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The Wrong Way to Fix Your 401(k)

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Many believe that the 401(k) is the biggest raw deal that American workers have ever gotten. If you agree, but you still have money in your employer's plan, then you need to be especially careful not to make irreversible missteps that could cost you even more over the long run.

Dealing with the fallout
401(k) plans have received more than their fair share of criticism for a long time. With limited investment options, complicated legal provisions, and sometimes extremely high costs, 401(k) plans have always seemed like a poor replacement for the monthly pension payments that previous generations used to enjoy.

When the market turmoil of 2008 and 2009 began, the chorus of anger about 401(k) plans only got louder. While plan participants watched their balances drop along with the stock market, many employers also abandoned the support they had been giving employees in their efforts to save for retirement. Dozens of companies, including big names like Starbucks (Nasdaq: SBUX  ) and Sears Holdings (Nasdaq: SHLD  ) , suspended or cut back on the matching contributions they provided for their workers.

Now, Starbucks -- along with many other past cutters including JPMorgan Chase (NYSE: JPM  ) , American Express (NYSE: AXP  ) , and FedEx (NYSE: FDX  ) -- has reinstated its match. Nevertheless, the experience has left workers wondering whether 401(k) plans are worth keeping in the first place.

Get out at all cost?
401(k) investors all face the same problem: Once you have money in your plan account, you can't just take it out with no strings attached. For the most part, there are two main ways you can pull at least some of your money out of a 401(k), and both have major shortcomings.

Let's look first at what looks like the easiest move: Simply closing your account, taking all the money, and putting it in your checking account. That's what many people do when they quit a job, but it's almost always a mistake. No matter how old you are, taking your 401(k) money will force you to include that amount as taxable income. That means you'll have to pay taxes on it. In addition, unless you're at least 59 1/2 years old, you'll also likely pay a 10% penalty on top of whatever taxes you have to pay. No matter how bad your 401(k) plan may be, taxes and penalties are a high price to pay for freedom.

Neither a borrower nor a lender (nor both) be
One investor on our "Ask a Foolish Question" discussion board had an interesting theory to circumvent those taxes and penalties. His original thought was that he could take a loan from his 401(k) and use it to invest in a regular brokerage account. That way, he'd have access to whatever investments he wanted, and he'd just have to make sure he paid back the 401(k) loan. In essence, he'd be paying himself back -- with interest. It looked like the best of both worlds.

The strategy has some merit, but it also has pitfalls. Consider:

  • Because you invest the loan proceeds in a taxable account, you're losing the tax advantages of investing within a 401(k).
  • You have to repay yourself with after-tax money, increasing your effective borrowing costs.
  • Most importantly, you're putting yourself at the short-term mercy of your investments. You need to make a 401(k) loan payment every month, so you may not be able to afford to wait for a long-term recovery if your stocks drop.

That last point may not seem like such a big deal. After all, even hard-hit stocks like Wynn Resorts (Nasdaq: WYNN  ) and Goldman Sachs (NYSE: GS  ) didn't take that long to recover from their losses during the market meltdown.

Nevertheless, you can't count on being that fortunate the next time your investments tank. And if you can't repay your loan, then you'll be treated as taking a distribution from your 401(k) anyway -- with all the tax and penalty implications that follow.

The right way
There's only one good way to get out of a 401(k) plan -- by moving your balance to a rollover IRA when you change jobs. Unfortunately, even if you're not happy with your current employer's plan, most employers don't let you do IRA rollovers while you're still an employee.

Until then, you may need to grin and bear it. Just keep in mind that even if your 401(k) isn't the best deal in the world, trying to get out without following the rules can cost you even more.

If you feel like your retirement got derailed somewhere in the past couple of years, don't despair. Selena Maranjian can help you get back on track. Discover how one of her readers earned $1.5 million for his retirement.

Fool contributor Dan Caplinger couldn't be happier with his 401(k). He owns shares of Starbucks. American Express is a Motley Fool Inside Value pick. FedEx and Starbucks are Motley Fool Stock Advisor selections. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy doesn't expect to retire anytime soon.


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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