Does it make sense to invest in a 401k for a short term?

Mohit left the following comment on the Suggest a Topic page recently:

Mohit Agrawal March 18, 2015 at 8:13 pm [edit]

Hi,

I would love to know your views on investing in 401(k) in USA if a NRI plans to remain in USA short term like 5-7 years. Is it still worth it?
Because the tax you save and employee matching comes down to around 40% benefit. But when you cash out your 401k account when you leave for India you have to pay tax on that amount in USA at around 30% and then 10% is penalty. Is is really worth the hassle to invest in 401(k) in USA? or should I be investing that money in India

First, let’s take a look at what happens when you prematurely withdraw money from your 401k

  1. Negative: You pay 10% of the withdrawal money as penalties because this is a retirement account, and you are supposed to keep money in it till retirement.
  2. Neutral: Pay taxes that you had saved in previous years on the money withdrawn at the time of withdrawal because you didn’t keep your money for as long as you said you would.
  3. Positive: You keep the employer match to your 401k intact as long as there were no vesting rules that were flouted, so this is free money that you still got to keep.

If you think of these three factors, you can look at your own situation, do a rough calculation of how much free money you are getting, how much you will pay in penalty, and then treat the penalty as simply reduction of the free money you get from your employer’s match. In most situations, I would imagine that the employer match will take care of your penalty, so from a numerical standpoint it will┬ámake sense to invest in a 401k for even if it is for a short term like five or six years.

Now, the next thing to consider is whether this employer match is a big enough sum that you couldn’t accumulate while investing in India for four or five years, and that’s a tricky question. I believe that the match will still edge out the high interest rates in India, but perhaps not the high equity returns.

The last thing to consider is that when you are withdrawing the money, you will effectively have to pay around half of it in taxes and penalties, and based on your salary, 401k contribution and employer’s match, the money that you get at the end may not be worth the little hassle you go through during the five or six years for investing it.

So, I think whether you invest or not is based on your situation, and how comfortable you are with the idea of a penalty, and paying a big sum as taxes at the end as opposed to extracting whatever benefit you can from this investment.