John D. Perrings
Even Ted Benna, the man who popularized the tax loophole that turned into the 401(k) program, is very critical of what it has become. But should you cash our your 401(k)? There are serious disadvantages as well as advantages, and it’s often not a simple or clear-cut decision.
- Ted Benna, "father" of the 401(k), quoted in MarketWatch.com
There are some good reasons to liquidate your 401(k) for good or redirect future contributions elsewhere. Here are seven advantages to freeing your dollars (current or future) from a 401(k) or other qualified plan.
Costs: Layers of hard-to-find fees that drain profits and slow growth. A fund costs more in a qualified retirement plan than it does outside of one, because of the management and administrative fees that exist on top of the regular (often expensive) mutual fund fees.
Limited choices: Investment choices are extremely limited and mostly consist of a handful of mutual funds, which are comprised of securities and carry the risks of the stock market. Safer choices are less popular, especially as the extra fees of the qualified plan make them less attractive.
Future taxes: Do you think taxes are going up or down? Many fear (for good reason) that income taxes may rise and increase the future cost of taking income from a qualified plan. If so, that makes either a Roth account or other investments a better bet than anything tax-deferred.
Rules of Borrowing: Plan participants have restricted access to their qualified plan money. They can only access their money for limited, approved reasons. They also cannot leverage against their retirement accounts. Funds cannot be used to start a business, purchase a second home, or used as collateral for other purposes that may be preferable to keeping money in mutual funds.
The horrendous inefficiency of 401(k) loans: Money borrowed from 401(k) have gone into the account “tax deferred,” but if borrowed, must be replaced with “after tax” dollars that will be taxed AGAIN upon withdrawal. That can mean a 25%, 28%, 35% or more automatic loss! To prevent this, you should always have adequate liquid savings and/or assets that can be borrowed against without tax consequences, such as life insurance cash value.
Political uncertainty: There are risks in keeping your money in accounts governed by policymakers and a government in debt. Though rules have been quite stable in the past, Congress has debated all kinds of things they’d like to do with “your” qualified plan funds.
Consumer debt: Many plan participants have high interest debts they could pay off with 401(k) dollars to increase their cash flow position and enable more saving. (And if they have high interest debts, it’s precisely because they tried to “invest” before saving!) It is a common quandary – what should you do with investments you can’t access when you have current bills, debts or other needs? There are no easy answers, but there is a preventative solution: maintaining adequate liquidity in the first place.
In spite of compelling reasons to liquidate a 401(k), there are also important considerations and good reasons why cashing out your 401(k) may not be appropriate.
Before considering pulling your money out of any tax-deferred qualified plan, be well aware of the following considerations:
Taxes: You must be prepared to pay the taxes and penalties. Even when it makes sense numerically, it is often very difficult to pay all those taxes at once. If you do decide to cash out your 401(k), you may want to do split the process up over more than one tax year to keep yourself from paying higher-than-necessary tax bracket rates.
Timing: Cashing out your 401(k) also means pulling out of your current investments. Nervous investors tend to pull their money after large losses – which may be exactly the wrong time. It feels counter-intuitive, but the best time to move your money from the market is usually when it has been performing well!
Savings Habit: Do you have an alternative structure in place (such as a cash value life insurance policy) to continue your savings habit? As problematic as qualified plans are, too often those who don’t save in qualified plans find themselves not saving at all.
What Next? Where will you put the money from your 401(k) or other qualified retirement plan AFTER you liquidate it? Do you have a solid next-step strategy? Are you confident it is a better place for you money than your 401(k)?
Andy Tanner, author of 401(k)aos, makes the point that liquidating your 401(k) without having a sound strategy for what to do next is not a good plan. As Tanner points out, the reason that many employees are in 401(k)s in the first place is that they don’t know how to do better on their own. People leave their money in 401(k)s, perhaps choosing a target-date fund or letting their company plan administrators determine what to do with it because they don’t know how to invest.
The limited and rather skewed “investment education” programs from plan administrators won’t solve the problem of teaching people to invest. (Ironically, the plans are designed so that this problem can’t be solved, as truly educating employees how to invest would lead them to choose different options than the ones offered in their company plan!)
“We will never teach 40 million participants to become highly skilled investors,” Ted Benna told MarketWatch.com, after observing that “a 20 percent drop on your account value feels a lot different when your balance is more than $100,000 at age 56 than when you are 29 and have a $10,000 balance.” And the problem goes deeper than teaching people how to get a better rate of return. If anything, chasing high rates of return may actually be a symptom of bigger problems.
Qualified plans lead people to INVEST more than they can afford while SAVING too little. It is imperative that people SAVE MORE. We recommend saving 10-20% as a guideline or goal, and some people save even more!
Most people have far too few liquid assets that can be used for emergencies or opportunities, and too many assets in restricted environments. As a result, they are subject to unreasonable risk and also “raid” their qualified plans when emergencies strike – with costly results.
Saving helps you keep control of your money, while too often investing involves giving control to a manager or broker and the whims of the stock market.
Interestingly enough, when Benna tells the history of 401(k) plans, he reveals that they began with a mere 2 options: one for saving, and another for investing. An insurance company would offer a fund at a guaranteed rate, and the other option would be a broad, generally growth-oriented mutual fund, though sometimes it was the company stock plan (which, as we all know now, is a risky proposition.)
As Benna recounts, most participants chose to split their contributions between the two 50/50. That didn’t solve the issue of having the employee’s savings locked behind the qualified plan wall, but it DID offer them some security and protection against market instabilities.
Yet there is another issue with the investment options provided in a typical 401(k). It has to do with the limited way many people have come to define “investments” as too often limited to stocks, bonds, and mutual funds.
We’re conditioned to equate “investments” with the limited options a salesperson at a brokerage house or bank might give us. We’re conditioned to equate healthy returns with higher risk. We’re conditioned to expect that we’ll inevitably lose money sometimes. Yet none of these assumptions needs to be true.
Even if you are looking for an INVESTMENT vehicle (not simply a savings vehicle), there are better choices than the severely limited choices in your 401(k) account.
Get the Facts, Explore Your Options
My mission is to teach people how to strategically accumulate capital in a way that makes all of their other financial activities perform better, and with less risk.
What are you doing, today, to ensure that you are in a position to take advantage of change, rather than react to it?