Since 1979, private sector work-related retirement plans have been gradually shifting from defined benefit pension plans to defined contribution plans. The 401(k) plan is among the most common and best known of this type of retirement plan. Defined contribution plans shift important retirement planning responsibilities from the employer to the employee, according to the U.S. Social Security Administration Office of Retirement and Disability Policy. Those responsibilities come with choices. These decisions are far-reaching in their impact and mistakes have the potential to be costly, so think carefully before borrowing from your 401(k) plan.
Weigh Your Reasons
According to a January 2015 CNN Money report, the average Fidelity 401(k) balance was $91,300. That’s a far cry from the $1 million in retirement funds that many financial planning professionals consider adequate. At a 3 to 5 percent annual draw-down, that $1 million will provide $30,000 to $50,000 per year during retirement. Building a retirement fund of that size isn’t easy for the average person. It takes work – planning, saving and investing. Taking money out of your retirement savings isn’t something you should ever do lightly.
Generally, spending and debt fall into three basic categories – consumptive, productive or obligatory. Consumptive borrowing, spending and debt refers to monies used for consumer goods or services, such as remodeling your home, buying a perfectly restored classic car or taking an extended tour of Europe. Productive debt refers to money borrowed for a practical, productive purpose, such as for an income producing small business. Obligatory borrowing describes the borrowing done to fulfill certain obligations, such as to meet the care needs of an elderly parent.
Borrowing from your 401(k) isn’t something the average financial planning professional is likely to encourage in most circumstances and most certainly not for consumptive spending or to pay down debts related to consumption, such as credit card debt. However, there are a few circumstances in which it can be a good financial move, such as for buying a small business or a home, though it is important to keep in mind exactly what you are risking when you take that money out of your 401(k).
Consider the Cost
As with any borrowing option, when deciding whether or not to borrow funds from your 401(k) plan, it is essential to consider the cost of that loan. It is a loan that will have to be paid back with interest, which is typically set at the current prime interest rate plus a couple of percentage points. If the loan isn’t paid back according to the agreed upon repayment schedule, you can be subject to a 10 percent penalty and income tax on the amount if you are under 59 years of age, as it will count as an early withdrawal. If you lose your job while you have that loan, you may face that same penalty if you cannot repay the loan in full within 30 to 60 days.
Those are just the overt costs associated with borrowing from your 401(k). There are also hidden costs, as noted in a July 2015 Time article. Money that you take out of your 401(k) plan is money that is no longer working for you. According to data from Fidelity Investments, one loan of $9,000 can put you 7.6 percent behind on your retirement funds. Another way to look at it is that by borrowing from your 401(k), you can decrease your monthly retirement income by $180 to $650. Often, while repaying the loan, additional contributions to the 401(k) aren’t made, further reducing the money available for growth in the account. If your plan is one in which your employer matches your contributions, then you suffer a double loss.
Review Other Options
In most cases, you may be better off to consider other options before borrowing from your 401(k) plan. After all, just because you can borrow from your retirement plan, doesn’t mean you should. It is better to view your retirement savings as off-limits for all but the most essential needs or dire circumstances. The closer you are to retirement age, the higher the risk that you won’t be able to replace those funds, not the cash and what that money would have produced had it been left in your 401(k) plan to grow. Before choosing to borrow from your 401(k), look not just at other borrowing options, but also at other means of achieving your goal, such as taking up part-time work and instituting an aggressive savings plan to come up with the money you need.
If you are tempted to take advantage of the lower interest rate a 401(k) loan offers to pay off your higher interest credit card debt, try negotiating with credit card companies to secure a better interest rate. Medical bills can often be negotiated into a payment plan, as can other expenses and debts. If you are considering borrowing from your 401(k) to cover college costs, invest time in seeking out scholarship potentials and encourage children to work towards them. It may even be a good idea to encourage college-bound children to get a job and help defray some of those college costs. Seek out applicable grant opportunities. And, if all else fails, it may be best to go with the standard student loan opportunities, rather than risk borrowing from your retirement savings.
Sometimes Borrowing Makes Sense
Not every 401(k) plan offers the loan option. The rule for those that do is that you can borrow up to $50,000 or up to 50 percent of the money in the account, whichever is the lesser amount. Typical terms require that the loan is repaid within five years, unless the loan is for the first time purchase of a home. In that case, the repayment period can be as long as ten years. Because of the ease of obtaining the loan and what is often a lower interest rate than other borrowing options, especially true for those with credit score challenges yet to be worked out, there are circumstances in which taking a 401(k) loan does make good financial sense.
A home is an important asset. However, it is also an expensive one, frequently purchased with mortgages that extend for decades. Thus, the interest rate really matters. A few interest points can translate into tens of thousands of dollars over the lifetime of a home loan, making it worthwhile to choose the lower rate of interest typical of a 401(k) loan over loan options with a higher interest rate. Borrowing from your 401(k) plan to beef up a down payment on a house can eliminate the need for mortgage insurance, saving you a significant amount of money monthly. Lowering the principal of the loan can reduce the amount you’ll pay in interest over the long-term, yielding great savings over the life of the mortgage.
The quick financial liquidity that a 401(k) loan offers can be a real boon to you if you need funds to invest in your business, perhaps to upgrade equipment or to facilitate expansion, provided you are sure that you’ll be able to repay that loan within the proscribed time period. If, however, you are investing in starting a small business and will be relying on profit from that business to help repay the loan, think carefully about that choice. With the high rate of failure for new businesses, it could be a risky move.
Make A Plan
A 2014 Pension Research Council working paper estimated a national annual 401(k) loan default amount of $6 billion. That’s a lot of people not repaying t
he loans they take out from their retirement savings. If, after weighing all of the evidence and all of your options, you do decide to borrow from your 401(k) retirement savings, be sure to take the time to craft a solid repayment plan. It’s important to be sure that you can repay the loan if you do decide to use this borrowing opportunity.
Sit down and create a budget with the goal of freeing up the cash for your monthly loan payment. If, after cutting out what expenses you can, such as canceling cable television and bringing your lunch to work instead of buying it out, you still find yourself without the money in your budget for your loan payments, you’ll have to generate additional income. Whether you take a part-time job, start a micro-business or venture into the sharing economy to make a bit of extra cash monthly, it is important to make sure that you can repay the loan if you do borrow it from your retirement funds.
After paying back the loan, it would be a wise financial move for you to keep that additional income flowing, funneling it directly into your savings account until you’ve got a good sized emergency fund or just-in-case fund built up. Then, you’ll be prepared for the next time you need some liquidity and won’t have to consider borrowing from your 401(k) plan, because not borrowing on your retirement really is the best decision in most cases. A 401(k) loan is often the easiest borrowing opportunity, but that doesn’t make it your smartest option financially. The future is never sure and borrowing from your retirement really is not the best decision in most cases.
4 Ways To Get Your Retirement Plans Back On Track
Whether you are nearing retirement or already enjoying your golden years, the recent market correction – and subsequent rally – has millions of Americans reconsidering their retirement plans.
If you’ve found that your retirement accounts aren’t quite where you would like them to be, don’t worry, there’s still time – and steps you can take – to improve your financial situation.
Play “Catch Up” In Your Retirement Accounts
If your nest egg isn’t as sizable as you had hoped it would be by this stage, there is some good news. If you are over the age of 50, you can make what are called “catch-up contributions to your retirement accounts. These allow you to put more money into your retirement account each year than is permissible for those under the age of 50.
For example, the 401(k) contribution limit for those 50-and-under in 2020 is $19,500. But for those over 50 years of age, you can contribute an extra $6,500 this year as a “catch-up” contribution, for a total of of $26,000.
The same thing goes for a traditional IRA. The typical limit for 2020 is $6,000 per person. But for those over 50, you can contribute an additional $1,000 to catch up, for a total of $7,000.
Convert Your IRA To a Roth IRA
As Suze Orman recommended a few weeks ago, if you have a traditional IRA, it might make sense to convert over to a Roth IRA this year. With a traditional IRA, your money is invested pre-tax and you don’t pay any taxes until you start withdrawals.
With a Roth IRA, your deposits are after-tax, so you don’t pay any taxes when you withdraw money in retirement. Given the massive budget deficits our country is running, there’s a very strong likelihood that taxes will be much higher in the future than they are today.
So while it may be appealing to let your money grow tax-deferred in a traditional IRA, you could end up paying a higher tax rate in the future. If you convert your IRA to a Roth IRA, you would pay your taxes in the year you convert. This could be extra-beneficial if you will fall into a lower tax bracket this year due to job losses or retirement. Pay the taxes this year at a lower tax rate and let the money grow tax-free going forward.
Review Your Social Security Blanket
Social Security is a major part of every retiree’s monthly income. Fortunately, that monthly income won’t ever decrease, and is automatically adjusted for inflation every year. So it makes the decision of when to start collecting Social Security very important.
You can start collecting as early as age 62, but your benefits will be permanently reduced as much as 30%. If you were born between 1943 and 1954, your full retirement age is 66, and for those born between 1955 and 1960 the full retirement age is 67 – and is also 67 for everyone born after 1960.
Here’s where some patience can pay off: if you can afford to wait until age 70 to collect your benefits, your monthly checks will be 8% larger for every year you delay claiming your benefits.
Pay Off Loans Against Your Retirement Savings As Soon As You Can
Pay off any 401(k) loans as soon as possible. A loan against your 401(k) is counter to your goal of saving for retirement. inadequately funded.
Also, the money you are paying your loan back with has already been taxed, so you are paying back pre-tax money with after-tax money. To further frustrate you about taking out the loan, when you eventually retire and start withdrawing from your 401(k) you will be taxed again.
So you will end up paying taxes twice. It’s better to not take a loan against your 401(k). Although, if you must, pay it back as soon as you can.
Are Traditional 401(k) Accounts Bad For Your Retirement Dreams?
If your retirement account is in a traditional 401(k), you might want to consider switching to a Roth IRA, according to personal finance guru Suze Orman.
The reason, says Orman, is the idea that you will be withdrawing funds from your 401(k) in retirement when your personal tax rate is lower than it is today is likely not going to be true.
The amount of debt the country is carrying means tax rates in the future are going to be higher than they are today, not lower.
With a traditional 401(k) account, you put your money in “pre-tax” today and let it grow tax-deferred until you start your withdrawals. Those withdrawals will be at whatever the future tax rate is, which Orman says will be higher than today.
With a Roth IRA, you put in “after-tax” money today, but because you already paid taxes, your withdrawals are tax-free.
“The main thing really is this… please, if you have the ability to do a Roth 401(k), 403(b) or TSP, or a Roth IRA, those are the type of retirement accounts you want to be in,” says Orman. “Stay away from the “traditional” ones, that’s what they are called “traditional” IRAs or 401(k)’s, where you get a tax write-off today, but in the long run when you go to take your money out, you’re going to have to pay taxes on it. A Roth, you pay taxes today, and in the long run when you take it out, it’s tax free.”
Orman says the government can see all the money sitting in individual retirement accounts and knows when the tax-deferred accounts will need to take required minimum distributions, the first time the government will get their chance to tax the money.
“Do you really think that tax brackets aren’t going to have to go up 5, 10, 15-years from now in order to pay for all the debt we are carrying? Of course they are going to have to. When you put money in a retirement account, the government knows exactly how much money you have in there. The government knows you have to start taking required minimum distributions out by the time you are 72,” says Orman.
She suggests we just bite the bullet today and fill our accounts with “after-tax” money so we don’t have to worry about rising tax rates in the future.
“So given everybody’s going to get there soon rather than later, I’m telling you, I would rather pay the taxes today when we’re in the lowest tax brackets of a long time still, and let the money grow tax-free versus tax-deferred.”
Financial Advisers Agree
Mark Beaver, a financial adviser at Keeler and Nadler, agrees with Orman’s preference for a Roth IRA over a traditional 401(k).
As per Market Watch, “Orman is right in that these tax rates are a deal right now. ‘The tax code today is about as favorable as it’s ever been and the likelihood of that changing (to be higher) in the future is pretty good … Because of that, we look to add to Roths directly or do things like backdoor Roth contributions or conversions where it makes sense.’”
Monica Dwyer, vice president at Harvest Financial Advisors, warns that the government can also change the rules at any time about how it taxes retirement accounts, so today’s benefits of a Roth IRA could disappear in the future.
“Congress can get pretty creative about where they are going to collect taxes from and there is no guarantee that they won’t someday go after Roths,” she said.
Have a 401k? You Can Now Invest In Private Equity Funds
There’s good news for investors who are looking to add a little spice to their retirement accounts. For the first time ever, defined contribution plans – like 401ks – have access to private equity investments.
U.S. Secretary of Labor Eugene Scalia said in a statement yesterday that this step “will help Americans saving for retirement gain access to alternative investments that often provide strong returns.”
Typically viewed as a way to outperform the stock market, the average private equity investment has actually underperformed the stock market over the last 10 years. According to a study by Bain & Company, private equity investments returned an average of 15.3% compared to 15.5% for the S&P 500. The study does mention that top-tier private equity funds did manage to outperform the market.
Scalia’s announcement went on to add, “The Letter helps level the playing field for ordinary investors and is another step by the Department to ensure that ordinary people investing for retirement have the opportunities they need for a secure retirement.”
You won’t be able to invest directly into private equity funds in your 401k. You’ll only have access through specific investment vehicles like target-date funds. Defined benefit plans – like pensions – have had access to private equity investments for some time now. So, as Scalia mentions, this move now levels the playing field for investors.
Securities and Exchange Commissioner Jay Clayton supports the decision to allow defined contribution plans access to private equity investments. He also mentions that the new capital coming in will increase the funding sources available to private businesses.
How It Should Be Perceived
Investors, however, shouldn’t look at the ability to invest in private equity funds as a panacea of retirement riches.
Private equity investments are often much riskier than traditional stocks. As we mentioned earlier, they don’t always provide greater returns.
In an interview with Fox Business, Ed Slott, founder of IRAHep.com, said that investment losses in February and March may have caused a sense of panic among savers who might be searching for larger returns.
“Some of those [private equity] returns are sensational but, with anything, you could lose a boatload too,” Slott said. “It doesn’t mean private equity always makes money.”
You may lose money while investing in private equity funds. When that happens, you’ll likely have no recourse against your broker or fiduciary who put you in those investments.
As part of the announcement, Slott noted that there is a “liability shield” for fiduciaries. As long as they follow the guidelines set out by the Department of Labor, they will be within their fiduciary obligations. This makes it harder for investors to sue over losses.
The ability to invest in a private equity fund is alluring. However, the best advice comes from Alano Massi, the managing director of Palm Capital Management.
“Should that investor not feel comfortable with private equity, or simply does not understand it, then he or she should not participate,” Massi said.
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