As a Chartered Retirement Planning Counselor and someone who deals specifically with retirement issues I spend a lot of time helping participants with their retirement plans. One of the most common reasons participants would meet with me is because they say need money and they are looking to take it out of their retirement plan. I never had people coming to me asking things like what is the maximum 401k contribution, or how to become a millionaire. Unfortunately, this conversation almost never goes over too well since they are usually upset with the fact that they cannot cash out their entire account while an active employee or can’t tap into funds that aren’t vested. It’s just as bad when I explain to those who are eligible for a distribution that they are likely going to lose 30% or more of their money to taxes and penalties.
What is probably more shocking is that many of the people coming in looking to take money out of their retirement plan only need a small amount (generally under $1,000) to cover some unexpected expenses and I’ve even seen people take out $500 loans from their 401k on three year terms. With so many people tapping into their employer plans for minor emergencies I think this highlights the importance for keeping a cash emergency savings account available even if it isn’t a significant amount.
Congratulations on Saving for Retirement, but Your Responsibilities Don’t Stop There
I have to applaud those who actually take the time to enroll and begin contributing to their plan, especially if money is tight as it often is. Generally, the people who need to borrow against their 401k are earning modest incomes and are just able to make ends meet. There is a lot to be said for someone in such a situation. They understand the importance of saving and have learned to make due without that little extra money coming home in their paycheck.
But taking the step to actually save for retirement is only the first step. That money doesn’t do any good if you’re constantly tapping into your nest egg via loans, premature distributions, or cashing out instead of doing a 401k rollover. Saving is good, but not managing those funds properly can be just as bad as not saving anything at all.
Taking the Next Step
While participating in the plan is a great initial step it is often the only savings many people are taking part in. It is automatically taken out through payroll so it is simple to set up and easy to forget about. The problem is that people stop there and don’t apply the same technique for other savings. If you can spare $50 every two weeks from your paycheck for retirement you should strive to save at least $25 as well for your emergency savings so you don’t have to treat your retirement plan as an emergency fund.
The problem is that this takes additional work and you either need to change your direct deposit to put money into a savings account or you need to manually set up the transfer or deposit. The other big problem is how easy the money can be to access. Most people simply set up their savings account where they do the rest of their banking and more often than not the savings account is linked to the checking or even their ATM card. The ease in accessing this money can make it difficult for some people to keep the money in savings where it belongs and occasionally tap into it for things that aren’t quite emergencies. The benefit of a retirement plan is that the money isn’t as easy to access, so after a few years of constant contributions and no withdrawals people are surprised at how much they have saved and see that as money that can be used for other things.
So, if you can manage to get by saving automatically in your retirement plan, you can just as easily set up an automatic savings plan with a savings account. The best thing to do is to open an high-yield online savings account. Then, all you have to do is establish a regular and automatic transfer to fund the account. Maybe you set the transfer up for payday so you don’t even miss the money. Whatever you do, it has to be automatic and require little action from you. If you have to force yourself to remember to make a deposit every two weeks how long will that last before the habit fades away?
Loans Should Be Your Last Resort
If your 401(k) plan allows you to take a loan it should be treated as a last resort. Some people argue that taking a 401k loan isn’t all that bad of an idea because it is your money and you are simply paying yourself back the interest. While that is true, you are still hurting yourself over the long run. Money that you take out of your plan can no longer earn interest or see capital gains. For some loans this could be a period of five years of foregone compounding interest. Second, most people who take a loan end up stopping their regular contributions as well so that they can afford to make the loan payments. This just compounds the problem of foregone gains and what is even worse are those who end up forgetting to begin contributing again once the loan has been repaid.
Another thing to consider are the tax consequences on the loan. Money you borrow from your plan is pre-tax money, but your loan payments are from after-tax dollars. This means you are effectively going to be taxed twice on some, not all, of the money that you borrowed. If that isn’t a raw deal I don’t know what is. Finally, in the event you default on your loan because you change jobs and stop making loan payments the IRS will treat that as a premature withdrawal resulting in taxes owed on the distribution with a 10% penalty on top if you were under the age of 59 and a half. You say to yourself it won’t happen, but I have seen people take out $10,000 loans only to find themselves out of work a month later, fail to repay the loan in time, and get hammered with a $10,000 early distribution and all of the taxes that go with it.
Check to See if Your Employer Offers an After-Tax Retirement Account or Christmas Club
If you find it difficult to save money the traditional way and want to avoid the pitfalls of tapping into your qualified retirement account there may be another option available to you in the form of an after-tax portion of your 401(k) or 403(b). Some employers actually offer the option to also contribute after-tax dollars into your retirement account, either within your current plan or through a separate account like a Christmas Club program.
The benefits of doing this are that you can begin saving money easily through payroll deduction just like your current retirement plan and yet you have access to 100% of this money without needing to take a loan or worry about IRS early withdrawal penalties. While you won’t receive the tax benefits of a qualified plan you can at least create a cushion of money that is available without excess penalties or taxes. Most plans allow this money to go into a savings type account or in some sort of fixed fund so your money is usually not at risk.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.