Dave Ramsey Says This Is The 'Worst Thing You Can Do With Your Old 401(k)'

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KEY POINTS

  • Many people have a 401(k) at work.
  • When you leave your job, you'll have to decide what to do with it.
  • Dave Ramsey said you definitely shouldn't cash out your 401(k).


If you do this with your old 401(k), you could regret it.

Workplace 401(k)s are popular retirement savings accounts. These investment accounts are easy to put money into because contributions can be taken directly out of your paycheck. You also get to contribute with pre-tax money, and there's a good chance your employer will match part of your contributions.

There is one issue with using a 401(k), though. When you leave your job, you'll have to decide what to do about the account. And you have many different options -- some of which are better than others.

There's one option, though, that finance expert Dave Ramsey said you absolutely should avoid. Here's what it is.

Don't do this with your old 401(k), Dave Ramsey warns

The one thing you absolutely don't want to do with your retirement account when you leave your job is to cash it out, according to Ramsey,

"This is the worst thing you can do with your old 401(k)," Ramsey said. "If you withdraw the money from your 401(k) plan and take a direct cash distribution, you’ll have to pay any state and federal income taxes you owe on every last penny. And if you’re under 59 1/2 years old, you can go ahead and add another 10% early withdrawal penalty to your tab."

These taxes and penalties are imposed because 401(k) accounts come with special rules. While you get to make pre-tax contributions, you have to pay taxes on withdrawals. If you wait until retirement to take the money out, you may be in a lower tax bracket, so that won't be as big of a financial hit. But if you withdraw the money when you change jobs, you could end up losing a lot of it to the IRS -- and potentially pushing yourself into a higher tax bracket on your other income, too.

As for the 10% penalty, that's another special rule that applies since these accounts are tax-advantaged specifically to encourage you to save for your future. If you take the money out early, the IRS takes a bigger cut.

While losing all this money to taxes sounds bad -- and indeed is one reason not to cash out your 401(k) -- this isn't even the biggest reason why Ramsey advises not taking this approach to dealing with your retirement plan.

"The worst part is you’re robbing yourself of the chance to continue earning tax-free or tax-deferred growth on your investments for years, maybe decades. It’s just a bad idea all around, folks," Ramsey said.

What should you do instead?

So if you shouldn't cash out your 401(k), what should you do with it?

Ramsey explains several other options, including leaving it where it is or moving the money into your new employer's 401(k). However, he said the best plan is to roll over the retirement money into an IRA you open yourself with a brokerage firm of your choosing.

"That’s because an IRA gives you the most control over your investments," Ramsey said. "An IRA gives you potentially thousands of mutual funds to choose from. You can pick from the best of the best instead of just a few so-so options. You can work with an investment professional who can walk you through the rollover and help you manage your investments for the long haul -- no matter where your career takes you."

Ramsey is absolutely right about this. In fact, when you rollover your 401(k) money into an IRA, you can invest in just about any asset you want, including individual stocks. The added flexibility means you have much more control over building your portfolio and investing for a secure future.

So, if you've left a job recently, consider rolling over your 401(k) into an IRA -- and, whatever you do, avoid making the crucial mistake of cashing out your account and taking a big hit.

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