The odds of winning a lottery are infinitesimal. Yet inevitably, someone does. Inspired by the idea of a huge payoff, millions of people burn money on lottery tickets.
The financial strategies below aren’t as much of a long shot as the lottery. More than a handful of people may actually benefit. But many who are tempted to use them don’t understand how high the odds are stacked against success. What seem like smart money moves on the surface may hide perils underneath.
Using a 401(k) loan
The pitch: Retirement fund loans may be cheaper than other loans, and borrowers pay themselves interest instead of paying a lender.
The problem: The risk of a loan turning into a withdrawal is huge.
A study published by the National Bureau of Economic Research found that 86 percent of workers who had outstanding 401(k) loans defaulted when they left their employer. Most plans require borrowers to quickly pay back balances after they quit, get laid off or get fired. Those who can’t are considered in default. The money owed becomes a withdrawal, triggering taxes, penalties and the potential loss of tens of thousands of dollars in future tax-deferred, compounded gains.
Rather than asking if a 401(k) loan will be cheaper, the real question might be whether borrowing is the right move at all. The answer often is no. Loans can mask overspending that the borrower doesn’t want to confront.
Think of a 401(k) loan as putting your future in hock. If you have a rock-solid job and a compelling reason to borrow, it might be worth the risk. Otherwise, it’s not.
Investing in a variable annuity
The pitch: Variable annuities offer a tax-deferred way to save for retirement without contribution limits. In retirement, annuities can provide a lifetime stream of payments.
The problem: Unlike other retirement accounts, variable annuities don’t offer a tax break. Contributions aren’t deductible, and withdrawals are taxable as income. Plus, variable annuities are more expensive than mutual funds.
A variable annuity is a contract with an insurance company. Your money is invested in mutual funds that may gain or lose value; that’s the “variable” part. Once payments start, the insurer typically promises to continue the checks for the rest of your life, or the life of your spouse or any other person you designate. If you die before you start receiving the payments, your heirs get a death benefit. Some annuities also have life benefits that guarantee certain levels of income.
These benefits come at a cost. The average annual expense ratio — the administrative and operating costs deducted from your returns — for a variable annuity is 2.27 percent, according to Morningstar, and some top 3 percent. That compares with the 0.63 percent average for mutual funds, according to the Investment Company Institute. High costs can reduce the amounts investors accumulate for retirement. Variable annuities often have surrender charges that take a chunk of early withdrawals. A typical surrender charge starts at 7 percent the first year and declines by 1 percent per year.
Investors also should understand the tax-deferral feature is a double-edged sword. Withdrawals are taxed at ordinary income rates that are typically higher — sometimes much higher — than the capital gains rates people could get if they invested in mutual funds directly rather than through a variable annuity.
Variable annuities may have a place in your plans if you’ve contributed the maximum to 401(k)s and IRAs, you’re comfortable with the higher costs and you like the idea of lifetime payments. But you shouldn’t rely solely on the advice of someone who profits if you buy one. Take the annuity prospectus to a fee-only financial planner for a second opinion. Also, check out the financial strength of the insurer with rating agencies such as A.M. Best, Fitch, Moody’s and Standard & Poor’s, since its failure could affect its ability to pay benefits.
Taking a lump-sum payout
The pitch: You could take a lump-sum payout from a pension or other retirement account and invest it so well that you wind up with more money than you’d get from a lifetime stream of payments.
The problem: Keeping your hands off a big pot of money.
According to a MetLife study, many people who took lump sums spent or gave away sizable chunks of their payout and later regretted their actions. One in five retirees who took a lump sum went through all of the money, and did so in an average of 5 1/2 years.
If you’re disciplined and savvy about investing and you get good, conflict-free advice, taking a lump sum can work. But if you struggle to live within your means, have a history of blowing through windfalls or are a novice at investing, lifetime payouts are the way to go.