How To Avoid Tapping Your 401(k)
According to a report by consulting firm Aon Hewitt, the aftermath of the financial crisis that occurred in 2008 has caused record numbers of Americans to tap their 401(k) retirement accounts. This drain of money from employer sponsored, tax-deferred retirement plans coupled with a contribution rate to retirement accounts that is already too low puts the retirements of millions of people in jeopardy.
Loans, withdrawals, and cashouts can devastate retirement accounts
Loans against 401(k) accounts are up nearly 24% over loan activity prior to 2008. While most loans are repaid if the employee remains with the company, 70% of loans held by terminated employees end up in default. That money is permanently lost from the retire account. For those under age 59½, a loan default is considered a taxable withdrawal and subject to penalties which can significantly reduce the net amount of the withdrawal.
Partial withdrawals from 401(k) accounts have increased almost 28% since 2007. Unlike a loan, withdrawals are permanent and that money cannot be redeposited into the plan.
In 2010, 42% of terminated workers opted to cash out their 401(k) accounts. A cashout is the removal of all money from a qualified retirement plan and closure of the account. Cashouts by those under age 59½ are considered taxable withdrawals and subject to penalties which can significantly reduce the net amount of the proceeds.
Contributions to 401(k) accounts are automatically withheld from the participant’s paycheck which make it the most painless way to accumulate money for retirement. However, once that money is withdrawn from the plan and spent, it is unlikely that it will be replaced in the future. Replacement simply requires too high a rate of saving and too much sacrifice for most people. Consequently, their retirement accounts take a permanent hit. And not just for the principal that is withdrawn, but also for the compounded interest that would have accrued over the years if that money had remained in the plan. This can leave them deficient of savings when it comes time to retire.
Retirement savings is not an emergency fund
Retirement savings should be just that, for retirement. Too many people equate retirement savings with savings in general. They think they have plenty of savings because they have a lot of money in their 401(k) account, but that’s for retirement. It’s not for emergencies.
Four steps you can take to preserve your 401(k) account
To avoid tapping your 401(k) for emergencies, follow these suggestions:
- Establish and fund an emergency savings account, separate from your 401(k) account, equal to at least six months of living expense. Note: Some experts are suggesting a twelve-month emergency fund due to a perceived structural change in unemployment as a result of the Great Recession.
- Establish accounts within your budget for unpredictable expenses such as medical co-pays and deductibles, automobile repair, appliance repair and replacement, home repair and maintenance, etc. Set aside money monthly in each of those accounts and continue to accumulate money in them until a need arises. These expenses will occur; be prepared for them.
- If you are a dual-income household, live on the equivalent of one income and save the difference. This will insulate you from unemployment. If one of you loses his job, you will be able to get by on the earnings of the other. If you both lose your full-time jobs, you should be able to get by on combined part-time earnings or combined unemployment compensation or some combination of both.
- Eliminate debt. This will give you the flexibility to adjust your standard of living to a reduced income during a crisis.
It takes more than retirement savings to secure your future. It takes a lifestyle devoid of debt, a cash-based lifestyle, with multiple forms of saving that act as a buffer against hard times.
K.C. Knouse is the author of True Prosperity: Your Guide to a Cash-Based Lifestyle, Double-Dome Publications, 224 pages
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