Why 401(k) Loans and Cash-Outs Could Cause Big Problems for Retirees

Are you one of the millions of Americans who use an employer 401(k) to save for retirement? A 401(k) can be a powerful savings vehicle because it offers tax-deferred growth and possibly employer matching contributions. Those two features can help you accumulate a significant amount of assets over time.

While a 401(k) plan is meant for retirement, many plans offer opportunities to take distributions while you’re still working. For instance, you may be able to take a loan from your plan. Or you can even cash out your plan balance if you leave your employer.

Although it may be tempting to dip into your 401(k) in the event of an emergency, you may want to resist doing so. New studies show that 401(k) loans and distributions are creating a potential crisis for future retirees. 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

Another growing problem is the cash-out of plan balances after employees change jobs. Many people choose to take their vested balance in a lump sum rather than roll it into an IRA. This decision eliminates future tax-deferred growth and creates current penalties and tax liabilities. More than 40 percent of job changers cash out their plan, and in 2017 the total value of cash-out distributions reached nearly $68 billion.2

Fortunately, you can avoid both issues with a little planning. Below are some tips and best practices to help you protect your 401(k) plan and your future retirement. Your financial professional can also help you develop a strategy.

 

Loans

 

The best way to avoid a 401(k) loan is simply not to take one. Of course, if you’re facing a significant financial challenge, it may be too tempting to pass up. You may feel like a loan is your best option.Before you take the loan, though, consider the consequences. You’ll lose future compounded growth on the loan amount. Also, a portion of your future 401(k) contributions will go toward loan repayment instead of retirement savings. And if you default on the loan, you’ll have to pay taxes and maybe an early distribution penalty. Look at your budget and other options to find an alternative to taking a loan.

If you already have a 401(k) loan, you may want to see if your plan administrator allows early repayments. Some plans allow you to increase your regular contribution and pay the loan off faster. That could reduce your interest payments and get you back on track to saving for retirement.

 

Distributions

 

Job changes are commonplace today. There was a time when people stayed with one employer their entire career. Those days are long gone. Today, more than 20 percent of 401(k) participants change jobs each year.2

When you change jobs, you face a decision about what to do with your old 401(k) balance. It can be tempting to cash out the plan. The distribution can provide a quick lump sum of cash to help you pay off debt or achieve other short-term goals.However, a plan cash-out can be costly. You lose future tax-deferred growth on those funds, and you’ll likely have to pay a 10 percent early distribution penalty on the entire amount. The result is that you’ll get an amount that’s far less than your actual balance.

One way to avoid these costs is to roll your 401(k) balance into an IRA. There are no taxes or penalties when you roll over a 401(k) balance. Also, an IRA offers tax-deferred growth. You can choose from a wide range of tools and allocation options to meet your needs, and then grow your funds tax-deferred until you retire.Ready to implement a strategy to protect your 401(k) plan? Let’s talk about it. Contact us today at Protecting Your Retirement at 913.648.2700. We can help you analyze your needs and develop a plan. Let’s connect soon and start the conversation.

 

1https://www.thinkadvisor.com/2018/10/10/leakage-loan-defaults-to-spark-2-5-trillion-retire/

2https://www.workforce.com/2018/02/14/retirement-account-bank-account-employees-cash-401ks-record-numbers/

 

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18184 – 2018/10/22