Why You Shouldn't Cash Out of Your 401(k) Retirement Plan

If you're like me, you've probably been avoiding your IRA and/or 401(k) lately. Is it any wonder? With a national recession that is now predicted to last for the next several years, rising inflation, sinking home values, and tanking stocks, you knew that your retirement account was the next item on the economy's hit list. In 2008, the Wall Street Journal reported that Americans lost about $2 trillion in workplace-sponsored retirement plans over the past 15 months (1). Furthermore, there is no good estimate of when we'll finally hit economic bottom (if we even have) and start making a comeback.

And then there is your job. You've probably been spooked by several of your coworkers getting the ax, affectionately called "being laid-off". You might be worried about your own job. Or, you may have already been laid-off.

When you leave your job, you are given the option of either cashing out your 401(k), keeping your 401(k) with your old employer, or transferring your assets to an IRA or a 401(k) with your new employer. In 2004, a Hewitt Associates survey found that 45% of employees who were laid-off from a job chose to cash out of their 401(k) plans (2). Furthermore, most of these ex-employees were not recent college graduates living on a meager income, but rather, established folks in their mid to late 40's!

It's understandable that, as you look at your shrinking retirement portfolio, there is the temptation to take what's left and run. However, cashing out your retirement savings is one of the worst financial maneuvers you can make. Unless you are completely destitute or have medical bills to pay (at which point, you may want to consider declaring bankruptcy), there are several ways in which cashing out of your retirement portfolio will hurt you:

1. If you cash out before age 59 ½, you will pay a 10% penalty on what you withdraw.
2. Your employer, per IRS law, will be obligated to hold 20% of your distribution for taxes.
3. Your cashed out retirement assets are no longer under bankruptcy protection.

Of course, the biggest cost of cashing out your retirement savings is the loss of compounded interest. If any of your stocks pay a dividend that is then reinvested, cashing out your portfolio ends that free ride on passive income. Even if your stocks earn no dividend, a portfolio that earns an average yearly percentage of say, 7%, can easily grow into half a million dollars by the time you retire. For a graphical illustration of how this looks, see the U.S. Department of Labor's article on preparing for retirement.

Of course, from talking with your coworkers around the water cooler, you have yet to find a retirement account that is growing in value rather than shrinking. Experts disagree, but most say that retirement portfolios started getting hit hard back in mid to late 2007. Even dividend-based portfolios are not increasing in value.

Thus, the ever-present temptation to cash out.

However, even if your current retirement savings have dropped, there is one big reason you should not cash out: bargain stocks. For the first time in a long time, companies like Apple, Microsoft, Johnson & Johnson, General Electric, and Coca-Cola, all with solid earnings and cash to spare, have seen their stock prices drop significantly. This is also why your own portfolio has diminished in size. Still, if you use this time as an opportunity to bolster your holdings, you will see a significant upswing in your IRA and/or 401(k) once market conditions start turning around.

If you're still burning from the losses you've taken on stocks already purchased, remember that by buying the same discounted stocks now, you are dollar-cost averaging the higher prices that were initially paid. This not only softens the financial blow, but it gives you a greater share in the corporate pie(s) of the future.

Still not sure of what to do with your "new-found" wealth, which was your old IRA or 401(k)? Then look to Warren Buffett, arguably one of the most successful investors in history and a billionaire many times over. Buffett has not been reported to be cashing in his stocks for cash as of late. Rather, the man is investing even more aggressively, in companies like United Healthcare, US Bancorp, and USG Corp (3). There is a reason that Buffett is worth over 37 billion, even after giving away at least half of his wealth to charitable organizations.

References:

1. "How to Salvage Your Retirement Plan Now," by Chuck Saletta, The Motley Fool, November 6, 2008.
2. "Rollover, cash out or do nothing," by Eve Mitchell, Oakland Tribune, Mar 30, 2009.
3. The Complete User's Guide to Warren Buffett's Portfolio, by James Altucher, Yahoo Finance.