3 Ways Cash Leaks Out of Your 401(k)

And how much each type of loss will harm your nest egg

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While many Americans have valid reasons for raiding their 401(k) during their working years, these early withdrawals can have dire consequences in retirement. Fees and penalties for early distributions can further eat away at your retirement account balance. About 15 percent of 401(k) participants spend some of their nest egg before they’re ready to leave the workforce, according to new Government Accountability Office report. The study identifies three major ways money leaks out of 401(k)s before retirement and how much each one affects your financial security.

[See IRA and 403(b) Owners Pay Higher Fees than 401(k) Savers.]

Cashouts. When you leave your job you are given an opportunity to cash out your 401(k). American workers took about $74 billion from their retirement accounts when they job hopped in 2006. But when you cash out a 401(k), typically 20 percent of your account balance is withheld by your employer to pay for federal and state income taxes now due on the amount withdrawn and account holders under age 59½ must also pay a 10 percent early withdrawal penalty. 401(k) participants who voluntarily cashed out their entire account balance at the time of job separation experienced a larger reduction in their retirement savings over their career than any other type of 401(k) withdrawal, GAO found. For example, a 401(k) participant born in 1970 who began saving 6 percent of his pay annually for retirement at age 21 plus a 3 percent employer match would typically accumulate $588,049 by age 65, according to GAO calculations. But if that same participant cashed out his nest egg at age 35 when he changed careers and paid the resulting tax penalties, he would have only $404,431 at retirement age. And that’s assuming he immediately gets a new job and saves the same amount with an identical employer match, which could be difficult for a laid off employee to do.

[See Employers Can Override Your 401(k) Investment Choices.]

Hardship withdrawals. Some 401(k) plans also allow current employees to use some of their retirement stash to pay for a sudden bill. Withdrawals are typically limited to the employee’s contributions to the retirement account and do not include income earned on the savings. Allowable reasons for a hardship withdrawal include medical care, payment of tuition or other education expenses, purchase or repair of a primary residence, to prevent forclosure or evection, or funeral expenses. Americans took $9 billion from their retirement accounts for these expenditures in 2006. Hardship withdrawals had the most negative impact on young and low-income retirement savers, GAO found. A low-earning 35-year-old participant who took a $5,000 withdrawal generally ended up with 12 percent less in savings at retirement resulting from the hardship, whereas higher-earning participants who withdrew the same amount had only 5 percent less at retirement age due to higher contribution amounts, GAO calculated. 401(k) participants are typically not allowed to contribute to their account again for six months after a hardship withdrawal, which makes replacing the savings even more difficult.

[See 5 Ways to Protect Your 401(k) if You're Laid Off.]

Loans. Retirement savers are generally allowed to take a 401(k) loan of up to 50 percent of the vested account balance or $50,000, whichever is less. The amount withdrawn must be paid back with interest. If the loan is not repaid, the outstanding loan balance becomes a taxable distribution of income and, if under age 59½, the borrower could also face the 10 percent early withdrawal penalty. If you are laid off or otherwise leave your employer, the loan balance typically becomes due in full shortly after the separation. Some plans also require loan recipients to pay loan origination fees or maintenance fees. Americans lost $561 million in retirement savings due to loan defaults in 2006. Yet, loans paid back to the plan in regular installments are the least damaging way to tap your 401(k) early, GAO found, because participants who do make the payments are able to recover most of their losses.