Do Not Cash Out Your 401k

By Pinyo, on October 20, 2008

A friend of mine is hit hard by the 40% plus drop in his 401k and the daily gyration haven’t made it any easier.  He was seriously considering cashing out of his 401k and stop contributing altogether.  After a long conversation with him, I was able to explain to him why this was a bad idea.

What Happens When You Cash Out Of Your 401k

If you are planning to cash out of your 401k, there are several consequences that you’ll have to face — and these are expensive consequences.

1. Income Taxes

First, you’ll have to pay the federal income tax at your marginal tax rate for the entire amount of withdrawal.  Depending on your tax bracket, you could pay anywhere from 10% to 35% on the amount withdrawn.  Let’s say your normal income will be $50,000 this year and you withdraw $25,000 from your 401k.  You’ll have to pay 25% in federal income tax, or $6,250.

Depending on your city and state laws, your withdrawal can be taxable to the city and state also.  Let’s assume this is about 10%, that’s another $2,500.

You’re not left with $16,250.

2. Early Withdrawal Penalty

If you’re younger than 59½ — and my friend is significantly younger — you’ll be assessed another 10% on the withdrawal amount.  Follow the example above, that’s another $2,500 gone and you’re left with $13,750.

3. Redemption Fees

Depending on your investment options, you may be assessed redemption fees.  For example, some of our investment options — i.e., international funds and small-cap funds — assess 1% penalty on shares purchased and redeemed within 180 days.

4. Opportunity Cost

I believe that in the long-term the stock market can sustain an 8% annual growth rate.  Since my friend has about 30 more years to go, the $11,250 paid in taxes and penalty represents approximately $105,000 in lost potential.

I think $116,250 is extraordinarily expensive price to pay for a $25,000 withdrawal because your emotion got the better of you.

What Happens When You Stop Contributing To Your 401k

1. Company Match

Our company matches 50 cents on the dollar up to 6%.  Since my friend contributes 10% of his $50,000 salary, the match comes to about $1,500 a year.  If he stops, that’s $1,500 out the window right away.

2. Tax Deduction

As it is, my friend is able to write off $5,000 in tax deduction for federal, state, and city level each year.  For him that amounts to about 35%, or $1,750 in tax savings.

3. Income Taxes On Interest

His idea is to put the money in a high yield savings account instead of the stock market.  Since you have to pay income taxes on earned interest at the same rate, he’s looking at another immediate 35% loss on his interest income.  These things do add up quick don’t they?

4. Opportunity Cost

Again, we are talking about opportunity cost because the best time to buy is when you see blood on the street — and it’s messy out there right now.  If you are able to stay with your long-term strategy, this is a great opportunity to average down your cost basis.  In other words, buy more shares at really cheap prices.

What Should You Do With Your 401k

Only you could answer that question because you know your risk tolerance level and time horizon the best.  As for my friend, it’s apparent that he’s nervous about the current market decline and volatility.  So I told him to seriously reconsider his risk tolerance level and adjust his future investment allocation accordingly; specifically, he should consider adding a little more money to fixed-income and income fund options.  Additionally, I also told him that scaling back on his contribution, or reallocating a big chunk of money right now is probably not a good idea.

Have you encountered a similar situation?  How did you handle it?

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Pinyo is the brain behind Moolanomy personal finance blog and a few other web sites. If you like this article, please subscribe for free daily email updates.

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