Is It Ever Wise To Make Early Withdrawals From Your 401(k)?
It is only natural to worry about the financial pressures brought on by our retirement years. So, for an employee of a company, a 401(k) plan can seem like a godsend. The 35-year-old program helps workers ease into their twilight years by giving them the right to defer a portion of their compensation to the 401(k) account without having to pay taxes on it. Small wonder, then, that the 401(k) has become the most popular form of employer-sponsored plan in the United States.
One of the greatest advantages of maintaining a 401(k) is what investment industry professionals like to call the “employer match.” This term refers to the amount of money that your company contributes to the retirement account. Most companies match an employee’s contributions, dollar for dollar, up to a certain percentage. As of 2013, the most that an employee can contribute to a 401(k) is $17,500, though the figure could change as it is often adjusted for inflation. Employees 50 years of age and older, by the end of the year, are permitted to make added contributions of as much as $5,500.
There is a catch, however. If you begin taking funds out before you reach the age of 59.5, you may face a 10% penalty. A person is required to start withdrawing money from a 401(k) by April 1 of the year after he or she hits 70.5; these withdrawals are referred to as required minimum distributions (RMDs).
Millions of people rely on this nest egg to help them through their retirement years. But what if real-life needs intrude - such as mortgage payments, or a child’s college education or credit card debts - and the holder must withdraw funds from the 401(k)?
Investment experts generally frown on early withdrawals, but is there ever a time when it is wise to take money out of this tax-free investment?
Dealing With Debt
While every investor is different, financial professionals point out that many people find themselves in similar situations.
Carol Hoffman of Clear Perspectives Financial Planning, in Blue Ash, Ohio, which manages $55 million in customers’ assets, cites an example of someone who should “possibly withdraw” funds from a 401(k). Hoffman’s client is married and her husband is employed with a retirement plan. She has a pension of her own of about $6,000 a month and a 401(k) containing $60,000.
What makes the client’s situation compelling is that she is leaving her employer at a time when she and her husband are facing a daunting financial challenge. This couple, Hoffman notes, has incurred “significant debt.” It relates largely to the expense involved in sending their three children to college as well as the $25,000 they have racked up in credit card debt.
“We recommended this client withdraw the full 401(k) and pay down debt,” Hoffman said. “The client did not know that the IRS allows the withdrawal of the 401k at age 55 after termination of employment.”
Hoffman has another bit of caution to offer: “People who run up a lot of debt once tend to do it repeatedly, so we can only recommend this strategy if we are working with them to plan their spending and increase their savings. We cut up their credit cards.”
People who don’t maintain the 401(k) plan may wind up regretting the neglect. Just before he turned 60, the respected New York Times business columnist Joe Nocera publicly lamented his predicament in an April 2012 piece when he took stock of his life: ”The only thing I haven’t dealt with on my to-do checklist is retirement planning,” he wrote. “I don’t plan to retire. More accurately, I can’t afford to retire. My 401(k) plan, which was supposed to take care of my retirement, is in tatters.” Unforeseen circumstances, such as divorce and the bursting of the dot-com bubble in 2000 worked to cut Nocera’s 401(k) in half twice.
Some investors want to have an alternative to a 401(k) while realizing the tax savings.
Taking the funds from the 401(k) and “rolling them over” to an Individual Retirement Account (IRA) offers tax benefits, too. Hildy Richelson, president of the Scarsdale Investment Group, with $242 million of assets under management, says: “Individuals should roll their 401(k) into a self-directed IRA and purchase high-quality, individual bonds to fund their retirement, then they are able to self-manage their retirement assets.”
“If you are no longer with your employer but your 401(k) was never moved, you should consider rolling the assets over to another qualified account such as an IRA,” suggests Philip Christenson, a chartered financial analyst in Plymouth, Mass. “You will probably have many more investment options, and potentially lower cost options than your old 401(k) plan offer.”
At the same time, Christenson cautions investors: “... in some cases your 401(k) plan may have an investment that you won’t have access to outside of your plan, such as a Guaranteed Principal Account. Especially in this low-rate environment, I have seen these types of funds offer attractive rates with no loss of principal.”
Before people roll over their 401(k) funds to an IRA, however, they should consider the potential consequences. “Consider the costs inside the 401(k) funds versus the total cost of an IRA,” including advisor fees and commissions, urges Terry Prather, a financial planner in Evansville, Indiana.
Prather raises another, noteworthy scenario. “A 401(k) typically requires a spouse to be named as the primary beneficiary of a particular account unless the spouse signs a waiver provided by the plan administrator. An IRA doesn’t require spousal consent to name someone other than the spouse as the primary beneficiary. If a participant is planning to remarry soon and wants to name someone other than the new spouse as the beneficiary – children form a prior marriage, perhaps – a direct rollover to an IRA may be desirable.”
Investment advisors emphasize that people should exit a 401(k) only when they deem it absolutely necessary and have exhausted all other options. Remember, they note, it is, above all, a retirement-oriented account.
It is wise to consult an investment professional before taking such a dramatic course of action. “Many employees, as they are exiting their employment through retirement or a job change, rightly seek out advice from financial professionals,” noted Wayne Titus III, who owns AMDG in Plymouth, Michigan, and manages approximately $66 million of clients’ assets. “These may include a range of professions, from insurance agents, brokers, tax preparers or CPAs.”
The Bottom Line
Experts point out that a 401(k) that is totally invested in stocks can expect to yield an annual return of about 9 to 10%. They stress that alternative investments may provide larger short-term returns. But a 401(k) should be regarded as a safe haven, at all costs. Risk should not be part of the investing equation here.
A qualified plan established by employers to which eligible employees ...
A 401(k) plan set up for an individual running a sole proprietorship ...
A type of 401(k) plan that automatically enrolls the employees ...
An individual retirement plan in which employees can have all ...
A type of annuity that allows an employee to make contributions ...
A retirement savings plan created by the Federal Employee's Retirement ...