Each year, 14.8 million 401(k) participants will change jobs. Of these, six million will eventually cash out, according to the Retirement Clearinghouse Auto Portability Simulation
The bad news is many 401(k) participants aren’t rolling over their retirement plans with their new employer.
Outside of a true financial emergency, there’s no need to take 401(k) money out early – but that’s a message not getting through to retirement savers.
“The downside to the 401(k) loan is your plan most likely requires you to pay back immediately if you leave or they ask you to leave or it will be considered a distribution and you will have to pay income tax and a 10 percent penalty on the amount outstanding,” said Lou Cannataro, a partner at Cannataro Park Ave Financial, in New York City. “Also, if your alternative investment or business goes south, you just lost ground on securing your retirement.”
So, how can advisors step in and save 401(k) cash out takers from themselves?
Have A Conversation
The key is covering the following key 401(k) withdrawal issues to take care of any threats to their clients’ retirement savings:
Emphasize the downside. Tom Hawkins, vice president of sales and marketing at Retirement Clearinghouse, in Charlotte N.C. said, “Participants who have cashed out have effectively removed themselves from the defined contribution system, as if they’d never enrolled, and may also be throwing away their employers’ matching contributions, if that option is part of their plan.”
Most 401(k) cash outs are unnecessary, and clients should know that. Out of the six million participants who will cash out their plans each year, only about 2.2 million will cash out for a true financial emergency. “As a result, that leaves 3.8 million cash outs per year that are completely unnecessary and should have been left in place,” Hawkins said. “These unnecessary cash outs can be driven by external factors like systemic issues and a lack of participant education and assistance.”
Point out how clients are “stealing” from themselves. Michael Tanney, co-founder of New York City-based Wanderlust Wealth Management said, “I explain the tax penalty the client will incur from the IRS for withdrawing the funds early and mathematically (assuming historical return rates), what money they are stealing from their future-selves, by taking early withdrawals. The math doesn’t lie and is extremely effective; I’ve not had one client ever go through with the withdrawal.”
Triple up. Scott Stevens, a financial advisor at California Wealth Transitions, in San Diego, said he uses a three-tiered conversation to talk a client out of early 401(k) distributions.
- Compounding Growth. “Ask them if they want $1,000,000 or a penny that would double every day for a month,” Stevens said. “When they undoubtedly take the $1 million, I inform them they left over $4 million on the table by not allowing their savings the opportunity at compound growth.”
- Tax Implications. “This discussion is even easier here in California with our high state tax rate, but running numbers on how much they stand to lose (sometimes as much as half or more with pre-payment penalties and taxes) it steers them away from cashing out,” said Stevens.
- Rule of 72. “The third selling point I will sometimes use is the Rule of 72,” he said. “I’ll explain to the client that if they can roll their assets over to an IRA and just garner returns on average of 6 percent per year, their assets would double in value in 12 years.”
Investigate other loan options. “401(k) savers should look at other loan options, such as home equity, cash value life insurance or bank/business loans,” said Cannataro.
A Bad Idea
In general, taking out cash from a 401(k) plan is a bad idea, unless a client is dealing with an extreme emergency.
If your client is thinking of doing so, make sure your client understands the consequences both short- and long-term by having a conversation with the tips listed above to guide the discussion.
Brian O'Connell is a former Wall Street bond trader, and author of the best-selling books, The 401k Millionaire and CNBC's Guide to Creating Wealth. He's a regular contributor to major media business platforms. Brian may be contacted at email@example.com.
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