When you withdraw money from a 401(k) account, or take an annual Required Minimum Distribution, you may not pay close attention to where that money is coming from.
But you should.
Why? Because the method a 401(k) recordkeeper uses to redeem shares of funds in your account to generate cash for the withdrawal can potentially put your asset allocation out of whack in ways you never intended.
The advantages of doing it yourself
You don’t need to let your recordkeeper choose which funds to redeem. You can do it yourself. One reason you might do so is to maintain your account’s current asset allocation.
A simple example
Let’s say you want to withdraw $50,000 from one of your $400,000 401(k) accounts with $240,000 (60%) invested in a stock fund and $160,000 (40%) invested in a bond fund without disrupting this allocation.
To accomplish this, you might redeem $30,000 worth of shares from the stock fund (leaving $210,000) and $20,000 worth of shares from the bond fund (leaving $140,000). These adjusted balances would maintain your 60%/40% split.
If you don’t make your own redemption decisions…
…The 401(k) plan recordkeeper will make them for you when a withdrawal request occurs.
Some plans use a proportionate approach, where redemptions are made from your funds in a manner that preserves your desired asset allocation objective.
However, some plans use a “risk-tiered” approach, where redemptions are made from the most conservative investments first.
A typical process might look like this:
- Initial withdrawals are made from the cash position in the account.
- If the cash position doesn’t cover the entire withdrawal, shares of bond funds are redeemed to provide additional cash.
- If there’s not enough money in the bond funds to cover the remainder of the withdrawal, shares of stock funds are redeemed.·
How the risk-tiered approach can throw your allocation out of whack
Using the same $400,000 401(k) account scenario from before, let’s say your recordkeeper uses a tiered approach to handle your $50,000 withdrawal request.
Assuming there’s no cash in the account, the recordkeeper would redeem the entire $50,000 from your account’s bond fund.
This action would leave $240,000 (69%) in your stock fund and $110,000 (31%) in your bond fund. This unintentional overweighting in stocks could increase the risk of your portfolio in ways you never intended.
To restore this balance, you would need to move $30,000 from your stock fund to your bond fund.
The tiered approach becomes even more complicated if your account is allocated among several different stock and bond funds. Within each asset class, how does the recordkeeper determine which funds will be tapped for redemptions? Only the recordkeeper knows.
It’s up to you to control your account’s redemption strategy
Unfortunately, many recordkeepers don’t disclose which redemption approach—proportionate, risk-tiered, or some other method—they use to fulfill withdrawals and RMDs. It’s usually not mentioned in the plan’s Summary Plan Description or other plan documents provided to participants.
But you have a right to know. Find out by contacting your recordkeeper and ask for a copy of its redemption policy. Read it carefully to determine the approach they use and whether you can request a different method.
If you’re not sure which method to use, a financial advisor can help you balance allocation risk and also make sure you are taking retirement withdrawals in a tax-efficient manner.
This article was authored by Michael Flaherty and Jeffrey Briskin. Michael is a senior financial advisor with Canby Financial Advisors, a SEC-registered investment adviser. SEC registration does not constitute an endorsement by the SEC nor a statement about any skill or training. Michael can be reached at 508.598.1082 or mflaherty@canbyfinancial.com. Jeffrey Briskin is Director of Marketing at Canby Financial Advisors.
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