The '401(k)-Rich and Cash-Poor' Retirement Trap
Why advisers recommend holding one to three years of cash outside (or even inside) your retirement plan.
Are you 401(k) rich but cash poor? If so, your retirement nest egg may have some dangerous fault lines.
Just as being house poor can create a cash squeeze in your prime earning years, investing the bulk of your money in a traditional retirement account can make a seemingly solid retirement plan more vulnerable.
The big risk of retiring with too little cash is a costly liquidity crunch if a large, unexpected expense hits. Not having adequate cash reserves may force you to take withdrawals from your retirement account at the worst possible time — when markets are tanking and asset prices are falling.
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The case of the missing bucket
There are two major downsides to forced selling of stocks and other so-called risk assets: 1) it can trigger taxes, and 2) it can deplete your nest egg prematurely.
That's where a large cash hoard comes in. Cash, as is often said, is king — mainly because it's safe, liquid, and easy to access with zero tax consequences. Financial planners recommend putting money in three separate buckets.
- An emergency savings bucket (e.g., cash savings)
- A goals bucket (e.g., car down payment)
- A retirement bucket (e.g., long-term savings, typically invested in a tax-advantaged account that holds more volatile assets with growth potential like stocks)
Ideally, the cash bucket should be outside a traditional 401(k) so you won't have to pay taxes on any withdrawals. But in reality, many people don't have an emergency savings bucket. More than half of Americans (53%) say they don't have sufficient liquidity to cover a $1,000 emergency expense, according to Bankrate. That's where Plan B (which we'll discuss in more detail later) comes in: holding ample cash reserves for emergencies in a retirement account, where you're likely to have the bulk of your assets.
Risk 1: a bigger tax bill
Withdrawals are taxed as regular income. Distributions from traditional 401(k)s are treated as income. That means your withdrawals will get taxed at ordinary tax rates, which range from 10% to 37%. The tax you pay to the IRS also puts an extra drain on your account balance. Let's say you're in the 24% tax bracket and need to raise $45,000. To net that large lump sum, you'll need to withdraw $59,211 from your 401(k) to account for the $14,211 tax owed to Uncle Sam.
Withdrawals may push you into a higher tax bracket. The extra income generated from 401(k) withdrawals may bump you up to a higher tax bracket, increasing your tax bill. Say you're at the tippy top of the 24% bracket and you withdraw $45,000 from a traditional 401(k). All that extra income will bump you up from the 24% bracket to the 32% bracket. The tax amount on $45,000 at 32% is $14,400, which is $3,600 more than the $10,800 tax hit in the 24% bracket.
That additional income could also inadvertently result in a future increase in Medicare Part B and Part D premiums (IRMAA) if it pushes your modified adjusted gross income (MAGI) above certain income thresholds.
Another financial drawback of keeping most of your savings within a traditional 401(k) is less flexibility in managing taxes on withdrawals.
"You don't have optionality around crafting an income tax-efficient cash flow stream," says Charles Carter, managing director at Oxford Financial Group. "You're beholden to the ordinary income tax rate. The more you take out of the retirement plan, the more your ordinary income goes up, the higher your marginal tax rate. It becomes sort of a vicious cycle."
Risk 2: the growth hit and sequence of returns risk
Withdrawing money during a down market means you must sell more shares to raise the cash you need. So, you now have fewer shares in your retirement account to benefit from a market rebound. That, in turn, means you lock in losses and miss out on compound growth.
This risk, known as sequence of returns risk, is particularly damaging for retirees at the beginning of retirement, as their account balance is depleted more quickly than planned, which is hard to overcome.
"Retirees who withdraw from a retirement portfolio in a down market are unfortunately steepening the already uphill battle," says Jonathan Lee, investment adviser at U.S. Bank Private Wealth Management.
Liquidating stocks, equity funds, or other positions in your 401(k) permanently reduces the dollar amount and share count in your account, shrinking the amount of assets that can benefit from compounding over time. For example, at a 7% average annual return, $10,000 withdrawn 20 years before it would have been needed represents $28,697 in lost appreciation.
"We don't know what the market is going to do in two days, two months, or two years," says Jason Grover, a financial planning specialist at Grover Financial Services. "What we don't want to do is be forced to sell positions to generate cash that we need to pay our everyday bills." That cash protection, Grover adds, allows the retiree to stay invested and benefit from an eventual market recovery.
Where to keep your cash buffer
Ideally, you have set up an emergency fund outside of your 401(k). Financial advisers recommend retirees keep one to three years of expenses in a cash account, preferably in a high-interest savings account they can access without incurring penalties or taxes.
Grover recommends retirees set aside a cash reserve totaling at least two years of living expenses. "Anything less than that is irresponsible," says Grover. "For a client who is taking $5,000 a month (or $60,000 a year) from their 401(k), I'm going to have $120,000 minimum in cash," says Grover.
You should also pay close attention to "asset location" as you save for retirement. That strategy refers to having a mix of investment buckets with different tax treatments such as taxable brokerage accounts, tax-free Roth accounts, and traditional retirement accounts. However, a sound plan also requires proper "asset allocation" — including an ample cash buffer to ride out market downturns.
If you don't have an emergency fund and most of your savings sit inside a tax-deferred (traditional) retirement account, you can still take action. You should build a cash hoard inside your traditional 401(k), even though any withdrawals will be taxed as ordinary income. Having a cash allocation in your 401(k) gives you an all-important liquidity option that's not negatively impacted by short-term market movements.
"If your 401(k) is your sole bucket for cash flow, it would be risky, if not foolish, to not have a sufficient cash reserve sitting there ready and waiting," says Carter.
Actionable ways to replenish cash savings
Rebalance your 401(k) portfolio. If the lion's share of your assets is in a traditional retirement plan, a short-term fix is to rebalance your portfolio periodically to bolster your cash bucket in your 401(k), Carter advises. Ideally, opportunistically sell stocks when the portfolio's equity weighting has swelled beyond financial plan targets — and when markets are up. "Those are opportunities to strategically raise cash," says Carter.
Consider Roth IRA conversions. Roth accounts allow tax-free withdrawals and are a valuable tool for managing cash in retirement. However, Roth conversions are a taxable event, so work with your financial adviser and run the numbers to see whether you can convert savings held in traditional IRAs or 401(k)s to a Roth account.
Buy a short-term Treasury and hold it to maturity. If you have an adequate emergency fund now but plan on burning through the money in the next two years, you can replenish your bucket for year three and beyond by purchasing a short-term U.S. Treasury bond of, say, three years' duration, says Grover. "Hold the bonds to maturity," said Grover. By holding to maturity, you'll lock in the current yield of roughly 4.25% and know the money will be there when you need it in a few years.
Commit to a savings plan to build a rainy-day fund. A long-term solution to a cash shortage is to start building an emergency fund outside your 401(k), advises Carter. Rejigger your budget and start setting aside money in a high-yield savings account or a taxable brokerage account. "Take a thoughtful, intentional, and diligent approach to saving," says Carter. Building an ample emergency fund this way won't happen overnight. It could take a few years.
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