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Don’t cash out that 401k

July 9, 2012

You may think you hit your payday, but hold on a second.

You’ll get your payday — but it will take awhile 

“Advance to Go. Collect $200.” This is usually one of the best cards to get in the game of Monopoly. Just by landing on the right space, you get to collect a couple of C-notes.
I think it was cards like this that have taught us it is fun to come into money, even when it may not be the best thing. For example, we generally all love getting a big tax return. This is great, but that basically means we’ve been loaning the government money for free all year long.
I’m not going to beat you up for paying a little too much in taxes during the year and getting a return the next year. Honestly, this forced savings that gave you 0% interest isn’t much worse than what you could get at a bank with a savings account.
Getting a little larger tax refund may not be a bad thing, but the habits it creates can be hurtful for other life incidents. The one major mistake many people make when switching jobs is to take a refund payment for their tax deferred retirement plan (think 401(k)).
If you have worked for an organization for awhile that has a retirement plan to which you were contributing, you might be pleasantly surprised with what you had saved when you leave that employer. When you get the information, it may feel like that nice tax return or your very own Advance To Go card.
Don’t fall for it. Even though you may have the best intentions to pay off credit card debt, save for a down payment on a home or give yourself some well-earned rest and relaxation, it isn’t worth it.
If you take money out of a tax deferred retirement plan after you switch jobs, you pay a 10% penalty on the withdrawal if you aren’t 59 1/2 years old yet. Also, you must count the withdrawal as income. Most people will pay at least an additional 15%, and if the withdrawal is large enough, it even can bump you up to the 25% income tax bracket.
You do not want to give up a fourth to a third of your retirement savings to purchase something right now. Even if you pay off credit card debt with an average interest rate of 15%, it still will look like you are borrowing money at 25-35% to pay off 15% interest.
Instead, you can roll over your money into a traditional IRA. By completing a rollover, you avoid the 10% penalty and the income tax right now. It also gives your retirement savings a chance to continue to grow.
There are some exceptions, such as if you lose your job, you may need that retirement money right now to provide your family with basic needs.
However, if this isn’t the case and you chose to switch employers and get a new job, roll over that retirement savings. Find a low-cost or no-load mutual fund or target date retirement fund and let that money sit and grow over the years. It may be difficult right now, but it definitely can pay off down the road.
Even though it may feel like you missed out on your chance to advance to go and collect your $200, by keeping your retirement savings invested in retirement accounts, you can avoid penalties, current taxes and the loss of future growth. You may not have the money now, but you still have the chance to get second place in a beauty contest and collect your $10 today.

Winning second prize in a beauty contest is almost as good as buying Boardwalk.

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