How To Withdraw Money From Your 401k
Are your funds trapped in a 401k? You could ask your employer to do an “in service” transfer to your IRA. 401k’s with in service transfers are not common. ("In service" means that you are still working at the employer). Usually the Plan Documents do not allow an employee to transfer the funds out of his or her 401k while they are still an employee, so the funds may be trapped in the 401k until the person is no longer an employee of their company.
If you are allowed to transfer the funds out of a 401k while still at the employer then be sure to rollover the funds directly into an IRA to avoid tax. If you withdraw the funds with a check payable to yourself then that is a taxable transaction which probably can’t be undone, resulting in a catastrophic tax consequence. Ask the new IRA Custodian how to engineer the transfer and have them pull the funds from your 401k. The IRA Custodian can open a zero balance account before receiving any transfers, to hold the money. That way there will place for the 401k Custodian to send the funds to.
Some employers allow 401K money to be invested in a “brokerage window” where the employee can buy any publicly traded stock or bond or mutual fund, but most employers don’t allow that.
Exotic strategies for working funds trapped in a 401kSuppose you have $100,000 in a 401k that offers poor choices. You could get a loan for $50,000 from it and invest that in a taxable account. The remaining $50,000 in the 401k could be invested in a short term or intermediate term bond fund in the 401k, assuming that there were no good investment chocies in the 401k and assuming that you share my bearish viewpoint that stocks are overpriced and should not be bought.
The best place for bonds is in a retirement account because of the tax deferrals. However, since U.S. Treasuries are free of state income tax (9.3 to 10.3%% in California) then they should be held in a taxable account, since income earned in a retirement account when withdrawn is treated as ordinary income and thus the character of tax-free income is washed out and becomes taxable ordinary income.
Now suppose you have $1,000,000 in a 401k. If you borrow $50,000 from it, how do you invest the remaining $950,000 if the investment choices are very poor? (I wrote a post “Tax traps in 401k’s” warning about tax traps when borrowing from 401k’s, so please don’t borrow from a 401k). One hypothetical solution, which is risky, confusing, and needs to be analyzed with a personalized consultation with a financial planner to see if appropriate for each unique client, would be to invest the $950,000 in a generic short term bond fund in the 401k and then in a taxable account buy the desired investment using leverage that is used to acquire $950,000 of desired assets.
For example, in a taxable account one could be a commodity futures contract on the stock market or on foreign currency with only a modest down payment, thus replicating ownership of stocks or foreign currency. The problem is that commodity futures by law are taxed as a blend of short and long term gains and require marking to market and recognizing gains every year. But the big risk is that most investors lack the sophistication and discipline to handle this.
For example suppose you buy $950,000 of stock futures with $50,000 down payment and the market crashes 25% in a day. Now you lost $250,000 and have a $200,000 negative equity at the futures brokerage. You are not allowed to get more funds from you 401k so what do you do to meet the margin call? That is simply too risky. Buying Call options is risky since they could expire worthless. However, if someone had $3,000,000 in a taxable account, small or no debt and then he or she could try buying stocks on margin in a taxable account instead of using futures contracts.
This means they would own the stocks and mutual funds and would get long term gains treatment if they were successful in investing. This as a way of avoiding the constraints of a 401k that would be somewhat less risky than a futures contract, but still too risky. Basically, to invest, it is best to avoid leverage because leverage can make someone nervous and cause them to panic and sell under pressure during a temporary dip in the market. In addition derivatives such as futures contracts or options do not always properly track the “real” or underlying asset that they are based on and may have some bizarre “tracking error” that causes the derivative to behave differently than the underlying investment that it is based on.
The best thing to do if you have “too much” in a 401k is to be grateful that you have it and to consider simply investing in a low cost bond index fund in the 401k and wait until it is time to change jobs when you will be free to roll the funds to an IRA where there is unlimited freedom to invest in publicly traded securities that are traded in the U.S. If you have a million in a 401k perhaps you are a high ranking executive and have some connections at work and can ask the management to approve of a new 401k Plan Document that gives employees freedom to do “in service” withdrawals or freedom to use a Brokerage window. Or perhaps it is time for a job change in which case your trapped 401k funds will be free to migrate to an IRA.