A Financial Mistake Wealthy People Don’t Make and You Shouldn’t Either

Probably reading no phrase causes me to shout out into the room and bother my wife and sleeping cats more than, “I cashed out the 401k.”  I usually see this in Money magazine when they have a story about a reader starting a business at age 50 as a second career.  (The worst one was in 2009 from a lady who added speaking about the money in her 401k, “It wasn’t doing anything anyway.”  I wonder if she ever looked back after 2010 or the years since then, during the period where she probably would have seen her 401k double, and realized mow much she gave up.)  I’ve also read it in blogs when people are talking about getting out of debt.  Thankfully I haven’t heard it in real life or I might commit homicide, shaking them and yelling, “WHAT WERE YOU THINKING?!!”

Why does this simple phrase give me so much frustration?  Three reasons:

1.  By cashing out before retirement, these people are going to give away about half of the money to the government for taxes and penalties.

2.  More importantly, they are giving up about $8 for each dollar they cash out.  If they had held the money in their 401k from age 50 and retired at about age 70, that $150,000 they took to start a coffee shop would be worth about $1.2 M – enough to finance a good portion of their retirement.  Instead it all now rests on the fortunes of a small business that very well may fail as most do.

3.  Now, when they reach retirement, they’ll probably get there with no money and everyone else will need to support them because they decided to leave a six-figure job to “pursue their dream” or because they used their retirement savings to pay off credit cards that they’ll probably run the balance right back up again within a year because their behavior hasn’t changed.

Don’t get me wrong – I think it is great to pursue your dream or to get out of debt and stop paying credit card companies 18% interest.  It is just that using your 401k to do so means that you’re throwing away the one thing that, no matter how badly you screwed up your budgeting and savings while you were working, would nearly ensure you have a comfortable retirement.  If you want to start a business, start living like a college student and direct some of that six-figure income into a savings account until you save up enough money.  If you want to get out of debt, change your spending and start down Dave Ramsey’s “debt snowball.”  If things really are impossible – like you have $100,000 in medical bills and $50,000 in credit card debt but you only have a $60,000 per year salary, maybe a bankruptcy is the right path for you (not something I say lightly).   Don’t give up your retirement assets.

This brings us to the next item in the list provided in 10 Dirt Simple Rules of Money Management.   (Note, as always, you can find all of the posts in this series by choosing Dirt Simple from the category list in the sidebar or searching for Dirt Simple in the site.) Today we cover the eighth rule:

8.  Once money becomes an asset, it stays an asset unless an emergency happens.  This is especially true with money in retirement accounts.  Never borrow against a 401K or take money out unless you are retired or facing homelessness.

As discussed in the seventh rule, you should spend part of your money building up assets.  These are things like stocks and bonds, a reasonable personal residence for your needs, and maybe a rental property or two.  These are your “pipelines” that will keep you from needing to carry buckets for all of your life.  They are hard to build and it takes some sacrifice to build them, so don’t go ripping them out on a whim just when they are starting to flow water.  

A huge, critical asset everyone should have is a 401K account, with maybe an IRA account on the side.  If you work for the government or are self-employed so that you don’t have a 401k option, use whatever options you do have, even if it is an account at a mutual fund invested in index funds called “Sam’s Retirement Account.”  People talk about how wonderful pensions were while they bad-mouth 401k plans, yet you were never able to go up to the pension fund manager and ask to take out your portion at 45 to start a doughnut shop.  It wasn’t happening.  Leave your 401k alone and compare the outcome with that of a defined benefit plan and you’ll find the 401k isn’t such a bad route after all.

Beyond the 401k, if you want to become financially independent, you need to be building up assets.  As discussed in the 7th rule, Rich People Buy Assets,  you should always be putting some of your paycheck away into investments since those investments will add to your income.  When you have enough assets that your investment income equals your work income, you’ve become financially independent.  

You should also be looking at buying assets to pay for things rather than pay for them directly with your salary.  For example, rather than just paying for a vacation each year from your salary, start putting money away regularly into a mutual fund designated for vacation funding and then use a portion of the proceeds from that mutual fund for vacations each year.  You can do this for car purchases, meals out, and even donations to charities.  You then scale your spending based on the revenues generated by your assets.  As your assets grow, so does your lifestyle.

The beauty of this technique is that you get to have your cake and eat it too.  You get to go on the vacation, but then you come back and instead of having a big credit card bill to pay off, you still have the assets, producing more income and replacing the money you used.  You work to pay for your vacation once and then you’re done.  You never have to work to pay for vacations again.  Kind of like growing an apple tree and then getting apples every fall for the rest of your life with little work on your part once you’ve done the work of digging the hole, conditioning the soil, and training and pruning the tree as it grows until it is fully established.

But you don’t take out a saw and start cutting off limbs from the tree for firewood.  If you start selling off assets and using your principle instead of the interest you’re generating, you will reduce the amount you get next year.  This builds on itself, requiring you sell more assets to pay for things because you reduce the number of assets you have and the income they provide.   

So once you buy an asset, do all you can to avoid using the principle.  Instead, limit your spending to the income produced, minus a little bit to allow your assets to reinvest and grow bigger while your net worth is still fairly small.  Especially leave your most important asset alone – your retirement funds.  The time when you will not be able to work anymore is coming, and you owe it to yourself and everyone else to be prepared.

Got an investing question?  Write to me at VTSIoriginal@yahoo.com or leave a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.


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