Our 2 Cents

Welcome to Professional Financial Solution’s blog, Our 2 Cents! We aim to provide you with brief insights and analysis on financial planning and investment topics on a weekly basis. If any clients or other readers have questions or topics that they would like to see covered here, please feel free to contact us by email or by posting a comment to a recent blog post. By reading the articles on this blog, you acknowledge our warning and disclaimer, provided here. Articles are provided for informational purposes only and shall not be relied upon as personal financial or investment advice.

Avoiding Leaky Nest Eggs, Part 2: What to Do with Old Retirement Accounts

As we discussed in our last post (“Avoiding Leaky Nest Eggs, Part 1:  Where to Turn When You Need Money Fast”), a common problem in the retirement planning world occurs when employees cash out their retirement plans after switching jobs or take loans from retirement plans and fail to pay themselves back.  This problem is known as “leakage,” and it can significantly deplete retirement savings over time, jeopardizing employees’ ability to retire comfortably.  So, how do you avoid having a leaky nest egg?  First, as discussed in Part 1, know the risks of taking loans from your retirement plan and consider the pros and cons of various options if you need a lump sum of money fast.  Second, it is imperative that you make conscientious choices regarding retirement plans from former jobs.  You have several options for what to do with those accounts, as we outline below.

Leave the funds in your former employer’s plan.  Many people default to this option since it doesn’t require any effort.  And, if your former employer plan has well-diversified, passively-managed, low-cost investment options, this might not be a bad choice.  The problem comes, however, when you switch jobs several times and have multiple old retirement plans.  At that point, it is impossible for most people to keep track of the plans and manage their investments attentively while they are working, not to mention trying to manage withdrawals in retirement and required minimum distributions (RMDs) at age 70 ½.  In the interest of simplicity (which also can help investment returns since you’ll be able to pay better attention when you have fewer accounts), you should consolidate funds into a new employer plan or a Rollover IRA if you have more than one former employer plan outstanding.  (Also, if you have a low balance in your former plan, e.g. less than $5k, the plan sponsor will often force you to roll the funds over or cash them out because the administrative costs are too high to keep open such a small account.)

Roll the funds into your new employer’s plan.  If your new employer plan has excellent investment choices (again, we define “excellence” in this regard as well-diversified, passively-managed, low-cost mutual funds), rolling over the funds into the new plan might be a good choice.  This achieves the goal of consolidation, leaving only one account for you to monitor and manage.

Roll the funds into a Rollover IRA.  If, however, you do not have excellent investment choices with your former employer plan or new employer plan—or you are starting to accumulate old employer plans and they are getting hard to manage—you may want to consider moving the funds into a Rollover IRA.  This gives you more control over your investment options, and you can consolidate multiple accounts into one IRA.  Even if you do have excellent investment choices in your old plan or new plan, but you realize that personally you are not very adept at or interested in monitoring and managing your retirement savings, you may still want to consider moving the funds into a Rollover IRA and have the account managed by a financial adviser (like us!).  Assuming that the financial adviser is a good one (like us!), this move will have the advantage of excellent investment choices as well as close management of the account, meaning that the adviser will regularly rebalance the portfolio, manage your withdrawals and RMDs, strategize how to minimize taxes when drawing on your accounts, etc.

Cash out your retirement plan.  As we hinted above, cashing out your retirement plan is our least favorite option.  Not only will you likely face income tax and a 10% penalty on the withdrawal (if you’re under age 59 ½), you will forego years of tax-deferred growth that would otherwise have aided your ability to retire comfortably.  However, if you anticipate needing money from your retirement account prior to age 59 ½ due to unemployment or another significant reason, be sure to consult a financial adviser on what to do with your old retirement plan, since there are some exceptions to the penalty on early withdrawals that differ between IRAs and qualified retirement plans like 401(k)s.

If you are switching jobs, please give us a call so that we can talk through the options for your old retirement plan.  We certainly hope that you won’t indulge in retirement savings leakage, but we also don’t want you to fall victim to inertia and just stick with the status quo (leaving the plan where it is) if that is not the best option for your financial future.  We can evaluate the investment options at your old plan and new plan, compare them to the investment choices at our disposal, and discuss which option might be best for you.

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Avoiding Leaky Nest Eggs, Part 1: Where to Turn When You Need Money Fast

In the wake of the Great Recession, U.S. companies have been trying to bolster employees’ retirement savings habits.  One technique that has become popular is automatically enrolling them in retirement plans.  However, many employees cash out their retirement plans when switching jobs or take loans from their retirement plans and fail to pay themselves back, thereby unraveling the hard work that they and their employers did to amass retirement savings in the first place.  In the retirement planning world, this problem is described as “leakage.” So, how do you avoid having a leaky nest egg?  First, make conscientious choices regarding retirement plans from former jobs (we’ll discuss this in “Avoiding Leaky Nest Eggs, Part 2”).  Second, know the risks of taking loans from your retirement plan and consider the pros and cons of various options if you are in a position of needing a lump sum of money fast.

We all occasionally find ourselves in need of funds to cover unexpected lump sum expenses.  Perhaps you thought you could get a few more years out of your old car, old roof, or old HVAC unit, and then it breaks down and requires a major outflow of cash right away to fix or replace it.  Where should that cash come from?  While some may turn to 401(k) loans, there may be preferable options, as we discuss below.

Savings Account.  If you have an adequate emergency fund, that is likely the easiest and most cost-effective solution.  Just be careful not to drain it too much in case of any interruptions in income or additional unexpected expenses in the near future, and be sure to build the emergency fund back up in the months that follow. 

Investment Account.  If you have investments in a taxable (non-retirement) account, that could be a source of the needed funds.  However, selling investments to generate the cash may result in capital gains taxes.  In addition, if you intended to use your taxable investments for a major financial goal, such as paying for kids’ college or retirement, tapping them for smaller expenses along the way could jeopardize your ability to reach your goal.

Home Equity Line of Credit.  If you own a home and have equity in it—i.e. you owe less on your mortgage than the value of the home—you may be able to borrow money on a home equity line of credit (HELOC) to cover major unexpected expenses.  The interest rate on a HELOC is generally low (relative to other forms of debt), and banks will often let you establish one without any closing costs.  In today’s low-interest rate environment, this is a good option, especially for those with high monthly income and positive cash flow.  (And it is best to establish a HELOC now, when you don’t need the funds.  Once established, it is easy to draw on the line.  You just have to write a check.)  Two drawbacks, however, are that the interest rate is likely to be variable (may rise over time) and that your home is being used as collateral, which could be problematic if your situation changes and you are are unable to make payments.

Retirement Account Withdrawals.  If you are over age 59 ½, you could tap your retirement accounts for needed funds without penalty, though you would need to pay income tax on any withdrawals.  Under age 59 ½, you would need to pay income tax and a 10% penalty, unless you qualify for one of the early withdrawal exceptions.  If you need funds for only a short time, you could potentially withdraw funds from an IRA for less than 60 days without incurring tax and penalty.  However, if you fail to return the funds to your retirement account by Day 61, it would be deemed a withdrawal, and you would owe the penalty and taxes on the full amount.  Thus, that would be a risky strategy and not one we would recommend.  If your retirement portfolio includes a Roth IRA, you can likely take withdrawals without any tax ramifications.  However, as mentioned above, if you intend to use your retirement savings to fund your lifestyle in retirement, tapping it for smaller expenses could jeopardize your goal.

Retirement Account Loans.  The majority of retirement plans offer the option of taking loans against the account, according to a recent Wall Street Journal article.  Participants generally can borrow up to half of their plan balance or $50,000, whichever is less, without demonstrating hardship or providing any other compelling reason to take the loan.  One problem, however, is that many borrowers default on the loan or reduce their retirement plan contributions while paying the loan back, thereby hindering their progress in saving for retirement and potentially making it a very expensive borrowing option.  If, e.g., you leave your job with a 401(k) loan outstanding, you typically will have a short period of time in which to repay the loan, otherwise it will be deemed a withdrawal, subject to income tax and penalties, as described above.  Another drawback with retirement plan loans is that, even though you will pay yourself interest on the amount borrowed, those borrowed funds are no longer invested, so you forego the investment returns that may have resulted had you left the money in the plan.

If you face an unexpected expense and don’t know how to pay for it, please give us a call, and we can talk through the various options with you.  (Note that we didn’t even discuss the possibility of using credit cards in this post, given that credit card debt is generally a very expensive way to borrow and can have other negative side effects, such as damaging your credit score.)  We don’t want retirement plan leakage to jeopardize your financial goals, so consider the pros and cons of these options before choosing where to turn.

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