Ever cash out your 401(k) when changing jobs?
I did, after leaving my very first post-college job. I was 26, and after all the various taxes and penalties, I was left with about $2,000 -- just enough for a guitar I wanted.
I still have the guitar, though I don't play it much anymore. And I deliberately haven't sat down to figure out how much money I'd have now, 14 years later, if I'd rolled the balance into an S&P 500 index fund in an IRA and let it grow instead.
But I'm sure it would be a lot -- enough that I should regret blowing my first-ever retirement nest egg. I can take a little comfort from knowing that I'm in good company. Studies have shown that about 45% of workers withdraw their money from their 401(k) when they change jobs. But that doesn't make me feel much better. While plenty of those people are twentysomethings with small balances, like I was, a Hewitt Associates survey done in 2005 found that 42% of workers in their forties cash out when they leave a company.
It turns out that many of those folks have balances of less than $20,000, perhaps because they've been cashing out their past 401(k) balances as they've changed jobs throughout their careers. In the context of a 15-plus-year retirement, $20,000 might seem like small potatoes -- especially if it'll buy you that bright, shiny new zillion-inch plasma TV right now instead.
But ... you know what I'm going to say, right?
Not a good plan
Cashing out a 401(k) is almost never a good plan, zillion-inch TVs notwithstanding. Take that fortysomething person who cashed out a $20,000 balance. If they'd left that money in an S&P 500 index fund that returned an average of 10% a year, and just waited 20 years without adding another penny, they'd have $134,550. If they contribute $6,000 a year between now and then, the 20-year total is $512,565. Suddenly it's looking like real money, isn't it? Get that annual contribution up to $10,000, and the total after 20 years is more than $760,000.
Picture yourself at age 65, thinking about retirement. Would you rather have $760,000 in investments ... or a 20-year-old TV?
But wait, there's more
That 10% average return is a no-brainer. It's the historical return from the S&P 500, the return anyone can get via an index fund. If you skip cashing out and roll that money into a Rollover IRA instead, you only need to make one investment decision to carry you up until three or four years before retirement in order to get that return.
Of course, with just a little bit of work, you can give yourself a great chance of exceeding that number. Take that $20,000, add $10,000 a year, and invest it in a well-run actively managed stock fund instead, and you could come out even farther ahead. Take Fidelity Capital Appreciation Fund, a longtime large-cap-growth stalwart. Here's a fund that has returned an average of 19.07% over the last five years, powered by big positions in stocks like agriculture technology giant Monsanto
Doesn't 19% sure beat 10%? But that's a little deceiving because the S&P 500's returns over that same five-year period are closer to 14%. But let's say, just as an example, that the fund can average 15% over 20 years and plug that into our earlier example.
To review: You're fortysomething, you've got $20,000 in your 401(k), and instead of cashing it out and buying a big TV, you decide to roll it into an IRA. You get serious about this retirement thing, managing to invest $10,000 a year for the next 20 years. With 15% returns, you're looking at just more than $1.5 million at the 20-year mark.
Hmm -- $1.5 million or a TV?
See my point?
Making it even easier
I hear you asking, "But how would I know how to invest that money?" Good question -- and this isn't the first time I've heard it. I've talked to lots of retirement investors over the years, and I suspect that most people who cash out do so in part because they feel clueless -- and powerless -- when it comes to managing their retirement portfolio.
Happily, this stuff isn't that hard -- if you approach it the right way. You don't have to be a hedge-fund whiz to make smart decisions with your retirement portfolio.
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Fool contributor John Rosevear wouldn't dream of paying a million bucks for a TV, unless he could watch future stock market returns on it. He doesn't own any of the stocks mentioned in this article. Biogen Idec is a Stock Advisor recommendation. Fidelity Capital Appreciation is a Champion Funds recommendation. The Motley Fool has a 60-inch DLP 1080p disclosure policy with three HDMI inputs.