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Flex Your 401(k): Don't Tap It

Dipping into your retirement savings can have a big impact on your nest egg.

Editor's note: As a special feature for Feburary, offers a four-part series on 401(k) plans designed to help you maximize your retirement savings. Today is Part 3. Part 1 was on maximizing your contributions, and Part 2 was on asset allocation .

Need a new car? Want that great condo? Thinking about tapping your retirement savings? Think again.

While it might be tempting -- particularly when you leave a job -- to dip into your 401(k) plan, your future financial security relies not just on saving money in your employer-sponsored retirement account but also on leaving it there.

"These plans are designed to be retirement accounts, and the government is giving you tax benefits to use them as retirement accounts," says Stuart Ritter, a financial planner at T. Rowe Price. "So if you break that contract with the government and use them for something else, there will be penalties."

Yet an unsettling number of people do just that. According to a Hewitt Associates study of 2004 data, 45% of U.S. workers choose to cash out of their 401(k) plans when they leave their companies.

Younger workers were by far the worst offenders. Sixty-six percent of those ages 20-29 elected to cash out when they changed jobs. Employees who were older and more tenured were more likely to preserve their retirement wealth, either keeping the assets in their former employers' plans or rolling them over to qualified IRAs or other retirement accounts. Still, more than 42% of workers ages 40-49 elected to cash out of their 401(k) plans upon leaving their jobs.

Paying income taxes and a 10% penalty on the funds you withdraw aren't the only consequences. You're also forfeiting the returns you would have earned on the money had you left it in a retirement account. Withdrawing even a relatively modest amount can have a big impact on your nest egg. For example, if a 40-year-old employee with a $10,000 balance earned a 7% annual return, the money would grow to more than $50,000 by the time she retired at age 65, according to Hewitt.

Ritter says you have options if you leave a firm: "If your balance is more than $5,000, you can simply leave the account with your former firm. The second option is to roll it into an IRA, and the other option is to roll it into a new employer's 401(k) plan."

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If your old company makes the distribution check out to you, it is required to withhold 20% for taxes. To avoid the 20% withholding, you must arrange for a "direct" rollover. The distribution check from the retirement plan at your old company must be made out in the name of the trustee or custodian of the IRA account that you want to receive the rolled-over funds.

"Obviously, it depends on the individual, but the IRA option gives you a little more flexibility," says Ritter. "If you had to pick one that applies to the vast majority of people, rolling it to an IRA is probably the right choice."

If financial hardships make it necessary to tap your 401(k) savings, consider borrowing money from the plan. "If you withdraw, you are paying the taxes immediately and paying the penalty. If you're taking a loan, it's not considered a taxable distribution and no penalties are involved," explains Ritter.

But Ritter says you should use this option only in a dire situation.

Typically, you're allowed to borrow up to half your vested account balance but not more than $50,000. You have five years to pay back the loan and can take even longer if the money is going for the down payment on a primary residence. You pay interest as well as the principal on the loan to yourself, usually through an automatic payroll deduction. But the interest you pay goes into your retirement account instead of a bank.

Keep in mind that if you should lose your job or change jobs, the loan becomes due immediately. "If you can't pay it back, it's treated as an early withdrawal with corresponding penalties," Ritter says.

Watch for one more step to fixing your 401(k) on Friday: Consider a Roth 401(k).

Steve Viuker is a business and finance writer based in Brooklyn, N.Y. He has been published in The New York Post, The New York Times and other national media outlets.