Loans in a 401(k) plan may be a double-edged sword.

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If your situation requires a loan from your 401(k) plan please seek the advice of an objective adviser. The money spent on this adviser could save you much more down the road. Be certain that this is not a band aide and your financial woes will continue. Remember should bankruptcy be necessary in the future the money in your 401(k) plan is exempt.

6. Loans in a 401(k) plan may be a double-edged sword. If you contribute to your 401(k) plan on a pre-tax basis and take a loan from your account, you will be paying yourself back on an after-tax basis. When you retire and distribute your account, you will have to pay taxes again. This double taxation is the double-edged sword of loans.In addition, if you take a loan and are unable to pay it back within the outlined time period, your loan will become a premature distribution, taxable in the year your loan goes into “default,” and may be subject to an additional 10% in penalty taxes. If you terminate employment with an outstanding loan, while your account balance may be eligible to stay in the plan, your loan will default if you cannot pay the amount in full prior to the end of the grace period.

It’s also important to keep in mind that removing your hard-earned money from your 401(k) plan reduces the amount of time that money could be accruing earnings and compounding interest. Please take the time to consider the consequences prior to requesting a loan from your 401(k) account.

Taking a loan from your 401(k) plan should be a last resort option. As desperate as your current situation is, raiding your retirement plan is not in your best interest. You need to protect your future self from your current self.

Please comment or call to discuss how this affects you and your finances.

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Best Practices for Reducing Loans, Hardship Withdrawals, and Impulsive Investment Decisions

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These practices will not only help employees successfully retire, you will also reduce the workload of your staff. Employees must be reminded that the money in their 401k plan is protected from creditors in the event of bankruptcy.

Employees who take 401k plan loans contribute less for retirement. According to the Aon Hewitt study Leakage of Participants’ DC Assets: How Loans, Withdrawals, and Cashouts Are Eroding Retirement Income, employees with loans have an average contribution rate of 6.2% while employees without loans contribute on average 8.1% to their defined contributionplans. This difference in contribution rates could mean tens of thousands of dollars to participants in retirement. The study also noted that withdrawals (including those due to hardship ) have a great impact on retirement income as well, noting that full-career contributors who take withdrawals and stop contributing for two years thereafter reduce their retirement income by 7% to 25% depending on income and enrollment methodology.Investment timing can negatively affect investment performance, but many employees don’t know what else to do when they don’t understand basic investment strategies. A recent study by Fidelity Investments® showed employees that moved all of their funds out of equities during the recession of 2008 – 2009 experienced an average increase in account balance of only 2% through June 30, 2011 while those who maintained their investment strategy realized an average account balance increase of 50% during the same period. Reducing impulsive investment decision making and encouraging strategic decision making will improve retirement preparedness along with employees’ investment confidence.

This is a problem that could come back to haunt employers. There is a growing concern that lawsuits from employees who claim they weren’t given enough information on how loans, hardship withdrawals, and poor investment choices could severely impact their retirement may increase. The claim may be that employees shouldn’t have been allowed to take loans or hardship withdrawals, or that they should have been given more information on asset allocation.

The 401(k) plan has become the sole source of retirement for many Americans. Yet many see their 401(k) account balance as a source of emergency funds. This will negatively impact their ability to retire when they choose.

Please comment or call to discuss how plan design can improve your plan.

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When is a 401k Distribution Not Subject to the 10% Penalty?

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When is a 401k Distribution Not Subject to the 10% Penalty?

There are only a couple of situations where the IRS will waive the 10% 401k early withdrawal penalty, i.e., a withdrawal prior to the participant reaching age 59½.

  • Amount of your unreimbursed medical expenses greater than 7.5% AGI ( IRC §72(t)(2)(B) ).
  • There is a Qualified domestic Relations Order (QDRO) from the courts that mandate funds from your account go to a former spouse, child, or dependent ( IRC §72(t)(2)(C) ).
  • You have separated from service and were at least 55 years of age when you did so (or separated from service in the year in which you turned 55) ( IRC §72(t)(2)(A)(v) and 72(t)(10) ).
  • You have elect a Section 72(t) distribution.
  • You are totally disabled. (The key to the disability exception seems to lie in the permanence of the condition, not the severity. Therefore, to claim this exemption you have to furnish not only information proving that you are totally disabled, but also information on the permanence of the disability.) ( IRC §72(t)(2)(A)(iii) )
  • You have died and your beneficiary gets the money ( IRC §72(t)(2)(A)(ii) ).
  • You have made contributions under special automatic enrollment rules that are withdrawn pursuant to your request within 90 days of enrollment ( IRC §414(w)(1)(B) ).
  • Certain distributions to qualified military reservists called to active duty (IRC §72(t)(2)(G) )
  • Because of an IRS levy of the plan ( IRC §72(t)(2)(A)(vii) )

It goes without saying that early withdrawal from your retirement plan should be your last resort.

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The Two Biggest Traps Behind 401(k) Loans and How to Avoid Them

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The old pension funds would very seldom allow loans why then should the 401(k)? This is your future. Avoid loans at all cost.

Hazard #1 – Steep taxes and penalties that come from late payments or switching jobsIf you don’t make a payment on your 401(k) loan for 90 days, the outstanding amount of the loan is treated as a distribution. That means it loses its tax-deferred status and Uncle Sam will require the taxes paid on the outstanding amount plus penalties.  Specifically, the IRS taxes the outstanding balance at your current tax rate, and if not of retirement age (59 ½), you will owe an additional ten percent penalty.  If you took a loan, finding the money to cover this penalty is insult to injury – not to mention hard to pay off.

There are several equally hazardous scenarios that have the same brutal outcome on your pocketbook. If you decide to quit or are let go from your job, the outstanding 401(k) loan amount is due quickly — typically within 60 days. If you don’t pay it back in this time period, it is considered a distribution and will be taxed at your current tax rate plus a ten percent penalty.  Not pretty.

Hazard #2 – A big dent in your retirement savings

While borrowing from a 401(k) provides an easy and low-cost path to immediate cash, the impact on your retirement savings can be dramatic. Time is the key to building a healthy nest egg.   It’s why 20-year-olds who start by contributing small amounts in a 401(k) are often much better off than those in their 40s that contribute a much greater amount to their accounts. This effect is called compounding.  The time your money is out of your 401(k) from the loan is time it will never have again to work for you and grow through compounding.  Additionally, the tax advantages you were enjoying by contributing to your 401(k) vanish.

This is why it’s so important to exhaust every other means to manage your cash needs such as bank loans, a home equity line, etc. before turning to your 401(k).

Loans from your 401(k) must be your last resort. This is another case of protecting your future self from your current self.

Please comment or call to discuss.

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