Whether it’s just changing jobs or a personal financial crisis, the opportunities to cash out your 401(k) plan are plentiful. The fact is, though, doing so is a big retirement planning mistake — one that could potentially railroad your entire long-term savings once you leave the workforce.
Too many Americans are cashing out their 401(k) plans before they retire. According to new data from Natixis Global Asset Management’s 2016 survey of U.S. Defined Contribution Plan Participants:
When changing jobs, 28 percent of plan participants surveyed took a lump sum distribution without saving into another plan. That percentage rose to 42 percent for Generation Y members and 32 percent of Generation X members.
[See: 11 Tips for the Sandwich Generation: Paying for College and Retirement.]
The primary reasons given by plan participants taking a withdrawal from a workplace savings plan include:
— Financial hardship (37 percent)
— Health care expenses (29 percent)
— Pay down debt (25 percent)
— Home repairs (24 percent)
— Medical emergency (23 percent)
— Home purchase (22 percent)
— College tuition (19 percent)
No matter your needs, you’re taking a sledgehammer to your retirement when you raid your 401(k) plan.
“Withdrawals can have severe consequences, as non-qualified withdrawals are taxable and are often subject to a 10 percent IRS penalty,” says David Goodsell, executive director of the Natixis Durable Portfolio Construction Research Center. “They also rob younger workers of a chance to see those assets grow over the long term. Taking a distribution can have serious consequences, as it can wipe out assets that have taken years to accumulate.”
Those aren’t the only financial penalties tied to dipping into a 401(k) plan, retirement planning experts say.
“By taking money out early, not only are you reducing your retirement nest egg in the present, but you may be paying a larger price than you realize once you factor in the opportunity cost of tax-deferred growth and possible income tax consequences,” says Anthony D. Criscuolo, a portfolio manager with Palisades Hudson Financial Group in Fort Lauderdale, Florida.
Criscuolo says a direct withdrawal from 401(k) is “nearly always” a terrible idea because of the tax consequences. “Premature withdrawals are taxed as ordinary income plus a 10 percent penalty, and are also subject to state income taxes,” he says.
[See: 13 Ways to Take the Emotions Out of Investing.]
“There are a few specific exceptions where the 10 percent penalty does not apply, including paying college expenses for you, your spouse, your children or grandchildren; paying medical expenses that are deductible on your tax return; paying for a first-time home purchase up to $10,000; and paying for the costs of a sudden disability,” Criscuolo says. “But even if you avoid the penalty, you still have to pay income tax and you miss the opportunity cost of the tax-deferred growth.”
Broken down by the numbers, the case for not taking any cash from a 401(k) grows more convincing.
Spencer Williams, chief executive officer at Retirement Clearinghouse, provides some good examples that illustrate the significant impact cashing out has on a younger worker’s retirement savings:
A 25-year-old, born in 1992 and who might cash out four times for a total of $17,622 — after 40 years could wind up with $151,354 less in retirement savings and $193,612 less in retirement income.
Or consider that a 30-year-old who cashes out a 401(k) account with a $5,000 balance today would forfeit more than $52,000 in compounded savings by age 65, assuming the account increases in value by 7 percent per year.
“In addition to hitting retirement savers in their pocketbooks during retirement, cash-outs require them to pay taxes and early withdrawal fees — a double whammy against the worker’s retirement readiness,” Williams says. “Loans from a 401(k) are often defaulted on as the worker changes jobs, effectively resulting in a cash-out and triggering the same adverse results.”
Cash-outs represent 89 percent of total retirement plan “leakage,” he says, with loan defaults and hardship withdrawals making up the remainder, according to a U.S. General Accounting Office report.
If you really need quick access to cash, there are alternatives.
“Most retirement experts will tell you that you can borrow for pre-retirement goals and expenses, but you can’t borrow for retirement,” Williams says. “For quick access to money, having a standing home equity line of credit may be the best option, given the tax deductibility of the loan (subject to certain limits).”
[See: 10 Ways to Avoid the IRA Early Withdrawal Penalty.]
Williams also suggests a cash advance from a credit card or unsecured line of credit.
“Even if the borrower runs into financial problems, a debt reduction plan can be worked out when one still has income — an option typically not available in retirement,” he says.
But the best way to avoid borrowing is to have an emergency fund for quick cash needs, Williams says.
“If one does not have the income to set aside a set amount each month for an emergency fund, use tax refunds or annual bonuses to fund the emergency fund,” he says. “On an ongoing basis, using a cash-back credit card for paying expenses can also help build an emergency fund.”
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Why You Shouldn’t Raid Your 401(k) originally appeared on usnews.com
