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Spending money from 401(k) a course of action that can't be easily rectified

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It was a tough decision for Jeffery and Jessica Harper, but they said they didn't see another choice.

Earlier this year, Mr. Harper's employer went bankrupt and he lost his job as a payment processor at a mortgage company.

When he got his check from his 401(k) retirement savings plan, he and his wife wanted to roll the money over to another investment account, but reality got in the way. They used the money, a little more than $1,000, to pay bills.

"I didn't know how long it would be before I would get a job," Mr. Harper said. "I knew that unemployment [compensation] wasn't going to be that much, so I figured this was a way I could at least stay ahead of my bills."

As it happened, the 33-year-old Dallas resident was out of work for almost a month before he landed a job as a bookkeeper.

At least the Harpers put their 401(k) money to good use.

Many employees – facing the decision under more favorable circumstances –aren't even doing that.

A whopping 68 percent of 401(k) participants, regardless of age, choose to take lump-sum payments from their plan when changing jobs, instead of rolling the money over into their new employer's plans or individual retirement accounts, according to a survey by Hewitt Associates, a management consulting firm.

Twenty-six percent roll their balances into IRAs, and 6 percent move their money to their new employer's retirement plan. Experts said that's a bad sign because employees are jeopardizing their retirement by spending 401(k) funds prematurely.

"It's troubling to see that many 401(k) participants are making costly mistakes," said Mike McCarthy, a 401(k) consultant at Hewitt. "Whether it's using the money to buy a new car, take a vacation or pay off credit cards, 401(k) participants are losing out in the long run.

"The pattern has been fairly consistent. The bad news is that it's not gotten any better."

The Harpers, parents of a 5-year-old and an 11-year-old, wanted to reinvest Mr. Harper's 401(k) money. However, more pressing needs arose.

"When we got the check, we put it away for a while, then a nibble here and a nibble there, and by the time he got another job, it was gone," said Mrs. Harper, 33, an accounts payable coordinator at an accounting firm. "It's really bad because you spend that money, and you have to start all over again."

Spending 401(k) money before retirement goes against the original intent of the plans, which are named for section 401(k) of the Internal Revenue Code.

Employers set up the 401(k) as a "defined contribution" plan, meaning that employees contribute to the plan through automatic payroll deductions.

Some retirement experts say the 401(k) is the most important national retirement vehicle since Social Security was introduced in the 1930s.

Here's why:

First, your 401(k) contribution is deducted before taxes are taken out of your paycheck, so it lowers your taxable income.

Second, your money in a 401(k) grows tax-deferred, meaning you don't pay federal income tax on the money until you withdraw it at retirement. Since you don't pay taxes on your 401(k) return until retirement, you'll build up savings faster.

This compounding effect of money or "time value of money" can't be overemphasized. Here's an example of the effect of compounding from 401Kafe (www.401kafe.com), a Web site that educates consumers about 401(k)s:

Say you are 40 years from retirement and begin contributing $2,000 a year to a 401(k). If your return were 10 percent a year, at the end of 40 years, you would have contributed a total of $80,000. But your 401(k) would be worth $973,684, thanks to the power of tax-deferred compounding.

Because it takes time to realize the full power of investing in a 401(k), spending that money before retirement can jeopardize your ability to finance your old age, experts said.

"It's costing anywhere from three to 20 times what they're taking out in terms of compounding," said Alan Goldfarb, a certified financial planner and director of financial planning at AXA Advisors in Dallas. "The economic term is 'alternative cost.'"

When you spend your 401(k) for a car or vacation, "you're exceeding the purpose of the retirement plan," said Jude Barcenas, a certified financial planner at BFG Financial Benefits in Dallas.

"The more you deviate from a retirement program, the more you lose track that that money is for retirement purposes," he said.

A question of interest

Some consumers may argue that it's better to use their 401(k) money to pay off high-interest credit cards, but that's not necessarily the case, said Douglas Gill, a certified financial planner and president of Gill Capital Management in Dallas.

"If you pay off a high-interest source of borrowing, that is in essence a risk-free rate of return," he said. "But what you have to weigh is the short-term cost.

"But over the long term, if you're talking about 20 or 30 years of time, it's far better for those dollars to be growing on a tax-deferred, compounding basis than it is to make an immediate savings by paying off a high-interest credit card," he said. "I just don't think it makes sense to turn off the clock on any dollars that are growing tax-deferred."

The government tries to protect 401(k) participants from themselves by making it painful to spend money invested in the plan before retirement.

Under the law, your money can't be withdrawn from your 401(k) unless you're disabled, you die (in which case your beneficiary can make the withdrawal), you meet the plan's requirements for early retirement or you have a financial hardship, such as funeral expenses, medical care or are facing eviction from your home.

Or if you change jobs.

It's here that so many 401(k) participants get into trouble. Rather than roll their tax-deferred investment into a 401(k) plan offered by their new employer – or an individual retirement account, which is also tax-deferred – the majority take a lump-sum payout. And if you're younger than 591/2, you have to pay ordinary income tax on the money and a 10 percent penalty.

Taxes socked the Harpers good.

And one more penalty

"Compared to what I was really expecting, that's a lot, ... " Mr. Harper said. "I wish I had rolled it over, just for the kids' sake."

Young people mistakenly believe that they have time to recoup the money they withdraw from a 401(k) plan, Mr. Gill said.

"Once you pull that money out, you really can't get it back – ever," he said. "It's not just lost time, it is lost dollars, because the dollars that are in the plan before you withdraw them could be growing for many, many years in the future."

For example, between ages 30 and 65, there are 35 years of compounded tax-deferred growth on 401(k) money, Mr. Gill said.

"You just can never get that time back [if you withdraw the money]," he said.

Mr. Harper said he would do things differently today.

"I would stick it out and just tighten our belts a little bit more," he said.

The trouble with 401(k) withdrawals

Withdrawing money from your 401(k) plan isn't a good idea. Not only do you lose the compounding value of your contributions over time, you also get socked with interest and penalties.

For example, let's say you have $15,000 in your 401(k) account and you decide to change jobs. You choose to use the entire $15,000 you've saved in your 401(k) to pay off consumer debt.

Uncle Sam gets his share first.

If you're in the 28 percent federal income tax bracket and you're younger than 591/2, your tax would be $4,200, plus a 10 percent penalty, or $1,500, for taking the money out early.

That would leave you $9,300 to pay off your debt that has an 18 percent annual percentage rate and you would have wiped out your entire retirement account.

If you left that $15,000 alone and it was earning a 10 percent annual return, you would have $297,560.99 after 30 years.

That's excluding future contributions.

By Pamela Yip / The Dallas Morning News
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