Employers have been transitioning from defined benefit pension plans to defined contribution plans for several years. In 1980, four out of five private-sector workers were covered by traditional pensions that paid them a fixed benefit based on their salary and length of service once they retired. Now, just one in five workers has a pension. So when planning for retirement, many working Americans today will not have a monthly pension income for their lifetime as their parents did.
Ah, but there is social security. However, Social Security is a big unknown. While politicians will unlikely take this benefit away, who knows what you will receive when you retire. The SSA website even states “The law governing benefit amounts may change because . . . the payroll taxes collected will be enough to pay only about 75 cents for each dollar of scheduled benefits.”
If pension plans and social security are not sufficient to fund a retirement, it brings us to the question: “Will the American worker be able to depend upon his/her 401(k) or similar retirement benefit to supplement their Social Security benefit?”
It has been reported that a large and growing number of American workers (over one in four) are tapping their retirement savings accounts for non-retirement needs (e.g., mortgage, credit cards, other bills), raising broad questions about the effectiveness of one of the most important savings vehicles for old age and perhaps warning future retirees of dire implications when they retire. HelloWallet reported that one-third of those in their 40s are turning to their 401k plans for debt relief.
The most common way Americans tap their 401(k) retirement funds is through loans, which must be repaid with interest. Those who withdraw money from a retirement account (other than a loan) face hefty penalties. Persons under age 59.5 incur a 10 percent federal tax penalty and also pay income taxes. Tax consequences are incurred when the employee leaves his place of employment and is unable to repay the loan from the 401k plan.
“Encouraging or enabling people to spend down retirement money in anything other than the most severe circumstances is a terrible mistake,” said David C. John, a senior fellow at the Heritage Foundation who studies retirement policy.
But millions of Americans, experiencing flat wages, increasing expenses, unemployment, weddings, soaring college costs, major or unexpected home repairs, feel as if they have no choice.
It appears that 401(k)s are not being used for retirement by a large and growing share of workers because such plans do not fit within the financial needs most workers face. Employers offer these plans because they relieve themselves of the financial risks that come with managing a traditional pension plan and those with higher salaries find these funds as a favorable way to reduce their current taxes and can make the maximum contributions without creating a financial cash flow problem.
What can the employee do? First, if the employer has a matching 401k plan, be sure to contribute the amount necessary to obtain the employer’s full match. Second, be sure to have on hand an emergency fund to meet your spending obligations for at least six months before investing monies in accounts that are not liquid or that have penalties for early withdrawal. Third, only borrow from your 401k if absolutely necessary. You want those retirement funds to grow tax deferred for as many years as possible to have sufficient funds available when you retire. Remember that when investing in the mutual funds in your employer’s plan, the thought process is that the stock market over a long period of time will increase in value. If you take monies out early, you may also be exposing your money to market risk volatility associated with not investing for the long-term. Fourth, look at the historical performance of your employer’s retirement funds. You want to make sure that you are not investing your hard-earned monies in a portfolio that is lagging behind benchmark investment returns? Fifth, meet with your financial advisor and CPA at least annually to see if you are on plan to meet your retirement benefit goal. Sixth, consider other options available to you, such as annuities or life insurance policies.
Please be sure to read the disclaimer page on our blog. This blog is for educational purposes only and should not be considered as the rendering of tax or investment advice.