Why not to cash out your 401(k)

Flickr user 401(K) 2012

(MoneyWatch) If you are automatically enrolled in a 401(k) account and have not made any changes, then you are typically invested in a default investment fund. The default investment election for folks who are auto-enrolled is a single fund that is typically a balanced, target-date retirement fund or lifecycle fund.

Target-date retirement or lifecycle funds are diversified and include cash, stocks and bonds all inside a single fund. These funds automatically re-balance the allocation and may, for example, gradually reduce the investment in stocks and increase it in cash and bonds as the funds target maturity date approaches. In short, these funds provide professional investment management and asset allocation.

Still, folks who are automatically enrolled in one of these default funds need to know that these are not personalized for your specific situation or investment objectives. For example, if you want to increase your allocation to stocks and decrease your allocation to bonds, these default funds would not allow you to make this adjustment. Also, if you wanted to maintain a higher allocation in stocks even as you near retirement, these funds would not allow that, either.

401(k) savings advice for Gen-XersDo a simple retirement savings check upAre your 401(k) investment funds money-losers?

There are good reasons to personalize your 401(k) allocation. Also, some plans offer managed account services, where you can hire a professional investment advisor to take control of, allocate and manage your 401(k) account.

Never cash out

One of the weaknesses of automatic 401(k) enrollment is that workers start a small account in the plan and then cash it out when they leave their employer.

Nearly half of all employees cash out their 401(k) savings when they change jobs, and that's despite having to pay personal income tax on the amount and a 10 percent penalty for early withdrawal. Most people cash out are younger workers with smaller balances, figuring that it's not worth the trouble of saving such sums.

The problem is that cashing out these even small 401(k) balances can have a significant impact on future retirement savings. Workers are likely to change jobs five to seven times before they settle into a long-term job. So shift employers every two years, they could be cashing out their retirement savings -- with nothing saved for retirement -- well into their 30's.

Instead of cashing out, consider transferring your 401(k) plan account from your previous employer's 401(k) plan into your new employer's 401(k) offering. Before you do, make sure the new employer's plan is as good as the previous one you had.

If your new employers 401(k) plan does not permit plan-to-plan transfers, then consider rolling it over to an IRA.

Rollover 401(k) account

Anyone who has participated in a 401(k) plan and changed jobs has confronted the question of what to do with their account. The most common practice (second to cash payments) is to direct a distribution from the plan to a rollover IRA. These are the basic steps to doing this and avoiding taxes:

Open a rollover IRA with a brokerage or mutual fund company. Instruct your prior plan's administrator to make the distribution payable directly to your new rollover IRA, as custodian for your benefit. Do not elect to have any taxes withheld from the distribution, as it will be tax-free.

If your plan will only send a check to your address, include your new IRA number on the check and forward it to your rollover IRA within 60 days of receipt, which is typically the postmark date on the envelope in which the check was mailed.

Contributions that were previously taxed cannot be rolled over. Consider investing those amounts in a Roth IRA or with your taxable savings.

Today's worker needs a 401(k) and a rollover IRA if they want to preserve and build their retirement assets. Choose an IRA provider carefully, making sure that it provides the investment flexibility and access you need today and as your balance grows in the future.

Image from Flickr user 401(K) 2012

  • Ray Martin

    View all articles by Ray Martin on CBS MoneyWatch»
    Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS Moneywatch.com and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.

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