Increased Cashouts at Job Separation Highlight Need for Auto-Portability

When switching or leaving jobs, many employees are cashing out their 401(k) savings, despite warnings from financial professionals against incurring the accompanying 10% penalty, according to research recently published in Marketing Science and Harvard Business Journal. 

After evaluating more than 162,000 terminated employees covered by 28 different retirement plans, researchers found that 41.4% of employees cashed out their 401(k) savings at job separation, with most draining their entire accounts, the “Cashing Out Retirement Savings at Job Separation” report stated. 

The authors of the study—Yanwen Wang, Muxin Zhai and John G. Lynch Jr. —found that employers’ choices in the design of their defined-contribution plan, as well as a lack of communication, affect employees’ tendency to cash out at job separation. The authors also expressed their belief in the need for automatic portability in retirement plans to allow participants to more easily roll over account balances from one job to the next.  

Too Much Leakage 

To discourage early withdrawal, the Internal Revenue Service imposes a 10% penalty on preretirement withdrawals, and the study explained three sources of this leakage: default on loans from one’s retirement account; hardship or non-hardship withdrawals during active employment; and cash distribution upon job termination.  

The study found it was much more common for people to withdraw their 401(k) funds when they separated from a job. This is particularly concerning, given that people tend to change jobs more frequently now than in past years. For instance, a Pew Research survey estimated that 30% of American workers changed jobs in 2022 alone, higher than in 2021 when 2.3% of workers switched employers each month.  

While some employees may decide to cash out their retirement savings if they face an unexpected job loss and need the funds for day-to-day expenses, researchers found that this does not fully explain the phenomenon. Of the 41.4% of people who withdrew their funds, only 27.3% had experienced an involuntary job separation, such as a layoff or termination, and it is unlikely all of them needed emergency funds.  

Researchers concluded that the reason for draining one’s retirement account when exiting a job is partly psychological. 

As most 401(k) statements separate an employee’s contributions from an employer’s contributions, the study argues that some employees may view their own contributions as “untouchable” or illiquid, yet view their employer’s contribution as “free money” they can treat as a liquid windfall. Therefore, this mentality might cause an employee to withdraw some retirement funds when they leave a job, even though the IRS and financial professions heavily advise against it. 

The research also found that the more generous an employer’s matching rate is (such as contributing $0.75 per $1 of employee contribution, rather than $0.50), the more likely the employee is to cash out when they leave. 

“Employees with a higher employer match rate might be opportunistic and plan to leak,” the research stated. “Assume that an employee would save $X for retirement without an employer match but might save $X + $Y with a match. One might plan to generate a pool of employer ‘free’ money [to] use at job separation even after paying taxes and penalties.” 

Lack of Guidance 

Lynch, one of the authors of the study, adds that plan sponsors and recordkeepers play a role in this tendency for people to cash out retirement money when they leave their job.  

“Employers are not communicating about this as part of an exit interview process,” Lynch says. 

While participants have the option of rolling over their balance into an IRA, keeping the money in their current employer’s plan or transferring assets to a new employer’s plan, Lynch says these options are typically not explained to a participant when they are leaving a job.  

Instead, Lynch says employers typically rely on their recordkeepers to communicate this information. In the letters recordkeepers send to terminated employees, Lynch says they often outline legal options, including the option of cashing out.  

Overall, Lynch says there is a lack of guidance coming from both recordkeepers and plan sponsors. 

In addition, Lynch explains that if an employee chooses to stay in their employer’s retirement plan after they leave the company, the employer has to pay around $50 per year to keep track of the participant and continue sending paperwork. As a result, if an employee does not have a significant sum of money already accumulated in the retirement plan, the employer will likely cut the employee loose and cash out their savings. 

“The system is not at all built for people who are changing jobs,” Lynch says.  

This is why many, like Lynch, are advocating for auto-portability, which allows employers to automatically roll small-balance accounts of a terminating employee into the new employer’s plan. 

Lynch encourages more recordkeepers to join the Portability Services Network, which would enable employees with smaller balances to roll over 401(k), 401(a), 403(b) and 457 accounts to a new employer’s plans as they change jobs.  

“If the employer really cares about their employees, they should care about them when they’re on the way out the door as well,” Lynch says.  

The research, published in November 2022, examined a sample size of 162,360 employees terminating 28 retirement plans in a period from 2014 to 2016.