Is It Ever Wise to Make Early Withdrawals From Your 401(k)?

It is only natural to worry about the financial pressures brought on by our retirement years.

Jan 25, 2014 at 1:45PM
Gran

Flickr source

It is only natural to worry about the financial pressures brought on by our retirement years. So, for an employee of a company, a 401(k) plan can seem like a godsend. The 35-year-old program helps workers ease into their twilight years by giving them the right to defer a portion of their compensation to the 401(k) account without having to pay taxes on it. Small wonder, then, that the 401(k) has become the most popular form of employer-sponsored plan in the United States.

One of the greatest advantages of maintaining a 401(k) is what investment industry professionals like to call the "employer match." This term refers to the amount of money that your company contributes to the retirement account. Most companies match an employee's contributions, dollar for dollar, up to a certain percentage. As of 2013, the most that an employee can contribute to a 401(k) is $17,500, though the figure could change as it is often adjusted for inflation. Employees 50 years of age and older, by the end of the year, are permitted to make added contributions of as much as $5,500.

There is a catch, however. If you begin taking funds out before you reach the age of 59.5, you may face a 10% penalty. A person is required to start withdrawing money from a 401(k) by April 1 of the year after he or she hits 70.5; these withdrawals are referred to as required minimum distributions (RMDs).

Millions of people rely on this nest egg to help them through their retirement years. But what if real-life needs intrude – such as mortgage payments, or a child's college education or credit card debts – and the holder must withdraw funds from the 401(k)?

Investment experts generally frown on early withdrawals, but is there ever a time when it is wise to take money out of this tax-free investment?

Dealing With Debt
While every investor is different, financial professionals point out that many people find themselves in similar situations.

Carol Hoffman of Clear Perspectives Financial Planning, in Blue Ash, Ohio, which manages $55 million in customers' assets, cites an example of someone who should "possibly withdraw" funds from a 401(k). Hoffman's client is married and her husband is employed with a retirement plan. She has a pension of her own of about $6,000 a month and a 401(k) containing $60,000.

What makes the client's situation compelling is that she is leaving her employer at a time when she and her husband are facing a daunting financial challenge. This couple, Hoffman notes, has incurred "significant debt." It relates largely to the expense involved in sending their three children to college as well as the $25,000 they have racked up in credit card debt.

"We recommended this client withdraw the full 401(k) and pay down debt," Hoffman said. "The client did not know that the IRS allows the withdrawal of the 401k at age 55 after termination of employment."

Hoffman has another bit of caution to offer: "People who run up a lot of debt once tend to do it repeatedly, so we can only recommend this strategy if we are working with them to plan their spending and increase their savings. We cut up their credit cards."

People who don't maintain the 401(k) plan may wind up regretting the neglect. Just before he turned 60, the respected New York Times business columnist Joe Nocera publicly lamented his predicament in an April 2012 piece when he took stock of his life: "The only thing I haven't dealt with on my to-do checklist is retirement planning," he wrote. "I don't plan to retire. More accurately, I can't afford to retire. My 401(k) plan, which was supposed to take care of my retirement, is in tatters." Unforeseen circumstances, such as divorce and the bursting of the dot-com bubble in 2000 worked to cut Nocera's 401(k) in half twice.

Roll Over
Some investors want to have an alternative to a 401(k) while realizing the tax savings.

Taking the funds from the 401(k) and "rolling them over" to an Individual Retirement Account (IRA) offers tax benefits, too. Hildy Richelson, president of the Scarsdale Investment Group, with $242 million of assets under management, says: "Individuals should roll their 401(k) into a self-directed IRA and purchase high-quality, individual bonds to fund their retirement, then they are able to self-manage their retirement assets."

"If you are no longer with your employer but your 401(k) was never moved, you should consider rolling the assets over to another qualified account such as an IRA," suggests Philip Christenson, a chartered financial analyst in Plymouth, Mass. "You will probably have many more investment options, and potentially lower cost options than your old 401(k) plan offer."

At the same time, Christenson cautions investors: "... in some cases your 401(k) plan may have an investment that you won't have access to outside of your plan, such as a Guaranteed Principal Account. Especially in this low-rate environment, I have seen these types of funds offer attractive rates with no loss of principal."

Before people roll over their 401(k) funds to an IRA, however, they should consider the potential consequences. "Consider the costs inside the 401(k) funds versus the total cost of an IRA," including advisor fees and commissions, urges Terry Prather, a financial planner in Evansville, Indiana.

Prather raises another, noteworthy scenario. "A 401(k) typically requires a spouse to be named as the primary beneficiary of a particular account unless the spouse signs a waiver provided by the plan administrator. An IRA doesn't require spousal consent to name someone other than the spouse as the primary beneficiary. If a participant is planning to remarry soon and wants to name someone other than the new spouse as the beneficiary – children form a prior marriage, perhaps – a direct rollover to an IRA may be desirable."

Investment advisors emphasize that people should exit a 401(k) only when they deem it absolutely necessary and have exhausted all other options. Remember, they note, it is, above all, a retirement-oriented account.

It is wise to consult an investment professional before taking such a dramatic course of action. "Many employees, as they are exiting their employment through retirement or a job change, rightly seek out advice from financial professionals," noted Wayne Titus III, who owns AMDG in Plymouth, Michigan, and manages approximately $66 million of clients' assets. "These may include a range of professions, from insurance agents, brokers, tax preparers or CPAs."

The Bottom Line
Experts point out that a 401(k) that is totally invested in stocks can expect to yield an annual return of about 9 to 10%. They stress that alternative investments may provide larger short-term returns. But a 401(k) should be regarded as a safe haven, at all costs. Excess risk should not be part of the investing equation here.

Boost your 401(k) with these three stocks
It's no secret that investors tend to be impatient with the market, but the best investment strategy is to buy shares in solid businesses and keep them for the long term. In the special free report, "3 Stocks That Will Help You Retire Rich," The Motley Fool shares investment ideas and strategies that could help you build wealth for years to come. Click here to grab your free copy today.

This article originally appeared on MyBankTracker.com

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

1 Key Step to Get Rich

Our mission at The Motley Fool is to help the world invest better. Whether that’s helping people overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we can help.

Feb 1, 2016 at 4:54PM

To be perfectly clear, this is not a get-rich action that my Foolish colleagues and I came up with. But we wouldn't argue with the approach.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich" rated The Motley Fool as the #1 place online to get smarter about investing.

"The Motley Fool aims to build a strong investment community, which it does by providing a variety of resources: the website, books, a newspaper column, a radio [show], and [newsletters]," wrote (the clearly insightful and talented) money reporter Kathleen Elkins. "This site has something for every type of investor, from basic lessons for beginners to investing commentary on mutual funds, stock sectors, and value for the more advanced."

Our mission at The Motley Fool is to help the world invest better, so it's nice to receive that kind of recognition. It lets us know we're doing our job.

Whether that's helping the entirely uninitiated overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we want to provide our readers with a boost to the next step on their journey to financial independence.

Articles and beyond

As Business Insider wrote, there are a number of resources available from the Fool for investors of all levels and styles.

In addition to the dozens of free articles we publish every day on our website, I want to highlight two must-see spots in your tour of fool.com.

For the beginning investor

Investing can seem like a Big Deal to those who have yet to buy their first stock. Many investment professionals try to infuse the conversation with jargon in order to deter individual investors from tackling it on their own (and to justify their often sky-high fees).

But the individual investor can beat the market. The real secret to investing is that it doesn't take tons of money, endless hours, or super-secret formulas that only experts possess.

That's why we created a best-selling guide that walks investors-to-be through everything they need to know to get started. And because we're so dedicated to our mission, we've made that available for free.

If you're just starting out (or want to help out someone who is), go to www.fool.com/beginners, drop in your email address, and you'll be able to instantly access the quick-read guide ... for free.

For the listener

Whether it's on the stationary exercise bike or during my daily commute, I spend a lot of time going nowhere. But I've found a way to make that time benefit me.

The Motley Fool offers five podcasts that I refer to as "binge-worthy financial information."

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. It's also featured on several dozen radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable ... and I don't say that simply because the hosts all sit within a Nerf-gun shot of my desk. Rule Breaker Investing and Answers contain timeless advice, so you might want to go back to the beginning with those. The other three take their cues from the market, so you'll want to listen to the most recent first. All are available at www.fool.com/podcasts.

But wait, there's more

The book and the podcasts – both free ... both awesome – also come with an ongoing benefit. If you download the book, or if you enter your email address in the magical box at the podcasts page, you'll get ongoing market coverage sent straight to your inbox.

Investor Insights is valuable and enjoyable coverage of everything from macroeconomic events to investing strategies to our analyst's travels around the world to find the next big thing. Also free.

Get the book. Listen to a podcast. Sign up for Investor Insights. I'm not saying that any of those things will make you rich ... but Business Insider seems to think so.


Compare Brokers