Last week I began a series on the eight principles for achieving financial independence. 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 is something for old people. The goal should be to become financially independent so that you can choose to work or not. Changing the goal to financial independence psychologically makes it more immediate and more exciting to pursue.
This week we’ll look at the next two principles:
Principle 4: Never kill the golden slaves you have accumulated.
Don’t invade the money you have accumulated for financial independence for any other reason. To do so will cause a significant setback to the timing of achieving your goal. Money spent can no longer grow and compound and serve us. Assuming an 8% rate of return, $10,000 spent today could have grown to $110,000 in 30 years. Using the 4% rule, that money would provide $4,400 per year of income for your financial independence.
One trap that people fall into is accessing their savings by borrowing against them. They argue the money is not spent because they are just using it for collateral. Loans are a popular feature of 401(k) plans. You can borrow from your 401(k) account for almost any reason as long as your employer permits plan loans. But, is it a good idea to borrow from your 401(k)?
When you borrow money from your 401(k) account, the custodian moves the amount of assets securing your loan to the “safe” option in your plan. That is typically the money-market fund. The interest rate on money-market funds today is well below one percent (probably much closer to zero). Essentially you have just choked off any growth this money could have until you pay back the loan. One of the hidden costs of borrowing from your 401(k) is the opportunity cost that is lost on those funds.
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 your retirement plans could be significant.
In most cases 401(k) loans are used to fund overspending. If you are considering one of these loans go back and review principle number 1.
Principle 5: Rollover and consolidate.
Funds held in company sponsored retirement plans are restricted until you retire or leave the employer. Many people think of their retirement savings as a windfall of available cash when they change jobs. It may be difficult to resist the urge to take that money as cash especially if you have left your employer due to a layoff. However, this is a very expensive source of funds both currently and to your future financial independence. Distributions from a company plan are generally subject to federal income taxes and state income taxes (if applicable). If you are under age 55 a 10% penalty could apply on top of the tax. These costs can cut into your investments significantly.
Most employer plans will give you the option of leaving your retirement money in the plan or rolling it over to an IRA or your new employer’s 401(k) provided they accept rollovers. The best option for you will depend on your circumstances but generally you want to consolidate your retirement accounts. Consolidating retirement funds provides for:
Less Record Keeping – You will get fewer monthly statements, fewer emails and not as many forms at tax time.
Coordinated Investments – Making sure you have a well-diversified portfolio is more difficult when you have your retirement funds held in different places.
Reduced Expenses –Consolidating retirement accounts could reduce the amount of fees you are paying by keeping the accounts separate.
Simpler Estate Administration – If you have ever settled someone’s estate, you know all about this. More accounts equal more work and more complexity! Make it easy on your kids and/or your executor.
- Always spend from your income within your budget and avoid touching your long-term savings.
- 401(k) loans seem like a cheap source of funds but the costs are high when you consider the lost opportunity to grow.
- When you change jobs be sure to take your retirement funds with you. Roll them over to your new 401(k) or a rollover IRA.