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How Does an Early Withdrawal from a Retirement Plan Affect My Taxes?

Image courtesy of adamr at FreeDigitalPhotos.net

Image courtesy of adamr at FreeDigitalPhotos.net

Oftentimes we are faced with difficult situations in life – where we need extra money to pay for a major car repair, a new roof for the house, or just day-to-day living expenses – and our emergency funds are all tapped out.  Now your options become poor: should I go to a payday loan place, put more on my credit card?  My mortgage is upside-down so there’s no home equity loan in my future, and I can’t ask my folks for a loan, I’ve asked them for too much.  Hey, what about my retirement plan?  I’ve got some money socked away in an IRA that’s just sitting there, why don’t I take that money?

It’s really tough to be in a situation like this, but you need to understand the impacts that you’ll face if you decide to go the route of the IRA withdrawal, especially if you’re under age 59½.

Any money that you take out of a retirement plan as a withdrawal will be taxed as ordinary income – just like wages, salaries, and tips.  So if you’re in the 25% marginal tax bracket, every dollar that you withdraw from your IRA or 401(k) plan (if allowed) will cost you 25 cents right off the top.

In addition to the ordinary income tax, if you’re less than 59½ years of age you’ll also be hit with an additional 10% penalty for an early withdrawal (unless your withdrawal meets one of these 19 exceptions). So now every dollar that you withdraw costs an extra 10 cents on top of the ordinary income tax.  If you’re in the 25% bracket, that $10,000 withdrawal from your IRA can cost you as much as $3,500 in extra taxes and penalties.

Bear in mind that you may be able to take a temporary loan from your 401(k) or other qualified retirement plan (QRP) if you’re still employed by that employer.  Naturally you’ll need to repay the loan, but it might be a better option cost-wise than the other choices.  Plus, if you have an outstanding loan from your QRP and you leave the employer you’ll be required to either recognize the balance of the loan as a withdrawal or pay it back to the plan immediately.

Armed with this information makes your decision points much more clear: review all of the available options mentioned above (loans from family and friends, home equity loans, payday loans, and the like) against the cost of the taxes for taking an early withdrawal from your retirement plan.  The best option may be to see about a formal loan from family, paying them a reasonable rate of interest.  But of course, your circumstances are going to dictate the best option for you.  Just go into it with your eyes wide open.

Bloggers Are Encouraging Adding 1% More to Your Savings Rate

English: Chart of United States Personal Savin...

Chart of United States Personal Savings Rate from 1960-2010. Data source: FRED, Federal Reserve Economic Data, Federal Reserve Bank of St. Louis: Personal Saving Rate [PSAVERT] ; U.S. Department of Labor: Bureau of Labor Statistics; accessed August 14, 2010. (Photo credit: Wikipedia)

 

In November we financially-oriented bloggers have banded together to encourage folks to increase their retirement savings rate by at least 1% more than the current rate.  It’s a small step, but it will pay off for you in the long run.  Given the poor level of savings rate (less than 5%) these days, even this small step will be a big boost for many people’s savings.

Below is the list of my fellow bloggers who have written articles showing ways that you can start to increase your savings rate, as well as showing what the benefits can be.  Thanks to everyone who has participated so far – and watch for more articles in the weeks to come!

The Journey of $1 Million Dollars Begins with 1% by Richard Feight, @RFeight

Give Yourself A Raise by Ben Rugg, @BRRCPA

The 1 Percent Solution by John Davis, @MentorCapitalMg

Friday Financial Tidbit-What increasing your retirement contributions 1% can do for your retirement account by Jonathan White, @JWFinCoaching

THE 1% MORE BLOGGING PROJECT by Robert Flach, @rdftaxpro

A Simple Strategy to Maximize Open Enrollment by Jacob Kuebler, @Jakekuebler

Take a Small Step: Increase Your Savings by 1% by Jim Blankenship, @BlankenshipFP

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C’mon America! Increase your savings rate by 1% more!

English: "Joan of Arc saved France--Women...

lithograph(Photo credit: Wikipedia)

This November we’re encouraging folks to increase their retirement savings rate by at least 1% more than the current rate.  It’s a small step, but it will pay off for you in the long run.

Below is the list of my fellow bloggers who have written articles showing ways that you can start to increase your savings rate, as well as showing what the benefits can be.  Thanks to everyone who has participated so far – and watch for more articles in the weeks to come!

THE 1% MORE BLOGGING PROJECT by Robert Flach, @rdftaxpro

A Simple Strategy to Maximize Open Enrollment by Jacob Kuebler, @Jakekuebler

Take a Small Step: Increase Your Savings by 1% by Jim Blankenship, @BlankenshipFP

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Retirement Plan Contribution Limits for 2014

United Way tax prep volunteers help hard-worki...

United Way tax prep volunteers help hard-working families avoid tax prep fees (Photo credit: United Way of Greater Cincinnati)

The IRS recently published the new contribution limits for various retirement plans for 2014.  These limits are indexed to inflation, and as such sometimes they do not increase much year over year, and sometimes they don’t increase at all. This year we saw virtually no increases for most all contribution amounts, but as usual the income limits increased for most types of account.

IRAs

The annual contribution limit for IRAs (both traditional and Roth) remains at $5,500 for 2014.  The “catch up” contribution amount, for folks age 50 or over, also remains at $1,000.

The income limits for traditional (deductible) IRAs increased slightly from last year: for singles covered by a retirement plan, your Adjusted Gross Income (AGI) must be less than $60,000 for a full deduction; phased deduction is allowed up to an AGI of $70,000.  This is an increase of $1,000 over the limits for last year.  For married folks filing jointly who are covered by a retirement plan by his or her employer, the AGI limit is increased to $96,000, phased out at $116,000, which is also a $1,000 increase over last year’s limits.  For married folks filing jointly who are not covered by a workplace retirement plan but are married to someone who is covered, the AGI limit for deduction is $181,000, phased out at $191,000; this is an increase of $3,000 over 2013’s limits.

The income limits for Roth IRA contributions also increased: single folks with an AGI less than $114,000 can make a full contribution, and this is phased out up to an AGI of $129,000, an increase of $2,000 at each end of the range.  For married folks filing jointly, the AGI limits are $181,000 to $191,000 for Roth contributions, up by $3,000 over 2013.

401(k), 403(b), 457 and SARSEP plans

For the traditional employer-based retirement plans, the amount of deferred income allowed has remained the same as well. For 2014, employees are allowed to defer up to $17,500 with a catch up amount of $5,500 for those over age 50 (all figures unchanged from 2013).  If you happen to work for a governmental agency that offers a 457 plan in addition to a 401(k) or 403(b) plan, you can double up and defer as much as $35,000 plus catch-ups, for a total of $46,000.

The limits for contributions to Roth 401(k) and Roth 403(b) are the same as traditional plans – the limit is for all plans of that type in total.  You are allowed to contribute up to the limit for either a Roth plan or a traditional plan, or a combination of the two.

SIMPLE

Savings Incentive Match Plans for Employees (SIMPLE) deferral limit also remains unchanged at $12,000 for 2014.  The catch up amount remains the same as 2013 at $2,500, for folks at or older than age 50.

Saver’s Credit

The income limits for receiving the Saver’s Credit for contributing to a retirement plan increased for 2014.  The AGI limit for married filing jointly increased from $59,000 to $60,000; for singles the new limit is $30,000 (up from $29,500); and for heads of household, the AGI limit is $45,000, an increase from $44,250.  The saver’s credit rewards low and moderate income taxpayers who are working hard and need more help saving for retirement.  The table below provides more details on how the saver’s credit works (Form 8880 is not updated yet for 2014, so the figures for the 50% and 20% limits will likely change):

Filing Status/Adjusted Gross Income for 2014
Amount of Credit Married Filing Jointly Head of Household Single/Others
50% of first $2,000 deferred $0 to $35,500 $0 to $26,625 $0 to $17,750
20% of first $2,000 deferred $35,501 to $38,500 $26,626 to $28,875 $17,751 to $19,250
10% of first $2,000 deferred $38,501 to $60,000 $28,876 to $45,000 $19,251 to $30,000
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How the 3.8% Surtax Could Influence Roth Conversions

Note: This is a dust-off of an article written in April 2010 that dealt with the special two-year taxation of Roth Conversions that was available in that year.  An astute reader noted that the original was a bit dusty and not applicable to today’s decision-making (thanks S!). Income tax

One of the provisions of the Affordable Care Act is a new tax – a surtax on investment income over certain amounts.  This surtax has come into play this year, for tax returns filed in 2014 on 2013 income.  The income amounts are, admittedly, rather high, but nonetheless will likely impact a lot of folks.  What you may not realize is that, due to the application of this surtax, Roth IRA conversion strategies that you may have had in play may be impacted.  Depending upon your overall income, you may have to pay the surtax on some or all of your conversion amount. On the other hand, by converting, in the future you could avoid surtax, and likely reduce the bracket that you have to pay from for all income.

The New 3.8% Surtax

Here’s how the new 3.8% surtax is applied:  a tax will be imposed for each taxable year, equal to 3.8% of the lesser of 1) net investment income; or 2) the excess of Modified Adjusted Gross Income over the threshold amount. So, in order to understand what this means, we need to define a few things.

Net Investment Income – this is the total of all interest, dividends, annuities, rents, royalties, income from passive activities, and net capital gains from disposition of capital property not held in an active trade or business.  The IRS has specifically excluded the following from Net Investment Income:

  • Income (including self-employment income)
  • Distributions from IRAs or other qualified plans
  • Gain on the sale of an active interest in an S Corporation or partnership
  • Items that are otherwise excluded from income, such as interest from tax-exempt bonds

Modified Adjusted Gross Income – for the purpose of the surtax, this is simply your Adjusted Gross Income (Form 1040 line 37) plus the net amount related to the foreign earned income exclusion.

NOTE:  THIS IS NOT THE SAME AS THE MAGI THAT YOU USE TO DETERMINE YOUR ELIGIBILITY FOR VARIOUS IRA DEDUCTIONS OR CONTRIBUTIONS.  You can find that calculation by reading “Determining Your MAGI”.  Don’t confuse the two, as they are completely different calculations – thanks, IRS!  To keep the confusion at a minimum, I will explicitly refer to this Modified Adjusted Gross Income as Modified AGI within this surtax context.

Thresholds – the thresholds for applying the surtax are as follows:

  • $250,000 for filing status of Married Filing Jointly
  • $125,000 for filing status of Married Filing Separately
  • $200,000 for filing status of Single or Head of Household (yes, Virginia, it is more tax efficient to be single)

Examples

Now that we know the definitions, let’s look at a couple of examples to see how the surtax would be applied:

Example 1. Joe and Mary, a married couple filing jointly, have net investment income of $50,000 and pension income of $125,000.  They are also strategically converting distributions from their IRA to Roth annually in the amount of $100,000, which brings their Modified AGI to $275,000.  So in 2013 Joe and Mary will be subject to the surtax on the lesser of their net investment income ($50,000) or the amount of their Modified AGI over the threshold ($275,000 minus $250,000 equals $25,000).

In this case, the amount of the Modified AGI over the threshold is the lesser amount, and so Joe and Mary will have to pay the surtax on $25,000, or $950 in surtax.

Example 2. Les, a single taxpayer, also has net investment income of $50,000, and pension and other income of $155,000.  Les also is converting amounts each year from his IRA to Roth, in the amount of $50,000 annually.  Les’s Modified AGI, combining of all of this income, is $255,000, which is over the threshold.  Applying the calculation, Les will owe the surtax on $50,000 – which is the lesser of his two amounts (Modified AGI of $255,000 minus $200,000 threshold equals $55,000, which is greater than his net investment income of $50,000).  The surtax will be $1,900.

How a Roth IRA Conversion Strategy Could Be Impacted

You’ve undoubtedly heard about Roth IRA conversions – where you move money from a traditional IRA or 401(k) plan to a Roth IRA, paying income tax on the pre-tax amount moved.  This overall concept should be considered by all folks who have IRAs, especially folks with higher incomes.  This is especially true if future (taxable) distributions from traditional IRAs will have an impact on your tax bracket – and potentially cause the surtax to be applied.

When the money is moved to a Roth IRA, there are no future Required Minimum Distributions (RMDs) from the Roth IRA account during your lifetime, whereas if the money is in a traditional IRA when you reach age 70½ you will be forced to withdraw funds (via RMDs) from your IRA and pay tax on it in that year.  Plus, any amount that you withdraw from the Roth IRA in the future will not be taxed, and therefore will not impact the calculations for the surtax.

In Example 1 above, the only reason the surtax was applied at all was because of the IRA distribution for conversion.  If Joe and Mary had completed the conversion of the $500,000 in IRAs to Roth IRA in prior years, they would have paid tax on the conversion in each year of conversion.  This would mean that for 2013 they would not have Modified AGI above the threshold, so they would not owe the surtax.

If they waited until 2013 to do a total conversion, they’d have Modified AGI of $675,000 – with a pretty hefty income tax and surcharge applied.  However, if they adjusted their conversion amounts to only $75,000 for 2013 their Modified AGI would be exactly $250,000, so they wouldn’t owe the surtax.  Keeping up at the rate of $75,000 per year, they’d have their IRAs converted to Roth within the coming 7 years, eliminating RMDs from their future income – but since they wouldn’t be subject to the surtax from future RMDs, they might opt to discontinue Roth Conversions at this stage and opt to take future RMDs at a much smaller pace.  This could result in lower overall taxes for the couple.

In Example 2, Les was already going to be subject to the surtax even without the IRA distribution.  If we assume that Les also had $500,000 in his IRA account, converting that amount to a Roth IRA would result in a Modified AGI of $705,000, again with a hefty tax bill and surtax.  Unlike the Example 1 couple, Les can’t make an adjustment to his Roth Conversion amounts to eliminate the surtax.  But he might want to continue with his conversion activity nonetheless in order to eventually eliminate the additional amounts being withdrawn via RMDs.  Like most Roth Conversions, a decision must be made as to whether or not you believe future taxes will be more or less than the current rates.

Conclusion

While the surtax on its own should not be a reason to enact a Roth IRA conversion strategy, one of the tenets that we’ve talked about in the past that can cause the conversion to work in your favor is a future increase in tax rates.   If you believe that future taxes are likely to be higher (and let’s face it, who doesn’t believe this?) then any amounts that you can afford to convert should be considered now.  The surtax just gives you more reason to consider it.

Photo by alancleaver_2000

What You Can Do If Your 401(k) Has High Fees

Image courtesy of anankkml at FreeDigitalPhotos.net

Image courtesy of anankkml at FreeDigitalPhotos.net

Now that we’ve all been receiving 401(k) plan statements that include information about the fees associated with our accounts, what should you do with that information?  Some 401(k) plans have fees that are upwards of 2% annually, and these fees can introduce a tremendous drag on your investment returns over a long period of time.

There are two components to the overall cost of your 401(k) plan.  The first, and the easiest to find, is the internal expense ratios of the investments in the plan.  Recent information shows that, on average, these investment fees are something on the order of 1% to 1.4% or more.  The second part of the costs is the part that has recently begun to be disclosed: the plan-level fees.  These are the fees that the plan administrator has negotiated with the brokerage or third-party administrator to manage the plan.  These fees can average from 1% up to around 1.5%.  When added together, these fees can amount to nearly 3% for some smaller 401(k) plans.  Larger employers’ plan fees average about 1% less, at approximately 2% per year.

For example, if average investment returns are 8% you should be doubling your investments (on average) every 9 years.  However, if there is just a 1% fee deducted from the average investment return (so that now you’re only earning 7% annually) the doubling will take a bit more than 10 years.  A 2% fee brings you down to a 6% net average return, and so now your account won’t be doubled until 12 years has passed.  If you started our with $10,000 in your account, this would result in a differential of more than $42,000 over the course of 30 years – at 8% your account could grow to $100,627, while at a 6% return would only grow to $57,435.

The information about fees used to be kept pretty much secret, but beginning in 2012 the plan-level fees have begun to be disclosed to participants in the plans.  Now you know more about the overall fees that are charged to your plan and thereby reduce your overall investment returns.

What Can You Do?

So, now that you know what your expenses are in your 401(k) account, there are a few things that you might do to improve the situation.  While it’s unlikely that you can have an impact on the plan-level fees, you may be able to control some of your exposure to investment fees.  Listed below are a few things you can do to reduce your overall expenses in your 401(k) account.

  1. Lobby for lower fees.  Talk to your HR representatives and request that your plan has lower-cost options made available.  Index funds can be used within a 401(k) plan to produce the same kinds of investment results as the (often) high-cost managed mutual funds, with much lower expense ratios.
  2. Take in-service distributions, if available.  If your plan allows for distributions from the plan while you’re still employed, you can rollover some or all of your account to an IRA, and then choose lower-cost investment options at that time.  Typically a 401(k) plan may offer this option only to employees who are at least 59½ years of age – but not all plans offer in-service distributions.
  3. Balance the high-fee options with lower-cost options outside the plan.  If your 401(k) plan is unusually high-cost, if available do the bulk of your retirement investing in accounts outside the 401(k) plan, such as an IRA or Roth IRA, if you are eligible to make contributions.  Review the investment options in your 401(k) plan for the “diamonds in the rough” – such as certain institutional funds with very low expenses – that can be desirable to hold.  Then complete your allocations using the open marketplace of your IRA or Roth IRA account.

Don’t forget that there are sometimes very good reasons to leave your money in a 401(k) plan, even if the expenses are high.  See the article Not So Fast! 9 Special Considerations Before Rolling Over Your 401(k) for more information on why you wouldn’t want to make a move.

Did the Advent of 401(k) Plans Hurt Americans?

The 87-vehicle pile up on September 3, 1999

The 87-vehicle pile up on September 3, 1999 (Photo credit: Wikipedia)

There’s been quite a bit of press lately about the recent Economic Policy Institute study (see this article “Rise of 401(k)s Hurt More Americans Than It Helped” for more), which indicates that the 401(k) plan itself is the cause of American’s lack of retirement resources.  I think it has more to do with the fact that the 401(k) plan (and other defined contribution plans) were expected to be a replacement for the old-style defined benefit pension plans, and the fact that those administering the retirement plans did little to ensure success for the employees.

Traditional defined benefit pension plans didn’t ask the employee to make a decision about how much to set aside – this was determined by actuaries.  Then the company made sure that the money was set aside (in most cases) so that the promised benefit would be there when the employee retires.  In the world of 401(k) plans, the employee has free choice to decide how much and whether or not to fund the retirement plan at all.  Human nature kicks in, and the nearer term needs of the employee win out over long term needs – of course the long-term requirements get short shrift!

It’s the same as when we turn over the car keys car to a 16-year-old.  Up to this point, the child has just ridden along, not having to know anything about rules of the road, car maintenance, or paying attention.  You wouldn’t just toss Johnny the keys and say “You know where you want to be. Do your best to get there!”  Of course you’re going to make sure that he has all the training necessary to operate the vehicle safely, and that he knows when to put fuel in the car, as well as that he knows how to navigate to his destination on time.

If the playing field had been level – that is, if when 401(k)-type plans were introduced as replacements for pension plans that there was no choice regarding participation and funding level, we’d see a much different picture.  I don’t think education alone is the answer, because the importance of continual funding is so difficult to comprehend.  Forced participation runs counter to the “American Way”, but that would have changed our outlook dramatically.

The problem isn’t the 401(k) plan itself – it’s that when companies dropped pension plans in favor of 401(k) plans they didn’t provide employees with the correct message about the importance of participation.  Free will is a good thing, don’t get me wrong.  But I think employers could have done much, much more to emphasize the importance of participation, of making long-term investment decisions, and of providing for your future with today’s earnings.

It wasn’t the account that is the problem, it’s in the implementation.

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5 Essential Financial Planning Steps for Your 30s and 40s

(jb note: the article below is from my friend Roger Wohlner, who blogs at The Chicago Financial Planner.)

Finance

Many of the calls that I receive are from folks in their 50s or 60s who are either within sight of retirement or already retired.  Many of these callers are pretty well-prepared for retirement and are seeking my help to fine-tune their situation and/or to help them through this next phase of life.  This type of financial readiness doesn’t just happen it takes planning and preparation.  Here are 5 essential financial planning steps for those of you in your 30s and 40s to help you reach your retirement goals and more importantly to help you achieve financial independence.

Get started 

If for whatever reason you haven’t done much of anything to ensure your financial future it’s time to get going.  Today is the best day to get started, tomorrow is the second best day, and so on.  If you are in your 30s or 40s and haven’t begun to save for your retirement, if you have a family and don’t have a basic will or any life insurance, if you have debt or spending issues it’s time to get started on a path to secure your financial future.

Protect your family 

I can’t tell you how many phone calls I’ve received from a 30 or 40 something professional (always a male) with young kids and a stay at home spouse.  Typically the caller is all excited about investing or perhaps about buying income property.  Both are great ideas.  However when I ask whether he has any life insurance in place or even a basic will naming a guardian for his young children the answer is something like “… we’ve talked about that…”  My response is to implore him to stop talking about it and get it done.  I generally follow-up the phone call with a list of estate planning attorneys for them to consider.

My point is this, if you are in your 30s or 40s and have a family you need to ensure their financial security.  Term life insurance is very cheap in this age range assuming that you are in good health.  Until you’ve accumulated sufficient assets to provide for your family in the event of your death, life insurance is a great way to build an estate quickly.

It is vital that parents of minor children at least have a will in place that names a legal guardian for their children in the event of their death.

While we are on this subject make sure that all beneficiary designations on retirement accounts, annuities, and insurance policies are up to date and specify the correct beneficiary.  There is no better way to say “I love you” to a spouse than to have you life insurance go to an ex-spouse or somebody else because you forgot to update the policy’s beneficiary designation.

Even if you are single at the very least you will want to give some thought as to where your money and assets would go if you were to die and take the appropriate actions to ensure this would happen.

Save for retirement 

There is still time to accumulate assets for retirement.  Time in fact is one of your greatest assets here.  Contribute to your 401(k) or similar retirement plan.  Contribute to an IRA.

In many cases you may be starting a family or looking to fund college during these years.  While there may be conflicting demands for your money, save as much as you can for retirement.  As you get to your 50s, 60s, and beyond you’ll be glad you did.

If you are single this is all the more reason to ramp up your retirement savings, assuming you never marry it’s all on you to save for a comfortable retirement.

Financial planning is vital 

Many folks get serious about financial planning in their 50s and 60s as they approach retirement.  There’s nothing wrong with this.  However having a plan in place in your 30s or 40s gives you a head start.  Are you on track to beat the odds in the “retirement gamble?”  Better yet what will it take to help you achieve financial independence?

Make sure the basics are covered.  Get your spending in check and pay down your debts.  If you haven’t done so already, adopt the basic fiscal habits needed to live within your means.

If you work with a financial advisor become knowledgeable.  Take an interest in your situation.  This doesn’t mean that you need to be a financial expert, but a bit of knowledge combined with your own good common sense will help shield you from fraud or just plain bad advice.  If your financial advisor recommends what seems to be costly, proprietary (to his/her employer) financial products trust your gut and look for advice elsewhere.  My very biased view is that you should seek the help of a fee-only financial advisor.  Check out NAPFA’s guide to help you in finding the right advisor for your needs. 

Combine and consolidate 

By this time you’ve likely worked for several employers.  If you are like many people you haven’t paid as much attention to your old 401(k) accounts as you should have.

This is a good stage of your life to do something with these old retirement accounts.  Combine them into a consolidated IRA account.  Roll them into your current employer’s plan.  Do something with these accounts, don’t ignore this valuable retirement asset.

Invest like a grown-up 

There’s nothing wrong with allocating a portion of your investment assets to taking some”flyers” on a stock you like, or an ETF that invests in a hot sector of the market,  play money in other words.

The vast majority of you investments should be allocated in a fashion that dovetails with your financial plan.  Have an allocation plan, stick with it, rebalance your holdings periodically, and adjust your allocation as you age or if your situation warrants.

This investing plan should take into account all of your investments including IRAs, company retirement plans, taxable investments, and so on.  If you are married this should include both of your accounts.

For most people mutual funds and ETFs generally make the most sense.  There is nothing wrong with individual stocks, but they require a level of expertise and research that most investors don’t have.

The planning, saving, and investing that you do in your 30s and 40s will pay major dividends down the road, as you seek a comfortable retirement and financial independence.  Don’t waste time, get started today.  Don’t become part of the retirement savings crisis in the U.S.

Please contact me at 847-506-9827 for a free 30-minute consultation to discuss all of your investing and financial planning questions. Check out our Financial Planning and Investment Advice for Individuals page to learn more about our services.   

Please check out our Resources page for some additional links that might be beneficial to you.  

Photo credit:  Flickr

 

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Don’t Just Walk by That Dime on the Ground!

The Government Dime

The Government Dime (Photo credit: scismgenie)

Have you ever been walking along the street and saw a dime on the ground?  Did you just walk right by, or did you stop to pick it up?  Heck, it’s only a dime, it’s not hardly worth the effort to bend over, right?  But what if it was a dollar?  Or a hundred dollars?  You wouldn’t just walk by that, would you?  What about $1,200?

Unfortunately, many folks do this very thing with their 401(k) plan employer matching funds.  Most employers that sponsor 401(k) plans provide a matching contribution when you defer money into the plan.  Often this is expressed as a certain percentage of your own contribution, such as 50% of your first 6% of contributions to the plan.

So if you make $40,000 a year and you contribute 6% to the 401(k) plan, that means you’ll be contributing $2,400 to the plan from your own funds, pre-tax.  Since your employer contributes 50% of your first 6%, you’ll have an additional $1,200 added to the account for the year.

If you can only afford to contribute 2% (or $800) to the plan, you’re still getting an additional 50% of your contribution added by your employer for a total of $1,200 for the year.  It still makes sense to participate even if you can’t maximize the employer contributions.

However, if you choose not to participate at all, you are giving up the extra money from your employer – forever.  You can’t go back and get this money later when you think you can afford to.  You’re essentially walking by that $1,200 that’s just sitting there on the ground waiting for you to pick it up.

Arguments against

After having this conversation with several folks, I’ve heard many different excuses to not take advantage of a 401(k) plan.  The excuses usually fall into a few limited camps, which I have listed a below.

It’s my money! You’re darn right it is!  And if you don’t participate in your 401(k) plan you’re throwing some of *your* money away.  Many times people believe that when they put money into a 401(k) plan, it’s gone for good.  Nothing could be more untrue!  The 401(k) plan is your property. All of your contributions and (as long as you’re vested in the plan) the employer contributions are yours to keep.  Granted, it’s locked up behind some significant fees and penalties until you reach retirement age (59½ in most cases) – but it’s still yours.

I don’t trust my company – they’ll go bankrupt and lose my money! As noted above, the 401(k) account is yours, not the company’s.  Even if the company goes bankrupt completely, as long as you haven’t invested your entire 401(k) plan in company stock (a la Enron), you still have your 401(k) plan intact.  They can’t lose your money, in other words!  It’s not theirs to lose.

I can’t afford to put money in the plan!  These days, money can be pretty tight (but when isn’t it?).  Unfortunately, regardless of how much money you make, it’s always possible to spend up to and more than what you bring home each payday.  The reverse of this is also true.  Within limits, it’s usually possible to make do with less.  If your paycheck was a dollar less every payday you’d figure out how to get by, right?  How about $78 less?

Using our example from above, for a single person with an annual income of $40,000 per year, before you participate in the 401(k) plan, your total income tax would be approximately $4,054.  If you chose to put 6% or $2,400 in your company 401(k) plan, your income tax would work out to $3,694 – $360 less.  So your take home pay would only reduce by about $78 per paycheck (if you’re paid every other week).  In return for this annual reduction of $2,040 in take-home pay, you’d now have a 401(k) account with $3,600 in it when counting the employer contributions.

Pretty sweet deal, if you asked me (but you didn’t, I just threw this in your face!).  For a total “cost” of $78 per paycheck, you get lower taxes PLUS a retirement savings account worth 75% more than what you had to give up.  Not too shabby.

One great benefit of participating in a 401(k) plan is that once you’ve made the decision to participate, you are deferring this income before it makes it into your hands. You don’t have to (or get to) make a decision about saving, it’s done automatically.  This helps you to get past one of the real difficulties that many folks face with saving: the money always seems to find another place.  This way it automatically goes into savings, before it can find another place.

The bottom line

The best and most important way to assure success in retirement savings is to put away more money over time.  Of course your investment returns will help, but if you don’t save the money, it can’t produce returns, right?  So do yourself a favor and don’t walk past that $1,200 that’s just lying on the ground!

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