Cashing out 401(k) accounts: the new retirement crisis

Millions of Americans are paying billions of dollars a year in taxes by cashing out their 401(k) accounts as they change jobs, an immediate financial hit that sets them up for leaner times in retirement.

Cashing out is an emerging front in the country's lack of financial readiness for life after work. Amid robust job-hopping and the rise of the gig economy, the combination of tax bills now and slimmer nest eggs later is most frequently seen with millennials, the largest adult generation, according to Fidelity Investments.

The first financial hit comes as a one-time tax bill at ordinary rates.

There's also a 10% penalty, tallied as a percentage of an account's balance, for yanking out money before age 59½. Middle-aged workers are typically in their peak earnings years, so they're already in a bracket higher than the one they'll usually face in retirement. 

Meanwhile, departing employees expecting severance packages can find that taxable 401(k) distributions hurl them into the next bracket, said Jim Eutsler, a wealth advisor and partner at HCM Wealth Advisors in Cincinnati.

The second hit comes from losing out on the opportunity for time to work its magic and compound the growth of an account over three decades or more. 

The ramifications are a giant opportunity for financial planners and wealth advisors to educate their clients, Eutsler said, adding that "Once you blow out your 401(k), you can't unwind this."

'Leakage'
What's known as "leakage" of dollars from employer-sponsored retirement plans amounts to anywhere from $60 billion to $105 billion a year, according to the Savings Preservation Working Group, a nonprofit online research group. People cashing out some or all of their accounts have different tax rates, of course, but even assuming a low 12% bracket translates into $7.2 billion to $12.6 billion that savers lose to taxes each year.

Withdrawals from 401(k)s are taxed no matter when taken, so savers end up paying Uncle Sam one way or the other. The issue is that a one-time tax bill for cashing out early means a big outlay up front and less money in future decades because there's nothing left to grow in value.

Tax

Direct indexing's biggest lure isn't a customized investment portfolio

April 7, 2023 8:00 AM

Leakage tends to take a back seat to the big wealth management question of whether Americans are saving enough for their golden years. Nearly half, or 47%, of all American households told a McKinsey survey that they have not achieved financial sufficiency.

"While the industry has made great strides in helping more Americans save for retirement, we know that retirement plan leakage can inhibit an individual's ability to achieve a financially secure retirement," said Jane Greenfield, a principal and head of consultant success at Vanguard.

More jobs, more 401(k)s
The leakage question comes as Americans increasingly change employers. The typical 401(k) participant will hold 9.9 jobs in their lifetime, with 14.8 million people with the accounts switching jobs each year, according to Employee Benefit Research Institute data cited by Retirement Clearinghouse. A 40-year work career can easily produce eight or more retirement accounts, each with a different provider, Georgetown University's Center for Retirement Initiatives says.

Notwithstanding federal policies aimed at boosting long-term savings, there's no quick and easy way to roll over an employer-sponsored plan to a new employer's plan. Roughly 60 million Americans were active participants in more than 625,000 401(k) plans last September with around $6.3 trillion in assets, Investment Company Institute data shows. At Vanguard, the median balance for all ages of account holders in 2021 was $35,345.

Vanguard, Fidelity, Alight and Empower, all major 401(k) providers and recordkeepers, and Retirement Clearinghouse, a company focused on smaller plans, are part of a consortium offering "auto portability." Launched last October, the service allows workers with lower balances who change jobs to have their workplace savings automatically moved to their new employer's plan.

Under current law, companies can forcibly distribute a plan participant's balance, without the worker's consent, if it's less than $5,000 when they leave the company. They can also roll the distribution into a default IRA if the account balance is at least $1,000. But under a sweeping retirement package late last year, companies can automatically transfer accounts of up to $7,000 to a new employer's plan, unless the worker opts out.

Tapping the money
The double whammy of taxes now, a smaller nest egg later, is evident in data from academics, industry research groups and investment companies.

More than 1 in 3 Americans between the ages of 25 and 55, or just over 35%, fully cash out their 401(k)s when they leave their employer for a new job, according to data in a new study from UBC Sauder School of Business at the University of British Columbia in Vancouver. The study shows that 41% cash out some dollars, and 85% of those, or 35% of the total, take the whole thing.

Retirement

Almost half of Americans cash out their 401(k)s when changing jobs

More than 41% of U.S. workers drain their retirement savings when they quit or get fired, according to a new study. Why?

By Nathan Place

April 6

The UCB figure is slightly higher than a Vanguard tally showing that over a decade through 2021, cash-out rates ranged from 28%-34%.

The lower a 401(k) balance, the more likely a saver is to take a taxable distribution when changing jobs, the UBC study found. 

Still, earners with accounts holding at least $100,000 also take distributions. Nearly 1 in 10 workers with at least $100,000 in their employer-sponsored plan opted for a cash distribution in 2015, Aon found. For people with 401(k)s holding from $50,000 to $99,999, the rate was more than double, or 19%. For people who quit with accounts holding $30,000-$49,999, the rate was 28%.

Millennial 'danger zone'
The age group most likely to withdraw all of their 401(k) money, rather than leave it in a plan, roll it into another plan at a new employer or shift it to an individual retirement account is older millennials, according to Fidelity.

"The 'danger zone' seems to be among participants aged 30-39," Mike Shamrell, a vice president of workplace investing and thought leadership at Fidelity Investments, told a recent webinar for the Employee Benefits Research Institute, a nonprofit. Fidelity defines millennials as born between 1981 and 1996, so they're now ages 27-42.

Practice and client management

Millennials are seeking financial advice earlier: Ameriprise study

April 5, 2023 6:00 AM

Shamrell told the webinar that millennials may be juggling saving for a house, retirement and college educations for their children, all while carrying student debt. In other words, they may simply need the cash, even a lesser amount once the taxes are paid.

'Free' money
But the UBC Sauder School of Business study posits another theory: that many people aren't cashing out simply because they need the money. After all, cash-needy workers could also empty out their 401(k)s while still employed, but they tend not to.

Rather, the study posits two reasons, both detailed in a Harvard Business Review article summarizing its insights. 

First, companies and 401(k) recordkeepers do a poor job of telling departing workers what their options are, sending bureaucratic form letters that make a lump sum withdrawal the easy, "top-of-mind" option. It's an about-face by companies, which have a fiduciary duty to look out for their workers' best financial interests in employer-sponsored plans and emphasize saving for retirement.

When an employee with a 401(k) switches jobs, "they don't talk with you in HR about it. Nor does the recordkeeping company," said professor John G. Lynch of the Leeds School of Business at the University of Colorado-Boulder, one of the UCB study's three authors. "They just send you this really sterile letter suddenly nudging you to consider something that you weren't considering before."

Second, the UCB study posits that a worker may take her perception of employer matches to her own contributions too far: She may apply that mental construct of "free money" to her entire 401(k) account, making it untouchable while she's employed, but a windfall when she job hops.

"It's shameful that employers and the system are not built to assume people change jobs," Lynch said. "Nobody's looking out for you on your way out the door."

Unaware
More than 4 in 10 Americans between ages 35 and 65 who left a job where they had money in a 401(k) plan were unaware that it might have been possible to keep their money in the plan, Edelman Financial Engines found in a 2019 poll. More than 1 in 4, or 28%, were unaware that taking a distribution, either partial or whole, triggered tax liabilities and, for those under age 59 ½, penalties. 

And half didn't know that they can move money from an IRA to an employer-sponsored 401(k) plan, if the plan allows the move and the worker is still employed there.

It's a big opportunity for financial advisors. With clients considering a cash out, "We guide them that if you have other sources, that's probably the path to consider," Eutsler said.