Cashing Out a 401k? Stop Now and Read This First!

When you switch jobs, think long and hard before cashing out a 401k.

Had it not been for a phone call from a friend, I would've made one of the worst financial decisions of my life.

Long before I discovered or even knew what The Motley Fool was, I was a teacher at an inner-city charter school in Washington, D.C. Leaving the only job I'd even known, I had to decide what to do with my retirement funds. I didn't want to leave the money behind, but -- like many 20-somethings without much of a financial education -- didn't know how to roll it over and invest it myself.

"I'm just going to cash out my 401(k)," I told a college buddy, who happened to be a financial advisor.

The phone fell silent. He then spent the next half-hour trying to explain what an incredibly stupid decision that would be. It's a good thing he did -- my family's net worth would be far lower today if I had followed through.

Here's just how bad that decision could have been.

Why cashing out a 401(k) is a wealth destroyer

The government allows you to put away a certain amount every year into a 401(k). In 2015, that's $18,000 per individual, and as much as $24,000 if you're 50 or older. Of course, as a new teacher, I wasn't putting away nearly as much.

After five years of teaching, I had roughly $35,000 saved up in my 401(k). Had I decided to cash out my 401(k), here are the penalties that I, or anyone considering doing the same thing , would have to pay:

  • Employer withholding 20% : Your 401(k) will be cut by a whopping 20% before it ever reaches your bank. That's because your employer is required to keep that chunk to help pay off the income taxes you'll owe the IRS. Though federal and state taxes might actually be lower, it will be a while before you get some of this back.
  • A 10% early withdrawal penalty : In addition to income taxes, if you are under 59 1/2 years old, you'll pay a 10% penalty for withdrawing this money.

These two penalties alone would have shrunk my overall nest egg from $35,000 to just $24,500. But these would not have been the worst of my losses.

Years of tax-free, compounding growth

Getting 30% of my money taken away from me might hurt. But over the long run, it isn't the most damaging aspect of cashing out a 401(k) too early. That comes from the lost opportunity to let all of that money (in my case, the $24,500 I still had and the $10,500 I lost to taxes) grow tax-free, for decades.

When you leave your job, cashing out your 401(k) isn't the only option. You can choose to leave your money right where it is or roll it over -- penalty-free -- into a traditional IRA. By doing this, you preserve all that you've saved, and you can continue to let your money grow tax-free.

You won't owe any taxes until you withdraw the money for retirement purposes. And by then, if you have learned to live frugally, the taxes you owe could be significantly less.

Luckily, it was right around this time that I found The Motley Fool. Slowly easing my way into the investing process, I started putting my new IRA money to work for me. And over the past six years, that money has grown at an annualized rate of 15% per year.

I have much more now, from that original lump sum, than if I would have cashed it out, assuming similar results.

Initial Value After Six Years
Roll Over $35,000 $81,000
Cashing Out 401k $24,500 $56,700

That difference of about $25,000 is a big deal, and it will only become bigger as time goes on. In fact, given that I was 28 at the time I cashed out, and assuming my returns revert back to the historical average of annualized 9.1% returns, the difference would be enormous by the time I reach full retirement age of 67.

Nest Egg | Create infographics

That's right: You would have over $1 million if you just rolled it over and got average returns, but over $300,000 less if you cash it out and invest it. And the difference is obviously even greater if you cash out your 401(k) and just spend the money -- then you have absolutely nothing left come retirement time.

Obviously, your own path won't follow the exact same numbers, but the general point being illustrated here remains the same: Unless it's a life-or-death situation, you are always better off avoiding the option to cash out your 401(k).

The $15,978 Social Security bonus most retirees completely overlook

If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income.

In fact, one MarketWatch reporter argues that if more Americans knew about this, the government would have to shell out an extra $10 billion annually. For example: one easy, 17-minute trick could pay you as much as $15,978 more... each year! Once you learn how to take advantage of all these loopholes, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how you can take advantage of these strategies.

The article Cashing Out a 401k? Stop Now and Read This First! originally appeared on

Try any of our Foolish newsletter services free for 30 days . We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy .

Copyright © 1995 - 2015 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Other Topics


Latest Markets Videos

    The Motley Fool

    Founded in 1993 in Alexandria, VA., by brothers David and Tom Gardner, The Motley Fool is a multimedia financial-services company dedicated to building the world's greatest investment community. Reaching millions of people each month through its website, books, newspaper column, radio show, television appearances, and subscription newsletter services, The Motley Fool champions shareholder values and advocates tirelessly for the individual investor. The company's name was taken from Shakespeare, whose wise fools both instructed and amused, and could speak the truth to the king -- without getting their heads lopped off.

    Learn More