed, however, said Mike Alfred, the CEO of Brightscope Inc., a Web-based 401(k) ratings service.

"People are going to say if they oversimplify things, that it's a failure of the 401(k) plan, but in reality it's an issue of the failure of our educational system to incorporate financial literacy for kids at a young age," Alfred said.

Education is more important now because today's retirees are the last generation of workers to benefit widely from an employer-provided pension that guarantees an income for life. The rest of us are more likely to have only our own savings to supplement Social Security when we retire.