Hands Off the 401(k)
It can be tempting to tap retirement funds when the opportunity presents itself. It might look good short-term, but the long-term effects can be devastating.
By Ann Coleman (TMF AnnC)
October 23, 2000
In the grand tradition of our political process, I have an anecdote for you today. It features a secondhand story of a young tech worker -- lives at home, about 21, making lots of money, but not a tech genius.
This young chap was overheard complaining bitterly about taxes. (Hold on, don't click yet, I'm not going to get into politics, I promise.) It seems that when his company was bought out, he had the option to withdraw the cash in his 401(k). The balance was $4,000 thanks to his sweet salary and corporate matching. His complaint was that when he withdrew it, he only got half of it because of taxes. What a bummer.
Why, you ask, didn't he roll it over into the new 401(k)? He wanted to jack up his car about three inches, is the reason I heard -- more about the long-term results of his short-term thinking later. First, how could he possibly have lost more than half its value to taxes (completely unnecessarily, I might add)?
Well-paid though he is, I doubt that he is out of the 28% bracket, so let's do the math.
$4000 x 0.28 = $1120
10% penalty 400
State tax 400
Total taxes $1920
Big bite, eh? But our guy stuck his hand right into the tax tiger's mouth. He didn't have to pay those taxes at all.
Suppose he had taken the path of least resistance and rolled that 401(k) money into the new company's 401(k) and put it in an index fund? That would have cost him nothing in taxes (although it will cost him something in reduced car prestige). Know what that account would have been worth at retirement (age 59 1/2) if his index fund merely matched the market's 70-year average return of 11%?
$211,024
That's right, more than two hundred thousand dollars, and that's if he never added another penny.
Taking a non-qualified distribution from a 401(k) (or an IRA or any other retirement account) is tax suicide! If you're thinking about it, stop right now.
It's also retirement suicide. Suppose he had been lucky enough to average 16% per year instead of 11%. That's less than the market has averaged over the past 20 years, but well above the 40-year average rate of return. With an average annual return of 16%, he would have more than $1.25 million at age 59 1/2. (He would still owe taxes on the money as he withdraws it. But, personally, I'd rather have the million bucks to pay taxes on.)
Even taking out contributions to a Roth IRA (no tax penalty) is a pretty terrible idea when the account is young and growing. Withdrawing contributions means you have less cash to compound, and the long-term effect could be devastating.
The mess o' pottage our friend sold this birthright for wasn't even something that will contribute to his future well-being -- like college tuition, or a down payment on a house, or a car he needs to get to work. He wasn't even using it to pay off debt, the most frequently cited reason for taking an unqualified distribution. (Also a bad idea, although a noble one. No matter how appealing, the tax penalties are just too high.) It was to buy a car accessory!
This is a real person, by the way. I couldn't have made this up. And I'm not making up the hordes of people who take early distributions from 401(k)s or other retirement plans. This shortsightedness is not limited to the young.
Here in the Foolish Four area, we hope to beat the market over the next 20 or 40 years, but you can't beat it unless you have money in it. And you can't have money in the market if you take it out for short-term needs. Sure, there will be times when dipping into the retirement pot is justified. But they should be limited to dire circumstances indeed.
Fool on and prosper!
