How To Never Retire: Cash Out Your 401(k) When Leaving a Job

I mentioned Charlie Munger and his principle of inversion in a recent book review. Sometimes the best solution to a problem comes by approaching it backwards. You can learn more about it by reading the transcript from Mungers’ 2007 USC Law School Commencement speech. An excerpt:

Let me use a little inversion now. What will really fail in life? What do you want to avoid? Such an easy answer: sloth and unreliability. If you’re unreliable it doesn’t matter what your virtues are. Doing what you have faithfully engaged to do should be an automatic part of your conduct. You want to avoid sloth and unreliability.

What can you do to never retire? The broad answer is to never put anything aside for later. A specific answer is to cash out your retirement plan whenever you get the opportunity (i.e. when you leave a job).

Seems simple, right? But according to 401k behemoth Fidelity Investments, more than one third of all participants (35%) cashed out their 401(k) balances when leaving their job in 2013 (source). Among workers aged 20 to 39, a whopping 41% cashed out their 401(k) balances!

Cashing out before age 59.5 means you owe income taxes on the entire withdrawal amount immediately plus an additional 10% penalty. You only get allotted a certain amount of contributions to a tax-advantaged account each year, so that’s even more potential money washed down the drain.

I repeat, the most important thing to do is not cash out your 401(k). What you actually do with it instead is also worth some discussion:

  1. Roll it over into an IRA. I would say for most people, it is best to roll it over to an IRA at your own custodian. Brokerages like Vanguard, Fidelity, TD Ameritrade, and Schwab all have IRAs that feature low-cost ETFs and numerous other options (Barron’s broker rankings). They all want your money desperately, so if you have any problems at all, just call them up and ask for some help. My mom recently moved her 401k into a IRA at Vanguard and the Vanguard phone rep helped her through everything step-by-step.
  2. Keep it at your old employer. This may or may not be an option, but if you have a decent plan you could just leave it there for a while. Leaving assets in a 401(k) may allow you do contribute to a “Backdoor” Roth IRA for those people with high incomes.
  3. Move it to your new employer. It is harder to think of a compelling reason to do this these days. It used to be that some plans offered cheap institutional shares but now most ETFs already offer rock-bottom expense ratio. But again, you may want your assets to stay in a 401(k) and not an IRA for Pre-Tax IRA to Roth IRA conversion purposes.

The Power of Compound Interest Shown in a Single Chart

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It’s not just how much you save, it’s when you save that matters. The best time to start is now. This is the power of compounding returns, which this single chart will help you visualize:

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  • Susan (grey) invests $5,000 per year from age 25 to 35 ($50,000 over 10 years) and stops.
  • Bill (green) invests $5,000 per year from ages 35 to 65 ($150,000 over 30 years).
  • Chris (blue) invests $5,000 per year from ages 25 to 65 ($200,000 over 40 years).

You’ll note that Susan still ends up with more money than Bill, even though he invests three times as much money over 30 years, all because Bill starts late. Susan and Chris start out the same, except that Susan stops after 10 years while Chris keeps going. Chris only invests $100,000 more than Susan, but ends up with $500,000 more money in the end. A 7% annual return is assumed.

The chart is from a JP Morgan slide deck for their asset managers, via Business Insider.

I’m also reminded of Warren Buffett and his Snowball biography – “Life is like a snowball. The important thing is finding wet snow and a really long hill.”

Can I Really Withdraw My Roth IRA Contributions At Any Time Without Tax Or Penalty?

Revised for 2014. This post about how to withdraw past Roth IRA contributions has been popular over the years amongst search visitors, and I have completely updated it using the most recent IRS documentation. Besides emergencies, this information may also be useful for early retirees under age 59.5 that wish to access some of their tax-deferred funds without incurring taxes or penalties.

This is a follow-up to my post Roth IRA Contribution vs. Emergency Fund Savings, where I suggested that people should just fund their Roth IRAs first over an Emergency Fund. The simple reasoning was that anyone can withdraw their Roth IRA contributions at any time, without penalty. (Not earnings, just contributions.) Put in $5,000, and you can take out $5,000 later – be it one day later, one week later, or one decade later. But some concerns were raised about the validity of that assumption, so I wanted to iron that out here using IRS Publication 590.

First, we head to the Roth IRA section, specifically the subsection called Are Distributions Taxable?. Here, the first sentence states:

You do not include in your gross income qualified distributions or distributions that are a return of your regular contributions from your Roth IRA(s)

Sounds pretty clear, but let’s keep looking. The next section talks about qualified distributions, like those made after you turn 59½, which are definitely not taxable. We are given this decision flowchart (Figure 2-1), and… whoops, we may not even pass the first box. Taking out your contribution within the first 5 years is not a qualified withdrawal. 

But wait. Not all unqualified withdrawals are taxable. Going to How Do You Figure the Taxable Part?, we are directed as follows:

To figure the taxable part of a distribution that is not a qualified distribution, complete Form 8606, Part III.

Here is a link to Form 8606 [pdf] and the Form 8606 instructions [pdf].

Here’s how you would fill out the form for the simple situation of taking out former Roth IRA contributions. On Part III, Line 19, you would include the money you took out as a distribution – “Enter your total nonqualified distributions from Roth IRAs in 2013″. This would carry over to line 21. But then on Line 22 you would “Enter your basis in Roth IRA contributions”. Line 23 tells you to subtract the difference (21 minus 22). If you are taking out less than you formerly contributed over the years, your net taxable amount would be zero.

What about a possible 10% penalty? In the section on the penalties Additional Tax on Early Distributions, we see this:

Unless one of the exceptions listed below applies, you must pay the 10% additional tax on the taxable part of any distributions that are not qualified distributions.

Since this unqualified distribution of a former contribution is not taxable, there is no “taxable part” and thus no penalty to worry about.

In conclusion, although taking out a former Roth IRA contribution as a distribution may be (1) an unqualified distribution, it is also (2) not taxable and (3) not subject to any additional penalties. When subsequently filing your taxes, remember to fill out IRS Form 8606 as indicated above so show the IRS that you are only taking out your original basis.

How Do I Make A Withdrawal?
If you are under 59½, you usually need to make a specific request to your broker. Here is the info from my Vanguard account:

You can request a withdrawal from your IRA online, over the phone, or by mail. You can have a check sent to you, have the proceeds deposited directly to your bank account, or transferred to a nonretirement Vanguard account.

New myRA Retirement Accounts Quick Summary

Now that the dust has settled a bit, here’s a quick breakdown of the newly-announced myRA based on the description “simple, safe and affordable starter retirement savings account”.

  • Simple = Direct payroll deduction. myRA will be funded directly through paycheck withholding, likely using the same infrastructure used to buy savings bonds via TreasuryDirect. No employee match. No bank account required. One investment option.
  • Safe = Government-backed principal protection. The only thing you can buy in the myRA is a security identical to the G Fund of the Thrift Savings Plan available to federal employees. First, it has a principal guarantee so that your balance will never go down. Second, it pays interest based on the weighted average of all treasuries with maturities 4 years or more (2.5% as of January 2014). So it has the higher interest you’d get from owning longer-term bonds without the risk of loss.
  • Affordable = Low contribution requirements. Minimums of $25 needed to start, and $5 per paycheck for future contributions.
  • Starter = Temporary and small. Must be rolled over to a “regular” Roth IRA held at a private custodian when the account value reaches $15,000 or after 30 years.
  • Retirement account = Structured as a Roth IRA. The myRA is a Roth IRA with the US government as the custodian, as opposed to a private company like TD Ameritrade. Account grows tax-deferred, and qualified withdrawals at retirement are tax-free. Same contribution limits ($5,500 for 2014) and same income limits ($129k MAGI for single, $191k MAGI for couples in 2014).

I would also add that it is not available yet, and will only be coming to select employers in “late 2014″. The goal is to be available to all W-2 employees via payroll deduction eventually, but that is unlikely to be earlier than 2015. For a more in-depth discussion, I liked this article by Michael Kitces at Nerd’s Eye View.

Much like modern car manufacturing, this is an attempt at fashioning a “new” retirement vehicle using existing parts from other models. Why? The President had to piece this thing together using executive order instead of pushing new legislation through Congress.

Will myRA entice people who currently aren’t saving for retirement? I like the ease of paycheck deductions and the idea that you’ll never lose money. But the overall package just isn’t exciting enough. There is no buzz. People are not clamoring to sign up right away. Instead of just 4+ year Treasuries, it should offer both a principal guarantee and the highest interest rate of any US bond (30-year Treasuries?). Make it as attractive as possible.

15-Minute Resolution: Save More For Retirement Today

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The problem with most New Year’s resolutions is that they just take a moment to make but to actually accomplish it you’ll need to re-make that decision hundreds of times. If you’re trying to be healthier, every single day you’ll have to choose the grilled chicken with steamed vegetables instead of the bacon cheeseburger with fries. Walking the stairs instead of taking the elevator. Willpower is like a muscle, and it gets fatigued after a while.

The good news is that if you want to save more, automation technology allows you to make a decision now and never be asked about it again. If you can, consider simply increasing your 401(k) contribution rate by 1% (or more). Just log into your account today and make the change. Today being the operative word! Let’s see how much 1% is for a household with a single earner making $50,000 gross per year. For simplicity, let’s say they live in a state without income tax. If you are paid bi-weekly, putting away $500 pre-tax annually (1%) into a Traditional 401k amounts to an additional $19 per paycheck.

Alternatively, it is quite easy to set up recurring online transfers from your checking account to either a savings account or IRA account ($100 a month, $50 a week, etc). Once set up, it will happen automatically and you won’t have to think about it. I like the idea of opening a online savings account, as it gives you a separate “savings jar” that psychologically you’ll be less likely to raid.

If you do it this week, you’ll already be done with your 2014 resolution!

Retirement Portfolio Update – Year-End 2013

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Here’s a 2013 year-end update of our retirement portfolio, which includes employer 401(k) plans, self-employed retirement plans, Traditional and Roth IRAs, and taxable brokerage holdings. Cash reserves (emergency fund), college savings accounts, experimental portfolios, and day-to-day cash balances are excluded. The purpose of this portfolio is to eventually create enough income on its own to cover all daily expenses.

Target Asset Allocation

This has been mostly the same for over 6 years, although I did make some slight tweaks in my last June 2013 update.

I try to pick asset classes that are likely to provide a long-term return above inflation, as well as offer some historical tendencies to be less correlated to each other. I don’t hold commodities futures or gold because theoretically their prices should only match inflation. In addition, I am not confident in them enough to know that I will hold them through an extended period of underperformance (and if you don’t do that, there’s no point). 2013 turned out to be a tough year for both gold and commodities funds.

Our current ratio is about 70% stocks and 30% bonds within our investment strategy of buy, hold, and rebalance. With low expense ratios and low turnover, we minimize our costs in terms of paying fees, commissions, and taxes.

Actual Holdings

Here is our year-end asset allocation snapshot:

Stock Holdings (Ticker Symbol)
Vanguard Total Stock Market Fund (VTI, VTSMX, VTSAX)
Vanguard Total International Stock Market Fund (VXUS, VGTSX, VTIAX)
WisdomTree SmallCap Dividend ETF (DES)
WisdomTree Emerging Markets SmallCap Dividend ETF (DGS)
Vanguard REIT Index Fund (VNQ, VGSIX, VGSLX)

Bond Holdings
Vanguard Limited-Term Tax-Exempt Fund (VMLTX, VMLUX)
Vanguard High-Yield Tax-Exempt Fund (VWAHX, VWALX)
PIMCO Total Return Institutional* (PTTRX)
Stable Value Fund* (2.6% yield, net of fees)
iShares Barclays TIPS Bond ETF (TIP)
Individual TIPS securities
US Savings Bonds

The holdings haven’t changed through the latter half of this year, just some additional purchases of existing funds.

In terms of performance, in general stocks had a great year while bonds pretty much went nowhere or slightly down. I don’t expect everything to go up every year, not to mention my portfolio is bigger than I could have expected just a few years ago, so I can’t complain. Here are some 2013 YTD total returns for selected representative funds as of 12/27/13:

Stocks
Total US VTI +33%
Total International VXUS +14%
US Small Cap Value DES +37%
Emerging Market Small Cap Value DGS -5%
US REITs VNQ +3%

Bonds
Short-term Muni VMLUX +0.5%
Intermediate-term Muni VWALX -3%
Inflation-protected bonds -9%

How Do You Compare? Retirement Plan Savings by Age

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Vanguard, a big name in defined-contribution retirement plans like 401ks, recently released their How America Saves 2013 report (pdf) which included data from over a million retirement plan participants. The report itself is quite dense and a bit insider-focused, but this Vanguard blog post teased out some interesting data about the average account balance, savings rates, and asset allocation of these employees.

Whenever you hear an “average” statistic involving retirement plans, it can be confusing because you’re including both young, brand-new workers and those age 60+ who may have been working 30+ years. Thankfully, these stats are broken down into age groups. I threw the numbers into a spreadsheet to make the more palatable charts below. How do you compare?

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California Obamacare Health Insurance Sample Quote

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healthOpen enrollment for individually-bought health insurance through state exchanges was supposed to start October 1, 2013, although several states experienced some delays and/or technical glitches. If your state exchange isn’t up and running yet, you can still estimate your premiums and tax credits here.

However, I was able to get a sample quote from the California health exchange website CoveredCA.com using my family’s demographic information.

Income: Above 400% of federal poverty line (roughly $60,000 for a 3-person household), so no tax credits or premium assistance.

Number of people: 3, specifically

  • One 35-year-old male
  • One 35-year-old female
  • One under-18 dependent child

Here are the monthly premiums I was quoted for each plan tier. The lowest quotes for our family situation were all from Blue Shield of California. $628 a month for Bronze, $722 a month for Silver, $910 a month for Gold, and $1,042 a month for Platinum.


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Morningstar Target Date Retirement Fund Comparisons & Trends 2013

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Target date funds (TDFs) get their name because they adjust their portfolio holdings automatically over time based on a given target retirement date. In general, this means shifting from mostly stocks to less stocks over time (known as the “glide path”). TDFs continue to grow in popularity, especially within employer-based plans like 401k’s and 403b’s.

Morningstar Fund Research recently released its 2013 industry survey, Target-Date Series Research Paper [pdf]. While it feels targeted at financial professionals, there are some good nuggets for us individual investors looking to decide where to invest. For example, we have to be careful as look how widely the glide path can very between different brands of target funds:


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While the most popular TDF providers have much more similar glide paths, they still differ in important ways (especially after retirement age).


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Other highlights from the paper:

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Betterment.com Review: Application Process, Updated Asset Allocation

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betterment screenshot

Updated with new asset allocations 2013. Betterment.com is an online investment tool that rolls portfolio management, trading commissions, and rebalancing into one website. I opened an account when it started with $1,000 to look under the hood. Since then, they’ve actually made several changes in response to feedback and constructive criticism.

The main attraction of Betterment is simplicity. It boils everything down to a single slider (see above) to indicate your risk preference, and takes care of everything else in the background. ETF buying, ETF selling, rebalancing, and so on. On the surface, it’s as easy as having a bank account, besides the critical fact that you can lose money!

Application Process

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Chart: Investment Returns Vary, Even Over The Long Run

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Updated and revised 2013. You often hear that stock investing is a sure thing over the “long run”. But as this chart from the NY Times and Crestmont Research shows, there is still a lot of variability involved. The matrix below visually displays the annualized returns for the S&P 500 for every starting and ending year from 1920 to 2010, adjusted for inflation, taxes, and transaction costs.


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Your actual returns depend a lot upon when you start, and also when you finally withdraw:

After accounting for dividends, inflation, taxes and fees, $10,000 invested at the end of 1961 would have shrunk to $6,600 by 1981. From the end of 1979 to 1999, $10,000 would have grown to $48,000.

“Market returns are more volatile than most people realize,” Mr. Easterling said, “even over periods as long as 20 years.”

Some further observations:
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New 401k Plan Fee Disclosures Completely Worthless?

confusing401k

I’ve written about how recent fee disclosure requirements for 401(k) retirement plans have brought a spotlight on bad 401k plans and their potentially embarrassed plan sponsors.

But after reading the fee disclosure on my wife’s own 401(k) plan, I must say that I’m now thinking that maybe nothing really happened at all. Check out what mine says under “Potential General Administrative Fees and Expenses”:

Administrative Fee – Per Account When applicable, other general administrative fees for plan services (e.g., legal, accounting, auditing, recordkeeping) may from time to time be deducted as a fixed dollar amount from your account. The actual amount deducted from your account, as well as a description of the services to which the fees relate will be reported on your quarterly benefit statements.

Translation: We might charge you some fees. We might not. Helpful, eh?

There’s more:

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