Over 20 years ago the bank I worked at was taken over by another bank. Companies are bought and sold all the time. This of course raises the stress level of employees, rumors swirl on who will be let go and who will stay. There is talk of promotions and everyone is focused on a potential reorganization and possible physical move. If you've been through this you know what I mean.
One of the outcomes typically is a short notice from Human Resources informing employees that the 401(k) will be terminated and that the employee has a number of options. They can roll over into the new company's 401(k), they can roll over to an IRA with a broker like Schwab or Vanguard, or they can can paid out a lump sum. Getting paid out a lump sum typically involves a penalty and income taxes.
The big mistake is taking the lump sum. Unfortunately, I saw most lower income employees seeing it as some type of windfall. Visions of a happy holiday season danced in their heads. They were happy to get this opportunity to take the lump sum distribution.
But look at the situation. Suppose an employee back then had $20,000 in his or her 401(k). Let's suppose the employee was 35 years old. They take it as a lump sum payment and pay a 10% early withdrawal penalty of $2,000 and income taxes of roughly 20% say so they get a check for $14,000. Wow! Happy dance time.
But fast forward 20 years and note that over the period a conservatively allocated 65% stock/35% bond portfolio more than quadrupled. The $20,000 today would be worth more than $80,000! The employee is now 55 years old and possibly faces retirement within 10 years - meaning that the $80,000 can potentially tack on quite a bit more. By the rule of 72 the portfolio only needs a return of 7.2%/year on average to double in 10 years.
This is a mistake that comes in many guises. Whenever there is a sum of money lying around there is a temptation to take it. It is like the person who is trying to quit smoking but just can't as long as there is cigarette nearby.
But time goes by and one day we'll all be facing that 65 year old birthday and then mistakes or not will be obvious.
And don't forget re: the tax implications of withdrawing the 401k, the 20% is just what is withheld. Depending on their income & filing status, they might owe even more at tax time.
ReplyDeleteYou are right they would likely have a bigger tax impact. I found though that it was mostly the lower income people in the company opting for the cash out.
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