“I would blow up the system and restart with something totally different.”
– Ted Benna, “father” of the 401(k), quoted in MarketWatch.com
As investors educate themselves about the financial advice that is accepted as “common wisdom,” many begin to realize that 401(k)s might not be the “retirement solution” they were assumed to be. Even Ted Benna, the man who popularized the tax loophole that turned into the 401(k) program, is very critical of what it has become.
But should you cash our your 401(k)? There are serious disadvantages as well as advantages, and it’s often not a simple or clear-cut decision.
The Pros and Cons of Cashing Out Your 401(k) Early
There are many good reasons to liquidate your 401(k) for good (or perhaps just put future dollars elsewhere). Here are seven of them:
1. Costs: Layers of hard-to-fund mutual fund, management and administrative fees that drain profits and slow growth.
2. Limited choices: Investment choices are extremely limited and mostly consist of risky mutual funds. Safer choices are less popular, especially as the fees make them less attractive.
3. Future taxes: Many fear (for good reason) that income taxes may rise and increase the future cost of taking income from a qualified plan.
4. Rules of Borrowing: Plan participants have restricted access to dollars for limited reasons and cannot use accounts to leverage against. Funds cannot be used to start a business, purchase a second home, or other purposes that may be preferable to keeping money in mutual funds.
5. The horrendous inefficiency of 401(k) loans: Any dollars borrowed from 401(k) have gone into the account “tax deferred” but must be replaced with “after tax” dollars to be taxed AGAIN upon withdrawal. That can mean a 25%, 28%, 35% or more automatic loss!
6. Political uncertainty: There are risks in keeping your money in accounts governed by policymakers and a government in debt. Though rules have been quite stable in the past, Congress has debated all kinds of things they’d like to do with qualified plan funds…
7. Consumer debt: Many plan participants have high interest debts they could pay off with 401(k) dollars to increase their cash flow position and enable more saving. It is a common quandary – what should you do with investments you can’t access when you have current debts or other needs?
In spite of compelling reasons to liquidate a 401(k), there are also important considerations and good reasons why cashing out your 401(k) may be a BAD IDEA – or at least, not a good move to make right now.
Before considering pulling your money out of any tax-deferred qualified plan, be well aware of the following considerations:
TAXES: You must be prepared to pay the taxes and penalties – both financially and mentally! Even when it makes sense numerically, it is often very difficult to pay all those taxes at once.
TIMING: Cashing out your 401(k) also means pulling out of your current investments. Nervous investors tend to pull their money after large losses – which may be exactly the wrong time. It feels counter-intuitive, but the best time to move your money from the market is usually when it has been performing well!
SAVINGS HABIT: Do you have an alternative structure (such as a cash value policy) in place to continue your savings habit? As problematic as qualified plans are, too often those who don’t save in qualified plans find themselves not saving at all.
WHAT NEXT? Where will you put the money AFTER you liquidate your qualified plan? Do you have a solid next-step strategy? Are you confident it is a BETTER place for you money than your 401(k)?
We agree with Andy Tanner, author of 401(k)aos, liquidating your 401(k) without having a sound strategy for what to do NEXT is not a good plan. In this informative video, Tanner explains why liquidating your 401(k) won’t necessarily solve the “real” problem of why you were investing in a limiting and inefficient qualified plan to start with:
As Andy points out, the reason that many employees are in 401(k)s in the first place is that they don’t know how to do better on their own – in other words, they don’t know how to invest.
Solving the 401(k) Problem
In spite of some limited and rather skewed “investment education” programs from plan administrators, a 401(k) won’t solve the problem of teaching people to invest. (Ironically, the plans are designed so that this problem CAN’T be solved, as truly educating employees how to invest would lead them to choose different options than a 401(k)!)
“We will never teach 40 million participants to become highly skilled investors,” Ted Benna told MarketWatch.com, after observing that “a 20 percent drop on your account value feels a lot different when your balance is more than $100,000 at age 56 than when you are 29 and have a $10,000 balance.”
But the problem goes deeper than teaching people how to get a better rate of return. If anything, chasing high rates of return are actually a symptom. The bigger problem is that qualified plans lead people to INVEST more than they can afford while SAVING too little. (We use the term “invest” loosely, as we wouldn’t recommend mutual funds in a qualified plan in the first place, even if an investor did wish to be in a stock market environment.)
It is imperative that people SAVE MORE. Saving helps you keep control of your money, while too often investing involves giving the control to a manager or broker or someone else. (We recommend 20% as a guideline or goal, and some people can manage to save even more.)
Most people have far too few liquid assets that can be used for emergencies or opportunities, and too many assets in restricted environments. As a result, they are subject to unreasonable risk and also “raid” their qualified plans when emergencies strike – with costly results.
Interestingly enough, when Benna tells the history of 401(k) plans, he reveals that they began with a mere 2 options: one for saving, and another for investing. An insurance company would offer a fund at a guaranteed rate, and the other option would be a broad, generally growth-oriented mutual fund, though sometimes it was the company stock plan (which, as we all know now, is a risky proposition.)
As Benna recounts, most participants chose to split their contributions between the two 50/50. Now, that didn’t solve the issue of having the employee’s savings locked behind the qualified plan wall, but it DID offer them some security and protection against market instabilities.
Yet there is another issue with the investment options provided in a typical 401(k). It has to do with the limited way many people have come to define “investments” as too often limited to stocks, bonds, and mutual funds.
Investing – as opposed to saving – is commonly thought of attempting to get a higher rate of return than you could in a guaranteed account or whole life cash value. Unfortunately, that does not take into account the value of liquidity, use, and control.
Earning an attractive rate of return can be very important in cash flow investments, but when it comes to growth, Prosperity Economics also values assets and businesses that the investor can OWN or CONTROL or BUILD EQUITY in.
Real estate fits this definition. Business ownerships and partnerships can fit this definition. And cash value accounts within life insurance policies fit the definition as well, although they are not technically classified as “investments.”
In the Prosperity Ladder (a concept described further in Kim Butler’s book, Busting the Financial Planning Lies,) WORK is what lifts people from poverty to subsistence, SAVING is what takes people from subsistence to comfort, and OWNERSHIP is what helps people climb the rest of the way up the mountain to PROSPERITY.
Get the Facts, Explore Your Options
Consult with your Prosperity Economics Advisor to discuss the pros and cons and options – if appropriate – to cash out your 401(k) early or perhaps free your money from a qualified plan gradually. Even if you don’t wish to liquidate your 401(k) now, it may be high time you created other investment or savings vehicles for new dollars.
Get back with the advisor who referred you here, or if you don’t have a Prosperity Economics Advisor, fill out our contact form and we’ll help you locate one.