by Erin Lowry
WHAT HAPPENS WHEN YOU CASH OUT A RETIREMENT ACCOUNT EARLY?
Uncle Sam gets an early payday! I jest, a little bit. Tapping into your retirement accounts early, which is generally defined as taking money out before you turn fifty-nine and a half, can result in your paying a penalty to the IRS. (This penalty, in 2018, was 10 percent in addition to any federal and state taxes you owed.) Plus, you lose out on the gains of compound interest.
There are some particular loopholes about withdrawing money from your retirement accounts without triggering penalties—as mentioned earlier, the Roth accounts give you the most flexibility because contributions have already been taxed—but frankly, I don’t want to share them lest you consider using one! And because rules are always subject to change and I don’t want to outline an option that may not exist in a few years. It’s generally best to think of your retirement savings as just that: money to be used in retirement.
Considering a 401(k) loan? As long as you pay it back, taking out a loan against your 401(k) won’t trigger tax penalties, which is a positive if it’s a last resort. The loan terms usually require you to pay the money back within five years, plus interest that’s ultimately paid to you. However, please proceed with caution: if you’re fired or quit before the loan is repaid, then you’ll probably need to pay it back in full within sixty days.
Leaving a job and unsure what to do with your 401(k)? You may be able to leave it in the current account, or you can roll it over into the 401(k) with your new employer or put it into an IRA.
Oh, here’s a fun twist. You’re required to start taking money out of traditional IRAs and 401(k) or 403(b) plans once you turn seventy and a half. This is called required minimum distributions. Uncle Sam wants to get his cut of your tax-deferred money, so the government requires you to start taking distributions.
THE CASE FOR INVESTING IN MORE THAN YOUR RETIREMENT ACCOUNTS
I once received an email from a Millennial woman named Jessica asking if it was really necessary to invest outside her retirement account. Jessica was maxing out her 401(k), which in 2018 meant she was putting $18,500 a year into her employer’s retirement plan, and she had $80,000 in an emergency savings fund.
In truly dramatic fashion, I nearly did a spit take when I read that number.
Eighty thousand dollars is a huge emergency savings fund for most twenty-somethings. Nine months of living expenses is at the high end of what financial experts recommend for an emergency fund, and something told me Jessica didn’t need nearly $9,000 a month in case of an emergency. So, I opened up a dialogue to find out why she felt the need for such a high buffer; or if she was saving for a major purchase, like a down payment on a home; or if, as I suspected, she just didn’t know what else to do with that money.
Yup, my smell test on Millennial financial behaviors proved correct. Jessica’s parents only ever invested in their retirement accounts, and she had no model for why and how she should be putting her money in any investments other than a 401(k) or an IRA.
Jessica’s high savings rate and significant emergency fund aren’t common for your typical Millennial or, really, any generation, considering that more than half of Americans can’t come up with $400 in an emergency.3 But Jessica’s confusion and even concern about investing outside of a retirement account is quite common. I’d argue that plenty of people who do contribute to a 401(k) or 403(b) through work still don’t consider themselves investors. I’ve had many a conversation with a friend that goes something like this:
FRIEND: I don’t invest.
ME: Do you have a 401(k) at work?
FRIEND: Yeah.
ME: Do you contribute to it?
FRIEND: Yeah.
ME: Then you’re investing, unless it’s sitting in cash.
Now that you’re starting to think of yourself as an investor, even if it’s just in an IRA or 401(k), let’s talk about why you need to invest outside your retirement accounts. Not to mention that you’ll have trouble gaining easy, tax-free access to that retirement money before age fifty-nine and a half.
Goal Setting: Because You Probably Have Things You Want to Do Before Retirement
Saving for retirement is important, but it’s an incredibly long-term financial goal that’s decades away for most Millennials. You’re going to have other major financial goals between now and retirement age, which is why you absolutely need to invest outside your retirement accounts.
Because It’s Hard to Save Your Way to Your Goals
“Your money, when you invest it, is doing some of the lifting,” explains Jill Schlesinger, CFP®, CBS News business analyst and author of The Dumb Things Smart People Do with Their Money.
Trying to save your way to your financial goals will require you to have a significantly higher savings rate than if you invested as well. Just take retirement for example:
Lillian wants to have $1.5 million saved by age seventy in order to comfortably retire. She’s currently twenty-five years old and puts $250 out of each biweekly paycheck (i.e., $500 per month) into her 401(k). Assuming an average 7 percent return, Lillian will have more than $1.7 million by the time she reaches her retirement age of seventy.
If Lillian decided to just put $500 a month into a savings account for forty-five years, she’d only have a little over $270,000, especially if it’s in a measly 0.01 percent APY savings account. Even if she put that money in a savings account earning 1.00 percent APY, she’d only have about $341,000.
As Schlesinger said, investing allows your money to do some of the heavy lifting.
GOAL SETTING
Investing needs to be coupled with goal setting. After all, knowing your time horizon is part of how you build your portfolio. “I tell my clients all the time, ‘I don’t care what you spend your money on. I care what your goals are,’” says Douglas Boneparth.
When it comes to your goals, Boneparth recommends that you consider three things: identification, quantification, and prioritization.
Here’s how that looks in your life:
Identification: What are my financial goals in the next year, three years, five years, ten years, and so on?
Quantification: How much money will I need to meet each one of those goals individually?
Prioritization: Which goal am I going to focus on first?
Keep in mind: just because you’re prioritizing one goal doesn’t mean you stop funding your other goals. Paying off student loan debt aggressively doesn’t mean you press Pause on funding your 401(k) enough to get the employer match.
Once you identify, quantify, and prioritize your goals, it becomes much easier to put an investing strategy in place. Some financial goals won’t require you to invest, such as paying off your student loans or credit card debt. But others, especially medium- (i.e., four to ten years away) and long-term financial goals (ten-plus years away) could seriously benefit from you letting your investments do some of the heavy lifting.
An Example of Goal Setting in Action
When Heather and I found out we were having our daughter, we would’ve loved to have accelerated our student loan payments, we would’ve loved to max out our 401(k)s, but top of our priority list was buying a house and handling life logistics: schools, transit, basically getting our life where it needed to be to accommodate the change that was happening. By using the goal system, we were emotionally honest with ourselves about what was important to us. That really puts the “personal” in personal finance.
Heather and I started saving for a home in 2012, and we bought our home [in] August 2016. Take a look at what the market was doing during that time period—it was pretty good. So, you can imagine me as a financial advisor saying, “Man, if I’d just put my money in something as simple as the S&P 500, maybe we could’ve bought that home a little sooner.” Well, what’s the flip side? What if there’s a correction and things went the other way? I now
delayed a goal that needed to happen. There was a kid on the way! The flip side would’ve been Heather would’ve removed limbs from my body had I told her we’re unable to close on the house because the money we were saving for it went down 20 percent. Imagine if it were 2008. It would’ve gone down 40 or 50 percent. So, it’s a very real example of why, for short-term goals specifically, there is no reward out there appealing enough to outweigh the risk of not accomplishing the goal within the time frame you need. Buying that home a month earlier, because I invested the money, wouldn’t have helped my life. But what would’ve really hurt my life was not being able to close on the home when I really needed to.
—Douglas A. Boneparth
WHEN SHOULD YOU BE INVESTING FOR YOUR GOALS?
The next logical question is “Should I invest my savings for short- or medium-term goals?” Here’s the truthful but potentially infuriating answer: it depends.
There is always a risk when it comes to investing because the market is going to go down at some point during your time as an investor. Your need to liquidate an investment could coincide with a downturn in the market, which means you either won’t get as much bang for your buck or you’ll lose money. So, yeah, I get why you could be hesitant to invest for your goals. Saving it just sounds so much safer.
And for short-term goals, I agree with that sentiment. Cash or cash equivalents help mitigate any risk, particularly if your short-term goal isn’t a flexible one. Jill Schlesinger advises a one-year rule (two years if you’re risk averse). “You’re going to business school and planning to write the check or [you’re] making a down payment on a house or you need a car,” she says. “None of that money can be at risk if you need it within a year.”
My husband and I started saving for our honeymoon eighteen months before we planned to take the trip. We had a hard deadline of when we’d need that money, so I wasn’t going to invest it in the stock market, because we weren’t going to push back the trip if the market tumbled and we needed to wait for it to rebound.
The way in which you’d invest for your medium-term goals depends on your time horizon and on how flexible that deadline can be, and your risk tolerance. A medium-term goal with a deadline of a decade away is one for which you could take some risk early on by investing in stocks and then adjusting your portfolio from moderately aggressive to more conservative—think either bonds and cash or all cash—as your deadline to liquidate and use those funds to make your purchase grows closer.
But if your medium-term goal has a deadline of three years away, and you absolutely must have that money in three years, with no wiggle room to push it back if the market is going through a correction or recession, then it’s probably not worth the risk.
SHOULD YOU MAX OUT RETIREMENT ACCOUNTS BEFORE INVESTING IN ANYTHING ELSE?
“Maxing out” a retirement account simply means contributing the maximum allowable contribution. In a perfect world, you should be able to max out your 401(k) with ease and then move on to investing in taxable accounts. Retirement accounts are tax-deferred, so I’ll refer to nonretirement investments as “taxable accounts.”
“From a sheer growth-of-money perspective, all else being equal, maxing out retirement accounts will be more beneficial due to that fact that you’re either saving taxes on the front end, through the pre-tax contributions, or saving taxes on the back end, via Roth, by taking money out tax free,” says Boneparth. “If there aren’t any other goals or personal preferences and you just want to grow money in the best way possible, there is your answer.”
Again, that’s in a perfect world. But let’s face it, being able to put aside $18,500* into a retirement account is wishful thinking for many, if not most people of all generations.
Saving more than $1,500 per month in your retirement account in order to max it out is a great “reach goal,” but before you let it stress you out, reflect on how much you actually think you’ll need to live a comfortable life in retirement. Now, there are a lot of variables at play (e.g., inflation, whether your home is paid off, health care, the size of your family), so it can be difficult to know how much you’ll need in thirty or forty years. Despite these factors, you can probably come up with an educated guess based on your current lifestyle, factoring in paying down debts or adding children.
The Multiply by 25 Rule is a calculation based on the assumption that your retirement will last thirty years and that you’re using the 4 Percent Rule. The 4 Percent Rule is a commonly used rule of thumb for a safe withdrawal rate that comes from the 1998 Trinity study,4 which basically states that if you withdraw 4 percent or less of your portfolio per year and have an appropriate mix of stocks and bonds for your current risk tolerance and phase of life, then your money should last you at least thirty years. You can apply the Multiply by 25 Rule to the amount you think you’ll need in retirement in order to determine how much you have to save today.
Some experts prefer people act even more conservatively than the 4 Percent Rule allows and use a 2 or 3 percent annual withdrawal rate, to ensure they won’t outlive their nest eggs. Honestly, it’s always better to err on the side of caution when it comes to ensuring you won’t outlive your money, but I digress.
The Multiply by 25 Rule in Action
Lauren and Dan are currently both twenty-eight and want to retire at age sixty-five. Lauren runs the numbers and decides that she and her husband could comfortably live on $50,000 a year in retirement. Their home would be paid off, any children they plan to have would have graduated college and (hopefully) left home, and neither one of them currently has any sort of chronic medical ailment.
($50,000 x 25 = 1,250,000)
Lauren and Dan would need $1,250,000 saved in retirement. Now it’s time to do the backward planning to determine how much they’ll need to save today in order to reach that goal.
Simple situation: Lauren and Dan can each put $500 per month into retirement savings, for a total of $1,000 a month. Assuming a 6 percent annual return over the thirty-seven years they’re saving until retirement, that would result in just over $1.5 million saved. That’s $300,000 more than they calculated needing, which provides a healthy buffer. Putting $400 each (or $800) away for thirty-seven years would result in their reaching their goal of $1.2 million.
More realistic situation: Lauren has already saved $6,000 in her employer-matched 401(k), which she first got access to at age twenty-five. She receives a 3 percent match on her $45,000 salary. That means her employer contributes $1,350 annually, or $112.50 per month. Lauren contributes 10 percent herself, so she’s putting $4,500 a year into her 401(k), or $375 a month. Between Lauren’s contribution and her employer’s, that’s $487.50 a month.
Dan’s employer doesn’t offer a retirement plan, so he’s proactively contributing to a Roth IRA. He’s currently contributing $4,000 a year ($333 a month). Assuming the average 6 percent interest rate over the thirty-seven-year period, he and Lauren will have $1.3 million at age sixty-five.
Notably, I’ve ignored Social Security income in this example and the fact that they’d both receive raises over the years and probably also switch jobs, but you can certainly include all those factors into your own calculations. Have access to a health savings account? Don’t forget to factor that in to your retirement planning. Those are super-helpful when it comes to saving tax-deferred money for future medical expenses!
Another factor to consider when deciding whether to max out your retirement accounts: your medium-term goals.
“Here comes personal preferences: if you think you need that money for something else, like you want to buy a house at some point or you plan to make an investment in your business, maybe having accessibility makes sense,” says Boneparth.
Investing in a taxable account affords you flexibility. You aren’t required to wait until you’re fifty-nine and a half to start taking money out without facing a penalty or jumping through hoops. You also aren’t required to wi
thdraw your money at any point from a taxable account, as you are with many retirement accounts. Does it make sense for you to lock up all your money for life after age fifty-nine and a half instead of investing it for more medium-term goals?
Now, it is possible to pull money out of your retirement accounts early and, in some cases, without a tax penalty, but as a general rule, just leave your retirement money alone until retirement arrives.
CHECKLIST FOR MAKING SURE YOU’RE READY TO INVEST OUTSIDE OF YOUR RETIREMENT ACCOUNTS
☐ You don’t have any high-interest-rate debt.
☐ You’ve already fully funded your emergency savings with a minimum of three months’ worth of living expenses.
☐ You’re either maxing out your 401(k) or other retirement savings vehicles already or you have a pre-retirement short- or medium-term financial goal for which you’re investing.
☐ You’re maxing out your health savings account, if you have access to one.
Chapter 5
Should I Invest When I Have Student Loans?
WHEN PEACH AND I got married in 2018, it meant, in part, the merging of our financial lives. It also represented the first time I would truly have to contend with the student loan debt burden. I’d been fortunate enough to graduate college debt free through a combination of parental support and picking the school where I received the biggest scholarship package.