Cashing Out Your 401k Plan: Just Say No

I was reading a 401k study from Hewitt Associates which found that 45% of 401k plan participants took a cash distribution when they left their jobs. Apparently this trend is more prevalent for 401k accounts with low balances and for younger plan participants (who are more likely to have a low 401k balance).

It didn't take much effort to find that there are many people considering cashing out their 401k accounts to do things like pay off credit card debt, medical bills, student loans, or to buy real estate. It is alarming to see how many people seem to think of their 401k account as a checkbook. Here are three of the many examples that I came across:

• 401k: Cash out to pay credit card debt?
• ...cash in a 401K ?
• Should I use my IRA to pay off credit cards?

If you find yourself in a situation similar to one of the above links, please be aware that income taxes and a 10% penalty (see IRS 401(k) Resource Guide) will take a nice bite out of that 401k balance. The 10% penalty along with state and federal income taxes could easily cut your 401k balance by a third.

For example, suppose a 25 year old has $7,000 in credit card debt and wants to cash out a 401k (with an $8,000 balance) to pay it off. After penalty and tax, only about $5,000 of that 401k money would remain (leaving $2,000 in credit card debt). It is also important to consider the future 401k growth that would be sacrificed by cashing in early. If the money was left in the 401k until age 65, it would be worth about $200,000 (@8% return) even if another 401k contribution was never made. That is the power of compounding.

Even worse, if the credit card debt continues to pile up after it has been paid down with the 401k cash, then you are right back where you started (minus your 401k account).