M is for Money

Many years ago, facing both unemployment and uncertainty, I cashed out my 401k. At the time I had very little in savings and felt it was worth any negative consequences. Of course looking back I now realize how this decision continues to affect my goals years later.

Someone in a similar situation recently asked, why was cashing out the retirement fund a mistake? After all, it was only a few thousand dollars and you needed the money at the time. So what are all of the consequences of cashing out a retirement account?

Penalties and Taxes

The first and most obvious drawback to cashing out a 401k is the taxes and penalties you pay to the IRS. Since the money was invested pre-tax, taxes are due at the time you cash out. They also hit you with a 10% penalty meant to discourage early withdrawals. The $5000 in your account will only add $3750 to your wallet (assuming a 15% tax bracket). You don’t get the full benefit of that money.

Lost Future Gains

$5000 doesn’t sound like a lot of money, but what would that balance look like after 40 years of investing? At 7% annual return, that $5000 would grow to nearly $70,000! I didn’t take $5000 from my 20-something self, I took $70,000 from my 60-something self. Look at it in terms of the future value of the account, not the balance there is today. You are losing out on many years of tax-free gains when you cash out a 401k.

You Cannot Make it Up Later

The government limits the amount of money you can put in tax-favored retirement accounts each year. You cannot go back in time and replace the money you have taken out and you cannot add more than the yearly maximum to make up for earlier withdrawals. That is not all, a few years delay in saving will make a big difference in the amount you have at retirement. Let’s say you replace the $5000 three years later, with the same 7% return. Unless you also push back retirement by 3 years, you would have $13,000 less at the same age. You invested the same amount of money, but time has a major effect on the outcome.

A short time without retirement investments, even early in your career, will follow you in the form of fewer savings. In the future you will have to save more, just to get back to the same point you were before. The effects of cashing out a 401k aren’t limited to taxes and penalties, you will have lost benefits that cannot be reclaimed. What seems like a trivial amount of cash could grow to a tidy nest egg, if only you left it alone.


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