Most retirement planning discussions are focused on “accumulation.” You are urged to save money during your work life so that, in retirement, you will have the necessary resources to continue your lifestyle. Accumulation is certainly one important topic for every retirement discussion, but it is not the only topic. For example, you also should discuss “decumulation” --- that is, translating your savings into retirement income that will last for the rest of your life.
A third important topic is less obvious, but equally important, and less frequently discussed: “leakage.” That’s not a phrase we use in day-to-day conversation, so allow me to offer an analogy. Think of your retirement plan like a bucket. Accumulation is like filling a bucket with water. Ideally, over time, you will fill the bucket to the brim. Then, after you retire, your decumulation plan determines how you remove water from the bucket. If any water remains in the bucket, your family, friends, or other heirs will get it.
Leakage occurs when water seeps out of the bucket. Perhaps the bucket has a hole or water splashes out when it’s moved. Regardless, leakage reduces the amount of water in the bucket. Often, it’s hard to tell how much water will be lost due to leakage. Sometimes, you can’t see the leak until there is a puddle on the floor. Most important, leakage undermines your efforts to fill the bucket through accumulation. So, when it comes time to decumulate in retirement, leakage could mean a lot less retirement income than you want or need.
The good news is, you can manage leakage. The starting place is understanding the principal ways your retirement savings can leak out of your 401(k), Individual Retirement Account (IRA), or other retirement plan. With this understanding, you will be able to take action.
The surest way to leak money out of your retirement savings is to withdraw it for some non-retirement purpose. That’s a bad idea except in the most urgent circumstances. Except for Roth IRAs, “early” withdrawals from retirement accounts are taxed and potentially subject to an additional 10% tax penalty --- leakage that is lost forever.1 “Early” generally means before age 55 (or the ordinary retirement age for your employer’s plan) or age 59½ for individual accounts.2
There are exceptions from the 10% tax penalty for a few categories of early withdrawals. These “hardship withdrawals” (or “hardship distributions” from an employer’s plan) include withdrawals to pay your or a family member’s medical expenses; to satisfy a divorce decree’s “qualified domestic relations order”; for unemployed individuals’ health insurance premiums; for some higher education expenses; to buy your first home (in some cases, and IRAs only); and for armed services reservists called to active duty.3
As I explained in an earlier post on the Studio, Congress temporarily included a list of COVID-19-pandemic-related reasons for withdrawing money from their retirement plans without any tax penalty. Congress also allowed retirement plans to allow their participants take larger loans. This authorized leakage was intended to help families meet urgent, current spending needs associated with the pandemic recession.
A very important note: in ordinary circumstances, quitting, getting fired, or suffering a layoff before you reach retirement is not enough to justify a hardship withdrawal. If your employment terminates, some employer plans allow you to make a voluntary early withdrawal of your retirement funds. The plan doesn’t need your permission to distribute your retirement savings if it’s $5,000 or less. This is not free, found money. It’s your retirement savings, so don’t “cash out.” These disbursements must be rolled into your next employer’s plan or an IRA, or they will be taxed and penalized like any other early withdrawal.4
If possible, resist making early withdrawals from your retirement account even for a hardship exception or a pandemic-related exception, for two reasons. First, even though hardship withdrawals do not trigger an added tax penalty, they are subject to other taxes. As I explained in another earlier post on the Studio, income you contribute to your retirement account (up to specified amounts) and hold in that account is generally not taxed. The same is true when you invest your retirements savings and its value grows inside your retirement account. By contrast, withdrawals are taxed, so you must take those taxes into account when considering any withdrawal from your retirement account, especially early withdrawals. During the COVID-19 pandemic, you can choose to pay the federal income taxes associated with your withdrawals over three years rather than in the year you withdraw the money.
Second, your goal should be to fill your retirement bucket to the brim. If you take money out, you’ve reduced the level of savings in your bucket and surrendered any investment returns those savings might generate to help you fill the bucket. So, achieving your goal may require you to make even larger contributions to your retirement accounts in the future in addition to your regular contributions, if you can. Unless you are confident you will have more money in the future to repay your withdrawals and lost investment returns, don’t treat your retirement account like a savings account. Find some other reasonable option.
Your employer plan may allow you to take a loan of up to half the value of your vested retirement savings (up to $50,000, $100,000 during the COVID-19 pandemic) without the tax consequences of an early withdrawal. Owners of IRAs or participants in IRA-based plans, like a SEP or Simple IRA, don’t have the option of a loan. But just because you can take a loan doesn’t mean you should.
Loans from retirement accounts must be repaid within 5 years in most cases and roughly equal payments are typically due quarterly. Your employer’s plan may impose other requirements. Failure to repay the loan or satisfy the plan’s requirements transforms the loan into an early withdrawal subject to the rules described above.5 In other words, catch-up payments over and above your other contributions are mandatory, not optional, when you take a loan from your employer-provided retirement account. You also will suffer the same loss of investment returns that a withdrawal would cause. So, do not take a loan unless you know you can satisfy all the applicable requirements and you can make up for your lost investment returns with added contributions.
Commissions and Fees
Payments out of your retirement bucket for your financial professional’s or a financial institution’s commissions and fees will reduce your savings just as surely as a withdrawal or an unpaid loan. At the same time, the people who provide retirement investment advice, the companies that manufacture retirement investment products, and the institutions managing your retirement accounts deserve to be compensated for their work. So, unlike withdrawals and loans, you likely cannot avoid commissions and fees entirely.
As a result, add two tasks to your retirement planning. First, understand how much you are paying, what your payments buy, and whether all the costs are reasonable. The only way to gain that understanding is to ask your financial professional or whoever is involved with your retirement investments. Second, find ways to minimize commissions and fees that don’t buy you something valuable for your retirement. Simply, you should comparison shop. If your financial professional’s fees are too high, interview others. If one investment in an asset class is more expensive than its competitors, invest in a lower cost competitor.
These tasks can be challenging because the list of commissions and fees can be long and the language unclear. A “trade commission” or “transaction fee” is the cost of buying or selling a stock, mutual fund, or other investment. If one company has a lower fee, is there a compelling reason to pay a second company’s higher fee? Some financial professionals are paid a “sales load,” which is a commission for selling an investment, or a management or advisory fee. It is typically a percentage of the retirement investor’s assets under management by that professional. Which will cost you more --- a commission or a fee --- and what services would you receive in return for the higher cost? Investment products also come with costs. For example, most investment funds charge “expense ratios,” which are annual fees based on a percentage of your investment in the fund. Rather than percentages, these and other fees and commissions are sometimes expressed in “basis points.” The translation is easy: one hundred basis points is equal to 1%. So, if you are paying an expense ratio of 100 basis points on $250,000 in investments, you will pay $2,500 per year or thereabouts.
As I discussed in yet another post on the Studio, annuities can help guard against two important things you know you can’t know: how long you will live, and when the value of your investments will grow or shrink. When you buy an annuity* and decide to start receiving income, you can receive income for the rest of your life. Although an annuity can still fluctuate in value, many annuities offer guarantees that the amount of income you receive will not decline based on market performance. In essence, annuities provide insurance against the risks associated with these “known/unknowns,” but you will pay extra fees for these and other added protections that are not available with other products. The question you must answer with your financial professional is the same as the question you should always ask when confronting a fee or commission: does the added benefit justify the greater cost?
1. Internal Revenue Code 72(t), Internal Revenue Service, October, 2020.
4. "Retirement Topics - Termination of Employment", Internal Revenue Service, January, 2020.
5. "Retirement Topics - Plan Loans", Internal Revenue Service, May, 2020.
*What is an annuity?
An annuity is a long-term, tax-deferred vehicle designed for retirement. Variable annuities involve investment risks and may lose value. Income guarantees typically involve the purchase of an add-on benefit which involves extra costs in addition to the fees and expenses of the annuity. Guarantees are backed by the claims paying ability of the issuing insurance.
Investing involves risk and possible loss of principal.
The opinions and forecasts expressed are those of the author and individuals quoted and should not be construed as a recommendation or as complete.