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Retirement Planning > Saving for Retirement

Don’t Let Excess 401(k), IRA Savings Cause a Cash Crunch

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What You Need to Know

  • Advisors should help clients balance pretax savings with funds that can be accessed in an emergency.
  • Income taxes on early retirement account distributions are unavoidable, but excise taxes can be minimized in some cases.
  • A SOSEPP is one way to tap a 401(k) or IRA early, but there are strict rules and harsh penalties for breaking them.

Workers in the U.S. are often coached to put as much money as possible in their workplace 401(k) plan or individual retirement account, mainly because of the power of tax deferral.

Not only do contributions come out of the individual’s paycheck before income taxes are deducted, but the returns in the account also accrue tax free. In the case of 401(k) plans, an employer match might be available to help grow the nest egg even faster.

Ben Barzideh, a wealth advisor at Piershale, says these incentives indeed make pretax 401(k) plans and IRAs useful savings vehicles for clients. However, Barzideh warns advisors against making the blanket assumption that it is always better to put more money into tax-deferred accounts. In reality, he says, there are good reasons to save and invest in an after-tax setting as well.

This is especially true during the current moment of high inflation, and during moments when the economy is showing signs of a potentially painful recession. Simply put, it is all too easy for even wealthy clients with substantial investment portfolios to run into a liquidity crisis, for example in the case of an unexpected layoff or an earlier-than-anticipated retirement.

In these moments, it is essential to have a source of after-tax dollars to rely on, Barzideh says. Otherwise, ill-prepared clients could find themselves facing stiff excise taxes and other penalties on early withdrawals made from tax-deferred savings.

A Tough Road Ahead

In a word, Barzideh remains bearish about the market and economic outlook for the remainder of 2023. He sees strong evidence brewing for at least a shallow recession, which causes him to worry about the potential ramifications for clients stemming from possible job cuts and the persistence of high inflation.

“The shortage of workers is the one positive factor I see at the moment that could moderate or steer us away from a recession,” Barzideh suggests. “Otherwise, I really worry that the inflationary pressures we are all feeling will drive the Federal Reserve to raise rates to a really restrictive, painful level.”

When one reflects on past recessionary periods that brought sizable layoffs, Barzideh suggests, it is just a fact that many people found themselves running short of cash and turning to tax-deferred retirement funds to make ends meet.

As previously noted, it is not just lower- and moderate-income workers who can experience a liquidity crunch, and as such, Barzideh urges advisors to study up on all the rules surrounding early withdrawals. This is especially important with respect to wealth locked away in employer-sponsored plans, as the requirements can be complicated.

Hardship Distributions

As detailed on the IRS’ website, if a 401(k)-type plan provides for hardship distributions, it generally must provide the specific criteria used to make the determination of hardship. For example, a plan may provide that a distribution can be made only for medical or funeral expenses, but not for the purchase of a principal residence or for payment of tuition and education expenses.

With respect to IRAs, the IRS also waives the 10% penalty for hardship withdrawals, but only in certain situations. Generally speaking, a client can take an IRA hardship withdrawal to cover unreimbursed medical expenses that exceed more than 7.5% of adjusted gross income (or 10% if younger than 65). Qualified higher education expenses can also be exempted from the penalty, as can distributions under $10,000 that are used to purchase a first home.

Secure 2.0 Changes

The Setting Every Community Up for Retirement Enhancement (Secure) 2.0 Act expanded the number of situations in which penalty-free withdrawals are allowed. Starting in 2024, savers can withdraw $1,000 a year without penalty in an emergency.

Under the new law, savers can tap their retirement accounts if they’re facing domestic abuse, coping with a natural disaster or diagnosed with a terminal illness. These changes have varying effective dates and withdrawal limits and apply to workplace plans, IRAs or both. In some cases, the account holder can repay these amounts later.

As Barzideh emphasizes, it is far better for clients to avoid hardship withdrawals, for example by dedicating resources to a robust emergency fund. In cases where early withdrawal excise taxes must be paid, advisors and clients can work together to reposition the income and assets to ensure this situation can be avoided in the future.

Barzideh acknowledges that encouraging clients to have tax diversification in their savings might marginally reduce the lifetime wealth they can hope to accumulate, but that is a small price to pay to avoid a painful tax headache when times are toughest.

An Option for Near-Retirees

For older clients who own sizable pretax accounts and who face a liquidity crunch, there is the option to avoid penalties by crafting a “series of substantially equal periodic payments,” or SOSEPP.

SOSEPPs are defined in section 72(t) of the Internal Revenue Code, which sets out exceptions to the normal rules for retirement account early distributions. While they can be a source of cash for clients, SOSEPPs are themselves subject to strict IRS rules with steep consequences if violated, Barzideh warns.

Generally, a SOSEPP can be taken from an IRA or 401(k). For clients under 59 1/2, this is a way to tap their account without incurring the 10% early withdrawal penalty. However, once a SOSEPP is started, the client must continue to take these distributions for at least five years, or until they reach age 59 1/2, whichever is longer. Stopping the payments early will result in penalties and interest in most cases.

Currently, there are three distribution methods the IRS allows for SOSEPPs. The first is called the RMD method, which uses the appropriate life expectancy table for the client’s situation to calculate the SOSEPP payments each year. The amounts are calculated at the end of each year, much like RMDs.

The second method, known as the amortization method, allows clients to set a fixed amortization rate over a set number of years, based on the appropriate life expectancy table and the interest rate rules in place at the time.

Finally, the annuitization method is based on an annuity factor provided by the IRS and the interest rate rules in place at the time.


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