When you’ve spent years building your 401(k), the temptation to access that money can be strong, especially as you near retirement. However, it’s important to understand the implications and the opportunities available for managing your retirement savings—beyond just cashing out early. At Brickell Financial Group, we believe that retirement is like landing a plane: it’s something you want to nail the first time. One misstep could cost you dearly, and you won’t get a second chance to correct it.
This blog will guide you through your options, from keeping your money in a 401(k), using in-service rollovers, or moving to an IRA, with a special focus on understanding fees, tax implications, and the importance of a well-planned distribution strategy. Let’s dig into what you need to know before making any decisions about cashing out your 401(k) while still employed.
The Basics: How 401(k) Plans Work and Employer Incentives
A 401(k) is a tax-advantaged retirement savings plan sponsored by your employer. Contributions are pre-tax, allowing you to lower your taxable income while growing your investments tax-deferred. Employers often offer matching contributions, which can significantly boost your retirement savings.
However, it’s important to understand that employers have little incentive to promote in-service distributions or early rollovers from your 401(k). Here’s why:
- Administrative Costs: Employers can save money by keeping employees’ money in the plan rather than handling frequent withdrawals or distributions. Fewer transactions mean fewer administrative tasks, making the plan more cost-effective.
- Plan Balances: Larger 401(k) plan balances allow employers to negotiate better deals with plan providers, which benefits all participants. The higher the total balance, the better terms the company can secure. This is one reason why employers don’t often advertise in-service distribution options.
- Fee Structures and Cost Savings: For employers, larger 401(k) balances help to minimize plan costs because they can leverage economies of scale. When more money is kept in the plan, providers may offer lower fees for administrative services, translating to savings across the board. Employers benefit indirectly by ensuring funds stay in-house.
Despite these reasons, in-service distributions and in-service rollovers are available in many plans, and it’s important to know how they work.
401(k) In-Service Distributions and Rollovers: Weighing the Pros and Cons
In-Service Distributions: Pros and Cons
An in-service distribution allows you to withdraw money from your 401(k) while you’re still employed, but there are strict rules, and in most cases, this triggers taxes and penalties. Understanding this option and its implications is critical before making any decisions.
Pros of In-Service Distributions
- Access to Your Funds: If you’re facing a financial emergency or want to use the funds for a specific purpose, in-service distributions give you early access to the funds you’ve worked so hard to save.
- Control Over Your Savings: You can use the money for whatever you deem necessary—whether it’s medical expenses, tuition, or another pressing need. However, this freedom comes at a cost.
Cons of In-Service Distributions
- Taxes and Penalties: Most 401(k) in-service distributions are subject to income tax and an additional 10% penalty if you’re under 59½ years old. For example, if you withdraw $500,000 from your 401(k) and are in the 24% tax bracket, you’ll owe $120,000 in taxes and an additional $50,000 penalty. This means you could lose up to 40% of your retirement assets by taking an early distribution.
- Higher Tax Bracket: A large distribution could push you into a higher tax bracket, meaning you’ll be paying more in taxes than you normally would. For instance, if you are close to the next marginal tax bracket, the portion of your withdrawal that exceeds the 24% tax threshold could be taxed at 32%. This tax ‘creep’ can significantly increase your total tax liability, reducing the amount you take home from the distribution.
- Lost Growth: Taking money out of your 401(k) means you’re sacrificing compounded growth, which could result in significantly less money at retirement. The longer your investments remain untouched, the more they can compound and grow. Taking money out too early robs you of the ability to maximize this growth.
- Not a Sustainable Strategy: Relying on in-service distributions to cover expenses can quickly erode your retirement savings, putting your future financial security at risk. Without proper planning, you could end up depleting funds you’ll need for retirement, especially in the later stages of life when expenses may increase due to healthcare or lifestyle changes.
In-Service Rollovers: Pros and Cons
An in-service rollover allows you to move funds from your 401(k) to an IRA without triggering taxes or penalties. This can be a more tax-efficient way to access your funds while you’re still employed, but it’s important to understand both the benefits and potential downsides.
Pros of In-Service Rollovers
- Wider Investment Choices: Rolling over to an IRA at a custodian like Charles Schwab gives you access to a broader range of investment options, including ETFs, mutual funds, and individual stocks. Unlike a 401(k), which may limit your choices to a few funds, an IRA provides more flexibility to build a portfolio suited to your retirement goals.
- Tax-Deferred Growth: Like your 401(k), an IRA allows your investments to grow tax-deferred. There’s no immediate tax hit from transferring your funds, and your investments continue to compound, increasing your potential for long-term growth.
- Flexibility in Withdrawals and Investment Strategy: With an IRA, you have more flexibility in terms of how you invest and when you withdraw funds. This can be particularly important as you approach retirement and want to adjust your strategy to preserve capital while still achieving growth. IRAs also provide more control over when and how you take required minimum distributions (RMDs), which is an advantage for those looking to fine-tune their income stream in retirement.
- Portfolio Customization: By rolling over into an IRA, you can take a more personalized approach to asset allocation. For example, you might want to focus more on bonds and dividend-paying stocks as you near retirement or allocate some of your portfolio to alternative investments like real estate investment trusts (REITs). The flexibility of IRAs allows you to customize your portfolio to match your risk tolerance and retirement timeline.
Cons of In-Service Rollovers
- Reduced Creditor Protection: While 401(k) plans are protected under ERISA, offering strong protections against creditors, IRAs may not have the same level of protection depending on state laws. This is something to consider if protecting your assets from potential lawsuits or bankruptcy is a concern.
- Loss of Loan Options: One key difference between a 401(k) and an IRA is the ability to take a loan. Many 401(k) plans allow you to borrow up to 50% of your vested account balance or $50,000, whichever is less, and repay it over time. In contrast, IRAs do not offer this loan provision, which could limit your liquidity options in case of emergencies.
- Potential Rollover Mistakes: If the rollover is not done correctly (i.e., a direct transfer), you could trigger taxes or penalties. This is why it’s important to consult a CFP® professional who can help guide you through the process and avoid costly mistakes.
Why Target-Date Funds May Fall Short for Your 401(k) Plan
While a “set it and forget it” strategy like a target-date fund (TDF) might be better than having no plan at all, retirement is just too important for trial and error and relying on a boilerplate strategy.
One-Size-Fits-All Approach
Target-date funds are designed for the average investor, and while that might sound convenient, you are not the average investor. Your financial picture likely includes much more than just a 401(k)—there could be real estate, Social Security, pensions, and other assets that play a major role in your retirement income. A TDF doesn’t take into account these other sources or liabilities like college expenses, healthcare costs, or even your specific goals like world travel or downsizing.
Your 401(k) is just one part of your overall net worth. Your income needs and goals are highly personal and can vary drastically. A one-size-fits-all TDF is not going to account for these individual nuances.
Rigid Glide Path
The glide path is the set allocation of stocks and bonds in a target-date fund that shifts toward more conservative investments as you near your retirement date. The problem? It’s not flexible. While some target-date funds have evolved to include more adaptive features—such as adjusting risk based on economic conditions—they still don’t offer the level of personalization you would get with a custom retirement plan. Your milestones, health status, and other income sources like Social Security or real estate should also be factored in, which target-date funds don’t account for.
This lack of adaptability could result in you lowering your average returns or, even worse, distributing your funds at an inopportune time—for instance, selling stocks during a market dip because your fund remained too aggressive late into retirement. These inefficiencies could far outweigh the low fees that TDFs often boast about.
The Three Retirement Stages: Tailoring Your Strategy for Every Phase
Many people think of retirement as a one-stop event—like crossing a finish line—but it’s far more nuanced than that. In reality, retirement is a long journey made up of different stages, each with its own financial needs and priorities. Understanding these stages and tailoring your distribution strategy accordingly can make the difference between a comfortable retirement and one that’s filled with financial anxiety.
Early Retirement: Growth and Active Living
In the early years of retirement, which can span your 60s and early 70s, most retirees are still full of energy, engaging in travel, hobbies, or even part-time work. This phase is typically characterized by high activity levels, discretionary spending, and a desire to maximize experiences. Because of these factors, the financial strategy in this stage often emphasizes growth, with a portion of your assets still allocated to stocks and other higher-risk investments.
Even though you’ve technically “retired,” you still need your assets to last for several decades, potentially 30 or more years. As such, having too conservative a portfolio too early in retirement can stunt growth and lead to the risk of outliving your money. Growth investments during this phase can help mitigate the effects of inflation, which can erode purchasing power over time.
However, balancing growth with an initial withdrawal strategy is key. You may start tapping into taxable accounts, 401(k)s, or Roth IRAs to cover your expenses without taking large withdrawals from tax-deferred accounts, which could bump you into higher tax brackets. You’ll want to manage withdrawals carefully to avoid depleting your accounts prematurely.
Mid-Retirement: Income and Preservation
By the time you reach mid-retirement, typically in your mid-70s, your priorities may start to shift. You might travel less, focus more on day-to-day living, and potentially see an increase in healthcare costs. The need for steady, reliable income becomes more important during this stage, and your investment strategy should reflect that. At this point, the emphasis often moves toward capital preservation and steady income generation.
This is the time when fixed-income investments—such as bonds, annuities, or dividend-paying stocks—can play a bigger role in your portfolio. The goal is to minimize volatility while ensuring a consistent income stream to support your lifestyle. Required Minimum Distributions (RMDs) also start kicking in from traditional IRAs and 401(k) accounts once you turn 73, as mandated by IRS rules. Managing these RMDs strategically to avoid unnecessary tax hits becomes crucial.
Healthcare costs start to rise more noticeably during this phase, so it’s essential to ensure that part of your assets are allocated toward covering potential out-of-pocket medical expenses. Long-term care insurance might also be a consideration at this stage.
Late Retirement: Estate Planning and Healthcare
As you move into late retirement, typically in your 80s and beyond, priorities shift again. By now, your focus may be less on personal growth or hobbies and more on maintaining your health, covering increased healthcare expenses, and solidifying your estate plan. In this stage, having assets easily accessible for healthcare and potential long-term care costs becomes critical.
This is the stage where Medicare, Medigap, or long-term care insurance may cover some expenses, but out-of-pocket costs can still be significant. Planning for these expenses ahead of time ensures that you don’t have to make hasty financial decisions. Additionally, you may want to start making gifting decisions to your heirs, transitioning some of your wealth to the next generation, or focusing on estate planning to ensure that your assets are distributed according to your wishes.
Late retirement is also the phase where capital preservation becomes paramount. At this point, you may be more focused on liquidity and risk management, ensuring that you have enough easily accessible funds for healthcare needs while maintaining a modest but stable investment strategy to continue generating some income.
Fees: What to Look for in Your 401(k) and IRA
When considering whether to stay in your 401(k) or roll over into an IRA, understanding the fee structures of each option is critical. Fees can significantly impact your long-term returns, so let’s break down the costs.
Real World Example: Southwest Airlines 401K
1. 401(k) Fees: Breaking It Down
Using Southwest Airlines’ 401(k) Plan as an example, we can see the following fees:
- Expense Ratios: For instance, the Vanguard Target Date Funds in the plan charge 0.04% (p. 6 of the Summary Plan Description), meaning for every $1,000 invested, you pay $0.40 annually. Other funds, like small-cap options, have expense ratios of 0.62%. This may not sound like much, but over time, these fees can add up, especially for high-balance accounts.
- Administrative Fees: These include fees for recordkeeping, legal services, and other operational tasks, typically charged at a flat rate—such as $50/year per participant. While this fee might seem low, it’s important to account for all the associated costs that can chip away at your returns over time.
- Loan Fees: If you borrow from your 401(k), there may be additional fees like a $50 origination fee and $8.75 per quarter for loan maintenance.
Note: You can find this information on the Notice of Investment Returns and Fee Comparison. Here is an example of how it looks:
2. IRA Fees: Charles Schwab Example
When rolling over to an IRA at Charles Schwab, the fee structure looks different:
- No Platform Fees: Schwab charges $0 account fees for IRAs and doesn’t charge platform fees. This can be a major advantage compared to 401(k) plans that may include administrative fees.
- Transaction Fees: Schwab charges $0 for trades involving U.S.-listed stocks, ETFs, and Schwab mutual funds. However, non-Schwab mutual funds may incur transaction fees of up to $74.95.
- Expense Ratios: Like 401(k) plans, IRAs charge expense ratios for the funds you invest in. Schwab offers index funds and ETFs with expense ratios as low as 0.04%, comparable to 401(k) fees.
While fees may not be a deal-breaker, they play a significant role in how much of your savings actually works for you. Over time, reducing fees can help you keep more of your earnings compounding.
Advisory Services: Why You Might Want to Pay a CFP® Professional
If managing your own IRA feels daunting, you can work with a CFP® professional who will handle portfolio management, retirement strategy, and tax optimization.
Why Pay for a CFP® Professional?
- Comprehensive Planning: A CFP® professional goes beyond investments, helping you create a full financial plan that includes estate planning, taxes, risk management, and retirement distributions.
- Tax-Efficient Withdrawals: A CFP® professional can guide you on when to withdraw from your accounts and how to structure those withdrawals to minimize taxes.
- Ongoing Management: Markets fluctuate, and your financial needs evolve. A CFP® professional will ensure your portfolio adapts, making sure you’re never too aggressive or too conservative at any stage of your retirement.
- Peace of Mind: Working with a Certified Financial Planner™ Professional and their team of professionals to help guide you through this new exciting stage of life will bring you invaluable peace of mind knowing you are working with an experienced team to ensure you are making informed decisions every step of the way.
How Much Does It Cost?
At Brickell Financial Group, our advisory fees range from 0.5% to 1.5% of assets under management, depending on the size of your portfolio. These fees include ongoing portfolio management, regular reviews, and tax planning—ensuring your retirement plan remains optimized.
Why a CFP® Professional’s Financial Planning Services Can Pay for Itself
Working with a CFP® professional can add significant value to your retirement plan, often covering the cost of their services multiple times over. Here’s why it’s worth considering:
1. Tax Savings
A CFP® professional can help you implement advanced tax strategies like optimizing tax-efficient withdrawal plans. By drawing from your accounts in the right order—say, from Roth IRAs for tax-free growth—you can potentially save thousands of dollars in taxes throughout your retirement. A well-planned tax strategy could more than offset the cost of advisory services.
2. Strategic Asset Allocation
A CFP® professional tailors your investment strategy to your specific financial picture, ensuring that your portfolio is aligned with your long-term goals while balancing risk. This personalized approach can outperform “one-size-fits-all” strategies like target-date funds, delivering better results.
3. Risk Management
While there may be years where indexes can outperform managed portfolios, the true value that professional risk management brings to your portfolio is delivering more predictable returns. This allows you to better plan for long-term growth and build financial strategies around steady portfolio performance.
Although higher highs and lower lows might seem exciting when you’re younger and can tolerate more volatility, as you approach retirement and start relying on your assets, you’ll want to favor stable and predictable returns over unpredictable market swings.
A CFP® professional helps ensure that your portfolio’s risk level is aligned with your personal risk profile and financial objectives—so instead of experiencing a financial rollercoaster, you’re on a steady path toward meeting your retirement goals. Their focus is on managing risk, not chasing market highs, and ensuring your financial strategy remains sound and reliable over the long term.
How Tax Planning Can Save You Significant Money Over Time
One of the most crucial elements of a successful retirement strategy is tax planning, and this is where a CFP® professional can provide immense value. Let’s look at an example that goes beyond simple withdrawals.
Imagine you plan to sell a vacation home during retirement to free up additional cash. Without proper tax guidance, the sale could trigger significant capital gains taxes, pushing your tax bill much higher than expected. This, combined with required minimum distributions (RMDs) from your 401(k) or IRA, could lead to a hefty tax bill.
Now, consider how working with a CFP® professional could alter the outcome. With tax-efficient planning, you could time the sale of the property to minimize capital gains taxes, possibly by utilizing the primary residence exclusion if you lived in the property for a certain period.
Additionally, your advisor could help structure your retirement withdrawals to avoid combining a high-tax sale year with large taxable distributions. By carefully coordinating the sale with other taxable events, you might save tens of thousands in taxes.
This illustrates how proper tax planning—whether it’s timing asset sales, using Roth conversions, or managing RMDs—can help you preserve more of your wealth for your retirement years. A CFP® professional ensures that your overall tax strategy is optimized, ultimately enhancing your financial security and peace of mind.
Ready to Secure Your Financial Future?
At Brickell Financial Group, we specialize in providing personalized financial advice that helps you navigate the complexities of retirement planning and ensures your wealth is working for you.
Set up a free 15-minute consultation today to discuss your options with one of our experienced CFP® professionals. Together, we’ll create a strategy tailored to your unique goals and needs, ensuring your retirement plan delivers the peace of mind you deserve.
Written By: Pedro Gomez, CFP
Edited By: Marianne Tiamson
