Retirement Planning Step 2: Choosing the Right Account

May 10, 2017

Now that you’ve set your goal, you need to figure out where you are going to save all that money. Do you use a 401(k), an IRA, or something else? What’s the difference?

The 401(k) is the account you can save through payroll deductions at work (or if you work for a not-for-profit like a hospital it may be a 403(b), but they’re basically the same thing).

401(k) positives:

It’s easy. You just elect your percentage and voila! The money comes right out of your check and you don’t have to do anything else.
You may get a match. Most employers these days offer a match as an incentive to get you to use the 401(k). As long as you put a certain percentage or dollar amount in your account, your employer will match those dollars. FREE MONEY ALERT!
You may have other tools available. For example, the rate escalator, where you tell your account that you want to increase what you’re saving on, say, an annual basis. You can make it happen automatically – no calendar reminder or phone alarm needed.
You can reduce your taxes. If you’re saving in the pre-tax 401(k), your contributions will reduce your taxable income in the year you put them in. In other words, if you increase your contribution by 1%, your check will go down LESS than 1%. Bonus!

Most people start with their 401(k) because it’s easy and to capture their full match. Don’t leave that free money on the table!

What if you want to save more once you’ve reached the match (or even the max) in your 401(k)? At that point, an IRA can come in handy. The big difference between a 401(k) and an IRA is that you’re fully in charge of your IRA. You have to choose where to open it, how to invest it, and what type you want. There are some special rules that may not allow you to deduct deposits you make into a pre-tax IRA or you may not even be able to contribute to a Roth IRA because you make too much money, (although there are ways to get around that) so just beware as you’re making your choice.

Which account you choose will be up to you. But no matter what, it’s important to pick one and start saving. The good news is that you can always switch where your money is going in the future if your circumstances change!

Is a Roth IRA the Wrong Tool for Emergency Savings?

December 08, 2016

I recently stumbled across this blog post called “The Emergency Roth Fallacy,” which criticizes me (along with a host of other financial writers) for advocating the idea of using a Roth IRA for an emergency fund. The basic idea is that since Roth IRA contributions can be withdrawn tax and penalty-free at any time and come out before earnings (which can be subject to taxes and a 10% early withdrawal penalty if withdrawn before 5 years or age 59 ½), you could use a Roth IRA as your emergency fund. Just be sure to keep it somewhere safe like a bank account or money market fund until you’ve built up sufficient emergency savings (at least enough to cover 3-6 months’ worth of necessary expenses) elsewhere. At that point, you can then invest the Roth IRA money more aggressively to grow tax-free for retirement. Let’s take a look at the criticisms:

“Who cares about saving taxes on an account earning 1%!?” I don’t know about you, but I try to save every penny I can from taxes. The bigger point is the opportunity you may have to invest that money later for a higher tax-free return. By funding the Roth IRA while you’re building your emergency fund, you avoid missing the opportunity to stick as much money in a tax-free account as possible.

“Money you withdraw can’t be put back.” Technically, you can put the money back within 60 days one time each year. It’s also no worse than not having contributed the money at all, which would be the alternative for someone who can’t afford to do both. However, I would go further and say that this is actually a benefit of using the Roth IRA as an emergency fund. That’s because the pain of withdrawing money that would otherwise grow tax-free can discourage people from withdrawing money for non-emergency purposes.

“It’s a complex solution to a non-existent problem.” First, the strategy isn’t for everyone. Many people do prefer the simplicity of a simple savings account for their emergency funds. On the other hand, I also know people who are reluctant to build up their emergency savings because they want to get as much money as possible into tax-advantaged accounts like the Roth IRA. This solution can solve that dilemma for them.

“It’s WAY too hands-on.” There are plenty of people (like yours truly) who are willing to take a few extra steps to optimize their finances. It can also be implemented by financial advisors for clients who prefer being more hands-off.

There are some additional benefits of a Roth IRA vs a regular savings account for an emergency fund. The fact that it’s designated as a retirement account and requires extra paperwork for withdrawals can discourage you from tapping into it for frivolous “emergencies.” Some institutions may pay higher interest rates on IRA accounts. Finally, some states provide more creditor protections to IRAs and IRAs avoid the time and cost of probate as long as there’s a living beneficiary.

None of that may matter to you. You may prefer the simplicity and convenience of a regular savings account. But for others, the Roth IRA can be a useful tool in helping them build and preserve emergency savings.

Net Unrealized Appreciation is an Often Unrealized Option

January 19, 2015

I recently met with Dave, a long-term employee of a large company who came to me with a tinge of guilt in his voice. “You’re gonna yell at me, but I’ve got about 20% of my 401(k) invested in my company’s stock. I’ve been putting money in it since they started allowing me to, and it’s done about as good or better than my other stocks. The re-balancing tool on the plan website says I have too much company stock, and you’re gonna tell me to sell most of it – right?” Continue reading “Net Unrealized Appreciation is an Often Unrealized Option”

The Hidden Benefits of After-Tax Contributions

November 20, 2014

No, I’m not talking about Roth contributions. If your employer’s retirement plan offers this option, you may be able to contribute more than the annual limit of $17,500 (or $23,000 if you’re 50 or older) to your plan in the form of “after-tax” contributions. As the name implies, the contributions are taxed before you put them into the plan. And unlike Roth contributions (which are also “after-tax”), the earnings are taxed when you withdraw them. Continue reading “The Hidden Benefits of After-Tax Contributions”

What Would You Have Done For a Ticket to the World Series?

November 03, 2014

It’s always fun to sit back and watch others get caught up in a little friendly competition as they support their teams. Unfortunately, some people take their love of sports too far and this can have a drastic impact on their financial future. Take for instance a dedicated Royals fan who recently acknowledged in a post game “fan on the street” interview that he cashed in part of his retirement savings to purchase a ticket to the World Series. I am convinced that at the time of this interview, he probably wasn’t thinking his statement would get picked up by national media outlets and blogs. Perhaps the most embarrassing aspect of his professed fandom was his stated profession- financial advisor.

Most of America knows that prior to this season, the Kansas City Royals suffered a 29-year playoff drought, which left most Royals fans in a delirious state throughout the playoffs. But this financial advisor from the Kansas City area took his loyalty to insanity – he pulled nearly $1,000 from his IRA to get a ticket just four rows behind the Giants dugout. He checked to see if the withdrawal would trigger a penalty, which it would, and did it anyway. (Note: The IRS imposes a 10% penalty on IRA withdrawals prior to age 59 ½ plus these distributions are also subject to ordinary income taxes.)

The first thing many financial planners throughout the country likely thought was this guy must be nuts talking to the KC Star reporter and admitting this. It would be like Dr. Oz saying he eats a gallon of Dreyer’s ice cream in front of the TV every night. As a financial advisor, he should know better, and what’s that about him checking on it? Every qualified advisor helping folks with their investments should know the IRA withdrawal rules offhand – that’s basic stuff! And finally, financial planners tell clients to have 3 to 6 months of take home pay at hand for emergencies and unforeseen life events… like a Royals trip to the World Series. Apparently, some people just can’t eat their own cooking.

So why do seemingly smart people do stuff like this? One might be the sheer excitement of the playoff opportunity – “a once in a lifetime chance.” Psychological research says overspending usually happens in the face of emotional stress – good and bad.

Then there’s the desire to be seen as important and getting ahead. What financial advisor wouldn’t want to be seen four rows behind the dugout by friends or on TV? This guy got so excited by the idea, he let all his financial control gates down.

As retirement savers, we simply can’t afford to be like this guy, especially considering that only 1 in 5 Americans are confident in their ability to retire comfortably. Impulse buys and YOLO moments are a major concern, especially for those with one month or less of cash ready for emergencies. Retirement accounts, even small ones, aren’t to be taken lightly enough to raid for baseball tickets or our guilty pleasures…until we’re actually retired. Doing otherwise risks the fact we’ll never enjoy those ballgames in retirement but instead may have to sell hot dogs at the park to those that DID save enough to go.

Here is some good news for our financial advisor who could benefit from some long term planning. The IRS allows us up to 60 days to pay back the funds from an IRA withdrawal to avoid the 10% early withdrawal penalty. This would be considered a rollover and prevent the distribution from being taxable. Just be aware that this type of IRA to IRA rollover can only be performed once every 12 months.

Better yet, just avoid thinking of your IRA as an emergency fund in the first place. This will help you avoid future tax headaches and preserve your retirement savings and future growth potential. In the case of our determined Royals fan, avoiding early IRA withdrawals can also decrease the likelihood that your peers will question your financial savvy.

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Using Retirement Plan Assets for a First-Time Home Purchase

May 28, 2014

Updated June 14, 2017

First-time home-buyers are often surprised by the requirements of obtaining a mortgage, especially when it comes to your down payment. One way you can improve your chances of getting a home loan is by putting at least 20% down at the time of purchase. For existing homeowners like me, coming up with a 20% down payment usually starts with selling the home I’m in right now and using the equity to make a down payment on my next home.

But what about someone that may be buying a home for the first time? Coming up with a $50k down payment on a $250k home may take several years of aggressive saving, but your retirement account may not be a bad place to go for the additional funds needed to get you on the path to home ownership. In fact, the IRS offers certain breaks for taxpayers that choose to use retirement assets to purchase a first home.

Who qualifies as a first-time homebuyer?

Interestingly enough, you don’t actually have to be buying a home for the first time in your life to be considered a “first-time” homebuyer. IRS publication 590 defines a first-time homebuyer as any homebuyer that has had no present interest in a main home during the 2-year period ending on the date of acquisition of the new home.

In other words, as long as you haven’t lived in a home you owned for the last two years, you are considered a first-time homebuyer even if you owned a home previously. If you are married, your spouse must also meet this no-ownership requirement.

What are the tax benefits of using a traditional IRA for a first-time home purchase?

Well, as you probably know, when you take money out of a traditional IRA prior to age 59½ there is usually a 10% penalty tax for early withdrawal. However, the IRS offers an exception for first-time homebuyers: first-time homebuyers may withdraw up to $10,000 over a lifetime without penalty for first-time home purchases. Keep in mind that while the distributions are not subject to penalty, they are still subject to income taxes.

Does it make a difference if I use a Roth IRA?

It does. If you’ve owned a Roth IRA for at least five years, any distributions used for a first-time home purchase (subject to the $10,000 lifetime limit) are treated as qualified distributions. That means the amount distributed will not only be exempt from penalties, but also income taxes. If you have not owned a Roth IRA for at least five years, your distribution may still avoid penalties but some or all of it may be subject to income taxes.

One thing you should understand is that Roth IRA distributions are subject to ordering rules, which basically means any money you put in comes out first and is therefore not subject to taxes or penalties (since you already paid taxes on the money before it went in). Therefore, the exception described above is really only applicable after you have withdrawn all of your contributions.

Do I get the same benefits with an employer-sponsored retirement plan?

Not really. The only way to tap money in an employer-sponsored retirement plan (e.g. 401(k)) for a home purchase while you are working is through a plan loan or hardship. Plan loans are not subject to taxes and penalties—as long as you don’t default—but generally have to be paid back within five years (although some plans allow more years for funds used to buy a home). Also, if you leave work before paying off the loan, many plans require you to pay off the balance within a few months of separation or risk defaulting on the outstanding balance.

If you intend to use your employer-sponsored retirement plan assets to help pay for a home purchase, you may want to roll them over to an IRA after separation as the distribution rules for IRAs are generally more favorable than those of employer-sponsored retirement plans.

Is it a good idea to use retirement assets to purchase a home?

That depends. If you plan on using the equity in your home as supplemental income in retirement, some investors may consider this a good way of diversifying your retirement portfolio. However, if you have trouble making payments on the loan, not only could you end up losing your place to live, but you may also jeopardize part of your retirement nest egg. Read this Forbes article for more things to consider and like with all financial decisions, you should weigh your options carefully before deciding which approach to take.

Unconventional Wisdom: Confessions of a Financial Professional

January 18, 2012

When it comes to topics to write about in this blog, I usually look through the news or around the home, but this week’s topic actually comes from another reader, not because they asked me to write on a particular topic—although I welcome your suggestions—but rather because the reader gave me a new way to look at an old subject. I’ve written many times already on the topic of Roth IRAs, and each time I’ve taken the position that the Roth was somehow sacred, and that everyone in America should have one, but my new online friend gave me some compelling arguments as to why I shouldn’t be so down on traditional retirement accounts. Rather than try to recap the conversation, I welcome you to scroll through the dialogue that is found in the comments section of my June 8, 2011 blog titled To Roth, or Not to Roth. Continue reading “Unconventional Wisdom: Confessions of a Financial Professional”

Workforce Retirement Readiness: “Stepping Up” to the Challenge

December 27, 2011

I met with Lauren recently, a mid-career employee in her thirties who wanted to know if she was on track for retirement. I asked her how much she was contributing and she told me 6%, which is the minimum to capture the full match from her employer, and the default deferral that she was auto enrolled with when she got hired two years ago. However, when she handed me her latest retirement account statement, her actual salary deferral was at 8%. Continue reading “Workforce Retirement Readiness: “Stepping Up” to the Challenge”

How Risky is Your Income?

December 15, 2011

In his book “Are You a Stock or a Bond,” finance professor, Moshe Milevsky argues that how we invest should be based on the nature of our job. For example, if you have a safe job with a steady income like a tenured professor, then you are like a bond and you can afford to be more aggressive with your investment portfolio. On the other hand, if you work in an unstable industry or if you have an unstable income like a real estate agent or business owner, then you are like a stock and should be more conservative with your investments. Continue reading “How Risky is Your Income?”

The Roth 401(k) – Where’s a Crystal Ball When You Need One?

December 13, 2011

Will you be in a higher or lower tax bracket when you retire? This is the typical question asked of employees when they are faced with the decision to choose between a pre-tax or Roth 401(k) option, sponsored by their employer.

For a younger worker just starting their career, Continue reading “The Roth 401(k) – Where’s a Crystal Ball When You Need One?”

Should You Use Your 401(k) Funds to Purchase a Home?

August 17, 2011

Recently we received an inquiry from a gentleman who, at the age of 60, is relocating from the East Coast to the West Coast and wants to know if he should use funds from his 401(k) to make a larger down payment—and have a lower mortgage—on his next home. Continue reading “Should You Use Your 401(k) Funds to Purchase a Home?”

What Will it Cost if You Delay Saving for Retirement?

May 26, 2011

The other day, I have to confess, I was in a very sour mood as I just found out my flight had been delayed (that never happens right?) and I was not going to be home for THREE HOURS. Why did this bug me so much? My wife and I were scheduled to look at some homes as we are still in limbo relocating from California to Chicago. So this three hour delay cost me the ability to view some possible locations and extended our time horizon of not having a home by at least another week. The only redeeming factor here is that this delay was out of my control. Continue reading “What Will it Cost if You Delay Saving for Retirement?”