With the conclusion of tax season upon us, I thought it would be appropriate to discuss simple, yet often overlooked, financial behaviors that can catch us off guard.
The other day I was asked to discuss the reasons why someone should not cash out his 401K after being fired or laid off. As important as it is to not leave retirement savings sitting in a previous employer’s 401k, it is equally important to manage those dollars properly. It might be tempting to cash out the account and use the money as a stop-gap emergency fund, but it is not a wise idea to view the value of your 401k as liquid cash. For starters, the monies contributed to a 401k are pre-tax unless your previous employer offered the 401k Roth, where you were able to contribute post-tax dollars. In either case, the company matching contributions must be made with pre-tax dollars causing them to be subject to taxation if withdrawn. When you cash out a 401k from a previous employer, you are setting yourself up for a large tax bill. In addition to the tax liability, you may also incur a penalty for early withdrawal. As a matter of common sense, losing nearly fifty percent of the value of your 401k to taxes and penalties is not wise financial management. If you are beyond 59 ½ years old, you can escape the penalty. However, the 401k contributions (if made pre-tax) and the company incentive match are still subject to taxes at your current income bracket. If you are in the 25 percent tax bracket, cashing out your 401k might cause you to show income that is subject to the highest tax bracket. That means you could be liable for taxes at the 39.5 percent rate instead of the 25 percent rate. Again, not smart financial management. There are two less obvious reasons why cashing out an old 401k is not advantageous. The first reason is what is known as opportunity costs. Anytime you unplug an investment, that is, remove the cash from an investment vehicle such as a mutual fund, you reduce the growth opportunities of that investment. Cashing out the holdings in a 401k takes the assets designated as a growth plan and moves them to an asset that is impacted by inflation and taxes. Until you can reasonably transfer the assets to another tax favored investment arrangement, it is best to maintain the opportunity for growth, thus leaving the assets in the 401k for the time being. Another reason not to cash out a 401k is the temptation to live above your means. As of December 2012, nearly half of all Americans live paycheck to paycheck. This statistic suggests that nearly half of all Americans spend every dime they make between paychecks and that a large percentage of Americans would be tempted to spend the cash from the 401k. Failure to set aside the amount required to pay any taxes (and penalties) would result in a tax emergency the following year. Cashing out an old 401k could result in a ripple effect for years to come. For example, in 2013 you cash out an old 401k. You are under 59 ½ so there is a 10 percent penalty. Without considering the ramifications of your actions, you decide that until you find new employment, you are going to “take some time for yourself” and you plan a vacation. The following year (2014) you file your taxes and realize that instead of being accountable for 25 percent in taxes, you are now in the 39.5 percent tax bracket. Because you spent the 401k assets on a “well deserved vacation,” you have no resources available to pay the taxes you owe. So, you decide to take out a loan or use a credit card to pay your taxes. This is the biggest mistake of all. You use debt to pay off debt. Since you are not employed, you have effectively created a multi-year debt payment for a single year financial requirement. Not having a plan for meeting your financial obligations results in a ripple effect for years to come. The best thing you can do with a previous employer’s 401k is have it transferred from the employer’s 401k management company to a rollover IRA with a management company of your choice. Direct rollovers do not result in a tax or penalty situation and it only unplugs the investment for a short time. Once transferred, you can re-invest the assets in a variety of ways to facilitate growth. Consider this thought. You have lived without this money and even though you are now unemployed, your primary desire should be to preserve your tax-favored savings. If you cash out the 401k, you will have a propensity to spend the money while you search for and secure new employment. You will also guarantee that you will lose any opportunity for growth. You will be less likely to set the cash aside and more likely to lose value to taxes, penalties, and inflation. If at all possible, once the assets are transferred out of the previous employer’s 401k management company to a management company of your choice, forget that you have it. If you want to learn how to do this, contact a financial planner or mentor who can help you. The last thing you want to do is inflate your annual income with pre-tax savings. It is likely you will enter the highest tax bracket and also incur a severe penalty. If you desire to build a strategic life plan, contact me by visiting the contact page on http://kenrupert.com and express your interest in accelerating your life to achieve your destiny.