Retirement Planning
Dec 27, 2018

The Impact of Leakage on Your 401(k)

If you’re looking to save for retirement income sources outside of Social Security, you effectively have two choices: investing in a 401(k) or other similarly structured tax-qualified account, or investing in an IRA. Regardless of which vehicle you choose, if you’re to gain the maximum benefit from those retirement funds, you are probably best off to leave them in those accounts – and that might be easier said than done. In an Article published by The Center for Retirement Research (CRR) at Boston College they determined that the three main sources of leakage – withdrawals of funds held in a 401(k) or IRA prior to retiring – can lower savings earmarked for retirement by more than 20 percent (Munnel and Webb 2015) .

In the first installment of a two-part series on funding your retirement, we’re looking at the biggest source of leakage – in-service withdrawals – and how they can affect your retirement health.

In-Service Withdrawals: Hardship Withdrawals

According to the CRR at Boston College, in-service withdrawals fall in one of two categories: hardship withdrawals and withdrawals taken after age 59½ (Munnel and Webb 2015). Hardship withdrawals allow plan participants to withdraw funds if they face an “immediate and heavy financial need,” a threshold that is typically met by any of the following circumstances:

  • To cover medical care expenses
  • To cover funeral expenses
  • To prevent eviction from foreclosure on the mortgage on the principal residence
  • To cover certain expenses to repair damage to the principal residence
  • To cover costs directly related to the purchase of a principal residence
  • To pay for post-secondary education

Accessing 401(k) funds for any of these needs requires more than simply requesting a check be cut. First, the amount available is restricted to personal contributions and employer matching contributions – it does not include any investment earnings. Additionally, the money distributed from your 401(k) will still be subject to income tax, a 10 percent penalty tax and a 20 percent withholding for income taxes, even if the distribution is for one of the qualifying reasons listed above. Finally, if you take a hardship withdrawal, you are disallowed from making contributions to your account for six months.

All of these factors should certainly give an investor pause when considering withdrawing from their 401(k) plan early. But let’s take a closer look at those six events. The first three, medical expenses, funeral expenses and the prevention of eviction, can happen unexpectedly and are frequently hard to plan for. In the most extreme of these circumstances, when there are no other options available, 401(k) funds should be used.

However, the next three, using funds for repairs to the principal residence, to cover costs directly related to the purchase of a principal residence and for post-secondary education expenses, are typically less need-based than the first three and can be paid for through other means:

  • Most lenders require homeowner’s insurance be in force as part of the loan agreement, and the vast majority of homeowners retain some form of homeowner’s insurance. Home repairs have the potential to be quite expensive, but that risk can be offset with an insurance policy. It is far less expensive to retain risk protection than it would be to withdraw funds from your 401(k) to cover those expenses.
  • While funds in your 401(k) may seem quite attractive when trying to make a down payment for a home purchase, such a purchase is rarely a sudden and unpredictable event. Much like any other large purchase, this expense can be budgeted and achieved over time, allowing the funds you have set aside for retirement to grow.
  • Of all the qualifying reasons to withdraw funds early, paying for costs related to a post-secondary education could be the most frivolous. Unless this opportunity has the potential to increase earning capacity by a large margin in the future, a withdrawal from a 401(k) plan should not be considered to fund such an endeavor. There are many effective means of financing an education, and money set aside for retirement should not be one of them.

Let’s put this in perspective in terms of real dollars. Let’s say you are 25, have $10,000 saved in your 401(k) (well done!) and are planning on working until you are 65. However, you decide you want to withdraw $5,000 in order to make a down payment on a home – that seems like a perfectly reasonable use of your money. That early withdrawal of $5,000 will result in a real reduction of $6,750, due to the 10% penalty for early withdrawal and an additional 20% whitheld for taxes, leaving your 401(k) balance at only $3,250.

Now let’s say you never make another contribution and you just allow your investments to grow at a rate of 5% for the remainder of your career. In 40 years, with nothing else added to the principal amount, your $10,000 would have become $70,399.89, with nothing else added to your plan. However, the $3,250 would only be worth $22,879.96. That means the early withdrawal of $5,000, plus the associated penalties, has reduced your potential savings by $47,519.93 – plus, you will no longer be earning an income at this stage of your life

In-Service Withdrawals: Withdrawals after Age 59½

Withdrawals after age 59½ seem much less threatening to your retirement health, given the 10% early withdrawal penalty no longer applies at this time. However, the point remains: Generally, you should treat distributions from a retirement account as funds used for the sole purpose of retirement. Investors should treat access to 401(k) funds or IRA funds like we do Social Security, not being eligible to receive benefits until at least 62 or, if you continue to work, until full retirement age. Don’t forget, the CRR at Boston College has done the math for us: Even if you are above the age of 59½, taking distributions at this time, when coupled with other leakages, could reduce your retirement savings by more than 20 percent (Munnel and Webb 2015).

Conclusions

We strongly hope you take away the following guidance from this article:

  • Even if you meet the requirements to withdraw funds from a retirement account early, you will be assessed a severe penalty.
  • Most qualifying events can be financed and paid for by other means. Accessing retirement funds early should truly be a last resort.
  • Leakages at any point in the accumulation phase, even after age 59½, can result in a stark reduction in the funds available to you in retirement.

Losing 20% or more of the funds available to you in retirement could be devastating. The reason investors fall into this trap is it doesn’t happen quickly or all at once in most circumstances. Treat the funds you set aside for retirement as sacred. Once the accumulation phase is over, these funds will be your livelihood, and even large contributions late in the game will probably not even come close to matching moderate or even small but consistent contributions, left untouched, early in your career.

Hopefully, this article has provided some insight into the dangers of in-service withdrawals.
In Part II of this two-part series, we will explore the effects of cash outs
and plan loans on your retirement health.

 

Reference: Munnell, Alicia H., Webb, Anthony. 2015. The Impact of Leakages From 401 (K) s and IRAS. Center for Retirement Research at Boston College. http://crr.bc.edu/wp-content/uploads/2015/02/wp_2015-2.pdf.

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