It's something many people do and something you might be considering, too -- cashing in a retirement plan before you retire. Think twice before you do so, though, as it's often a mistake.
The classic example of this mistake happens when a worker leaves a job in which he or she has accumulated funds in a 401(k) account, but cashes in the money instead of rolling it over into a 401(k) account at a new employer or into an IRA. Here's how common this is: According to recent data from Fidelity Investments, which administers many companies' 401(k) plans, fully 35% of those plans' participants cashed out their accounts last year when leaving their jobs.
Why you might do it
Why are so many people cashing in their retirement plans? Well, for many reasons. The appeal of suddenly having a pile of money to spend or save or perhaps use to pay down debt is easy to understand. And if you don't understand why cashing in a poor choice, then it can seem like a no-brainer.
Why you shouldn't
The problem, though, is that these are retirement accounts, not windfall accumulation accounts. They're meant to help you sock away a growing pile of money for when you'll really need it later in life. This is even more crucial these days, now that corporate pensions have become so rare. More and more, individuals carry much of the responsibility for saving money to live on in retirement.
When you cash in a retirement plan, several bad things happen. For starters, you'll likely be socked with a 10% early withdrawal penalty, and will also face taxes on the money, if it was contributed on a pre-tax basis. (You might avoid penalties if you're withdrawing for one of a few qualified reasons, such as to buy your first home, for certain medical expenses, or for certain college expenses -- but be sure to read all the rules related to those withdrawals first.)
Next, the money you cash in will stop working for you in the retirement account. It will stop growing. Let's imagine you cash in an account holding $20,000. If it remained in your account for another 25 years and grew by the stock market's annual average growth rate of about 10%, it would amount to almost $217,000! That's a lot of money to forfeit, especially if you're cashing in just to remodel a kitchen or buy a fancy car.
How to decide
A first question to ask before cashing in is how much you need the money. If you determine that you can do without it, then don't cash it in. Instead, roll it over into an IRA or another employer-based retirement plan. If you're young and assume you'll have time to accumulate more money later, think again. Your earliest saved-and-invested dollars are your most powerful ones, as they'll have the longest to grow.
If you'd still like to cash it in, think harder. The main way to decide is to assess your expected cash inflows and outflows in retirement and whether you're on track to make ends meet once you stop working. Don't just assume you'll rely on Social Security and will be OK. After all, the average Social Security benefit was about $1,328 per month as of January 2015, which is only roughly $15,900 annually.
As you consider your financial condition and preparedness for retirement, be conservative. Aim to save at least a little more than you think you'll need, because life is full of surprises, and not all of them are good. You might, for example, lose your job a few years before you meant to retire, or you might have to spend a lot to help out a child. The folks at Fidelity also remind us that we need to sock away a lot for medical expenses in retirement, estimating that a 65-year-old couple will spend about $220,000, on average, on healthcare costs in retirement. That's just an average, too, meaning many will spend less and many will spend more.
A final consideration are your alternatives. A steep credit card borrowing limit is not a good one, as you'll likely be charged sky-high interest rates. But perhaps you can take out a home equity loan at a reasonable rate.
Cashing in a retirement plan can seem like a harmless and rewarding idea, but it can actually endanger your retirement.
Longtime Fool specialistSelena Maranjian, whom you can follow on Twitter, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.