What Cashing Out Your Retirement Plan Really Means: Atlanta Financial Planner Explains
The Coronavirus pandemic has us re-evaluating many things in life, which can be a positive thing – using this experience as a catalyst for change. However, while our short-term goals are front and center, it’s crucial that we understand how changes might impact our long-term goals.
For example, the market volatility we’ve experienced this year has some investors looking to cash out their retirement plans and get out of the stock market altogether. While this may settle your short-term roller coaster of emotions, there is a lot more to a sound investment strategy than the short-term numbers. As a financial advisor on our experienced team here in Atlanta, I encourage you to look at the big picture.
There’s no arguing: Market dips can be hard to watch. But discontinuing your retirement contributions is not the answer. We have learned in our nearly 50 years of working with savers and investors, many investors regret this decision later.
If the current market volatility has you losing sleep at night, it may be time to readjust your risk tolerance. Maybe you’re investing in the wrong retirement vehicles. The team at Linscomb & Williams can help you establish a more prudent alternative that reflects your real-life financial planning needs. Staying focused on the long-term benefits your retirement plans provide can also help you put things in perspective.
The Benefits of a Retirement Plan
Before you make a decision, consider the following important advantages a 401(k) offers:
You Can Plan Tax Advantages at the Best Time for You
One of the biggest differences between a Roth 401(k) and a Traditional 401(k) is that, while they both offer tax advantages, they do so at different times. If you contribute to a Traditional 401(k), the money is taken out of your paycheck pre-tax, which lowers your tax bill for the year you contribute, and may lower your effective tax bracket.
Contributions to a Roth 401(k), on the other hand, are taken out after-tax, so they do not lower your tax bill (or bracket) in the year of contribution. But Roth 401(k) withdrawals are not taxed when you withdraw them, as long as you’ve held the funds for at least five years. This is a distinct difference compared to withdrawals from Traditional 401(k)s, which are taxed.
The net result is that your decision between these two choices means a 401(k) allows you to plan when you want to receive your tax advantages.
You Don’t Have to Pay Taxes on Your Earnings
The earnings in both types of 401(k)s grow without being diluted by taxes as they build up. Given that the U.S. stock market rose an average of 11+ percent annually in the 43 years ending in 2016, even factoring in periodic bear markets, that’s a significant advantage. Investment returns can power your retirement savings. It is easy to lose sight of that long-term advantage in the middle of the short-term distractions of volatile markets and a pandemic.
You May be Eligible for an Employer Match
Roughly 80 percent of employers offer some kind of match to their employees’ 401(k) contributions. These can be very beneficial, since a match to your savings represents "free money!"
Say you save $10,000 per year, and your employer offers a 50 percent match. That equates to an additional $5,000 of savings that doesn’t come out of your pocket.
What Happens When You Withdraw Early
Early withdrawals from your retirement accounts (before the age of 59-½) is what we call “leakage,” because it saps the amount you are saving toward retirement. Retirement savings grow faster when they are left to compound earnings over time, and any early withdrawal, or loan, disrupts that, in addition to diminishing your capital at work.
Second, the Internal Revenue Service (IRS) levies a 10 percent penalty for early withdrawal in addition to taxing your withdrawals at your current tax rate. (Neither the penalty nor the tax applies to when you withdraw your own contributions previously made to a Roth 401(k), as long as you’ve held it for at least five years, but employer contributions are subject to the early withdrawal penalty, since they represent pre-tax contributions.)
Exceptions have been made to this rule in 2020, as many people suffered financial hardship in light of the pandemic, but it’s important to understand the full effect of this decision. Discuss your options with a fiduciary financial advisor first.
There are many reasons why an investor may desire to withdraw money from, or completely cash out, a retirement plan, but in our experience, very few of these motivations prove wise. Remember, an early withdrawal can cost more than you might imagine, when you add up taxes, penalties, lost employer matches and tax-free growth. Even if the withdrawal seems small and therefore, seemingly harmless, think again.
Let’s say you want to cash out a $4,500 retirement account. After taxes and penalties alone, you may end up with half that amount! And you will miss out on potential growth and any employer match for which you may be eligible.
What if it’s just a “loan,” and you promise to pay it back later? Talk with your financial advisor about this option, because there are several strings attached.
For one, a loan from your 401(k) will have to be paid back with interest, taking longer to save the same amount of money.
Second, if you’re busy paying a loan instead of making your monthly contribution, your money doesn’t have the potential to grow, resulting in a lot of money lost over time. Contributions to your 401(k) to repay a loan do not receive any matching contributions from your employer.
Discuss your specific situation with a fiduciary financial advisor, so you don’t make a decision you may later regret. You may have other options you wouldn’t consider on your own.
Retirement can sneak up on you, and if you don’t have a plan in place, you may find you can’t afford the lifestyle you’ve become accustomed, your dreams for retirement are out of reach, or things like cost of living and inflation took more of your savings than expected.
Retirement planning can be complicated. Don’t make it even harder on yourself.