Retirement Money Tips Mellody Hobson

In today’s “Money Mondays” segment, Mellody Hobson answers “Text Tom” questions about retirement.

This first one is more specific but it’s great. A listener texted that federal employees can borrow from their 401(k) plans for a one-time fee of $50. The interest and payment of the loan goes back to the employee because they’re borrowing from the money they contributed. Then the listener asks, “Is this not advisable?”

I have to love this listener because he or she clearly already knows what I’m going to say. First, they try to rationalize borrowing from their retirement by pointing out the low one-time $50 fee, then he or she further pitches the idea by qualifying that the interest and payment of the loan goes back to the employee, and finally the listener doesn’t ask “Is this advisable?” but rather, “Is this NOT advisable?” That makes me smile. The short answer is no, it is not advisable.

Here’s why: First, any money you take out of your 401(k) plan is money that’s NOT working toward a more secure retirement for you. Yes, the interest rate of the loan is generally lower than a commercial one and you’re paying yourself back as opposed to a bank, but your retirement money is money you can’t afford to lend to anyone—including yourself. Withdrawing money early means missing out on long-term appreciation. And that money is sure to trump any money you’d save short-term by getting a lower interest loan. And compound that missed opportunity if your plan is in the majority that won’t allow contributions until the loan balance is repaid. In addition, you’re paying yourself back with AFTER-tax money. Say you’re in the 20% tax bracket—that means earning a dollar only gives you eighty cents toward repaying the loan, and that money will be taxed AGAIN when you withdraw it for retirement.

That one-time $50 fee is misleading.

The whole point of a 401(k) plan is it allows you to save money on a tax-deferred basis, but if you borrow from it, you end up paying taxes on that money TWICE!

Even considering borrowing from your 401(k) is a major red flag that you need to reevaluate your spending habits and tighten your budget. It is a last, last, last resort in the most dire circumstances, because it comes with all sorts of penalties and potential pitfalls. For instance, it frequently locks you into your job unless you can immediately repay the loan when switching jobs or treat the loan as an early withdrawal and pay a punishing 10% fee. And if you stay at your job but can’t repay the loan, that’s also what happens: It’s treated as an early withdrawal and is subject to fees and taxes.

Our second question about retirement which is, “What is the right way to get money from your retirement account and when?”

It’s a great question and it’s very topical because the conventional wisdom is being hotly debated. The rule of thumb was known as the “4% rule.” The idea was that if you withdrew 4.5% of your retirement savings each year, adjusted for inflation, your money would last 30 years. But the truth is that retirement planning isn’t one size fits all. And what’s worse is that the 4% rule was popularized in the 1990s, when most investment portfolios were returning about 8% a year. Today, those accounts are more in the 3.5-4% range. Today’s retirees may need to learn to live on even less, because they’re living longer to boot. Planning your retirement withdrawals needs to account for your time horizon, your asset allocation and market volatility. Some of those factors you can control, but some you can’t.

The best way to approach this challenge is to sit down with a financial advisor and strategize about the best way to draw down your retirement funds from your various accounts—be they 401(k), IRAs or social security. On most accounts, you don’t want to take early withdrawals (before age 59 ½) or you’ll face penalties, but at the same time, some accounts—like traditional IRAs, Simplified Employee Pension plans and 401(k) plans, require minimum withdrawals by the time you reach age 70 ½. And failing to make those withdrawals triggers hefty penalties. There are also serious tax implications to consider when deciding which account to withdraw from and when. This is one of those critical times that professional advice pays for itself.

An easy way to get started on your own is to take a look at one of the numerous retirement calculators available online.  The AARP Retirement Calculator (at aarp.org) is a great tool to help you see if you’re on track. The site also boasts the AARP Social Security Calculator, which can help you plan the best way to use these benefits. The best part about both calculators is that they allow you to play with different scenarios depending on your life expectancy, retirement age and lifestyle.

Mellody is President of Ariel Investments, a Chicago-based money management firm that serves individual investors and retirement plans through its no-load mutual funds and separate accounts.  Additionally, she is a regular financial contributor and analyst for CBS News.