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How Small Cashouts Can Affect Future Retirement Income

Industry Trends and Research

Due to the power of compound interest, seemingly small amounts that leak from retirement accounts when people change jobs can lead to major erosion of retirement balances, a recent study explains. 

In pointing to the “butterfly effect” and how “little things may have great consequences and mistakes often cannot be undone,” the paper by Alight Solutions examines what people do with their 401(k) balances when they leave an employer, the demographics of people who roll balances to their new employers, and what impact small amounts of plan leakage can have on future retirement income. 

Citing earlier research, Alight notes that 4 out of every 10 people cashed out their balances after termination within a 10-year period. And in what may come as no surprise, the group most likely to cash out are those with the smallest balances. In fact, 80% of people who had an account of less than $1,000 cashed out, while nearly two-thirds of those with balances between $1,000 and $5,000 cashed out.

What’s more, the dollars rolled into IRAs outnumber those going into new employer plans by a factor of about 10 to 1, Alight notes. Among people with balances less than $1,000 at termination, only 1.7% rolled money into their new employer’s plan. And among those with balances between $1,000 and $4,999, only 3.9% initiated a plan-to-plan rollover.

Regarding the 2.5 million actively employed participants on its recordkeeping platform, Alight found that only 7% have money in their account that was rolled in from a prior employer’s plan. 

In addition to balance size, age has an impact on roll-in behavior. Alight’s data shows that workers in their 20s are least likely to roll in money, followed closely by those who are in their 60s. In contrast, workers in their 30s were most likely to roll in balances.

The Consequences

To illustrate the impact of what seemingly small cashouts can have on future retirement income, Alight projected the retirement accounts for a new-to-the-workforce employee. 

In the first example, Alight assumes no leakage from cashouts, which produces a projected balance at age 67 of almost $500,000. In the following cashout examples, Alight shows that taking one early cashout can have damaging consequences, while taking three small post-termination cashouts can lead to a nearly 20% reduction in a projected age 67 balance: 

  • one cashout at age 24 of $3,000 can lead to a $23,000 (5%) loss in projected age-67 balance (roughly half a year of additional working wages);
  • an additional cashout at age 26 of $4,500 leads to a $56,000 (12%) overall loss in projected age-67 balance (roughly one year of additional working wages); and
  • a third cashout at age 28 of $5,000 leads to a $91,000 (19%) overall loss in projected age-67 balance (roughly 1.5 years of additional working wages)

As if these numbers weren’t bad enough, Alight offers a caveat that these numbers may paint an “overly optimistic” picture of the situation for two reasons. First, Alight notes, these projections assumed a modest net-of-fees return of 5% per year. In contrast, the firm’s 2020 Universe Benchmarks shows that for the decade of the 2010s, the median return earned by participants was almost twice that, leading to an even more profound impact. Even assuming the person earned 7% each year, Alight notes that the impact of the three cashouts would be almost $200,000 or a 25% reduction in projected retirement income.

Second, the amounts shown for the cashouts do not reflect the impact of any taxes or withholding. In general, taxes on 401(k) balances are treated as income and would incur federal and state taxes. Moreover, people who take money out pre-retirement are also charged a 10% penalty tax in most cases. “So, if anything, the amounts shown for the cashouts in the projection can be viewed as an overstatement of the money the person would receive,” Alight warns.  

Of course, one reason for the high prevalence of small-amount cashouts is that most plans automatically cash out terminated employees with vested balances under $1,000. Nearly 60% of companies will also force out participants with balances between $1,000 and $5,000, but legal rules require the amounts to be distributed to IRAs instead of cash to the individual, the study notes. 

“Fortunately, there are emerging tools that can make it just as easy for participants to have their retirement accounts follow them from employer to employer,” Alight further emphasizes, in highlighting the emergence of auto-portability programs, such as one offered by the Retirement Clearinghouse.