Why You Should Talk To A Financial Planner Before Taking a 401(k) Loan

August 04, 2017

According to a report by EBRI, 20% of 401(k) plan participants have an outstanding loan against their retirement account — that is one out of every five employees. For this reason, many companies are now requiring employees who are taking out a 401(k) loan to talk with a financial planner first, to make sure that these people are making the best decision for themselves both today and for their financial future.

People take out loans for a variety of reasons, and when I talk to people who are in the process, I find that for most of them, it makes sense (they are buying a home or need it to pay tuition until their child’s financial aid check arrives). But sometimes there are better options, or often people don’t fully understand the implications of what they’re doing. Even if they end up taking the loan anyway, they are still better off having talked to us first.

Here are four ways that financial planners can help if you are thinking of taking a loan against your retirement.

Deal with financial stress. Many people who are taking a loan from their 401(k) are under a lot of financial stress — they either don’t have a cash reserve or any assets that they can sell for immediate liquidity or their credit cards could be close to maxed out and they have an immediate cash need. A financial planner can help with strategies to deal with the stress and also help you moving forward so that you don’t find yourself in this position again in the future.
Review options. Taking a 401(k) loan may be the best option, but a financial planner will help explore and evaluate possible alternatives that may be better.
Point out the pitfalls. 401(k) loans are paid back from your paychecks. If those paychecks stop for any reason (you quit, get fired or are laid off, etc.), your 401(k) loan could become a taxable distribution if you don’t continue to pay it back. (some employers allow you to continue payments after you’ve left, but others require you to pay it all back within a certain time frame after you leave). If you end up “defaulting” by not paying back any portion of the loan, you will have to pay taxes on the outstanding loan balance, plus a 10% early distribution penalty if you are younger than 59 1/2. There are also implications to the loss of investment growth that a planner can help you to better understand.
Solve the problem behind the problem. As people are in the process of taking out a 401(k) loan, they are very aware of the crisis that created the need for the loan — maybe it’s a failed transmission or an unexpected medical expense. And while the loan takes care of the immediate cash need, quite often that doesn’t address the root of the problem. It could be a lack of a spending plan (Easy Spending Plan) that has you living paycheck to paycheck, maybe it’s because you don’t yet have a plan to pay off your debt (DebtBlaster Calculator) or you haven’t been able to set up a cash reserve (Daily Savings Calculator) to address situations like this. Once the immediate need is taken care of, a financial planner can work with you going forward to help identify the cause of the crisis and develop a plan to help prevent this from happening again.

Unfortunately, a lot of us (myself included) don’t reach out for help until we are in a crisis. If you find yourself in that situation and are receptive to finding ways to avoid history repeating itself, reach out to a financial planner for help. We do it all the time.

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Why You Should Roll Your 401(k) to Your New Employer

September 19, 2016

When changing jobs, what should you do with your employer-sponsored retirement account balance? Our blog editor, Erik Carter, JD, CFP®, recently wrote a post titled What Should You Do With That Old Retirement Plan, in which he stated that if he left an employer, he would be very likely to roll over his retirement account balance to an IRA in order to have access to more investment choices. Erik outlined a job-changing employee’s four options: 1) leave the money in the former employer’s plan, 2) cash out your account, 3) roll over your balance to a new employer or to an individual IRA or 4) purchase an immediate income annuity (if it’s a feature of your former plan.)

Option 3, rolling over your balance, is by far the preferable choice for the large majority of retirement savers. For most people, it may make more sense to roll their retirement plan balance to their new employer’s plan rather than an IRA. Here’s why:

Lower Fees

Many 401(k) plans offer participants access to institutional share class mutual funds and very low cost index funds, especially those sponsored by large employers. Conversely, investing in your IRA can get expensive if you aren’t careful to monitor the mutual fund fees, trading costs and account fees. Before you make your distribution decision, compare and contrast the fees for all your options, including leaving your account with your previous employer, rolling your balance to an IRA and rolling it to your new employer. Not sure which option offers you the lowest cost of investing, given the type of investments your want to choose? Use FINRA’s free mutual fund fee analyzer tool.

Keep it Simple

While it’s true that there is a broader universe of investment options in a self-directed IRA account at a brokerage firm or mutual fund company than in your workplace retirement plan, many investors don’t need or want that kind of customization in their investment strategy. Keeping your retirement plan balances in one place allows you to see at a glance the investment mix of your retirement savings and how much you’ve saved simply by logging on to one site. If you’re a more “hands-off” investor, a target date fund in your plan with a date near your target retirement can offer you an easy, diversified, one-stop-shopping investment strategy.

Protection Against Lawsuits

Balances in retirement plans, such as 401(ks), are protected against civil judgments and bankruptcy. (But if you owe taxes, your 401(k) assets can be seized to settle the tax debt – and you’ll have to pay more taxes and a 10% penalty if you take an early withdrawal to settle the bill.) The higher your income and/or net worth, the more important it is to consider this factor. However, depending on where you live, your state may not extend that protection to IRAs.

Borrowing Power

Many 401(k) plans permit participants to borrow from their plan assets at a very low rate of interest. If you roll your old plan into your new plan, you’ll have a bigger base of assets against which to borrow. (A common borrowing limit is 50% of your vested balance up to $50,000, but check with your plan administrator for the specifics of your plan.)

While the disadvantages usually outweigh the advantages in borrowing against your retirement plan, there are times when it may make sense, such as preventing eviction, foreclosure or auto repossession, paying off very high interest debt or putting 20% down on a home purchase to avoid PMI. Keep in mind that you’ll repay the loan with after-tax dollars so you’ll end up being double-taxed on the interest when you eventually withdraw it, and those funds won’t have access to market performance during the loan repayment period. Also, if you leave your company for any reason before the loan is repaid, your unpaid balance becomes a taxable retirement plan distribution, subject to a 10% penalty.

Workplace Financial Guidance

More and more companies are offering workplace financial wellness programs, where financial education and guidance are offered to employees as an employer-paid benefit. Can you attend a workshop or webcast, use an online learning resource or work one-on-one with a financial coach? More 401(k) plan sponsors also offer access to robo advice, where an online investment adviser service sets your investment mix based on your risk tolerance and time horizon and regularly re-balances your portfolio.

How about you? What do you think is a better idea: rolling an old retirement plan into an IRA or into your next employer’s plan? Email me at [email protected] or let me know on Twitter @cynthiameyer_FF.

A Debate on 401(k) Loans

August 04, 2016

Asking questions and challenging assumptions are important components of financial self-defense. That’s why I was glad to see one reader take the time to raise some interesting points contesting some of what I wrote a couple of weeks ago in a blog post called “The Hidden Downsides of a 401(k) Loan.” Since other readers may have similar concerns, I thought it would be useful to address them. Besides, I love a good, friendly debate! Here are the 401(k) loan downsides from the original post, the reader’s critiques, and my responses:

Downside #1: You lose out on any earnings:

Critique: “You are wrong because the 401(k) loan continues to be a plan asset – bearing a fixed rate of interest. Instead, you should have encouraged her to reallocate so as to maintain her asset allocation (equity position) – treating the 401(k) loan principal as the fixed income investment it is.”

My Response: Yes, it’s true that the 401(k) loan continues to earn a fixed interest rate, but that’s interest you’re paying yourself. If you take money out of your savings account and then pay it back with “interest,” I wouldn’t call that earnings. Reallocating the remainder of your 401(k) balance is an interesting idea though that could help make up for the lower earnings.

Downside #2: Your payments may be higher.

Critique: “Are you seriously suggesting that a cash advance using a credit card (with interest rates of 15% – 30% or more) is a better liquidity solution because the minimum monthly payment might be less if you stretch repayment out over 20 – 30 years instead of 5 years? That is so obviously bad financial advice I don’t know what to say.”

My Response: I certainly wouldn’t say that a credit card cash advance is generally better than a 401(k) loan. I’m simply pointing out that using a 401(k) loan to pay off high-interest credit card debt could actually increase your cash flow problems because the payments on the 401(k) loan may be higher than the credit card debt.

Downside #3: You also can’t eliminate a 401(k) loan through bankruptcy.

Critique: “Are you are suggesting that when entering into a debt obligation, one consideration should be that if the combination of mortgage, car and 401(k) debt become unsustainable, you should anticipate being able to stiff the creditors? Remember that a plan loan is secured debt, secured with your vested assets. So, you can default on a 401(k) loan anytime you want (just stop repayment) – you don’t even have to declare bankruptcy. However, I am not sure why you would want to stiff yourself.”

My Response: I’m suggesting that if you’re considering filing for bankruptcy protection, you may not want to use a 401(k) loan to pay off debt that would otherwise be discharged in the bankruptcy. (As for “stiffing creditors,” keep in mind that creditors assume the risk that you may employ this legal protection and charge higher interest rates accordingly.) It’s also hard to default on a 401(k) loan when the payments are withheld from your paycheck.

Downside #4: You may not be able to take another loan.

Critique: “Really. If the plan only provides for a single loan, your recommendation is to borrow all you can and put the amount you did not need at this time into a passbook savings account or a money market fund? That is almost as bad as your recommendation concerning credit card debt. However, I will agree with you that this is one likely result where, based on “expert” advice, plan sponsors amend their plans to limit access to a single loan.”

My Response: If you’re going to take your only allowable loan and have no other emergency funds, you might want to borrow more than you need and put the remainder in savings. This can help you avoid accruing high interest debt or even worse, missing car or rent/mortgage payments in the event of an emergency. At least with a 401(k) loan, you’re paying yourself the interest.

Downside #5: You may be subject to taxes and penalties if you leave your job.

Critique: “The better response is for the plan sponsor to amend the plan to permit repayment post-separation. In the 21st Century we call this electronic bill payment. Your response confirms that service providers/recordkeepers have failed to keep pace with 21st Century electronic banking functionality. The other response is to prepare for any potential change in employment by obtaining a line of credit.”

My Response: I agree that plan providers should offer electronic bill payment after leaving employment, but if your employer doesn’t, you need to be aware of the risk of getting hit with taxes and early withdrawal penalties on the outstanding balance. Also, lines of credit can be cancelled. This is even more likely if you lose your job or if the economy is weak, which are two times when you’ll probably need it.

Downside #6: You’re double-taxed on the interest.

Critique: “When you receive a payout of interest earned on investments, it is taxed just like interest on any other fixed income investment. In terms of tax preferences, if you secure the plan loan with a mortgage, the interest you pay on your plan loan may be tax deductible. And, importantly, if the plan loan is secured with Roth 401(k) assets, the interest you pay may be tax free at distribution – just like it would be for the interest received on any other fixed income investment where Roth 401(k) assets were the principal. So, no, interest is not “double taxed”.”

My Response: I agree with the point about interest from Roth 401(k) accounts not being double-taxed. However, most 401(k) accounts are pre-tax and so the interest will be taxed on the interest when it’s eventually withdrawn. Since that interest was paid by you with money you already paid taxes on, I would call that “double taxed.” That’s one reason why the loan isn’t completely free (the other being the lost earnings from point #1).

Conclusion: The employee I was talking with decided to dip into her savings rather than borrow from her 401(k) due to the double taxation of her interest.

Critique: “Since she could take out multiple loans, there was an “emergency option” even if she borrowed this time. And, assuming the tax status of interest paid to the condo was the same as the tax status of interest paid on a plan loan, the calculation you should have performed was whether, after the loan was repaid, her total net worth (inside and outside the plan) would have been higher. In this case, because the condo rate was 3.75%, she might have been better off using that liquidity option – but nothing in your response suggests you proved which alternative was superior.”

My Response: I do think her choice was the most likely to maximize her net worth the interest she gave up on her savings was less than the the 3.75% the non-401(k) loan would cost her and what her 401(k) could be expected to earn (plus the taxes on her interest payments). That’s why she made the decision she did.

Final point: Finally, don’t forget that the real purpose of your 401(k) is retirement.

Critique: “Your suggestion is that people should avoid using plan assets for any purpose other than post-employment income replacement. However, if you (self-) limit liquidity, people will only save what they believe they can afford to earmark for retirement. Those who limit their saving by earmarking money for retirement are more likely to fall short of their savings goals. Importantly, reasonable liquidity access has been shown to increase (not reduce) retirement savings.”

My Response: I’m simply saying that you should understand both the pros and cons before taking a 401(k) loan. In some cases, the 401(k) loan may indeed make the most sense. However, I do think that the 401(k) is not the best vehicle if you’re saving for liquidity. After all, putting your emergency money in your 401(k) could leave you short in an emergency since you can generally only borrow up to half of your vested balance (up to $50k) and the loan will have to be paid back at a time when money might be tight. Saving first for emergencies in something more accessible like a savings account is not going to make or break your retirement.

None of this is to say that 401(k) loans are always a good or bad idea. It all depends on the situation. Just make sure you’re making an educated decision even if it means having a little debate with yourself (or a qualified financial professional).

When 0% Interest Looks More Like 44%

September 14, 2015

I happened to overhear the following conversation while visiting my local coffee shop the other day:

“Hey, nice laptop. Where did you get it?”

“We have this program at work where we can buy computers, electronics, furniture, appliances, and other stuff and pay for it with monthly deductions from our paychecks. This laptop will be paid for in 12 months, and I never had to use my credit card or pay any interest.”

Buy now and pay interest-free over 12 months with convenient payroll deductions? Sounds like a great way to buy, right?

Maybe. Maybe not.

The issue

Often touted as “employee purchase plans” or similar programs, companies engaged in this business can make it sound as if this is a great alternative to credit cards or personal loans to purchase items such as computers, household appliances and more – until you take a closer look at the total cost of the purchases you make under these programs. Granted, there are employee product purchase plans that allow employees to buy products at a significant discount. But too often, those who cannot obtain credit or who aren’t willing to save up cash for a purchase, buy these items at greatly inflated prices when less costly alternatives may be available.

An example

A popular employee purchase program offers a 40” named-brand LED television for $849.99 or “only” $70.83 per month over 12 months — all conveniently deducted from one’s paycheck, of course. There will also be additional charges for shipping and taxes, according to information buried in the fine print.

On the other hand, this same item can be purchased from a large online retailer (whose name is similar to a very large river in South America) for only $479! This is a savings of $371 or a whopping 44%. Of course, for someone who doesn’t have $479.00, that monthly payment of $70.83 can look pretty attractive. However, even for consumers who have poor credit or no credit, some creative thinking can help them find less expensive options for making these purchases.

Exploring the alternatives

For instance, there is Mom’s well worn and time-tested advice: save up for it and then buy it, particularly if the item is not something you absolutely must have to support your career or education. Using the earlier example of the monthly payments at $70.83, if we instead saved $70.83 in a savings account, it would take a little less than seven months to accumulate the much less expensive $479 purchase price offered by the online retailer. And if we kept saving $70 each month, we could use that money to build or improve our emergency fund, save up for a future vacation, pay off some credit cards, contribute to an IRA, etc.

But what if the item you want to buy is something you absolutely need right now? For example, my fellow java junkie at the coffee shop may have needed that laptop for some college courses she was taking in order to improve her career prospects. In that case, waiting seven months or more to save up for the purchase may not be practical.

When you can’t wait

Some other alternatives she could have considered instead of the expensive payroll purchase plan include borrowing from family members (a bit awkward at Thanksgiving), or she could consider borrowing some money from her 401(k) plan at work. There are pros and cons to borrowing against an employer’s retirement plan, of course, such as missing out on future investment growth or taxes and penalties if the loan is not paid back on time so we certainly do not want to use 401(k) loans as ATMs for frivolous purchases. But for overcoming occasional and relatively small financial tight spots, a 401(k) loan that you borrow from yourself and pay back over time may be a practical solution.

Better still, when you need or want to buy some new things, why not sell some old stuff you no longer use or like? An old fashioned yard sale still does the trick and modern technology can also help us quickly turn household items, collectibles, or heirlooms into quick cash. Social media sites are popular options for advertising your sale items, and there are well known websites such as ebay.com and craigslist.com you can use.

While you are busy thinning the herd and selling off excess possessions, this is a good time to also review your personal spending plan and see where some additional trimming can be done. In my case, cutting back on the weekly trips to the coffee shop can save me a tidy sum, though I may miss out on some interesting conversations.

5 Financial Rules You May Need to Break

March 15, 2012

There are certain guidelines that we financial planners tell people to help keep them out of trouble. Most of the time, they’re right on. But there’s almost always an exception to the general rule. Here are some of those rules, why they usually make sense, and when they might not. Continue reading “5 Financial Rules You May Need to Break”