Have you taken a loan from your 401(k) plan? Or are you thinking about cashing out the balance of a 401(k) from an old employer? It can be tempting to tap into your 401(k) savings, especially if you’re facing other financial challenges, such as credit card debt or medical bills.
However, you may want to resist the urge to use your retirement savings today. New studies show that 401(k) loans and distributions may present a significant challenge. In fact, they may be creating a new retirement crisis.
A study from Deloitte estimates that there will be more than $7 billion in 401(k) loan defaults in 2018 alone. The study also found that the loan distributions and the loss of future investment growth could create a $2.5 trillion shortfall for retirees.1
Plan cash-outs are another growing problem. These usually happen when people switch employers. Rather than roll their vested assets into an IRA, they cash out the plan and take a lump sum. Unfortunately, that eliminates future tax-deferred growth and creates tax liability. More than 40 percent of job changers cash out their plan, and in 2017 there were nearly $68 billion in cash-out distributions.2
The good news is you can avoid these risks with some planning. Below are some tips and guidance on both 401(k) loans and lump-sum distributions, and how to manage them to minimize your losses and tax liability. A financial professional can also help you implement a 401(k) strategy.
The best way to avoid 401(k) loan risk is to not take one. Of course, that may be easier said than done. If you’re facing a financial emergency, you may feel like a 401(k) loan is your best option. The truth, though, is that you probably have other options available. A financial professional can help you examine your budget and work out a strategy to overcome the challenge without threatening your retirement.
If you already have a 401(k) loan, consider ways to accelerate the repayment schedule. Your plan administrator can likely increase your 401(k) deductions to pay off the loan faster. That will help you start increasing your assets again and put more of your deduction into your plan.
Also, paying off your loan may help you feel more comfortable in switching jobs. Many 401(k) loan defaults happen when a person leaves an employer. They don’t pay off the loan before they leave, so the balance defaults and becomes a taxable distribution. By paying off your loan quickly, you can minimize that risk if you ever switch jobs.
It used to be common for workers to stay with one employer for decades, possibly even their entire career. Those days are long gone. Today, more than 20 percent of 401(k) participants change jobs each year.2
With that job change comes a decision about what to do with your vested 401(k) balance at your old employer. It’s understandable why many people choose to cash out their plan. It can provide a one-time financial windfall to address more urgent, short-term financial challenges.
However, a plan cash-out comes with significant costs. You lose all future tax-deferred growth on those funds. You’ll have to pay income taxes on the entire distribution. And, unless you’re over age 59½ or meet an exception, you’ll have to pay a 10 percent penalty.
You can avoid all those costs by rolling your funds into an IRA. The rollover isn’t a taxable event, so you avoid taxes and the early distribution penalty. You can also continue to grow your funds tax-deferred and choose from a wide range of options for your goals and risk tolerance.
Ready to implement a strategy to protect your 401(k) plan? Let’s talk about it. Contact us today at Capital Management Group. We can help you analyze your needs and develop a plan. Let’s connect soon and start the conversation.
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18184 - 2018/10/22