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.

Strategically Withdraw Money for Retirement

Jane Young, CFP, EA

Jane Young, CFP, EA

After years of contributing money to 401k plans and Roth IRAs you are finally ready for retirement and face the dilemma of how to best withdraw your retirement savings.  Many retirees have several sources of income such as pensions, social security and real estate investments to help cover their retirement needs. Review your annual expenses and determine how much you need to pull from your nest egg for expenses that aren’t covered by other income sources.

One way to manage your retirement income needs is to create three buckets of money.  The first bucket is for money that will be needed in the next twelve months.  This money should be fully liquid in a checking, savings or money market account.  The second bucket is money that will be needed over the next five years.  At a minimum, hold money needed in the next five years in fixed income investments such as CDs and short term bond funds.  By investing this money in fixed income investments it is shielded from the fluctuations in the stock market; avoiding the agonizing possibility of having to sell stock mutual funds when the market is down.

Consider buying a rolling CD ladder where a CD covering one year of expenses will mature every year for the next four to five years.  After you spend your cash during the current year a new CD will mature to provide liquidity for the coming year.

The third bucket of money is your long term investment portfolio.  This should be a diversified portfolio made up of a combination stock mutual funds and fixed income investments.  Every year you will need to re-position investments from this bucket to your CD ladder or short term bond funds to cover five years of expenses.  Rebalance your long term portfolio on an annual basis to keep it well diversified.

In conjunction with positioning your asset allocation for short term needs, you need to decide from which account you should withdraw money.  Conventional wisdom tells us to draw down taxable accounts first to allow our retirement accounts to grow and compound tax deferred, for as long as possible.  Gains on money withdrawn from a taxable account are taxed at capital gains rates where withdrawals from a traditional retirement account are taxed at regular income tax rates and withdrawals from Roth IRAs are generally tax free.

Withdrawing all your money from taxable accounts first isn’t always the best solution.  You need to analyze your income tax situation and strategically manage your withdrawals to avoid unnecessarily going into a higher tax bracket.  Additionally, the taxation of Social Security is graduated based on income.  After starting Social Security, you may be able to minimize taxation of your benefit by taking withdrawals from a combination of taxable, traditional retirement and Roth accounts.  Do some tax and financial planning to strategically minimize taxes and maximize your retirement portfolio.

Retirement Tips for All Ages

Jane Young, CFP, EA

Jane Young, CFP, EA

It’s always a challenge to balance between current obligations and saving for retirement.  A good start toward meeting your retirement goals is to get your financial house in order.  Create a spending plan that helps you live below your means.  Maintain an emergency fund of at least four months of expenses and pay off high interest consumer debt.    Establish a habit of saving at least 10% of your income.  If you are getting a late start, you may need to save 15-20% of your income.

Develop a retirement plan to determine how much you need to save on a monthly basis and how large a nest egg you will need to comfortably retire.  There are many on-line calculators available to help you run retirement numbers.  However, they are only as accurate as the data that you input and the assumptions that the model uses.  You may want to hire a fee-only financial planner to run some figures for you.

Work toward maximizing contributions to your employer’s retirement plan; take advantage of any employer match that may be provided.  Once you have contributed up to the level of your employer’s match, consider contributing to a Roth IRA.  A painless way to steadily increase your contribution percentage is to increase your contribution whenever you get a raise.  If you are self-employed, or your employer doesn’t offer a retirement plan, contribute to a SEP, Simple or an IRA.  If you are maxed out, increase your contributions as the maximum contribution limits increase or you become eligible for a catch-up contribution at age 50.

Invest your retirement funds in a diversified portfolio made up of a combination of stock and bond funds that invest in companies of different sizes, in different industries and in different geographies.  Generally, your retirement savings is long term money, so avoid emotional reactions to make sudden changes based on short term market fluctuations.  Develop an investment plan that meets your timeframe and investment risk tolerance and stick to it. 

Don’t use your retirement funds as a savings account for other financial objectives.  Unless you are in a dire emergency, don’t take distributions or borrow against your retirement funds.  When you change jobs, don’t cash out your retirement plans.  Roll your funds over to an IRA or a new employer’s plan.    Avoid sacrificing your retirement savings to fund college education for your children.

As you near retirement age, there are several ways to stretch your retirement dollars.  Retirement doesn’t have to be all or nothing.  Consider a gradual step down where you work a few days a week or on a project basis.   Try to time the payoff of your mortgage with your date of retirement.  Consider downsizing to a smaller home or moving to a more economical area.  Establish a retirement spending plan that provides funds for things you value and helps you avoid frivolous spending on things that don’t really matter.

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