Workers Persist in Cashing Out 401(k)s
Americans are getting better about keeping their mitts off their retirement money when they change jobs. But a troubling number still are jeopardizing their retirement security--and triggering staggering tax bills--by cashing out their retirement savings when they lose their jobs or change employers, according to a study released Tuesday.
The study, Retirement Savings in an Unsettled Economy, found that 30% of the 1,500 401(k) retirement plan participants interviewed took cash instead of rolling their retirement dollars into an individual retirement account or other tax-deferred vehicle when they left an employer.
At that rate, between $33 billion and $39 billion will be pulled out of 401(k) plans this year, triggering between $7.1 billion and $8.3 billion in taxes and penalties, according to Putnam Investments, which sponsored the study.
On the bright side, the percentage of participants who take the cash and run is declining from past years. Hewitt Associates, a national benefit consulting firm, did a similar study in 1999 and found that 68% of 401(k) plan participants took cash payments when they switched jobs.
“It was staggering,” said Jennifer Frighetto, a Hewitt spokeswoman. “The majority of people who switched jobs, regardless of their age, were cashing out.”
Cash-outs are declining for two reasons: People are increasingly aware of the immediate and long-term costs of cashing out, thanks to aggressive public information campaigns by both government and industry. And as 401(k) balances grow larger, participants are less likely to cash out. The majority of those taking cash had $10,000 or less in their retirement plan, both studies indicated.
Still, at 30% the rate is naggingly high, experts agree.
“Taking the cash now might feel good, but it costs investors a lot in the long run,” said Matthew P. Mintzer, a Putnam senior vice president.
The economic effect is felt immediately and long-term, Mintzer added. On an immediate basis, individuals must pay both state and federal income taxes and penalties on cash distributions. Once income taxes and penalties are added up, individuals can lose 50% of their money to the government.
For instance, someone in the 28% federal tax bracket would pay $2,800 in federal income taxes and $1,000 in federal tax penalties on a $10,000 distribution. In addition, this person would be subject to state taxes and penalties, which can take an additional 11.8% of the distribution amount in California--another $1,180.
The net cost would be slightly less than the total of all these costs because state taxes are deductible on federal returns, but tax penalties are not. Net cost: $4,720--or nearly half the account.
Part of the problem are the arcane rules that affect people who have small balances in these plans, said David L. Wray, president of the Profit Sharing/401(k) Council of America in Chicago.
Pension rules allow companies to force employees who have less than $5,000 in retirement assets to take their money with them when they leave, Wray noted. Companies don’t have to send former workers packing with their pensions in tow, but they can--and about 87% of plan sponsors do, he added.
“People [who are changing jobs are] in a stressful period in their life,” Wray said. “They may have been laid off or they’re in transition from one job to another. Dealing with finding an IRA that will take a $1,200 balance is just not on your radar screen when you have so many other life issues to manage.”
Wray’s group is attempting to solve this problem by urging Congress to update pension laws to allow a voluntary default provision, he said. This provision would allow the employer to automatically roll participant assets into an IRA, unless the employee specifies otherwise.
A similar provision was recently added to the Senate’s tax reform proposal. However, Wray is fighting that change because it would make default rollovers mandatory. Not all employers could afford to offer the default rollover option, he said.
