Becoming Financially Independent Part 2: Do Not Disturb Accumulation, Do Not Overlook Consolidation - Rodgers & Associates
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Becoming Financially Independent Part 2: Do Not Disturb Accumulation, Do Not Overlook Consolidation

Spending money that has been accumu­lated for financial indepen­dence extends the time it will take to achieve a goal.

Too many people procras­tinate on saving and investing because they believe they have plenty of time—and other prior­ities get in the way. People in their 20s believe retirement is a long way off, and that it’s something for older adults. The goal should be to become finan­cially independent so that you can choose whether or not to work. Psycho­log­i­cally, changing the goal from “retirement” to “financial indepen­dence” makes it more immediate and more exciting to pursue.

Our previous article began a series on the eight principles for achieving financial indepen­dence. Here are the next two principles:

Principle 4: Never disturb the funds that have been accumulated.

Do not spend money that has been accumu­lated for financial indepen­dence. Invading long-term savings extends the time it will take to achieve a goal. Money spent can no longer grow and compound. Assuming a 7% rate of return, $15,000 spent today could have grown to $114,000 in 30 years. Using the 4% rule, that amount of savings could provide $4,500 of income per year toward financial indepen­dence.

Another trap some people fall into is accessing savings by borrowing against them. The rationale says the money is not spent because it is only used for collateral. Loans are a popular feature of 401(k) plans. Funds can be borrowed from a 401(k) account for almost any reason, as long as the employer permits plan loans. Is it a good idea to borrow from a 401(k)?

When money is borrowed against a 401(k) account, the custodian moves the amount of assets securing the loan to the “safe” option within the plan. This option is usually a money market fund. The interest rate on money market funds today is well below 1% (probably much closer to zero).1 One of the hidden costs of borrowing from a 401(k) is the money that isn’t earned while the assets are held in a low-interest, safe option.

Another problem with this type of borrowing is that many employees who take loans stop making contri­bu­tions until the loan is repaid. The missed contri­bu­tions are rarely made up, and the loss of matching contri­bu­tions can never be recovered. The impact on a retirement plan could be signif­icant.

In most cases, 401(k) loans are used to fund overspending. Anyone consid­ering borrowing by using current savings for collateral should go back and review principle number one.

Principle 5: Roll over and consolidate.

Funds held in employer-sponsored retirement plans are usually restricted until the employee retires or separates from service. Many people think of retirement savings as a windfall of available cash when changing jobs. It might be challenging to resist the urge to take that money as cash, especially if a layoff caused separation from service. However, this is a costly source of funds. The current cost is in the form of income taxes and penalties. Distri­b­u­tions from a company plan are generally subject to federal income taxes and state income taxes (if applicable). Anyone under age 55 could also pay a 10% penalty on top of the tax. These costs can cut into savings signif­i­cantly and lengthen the time it will take to achieve financial indepen­dence.

Most employer plans provide options when an employee separates from service. Instead of taking a check subject to taxes and penalties, options may include:

  • Leaving savings in the existing plan.
  • Rolling the savings over to an IRA.
  • Rolling the savings over to a new 401(k) with a new employer.

Deter­mining the best option depends on several factors, but consol­i­dating retirement accounts is often a smart choice. Consol­i­dating retirement funds provides for:

Less Record Keeping: Fewer monthly state­ments, fewer emails, and not as many forms at tax time.

Coordi­nated Invest­ments: Coordi­nating a well-diversified portfolio is more difficult when retirement funds are held in different places.

Reduced Expenses: Consol­i­dating retirement accounts could reduce the amount of fees when accounts are held separately.

Simpler Estate Admin­is­tration: Anyone who has ever settled an estate under­stands how challenging it can be to make sure all the accounts belonging to the deceased have been identified. More accounts typically mean more work and more complexity!

Insights

  • Avoid spending funds that have been set aside for long-term savings goals.
  • 401(k) loans are not a cheap source of funds. The costs are high when consid­ering the lost oppor­tunity to grow.
  • Savings held in a former employer’s plan can be rolled over to the new employer’s plan or a rollover IRA.

Read the series: Part 1 | Part 3

Footnotes
  1. According to data from the FDIC, the average money market interest rate is 0.07% APY as of December 31, 2020.

Origi­nally posted August 2012