Employees Risk Their Future When Cashing Out 401(k), Report Warns

A report from the Harvard Business warns that too many workers cash out their entire 401(k)s when they leave a job.

American workers are on the move.

Employees are likely to change jobs several times before they retire. A Pew Research survey found that 30% of Americans changed jobs last year alone. 

DON'T MISS: A New Retirement Plan for Millions of Americans Ready for Something Different

And, despite warnings of a recession and layoffs, more than half of U.S. workers want to quit their jobs in 2023, according to a recent LinkedIn study. 

However, a report from the Harvard Business Review warned that too many people cash out their entire 401(k)s when they leave a job.

The U.S. is the only country among developed economies that allows companies to present departing employees with the option of cashing out their 401(k) accounts.

Withdrawing early is a bad idea for several reasons -- employees will need to pay income tax and, for withdrawals before age 59.5, also pay 10% in penalties. But according to the report, many still do it while employers do little to prevent it.

"Shockingly, 41.4% of employees cashed out 401(k) savings on the way out the door," the report said. "Equally surprising was that 85% of those who did cash out drained the entire balance."

Treating Savings Like 'House Money'

The report said that problems arise both due to bureaucracy and psychology. Employers delegate all communication when an employee leaves to financial services firms who administer their plans, such like Fidelity, Vanguard, TIAA, or Alight.

"These plans send anodyne form letters to employees with facts about what their options are, but not advice," the report said. "In addition, the form letter, by law, allows employers to give less attractive options to exiting employees if they have lower balances."

The form letters give employees the option to cash out far more front-of-mind than it was during years of employment. They turn psychologically illiquid retirement savings into a source of ready cash.

When exiting employees are nudged to consider the option to cash out, the report said, "it becomes quite appealing to spend what had previously been seen as an untouchable source of retirement security."

"No wonder so many more cash out when changing jobs than when working," the authors write.

The report said that if a larger part of the balance came from the employer, people are more likely to treat their savings as "house money" or "free money" when prompted at job change to consider the option to cash out.

Pay Attention to Departing Employees

"The lesson from our findings is not that employers should contribute less in employer matches," the report reads. "The lesson is that a socially responsible employer should pay attention to employees when they are leaving the firm, too."

The new Secure 2.0 Act that became law in December 2022 allows employees to automatically allocate up to $2,500 per year to pay for emergency expenditures without raiding their retirement fund.

"When onboarding new employees and explaining retirement benefits, employers could encourage use of these accounts and forewarn new employees of the danger cashing out at the point they later change jobs," the report said.

If industry does not solve this problem of retirement savings being drained at job change, the report said, governments might need to step in to create new systems.

"We think the more likely scenario is that businesses solve the problem, with employers working with financial services firms to make small changes with dramatic potential to change employee retirement readiness," the report said.