Cashing out a 401K early may cost more in long run

By Deborah Adamson
Advertiser Staff Writer

The engine of your 1974 Oldsmobile Cutlass is wheezing and the brakes are making squeaky noises. You need a new vehicle but you're short of money. Since you're switching jobs, you cash out of your 401K instead of rolling it over — and lose nearly half to taxes and penalties.

Cashing out early is one of the biggest mistakes people make, said Chad Adams, a financial planner at American Express Financial Advisors in Honolulu.

Withdrawing money before you reach 59 1/2 years of age while still employed triggers a 10 percent penalty and you have to pay taxes as well. So if you're in the 25 percent federal tax bracket and you pay 5 percent in state taxes, your total loss is 40 percent.

"Imagine how much you would have if you left it in," Adams said.

If you retire at 55 or older and wish to withdraw money, you can avoid the penalty but you'd still have to pay taxes, said Michael Iraha, a certified financial planner in Honolulu. Pleading financial hardship also gives you access to the money penalty free, but you would have to meet strict conditions — such as incurring emergency medical expenses.

Another mistake people make is not contributing enough money, thus falling short of retirement goals. The rule of thumb is to put in 10 percent of your gross income, said Robert Brokamp, senior personal finance writer at the The Motley Fool in Alexandria, Va.

Even if you can't put in that much, at least contribute up to what the company matches, Adams said.

Starting in 2004, the maximum contribution allowed is $13,000, up $1,000 from last year. Those aged 50 and older can put in $3,000 more, Brokamp said.

Brokamp encourages employees to sign up for 401K plans.

"Sometimes employees get a packet of information and they don't understand it, they set it aside," he said. "At least sign up."

You benefit because your money is taken out before taxes are assessed, Brokamp said. For instance, if you make $30,000 a year and you contribute $3,000 annually, you're taxed only on $27,000.

Mutual funds in 401K plans also charge lower fees and tend to be no-load — there's no sales commission. Brokamp said you also won't see 12b-1 fees — those that funds charge investors to pay for marketing costs.

Even an extra 1 percent in fees a year can make a big difference over time, he said. Let's say you contribute $4,000 a year and it earns 10 percent annually, compounded monthly. You pay half a percent in yearly fees. After 20 years, you'll end up with $237,000. If you had been paying 1.5 percent a year, you would end up with $208,000.

Borrowing against your 401K is another mistake people make.

In many cases, you'll be asked to pay the loan back in full if you leave your job. Let's say you borrowed $10,000 against your $50,000 balance to remodel your house. If you quit your job and can't repay, you'll be hit by two things — your $50,000 balance will go down to $40,000 and you will have to pay taxes and penalties on the $10,000 you borrowed. You could pay an extra $4,000 in penalties in taxes.

Advisers also urge investors to make sure their assets are diversified. If you have 30 years to retirement, one allocation to consider is putting 60 percent in a variety of stock mutual funds and the rest in bonds, he added. For stocks, divide it among large, mid-cap and small stocks, as well as domestic and international.

If you have 10 years to go, consider putting in 40 percent in stocks and 60 percent in bonds. Of course, the final allocation depends on your financial goals, how much risk you can handle and how active you plan to be in managing your assets.

Those who don't want to choose their own allocation can opt for "targeted retirement funds," said Ted Benna, who created the first 401K in the country and is president of the 401K Association in Jersey Shore, Pa.

These are funds that you choose based on when you plan to retire, such as Fidelity's Freedom Funds. If you plan to retire in 2025, there's the Fidelity Freedom 2025 fund. Vanguard and T. Rowe Price also offer similar funds, Benna said.

If you're company's 401K doesn't offer these choices, ask them to include it, Benna said.

Reach Deborah Adamson at dadamson@honoluluadvertiser.com or 525-8088.