By Tom Reese, ASA, Consulting Actuary
As published by the Patriot News on May 27, 2012
While the economy struggles along at a tepid rate of recovery, many families continue to face financial pressures. As mortgage payments, healthcare bills, tuition, or daily living expenses mount, there is a temptation to look to retirement accounts as a source of immediate funds. In fact, people are increasingly taking early withdrawals from their retirement accounts to pay short-term expenses. People are also tempted to cash out of their 401(k)s when they are leaving or changing jobs, rather than rolling them into a 401(k) at a new job or another qualified retirement account.
Turning to a 401(k) in order to meet an immediate financial need has negative short-term and long-term repercussions for financial planning. The tax penalties for such withdrawals will reduce the amount of cash you actually receive, and the reduction in your 401(k) account will result in “reduced” or “lost” tax-deferred growth over the life of your career, leaving you even further behind in your efforts to build wealth for retirement.
Let’s take a look at how taking an early withdrawal from a retirement fund impacted Bob, who just turned 40. Bob’s account balance was worth $80,000, and his 401(k) plan allowed him to take a hardship withdrawal of $25,000 to help pay for his son’s college tuition. However, Bob not only had to pay taxes on his withdrawal, but he also had to pay a 10% penalty. After taxes and penalties were accounted for, Bob lost nearly one-third of his withdrawal to taxes.
After taking the hardship withdrawal, Bob’s 401(k) account earned 6% annually until he retired at age 65. His account grew to over $236,000. However, if he had not taken the withdrawal, his account would have grown to greater than $343,000, a difference over $100,000.
So what else could Bob – or anyone in financial need – have done to meet immediate financial needs without jeopardizing his retirement future?
First, determine if the money is for a necessary need, or just for an item that would be nice to have. Avoid tapping into a 401(k) for nonessential items.
Second, examine all other options for funds. Interest rates are very low for loans or refinancing. Those with a good credit rating should pursue these possibilities before considering an early withdrawal from a retirement plan. If the need is education-related, pursue low-interest education loans, grants and scholarships, or talk to family members for help.
Third, if all else fails, consider taking a loan from a 401(k), which is preferable to an outright withdrawal. A loan from a 401(k) plan does not incur taxes if it is paid off on a timely basis.
When people leave or change jobs, they are faced with making some important decisions. One question their former employer will ask is what they want to do with their 401(k). This may come as a pleasant surprise to have immediate access to monies that were previously untouchable. They may begin thinking about how they could use their 401(k) to purchase a new car or remodel the bathroom, or possibly cover general living expenses. However, the same consequences apply. If you receive the cash, you will be taxed on the withdrawal and may be subject to a 10% penalty tax if you are under age 59 ½.
Consider rolling your account to an IRA or to your new employer’s 401(k) if they have one. It may make sense to leave your 401(k) untouched with your previous employer until you find a new place to rollover your account.
The takeaway here is that we cannot overemphasize the importance of thinking long-term, particularly in uncertain economic times. For many, the concept of a retirement and savings account has become blurred, when in reality the funds set aside for retirement are meant to be set aside over the long-term to grow. The challenge becomes how to grow your retirement fund on a tax-deferred basis, and to tap in to other means with a less negative long-term impact if you find yourself temporarily out of the workforce or with an unplanned financial need.
Too often the mentality is to use the money now, jeopardizing its intended use for retirement savings. The tax penalties of taking an early withdrawal are significant, and they dramatically erode the results of all your hard work in putting away funds for retirement. The IRS taxes such withdrawals because it wants to discourage people from siphoning off their 401(k)s. Given the decline in company pensions and pressures on the Social Security system, 401(k)s are considered the primary savings vehicles for retirement. This makes it that much more important to think long-term and place your short-term need within your broader financial plan.
Reese, T. (2012, May 27). Pressed for cash? Switching jobs? Don’t touch that retirement fund. Conrad Siegel Actuaries. Retrieved June 1, 2012, from http://www.conradsiegel.com