Cash-Out Concerns Ahead of Tax Season

Alex Reffett, the principal and co-founder of adviser firm East Paces Group in Decatur, Georgia, recently sat down with PLANADVISER for a wide-ranging interview, during which he reflected on some key lessons learned in 2021 and shared some suggestions for providing great client service in 2022.

Reffett described the experience of advising clients in 2021 as “volatile.” After a summer of relative economic calm, Americans became increasingly worried about financial risks stemming from market volatility, rising inflation and the resurgence of COVID-19 infections and hospitalizations.

“It was a challenging second half of the year for the country and our clients,” Reffett says. “However, what was rewarding for me personally was the actual reaction that our clients had and, that is to say, a majority of our clients actually had very little reaction. Very few of them called in with concerns about wanting to sell and flee to cash during the multiple sharp dips we have experienced. A few of them called in with concerns, of course, but it was very rare.”

Reffett says this is a testament to his firm’s commitment to the basic tenants of good advising—of clear communication and coaching about the need to define and commit to a consistent, long-term strategy.

“We work hard to make sure our new and long-term clients understand how market cycles work and the unpredictability of market movements in the short term,” Reffett says. “It was gratifying to see that, during a challenging year, this focus on the basics truly paid off. If you consistently coach your clients and have a disciplined strategy, they just aren’t going to be as worried when the stressful times arrive.”

Speaking to advisers who may still be learning the ropes, Reffett says it is important to “not veer in your principles and your advice.”

“Of course, you have to respond to the moment, and you have to make strategic investment decisions as the situation demands, but you also have to be assured and consistent in your meetings with clients,” he explains. “How I like to say this is that the details of your approach may change, but the principles of your approach should not. Your clients will pick up on it very quickly if you are not confident and consistent in your principles.”

With employers beginning to send out W-2 and 1099 tax forms in the coming weeks, Reffett suggests now is a good time for advisers to remind their clients about the tax implications of early retirement plan withdrawals. He cites the fact that so many Americans are moving between jobs right now as a reason to believe this may be a particularly bad year for untimely and ill-advised cash-outs from tax-advantaged defined contribution (DC) retirement plans and individual retirement accounts (IRAs).

“We have all heard the horror stories when it comes to cash-outs,” he says. “It’s not just small accounts that are cashed out, either. In previous roles, where I worked with larger groups of participants on a consistent basis, I would commonly hear from people that they had previously taken some very large 401(k) withdrawals with zero understanding of the tax consequences. If a person has $100,000 in income in a year, and they chose to take out, say $200,000 in 401(k) assets, with the idea of buying a home, they can get absolutely hammered by taxes and penalties.”

Reffett warns that even cash-outs that seem small can have substantial negative consequences, for example when a person is right on the cusp of a new tax bracket and chooses to cash out even a few thousand dollars.

“Even a modest early distribution can push you over the line into a new tax bracket,” he warns. “On top of the increased tax burden, you will likely have to pay penalties, and you are also missing out on the compounding effect of saving over time.”