How 'leakage' can ruin your financial future in retirement
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Most Americans have to save for retirement on their own, through 401(k)s or independent retirement accounts. But some see that retirement plan as a piggy bank.
“Retirement leakage” – a loan, cash-out or early withdrawal of funds – can have a serious impact on your financial security. You’ll lose some money upfront, in terms of taxes or an early withdrawal penalty. But a larger, overlooked issue is not having enough money later on in retirement.
“For every thousand you take out today, you’re reducing your retirement income at 65 by a thousand a month,” said Delia Fernandez, certified financial planner at Fernandez Financial Advisory.
Here’s a breakdown of the different types of retirement leakage and how they could affect your financial future.
When changing jobs, some workers opt to take out their retirement plans in cash. A 2015 survey from the Retirement Clearinghouse reveals that 34% of millennials and Gen Xers and 24% of baby boomers have cashed out at least one retirement account.
Those early withdrawals trigger a 10% penalty and generally will be taxed as income. You’ll also lose out on the compounding interest that money would have accrued.
Cashing out a retirement plan is easier than rolling it over into a new employer’s plan, or turning it into an individual retirement account. But the impact can be huge: A study from the Employee Benefits Research Institute estimated in 2015 cash-outs cost Americans $92.4 billion in lost retirement income.
Some workers feel they have no choice. The Retirement Clearinghouse survey notes that 37% of those who cashed out did so for emergency reasons, usually unemployment. Others may actually have no choice, since an employer can require cash-out of any account with less than $1,000.
However, even relatively small accounts matter in the long run. Fernandez gives this example: Suppose that at age 25 you decided not to cash out the $3,000 in your retirement account. Assuming 7% growth, that $3,000 would grow to $45,000 by the time you hit age 65 — and that’s in addition to any other retirement savings.
But it can be tough to view future needs against current wants. The survey suggested “prospect theory” often comes into play: Workers feel that the gain (thousands of dollars in your hands right now) outweighs the loss (penalty, taxes and loss of retirement income later on).
“That pile of money looks like a new truck,” said Fernandez.
Deciding not to take a cash-out may not be enough. The money’s rate of growth also makes a difference.
Some workers leave retirement plans behind because rolling them over seems like too much trouble. Fernandez has had clients with multiple small accounts from previous jobs.
The good news is that these “stranded” accounts can continue to grow. The bad news? They might not grow very much.
Suppose you opted for a conservative 401(k) plan in your first job. Three years later, you get a new job but don’t want to deal with the rollover. Leaving the account behind could mean leaving behind the possibility for growth, if your new employer offers more investment options. Or you might have been able to use the money in some other way, such as a Roth conversion.
“You’re missing out on flexibility,” said Adam Day, a certified financial planner with fee-only financial advisory firm, Wealthquest.
Stranded accounts might even become lost. While helping an elderly friend with her finances, Fernandez uncovered a retirement plan, worth nearly $50,000, that the friend had forgotten.
Taking a 401(k) loan is sometimes described as “paying yourself back.” That’s not entirely accurate, said Day.
“It’s not like you’re paying yourself a compounding rate of return. It’s interest on what you borrowed,” he said.
Say that you borrow $10,000 from your $100,000 retirement account. Now the plan has only $90,000 earning compound interest. This means decreased future earnings.
Other potential issues with 401(k) loans:
Some plans won’t let you contribute until after the loan is repaid. Not only does that mean fewer contributions for up to five years, you’ll also miss out on any employer match.
Even if you’re still allowed to contribute, you might not be able to afford to save as much. Eight in 10 workers under age 34 decreased their contributions during repayment, according to a study from Teachers Insurance and Annuity Association of America.
If you default, the loan will be considered an early withdrawal and subject to taxes (and an early withdrawal penalty if you’re younger than 59½).
Should you lose your job, the loan will be due in full, generally within 60 days. Again, if you can’t repay the loan, it’s now a withdrawal and subject to those taxes or penalty.
Some workers opt to withdraw money rather than borrow. Whether it’s due to hardship or to meet a financial goal, like buying a home, early withdrawals generally also carry penalties and will be taxed as income.
Retirement leakage can have a critical impact on your golden years. Pay attention to your money now in order to work toward a comfortable, secure retirement.
Here's how to budget in retirement.
Image: Serhat Beyazkayah
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