I have old 401(k)s. Should I cash them out?

what to do with old 401k accounts

One of my financial wellness students asked “I have old 401(k)s from previous jobs. I never put much into them. Should I cash them out to pay off some bills?

I would hate for someone to miss out on the compound returns and pay penalties for cashing out retirement accounts too early, but the answer is “it depends”.

THE NUMBERS

To compare different situations equally for cashing out a 401(k), we will assume the following:

  • There are 4 pretax accounts
  • $2,500 in each account
  • Fully vested
  • They will be in the 20% tax bracket
  • They are under age 55

Note: There will be a 10% penalty for early withdrawal before retirement in every situation below.

BEHIND ON PAYMENTS

In the situation where the couple is $5,000 behind on their mortgage then cashing out three of the four accounts will get them enough to catch up ($7,500 minus 10% tax penalty of $750 plus $1,500 income taxes leaves $5,250). I would recommend they do this as long as they can make future payments after bringing the account current. Otherwise they will find themselves in the same situation down the road and have lost three of the 401(k)s.

If they are a few car payments behind, have a couple thousand in medical bills, or need to catch up utilities and normal monthly bills (following a temporary layoff, for example) then cashing out one or two of the accounts can keep them whole. Again, they need to be solving a temporary problem or this becomes a very costly way to put a band-aid over a bullet wound.

TO KNOCK OUT A DEBT

The temptation is very real when looking at ways to knock out small debts. For example: The couple only has a few thousand dollars of credit card debt. If this were the case, I would not recommend they cash out unless they have tried cutting all budget expenses and still can't come up with an extra $100 to throw at the credit card debt.

Why not? Because credit card debt is a temporary problem. Finding ways to pay off debt with cash-flow is an incredible exercise in determination and builds confidence. That's all wonderful and “woo-woo”, so for the nerds we can also use math to show how cashing out a 401(k) to pay off credit card debt may not be the best example.

More than likely the couple is paying credit card interest of 12-18% (if the interest rate were less then the need to cash out is reduced even further). Cashing out a 401(k) is already eating away 10% with the penalty, so tacking on 20% income tax makes it as if they are borrowing money at 30% to pay off an 18% debt.

However, if the credit card is months in the rears and has been sold to a debt collector, then cashing out one of the small 401(k)s might be a good idea. Dealing with the debt would avoid a law suit, collection calls, and will help improve creditworthiness. If you find yourself in this situation then offer the debt collector a settlement amount (offer half the balance as settlement in full, then negotiate from there). If they accept, get the deal in writing and then send payment via cashier check or money order.

TO CANCEL A BAD DEAL

This specific couple has a timeshare with $1,400 in annual maintenance fees. They are stuck and need to get out.

If they can find a way to sell it or transfer ownership out of their name, it would eliminate future monthly obligations for something that is truly an expense they don't need.

In this situation I would cash out old, small 401(k)s and get on with my life!

WHAT ABOUT BANKRUPTCY?

There are situations where cashing out a retirement account to avoid bankruptcy is warranted. However, this isn't one of them.

That is not to say you should keep old 401(k)s and file bankruptcy. What it means is filing bankruptcy over $10k in debt isn't necessary. There are many other options to try before getting hit with 401(k) withdrawal penalty and income taxes. It's worth squeezing the budget tighter and selling stuff at a garage sale, working extra and overtime at work, or doing odd jobs around the neighborhood or cleaning houses can bring in much needed cash to pay back what has been borrowed. Negotiating a new monthly payment plan or re-setting the loan can also help alleviate the problem better than cashing out a 401(k).

It is very important to think it through before cashing out.

WHY ROLLOVER INSTEAD OF CASH OUT

As discussed earlier, cashing out a 401(k) prior to retirement will cost you dearly in penalties and taxes. It will also cost you by unplugging an investment.

Assuming an 8% return on investment, a $10,000 401(k) could turn into $46,000 if left alone for 20 years.

That's not a lot of money but it's more than a paid off credit card or 20+ year old car is worth.

Great consideration must be taken when weighing out the pros-and-cons of cashing out old 401(k)s.

WHAT TO DO WITH OLD 401(K)s

If the above scenarios did not apply to you then there is one more thing to consider doing with old 401(k)s:

Roll them over into an IRA.

Company sponsored retirement plans (401k) are limited to the dozen-or-so options they have made available to you. By doing a direct transfer rollover, you can open up the world of investment options: Stocks, bonds, mutual funds and index funds.

Listen to a millennial that rolled her old 401(k) into a Roth IRA:

Listen to the Episode Below

I like mutual funds and index funds for their simplicity, low cost (depending on who you go through), and reduced risk.

Rolling old 401(k)s into an account you control avoids taxes and penalties, offers you thousands of investment choices, helps you avoid risk by diversifying into a number of funds, and reduces the number of accounts you have to check in on from time-to-time.

what to do with old 401k accounts

 

Disclaimer: I am not a financial planner. I do not sell investments or insurance. If you are looking for someone to help you roll over old 401(k)s then contact me below and I can put you in touch with someone who can help you.

 


Request: Contact name for 401(k) rollovers

Ask to be recommended with a financial advisor or broker to roll over old 401(k)s instead of cashing them out.
What Does the IRS Consider Taxable Income?
When You Can't Pay The Tax Bill: Income Tax Collections and the IRS

Leave A Response

* Denotes Required Field