Bad Idea #1: Cashing Out a 401(k) to Pay Off Debt
These days, a lot of people are working to pay down debt, which is a great idea; few things are more stressful than owing money, so paying off your debts not only helps you to have a better retirement, it can have positive benefits on your health right now.
Still, that doesn't mean that paying down debt is always the best option. One particularly bad idea is to cash out a 401(k) plan to pay off your debt.
Why is that a bad idea? Here are the three biggest reasons:
1) The money is supposed to be for retirement! If you pull it out now, it may look like a smart move - after all, you're probably paying more interest on your credit card than you're making on your retirement plan - but it's a lot easier to ignore your retirement account being too small than your debt being too big (at least until you get close to retirement!) You should make a practice of never touching your retirement funds if it's at all possible; once the money is in there, it's off limits.
2) The government will even help enforce that practice; if you haven't reached retirement age and you try to take money out of your retirement account, you're going to face some hefty penalties and interest (with the exception of principle on a Roth IRA, of course). Just by taking the money out of your account, you could end up losing a third of it immediately, before it even has a chance to do you any good.
3) Retirement funds (up to a certain limit) are exempt from bankruptcy. If your debt gets the better of you and you're forced to declare bankruptcy, you can shed the debt and keep the retirement funds. As such, even when things feel hopeless, it's still best to leave the money in your 401(k) alone if at all possible.
Of course, sometimes there really is an emergency - most likely medical - that completely justifies pulling the money out; in this case, you may even be able to avoid the early withdrawal penalties. However, consider your options carefully; not having adequate retirement savings is always a bad idea!
What is the maximum 401k contribution per year?
You've probably heard that you should max out your retirement contributions each year, if you're financially able to do so. Aside from the obvious reasons - a little saved now can be worth more than a lot saved later - the government puts a limit on how much money you can put into a retirement account each year. The maximum amount generally increases each year, so even if you put aside the maximum last year, it's worth checking to see if you can increase your savings.
Notice that I said generally, not always...and as it happens, the maximum 401k contribution has stayed the same in 2011 as it was in 2009 and 2010. If you are under age 50, you can contribute a maximum of $16,500 to a 401(k), 403(b), or 457 plan; if you are 50 or over, you can put in an additional $5,500 (for a total of $22,000). Note that you may have multiple plans (for example, a traditional and a Roth 401k) but the combined contributions cannot exceed these limits. Additionally, you cannot contribute more money to a retirement plan than you actually earn!
In addition to the amount you put in, your employer is permitted to contribute to your account as well; this contribution (generally in the form of matching funds, such as a 50% match on your savings) must be made with pretax dollars regardless of whether you have a traditional or a Roth account. The employer contribution can be up to 25% of the employee's pretax earnings, up to a total of $32,500. This means that the combined contribution (employee + employer) can reach a total of up to $49,000 (more if you're over 50).
Maxed out your 401(k)? Not to worry - you still have IRA contributions to make! IRAs and 401k plans are completely separate; maxing out one doesn't affect your ability to contribute to the other. However, the IRA contribution limits are much lower: $5,000 per year, or $6,000 if you're 50 or older. As with the 401(k), you can divide your contributions between multiple IRAs, which may be traditional, Roth, or a combination, but the total contribution must be no more than $5,000 (or $6,000) per year.
Do note that if you make a lot of money, you may not be eligible for certain types of retirement accounts; once your income reaches six figures, you'll want to consult with a tax professional.
IRA Early Withdrawal Penalty Exceptions
While everybody knows they should be contributing as much money as possible to their retirement accounts, the problem is that once you put the money in, you often can't withdraw it without a penalty. This is by design, of course; the whole point is to force you to leave the money alone until retirement. That said, sometimes you end up in a desperate situation and your retirement account is the only place you can get the money you need. Under what circumstances can you take out some or all of your money, while still avoiding the penalty for early withdrawals?
Fortunately, there are hardship withdrawal exceptions available, but before we get into that, let's look at when you normally can and can't withdraw money from your accounts, and at what penalty.
Generally, if you contributed to an account using pretax dollars, you can not withdraw without a penalty. If you want to take money out of a traditional IRA, for example, then you have to pay taxes on any money you withdraw (which would have happened whenever you took the money out in any case), plus you owe an additional 10% penalty.
Normally, the early withdrawal penalty no longer applies once you reach age 59 1/2; at that point, you may withdraw as much money from your IRA as you want, and are required to take a minimum disbursement each year. However, the IRS also recognizes several special cases where you may withdraw money early without penalty; note that you do still need to pay tax on the withdrawals. Also, if you withdraw money during the same year that you contributed it (or rather, before the due date for filing your tax return for that year) then the penalty does not apply.
The first two are for medical reasons. If you lost your job and received unemployment benefits, then you may be able to withdraw enough money from your IRA to cover the cost of paying for medical insurance during the period of unemployment. Regardless of your employment situation, if your medical expenses are over 7.5% of your adjusted gross income, you can take a penalty-free withdrawal without paying the penalty.
If you become disabled such that you are no longer able to work, then your withdrawals are not subject to penalty; additionally, if you die before reaching age 59 1/2, then your estate can collect the money from the IRA without penalty.
Finally, you can use up to $10,000 from the IRA to buy your first home, and can also withdraw as much as you need to pay for college or to roll over into another qualifying plan. If you know you're going to need to take money out of your IRA in the future, but not immediately, you might be able to do a rollover into an annuity that will begin paying out before you need the money. The IRS actually provides a way for you to do this directly, without bothering with the rollover: you can "annuitize" the account and begin taking withdrawals immediately. The catch is that the amount you can withdraw is based on your life expectancy, and you must withdraw the same amount every year for five years or until you reach age 59 1/2, whichever is longer.
If you only need the money for a brief period of time, IRS rules do allow you to take a 60-day loan from your IRA without paying taxes or penalties, provided the funds are returned within that 60 day period. You can only take one such loan in any twelve month period.
A SIMPLE IRA files the same rules as the traditional IRA, but if you take the withdrawal in the first two years of participating in a SIMPLE plan, the tax penalty (if it applies) will be 25% rather than 10%.
In the case of a Roth IRA, you are allowed to remove any contributions you've made, as these are made with after-tax dollars; however, the penalty will apply if you remove any of the earnings, which have not yet been taxed. As with the traditional IRA, there are exceptions if you die, become disabled, or purchase your first home.
Hardship Withdrawal From IRA
With a 401(k), you are limited in when you can withdraw money, but there are exceptions that allow withdrawals due to hardship. With an IRA, there are generally no limits on when you can take a distribution, so there is no provision for an IRA hardship withdrawal.
However, there are certain expenses that allow you to take early distributions without paying any extra taxes; specifically, you do not have to pay the early distribution tax if you withdraw money from an IRA to fund higher education or to finance the purchase of your first home (up to $10,000). (Sections 72(t)(2)(E),(F)) of the tax code). You can also make a withdrawal without penalty if you will use the money to pay for unreimbursed medical expenses (but only if they exceed 7.5% of your adjust gross income), to pay the premiums on your medical insurance if you have received unemployment benefits for more than 12 weeks, or to pay back taxes after the IRA places a levy against the IRA.
Remember that with a Roth IRA, you are free to withdraw your money at any time and for any reason, with no justification required; while this is generally a bad idea (as you likely won't be able to replace the money, and may owe a penalty if you touch the earnings or any deductible contributions), it does mean that the money is available in an emergency.
401(k) with ETFs: Good Combination or Bad Idea?
You may or may not be familiar with ETFs, or exchange-traded funds. ETFs are similar to stocks, and are actually traded on stock exchanges. An ETF is basically a basket that holds a collection of assets for you to invest in, such as stocks, bonds, and commodities. The price of the ETF is approximately the same as the value of its assets. Many investors find ETFs attractive because they are not actively managed and thus have lower costs than other investment products. They also tend to have fairly low capital gains, making them efficient for taxation purposes.
The question is, should you be holding ETFs in your retirement plans? At the start of 2010, about $4 billion in 401(k) assets was in the form of ETFs, so a lot of people seem to think so.
The extremely low expense ratios offered by exchange traded funds can definitely make them an attractive choice; lowering fees can dramatically impact your return on investment over the long run. They also allow you to diversify without the hassle of choosing stocks or funds yourself.
However, ETFs are often used for timing the market, which is at odds with the buy and hold strategy appropriate for retirement funds. Additionally, because 401(k) and IRA plans are already tax-advantaged, the tax benefits of an ETC don't apply.
So should you use an ETF in your 401(k)? As with many financial questions, the answer is: it depends. If you want to actively manage your portfolio - for example, investing in commodities without the hassle of taking possession, or making sure that you don't have multiple holdings that are invested in the same company - ETFs can give you the control you seek. If you tend to be a hands-off investor, however, the standard mutual funds offered by your company's plan may be just fine for you.
2010 IRA Contribution and Deduction Limits
The rules regarding contributions to and disbursements from individual retirement accounts change from year to year based on what Congress does; here's what you need to know for 2010.
If you are under 50 at the end of 2010, you can contribute either $5,000 or your total taxable income for 2010, whichever is less. This limit applies to both traditional and Roth IRAs; you may split the money between them, but the total contribution must be no more than the numbers above. If you are fifty years old or older, the limit is raised to the lesser of $6,000 or your total taxable compensation for 2010, with the same restriction as above.
The income limits for claiming the deduction for contributions to a traditional IRA were raised for 2010, as follows. Note that all numbers refer to the modified adjusted gross income.
If your filing status is single or head of household, you can take the full deduction for contributions to a traditional IRA provided that you made (an adjusted) $56,000 or less; you're entitled to a partial deduction provided your adjusted gross income was less than $66,000. If you are married filing jointly or a qualifying widow(er), those numbers increase to $89,000 and $109,000. However, if you are married filing separately, you're entitled to only a partial deduction and only if your AGI was less than $10,000, unless you did not live with your spouse at any time during the year, in which case the rules for single filers apply.
The above numbers apply if you are covered by a retirement plan at work. If not, and you are single, head of household, a qualifying widow(er), married filing jointly, or married filing separately with a spouse who isn't covered by a plan at work, then you can take the full deduction regardless of your AGI. If your spouse is covered by a plan at work, then your limit is $167k for the full deduction, $177k for a partial deduction if filing jointly, $10k for a partial deduction if filing separately.
For a Roth IRA (which doesn't come with a tax deduction), your AGI may affect how much you can contribute. If you are single, head of household, or married filing separately and you did not live with your spouse at any time during the year, you can contribute up to the limits discussed above provided your modified AGI is less than $105k, and a reduced amount as long as it is under $120k. If you're married filing separately and lived with your spouse at any time during the year, you can contribute a partial amount if you made less than $10k. If you are married filing jointly or a qualifying widow(er), you can contribute the full amount if you make under $167k and a partial amount if you make less than $177k.
Another change for 2010 is the elimination of the filing status requirements for converting a traditional IRA to a Roth IRA, and the provision for extra catch-up contributions for certain employer bankruptcies no longer applies. Additionally, the provision allowing tax-free distributions from IRAs for charity is expiring and is no longer available.
The IRA distribution rules for 2010 state that if you made contributions to an IRA in 2009, you could withdraw them tax free at any time up until your tax return was due (either the original due date or the extended due date, if you filed for an extension); however, you may not take a deduction for the contribution and must withdraw any interest earned on that amount (in case of a loss, the amount of interest may be negative).
You must begin receiving distributions from your IRA by April first of the year after you reach age 70 1/2. However, there is an exception in 2010: if you reached this age last year, you do not have to begin taking disbursements at the normal time, but must take the first one by December 31, 2010.
You may take more than the required minimum, if desired, but this does not reduce the amount that you must take in future years. (The exception is that you can count money withdrawn in the year you turn 70 1/2 against the next year, when you would have your first minimum disbursement). The minimum required distribution varied based on the account balance and can be found by referring to the table provided by the IRS. Failure to withdraw the correct amount or more subjects you to an excise tax.
401(k) Direct Rollovers
A direct IRA rollover is when you move your retirement savings from your 401(k) directly to your IRA from the old account, through a trustee to trustee transfer. When you're rolling over a 401(k) to an IRA you always want to make it a direct rollover, as this avoids having to pay taxes or penalties; if you ever handle the money, you can trigger early withdrawal penalties that, combined with taxes, can wipe out half of your savings. The other type of rollover is, surprisingly enough, called an indirect rollover; when you do an indirect rollover, you get a check written out to you (with 20% of your IRA withheld) and you have 60 days to get that money deposited into an appropriate retirement account before triggering the aforementioned penalties. If for some reason you do an indirect rollover, you'll need to make up that 20% with other funds (it's held to pay taxes if needed) in order to avoid taxes on the part not rolled over.
Generally, when you're holding stock in your 401(k), you have two options. You can transfer the stock directly to your IRA, or sell it and transfer the cash to your IRA; in the latter case, you need to make sure that the sale occurs within 60 days of the rollover to avoid paying taxes.
While you would normally move your money into a traditional IRA or a rollover IRA, it is also possible to move it into a Roth IRA. In this case, you must pay taxes on the money (because the account was funded with pretax dollars) but you do not need to pay the early distribution penalties and taxes, provided you do not withdraw the money for at least five years. Obviously, when doing this you want to have cash on hand to pay the taxes, so that they don't reduce your retirement savings. This is essentially one way of getting around the $5000/year limit on Roth IRA contributions. (This limit will rise with inflation after 2010, and is also higher for people over 50).
Note: there are special rules for members of the military; see IRS Publication 3, Armed Forces' Tax Guide for details.
You can check the IRS Rollover Chart to see whether you can do a rollover between two accounts.
Annuity Investment: Does It Make Sense For You?
These days a lot of people are interested in adding an annuity investment to their portfolios. We previously discussed how annuities work; today we'll talk more about deciding if an annuity is right for you.
Annuities are similar to whole life insurance (which we never recommend) in that they mix an investment with an insurance component. Normally we recommend keeping the two separate - buy your insurance where it makes the most sense and invest your money where it makes the most sense. However, we're normally concerned with insuring health or property. Annuities are something different - they insure against longevity.
Retirement Savings and Taxes: Protecting Your Assets
One of the major considerations in deciding how to allocate your retirement funds is the tax treatment each retirement vehicle receives. Which tax treatment is best for you depends on a number of factors, but it basically boils down to one question: is it more important to not be taxed now, or to not be taxed later?
Tax-advantaged retirement plans generally fall into one of two categories. Either you are allowed to invest with pre-tax dollars, or you don't pay taxes on the earnings. Let's take a look at the advantages of each.
Tax Free Municipal Bonds
Municipal bonds, also known as munis, are a popular savings vehicle due to their tax-advantaged status: the interest on them is exempt from federal (and generally state) taxes. However, if you buy a bond issued in a different state than the one you live in, you will likely lose the state tax exemption. Read on to see if you should have some municipal bonds in your retirement portfolio.