Real World WynnSights: Please Don't Liquidate Your 401(k)

In this episode of Q&A: Real-World WynnSights, I tackle questions about investing in a tough economy, liquidating a 401(k), retirement allocation strategy and alternatives to the 529.

Names and personal information are excluded to protect privacy. NOTE: Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion.

Q: Because we’re experiencing tough economic times right now, what would you consider to be the best investment opportunity?

A: Since I seldom invest in individual stocks (I’m primarily an index fund guy) and most of my investing is on a dollar-cost averaging basis, any current state of economic affairs has very little impact on what I might consider “the best investment opportunities now.” Frankly, I don’t think our economy is in rough waters right now. With a 30,000 Dow and a 3,600-plus S&P 500 at new highs, the average investor seems to be quite comfortable with America’s state of economic affairs.

Yeah, our markets might be bordering on overbought, but they don’t yet seem frothy. Since I seldom follow individual stocks, any opinion I have about them should be taken with a grain of salt, but long-suffering Big Oil and its generous dividends might be worth taking a look at. And I’d be somewhat cautious of Big Tech. They’ve had quite a run (for good reason). I loll in the comfort of low-cost, highly diversified mutual funds… and dare to be average.

Q: What approach should I take to convert my 401(k) investments to cash?

A: I question taking such action. Because interest rates are so low, a cash position is a lot like a bar of gold. Gold produces nothing unless someone is willing to pay more for it than you did. Cash produces more only if interest rates improve. Other than setting aside some cash in a safe Rainy Day fund, it seems to me you need to have exposure to marketplace investments, perhaps earning dividends, interest, and hopefully, capital gains as a result. How do you benefit from the marketplace without being exposed to it? Remember, folks who cash out fearing market declines – or for other reasons – often absorb capital losses, create tax liabilities, or suffer “opportunity costs” by not reinvesting on a timely basis. We invest for good reason. In my mind, setting on surplus cash is not investing.

Q: I am a financially-independent mutual fund investor (100% equities) nearing retirement. Given today’s market, how would you suggest I go about changing my allocation strategy? Also, when retirement comes, should I take the lump sum or annuity?

A: Because interest rates are so low, and because the current climate doesn’t suggest much upward drift in rates, I would be in no particular hurry to adjust my allocation away from equities particularly in light of future inflation potential. In a few years, however, it might make sense to consider investing in some target-date [equity/bond] funds of funds that would automatically involve you in a growing percentage of both domestic and international bond funds. By the way, I like the fact that you keep things simple. As to your pension, a lump sum versus an annuity payout really boils down to greater control of your assets and whether or not you have other regular cash flow sources (social security, part-time work, etc.) to handle monthly expenses. The fact that you have long been a financially independent sort indicates to me that you’re a knowledgeable investor, in which case, I’d be inclined to consider taking a lump sum. You can always purchase an annuity later in life if circumstances indicate the wisdom of such a move.

Q: I want to save for my children's education. Do I have good options other than 529 accounts?

A: You have a number of options, but upfront let me emphasize that using a 529 Education Account is a really wise means of accumulating funds for educational purposes. I recently wrote a blog (The Coverdell vs 529s; 10-22-2020) detailing a 529’s many advantages. But 529 funds must be used specifically for education purposes or the tax-advantaged benefit is lost… as it should be.

A more free-wheeling approach that allows the “benefactor” greater control over investment and disbursement involves devoting a Roth IRA to the education of a child. Roth IRAs have tax advantages similar to 529 plans and are primarily intended as retirement savings vehicles. But they can be used for college planning. Of course, the benefactor won't get upfront tax deductions, but the account will grow tax-deferred and withdrawals will be tax-free no matter how used (as long as you're 59½ or older and have had the Roth IRA for at least five years). However, the benefactor can withdraw Roth contributions (but not their earnings) at any time and for any reason, tax-free. Also, the money held in retirement plans isn't counted as an asset when an application is made for financial aid through the FAFSA. Drawbacks to using a Roth versus a 529 include the annual limitation of contributions to $6,000 (or $7,000 if 50 or older), and using a Roth IRA to pay for college leaves less money for the benefactor’s retirement. Keep in mind, a child will have more years to repay an education loan than the benefactor will have to recoup lost retirement savings. Technically, another type of 529, a prepaid tuition plan, allows the benefactor to pay for future tuition at current rates. However, they generally apply only to certain colleges and universities in certain states. And unlike regular 529’s, these plans are often limited to covering tuition only. A more limited but tax-favored alternative to 529s is the Coverdell Education Savings Account (ESA). The Coverdell has a more restrictive $2,000 annual contribution limit for a particular child. Investors filing joint returns are further discouraged from setting up an ESA if their modified adjusted gross income (MAGI) is greater than $190,000 ($95,000 for single filers). Specifically, the $2,000 annual maximum is phased out for joint files with MAGIs falling between $190,000 and 220,000. Such monetary limitations represent downsides to many… and in addition, ESAs are age-limited. Contributions to a Coverdell plan must end when the beneficiary turns 18, and withdrawals for qualified expenses must be distributed by the time a beneficiary turns 30. These limitations are particularly discouraging to investors with large incomes. On the other hand, these same limits appeal to prospective benefactors with lessor resources. Custodial accounts such as Uniform Gift to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA) do not provide tax benefits like a 529 plan, but allow account holders much more discretion regarding investment options (virtually unlimited like Coverdells) and how the money is eventually used. Although proceeds are to be used for a child’s benefit, they’re not specifically earmarked for education… a useful feature for parents unsure if their offspring will actually go to college. Unfortunately, UGMA/UTMA contributions won't earn tax deductions or credits, and such accounts’ earnings are taxable. Also, because they are considered the child’s assets, up to 20% of their balance is counted in computing the Expected Family Contribution on the FAFSA. This is not so with 529 accounts because they are considered to be parental assets - only up to 5.64% of their balance is counted.