Don’t cash out (withdraw) your 401(k) assets unless you need to. A rollover is better for you in the long-term.
At Capitalize, we like to say that taxes and penalties aren’t our friends, so let’s not invite them to this retirement savings party. Nowhere is that more true than if you’re considering a 401(k) withdrawal, or a cash-out. While it’s easy to request a 401(k) withdrawal, the IRS will take a big chunk out of the money you get. Why? Because they want you to keep your money in a long-term retirement account so that you have money to support yourself. And we want that too. Most of the time you’ll pay income tax on the withdrawal in the year that it occurs, plus a 10% penalty on top.
“Compounding” is just the fancy finance term for what happens when your investments grow over time. Einstein called compounding the eighth wonder of the world, and face it, he was a pretty smart dude. The point is that when your money remains in long-term investments it grows much faster than it would if it was in a bank account. That’s because bank interest rates are so much lower than the returns you can get from long-term investments like stocks. For example, $3,000 invested in stocks today for the next 35 years will turn into over $40,000. That compares to just $4,000 if you leave it in a bank account. Put differently you’ll make 10x more by staying invested for the long-term.
When you withdraw your money it gets pulled out of these long-term investments and into cash. If you rollover your 401(k) into an IRA instead then you’ll continue to make long-term investments that will compound for you over time.
Retirement accounts like 401(k)s and IRAs have special tax advantages. That’s because Congress wanted to encourage people to use them and grow their wealth in the long-term so that there’s less pressure on the Social Security system. The biggest tax advantage is that your investments in a 401(k) or IRA can appreciate without you having to pay taxes on them until you withdraw them at retirement. That’s a big deal because you can basically kick the tax can down the road, legally. A dollar of tax paid 30 years from now is less of a burden than a dollar of tax paid today.
When you transfer money from your 401(k) into an IRA, the IRA preserves this tax advantage. The rollover itself also has no tax consequences. In contrast, a 401(k) withdrawal causes you to lose this big tax advantage. If you withdraw your 401(k) savings into cash and put it into a bank account then any interest you earn on that cash will be taxable as income tax.
Even if you agree that a 401(k) rollover is better than a withdrawal you might think that the extra work involved isn’t worth it. A lot of people who came to Capitalize thought the same thing. But doing a rollover doesn’t have to be that painful. There’s 3 key steps: 1) pick an IRA provider; 2) open an account at that IRA provider online and 3) transfer your 401(k) into that new IRA. Steps 1 and 2 can be done literally in minutes, and we can help you with it. Step 3 might involve a bit of waiting time once you’ve initiated a transfer, but again the amount of work time for you can be counted in minutes.
That’s not a whole lot of time for what could end up being a large difference in your long-term finances. We get that rollovers don’t sound fun. But it’s often worth the hassle.