Finally, another edition of Financial Tip Friday. Sorry I have been away from these, but this semester has been tough emotionally for Mrs. ROB and I. However, things are getting better so I hope to write a lot more posts on this blog.
Right now there are thousands of Americans who have switched jobs and have left their old retirement accounts at their previous employer. Many people are unsure of what to do with those accounts. Those same people might have debt (e.g. student loans, cars, credit cards, and a mortgage). Those old 401ks and/or IRA can look pretty tempting when we see ourselves in a mound of debt, lose our jobs, or have to pay for major expenses like college or the like.
If you are thinking about cashing out an old retirement account (e.g. 401k or IRA) STOP NOW! DON’T DO IT! Unless it is an absolute emergency you should NEVER cash out retirement plans to pay off debt, pay for college, etc. Your retirement funds and/or house are not piggy banks.
Reasons Why You Should Almost NEVER Cash Out That Retirement Account
First, you lose the growth of that retirement account. Perhaps one of the biggest reasons for not cashing out retirement is you lose the wonderful nature of compound interest. Albert Einstein was reported to have said that compound interest is the eighth wonder of the world. Let me give you an example.
Assumptions: $50,000 in an old 401k. Your rate of return is 8%. You contribute $200 each month over a 10-year period. According to hte investing calculator at Dave Ramsey.com you would have over $145,000 after 10 years.
However, let’s say that you begin with ZERO. You triple your contributions to $600 a month. 8% rate of return and over the same 10 year period. You would have only $115,000.
So you LOSE $30,000 by cashing out your 401k.
If you take that same scenario and chain out 20 years you actually have it about even. In other words, it took 20 YEARS to get to even by cashing out your retirement account. That is CRAZY.
Second, cashing out your retirement plan is like taking a loan for 25-35% interest. If you cash out a retirement plan the IRS automatically takes 10% for a penalty. Plus, you pay taxes at your tax rate. So if you tax rate is 15% you basically have a 25% loan, if it is 25% then you have a 35% loan. Why not just max out a credit card. The credit card gives better rates than that. Why take out that huge of a loan.
Third, it is mentally taxing to start from ZERO again. There is something really great about being out of debt (not that I would know). And I can understand why people would do it. They want the debt gone. However, if you clean out your savings you are really back to ZERO. You have nothing and have to start all over again. To me it is a better proposition to take some of the money you might be saving toward retirement pay off the debt and let your money that you have in that old 401k or IRA just grow naturally.
Finally, you lose the ethic of saving. Saving for retirement like a lot of things is like a muscle. You need to work it out or it will atrophy. By saving for retirement and cashing out your old plan you are destroying that ethic. You are basically saying that your 401k plan is a piggy bank and you can raid it any time you want. If that’s the case then what is the purpose of saving. You have to continue to make saving automatic. Start right away and as I mentioned in one blog post save like Ron Popeil “set it and forget it.”
What Should You Do With An Old Retirement Plan
Now I say old retirement plan because if you are enrolled in your company’s retirement plan you can’t cash it out. You might be able to take a loan (DON’T DO IT) but you can’t cash it out. This only applies for IRAs owned by you or old retirement plans from previous employers.
What you should do is contact your old employer and roll that retirement plan to an IRA that YOU can manage.
Now if god forbid you are facing long-term unemployment or your house is in foreclosure or you are homeless then these rules kind of go out the window. However, the vast majority of people don’t face that. Rather, they cash out retirement plans for other things not for a TRUE emergency, which homelessness would certainly qualify.
Paying for your kids college, not so much. So unless you are under extreme circumstances NEVER or raid your old retirement accounts. Roll them to a new one where you can control the investments and continue to save. You will be surprised how much money you will save in the end.