July 03, 2013
Is it Permissible to Double Dip?
Although we have experienced many changes in employee benefits over the last 20 years or so, none have had as much an impact as the shift from traditional defined benefit pension plans (where recipient receives a pre-determined monthly benefit when they retire), to a defined contribution plan, such as 401 (k) plans (where the participant and employer contributes and future results vary). While the advantages and disadvantages of each have been heavily debated over the years, what is clear is that these types of plans grant participants the right to access their retirements accounts prior to retirement.
Participants generally have a right to terminate their 401(k) plans (so called under the applicable Internal Revenue Code Section), request a loan from the plan that must be re-paid with interest, or simply take a pre-mature distribution. Regardless of which method is selected, the raiding of a retirement plan can have adevastating impact on funds that will be available for retirement. For example, for a 25 year old person who expects to earn an average annual rate of 8% until age 65 on retirement funds, each dollar that is withdrawn at age 25 from a 401(k) plan will impact funds available by approximately $24.00. As can be seen, simply withdrawing a $5,000 amount from the 401(k) will reduce amounts available for retirement by $120,000. Wipe out a plan with $50,000 and it becomes $1,200,000.
In the current challenging economic environment the quest for liquidity and instant access to funds has led to an increase in plan liquidations or loans that do not get repaid and result in plan liquidations. When faced with the prospect of a home foreclosure or unpaid health care insurance, most people without other avenues to resort to will readily view their retirement plans as a primary source of ready cash. Redemptions can easily be accomplished within a short period of time, and the pain is deferred until the day that one realizes that the power of compounding returns on invested funds is no longer available. Add the sting of premature early withdrawal penalties imposed by the IRS and the tax on the withdrawals, and the impact on the family’s finances can clearly be seen. Even in the lower tax brackets, a $5,000 early withdrawal can cost in excess of $1500.00 in added taxes and penalties right out of the gate.
Sound financial planning, even in times of dire financial distress should focus on options other than raiding ones financial retirement accounts. The tax deferred features of such plans coupled with the protections generally afforded under State laws and federal Bankruptcy laws make these plans something to cherish, not raid. Once taxes, penalties and foregone compounding of returns are taken into account, it should be clear that utilizing 401(k) funds to subsidize other needs is not a desirable option.
In my capacity as a bankruptcy trustee I am amazed at the volume of cases where debtors have drained their 401(k) and other retirement accounts to pay for debts that otherwise would be dischargeable, or worse, to maintain a lifestyle that cannot reasonably be maintained. It is essential that one be realistic and either avail themselves to the protections afforded under the bankruptcy laws or better still, attempt a restructuring of both debt and lifestyle. Alternatives do exist, and a careful evaluation and a sensible and realistic approach to a current distressed financial situation usually can be dealt with without resorting to mortgaging one’s future.