Yes, when you quit your job, you do have the option to cash out or "empty" your 401(k) account. However, this action comes with significant financial consequences that are important to understand.
After leaving your employer, your 401(k) funds remain with the former employer's plan until you decide how to manage them. While cashing out is one of the choices available, it's generally not the recommended path for maintaining your long-term retirement savings.
Your Choices for a Former Employer's 401(k)
When you leave a job, your 401(k) doesn't automatically disappear or transfer. You typically have several options for how to handle the funds:
- Leave it with your former employer: Your account can remain in the previous employer's plan. This might be a viable option if you're comfortable with the plan's investment options and fees. However, some plans may have higher fees for former employees, and if your balance is small (e.g., under $1,000 or $5,000), the employer might automatically cash it out or roll it over into an IRA on your behalf.
- Roll it over: This is often the most advisable option. You can transfer your 401(k) funds to:
- A new employer's 401(k) plan: If your new employer offers a 401(k) plan and accepts rollovers.
- An Individual Retirement Account (IRA): This provides more control over your investments and typically a wider range of investment options. You can roll it into a Traditional IRA to maintain tax-deferred growth or a Roth IRA (though this would involve paying taxes on the conversion).
A direct rollover ensures the money moves from one retirement account to another without you ever taking possession of the funds, thus avoiding immediate taxes and penalties. Learn more about 401(k) rollovers from reputable sources like FINRA.
- Cash it out (Empty it): This involves taking a lump-sum distribution of your 401(k) balance. While it provides immediate access to the funds, it comes with considerable drawbacks.
The Implications of Cashing Out Your 401(k)
Choosing to cash out your 401(k) means you are directly withdrawing the funds, which triggers several financial penalties and tax obligations:
- Income Taxes: The entire amount you withdraw is typically considered taxable income and will be added to your gross income for the year. This can push you into a higher tax bracket, increasing your overall tax liability.
- Early Withdrawal Penalty: If you are under the age of 59½, you will generally face an additional 10% early withdrawal penalty on the amount distributed. This penalty is on top of the regular income taxes. There are a few exceptions to this rule (e.g., permanent disability, substantial equal periodic payments), but they are limited. For details on distributions, refer to resources like IRS Publication 575.
- Loss of Future Growth: Cashing out your 401(k) means you are forfeiting the significant compound growth that these funds would have accumulated over years, or even decades, until retirement. This can severely impact your long-term financial security and ability to retire comfortably.
Example: If you cash out a $20,000 401(k) at age 35, you could face $4,000 in federal taxes (assuming a 20% tax bracket) and an additional $2,000 early withdrawal penalty, leaving you with only $14,000. More importantly, that $20,000 could have grown to over $150,000 by retirement (assuming an 8% average annual return over 30 years) if left invested.
Understanding Your Choices at a Glance
Here's a summary of your options and their key considerations:
| Option | Description | Key Considerations |
|---|---|---|
| Leave it | Your account remains with your former employer's plan. | Pros: No immediate action required; funds stay invested. Cons: Limited control, potential higher fees, may be forced out if balance is small (e.g., under $5,000). |
| Rollover (IRA or New 401k) | Transfer funds to another qualified retirement account. | Pros: Continues tax-deferred growth; avoids taxes and penalties; often provides more investment choices (especially an IRA). Cons: Requires active management of the transfer; potential for minor fees associated with opening a new account. |
| Cash Out | Receive the money directly as a taxable distribution. | Pros: Immediate access to funds. Cons: Significant financial penalties: Subject to ordinary income tax and typically a 10% early withdrawal penalty if under 59½. Severe long-term impact: Loss of future growth and a substantial reduction in your retirement savings, making it harder to achieve financial security in retirement. Generally the least recommended option unless facing extreme financial hardship. |
While you can empty your 401(k) by cashing it out after quitting your job, it's crucial to weigh the immediate gratification against the long-term financial repercussions. Exploring options like rollovers to an IRA or a new employer's plan is almost always the more financially prudent choice for preserving your retirement savings.
