Tax breaks. Matching contributions. It's one of those deals you can't pass up. The 401(k) and similar retirement plans offer several benefits to encourage people to save for their golden years. No wonder they're so popular.
But surprisingly, more and more Americans are letting those benefits slip through their fingers.
To begin with, a small but rising share of eligible workers are not participating in the plans. And many of those who do invest are "cashing out" when they leave their employer, according to a recent study. This despite heavy tax penalties that can cut their investment by nearly half.
Those are the kinds of moves that can send financial planners through the roof.
"People view saving for retirement as something they can do later," says Nevin Adams, editor in chief of Plansponsor.com, a retirement-industry trade publication. "They think they have time to start saving for retirement."
In fact, delay complicates saving (because money has less time to grow), planners say. Worse, workers who don't enroll in retirement plans are turning down free money.
Nevertheless, because of economic hardship or various other reasons, a growing number of Americans are opting out of retirement savings. Currently, about 73 percent of eligible employees are enrolled in 401(k) and similar retirement plans, Plansponsor.com found. That's down 3.6 percentage points from last year, which also experienced a 2.5 percentage point decline from the year before.
Meanwhile, an analysis of 160,000 employees found that 42 percent of them took their 401(k) balances in cash when they changed jobs, instead of rolling this money into IRAs or transferring the assets to their new employers' plans, according to Hewitt Associates, a benefits consulting firm based in Lincolnshire, Ill. While workers of all ages took distributions in cash from their 401(k)s, the highest incidence was among workers age 20 to 29. Half of these people cashed out their plans, the Hewitt study found. Even many of those with more to lose in terms of taxes and penalties failed to maintain the tax deferral of their 401(k)s: One-third of workers age 50 to 59 cashed out.
Workers did this despite multiple tax penalties. Premature withdrawals from 401(k)s are subject to federal income tax, a 10 percent early-withdrawal penalty, and any state tax. These taxes and penalties can cut the money left in the account by almost half.
For example, a $5,000 balance could grow to more than $38,000 in 30 years, assuming a 7 percent growth rate. But if the $5,000 is taken in cash, a person would receive only $2,850 after taxes, assuming a 28 percent federal tax, a 10 percent early-withdrawal penalty, and a 5 percent state tax.
Reasons for these trends vary, experts say. Cashing out a 401(k) may be the only option for people who have lost jobs and need the money to live on, Mr. Adams says. Even people with jobs may not feel secure about their employment and opt to keep cash in taxable accounts. But most of the time, people do not participate in 401(k)s because they have more immediate goals or desires, he adds.
Confusion plays a role too.
"Many clients I deal with have a lot of difficulty understanding the mutual-fund options" in materials their employers give them, says Karen Folk, a certified financial planner in Urbana, Ill. "They might have 30 mutual funds to choose from and little guidance as to what to do. So they don't do anything."
In situations like this, Ms. Folk says, she helps clients compare the funds' expense ratios, while comparing the performance of the funds being offered with funds with similar objectives. Those two steps alone, she says, can cut the options to a more manageable number, which makes it easier to choose the funds that meet the clients' goals and risk tolerances.
In the midst of a poor economy, some companies have reduced their workers' incentive to participate by cutting the "match" they contribute to the employee's 401(k). But the vast majority has continued to match employee contributions, Adams says. "This would be a very good time for companies to go to their workers and explain what's going on with matches and fund offerings."
He also urges employers to talk to workers about what the much-publicized mutual-fund trading and market-timing scandals mean - or don't mean - to their retirement plans.
Several companies, for example, are in the process of removing from their 401(k) plans some of the more prominent mutual-fund companies involved in these abuses, he says.
While many mutual-fund companies and other plan providers do a good job of educating participants about the long-term benefits of 401(k)s - as well as the consequences of not participating or cashing out early - others do not, Adams contends. Employers surveyed by the firm gave the lowest marks to plan providers' education efforts, including the quality of printed materials and call centers, he says.
Finally, many workers, particularly younger ones, change jobs frequently. These people may not stay in a job long enough to build up substantial balances in their retirement plans, says Reginald Bowser, president of RolloverSystems Inc., a service that matches 401(k) participants with a network of financial institutions offering rollover IRA products.
When they leave a job, these workers may feel their balances are too small to keep in the old company's plan, so they take the cash. Or, they leave the money where it is, which means they may have 401(k) accounts at several places.
Rolling over these accounts into one IRA can make them easier to manage. "With each job change, people don't look at the 401(k) as part of a long-term nest egg," Mr. Bowser notes. "They should."