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January 05, 2023 at 05:18 PM
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.
