Understanding 401(k): How it works and why it matters
What is the 401(k) plan? Key benefits and ways to maximize savings.
A 401(k) retirement account is assumed to be a handoff. In theory, it’s not your money, but your savings for the future.
Still, when Americans leave their jobs, a third of them cash out their 401(k) accounts.
This is called a 401(k) “leak,” and costs workers billions of dollars of lost retirement savings.
In a recent paper, Vanguard reflects on why many Americans are liquidating their retirement accounts, when they estimate about 33% of their employment, and what employers and employees can do about it.
The 401(k) is designed to help American workers build retirement savings and use tax credits as an incentive.
According to the Investment Company Institute, 401(k) accounts nationwide have around $9 trillion. Half of all private workers are currently taking part in the plan, which is a record high.
However, $401(k) does not always fund someone’s retirement.
At least $1.7 trillion is found in lost or forgotten 401(k) accounts, according to a survey by financial services company Capitaize.
The new Vanguard research notes focus on another issue. Workers are to cash in their retirement accounts when they leave their jobs.
Cashing out 401(k) is often the worst option
When you quit your job, you have several options on your 401(k). Keep your money in your account and you can’t do anything. You can perform a “rollover” to transfer funds to another 401(k) or individual retirement account.
Alternatively, you can cash out. And if you’re done with work, cash out may sound appealing. There may not be another job lined up. Perhaps you are planning a move. Maybe a new child has arrived.
“It’s very appealing. You’re making this big decision in your life,” said Rob Williams, managing director of financial planning at Charles Schwab. “Your first instinct is to take money, especially if it’s not a lot.”
However, cashing out a 401(k) is at least the worst option, financially.
If you settle a 401(k) before the age of 59½, you will usually pay a 10% penalty for early withdrawal in addition to income tax on the amount.
Additionally, you miss the opportunity to collect compound returns over many years with your 401(k) investment.
Cashing out your $7,000 retirement account at age 40 will allow you to earn just $4,270 in actual cash in cash after penalties and taxes.
However, if you invest the same $7,000 investment for another 20 years and your investment increases at an annual rate of 8%, the total will increase to nearly $35,000, according to the Nerdwallet Calculator.
“We’ve seen a lot of money,” said Anqi Chen, associate director of savings and household finance at Boston College’s Retirement Research Center.
Why do workers departing cash out their 401(k)?
Retirements will leave their 401(k) account for several reasons, resignation experts say.
Vanguard researchers theorize that financial needs more than anything else drive workers to settle their retirement accounts.
Hourly workers are more likely to cash out 401(k) than paying employees. Vanguard said the reason may be because workers have more income fluctuations per hour. These ups and downs can lead to cash shortages.
Workers with low incomes are more likely to earn cash than those with high incomes. That data point also suggests economic needs.
“What really explains many of these early withdrawals is the challenges of short-term cash flow liquidity,” said Aaron Goodman, economist at Vanguard.
Vanguard found that emergency savings workers are far less likely to cash 401(k) when they quit their job.
Therefore, Vanguard urges workers to save an emergency. Researchers found that even $2,000 in rainy day funds allowed workers to quit their jobs without raiding their retirement funds.
Additionally, employees are much more likely to cash out their 401(k) accounts on a small balance. A typical cash out includes “thousands of dollars,” Goodman said.
Some workers, especially younger workers, cash out their retirement accounts.
“We are pleased to announce that we are a great opportunity to help you understand how we are doing,” said Mike Shamrell, Vice President of Thought Leadership at Fidelity Investments. “If you do that every other year in your 20s, it starts to add up.”
Rolling beyond 401(k) can be “incredibly stiff”
Cashing out a 401(k) is relatively easy. In contrast, it’s “incredibly difficult” to roll it into another retirement account, said Chen of Boston University.
That’s another reason why many workers cash out their retirement plans.
In a rollover, you either move your retirement savings to another 401(k) account in your new company, or to your IRA, your personal retirement savings account.
Rollovers can be complicated, especially when funds enter a new 401(k) account managed by another company.
A study by retirement savings platform Capitaize found that rollovers were “outdated and painful.” Only 22% of savers could roll over without assistance with the account, while 42% said the process took at least two months. In many cases, rollovers involve tedious shapes and old-fashioned paper checks.
“Some employers encourage people who have died to cash in unbalanced retirement accounts just because it’s easy for them,” said David John, senior strategic policy advisor at AARP Public Policy Institute.
According to Chen et al., the ability to move a 401(k) from one employer to the next is called “portability,” and the lack of that disrupts workers as it maintains retirement savings.
“They’re a bit overwhelmed by the process,” said Fidelity’s Shamrell as they consider rolling over their 401(k) accounts. “They feel it’s time-consuming and complicated.”
Recent initiatives in the retirement savings industry aim to solve portability issues. In 2022, a consortium of private retirement plan providers announced a collaboration to improve the portability of small retirement accounts.
When someone leaves the job, the provider’s network will ensure that retirement funds will “translate seamlessly from one job to another,” said John of AARP.
The Auto Import Program applies to accounts under $7,000. Most large retirement plan providers are taking part in this effort.
“I think there should be an evolution in terms of creating exercises that are more point-and-click on this,” said Williams of Schwab.
