There’s no shortage of things that can knock retirement savers off track. Bear markets. Panic selling. Market timing.
But there’s another less-known landmine: A 401(k) withdrawal rule that automatically redeems some investment funds before others when retirees decide to withdraw money.
The downside? Retirees who own multiple funds in their retirement accounts, such as a large-cap stock fund, a bond fund or an interest-yielding money market, could get hurt when their 401(k) plan pulls money from one of the funds they own that they did not intend to sell.
From just $107.88 $24.99 for Kiplinger Personal Finance
Be a smarter, better informed investor.
Sign up for Kiplinger’s Free Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
This built-in, often undisclosed selling protocol can knock a portfolio asset allocation out of whack, potentially causing the portfolio to take on a riskier profile.
It’s called the “hierarchy trap.”
The 401(k) withdrawal snafu — the little-known hierarchy trap
This obscure withdrawal protocol pertains to retirement plan rules that specify the order in which 401(k) plans process withdrawals when retirees place a sell order.
“Rules vary among 401(k) plans, depending on how employers decide to set them up, including rules they may have in place for withdrawals from your plan,” said Marci Stewart, director, client experience, at Charles Schwab Workplace Financial Services.
Often, the 401(k) plan allows account holders to specify which fund or funds from which they want to withdraw and the amount they want to take out. However, retirement plans also have other rules that dictate more stringent selling procedures.
One common practice is for pro-rata, or proportional, withdrawals. This liquidation strategy is relatively benign, as equal amounts are pulled from each fund held in the 401(k), keeping the retiree’s asset allocation intact. Of course, if your goal is to adjust the weightings of your holdings up or down with any sale, even the pro-rata sell rule won’t achieve your goal.
But a recent Wall Street Journal story (I Got Burned by the 401(k) ‘Hierarchy Trap’) uncovered the heretofore relatively unknown hierarchy approach used by some 401(k) plans.
This method of handling 401(k) redemptions hasn’t gotten much attention and is a mystery to many financial advisers with whom we spoke. Often, there is no disclosure of this type of redemption rule in a 401(k) plan summary. The sell rules are often buried in the record keeper’s operating procedures or custodial agreements, rather than spelled out clearly in participant-facing materials.
“The hierarchy method is a fine print and disclosure problem,” said Jonathan Lee, senior portfolio manager at U.S. Bank Private Wealth Management. “At the very least, it is something that investors need to ask about, knowing that it is a possibility.”
No doubt, understanding how your 401(k) handles withdrawals is a key part of a retirement plan.
What is the 'hierarchy trap'?
Conservative investments first
In a hierarchy-based system, the 401(k) plan makes withdrawals in a specific order.
Typically, a hierarchy protocol starts with the sale of the most conservative, or low-risk investments, such as a money market account. If the first fund is fully depleted and more money needs to be withdrawn, the next fund or investment in the predetermined hierarchy is sold, and so on until the full dollar amount is raised from the sale.
While this sell system is designed to preserve the growth portion of a portfolio, it comes with a downside: Money can be withdrawn from funds in a retiree’s portfolio that they had no intention of selling. This can result in a portfolio’s asset mix getting knocked out of whack, potentially altering the risk profile of the portfolio.
Poor disclosure
“Here’s the problem: If you’re intentionally trying to reduce stock exposure, the hierarchy system can work against you, pulling from the very funds you were hoping to leave untouched,” a blog post from investment management firm Hanover Advisors noted. “Even worse, many plans don’t clearly disclose these rules in participant summaries. You might not know how your money will be pulled out until it’s too late.”
Some financial advisers recommend that when retirees want to make a withdrawal from their retirement accounts, they should request specific funds to be sold, not just a specific dollar amount, according to FA (Financial Advisor) magazine. The restrictions on clients’ withdrawals, FA magazine notes, are often imposed by the plans’ record keepers, not the plan sponsors. An employer might not even be aware of them.
Your portfolio risk profile might change without you realizing it.
Often, the unintended consequence of the hierarchy sell protocol is that it runs counter to one of the key pillars of a financial plan, which is to ensure retirees' holdings align with their risk tolerance.
“When you make a request for withdrawals from a retirement plan and you have the option to select where the money comes from — the bond fund or the stock fund or the money market fund — then that's all in your control, (which is fine),” said Lee. The pro-rata selling system isn’t disruptive to a portfolio, as it doesn’t alter the weightings of portfolio holdings.
“If your portfolio is 50% stocks and 50% bonds, half of the withdrawals are going to come from the bond fund and half from the stock fund,” said Lee.
In contrast, if a large distribution is pulled, say, from just the more conservative bond fund via the hierarchy method, the retiree is left with a larger weighting of riskier stock holdings, says Lee.
For example, let’s say a retiree with a $100,000 nest egg and a 50% stock/50% bond asset allocation withdraws $10,000, and the hierarchy sell system kicks in. After the $10,000 withdrawal from the bond fund (the least volatile investment), the asset allocation is now 55.6% stocks and 44.4% bonds.
The risk, of course, is that if the retiree doesn’t rebalance the portfolio to get the asset mix back in line with their financial plan, the risk complexion of the portfolio will undergo a dramatic change.
“If this happens over consecutive years, you could see your risk profile change quite significantly within a retirement account,” said Lee. “That's why it's important to understand the consequences.”
How to avoid the 'hierarchy trap'
Make sure you know the rules.
Before you decide to sell, contact your 401(k) plan administrator to determine how they handle withdrawals and if they use the hierarchy sell protocol. If they do, ask for a copy of the liquidation rule so you understand it and can take proactive steps to avoid any disruption to your portfolio if you need to pull from your retirement account.
"The investor should read the fine print and disclosures if presented," said Lee.
Doing the proper due diligence is key.
"The best approach to be sure withdrawals are conducted the way you want is to specifically request which investment funds you want a withdrawal to come from, or request and confirm that the withdrawal will be pro rata if that’s your preference,” said Schwab’s Stewart.
"Also, be sure to ask about which sources will be tapped if you have investments through multiple sources in your 401(k)," (e.g., if you have both traditional tax-deferred contributions and Roth 401(k) contributions in your plan), she said.
Ways to work around the 'hierarchy trap'
There are ways to withdraw money from your 401(k) without compromising your set asset allocation.
Be proactive. If you want to reduce your exposure to stocks, for example, consider reallocating from equity funds into the fund that sits at the top of the withdrawal hierarchy, before making a redemption, Hanover Advisors recommends.
For example, if you know your plan taps your money market fund first, transfer money from your stock funds to your cash account before withdrawing funds.
When withdrawing 401(k) funds, keep this in mind
The bottom line? “Understand how withdrawals are conducted, and (make sure) that withdrawal or redemption protocol keeps you in alignment with your target asset allocation and risk tolerance,” said Lee.
“Talk to the plan provider about options, and then, based on your options, take an option that puts you in control of your asset allocation. And, if you don't have the option of either pro-rata or pulling from specific funds, then you can ask about the option of a workaround.”
Read More
-
S&P 500 Hits New Highs as Rally Resumes: Stock Market TodayTech stocks were the biggest gainers on Wall Street today, with Nvidia and Dell making notable moves.
-
The Shutdown Standoff Is Heading for Its Next Big TestA key mid-October deadline could intensify the shutdown fight in Washington, and the fallout could soon hit workers and your wallet.
-
S&P 500 Hits New Highs as Rally Resumes: Stock Market Today
Tech stocks were the biggest gainers on Wall Street today, with Nvidia and Dell making notable moves.
-
Should You Buy Gold as It Tops $4,000? Here's What the Experts SayRate cuts, a weak dollar and macro uncertainty have helped create a "perfect storm" for gold this year. Should investors add exposure or is it too late to buy?
-
The 'Permission to Spend' Rules of Retirement SpendingHere’s how to spend guilt-free when you are in retirement.
-
Major Insurers Scale Back Medicare Advantage and Part D Plans for 2026Beneficiaries enrolled in Medicare Advantage and Part D prescription drug plans might be losing their plan as UnitedHealthcare, Humana, and Aetna (CVS Health) scale back offerings for 2026.
-
I Want to Retire, but I Have to Keep Working so My Adult Kids Have InsuranceIt's a tricky period when your adult child is under 26 but needs health insurance. We ask financial experts for advice.
-
Preferred Bank Stocks: The Investment Retirees (and Others) May Be Missing Out OnMost large banks issue preferred stocks that pay out fixed dividends, often with higher yields than bonds. Should you make room for them in your portfolio?
-
Don't Let Your Equity Compensation Trip You Up: A Financial Expert's GuideStock options, RSUs and other executive perks can come with some serious strings attached. To avoid a nasty tax surprise, you need a plan.
-
Rally Fades on Mixed AI Revolution News: Stock Market TodayAll three main U.S. equity indexes opened higher but closed lower as a seven-session winning streak for the S&P 500 came to an end.
