Bad Planning Penalty: Year of Hard Labor
Draining that 401k when leaving a job
By Kaye A. Thomas
Posted October 29, 2009
Easy come, easy go.
Participation in 401k plans is going up, partly because more employers are adopting automatic enrollment features. Yet many workers drain those accounts when they leave a job, especially younger workers with smaller balances. Would they consider more carefully if this kind of bad planning led to severe punishment, perhaps a year of hard labor? In many cases, it probably does.
Meet Rick, age 25. It's his last day at work on his first "real" job. Without even realizing it, he built up a $10,000 balance in his 401k account, and now he has a choice. He can preserve that money as permanent retirement savings (leaving it where it is, or rolling it to an IRA or another 401k) — or he can drain the account and have his hot little hands on more money than he's ever had before. Maybe get a new car. Maybe take his time finding a new job.
Draining the account means taxes and more taxes. His employer will withhold $2,000 from the payout, and there's a good chance he'll owe more when he files his tax return. That $2,000 won't cover what he owes even in the 15% tax bracket, because of the 10% early distribution penalty.
The bigger penalty is not having that money set aside in a qualified retirement plan. How much difference would that $10,000 make? At a reasonably attainable growth rate of 7%, compounded over 40 years, it would turn into about $150,000. With a sound approach to investing and a little luck he could do better than that. At 9% per year he'd end up with more than $300,000.
That much money could make a difference of a year or more in when he's able to retire. There's the penalty for bad planning: a year of hard labor.
