A new study by the consulting firm of Hewitt Associates shows the disturbing trend that most Americans who are entitled to take money from a 401(k) plan with them when they leave a job are cashing out the plan rather than reinvesting the money in another retirement fund.
Sixty-eight percent of workers aged 20 to 59 who received distributions from 401(k) plans last year chose to take the money and pay the tax consequences. The percentage was higher in the lowest age bracket -- 78 percent of workers aged 20 to 29 took the cash as compared to 60 percent in the 50 to 59 year old bracket.
A worker leaving a job with a 401(k) has the option of taking the cash from the account or rolling over the account into an IRA or another 401(k) with a new employer. If the worker takes the cash, even if he plans to ultimately place the money in a retirement fund, the IRS requires that the employer withhold 20 percent for federal income tax. This withholding represents about half of the tax that may actually be owed on the money, when you figure in the 10% penalty that applies to early withdrawals from tax-deferred retirement accounts.
Alternatively, if the worker requests that the former employer send the money directly to another retirement fund, there is no withholding requirement. Very few workers, it seems, are requesting this option, and are instead either willing to take the tax hit to get their hands on the money, or are uneducated about the consequences of taking the cash.