Are your retirement savings leaking?
A good retirement savings strategy can be undermined when money leaks out of your accounts before retirement, according to a recent study from Boston College's Center for Retirement Research (CRR). The center defines leakage as any type of withdrawal that's made before retirement that permanently removes money from your savings.
Money leakage is a serious issue for retirees, given the almost universal shift from traditional pension plans to 401(k) plans and IRAs as the primary source of retirement security. Historically, the leakage from traditional pension plans has been very small. According to an estimate from the CRR, leakage can ultimately reduce the value of 401(k) and IRA accounts by 25 percent in aggregate.
According to the CRR, there are three main sources of retirement savings leakage: in-service withdrawals, cashouts and loans. These sources affect 401(k) and IRAs differently, which is an important distinction. Because many employees roll 401(k) assets into IRAs when they terminate employment, total IRA assets ($7.2 trillion) far surpass that in employer-sponsored defined contribution plans ($5.3 trillion). Unfortunately, IRAs typically have a lower standard of regulatory oversight that's potentially more susceptible to leakage.
Let's take a more detailed look at the three sources of retirement savings leakage to see how they impact your savings.
In-service withdrawals. In-service withdrawals from 401(k) plans come in two forms -- hardship withdrawals and withdrawals after age 59-1/2. "Hardship" is defined as an "immediate and heavy financial need." That can include medical care; college education; and buying and repairing a home, as well as avoiding foreclosure on that property. IRA withdrawals, on the other hand, can be made any time for any reason.
The IRS imposes a 10 percent penalty on most withdrawals from 401(k) and IRAs before age 59-1/2. After age 59-1/2, withdrawals can be made penalty-free. In addition, there's a 20 percent withholding requirement for withdrawals from 401(k) plans; IRAs don't have withholding requirements.
Many, but not all, 401(k) plans permit in-service withdrawals after age 59-1/2 without a hardship requirement. Eliminating the penalty may serve as a signal to some people that 59-1/2 is an appropriate age to withdraw retirement savings, but this can be a mistake. Because many people will need to work beyond age 59-1/2 for a secure retirement, they may want to let their savings grow -- without making any withdrawals -- until a later age.
Cashouts. When 401(k) participants quit or retire, they have the choice of taking a lump-sum cashout or leaving their money in the employer's plan. Employers can only compel a cashout payment if the account has less than $5,000 in it. Since employers often negotiate investment fees that are lower than retail IRA accounts, it may benefit participants to leave their accounts in their employer's plan and not take the cashout.
Lump-sum payments from 401(k) plans are subject to the 10 percent penalty before age 59-1/2 as well as the 20 percent withholding requirement. You can avoid both the penalty and withholding if you immediately roll the payment over to an IRA.
The CRR study reports that most participants taking post 59-1/2 withdrawals roll their savings into an IRA, but that roughly 30 percent of such withdrawals may represent leakage.
Loans. About 90 percent of 401(k) participants have access to a loan feature. Loans generally don't require approval, but they must be paid back within one to five years.
The risk with a loan comes if you terminate employment before the loan is completely repaid. In that case, most plans require immediate payment of the unpaid balance. If the loan isn't repaid immediately, the remaining loan balance is treated as a lump-sum payment and is subject to income taxes and the 10 percent penalty tax (if the participant is under age 59-1/2).
IRAs do not allow loans at all.
What does this mean for you? The impact on your retirement savings is directly dependent on the decisions you make. You won't experience leakage if you:
- Don't take hardship or in-service withdrawals. This requires making a commitment that your retirement savings will be used for retirement, and not diverted for other purposes.
- When you terminate or retire, keep all of your account invested for retirement, no matter how small. You can do this by leaving the savings in your former employer's plan, rolling it over to a new employer's plan, or rolling it over to an IRA.
- Don't take loans from your plan, or if you do, make sure you can repay the entire loan if you terminate employment before the loan is completely repaid.
It should be pretty obvious that you'll want to grow your retirement savings as much as possible by the time you retire. Since you're responsible for your retirement security, one way to make this happen is to make sure that every last dollar stays invested for retirement and doesn't get diverted for other purposes. Your future self will thank you.
