Tag: 401(k)

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4 Big Legal Changes That Will Hit Your Wallet in 2018

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With all eyes on the GOP’s sweeping plans for tax reform, it’s easy to lose sight of other policy changes that could have an impact on your wallet.

In 2018, there are at least three key policy changes to keep tabs on — adjustments to Social Security benefits, 401(k) contribution limit changes, and the preservation of one of the year’s most controversial financial rules.

Here’s what you need to know:

More Social Security benefits

For Social Security beneficiaries, there is a lot to be excited about in 2018.

The cost-of living-adjustment, which determines the amount of money people receive from the system, is rising by 2 percent, the largest increase in five years. This means a growth in benefits for the more than 61 million recipients currently who currently utilize Social Security in America.

Additionally, the maximum payout—which is the amount you can receive once you’re eligible for 100 percent of your benefits—is also increasing, with the figure growing from $2,687 per month to $2,788 per month.

Greater 401(k) contributions

Saving for retirement will also be a little easier in the coming years, as the Internal Revenue Service announced that the annual limit for 401(k) contributors will increase by $500 in 2018.

Previously, anyone participating in a 401(k) or 403(b) plan, the majority of 457 plans, or the  Thrift Savings Plan could set aside $18,000 per year, but the number will grow to $18,500. To see how much this change might affect your retirement funds, you can use this calculator to track how your 401(k) funds will grow over time.

Mandatory arbitration contracts

Earlier this year, the Consumer Financial Protection Bureau (CFPB) issued a regulation banning mandatory arbitration clauses, the often-controversial sections of consumer contracts that effectively prevent customers from filing class-action suits against a company they are doing business with, such as a bank.

However, this law, which was set to come into effect in 2018, has been overturned by Congress, meaning the rule will remain in effect.

Martin Lynch, the compliance manager and director of education for Cambridge Credit Counseling Corp. in Agawam, Mass., says the repeal of the CFPB’s rule is a major defeat for consumers because forced arbitration is often used to scare customers out of taking action against the corporate world.

“That’s not fair, almost by definition,” says Lynch, who is also a member of the board of directors for the Financial Counseling Association of America. “It’s why the concept of consumer protection exists in the first place.”

Still to be determined: The GOP tax bill

It seemed as though 2017 might be yet another slow year for tax legislation. Then earlier this month Republican lawmakers moved to pass what is could be the biggest American tax overhaul since the 1980s.

While the U.S. House of Representatives and Senate still have to agree on a singular version of the new bill, which likely include close to $1.5 trillion in total tax cuts — $900 billion of which will be for businesses alone — they’re rushing to meet President Donald Trump’s Christmas deadline.

“If any or all of the proposed changes get enacted, we will have a lot to be concerned with,” says Cindy Hockenberry, director of tax research and government relations for the National Association of Tax Professionals.

So how will the Republican tax bill—in its current form—most affect consumers? Next year, not very much. The plan’s changes, which technically go into effect on Jan. 1, 2018, will be mostly marginal until 2019 because Americans will mostly be able to file their taxes in April under the current rules.

Being aware of these changes can help you plan in advance because filing taxes in the coming years might be extremely different, depending on your income bracket and your usual deductions. While the bill—officially named the Tax Cuts and Jobs Act—is not yet finalized, here are the parts of the bill’s current form that consumers are likely to feel the most:

  • Your income tax bracket could change: The House version of new law would reduce the number of standard tax brackets from seven to four, meaning many Americans would pay a new percentage of their income in 2019. You can check out this chart of the proposed percentages to see how your taxes might change.
  • Your state and local tax deductions will probably go away: The Senate plan would eliminate the State and Local Tax (SALT) deduction. This means that if you typically itemize your taxes—instead of just taking the standard deduction— you will be unable to write off taxes paid to state and local governments on your federal filing.
  • You will no longer be able to deduct a personal exemption: Currently, you can take a $4,050 “personal exemption” from your return that doesn’t count toward your taxable income. Under both the House and Senate bills, this option would disappear, however the standard deduction you can take each year would almost double—increasing from $6,350 to $12,200 under the House bill.

Hockenberry, who is based in Appleton, Wis., says the most important part of the plan is its proposed elimination of the personal exemption and a number of itemized deductions. Some Americans might have to pay more each year, she added, because the increase in the standard deduction might not be enough to make up for these changes, causing some consumers’ taxable income to grow.

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Investing, Life Events, Retirement, Strategies to Save

Think Twice Before You Max Out Your 401(k)

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Financial planners can’t emphasize the importance of saving for retirement enough: The earlier you start saving and the more you contribute, the better. But should you max out your retirement account? And if so, how do you do it? 

Unfortunately, there’s no solution suitable for all; every individual has a different financial situation.  

But let’s start with the basics: The maximum amount of money you can contribute to your 401(k), the retirement plan offered by your company, is currently $18,000 a year if you are under age 50, and $24,000 if you are 50 or older. If you were starting from scratch, you would have to tuck away $1,500 a month to max it out by year’s end.  

This is a big chunk of money. And although there are multiple benefits to saving for retirement, you may want to think twice before hitting that maximum.  

Remember, this is money that, once contributed, can’t be withdrawn until age 59.5 without incurring penalties (with some exceptions).  

What’s more, putting away a significant portion of their savings to max out their retirement fund doesn’t make much sense for some workers.  

If you are fresh out of college and your first job pays $50,000 annually, you’d need to save 36 percent of your paychecks to max out your 401(k) for the year.   

“Everyone needs to save for retirement, and the more dollars you could put in, the earlier, the better, but you also need to live your life,” says Eric Dostal, a certified financial planner with Sontag Advisory, which is based in New York. “To the extent that you are not able to do the things that you want to accomplish now, having a really really robust 401(k) balance will be great in your 60s, but that would cost now.”  

A few things to consider BEFORE you max out your 401(k)

  1. Do you have an emergency fund for rainy-day cash? If not, divert any extra funds to establish a fund that will cover at least three to six months’ worth of living expenses.  
  2. Do you have high-interest debt, such as credit card debt? High-interest debts, like credit cards, might actually cost you more in the long run than any potential gains you might earn by investing that money in the market.  Still, if you can get a company match, you should try to contribute enough to capture the full match. It never makes sense to leave money on the table.  
  3. Do you have other near-term goals? Are you planning to buy a house or have a child anytime soon? Do you want to travel around the world? Do you plan to pursue an advanced degree? If so, come up with a savings strategy that makes room for your nonretirement goals as well. That way you can save money for those big-ticket expenses and will be less likely to turn to credit cards or other borrowing methods. 

Maximize your 401(k) contributions

If your emergency fund is flush, your bills are paid and you’re saving for big expenses, you are definitely ready to beef up your retirement contributions.   

First, you’ll want to figure out how much to save.   

At the very least, as we said above, you should contribute enough to qualify for any employer match available to you. This is money your employer promises to contribute toward your retirement fund. There are several different ways a company decides how much to contribute to your 401(k), but the takeaway is the same no matter what — if you miss out on the match, you are leaving free money on the proverbial table. 

If you are comfortable enough to start saving more, here is a good rule of thumb: Save 10 percent of each paycheck for retirement, though you don’t have to get up to 10 percent all at once.  

For instance, try adding 1 percent more to your retirement fund every six months. Some retirement plans even offer automatic step-up contributions, where your contributions are automatically increased by 1 or 2 percent each year. 

Larry Heller, a New York-based certified financial planner and president of Heller Wealth Management, suggests that you increase your contribution amount for the next three pay periods and repeat again until you hit your maximum.  

“You will be surprised that many people can adjust with a little extra taken out of their paycheck,” Heller said.   

Once you’re in the groove of saving for retirement, consider using unexpected windfalls to boost your savings. If you get an annual bonus, for example, you can beef up your 401(k) contribution sum if you haven’t yet met your contribution limit.  

A word of caution: If you’re nearing the maximum contribution for the year, rein in your savings. You can be penalized by the IRS for overcontributing. 

If your goal is to save $18,000 for 2017, check how much you’ve contributed for the year to date and then calculate a percentage of your salary and bonus contributions that will get you there through the year’s remaining pay periods.  

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How to Jumpstart an Underperforming 401(k)

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retirement growing plant

A recent study from Schwab Retirement Plan Services found that “saving enough money for a comfortable retirement is the most common financial stress inducer for people of all ages.” Some 40% of survey participants stated that building adequate retirement savings was more stressful than the prospect of losing a job.

It’s hard to blame them. Watching that nest egg grow bit by bit over the course of several decades can be a challenge. And when your main retirement savings vehicle sputters and stalls, performance-wise, it’s difficult to know whether it might be time for a tune-up — or if you are better off leaving it alone.

If your plan is underperforming, and your balances are lower, it could be time to take some specific steps to correct the problem, and get that plan moving in an upward direction.

To get you motivated, MagnifyMoney reached out to finance and investment experts for effective strategies to turbo-boost those flatlining 401(k) plans. Here’s a look at what they said:

Kick it into overdrive when you hit 50.

The more cash you steer into your 401(k) plan, the more money you have working for you toward your retirement. That’s important, as compound interest builds more retirement wealth with more money in your 401(k) plan. “That’s why you need to take advantage of the 401(k) plan catch-up contribution,” says Shanna Tingom, co-founder and a financial planner with Heritage Financial Strategies, in Gilbert, Ariz. In a word, catch-up contributions allow retirement savers, usually older ones, to increase their 401(k) contributions.

Catch-up provisions enable plan participants who hit the 50-year-old mark before the calendar year is over to contribute extra “catch-up” 401(k) plan contributions on a pretax basis. In 2016 and 2017, for example, the catch-up limit stands at $6,000, in addition to the standard contribution limit of $18,000.

As Tingom puts it, “Too many people forget to increase their contribution when they turn the big 5-0.”

Get more aggressive, especially when you have more than 10 years until retirement.

The older investors get, the more conservative they may want to become with their retirement investments. But that could be a mistake, as Americans live longer and healthier lives and could need their nest eggs to last for decades beyond retirement. Forrest Baumhover, a fee-only financial planner with Westchase Financial Planning in Tampa, Fla., says he often sees retirement savers getting too conservative with their investments.

“You’ve got to look at your investment goals, and make sure your 401(k) selection matches those goals,” Baumhover advises. “Many people leave their money in the default money-market accounts and wonder why their plan performance isn’t going anywhere.” Studies show that investors who steered $100,000 into the Standard & Poor’s 500 stock index in 1987, would have earned over $1 million 25 years later. But a similar investment in the Barclays U.S. Aggregate Bond Index would have only accumulated $560,900, according to The Wall Street Journal, citing data from Morningstar.

Yes, stocks do represent a higher risk than bonds — the S&P 500 fell by 38% in 2008 — but historically, stocks make up the loss, and then some. Of course, if you are within a few years of retirement, it could be unwise to invest your entire portfolio in riskier stocks. Speak with a financial adviser who can help you determine the right mix of investments for your age, risk tolerance, and time horizon.

Keep a sharp eye on expensive fees.

Make sure the funds you are selecting are low cost, says Jeremy Torgerson, a money manager at nVest Advisors, in Brownsville, Texas. “Every 401(k) fund list should have a chart of the expense ratios of each fund,” Torgerson says. “Excessive fund fees — anything over 2%, especially — can really drag down your return over several years.” According to a 2014 study by the Center for American Progress, which cites government and industry plan data, the average American career professional loses $70,000 due to excessively high 401(k) plan fees over the course of their working years.

“The corrosive effect of high fees in many of these retirement accounts forces many Americans to work years longer than necessary or than planned,” the report states. Aim for low-cost exchange-traded funds, or index funds, which track major investment benchmarks, like the S&P 500, and offer management fees of well under 1%.

Get professional advice.

Too many people go it alone on with their 401(k) plans, and thus make poor choices on where and when to invest their money, warns Ed Snyder, a certified financial planner with Oaktree Financial Advisors, in Carmel, Ind. “An advisor can help you make choices and to stay the course during times of market volatility when you may have otherwise bailed out on your investments,” Snyder says.

The data backs up that sentiment. According to Vanguard Funds, a financial adviser using Vanguard’s own “best practices” can add 3% in net portfolio returns annually to an average investor’s portfolio. At 3% each year, for 30 or 40 years in the workforce, that can added hundreds of thousands of dollars to a 401(k) plan participant’s retirement savings.

And the good news is that hiring professional help doesn’t mean you necessarily have to fork over a percentage of your investment returns forever. There are low-cost alternatives to traditional financial advisers. You could hire a fee-only planner who charges on an hourly basis, or seek out services like Betterment or Wealthfront, which offer retirement investment advice at a fraction of the cost of traditional investment advisers.

Learn when to do nothing.

There’s a lot to be said for the vaunted “buy and hold,” long-term investment model. With this model, 401(k) savers (ideally working with a good money manager) choose several appropriate, low-cost mutual funds that fit their risk profile, their investment goals, and their asset allocation needs, and let the funds grow without worrying what the stock market is doing. Time and the miracle of compound interest are great retirement portfolio builders — if only 401(k) savers would leave them alone to grow, without buying and selling in an effort to time the markets.

Clearly, Americans are having problems getting their 401(k) plans on the performance fast track. Fix that issue by using the tips above to get your retirement plan into higher gear — the sooner, the better.

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Investing, Life Events, Strategies to Save

Retirement Accounts: What You Need to Understand

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Finances

With mounting concerns over Social Security, and a languishing number pensions, it’s more important than ever to start investing for retirement. Tax advantaged retirement accounts offer investors the best opportunities to see their investments grow, but the accounts come with fine print. These are the things you need to know before you start investing.

What are employer sponsored retirement accounts?

Employee sponsored retirement accounts often allows you to invest pre-tax dollars in an account that grows tax-free until a person takes a distribution. In some cases, you may have access to a Roth retirement account which allows you to contribute post-tax dollars. Contributions to employer sponsored retirement accounts come directly from your paycheck.

The most common employee sponsored retirement accounts are defined contribution plans including a 401(k), 403(b), 457, and Government Thrift Savings Plan (TSP). Private sector companies operate 401(k)s, public schools and certain non-profit organizations offer 403(b)s, state and local governments offer 457 plans, and the Federal government offers a TSP. Despite the variety of names, these plans operate the same way.

According to the Bureau of Labor Statistics, 61% of people employed in the private sector had access to a retirement plan, but just 71% of eligible employees participated.

How much can I contribute? 

If you’re enrolled in a 401(k), 403(b), 457, or TSP, then you can invest up to $18,000 dollars to your employer sponsored retirement accounts per year in 2016. If you qualify for multiple employer sponsored plans, then you may invest a maximum of $18,000 across all your defined contribution plans. People over age 50 may contribute an additional $6,000 in “catch-up” contributions or $3,000 to a SIMPLE 401(k).

In addition to your contributions, some employers match contributions up to a certain percentage of an employee’s salary. Visit your human resources department to learn about your company’s plan details including whether or not they offer a match.

What are the benefits of investing in an employer sponsored retirement plan?

For employees that receive a matching contribution, investing enough to receive the full match offers unparalleled wealth building power, but even without a match, employer sponsored plans make it easy to build wealth through investing. The funds to invest come directly out of your paycheck, and the plan invests them right away.

However, there are fees associated with these accounts. Specific fees vary from plan to plan, so check your company’s fee structure to understand the details, especially if you aren’t receiving a match. If you don’t have an employer match, then it may make more sense to contribute to your own IRA in lieu of the employer-sponsored plan.

Investing in an employer sponsored means getting to defer taxes until you withdraw your investment. Selling investments in a retirement plan does not trigger a taxable event, nor does receiving dividends. These tax benefits provide an important boost for you to maximize your net worth.

In addition to tax deferred growth, low income investors qualify for a tax credit when they contribute to a retirement plan. Single filers who earn less than $41,625 or married couples who earn less than $61,500 qualify for a Saver’s Tax Credit worth 10-50% of elective contributions up to $2000 ($4000 for married filers).

What are the drawbacks to investing in an employer sponsored retirement plan?

Investing in an employer sponsored retirement plan reduces the accessibility of the invested money. The IRS punishes distributions before the age of 59 ½ with a 10% early withdrawal penalty. These penalties come on top of the income taxes that you must pay the year you take a distribution. In most cases, if you withdraw money early pay so much in penalties and increased income tax rates (during the year you take the distribution) that you would have been better off not investing in the first place.

Additionally, investing in an employee sponsored retirement plan reduces investment choices. You may not be able to find investment options that fit your investing style through their company’s plan.

Should I take a loan against my 401(k) balance?

Since money in 401(k) plans isn’t liquid, some companies allow you  to take a loan against your 401(k). These loans tend to be low interest and convenient to obtain, but the loans come with risks that traditional loans do not have. If your job is terminated, most plans offer just 60-90 days to pay off the loan balance, or the loan becomes a taxable distribution that is subject to the 10% early withdrawal penalty and income tax.

It is best to only consider a 401(k) loan for a short term liquidity need or to avoid them altogether.

What if I don’t qualify for an employer sponsored retirement plan?

If you’re an employee, and you don’t have access to an employer sponsored retirement plan you have to forgo the tax savings and other benefits associated with the accounts, but you may still qualify for an Individual Retirement Account (IRA).

However, if you pay self-employment taxes then you can create your own retirement plan. Self-employed people (including people who are both self-employed and traditionally employed) can start either a Solo 401(k) or a SEP-IRA.

A Solo 401(k) allows an elective contribution limit of 100% of self-employment income up to $18,000 (plus an additional $6000 in catch up contributions for people over age 50) plus if your self-employed, then you can contribute 20% of your operating income after deducting your elective contributions and half of your self-employment tax deductions (up to an additional $35,000).

If you qualify for both a Solo 401(k) and other employer sponsored retirement plan, then you cannot contribute more than $18,000 in elective contributions among your various plans.

A SEP-IRA allows you to contribute 25% of your self-employed operating income into a pre-tax account up to $53,000.

What are Individual Retirement Accounts?

Individual Retirement Accounts (IRAs) allow you to invest in tax advantaged accounts. Traditional IRAs allows you to deduct your investments from your income, and your investments grow tax free until they are withdrawn (at which point they are subject to income tax). You can contribute after-tax money to Roth IRAs, but investments grow tax free, and the investments are not subject to income tax when they are withdrawn in retirement. There are income restrictions on being eligible for deductions and these vary based on household income and if an employer-sponsored retirement plan is available to you (and/or your spouse).

What are the rules for contributing to an IRA?

In order to contribute to an individual retirement account, you must meet income thresholds in a given year, and you may not contribute more than you earn in a given year. The maximum contribution to an IRA is $5500 ($6500 for people over age 50).

A traditional IRA allows you to defer income taxes until you take a distribution. Single filers who earn less than $61,000 are eligible deduct one hundred percent of deductions, and single filers who earn between $61,000 and $71,00 may partially deduct the contributions. Couples who are married filing jointly may make contribute the maximum if they earn less than $98,000, and they may make partial contributions if they earn between $98,000 and $118,000.

Roth IRAs allow participants to invest after tax dollars that are not subject to taxes again. The tax free growth and distributions can be especially beneficial for those who expect to earn a high income (from investments, pensions or work) during retirement. Single filers who earn less than $117,000 can contribute the full $5,500, and those who earn between $117,000 and $132,000 can make partial contributions. Couples who are married filing jointly who earn less than $184,000 may contribute up to $5500 each to Roth IRAs, and couples who earn between $184,000 and $194,000 are eligible for partial contributions.

What are the benefits to investing in an IRA?

The primary benefits to investing in an IRA are tax related. Traditional IRAs allow you to avoid paying income taxes on your investments until you are retired. Most people fall into a lower income tax bracket in retirement than during their working years, so the tax savings can be significant.  Roth IRA contributions are subject to taxes the year they are contributed, but the IRS never taxes them again. Investments within an IRA grow tax free, and buying and selling investments within an IRA does not trigger a taxable event.

Additionally, low income investors also qualify for a tax credit when they contribute to a retirement plan. Single filers who earn less than $41,625 or married couples who earn less than $61,500 qualify for a Saver’s Tax Credit worth 10-50% of elective contributions up to $2000 ($4000 for married filers).

IRAs also allow individuals to choose any investments that fit their strategy.

What are the drawbacks to investing in an IRA? 

Investing in an IRA reduces the accessibility of money. Though it is possible to withdraw contribution money for some qualified expenses, many distributions are to be subject to a 10% early withdrawal tax penalty when a person takes a distribution before the age of 59 ½. In addition to the penalty, the IRS levies income tax on distributions the year that you take a distribution from a Traditional IRA.

Should I withdraw money from my IRA?

Taking a distribution from an IRA means less money growing for retirement, but many people use distributions from IRAs to meet medium term goals or to resolve short term financial crises. The IRS publishes a complete list of qualified exceptions to the early withdrawal penalty.

If you have to pay the penalty, withdrawing from an IRA is not likely to be the right choice. Once the money is withdrawn from an IRA it can’t be contributed again. For short term needs, taking out a loan usually comes out ahead.

What’s the smartest way to invest?

Investing between 15-20% of your gross income for 30 years often yields a reasonable retirement nest egg, but even if you can’t invest that much right now, it’s important to get started. The smartest place to invest for retirement is within a tax advantaged retirement account.

If you don’t have access to an employer sponsored plan the best place to start is by investing in an IRA. On the other hand, if you have access to both an employer sponsored plan and an IRA, the answer is not as clear. Anyone who has an employer with a matching policy should aim to invest enough to take full advantage of any matching plan that your company has in place.

After taking advantage of a match, the next best option depends on your personal situation.

Employer sponsored plans and Traditional IRAs offer immediate tax benefits that can be advantageous for high income earners. However, investing in a Roth IRA keeps money more liquid than either an employer sponsored plan or a traditional IRA.

Of course, the best possible scenario for your retirement is to maximize contributions to both an employer sponsored account and an individual retirement account, but you should carefully weigh how investing in these accounts affects your whole financial picture and not just your retirement goals.

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Pay Down My Debt

3 Times a 401(k) Loan Can Be a Good Idea

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Working woman worried stressed

If you hear the words “401(k) loan” and immediately think to yourself “ooh, that sounds like a bad idea”, good for you! You’re on the right track.

In most cases borrowing from your savings isn’t a smart move, particularly when it’s from an investment account like your 401(k) that’s meant to sit untouched for decades so that it can grow and eventually allow you to retire.

But a 401(k) loan is unique. We covered the ins and outs of how it works in a previous post, but here are the basics:

  • The loan comes directly out of your 401(k) investments.
  • Repayment is made through automatic payroll deductions.
  • Both the principal and interest are paid back into your 401(k), so you truly are borrowing money from yourself.
  • The loan is typically easy and quick to get.

The fact that you pay the interest back to yourself is especially unique and makes 401(k) loans attractive in certain situations.

So while you should proceed with extreme caution when considering a 401(k) loan, and while in most cases there are better options available to you, here are three situations in which a 401(k) loan can be a good idea.

1. Increase Your Investment Return

There are certain situations where you can use a 401(k) loan to increase your overall investment return. Here’s a hypothetical example showing how it can work.

Let’s say that the following things are true:

Given that scenario, here are the steps you could take to increase your expected investment return while only adding a small amount of risk:

  1. Take out a 401(k) loan, borrowing money from the bond portion of your account.
  2. Put the loan proceeds into a taxable investment account and invest it in the exact same bond fund (or something similar).
  3. You will earn the exact same return on the bond fund as you would have in the 401(k), less the cost of taxes you have to pay on any gains.
  4. As you pay back your 401(k) loan, the 4.5% interest is essentially a 4.5% return since it’s going right back into your 401(k).

In other words, you’re getting essentially the same return on your bond fund in the taxable account, minus the tax cost. But you get a higher return in your 401(k) because the interest rate is higher than the expected return on the bond fund.

And since your bond investment is unlikely to fluctuate too much (though it can certainly fluctuate some), in a worst-case scenario where you lose your job and have to pay the loan back in full within 60 days, you will likely to have the money available to do so.

Here are a few things to keep in mind as you consider this approach:

  • The more expensive your 401(k) is, the more likely this is to work out in your favor. That’s because you can choose a lower cost bond fund in your taxable account and save yourself some fees over the life of the loan.
  • The higher your tax bracket, the less advantageous this is since the tax cost in the taxable investment account will be higher.
  • Make sure you’re not sacrificing your ability to contribute to your 401(k), and definitely make sure you’re not missing out on any employer match.

2. Paying off High-Interest Debt

If you have high-interest debt, taking a 401(k) loan to pay it off could be a good idea.

Before you do so, make sure you’ve exhausted all other options. Do you have savings you could use to pay it off? Are there any expenses you could cut back on so you could put that money towards your debt? Are there any creative ways you could make a little extra money on the side?

Any of those options are better than a 401(k) loan simply because they don’t require you to borrow against your retirement and they don’t come with the risks that a 401(k) loan presents.

But if you’ve exhausted those other options, paying off high-interest debt with a 401(k) loan has two big benefits:

  1. Your 401(k) loan interest rate is likely lower than the rate on your other debt.
  2. You pay the 401(k) loan interest to yourself, not someone else.

The big risk you run with this strategy is the possibility of losing your job and having to pay the entire 401(k) loan balance back within 60 days. If that happens and you’re not able to pay it back, the remaining balance will be taxed and subject to a 10% penalty. That outcome is likely much more costly than your high-interest debt.

3. Financial Emergency

If you’re in a situation where you absolutely need money for something and you don’t have the savings to handle it, a 401(k) loan may be your best option.

Here’s why:

  • It’s quick. You can often get the loan with just a few clicks online.
  • There’s no credit check. You’ll be able to get it even if you don’t have a great credit history.
  • It likely has a relatively low interest rate and you pay the interest back to yourself.

In an ideal world this is exactly what your emergency fund would be there for. But of course life happens and a 401(k) loan can be a good backup plan.

Be Careful

A 401(k) loan should almost never be your first choice. Other than situation #1 above, which should only be done very carefully, in most cases there’s another route that would be better.

But in the right situations a 401(k) loan can be helpful and may even lead to better returns. As long as you proceed with caution, it can be a valuable tool in your financial arsenal.

Advertiser Disclosure: The card offers that appear on this site are from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all card companies or all card offers available in the marketplace.

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Matt Becker is a writer at MagnifyMoney. You can email Matt at matt@magnifymoney.com

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What is a 401(k) Loan and How Does it Work?

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If you’re in need of money and your savings account balance is low, you may be tempted to use the handy little loan provision that most 401(k) plans offer. That’s right! You can probably borrow money from your 401(k). Right from your own account! It’s a nifty feature, but is it a good idea?

Today we’re going to start examining that question by diving into what exactly a 401(k) loan is and how it works. The next post in this series will look at a few situations in which borrowing from your 401(k) can work in your favor.

Let’s get into it!

Quick note: Every 401(k) plan has different terms and conditions and some plans don’t allow for loans at all. Consult your Summary Plan Description for specific details about how your plan handles loans.

What Is a 401(k) Loan?

When you borrow from your 401(k) you are actually borrowing money directly from yourself.

The loan is taken directly out of your 401(k) account balance. Then a repayment plan is created based on the amount you borrowed and the interest rate and those payments are made back into your 401(k) account, typically through an automatic payroll deduction.

In other words, you are borrowing from yourself and paying yourself back. Both the principal and the interest on the loan eventually make their way back into your 401(k).

How Much Can You Borrow?

Figuring out how much you can borrow from your 401(k) can be a little tricky, but here’s a quick summary.

If you haven’t had any outstanding 401(k) loan balance within the past 12 months, you are allowed to borrow the lesser of:

  • $50,000, or
  • 50% of your vested 401(k) balance. If that amount is less than $10,000 then you can borrow up to $10,000, but never more than your total account balance.

Sounds simple, right? But wait, there’s more…

If you have had an outstanding 401(k) balance within the past 12 months, the amount you’re allowed to borrow is reduced by the largest balance you had over that period.

Let’s look at a few examples:

  • Example #1: Joe has $25,000 in his 401(k) and has not had a 401(k) loan balance within the past 12 months. He is allowed to borrow up to $12,500.
  • Example #2: Theresa has $15,000 in her 401(k) and has not had a 401(k) loan balance within the past 12 months. She is allowed to borrow up to $10,000.
  • Example #3: Becca has $150,000 in her 401(k) and has not had a 401(k) loan balance within the past 12 months. She is allowed to borrow up to $50,000.
  • Example #4: Steve has $25,000 in his 401(k) and did have a 401(k) loan balance of $5,000 within the past 12 months. He is allowed to borrow up to $7,500.

What Is the Interest Rate?

Each 401(k) plan is allowed to set their own loan interest rate. You should consult your Summary Plan Description or ask your HR rep for details about your specific plan.

However, the most common interest rate is the prime rate plus 1%.

What Can the Money Be Used For?

In many cases there are no restrictions on how you use the money. It can be put to work however you want.

But some plans will only lend money for certain needs, such as education expenses, medical expenses, or a first-time home purchase.

How Long Do You Have to Pay the Loan Back?

Typically, your 401(k) loan must be paid back within 5 years. If the loan is used to help buy a house, the term may be extended up to 10-15 years.

The catch is that if your employment ends for any reason, the entire remaining loan balance is typically due within 60 days. If you aren’t able to pay it back within that time period, the loan defaults.

What Happens If You Default on the Loan?

A 401(k) loan defaults any time you aren’t able to comply with the terms of the loan. That could be failing to make your regular payments or failing to repay the remaining loan balance within 60 days of leaving the company.

When that happens, the remaining loan balance is counted as a distribution from your 401(k). That has two big consequences:

  1. Unless you’re already age 59.5 or meet other special criteria, that money will be taxed and hit with a 10% penalty.
  2. The defaulted amount is not eligible to be rolled over into an IRA or other employer retirement plan. So there’s no way to avoid the taxes and penalty.

The good news is that the default is not reported to the credit bureaus and therefore has no impact on your credit score. Though if you’re applying for a mortgage or other loan, the lenders may ask about any 401(k) loan defaults and factor that into their decision.

How Do You Apply for a 401(k) Loan?

And as long as you have a vested 401(k) balance, the process loan application process is typically pretty simple.

Other than adhering to any specific restrictions your plan may enforce (see above), it’s usually as easy as requesting the loan. That can often be done online or at worst with a little paperwork through your human resources department.

There is no credit check for 401(k) loans, which can make them easier to get than other types of loans. And loans must be available to all employees, so you should be able to get approved no matter what your position is in the company.

Other Considerations

Here are a few other things to consider as you weigh the pros and cons of taking out a 401(k) loan:

  • Other than the possibility of default, the biggest potential cost is the missed investment returns while the money is out of your 401(k). Depending on the size of the loan and the market returns during the life of the loan, that could be significant.
  • Your spouse often has to sign off on the loan.
  • You can have more than one 401(k) loan out at a time, but the total loan balance can’t exceed the limits described above.
  • There may be a fee involved with taking out the loan.
  • Your loan payments do not count as 401(k) contributions, and your employer may or may not allow you to keep contributing to your 401(k) while your loan is outstanding.
  • Because the loan is not reported to credit agencies, a 401(k) loan is not a way to build your credit history or increase your credit score.
  • You typically cannot take a loan from a 401(k) you still have with an old employer.

Is a 401(k) Loan a Good Idea?

Those are the nuts and bolts of 401(k) loans, so is taking out a 401(k) loan a good idea? The answer is a definite maybe. There are times where it can be the best option, times where it’s a bad idea, and times where it can actually increase your overall investment return. Regardless, you should be sure to do a deep analysis and determine if you will definitely be able to pay the loan back in a timely manner before utilizing the 401(k) loan.

Advertiser Disclosure: The card offers that appear on this site are from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all card companies or all card offers available in the marketplace.

Matt Becker
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Matt Becker is a writer at MagnifyMoney. You can email Matt at matt@magnifymoney.com

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When to Avoid a Company 401k

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Gone are the days of workers depending upon pensions when they retire. Today, instead of offering defined benefit pensions guaranteeing an employee a monthly payment for the rest of his or her life, employers are moving to more employee-managed retirement savings plans.

Today, more employers offer a 401k plan – if they have an employer-based plan at all. With a 401k, employees make a defined contribution from their income each year. With a pension plan, employees knew exactly how much income they could depend on each month during retirement. Now, it is up to the employees to determine how much they need to save in order to reach their retirement savings goals.

A 401k allows employees to make defined contributions, pre-tax (or post-tax), towards retirement. If you contribute to a traditional 401k, contributions are automatically deducted from your paychecks each pay period, pre-tax. As a result, you don’t pay taxes until money is withdrawn from the account and you cannot withdraw money before 58 ½ without penalties. Some employees offer the option to contribute post-tax in a Roth IRA, so money withdrawn in retirement will not be taxed.

With this change toward employee-directed retirement, rather than retirement guaranteed by the employer, it is up to you to make the best decisions regarding your retirement savings. This could mean it’s best to avoid a company 401k.

Take a look at these situations in which you should not pay into your employer’s 401K, and see if any of them apply to you.

No Employer Match

Many employers provide a match to their employees’ 401k contributions. Employer matches vary greatly by employer, but a common example of this is $0.50 per $1.00, up to 6% of employees’ pay.

Let’s say you earn 40,000 per year at your current job, and your employer provides a $0.50 per $1.00 match, up to 6% of your pay. If you were to contribute the full 6% of your pay annually, you would contribute a total of $2,400 to your 401K over the course of a year. Your employer would then contribute $0.50 for every dollar you contributed, for a total of $1,200 for the year.

In total, over the course of the year your 401K would contain $3,600, and you only would have contributed $2,400 of the balance.

But if your employer does not provide a match, it may be time to reconsider contributing to its 401K plan. Never walk away from an employer match, as it is basically free money, but if your employer does not provide a contribution match, it may be time to consider other options like saving for retirement in a traditional or Roth IRA.

You Have Reached The Contribution Limit

Effective January 1, 2015, the 401k contribution limits are $18,000 if you are age 49 and under. If you are 50 or older, you can contribute an additional $6,000 above and beyond the $18,000 regular contribution, for a total of $24,000. Of course, you are free to contribute less to a 401K, but saving as much as possible for retirement is always best.

Once you have reached the contribution limit on your 401k, you cannot make any more contributions pre-tax, and it is time to consider alternative investments.

One good alternative is a Traditional IRA. Contributions are made to a traditional IRA after tax, meaning that you pay taxes, and then make contributions out of your paycheck. For 2015, individuals can contribute up to $5,500 per year to a traditional IRA if they are 49 and under. You can contribute up to $6,500 per year if you are 50 or older.

Another solution for aggressive savers is a taxable account such as stock index funds or tax-free municipal bonds. When using taxable accounts such as these, you can expect to pay 15% on long-term gains and qualified dividends. Additionally, contributions to these plans are made after-tax. However, the benefits of using accounts such as these include being able to withdraw from them for things such as children’s college expenses before age 59 ½ without additional penalties and fees.

You Qualify For a Roth IRA

If you employer does not offer a 401k match – or a 401k plan at all – and you meet income thresholds, then a Roth IRA may be an excellent option for your retirement savings.

A Roth IRA allows individuals whose modified adjusted gross income, which you can calculate at the IRS website, is less than $135,000, or married couples whose income does not exceed $195,000 to contribute to their retirement.

A Roth IRA is different from other accounts, though, because of the way taxes are handled. Contributions are made after tax. However, once the initial contribution is made, you enjoy tax-free growth as long as you follow the rules:

  • 49 and under can contribute a maximum of $5,500
  • 50 and over can contribute up to $6,500
  • You can withdraw your contributions (not growth) at any time without penalty

How much can a Roth IRA save in taxes? If you contribute $5,500 per year to a Roth IRA for 40 years (and increase your contributions to $6,500 per year once your age allows), and your marginal rate is 15%, this is what your account’s growth could look like over the course of 40 years:

401k_1

In this scenario, you would have only paid in $230,000 during the entire 40 years you worked. You would have paid $34,500 in taxes from your paychecks.

However, your relatively small investment could grow to $1,189,636 – and you will not have to pay taxes on any of that balance when you withdraw it. If your marginal tax rate stayed at 15% when withdrawing money from your Roth IRA, you could save more than $143,000 in taxes alone.

See how much money you can save with a Roth IRA, and how much money it can save you in taxes here, with Bankrate’s Roth IRA calculator.

High Fees

If your employer offers a 401k without a match, a good way to gauge whether it is a good investment vehicle for your retirement savings is to take a look at the fees. Many times both employees and employers are unaware of just how much fees are costing them. After all, 3% seems like such a small number, doesn’t it?

3% may feel like a very small amount to pay in fees, but this example will show you just how much a small percentage can affect your retirement savings.

401k_2

In this example, the investor is a 29 year old, contributing $18,000 per year to her company’s 401k, and her retirement age will be 65. The current balance of their 401K is $100,000, and fees are 3%.

Just by switching to a plan that cuts fees in half, 1.5%, she could save $801,819.03. Instead of having $1.8 million upon retirement, she could have more than $2.6 million – making for a much better retirement.

You can check out a fee calculator here and find out just how much your fees are costing you!

Even if your 401k has high fees, be sure to consider the employer match. Many times the match will more than cover the fees, making the 401k a good investment vehicle in spite of the high fees.

If You Need Flexibility

401k’s, while they offer tax advantages, and often free money through the form of an employer match, do not offer any sort of flexibility. Contributions are automatically deducted pre-tax from an employee’s paycheck in pre-set amounts, and cannot be withdrawn without serious penalties until age 59 ½.

For many families, saving and investing money is not just about retirement. It is about college, medical expenses, large purchase, and even vacations. Always contribute to your 401k up to the maximum amount that your employer will match, but if no match is available and you need flexibility for other savings priorities, check out some of these options:

A 529 Plan: An education savings plan operated through your state or an educational institution to help families set aside income for education costs. Although contributions are not deductible on your federal income tax return, the investment grows tax-deferred, and distributions used to pay the beneficiary’s college costs come out tax-free. Some states offer tax breaks for 529 contributions, you can find yours here. In addition, there are very few income and contribution limitations, making the 529 plan a great, flexible way to save for college.

A Health Savings Account: An HSA offers individuals and families the opportunity to save money exclusively for medical expenses, and contributions are 100% tax deductible from gross income. For 2015, individuals can contribute up to $3,350, and families are allowed to contribute up to $6,650. HSA accounts holders age 55 and older can contribute an extra $1,000. If using savings for medical expenses if a priority, talk to your employer about an HSA. Not all insurance plans are eligible.

Taxable Investment Accounts: When saving for large purchases or vacations, more flexible accounts are better. As explained above, index funds, mutual funds, or even traditional savings accounts leave the account holder with more of a tax burden, but far greater flexibility for withdrawals. These accounts do not need to be opened through your employer, but can be opened and managed on your own, or with the help of a financial planner.

If your employer offers a contribution match, they are essentially offering you free money, so go ahead a take advantage of the 401k, regardless of high fees or a low income. However, if your employer offers no match, high fees, or you have reached the yearly contribution limit, then it is a good idea to avoid that 401k plan and look into other retirement savings options.

At the end of the day, saving for retirement or other goals is all about you. How much flexibility you need, how much you need to save, and your tax situation. Be sure to weigh all of your options to guarantee that you are making the best decision for you and your family.

Advertiser Disclosure: The card offers that appear on this site are from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all card companies or all card offers available in the marketplace.

Gretchen Lindow
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Gretchen Lindow is a writer at MagnifyMoney. You can email Gretchen at gretchen@magnifymoney.com

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Consumer Watchdog: Keep an Eye on Your 401(k) or 403(b)

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Employer-sponsored retirement plans are an easy way to lay the financial foundation of your post-work life. Employers typically offer a 401(k) – or in the case of non-profits a 403(b) – to employees as a benefit in placement of a pension. The employee needs to sign up for the plan, pick funds and contribute a percentage per paycheck to the 401(k). Employers then match employees’ contributions to a certain percentage, often between 3 to 6 percent. It all sounds so simple, until the process breaks down.

It isn’t terribly common for retirement contributions to go missing, but it happens and it’s your responsibility alerting the right people and tracking down the money.

Unfortunately, it’s easy to forget about a 401(k) or 403(b). The process is automated and you just get passive about ensuring your hard-earned dollars are actually ending up in your fund. Plus it’s fun to log into your account every few months and feel rich for a fleeting moment. But similar to clerical errors causing issues on a credit report, a small glitch can result in your contributions lingering in no-man’s land.

How to Keep an Eye on Your 401(k) or 403(b):

  1. Know exactly how much is coming out of your paycheck and being contributed to your retirement plan each month.
  2. Know the exact amount of your employer contribution as well.
  3. Verify human resources, or whoever handles your 401(k), has the right Social Security Number associated with your account.
  4. Keep track of the login information to access your 401(k) plan. It’s easy to just set up your plan, pick your funds and then forget about it. Keep the URL of your 401(k) provider, login in and password in a safe place you can access if needed.
  5. Check your 401(k) or 403(b) once a month to ensure the proper contributions were allocated to your plan.

 What To Do If Your Money Goes Missing

If you realize a contribution has gone missing, immediately alert your company’s HR department and make sure your 401(k)/403(b) provider is aware of the situation. Stay patient and courteous during the process, but diligent about following up. No one cares as much about your money as you do.

Overwhelmed at the prospect of setting up a 401(k) in the first place? Read our Simple Guide to Setting Up Your 401(k)

Advertiser Disclosure: The card offers that appear on this site are from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all card companies or all card offers available in the marketplace.

Erin Lowry
Erin Lowry |

Erin Lowry is a writer at MagnifyMoney. You can email Erin at erin@magnifymoney.com

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