401k Investors Whacked With Big Penalty

He could have dined out more often. He could have treated himself to a gym membership. He could have bought his first home.

Instead, 24-year-old Bodie Partsch said he did the responsible thing by investing a quarter of his income into his 401(k) retirement account. But now, with Wall Street seeing some of its biggest declines in years, Partsch's account is suffering and he's questioning his investment decisions.

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If things get much worse, the Oregon man said, he might consider closing down the account entirely.

"I could have the money sitting in a jar on my kitchen counter. It'd be safer than in my 401(k)," he said.

It's the kind of thinking that makes financial planners cringe. They argue that taking money out of your 401(k) is almost never a good plan, even when the stock market is in the doldrums.

"It's such a bad idea," said Rick DeChaineau, owner of Secure Choice Financial Planning in Tacoma, Wash., and a member of the Garrett Planning Network whose members provide financial advice to clients on an hourly, as-needed basis. "There's very little upside. It's an option of very, very, very last resort."

Taking money out of your 401(k) account or stopping your contributions will deprive you of important tax benefits -- traditionally, income contributed to 401(k) accounts is not taxed -- and will hurt your retirement planning down the road, said Stuart Ritter, a certified financial planner with T. Rowe Price.

Market slumps notwithstanding, he said, the S&P 500 -- a broad composite index of large U.S.-based companies -- has consistently been higher at a given point in time than in the period 15 years prior.

"You need the growth stocks have historically provided to keep up with your rising expenses," Ritter said.

Even those nearing retirement shouldn't consider pulling out of the stock market entirely, he said. Many will still live 30 years beyond the traditional retirement age of 65. Some of the money that isn't spent immediately after retirement should remain invested, he said.

Risks of Taking Out Your Investments

If you are just nervous about the market and want to get out of stocks, every retirement plan offers relatively safe investments such as money market accounts. Moving money into those funds doesn't trigger any penalties, said Dean Kohmann, vice president of 401(k) Plan Services at Charles Schwab.

"People do make that mistake of trying to time the market by simply stepping out of the market," Kohmann said. "Retirement money is long-term money. If you're in your 30s, or 40s, or early 50s, you have a lot of years."

In the short term, withdrawing money from a 401(k) account before age 59 ½ -- known as a "hardship withdrawal" -- can open an investor up to steep penalties: Investors must pay a 10 percent federal penalty tax on the money they withdraw and must also have that money subject to income tax. For instance, if a person in the 25 percent tax bracket withdraws $50,000 from their 401(k) account, he or she will ultimately pay $17,500 in taxes on the withdrawal.

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