How 'Leakage' Can Ruin Your Financial Future in Retirement

Most Americans have to save for retirement on their own through 401(k)s or independent retirement accounts. But some see that retirement plan as a piggy bank.

“Retirement leakage” – a loan cash-out or early withdrawal of funds – can have a serious impact on your financial security. You’ll lose some money upfront in terms of taxes or an early withdrawal penalty. But a larger overlooked issue is not having enough money later on in retirement.

“For every thousand you take out today you’re reducing your retirement income at 65 by a thousand a month,” said Delia Fernandez, certified financial planner at Fernandez Financial Advisory.

Types of Retirement Leakage and Their Impact

Cash-Outs

When changing jobs, some workers opt to take out their retirement plans in cash. A 2015 survey from the Retirement Clearinghouse reveals that 34% of millennials and Gen Xers and 24% of baby boomers have cashed out at least one retirement account. Those early withdrawals trigger a 10% penalty and are generally taxed as income. Additionally, you’ll lose out on the compounding interest that money would have accrued.

A study from the Employee Benefits Research Institute estimated in 2015 that cash-outs cost Americans $92.4 billion in lost retirement income.

Some workers feel they have no choice. The Retirement Clearinghouse survey notes that 37% of those who cashed out did so for emergency reasons, usually unemployment. Others may have no choice since an employer can require cash-out of any account with less than $1000.

However, even relatively small accounts matter in the long run. Fernandez gives this example: Suppose at age 25 you decided not to cash out the $3000 in your retirement account. Assuming 7% growth, that $3000 would grow to $45000 by the time you hit age 65 — and that’s in addition to any other retirement savings.

Description: Graph showing the impact of cashing out a retirement account early versus leaving it to grow.

Stranded Accounts

Some workers leave retirement plans behind because rolling them over seems like too much trouble. Fernandez has had clients with multiple small accounts from previous jobs. The good news is that these “stranded” accounts can continue to grow. The bad news? They might not grow very much.

“You’re missing out on flexibility,” said Adam Day, a certified financial planner with fee-only financial advisory firm Wealthquest.

Stranded accounts might even become lost. While helping an elderly friend with her finances, Fernandez uncovered a retirement plan worth nearly $50000 that the friend had forgotten.

Borrowing or Withdrawing from a Retirement Plan

Taking a 401(k) loan is sometimes described as “paying yourself back.” That’s not entirely accurate, said Day.

“It’s not like you’re paying yourself a compounding rate of return. It’s interest on what you borrowed,” he said.

Say that you borrow $10000 from your $100000 retirement account. Now the plan has only $90000 earning compound interest, meaning decreased future earnings.

Other potential issues with 401(k) loans:

• Some plans won’t let you contribute until after the loan is repaid. Not only does that mean fewer contributions for up to five years, but you’ll also miss out on any employer match.
• Even if you’re still allowed to contribute, you might not be able to afford to save as much. Eight in 10 workers under age 34 decreased their contributions during repayment according to a study from Teachers Insurance and Annuity Association of America.
• If you default, the loan will be considered an early withdrawal and subject to taxes (and an early withdrawal penalty if you’re younger than 59½).
• Should you lose your job, the loan will be due in full generally within 60 days. Again, if you can’t repay the loan, it’s now a withdrawal and subject to those taxes or penalties.

Description: Illustration of how borrowing from a 401(k) impacts future growth.

Conclusion

Retirement leakage can have a critical impact on your golden years. Pay attention to your money now in order to work toward a comfortable, secure retirement. Deciding not to take a cash-out, rolling over accounts, and avoiding unnecessary loans can help ensure your retirement savings grow as intended.