Did you listen to me?
Did you start your 401K?
Now leave it alone! No, I don’t mean the occasional rebalancing. I mean the whole thing! Leave it alone!
Nearly every year that I have prepared taxes, someone comes in with a decimated 401K. No, I’m not talking about a 401K that is riding the roller coaster of the market; I am talking about a 401K that has been purposely destroyed. This is the account that was cashed out in one ill conceived moment.
Let’s review the attributes of the 401K.
It is first and foremost a retirement plan. You are saving for your future self. With a little luck and a modest 6% return, it should double every twelve years. That means that one thousand dollars (invested at 22) will turn into two thousand dollars by the time you turn 34; then four thousand dollars at age 46; eight thousand dollars at 58 and sixteen thousand dollars by the time you are 70 and ready to retire. Save two thousand dollars when you are 20, and you will have thirty-two thousand dollars at 70. Many companies will match whatever you are willing to invest in your own 401K. So, if you save two thousand dollars in your 401K, your employer will place an additional two thousand dollars in your 401K. Now you will have sixty-four thousand dollars at retirement, and all you had to do was save two thousand dollars in your 401K.
A 401K is designed to be used for retirement. To encourage you to save, the federal government will NOT tax you on any money you put in your 401K. This means that you will save $300 in taxes if you invest two thousand dollars in your 401K and you are in the 15% tax bracket. Put another way, that sixty-four thousand dollar retirement only cost you one thousand seven hundred dollars. If you are in the 25% tax bracket, you will have actually only spent one thousand five hundred dollars, since your taxes will be decreased by five hundred dollars. It is only when you retire and start using the 401K that you will pay taxes on this money. By then, your peak wage earning years will be over and you will probably be in a lower tax bracket. Until that future date you will not owe any tax money on your own contributions, your boss’s contributions, interest, dividends or any growth in your 401K.
So, we have a retirement plan with no tax liability until we take it out. Hopefully, we will be in a lower tax bracket when we take it out. However, if we take it out BEFORE retirement age – usually 59 1/2 – there is a ten percent penalty on the money withdrawn early. That doesn’t sound like much. IT IS!!!!
I have seen many naïve individuals in their peak earning years cash out their 401K’s early. My last simpleton was 40 years old when he was laid off last year. His severance package swelled his taxable income to nearly one hundred thousand dollars. Then he decided to use his 401K to pay off his mortgage, so he cashed that out too. With that decision, all of his 401K became taxable. Tacked onto his regular pay and severance package, the tax rate on his 401K soared up to 28%. An additional 10% was required to pay a penalty for early distribution. With state taxes taking another bite, fully one third of his nest egg was used to pay taxes.
What should he have done? Well, he used it to pay his mortgage off. But, he could have tightened his belt and continued to make payments. He could have taken the minimum necessary to survive from his 401K and allowed the balance to grow. Assuming that he needed an additional one thousand dollars a month, he could have opted to only take twelve thousand dollars out last year. The penalty would still be 10%, but the tax rate would have been lower, and he would have had time to find another job. He could have opted to start taking annual payments from his 401K, generally known as a 72T to avoid any penalties. (Google it if you are in these circumstances – Mommy)
My simpleton was 40. Last year, he had a 401K worth seventy-two thousand dollars. By the age of sixty-six, assuming 6% growth, he would have had two hundred eighty-eight thousand dollars, over a quarter of a million dollars, to use during his retirement. Instead he settled for just over fifty thousand dollars after taxes.