Disadvantages Of Closing Your 401k
Whether you should cash out your 401k before turning 59 ½ is another story. The biggest disadvantage is the penalty the IRS applies on early withdrawals.
First, you must pay an immediate 10% penalty on the amount withdrawn. Later, you must include the amount withdrawn as income when you file taxes. Even further down the road, there is severe damage on the long-term earning potential of your 401k account.
So, lets say at age 40, you have $50,000 in your 401k and decide you want to cash out $25,000 of it. For starters, the 10% early withdrawal penalty of $2,500 means you only get $22,500.
Later, the $25,000 is added to your taxable income for that year. If you were single and making $75,000, you would be in the 22% tax bracket. Add $25,000 to that and now youre being taxed on $100,000 income, which means youre in the 24% tax bracket. That means youre paying an extra $6,000 in taxes.
So, youre net for early withdrawal is just $16,500. In other words, it cost you $8,500 to withdraw $25,000.
Beyond that, you reduced the earning potential of your 401k account by $25,000. Measured over 25 years, the cost to your bottom line would be around $100,000. That is an even bigger disadvantage.
Take An Early Withdrawal
Perhaps youre met with an unplanned expense or an investment opportunity outside of your retirement plan. Whatever the reason for needing the money, withdrawing from your 401 before age 59½ is an option, but consider it a last resort. Thats because early withdrawals incur a 10% penalty on top of normal income taxes.
While an early withdrawal will cost you an extra 10%, it will also diminish your 401s future returns. Consider the consequences of a 30-year-old withdrawing just $5,000 from his 401. Had the money been left in the account, it alone would have been worth over $33,000 by the time he turns 60. By withdrawing it early, the investor would forfeit the compound interest the money would accumulate in the years that follow.
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Leave Your Retirement Savings In Your Former Qrp If The Qrp Allows
While this approach requires nothing of you in the short term, managing multiple retirement accounts can be cumbersome and confusing in the long run. And, you will continue to be subject to the QRPs rules regarding investment choices, distribution options, and loan availability. If you choose to leave your savings with your former employer, remember to periodically review your investments and carefully track associated account documents and information.
Features
- Your former employer may not allow you to keep your assets in the plan.
- You must maintain a relationship with your former employer, possibly for decades.
- You generally are allowed to repay an outstanding loan within a short period of time.
- Additional contributions are generally not allowed. In addition to ordinary income tax, distributions prior to age 59½ may be subject to a 10% additional tax.
- RMDs, from your former employers plan, begin April 1 following the year you reach age 72 and continue annually thereafter, to avoid IRS penalties.
- RMDs must be taken from each QRP including designated Roth accounts aggregation is not allowed.
- Not all employer-sponsored plans have bankruptcy and creditor protection under ERISA.
If you choose this option, remember to periodically review your investments, carefully track associated paperwork and documents, and take RMDs from each of your retirement accounts.
Summary: Keeping Your 401k Safe
Finally, history proves stock market crashes are rare events that long-term market gains will make up.
If you can time the market to avoid the worst of a crash, then this is a good option.
Secondly, another way to keep your 401K safe is to keep your money in the market and use dollar-cost averaging to your advantage. Notably, the stock market erased all the losses from the 2007-2008 crash by October 2012, just four years later, and if you had doubled down on your investing during the worst periods of the crash, you would have a chance to outperform the market.
- Highly Recommended Reading: Fact-Based Research of 6 Major Stock Market Crashes & What Caused Them. The Facts About The Impact of Crashes & How To Avoid & Profit From Them.
This is not specific financial advice I am not a registered financial advisor I am a market analyst. If you are concerned about your investments, seek the help of a registered financial advisor who can provide tailored advice to suit your specific risk and portfolio requirements.
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Use An Outside Company Like Beagle
If your search in the above databases doesnât provide any results, utilizing an outside company to find your old 401s and do the difficult work of consolidating them is a great option.
Beagle is the first company of its kind that will do the difficult work for you. We will track down your old 401s and find any hidden fees in your current 401 plan.
Then, they will provide you with options on how best to rollover your 401s into one convenient, low-cost investment option.
This is a great option for anyone who is not sure where to start or even where to begin looking.
Understand How Your Portfolio Is Impacted
The key to understanding how your stock portfolio may be impacted is to use the right tools to analyze your current holdings and enable you to perform the proper research to enable your investing strategy.
For example, if your current portfolio is already very defensive and has a low correlation with the current market direction, you may not need to take aggressive action.
Portfolio analytics and stock research are the keys to long-term successful investing. You need a tool that can provide:
- Detailed Company Financials
- Dividend History and Estimates
Stock Rover is our recommended Stock Screening, Research, and Portfolio Management tool, winning both our Best Stock Market Software Review and our Best Stock Screener Review.
Stock Rover can perform detailed portfolio analytics and assessment and help with rebalancing your portfolio. Not only that, but it can also connect to your broker and even help you create a Warren Buffett Value Investing Portfolio or a stable Dividend & Income Portfolio.
Read the Stock Rover Review or get Stock Rover for Free.
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Should You Use Your 401 To Buy A House
There are good reasons for not using your 401 to buy a house. Even if youre comfortable with the 10% early withdrawal penalty, you will still be incurring long-term consequences by reducing your savings. That, in turn, will damage your future growth potential.
Taking out $10,000 from a $20,000 401 account, for instance, leaves you with only $10,000 that will continue accruing interest. With a 7% annualized rate of return, that $10,000 could become $54,000 over 25 years compared to $108,000 had you not withdrawn $10,000.
Withdrawing from your 401 account is essentially taking out a loan against yourself. If you want to pay it back, you also need to pay interest, and the time spent paying it back is time that could have been spent on growth.
What Is An Ira
While there are a number of benefits to 401ks, they’re not the only retirement plan in the game. An IRA is an individual retirement account. Where a 401k can only be offered through an employer, an IRA account can be opened up by an individual whether they’re associated with an employer or not. That means they’re the best option for independent contractors without an employer or anyone who wants to do some extra retirement planning on top of their 401k.
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The 4% Withdrawal Rule
The 4% rule says that you can withdraw 4% of your savings in the first year, and calculate subsequent yearâs withdrawals on the rate of inflation. This rule is based on the idea that you should withdraw 4% annually, and maintain the financial security in retirement for 30 years. This strategy is preferred because it is simple to compute, and gives retirees a predictable amount of income every year.
For example, if you have $1 million in retirement savings, 4% equals $40,000 in the first year. If the inflation rises by 2.5% in the second year, you should take out an additional 2.5% of the first yearâs withdrawal i.e. $1000. Therefore, the withdrawal for the second year will be $41,000.
Withdrawing From A Roth 401k
Most 401k plans involve pre-tax contributions, but some allow for Roth contributions, meaning those made after taxes already have been paid.
The benefit of making a Roth contribution to your 401k plan is that you already have paid the taxes and, when you withdraw the money, there is no tax on the amount gained as long as you meet these two provisions:
- You withdraw the money at least five years after your first contribution to the Roth account
- You are older than 59 ½ or you became disabled or the money goes to someone who is the beneficiary after your death
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A Beginner’s Guide To Understanding 401k Plans
The word 401k is synonymous with retirement, but how many of us actually know all the rules around 401k accounts? We’ll walk you through all the finer details, but we also know you’re busy, so we’ve also whipped up this handy table of contents for you, too. Feel free to self-serve some of the most frequently asked questions about 401k plans, or binge it all, top to bottom.
Now, onto the good stuff:
What Happens If I Stop Contributing To My 401k
If you are considering stopping contributions to a 401k, you would be better served to merely suspend those contributions. A short-term suspension will slow the performance of your retirement fund, but it wont keep it from growing. It also will lessen the temptation to simply withdraw all the funds and wipe out retirement savings in the process.
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Using 401 To Buy A Car
Retirement plans like 401s are a great way to build up investment portfolios, and as long as the money stays invested, all of your contributions are tax-deductible. Financial advisors do not recommend withdrawing the money before age 59½ if at all possible, because of the significant income taxes and fees that are incurred.
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Unless you are facing a financial hardship, using your 401 savings before the age stipulated is not typically the best option the associated penalties can render your investment gains much less effective. It’s ideal to look for other ways to finance a car. In addition, it’s important to note that every employer that offers 401 plans has different rules that apply to loans and withdrawals.
If the plan does allow for loans, you will need to sign a loan agreement that includes terms like the length of the loan, interest rate, principal amount and fees that will be charged. According to FINRA, the IRS sets limits on the maximum amount that can be borrowed, which is either $50,000 or half the amount that you are vested. The usual term for a 401 car loan is five years, but it can be shorter 401 home loan can have much longer repayment terms.
Using Your 401 To Buy A House: A Guide
If youve been dreaming of owning a home, youve probably imagined yourself cooking in the perfect kitchen or having a fenced yard for the dog. But making that dream come true requires an incredible financial commitment and the first step is to cobble together the cash youll need for a down payment and closing costs.
You may be wondering whether you should consider using the money in your retirement account toward the purchase of a home. Before you decide, you need to be aware that there are both financial and legal considerations to take into account.
Lets examine the pros and cons, and see whether using a 401 to buy a house is right for you.
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Things To Do In Corrections
The first is to make sure that you’re not overextended in your stock positions. Many investors used margin loans or other forms of leverage when the market was red-hot in order to boost their returns even further. But when downturns happen, those measures exacerbate losses and can sometimes force you to sell at exactly the wrong time. The ideal time to get your leverage in line is before a correction happens, obviously, but it’s vital to take action before things get out of hand.
Next, whether you’re a seasoned investor or you’re going through your first downturn, it’s helpful to start taking some notes. Keep track of how you react to volatility, both in terms of what investment actions you take and the reasons behind them. If you find yourself reacting emotionally to the correction, note that, too. It’s always hard to remember the fear from being in a downturn after it’s over.
If it’s been a while since you rebalanced your portfolio, take a look and see if your current asset allocation is in line with your risk tolerance. Many people who don’t rebalance regularly are surprised to find out that a rising stock market can dramatically boost the percentage of their portfolios that are invested in stocks. That leaves them more exposed to subsequent downturns than they’re prepared to handle. Rebalancing keeps your risk levels in line with your comfort zone.
Are There Other 401 Options
Withdrawal is not the only way to access 401 funds for a down payment.
Your benefits provider may also offer 401 loan options. If available, this option not only helps you avoid the early withdrawal penalty fee, but also paying income tax on your withdrawal.
401 loans let you borrow up to 50% of your vested account balance Taking out this type of loan puts your 401 account on hold for the duration of the loan you wont be able to make additional contributions until the money is paid back.
But how can you calculate whether the 401 loan is a smart financial decision? As with any lending scenario, the price you pay to borrow the money has a big impact on determining whether the loan is worth it. You can typically expect a 1%-2% spike above the prime rate for these types of loans. Another factor to consider has to do with your employment. If youre unable to pay back the loan on time or before leaving/losing your job, you may be subject to the same financial penalties that come with a withdrawal.
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No Opportunity For An Advisor To Add Value To Your Asset Allocation
Depending on the options in your plan and your own investing acumen, there might not be an opportunity for a professional money manager to add value to your asset allocation. Most 401 plans limit the investment choices they offer participants, but some plans are better than others. Morningstar reports the average 401 plan offers 21 funds .
It’s not just about the number of funds, though. The characteristics of the funds, expense ratios, breadth of styles and asset classes, etc., are factors to consider. Some plans achieve bread diversification with fewer than the average 21 options so it’s important to consider quality and quantity. Assuming you have the time to select and monitor the investments, and are comfortable with the outcome, you might not need an advisor to manage the account.
Things To Know Before Opening A 401 Brokerage Account
If you’re considering a 401 brokerage account, the first thing you must decide is what percentage of your retirement savings you’d like to put there. You can put all of it there if you’d like, but it may be better to leave part of it in a mutual fund chosen by your employer, just to be safe.
You should also note that some 401s only allow you to transfer funds to a brokerage account during a certain window each year. If this is the case for your plan, make a note of this time frame so you don’t miss it.
Next, look into the account maintenance fees and any other fees associated with the investment products you’re considering. Ideally, you can keep these at or below 1% of your assets. That means you’ll pay $1,000 or less per year for every $100,000 you have in the account. If you plan to employ a financial adviser to help manage or offer suggestions for your 401 brokerage account, don’t forget to factor in those fees as well.
If a 401 brokerage account isn’t a good fit for you, go with one of your employer’s investment selections instead. This is the safer bet if you don’t have the time or interest to learn more about investing. These are your retirement savings at stake, so you don’t want to take unnecessary risks.
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