With the enactment of the Revenue Act of 1978 the modern day 401(k) retirement plan was born. After a modest beginning, employer sponsored retirement plans have become a major factor in how we save. So much so that, for many Americans, the employer sponsored 401(k) plan is the only place they are saving for retirement. In many cases there is an incentive – an employer match or a profit share contribution – for the employee to continue to save in this fashion.
And it’s a good thing. With only 14% of workers covered by a defined benefit plan (pension), the vast majority of us will have to survive on a combination of Social Security and 401(k) savings after our years of working have passed.
Making matters worse, some people do not prioritize their retirement savings, eventually utilizing their 401k balances for purposes other than retirement. This comes in two forms – the early withdrawal/cash out and plan loans. According to a report from Transamerica Center for Retirement Studies:
“’Leakage’ from retirement plans in the form of loans and withdrawals severely inhibit the growth of workers’ long-term retirement savings. Among workers who are currently participating in a plan, 23 percent have taken some form of loan and/or early withdrawal from a 401(k) or similar plan or IRA …” (The Retirement Readiness of Three Unique Generations: Baby Boomers, Generation X, and Millennials, Transamerica Center for Retirement Studies, page 12)
Taking a loan is less damaging than cashing out some or all of your 401(k) balance, assuming you pay the loan back. The IRS has set broad guidelines for plan sponsors, allowing each employer flexibility on how their plan handles (or even allows) loans on vested balances. On the positive side you will be required to repay your account at a pre-determined interest rate, allowing you to “earn” for your retirement account. On the negative side you may not save in the 401(k) plan again until the loan is repaid.
When you cash out some or all of your 401(k) plan you have both immediate costs and long-term consequences. The immediate expense is the taxes due and the 10% penalty for early distribution (assuming you are younger than 59 ½ years of age). The long-term consequences would be the loss of principal and the future cash flow these assets would produce. At Magellan Financial we think this is a large price to pay.
What are the costs of cashing out some or all of your 401(k) plan?
A $16,000 cash-out would net $11,200 after about $3,200 in taxes and $1,600 in tax penalties (Bloomberg)
A 30-year old who cashes out $16,000 could lose an income cash flow of $471 per month by leaving it invested in a retirement account (assuming retirement at age 67, a 4.7% return and a 401k balance of $87,500 at retirement) (Bloomberg)
What can you do to avoid the high cost of pre-mature distributions from your 401(k)?
When you leave a job for a new employment opportunity, instead of cashing out your savings, roll your balance into either a Traditional IRA or your new employer’s retirement plan
Set up dedicated, non-retirement accounts for college savings and other big-ticket expenses, like the purchase of a car or a down payment on a house
If you have a short-term cash crunch, using your dedicated retirement savings should be your last option. Use money from other savings or a home equity line of credit. If your only choice is to use 401(k) balances, a loan is often times the better option
With the majority of Americans not covered by a defined benefit (pension) plan, saving for retirement is more important than ever. The 401(k) is both a very effective tool for retirement savings and incredibly popular. There are, however, financial obligations beyond saving for retirement, and retirement investments should be complimented by other savings. By planning for non-retirement expenses you can be prepared for the expected as well as the unexpected without the additional expenses associated with early distributions from 401(k) savings.
For more information on your savings options, Magellan Financial can be contacted via email or by calling 610-437-5650.
Other Resources:
The Retirement Readiness of Three Unique Generations: Baby Boomers, Generation X, and Millennials from Transamerica Center for Retirement Studies
History of 401(k) Plans from Employee Benefit Research Institute
A Timeline of the Evolution of Retirement in the United States from Georgetown University Law Center
Wells Fargo Advisors Financial Network/Magellan Financial, Inc. and its financial advisors provide non-fiduciary services only. They do not provide investment advice [as defined under the Employee Retirement Income Security Act of 1974 as amended (“ERISA”)], have any discretionary authority with respect to the plan, make any investment or other decisions on behalf of the plan, or otherwise take any action that would make them fiduciaries to the plan under ERISA.“