401k Loan Not a Great Idea

Jane Young, CFP, EA

When you need extra money to pay some bills, make home improvements or buy a new car, a 401k loan may seem like the perfect solution. At first glance, it seems like a great idea to borrow money from your 401k account and pay interest back to yourself. However, in reality taking a loan against your 401k can put a significant dent in your retirement saving and could result in unnecessary taxes.

Most 401k plan providers allow employees to take loans against their 401k account of up $50,000 or 50% of the account value. The interest rate charged on most 401k loans is the prime rate, which is currently around 4%, plus 1 or 2 percentage points. Loans must be paid back in five years, potentially longer if you are borrowing to purchase a primary residence. Repayment is typically made via automatic payroll deduction and loans automatically come due if you discontinue employment.

The advantages of a 401k loan include the ease with which you can get your money. A 401k loan is a quick, no hassle process that doesn’t require a credit check or the completion of a time consuming credit application. The loan is automatically repaid from your paycheck and the interest rate is generally lower than what you would pay for a bank loan or a credit card. There is no income tax or penalty due on the money taken out for the loan and the interest goes back into your account.

On the surface this sounds like a great deal but there are significant disadvantages. The most obvious may be the opportunity cost of losing the chance to earn compounded returns on the money that you have borrowed. This can have a dramatic negative effect on the amount of money you have available at retirement. Additionally, while making payments on a 401k loan, most borrowers stop making contributions. This results in lost tax deductions and may cause you to miss out on your employer’s match, not to mention less money in retirement.

Another less obvious downfall is the double taxation on the interest. Your interest payments are made with after tax dollars and then you pay taxes a second time when distributions are taken in retirement. Additionally, you may have to pay taxes and penalties if you lose or quit your job before your loan is paid off. A 401k loan typically becomes due within 60 days of separation from your employer, regardless of the reason. If you are unable to pay off the loan you will owe regular income tax on the full amount plus a 10% penalty if you are under 59 ½.
Generally, you are better off taking out a bank or home equity loan or postponing consumption until you can pay cash than taking out a 401k loan. Avoid 401k loans unless you are truly in dire circumstances or the money is needed for a very short term loan.

401k Options When You Change Jobs

Jane Young, CFP, EA

In addition to the other commotion related to changing jobs, you need to decide what to do with your 401k account.  You have four possible options; leave it with your employer, transfer it to your new employer’s plan (if allowed), transfer it to a Rollover IRA or cash it out.  Unless you’re in a dire situation, avoid withdrawing your 401k funds.  Cashing out your 401k will result in taxation of the full amount at regular income tax rates as well as a 10% early withdrawal penalty if you leave your job prior to age 55 and don’t qualify for an exception.  Additionally, you will forfeit the opportunity to earn tax deferred, compounded growth on the hard earned money you have put away.

If you have at least $5,000 in your 401k account, you should be able to leave it with your old employer.  The decision to transfer your 401k or leave it in place largely depends on the quality and variety of investment options and the fees charged by the plan.  Some 401k plans provide access to low cost institutional funds that have lower or comparable fees to those available in an IRA.  If the fees are high and your choices are limited consider moving your account.  Another downfall to leaving your 401k with your old employer can be the danger of neglecting or forgetting about it, resulting in the failure to monitor and rebalance your account.

When changing jobs you may want to consider transferring your 401k to your new employer’s plan. Again, this should only be considered if they have a wide variety of low cost investment options.  You also may find it more convenient to have all of your funds in one place.  A disadvantage to this choice is once you transfer your 401k to a new employer’s plan you may lose the option to later move it to another plan or custodian.  You are locked in if the new plan administrator makes changes to the investment offerings or fees that you don’t agree with.  Alternatively, some advantages of a 401k over an IRA include the ability to borrow against your account, as long as you remain employed, and a 401k may offer greater protection against creditors than an IRA.

Your final option is to transfer your 401k to a Rollover IRA.  A Rollover IRA can provide you with the greatest variety of investment options including mutual funds, individual stocks, bonds and CDs.  You have the freedom to choose from a wide variety of custodians including discount brokerage firms and mutual fund companies to get the best quality, selection, service and cost.  If you decide to transfer your 401k to an IRA; select a custodian, open an IRA account, and ask your 401k administrator to process a direct transfer to your new account.  To avoid negative tax consequences be sure the check is payable to the custodian, not directly to you.

Do You Need Long Term Care Insurance? – Part 1

Jane Young, CFP, EA

Jane Young, CFP, EA

As retirement grows closer the decision on how you will cover potential long term care expenses becomes a serious concern.   Unfortunately, with the high cost of long term care (LTC) and the high cost of long term care insurance there is no easy solution.  LTC refers to services or support to help you with medical or non-medical personal care needs.   LTC can provide assistance with cognitive impairment and activities of daily living such as eating, bathing, dressing, using the toilet and assistance with incontinence.  About 80% of all LTC is provided in the home.

LTC expenses can be paid with a combination of personal or family savings, LTC Insurance and government assistance.  Generally Medicare does not cover long term care.  Medicare will provide 100 days of skilled nursing care following a 3 day stay in the hospital.  Medicaid will pay for LTC after most of your assets have been depleted but Medicaid is usually limited to skilled nursing home care.

The decision to purchase LTC insurance is straight forward for the affluent who can self-insure and for those with little or no assets who must rely on Medicaid for their LTC expenses.  The decision is more complicated for those who can’t afford to self-insure but want to protect their assets to provide a livelihood to a surviving spouse, an inheritance to children or want to avoid being a burden to family.

Individuals who are at the greatest risk for needing LTC are those with a history of a chronic condition such as high blood pressure or diabetes, or have family members with a history of a chronic condition.  You may also have a higher risk if you are in poor health or have poor diet and exercise habits.  Women are at greater risk than men because on average, they live 5 years longer.

According to a study using a microsimulation model performed by Kemper, Komisar and Alecxih, on average people currently turning 65 will need LTC for three years.   They found that 3 out of 10 people will rely on family for their care for more than 2 of these years.  They also found that 2 out of 10 people will need care for over 5 years.  Overall, their analysis indicated that 50% will have no out of pocket expenditures for LTC, 25% will spend less than $10,000 and 6% will spend over $100,000.

Additionally, based on information from leading insurance actuaries, the Association for Long Term Care Insurance reported that someone who buys a LTC insurance policy, with a 90 day elimination period, at age 60 has a 35% chance of using it before they die.  They also reported that the average stay in a nursing home is 2.3 years for men and 2.6 years for women. Most care is provided at home but statistics on this are limited.

My next column will address the cost of LTC and LTC insurance and the pros and cons of purchasing LTC insurance.

Gradual Retirement Can Ease Stress and Cash Flow

Jane Young, CFP, EA

Jane Young, CFP, EA

As the average life expectancy increases retirement is starting to look very different.   We may be less likely to completely stop working on a fixed, predetermined date.  As the traditional retirement age of 65 approaches many are considering a more gradual transition into retirement.

One advantage of easing into retirement includes the ability to supplement your cash flow and reduce the amount needed to be withdrawn from your retirement savings.  If you continue working after 65 you may be able to earn enough to delay taking Social Security until 70.  This will provide additional financial security because your Social Security benefit increases 8% per year from your normal retirement age to age 70.  The normal Social Security retirement age is between 66 and 67.

Abruptly going into retirement can be very traumatic because careers provide us with a sense of purpose, a feeling of accomplishment and self-esteem.   Your social structure can also be closely tied to work.  By working part time before completely retiring, you can gradually transition into the new phase of your life.   As you approach retirement age the grind of working 40 to 50 hours per week can become very trying.   Working part time allows you to stay engaged with your career while taking some time to relax and pursue other interests.

According to a 2012 study by the Bureau of Labor Statistics, more people are working beyond age 65.  In 2012 about 18.5% of Americans over 65 were still working vs. only 10.8% in 1985.  A study reported by the Journal of Occupational Health and Psychology stated there are health benefits from working part time during retirement.  This may be attributed to less stress and a more balanced life while experiencing the mental stimulation gained from continued engagement at work.

Gradually transitioning into retirement may be more practical for someone who is self-employed.  However, the concept of phased retirement is a hot topic among human relations firms and departments.  Phased retirement programs usually involve working about 20 hours a week with some element of mentoring less experienced workers.  Formal phased retirement programs are still rare but they are gaining popularity.  A 2010 study by AARP and the Society for Human Resources Management found that about 20% of the organizations polled had a phased retirement program or were planning to start a one.  In fact, the federal government just launched a phased retirement program.

Before signing up for a phased retirement plan, take steps to fully understand the impact it may have on your benefits.  If you are under 65 there may be restrictions on your health insurance.   Additionally, some pension calculations are based on your final years of salary, working fewer hours at this time could negatively impact your benefit.  Also avoid situations where you are only paid for 20 hours a week but still work 30 or 40 hours to get your job done.

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