Q: I know that cashing out a retirement account isn't a great choice, but does it ever make sense? Say, if I have a lot of high-interest credit card debt or if I have no other way to pay bills?
The short answer is no. Unfortunately, more than one-third of Americans end up cashing out their 401(k) after leaving a job.
Generally speaking, cashing out a 401(k) should be seen as a last resort. Any of the other options for an old 401(k) are preferable to cashing out.
Think of it this way. Let's say that you have $20,000 in a 401(k) from your former employer. Cashing out will trigger a 10% penalty from the IRS if you're under 59 1/2 years old, plus you'll have to pay income taxes on the withdrawal. Let's assume that you're in the 22% marginal tax bracket for federal income taxes and 5% for your state. All of a sudden, your $20,000 becomes just $12,600.
So even if you have high-interest credit card debt, it's probably a bad idea to cash out. You're taking a 37% haircut on your savings just to pay it off. That's tough to justify, no matter how high your credit card's interest rate is.
Even worse is what would happen to that $20,000 if left alone. If you're 35 now, leaving it alone until you're 65 would result in more than $152,000, assuming 7% annualized returns. The choice between $12,600 now or more than 12 times that amount when you retire seems like a no-brainer to me.
Having said all of that, a gray area arises if you're having serious financial hardship. For example, if your mortgage is overdue and you have no other way to pay it. Or, let's say you lose your job and can't cover necessary living expenses. In situations like these, it can make sense to consider cashing out, but only if you've exhausted every other reasonable option.