With all of the concern over the credit crisis, the bailout package, and the troubles facing corporate America in general, let's not forget the troubles now facing the average working American:

  • A recession that may last through 2009.
  • Rising inflation.
  • A stock portfolio piling up huge losses.
  • Stagnant or declining home values.
  • The cancellation of that Christian Slater show a few months back.

I hate to be a downer
That's a not-exactly rosy picture. Belts are tightening in households across the country, and for good reason: This is a downturn without much precedent. I don't believe there's a question of whether we'll bounce back from this, but there's no clear answer on when that'll be.

But there's one thing you should absolutely avoid, if at all possible. It's a decision that will save you tens of thousands of dollars and allow you to retire earlier. Please, if you are debt-free and have emergency money set aside, don't cash out your 401(k).

Seem obvious? Think again. A 2005 survey from Hewitt Associates showed that almost half of employees took a cash distribution of their 401(k) plan when leaving a company. Not because they needed the cash for a new roof or medical care, but simply because they were switching jobs! And these aren't recent college grads with less than one month's rent in the account -- 42% of those who cashed out were ages 40 to 49!

The not-so-golden years
According to the U.S. Department of Labor, the average American will have 10 jobs between ages 18 and 38. When leaving one job for another, you have the choice to cash out your 401(k), keep your account with the old employer, or roll it over to the new employer or into an IRA.

Unfortunately, too many folks are shooting their retirement in the proverbial foot. Taking the road that may seem to offer less paperwork will end up costing you big time in the end. In fact, Motley Fool Rule Your Retirement advisor Robert Brokamp has said that cashing out your 401(k) is among the worst possible financial moves you can make, for many reasons:

  1. Investors face an automatic 10% early withdrawal penalty if they are younger than 59 1/2.
  2. Because of IRS rules, employers have to hold back 20% of your account balance for taxes.
  3. Retirement accounts are protected in the event that your company (or you) declared bankruptcy.
  4. Most importantly, even if your account balance is relatively small, you're cheating yourself out of years of compounding interest. According to the U.S. Department of Labor, workers will have to save three times as much per month for every 10 years they delay.


This is an especially bad move now
Cashing out is extremely tempting -- especially if you've seen the value of your portfolio decline in recent months. But point No. 4 above is a major reason why you should be looking to add to your 401(k)s right now.

That's right, adding to. I know things have been brutal for the past year, but it's a fantastic time to be a net buyer of stocks or funds right now. Warren Buffett has said as much (in a New York Times op-ed last fall), and his holding company has been putting cash to use by taking stakes in Eaton (NYSE:ETN), NRG Energy (NYSE:NRG), and Nalco Holding (NYSE:NLC).

This is a buyer's market. Many institutional investors have to sell, and in the process, they're driving some great businesses down to prices that may well fall below their intrinsic value. The beauty of the 401(k) is that it allows you to dollar-cost average into great funds such as Bridgeway Large Cap Growth (BRLGX). This fund had a tough year in 2008, but manager John Montgomery is one of the best in the business. His fund currently owns a few solid but hard-hit businesses, including AT&T (NYSE:T) and Mosaic (NYSE:MOS). Less beaten-down blue chips Hewlett Packard (NYSE:HPQ) and Johnson & Johnson (NYSE:JNJ) are also top 25 holdings.

These are sound businesses built for the long run. By sticking them in your retirement plan -- and allowing dollar-cost averaging to limit your itch to try to time the market -- you'll be getting a heck of a lot more shares of these great businesses, which you can allow to compound for years to come.

On the road to retirement
Of course, my long-term bullishness in no way disregards the seriousness of the current economic climate. But unless you're in debt or have cash emergencies right now, cashing out your 401(k) will likely be a terrible impediment to a happy retirement.

Never forget the rules of investing, as set forth by Foolish retirement expert Robert Brokamp:

  • If you need the money in the next year, it should be in cash.
  • If you need the money in the next one to five (or even seven) years, choose safe, income-producing investments such as Treasuries, CDs, or bonds.
  • Any money you don't need for more than seven years is a candidate for the stock market. 

Live by these rules, and you'll thank yourself down the road.

Advice from the pros
Need help making educated decisions about your retirement -- and staying disciplined throughout market turmoil? Robert and the Rule Your Retirement service may be able to help. For model portfolios, expense planning, and estate and tax tips, check it out free of charge for 30 days. We offer a free trial with no obligation to subscribe. Just click here for more details.

This article was originally published Nov. 18, 2008. It has been updated.

Claire Stephanic does not own shares of any company or fund mentioned. The Fool owns shares of Bridgeway Large Cap Growth, a Champion Funds recommendation. Johnson & Johnson is an Income Investor recommendation. The Fool has a disclosure policy.