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401(k) and 403(b): 4 Good Reasons to Leave Your Retirement Fund Alone

When you’re in a rough patch and at your wit’s end on where to get the extra cash for that something which you just can’t do without, your retirement fund might be the most tempting nest from which to pick those precious eggs. Should you go ahead and pick?

Denied! That’s Suze Orman’s answer if you ask her the question. On her CNBC program, the Suze Orman Show, this personal finance guru echoes what most other financial advisers say about the matter each and every time. Never, ever withdraw from your retirement savings before it is due. It really makes sense, and we’ll explain why.

What is 401(k)?

401(k) is an employer-sponsored retirement savings fund. You have to be employed to qualify for 401(k). It’s as simple as that. It’s named after a special section of the Internal Revenue Service code that offers special tax advantages. Employee can make contributions to the retirement plan with pre-tax money, which means that you do not pay taxes on the amounts you contribute to the 401(k) plan.

If you make $60,000 per year and you put $5,000 of that into your 401(k) plan then you only have to pay taxes on the remainder — $55,000. This, on its own, is already a big boost to your financial health. All other things being equal, a $60,000 income will owe $8,429 while $55,000, on the other hand, will only be taxed $7,179. That’s a reduction of $1,250. Quite a tidy sum, yes?

403(b) plans are offered by school districts and other educational institutions, although certain non-profit organizations may offer them. It’s also called a Tax Sheltered Annuity plan, or TSA plan. It functions much like a 401(k) plan. The main differences are in the employer side. 403(b) plans are easier to administer and do not require a discrimination test because the objective is universal availability – all employees must be permitted to make salary-deferral contributions.

But that’s not the only tax advantage. All taxes generated by your 401(k) account are tax-deferred, meaning you do not pay taxes on those events until much later.

What if I withdraw my retirement savings early?

This is where Suze Orman says denied! And for greater emphasis – denied, denied, denied. Your 401(k) isn’t for house remodeling, a three-week European vacation, or your only daughter’s wedding. It’s for making sure you’re financially stable after retirement. That’s why there are controls in place to ensure that you’re not tempted to withdraw your funds before the proper time. A penalty of 10%, to be exact. That’s on top of the income tax on the amount that you withdrew.

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Let’s say that as your 50th birthday gift to yourself you took out $25,000 to redo your whole kitchen because you’ve just got to have those Spanish tiles and matching cedar cabinets. You’ll have to $2,500 penalty for that, plus pay regular taxes. In the 25% tax bracket that works out to $6,250. That $25,000 withdrawal will cost you $9,000 overall so your net proceeds will only amount to $16,000! Now it’s plain to see why Suze Orman and just about everyone else say taking money from your 401(k) is a bad idea.

The opportunity cost of early 401(k) withdrawals

Remember that your retirement is also an investment vehicle. You can decide on how your 401(k) assets are allocated. You have the option to invest them in stocks, bonds, mutual funds and other instruments. If you subtract from the amount invested in 401(k), you also subtract from the potential earnings of your investments. This might cost you dearly in the long run.

Hardship withdrawals are permitted, yes, and some the valid reasons include:

  • Prevention of eviction from, or a foreclosure on, your primary residence;
  • purchase a primary residence;
  • repairs to your primary residence;
  • unreimbursed medical bills for you or your family;
  • funeral expenses;
  • costs of higher education for yourself or for someone in your family.

However, always remember that these withdrawals are not loans and you can’t put back the amount you withdrew any time that you wish to. There is usually a 6-month waiting period before you can start making contributions to your 401(k) account again, and only up to the maximum amount stipulated by the plan.

401(k) is protected from bankruptcy

If, for any reason, you fall into really hard times and declare bankruptcy so your debts are wiped out, your creditors cannot run after the money you have stashed away in your 401(k) account. Not a single penny.

If your company goes bankrupt, your retirement plan assets are protected under ERISA – the Employee Retirement Income Security Act of 1974.

“ERISA requires that promised pension benefits be adequately funded and that pension monies be kept separate from an employer’s business assets and held in trust or invested in an insurance contract. Thus, if an employer declares bankruptcy, the retirement funds should be secure from the company’s creditors.”

Your company’s creditors can’t run after the company’s counterpart to your 401(k) account. Not a single penny.

Don’t touch your 401(k) and 403(b)!

To emphasize, there are four main reasons why tapping into your 401(k) or 403(b) funds is never a good idea:

  1. An automatic 10% penalty if you’re younger than age 59½.
  2. You lose out on years or decades of account growth.
  3. There’s a six-month waiting period before you can make new contributions.
  4. Retirement accounts are protected against bankruptcy.

Read the article Retirement 101: The Basics of 401(k) for a more detailed account of 401(k) and other retirement funds.

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Now that you’ve been warned, will you still tap into your 401(k)?
Tell us why or why not in the comments section below.

 

Category: Financial News

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