You may be unpleasantly surprised if you cash out your retirement plan because your distribution will be treated as current income and will be subject to federal, state, and local income taxes. You'll also incur a 10% early withdrawal penalty if you're under age 59½ (certain exceptions apply). In addition, your money will lose its tax-deferred status.
Taxes and Penalties
The early withdrawal penalty means that if you saved $50,000 in your retirement plan and made no after-tax contributions, you would lose $5,000 to the IRS. And that's not all—your distribution will be subject to income taxes. Your employer is required to withhold 20% of your distribution assets for federal income taxes. When all is said and done, you could lose close to half of your savings paying penalties and taxes if you take your distribution in cash.
There's another important factor to consider when deciding whether or not to take your retirement plan assets in cash. Tax-deferred investing can make a substantial difference in your account's value over time. When you keep your money in a tax-deferred plan, the earnings from your investments are automatically put back into your account. In addition, as the term implies, your contributions and earnings are not taxed until you take a withdrawal. You will have to pay taxes when you withdraw money from your account, but at that point you may be in a lower tax bracket.
To put this concept in perspective, consider this hypothetical example (illustrated above). Mary leaves her job after accumulating $50,000 in a qualified tax-deferred account. If she takes the money in cash, the early withdrawal penalties and income taxes would reduce the amount to $28,500. Now assume she invests the money in a taxable account earning a hypothetical 8% a year. After 30 years the account could grow to $150,469.
But what if Mary's original $50,000 is rolled over into another tax-deferred account, such as an IRA, also earning a hypothetical 8% a year? After 30 years of benefiting from compounding and tax-deferred investing, her account could grow to $503,133—more than double the amount of "cashing out" and reinvesting in a taxable account.
Assumes a 28% federal tax rate, 5% state income tax rate, 10% early withdrawal penalty, and 8% hypothetical return. Not an indication of any specific investment.
Determine if the plan's investment and service options meet your needs
Ask your previous employer if you are eligible to keep your assets in the plan
Inquire whether the plan limits options for inactive or retired participants
Determine if any paperwork needs to be completed
Don't forget about outstanding loans—if you don't repay the balance, the IRS will deem the loan to be a distribution from your plan. If this occurs, you'll have to pay current federal, state, and local taxes and you could incur the 10% early withdrawal penalty.
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