Early 401(k) Withdrawal Costs How Much?

With a slew of layoffs, rising costs and loans becoming harder to obtain, an increasing number of Americans are breaking the guidelines of retirement savings and cashing out their 401(k)s. But before breaking open the piggy bank, plan participants should consider the taxes and penalties they will have to pay, as well as the thousands of dollars in compounding interest they will lose.

Mutual-fund giant Vanguard says that in 2007 alone -- before the credit crunch and housing downturn hit in full force -- hardship withdrawals rose 9%, on top of a 17% increase the previous year.

Vanguard's record keepers noticed "a sharp increase in hardship withdrawals, suggesting rising economic pressures on financially vulnerable households, possibly related to the national crisis in subprime and adjustable rate mortgages."

Jim Langenwalter, chief sales and marketing officer at Rollover Systems, says loans taken from 401(k) plans have increased as well.

"Loans are always better than a cash-out because there's always the hope of trying to pay it back," he adds. "But about one-third don't."

Rollover facilitates the movement of retirement funds from a company plan to an IRA or a new 401(k) once an employee leaves the company that initially sponsored his plan. Langenwalter noted that younger participants -- who hop around more from job to job and have less income in each plan -- tend to cash out more frequently than older participants. And while it may seem appealing to use that $1,000 or $2,000 for immediate needs rather than saving it for decades down the road, taxes, penalties and compounding interest make such choices undesirable.

For instance, Rollover estimates that a 35-year-old participant with a $5,000 balance in his 401(k) will pay $500 in penalties and $1,500 in taxes -- stealing away 40% of his cash. Had the employee rolled over the savings into an IRA with an 8% return, then by the age of 65 he would have more than $50,000.

While small balances are more frequently cashed out, larger balances take bigger hits on compounding interest. A 45-year-old with $50,000 might pay $20,000 in penalties and taxes if he cashes out. However, he would earn $183,000 in interest had he left the retirement savings alone for 20 years.

"It's surprising how many people don't understand the long-term ramifications," says Langenwalter. "Just like it's surprising in high school they don't teach kids how to balance their checkbook, and they should. Some folks think they have their whole life ahead of them and they can just cash it out now."

Rollover offers a cash-out calculator on its Web site where consumers can find out the taxes and penalties they'd have to pay as well as what they would earn in interest by entering their age, planned retirement age, plan balance and expected rate of return.

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