Should You Cash Out of Your Retirement Savings Plan?

by Todd Smith on 2012-08-1112

During these times of historically high unemployment rates, many people have had to resort to dipping into their retirement savings simply to survive. It’s something I understand since I’ve been in this situation before. When I first became an entrepreneur, after several years in corporate America with nice retirement benefits, I would often be strapped for cash while waiting for clients to pay. As a last resort, I had to dip into my IRA (which was a rollover from my 401(k)). On another note, my sister was also happy that she had the chance to fall back on her retirement savings account after being laid off from a major airline shortly after 9/11. “Sometimes you do what you have to do,” as my father would say.


However, the bigger issue here is that many employees are cashing out of their savings even if it’s not absolutely necessary for them to do so. Even those who are not necessarily faced with serious survival decisions are simply of the mind to “take the money and run”. I think part of the reason for this is that we live in a society that consumes now and plans later. We want immediate gratification. Thus, a lot of us are not quite sure if we’re saving and investing enough for our retirement.

Cashing Out of Employee Retirement Savings Plans: A Study

I remember a study that Hewitt, a global resources firm, conducted a few years ago (when the economy was seemingly in better shape) that was pretty enlightening. Hewitt found that most of those who cashed out their savings plans where younger workers in the 20 to 29 age range, while the more senior employees tended to preserve their money in their retirement accounts. Then there are those employees in their 40s who chose to take out their savings from their 401k accounts once they’ve left their companies. So if we were to see who ended up cashing out, then 66% of young workers did while 42% of middle aged folks did so, upon their resignations.

You can open an IRA and invest in a variety of investments these days. You can take a look at opening an IRA with a peer to peer lender (yes, even P2P companies provide retirement accounts) or an IRA with an online broker, for instance.

In addition, those with less money in their plans tended to cash out more often. So what else did this study show us? That the amount of money you had in your plan made a difference. So 72.5% of employees who had smaller savings (under $10K) were more willing to make the move. Those with savings that ranged between $10K to $20K tended to stay put. But all in all, almost 30% did cash outs.

cash out retirement savings plan
Image from Jason Tester @ flickr.com

Sure it’s your money to take, but if only you knew how much you were hurting yourself. “So, what’s the problem,” you may ask?

What To Consider Before You Cash Out Of Your Retirement Savings

1. Opportunity Cost
Know that due to the power of compounding, you can make a huge difference when you save and invest early enough through your retirement accounts. You may be surprised by how much money you can amass over time by just sticking to an investment contribution plan.

2. Taxes and Penalties
When you take money out of a retirement plan, that money (with the exception of Roth/after-tax type money) is treated just like earned, taxable income most of the time. Meaning, you have to pay normal state and federal income taxes; and if you are under age 59.5, a 10% premature withdrawal penalty will be imposed. Ouch! So cashing out will cost you.

3. Longer Work Life
When you’re given a choice, are you tempted to consume rather than save? Well, think about how much longer you may have to work if you end up having to make up for lost savings. Social Security won’t cut it. If your savings are not adequate, you may have to work a lot longer than you expected.

Try the Following Ideas First Before You Cash Out

1. Get Back to Basics and Budget
Make sure you have a clear idea of what you NEED to spend each month. For instance, see if you can make a budget. Cut back on extra expenses and only take out money from your retirement account(s) that is absolutely necessary.

2. Take Money out Slowly
When I dipped into my account, I took out only a little at a time over more than one tax year. This kept my account balance intact and invested for a longer period of time, and it also minimized my taxes. Had I taken the entire amount (or a good portion) in one tax year, I would have been pushed into a higher tax bracket.

3. Make Sure To Withhold Enough Taxes Upfront
In a past life, I worked in a customer service role at a large financial firm. We used to get a lot of callers who would complain that we did not withhold enough taxes, and now they owe the IRS. Sorry, but it is up to YOU to figure out and tell your institution how much to withhold for taxes. Normally, when you cash out of a 401(k), an automatic 20% withholding fee applies. But, you may be in a higher tax bracket and have the 10% penalty imposed. So, that 20% probably won’t cover it. Better to play it safe and have them withhold more so you are not stuck with a hefty tax bill at the end of the year.

Bottom Line

My colleagues certainly would accuse me of committing a cardinal sin of personal finance by taking money from my 401(k). And given the choice, I would have avoided it. To all of you who are currently contemplating this choice, my recommendation is: Don’t do it.

Created November 4, 2010. Updated August 11, 2012. Copyright © 2012 The Digerati Life. All Rights Reserved.

{ 12 comments… read them below or add one }

Jessica07 November 4, 2010 at 8:13 pm

Great advice! I think the “longer work life” is really the key for me. Sometimes the ease of the short-term just doesn’t outweigh the extra work that will be required later.

Silicon Valley Blogger November 4, 2010 at 8:31 pm

@Jessica07,
I used to think I would be a lifer at my job. But then again I took a look at what happens to older engineers here in Silicon Valley, and I had second thoughts about staying employed in the field at my age (I’m not that old, but I was extrapolating events). Here is a piece I wrote some time ago on Age Discrimination In The Workplace.

Now that I have discovered online business, I can imagine myself being able to “work for life”. It probably won’t be as tough if I can work from home the whole time, or if I could continue being my own boss! :) You can do this sort of thing even when you’re higher up in age!

Freckles November 5, 2010 at 11:27 am

It’s called “retirement savings” for a reason. You did give some valid cases of when it’s okay to use part of it. But if you’re going to use it just to buy a car or something like that, time will come when you’ll regret it. If you save up for retirement, you can actually live off from the savings pretty comfortably.

Kaz November 5, 2010 at 1:49 pm

I actually feel like if you know you’re going to be at a job for a set amount of time and then not be working for a while, then it’s arguably worth the effort of stuffing cash into a 401k with possible intentions of withdrawing it later for non-retirement purposes. For example, if you went to school, got a job, and planned to go back to school, I don’t think it’s unreasonable to stuff extra cash (assuming you’ve budgeted correctly) into the company 401k rather than building up a cash reserve at the bank.

When you leave the company, roll it over into a traditional IRA. In the year(s) you aren’t generating any/much income, convert it into a Roth IRA. You end up deferring taxes, reducing taxes, and have access to money in a retirement account without needing to pay penalties. Money is money is money. A retirement savings account gives you tax benefits that incentivize you to save for retirement, but it’s not necessary to only use it for that purpose.

John Hunter November 7, 2010 at 5:51 am

I agree: don’t do it. But if you have to, do it slowly. Also it is a matter of degree. If someone had been saving 15% of their salary in retirement since they started working if they took an amount that left them at 10% that is hardly a horrible result. While someone that was already behind by say adding just 3% to retirement savings and they took out all of it that would be much worse.

Also the problem of “having to do it” is really about what was not done years before than what is done the day the withdrawal is needed. We by and large chose to spend today and hope tomorrow will be good rather than first establishing a good financial safety net before expanding spending. At the same time even having a retirement account to withdraw from might put you ahead of more than 50% of the population.

Jacob @ My Personal Finance Journey January 23, 2011 at 9:49 pm

I agree. It is sort of a double-whammy to take savings out of your rollover IRA. First, you have to pay taxes and a 10% penalty on the money. Second, you have the mental anguish of knowing that you did something that is less than optimal. I think that in certain circumstances, such as a severe shortage of money for food, housing, or medical care, it would be appropriate to pursue a withdraw from your retirement savings.

krantcents August 12, 2012 at 6:52 am

Retirement savings is the last place I would go for money because of the penalty and taxes. Depending on the circumstances, I would borrow short term rather than raid savings.

William @ Drop Dead Money August 12, 2012 at 6:56 am

If you are going to take something out, first take it as a loan. That way it stays on the other side of the tax line. And if you get back on your feet, you can repay it and end up with even a little more (interest) in the nest egg.

anne August 13, 2012 at 6:06 am

I am from Europe and most people are well cared for, with health insurance still affordable. I moved to Mexico 2 years ago and met a lot of expats from the US who live here in the Yucatan. Health care is very affordable with a visa and you can live comfortably with $1000 usd. It’s also easy to own your own home.

Ken Faulkenberry - AAAMP Blog August 13, 2012 at 11:24 am

Withdrawal from retirement accounts should be the very last option. The loss of future compounding on top of all the other reasons make withdrawal a very bad option.

Paul Hemann August 17, 2012 at 11:25 pm

Interesting article, I really liked the tips. I am quite inspired by your post. I’ve had 30 years of marriage life. I am quite happy now. We both have retired from our work respectively. We are thinking to move to a retirement community and I heard about garden spot village (GardenSpotVillage.org), which seems like it is a great retirement community. It is situated amid nature & they have health care services too. Do you have any thoughts on them?

K. Lewis August 18, 2012 at 5:59 pm

Very interesting facts. I personally know of several people who cashed out their IRA, with the common reason being they lost their job and NEEDED money to keep their home, etc. It seems as though retiring with a nest egg is a luxury fewer and fewer people can afford. One thing to add: if you’re disabled and receiving disability benefits then you can cash out your IRA without the penalty.

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