The worst decision you can make with your 401K

Stan Choe for Delcotimes.com writes: Workers’ 401(k) balances have never been bigger, thanks to continued contributions and a surging stock market. But many savers continue to make a mistake that’s costing them thousands of dollars, if not more.

When workers leave their jobs, they have the choice of leaving their 401(k) accounts alone, rolling them over into another tax-deferred retirement account or cashing them out and pocketing the money. Last year, 35 percent of all participants who left their jobs cashed out their accounts, according to the nation’s largest 401(k) provider, Fidelity Investments. That’s up slightly from 32 percent in 2009.

The move provides some quick cash, but it’s also likely the accountholder will have to pay penalties: Nearly everyone younger than 59 1/2 must pay 10 percent of their account balance as a penalty. Add on top of that the income taxes that come due, and the price tag quickly escalates.

The average balance of a 401(k) account that was cashed out last year was close to $16,000, Fidelity says. Of that, the typical person pocketed just $11,200 assuming 20 percent was withheld for taxes and the 10 percent penalty was assessed. But that’s not the worst of it, says Jeanne Thompson, vice president at Fidelity Investments. It’s the lost opportunity for the saver, who no longer gets the compounded growth the savings would have had in a retirement account.

Cash-outs are most prevalent among younger workers, the ones who would most benefit from keeping the money in a tax-deferred retirement account. They have the most years of possible compounded growth ahead of them before retirement. Among workers from 20 to 39 years of age who left their jobs last year, 41 percent cashed out their 401(k) balances.

“Many young people are struggling: They’re paying off debt or trying to buy their first car or first home,” Thompson says. But if they had kept the $16,000 invested, Fidelity says it could have grown big enough to provide nearly $500 per month in income during retirement.

To be sure, some younger workers don’t have a choice. Some plans can automatically cash out a 401(k) balance when a worker leaves if it’s below a certain amount, such as $5,000, and younger workers are more likely to be under that threshold.

Instead of cashing out, Thompson suggests savers consider leaving the money in their old employer’s 401(k) plan, rolling it over to an individual retirement account or rolling it over to their new employer’s 401(k) plan. Each option has its pluses and minuses: An IRA can offer more mutual fund choices, for example, but a 401(k) may offer access to share classes of funds with lower expense ratios than savers can get on their own.

The bull market means that workers may find their 401(k) account balances all the more tempting. At the end of last year, the average balance was $89,300, up 15.5 percent from a year earlier, according to Fidelity. The surging stock market fueled most of that growth: The Standard & Poor’s 500 index returned 32.4 percent last year, including dividends. But contributions made by workers and their employers accounted for 22 percent of the growth.

For savers who have both IRA and 401(k) accounts with Fidelity, the company found that the average combined balance was $261,400 at the end of 2013, up 16 percent from a year earlier.