Over the years, we've received many questions from our clients regarding their employer-sponsored 401(k) plans. Rarely do any of these questions come as a surprise, given the financial complexity of most 401(k) programs.
Therefore, to help you better manage and maximize the potential growth of your 401(k) retirement plan (or any other retirement savings plan for that matter), we sat down with GW & Wade Counselor Matthew E. Ryan, MSF, CFP®, EA to find answers to the most common questions we repeatedly receive.
For every dollar saved in a 401(k), the government essentially “subsidizes” the saver by deferring taxes on those dollars until they are withdrawn in retirement. So in a sense, the saver gets an immediate “return” on every dollar contributed, commensurate with his or her tax bracket. For example, if an individual is in the 30% tax bracket, every dollar s/he puts into a 401(k) avoids the 30% tax. One could say s/he will have enjoyed a 30% “return” on those dollars, even before considering what investments in which to put them. Furthermore, if that person’s employer matches the contribution, which is quite common with 401(k)’s, then the incentive is even greater. An example of an employer match is 2-3% of salary, up to a maximum specified by the employer. This is often referred to as “free money.” If one does not utilize the 401(k), then those “free dollars” are left on the table.
Net, net? Even at the expense of an occasional dinner out or weekend away, it can make sense to contribute as much as you can to your 401(k), keeping in mind your other financial needs.
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Short answer, only as a last resort.
About 21 percent of 401(k) plan participants who are eligible to take loans against their retirement savings exercise this option, according to the Employee Benefit Research Institute [1].
Ryan explains why we recommend that you avoid taking a loan from your 401(k) plan:
First and foremost, your 401(k) savings are for your retirement. It’s money that you’ll need to support yourself when you are no longer working. When you borrow money from your 401(k), you eliminate the opportunity for investment growth and the powerful effect of tax-deferred compounding on those monies during the borrowing period. Additionally, many plans will not allow you to make continued contributions to your 401(k) plan while your loan is outstanding. Therefore, you’re not just borrowing money from your future, you’re also losing money saved on a tax-deferred basis. Essentially, you set yourself back financially twofold.
At GW & Wade, we believe that if you need to borrow from your 401(k), it may suggest that you’re living outside your financial means. Of course, there are some reasonable exceptions, such as needing the funds for medical care or other unexpected immediate short-term capital need. In these cases, paying back the loan when possible should be a priority.
Some clients also ask about borrowing from their 401(k) to help pay for the down payment on a home. In fact, according to a National Association of Realtors® trends report, approximately 12 percent of home buyers borrow from their 401(k) and/or take Individual Retirement Account (IRA) withdrawals to do just that. Again, Ryan suggests that while buying a home can be an excellent investment, tying your retirement savings to your home exposes you to a reduction in retirement saving benefits and fewer liquid assets to draw from during retirement.
One last reason not to borrow from your 401(k):
According to legal information provider Nolo [2], 401(k) retirement plan assets are generally protected from creditors. We never know what curve balls life will throw our way, including lawsuits, foreclosures and so on. Your 401(k) funds are protected assets from such judgments, but funds borrowed from the plan are not.
According to Ryan, you essentially have four options:
In most instances, we recommend you rollover your 401(k) plan into either your new employer’s retirement plan or a Rollover IRA account. This will preserve the tax-deferral on the funds rolled over. Importantly, the rollover request should be “direct” and payable to the new custodian, not to you, to avoid any withholding or taxation on the distribution. Keep in mind that not all employers allow for rollovers into their 401(k) plan from an outside 401(k) plan.
We generally do not recommend leaving your 401(k) in the hands of a previous employer. One reason is that those funds are often ignored by the former participant, resulting in a lack of periodic financial reviews and rebalancing. Another reason is the limited number of investment options available in most company sponsored retirement plans.
IRA Advantages
Many of our clients opt to rollover their 401(k) funds into an IRA when switching employers. Typically, we encourage this approach; however, there are exceptions. In general, IRAs provide greater investment control and flexibility as compared to many 401(k) programs where your employer dictates the various investment vehicles and withdrawal provisions, thus limiting your options. What’s more, with an IRA, you also have access to professional advisors and money managers.
Least Desirable 401(k) Transfer Approach
The most unfavorable 401(k) distribution method is to withdraw the funds directly, taking possession of the monies. By doing so, you expose those funds to Federal and state (if applicable) income taxes. In fact, your employer is required by law to withhold 20 percent Federal income tax on any taxable distribution before distributing to you the remaining 80 percent of your 401(k) funds. You will have only 60 days to deposit the total distribution amount (the 80% received plus the equivalent of the 20% withheld) into an IRA in order to avoid taxation and potential penalties on the amount withdrawn.
Before You Leave Your Employer
Another item to be mindful of before leaving your current employer is to make sure you’re fully aware of the vesting schedule of your employer’s contributions to your 401(k) account. These contributions could include company matching and/or profit sharing contributions. Specifically, many employers require employees to remain employed for a certain period of time (typically several years) before becoming fully vested in the company’s contributions to the plan. Thus, if you’re not fully vested at time of separation, you risk forfeiting some of your employer contributions and related earnings. Note, you are always 100% vested in your contributions and any related earnings no matter how long you’ve worked for the employer.
According to the IRS, to discourage the withdrawal and spending of “qualified” retirement funds for purposes other than normal retirement, the law imposes an additional 10 percent tax on certain early distributions from qualified retirement plans, including 401(k)s and IRAs. The 10 percent penalty tax is applied to the gross taxable amount withdrawn while the account owner is under 59.5 years of age.
However, there are exceptions to the 10 percent penalty tax for early withdrawals. One in particular worth mentioning is known as the Age 55 Provision or Age 55 Rule. Specifically, you’re exempt from the additional 10 percent tax on a distribution made to you after you separate from service with your employer if the separation occurred in or after the year you reached age 55. Other exceptions to the 10% early withdrawal (pre 59.5) penalty tax include distributions due to total & permanent disability, medical expenses in excess of 10% of adjusted gross income (AGI), and qualified higher education expenses (IRAs only).
Special Age 55 Rule Exception: This rule applies only to qualified retirement plans other than IRAs. Therefore, if you rolled over your 401(k) funds into an IRA, you would no longer be eligible for this exception if taking premature withdrawals from the IRA.
Quick Rule-of-Thumb:
Overall, avoid taking any distribution from your 401(k) before age 59-1/2 or you’ll likely be exposed to an additional 10 percent federal tax penalty on top of the regular taxes paid on the distribution. Of course, there are exceptions, such as the Age 55 Provision.
Biggest 401(k) Mistakes
This post wouldn’t be complete without sharing with you the greatest mistakes we see investors make when it comes to their retirement savings plans. These include: Being too conservative with investment allocations during the accumulation phase, limiting growth potential, failing to review plans on an annual basis and, lastly, not taking advantage of company matching, a.k.a. free money.
All of us at GW & Wade encourage you to contribute as much as you can afford to your retirement plans, including unexpected windfalls, such as an inheritance or a raise. Our expertise includes integrating 401(k) retirement plans into your overall long-term financial plan, including asset allocation and diversification analysis.
If you’re seeking to optimize your 401(k) strategy, have general questions regarding your 401(k) retirement plan, or would like to undertake a more comprehensive approach to planning your overall financial well-being to protect the things you value most, please contact us.
The information provided above is general in nature and is not intended to represent specific investment or professional advice. No client or prospective client should assume that the above information serves as the receipt of, or a substitute for, personalized individual advice from GW & Wade, LLC, which can only be provided through a formal advisory relationship.
Clients of the firm who have specific questions should contact their GW & Wade Counselor. All other inquiries, including a potential advisory relationship with GW & Wade, should be directed to:
Laurie Gerber, Client Development
GW & Wade, LLC
T. 781-239-1188
[1] http://www.investopedia.com/articles/retirement/06/eightreasons401k.asp
[2] http://www.nolo.com/legal-encyclopedia/can-judgment-creditors-go-after-my-retirement-accounts.html#
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