Many Americans make this financial mistake when switching jobs — here's how to avoid it

A shocking number of Americans make the same mistake when they switch jobs — and it's putting their financial futures at risk.

Just over 2-in-5 (41.4%) of employees are choosing to cash out their defined contribution 401(k) plans early, according to a study from the UBC Sauder School of Business.

While this type of account is a go-to retirement savings tool for millions of Americans, the researchers who wrote the UBC Sauder study believe the challenging exchanges around job changes are what's driving workers to dip into these critical funds from their 401(k)s.

But Moneywise has found that cashing out your 401(k) early — whether because you're changing employers or desperately need the funds — is something personal finance experts consider one of the worst financial fumbles. Here's why it gets the experts so heated — and what you should be doing instead.

What's at stake if you cash out your 401(k) early?

The UBC study used a data set of 162,360 terminated employee contribution records from 28 employers and 28 retirement plans.

Of the 41.4% of workers who withdrew their retirement savings, about 85% drained their account completely — with 64% taking a one-time total cashout, and 21% depleting their 401(k) balances in two or more withdrawals within eight months.

Cashing out your 401(k) early is problematic for multiple reasons: you'll have to pay taxes and penalties, you'll lose out on the benefits of compound interest, and ultimately, you may not save enough money to retire.

It also creates a larger systemic issue, says UBC Sauder Associate Professor Yanwen Wang. That's because 401(k) contributions from the currently employed are used to fund the withdrawals of retired workers. When those funds "leak" out of the system, it jeopardizes everyone's retirement security.

To discourage people from cashing out before the legal age of 59.5 years old, the Internal Revenue Service (IRS) imposes a 10% penalty for what they call "pre-retirement leakage."

The three main sources of leakage are: defaults on loans from retirement accounts; hardship and non-hardship withdrawals during active employment; and cash distribution upon job termination.

Before the COVID-19 pandemic, only about a third of 401(k) leakage was due to emergencies, according to Retirement ClearingHouse. Most people cashed out due to "friction" in the 401(k) rollover procedure and a lack of education.

But during the pandemic, when many Americans lost their jobs, the CARES Act temporarily waived penalties for leakage up to $100,000 — but the expected wave of withdrawals never came. In fact, financial well-being and retirement plan participation actually increased during the pandemic due to government assistance and decreased spending.

Why are Americans withdrawing their retirement funds?

So if it's not a matter of need, what's driving the leakage now? The experts behind the study suggest that when people quit their jobs, the money in their 401(k) transforms from a "perceptually illiquid source of long-term retirement security into a psychologically liquid pile of cash."

In other words, your hard-earned retirement savings turn into a tempting windfall fund that's easy to spend — especially if you're currently job hunting and without a source of stable income.

The study shows that this mentality often shines through when employers offer generous 401(k) matching programs, helping employees to substantially grow their retirement funds.

"For example, if the employer does a one-to-two match, where for every $1 you contribute your employer will match $2, it can change the psychological sense of ownership of those 401(k) accounts," says Wang, who co-authored the study with Muxin Zhai of Texas State University and John G. Lynch, Jr. of the University of Colorado.

"So instead of your own saved money, it's like a windfall. And then it feels more touchable, and more legitimate to spend it when you change jobs."

What should you do instead of cashing out?

The average worker will have 12.4 jobs in a career, according to the Bureau of Labor Statistics, but that doesn't mean you have to cash out your 401(k) every time you make a move. You can keep the money in your employer's plan, or you can transfer your assets to your new employer's plan.

Alternatively, you can roll your balance to an Individual Retirement Account (IRA) where you can continue growing your retirement savings tax-free until you make withdrawals in retirement.

IRAs are playing an increasingly important role in helping Americans save for retirement, especially as workers now change jobs more frequently over their careers.

More than four in 10 U.S. households owned IRAs in mid-2022, according to an ICI study. With $11.7 trillion in assets, IRAs represented 34% of U.S. total retirement market assets, compared with 24% two decades ago and 18% three decades ago.

However, Americans still need more education on the benefits of 401(k) rollovers and the consequences of cashing out, according to Wang.

"If there is no assistance for quitting employees, there's an unintended nudging for people to take the money out, especially if there is a large match," says Wang.

"Something has to be done — not to control people's 401(k)s, but to provide enough knowledge so they're aware of the consequences of their actions."

This story was produced by Moneywise and reviewed and distributed by Stacker Media.