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Don't be dumb -- don't cash out your 401(k)
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Cash out a 401(k) before age 59½ and you'll fork over a 10-percent penalty to Uncle Sam and get whacked for the taxes due on those pretax contributions. So, there's a good chance you'll lose 35 percent coming off the top of whatever you have in the plan.

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"I think that's what the majority of employees don't understand," says Kaye Worden, certified financial counsel with Consumer Credit Counseling Services of Greater Fort Worth, Texas.

"They get a check with a 10-percent hit and they assume that's all the hit they'll have to take. They tell me that the company already took out the penalty and the taxes. I look at their paperwork and tell them the company only took out 10 percent, now they'll have to pay the taxes, too. They turn to paste."

Eric Hutchinson is a certified financial planner and founder of Hutchinson/Ifrah Financial Services in Little Rock, Ark. In part, he blames the idea of cashing out on the move away from defined benefit plans to defined contribution plans where much of the responsibility shifts to the employee.

"There's a lack of sophistication to understand the issues involved. We hear about it in the companies where we handle the retirement plans. We might have contact with the employee and counsel them about the taxes and the penalties, but their eyes glaze over with their immediate wish list -- a boat, a car. What they don't understand is that they're shortchanging their future."

New federal rules regarding low-balance 401(k)s should help alleviate the problem of employers cashing out balances of less than $5,000 when a former employee neglects to provide rollover instructions. The new law says employers can only do that when an account has a balance of less than $1,000. But all employees need to grasp the damage that's done to retirement plans when money is withdrawn prematurely.

Even twentysomethings should have a hands-off policy when changing jobs. A couple thousand dollars may not seem like much, but if it's left in the account for 40 years and grows at just 6 percent a year, it'll turn into more than $20,000. An account with $5,000 would grow to more than $51,000. That's a lot of money to miss out on when you retire. For older employees, the consequences of cashing a 401(k) are worse, because there's less time to rebuild that nest egg.

Too many Americans are setting themselves up for a fall when they retire. The most recent government statistics say we're saving at a rate of negative 0.6 percent. That means we're spending more than we're making. We're not saving, we're dipping into our savings. Combine that with people cashing out retirement plans, or not contributing to begin with, and the scenario is quite sobering.

Bankrate.com's corrections policy-- Posted: Oct. 5, 2005
 
 
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