Raiding Your 401(k): the Consequences of Cashing Out

A whopping 40 percent of workers between the ages of 20 and 40 cash out of their retirement plan when they switch jobs, according to a recent Fidelity survey. Raiding your 401(k) piggy bank can be tempting—what with the shaky economy and the shrinking value of investments—but the consequences are steep.

Fidelity came up with this calculation: A person in the 25 percent federal tax bracket who makes a $50,000 withdrawal before age 59½ will pay federal taxes of $12,500 on that money. Assuming a hypothetical 7 percent state tax, that's an additional $3,500. Then, there's a 10 percent early withdrawal penalty ($5,000 in this case). So, after taxes and penalties, that $50,000 in retirement savings becomes $29,000.

If that's not motivation enough to keep your retirement money in play, consider the long-term compounding you'll be missing out on. Assuming a 7 percent annual rate of return, just $5,000 invested today would be worth $53,000 after 35 years of tax-free compounding growth, says John Ragnoni, senior vice president of Fidelity's retirement services business. "The cash distribution is really the worst thing a young saver can do," he says. (You can calculate the growth of your own 401(k) savings here.)

Better options when switching jobs include rolling your retirement savings into an IRA. Not only will you avoid paying taxes, but you're likely to have a broader menu of investment options. (Look for a brokerage that doesn't charge rollover fees.) You could also leave your 401(k) at your old employer or roll the money into your new employer's 401(k). A calculator on Fidelity's website helps you compare the pros and cons of each option.

Why do people dip into their retirement savings early? According to a recent survey, common reasons include a down payment for a house, job loss, education expenses, mortgage payments, and—this is appalling—paying for an event, such as a wedding.