Retirement Accounts-Some Obvious Benefits and Not So Obvious Pitfalls
Retirement accounts come in various shapes and sizes. You have your IRAs, Roth IRAs, SIMPLE plans, 401(k) plans and pension plans. Retirement money also takes shape in the form of annuities. Each way is a great way to set aside a nest egg for retirement, saving taxes simultaneously.
Imagine putting money into your pocket while putting money away to fill your pocket later. For example, if you are in the 25 percent tax bracket, a $1,000 retirement contribution will put $250 into your pocket today. It’s a win-win!
Many of us are enrolled in employer-sponsored retirement plans, the most popular of which is the 401(k) plan. Very often, employers will match a portion of what you contribute. This is a great opportunity for additional, tax-deferred compensation. If you are a 401(k) participant, investing up to your company’s match is a no-brainer. And beyond the matching portion, it may make sense to maximize your contribution ($19,000 annually and even more if you’re over age 50). Or, depending on your income, it may make more sense to do something different. We would be more than happy to review your 401(k) and other retirement options with you.
Of course, as with any benefit, there are always caveats and pitfalls. One of those is the ever-popular 401(k) loan. Many 401(k) plans have a provision where you can borrow some of your own money. The interest rate is tied into the prime lending rate, so it’s less than average credit card interest rates. Why not pay interest to yourself? Here’s the problem. 401(k) loans are repaid via payroll deduction. In today’s economy, it’s not unusual for us to find ourselves changing jobs or careers fairly frequently. Once you’re no longer being paid by a particular employer, the only way to re-pay your 401(k) loan is with a lump sum. More likely than not, we won’t be able to do this, as we borrowed the money in the first place because we didn’t have available cash for something. And if you don’t re-pay your 401(k) loan within a certain period of time after you’ve left the job, it will default. This means that the remaining loan balance becomes taxable income to you. And of course, when you take out a 401(k) loan, they don’t necessarily tell you that, or as an employee/401(k) loan consumer, you don’t necessarily think about it or read it in the fine print.
Speaking of job changes, what happens to your 401(k) plan when you change jobs? It’s your money – you take it with you. A direct rollover is the easiest, and safest thing to do you can move your 401(k) plan to a new employer, or you can put it in an IRA, and invest it where and how you choose. If you move the money from one custodian to another (in other words, if it goes from your former employer directly to an IRA account someplace else), there’s no chance that you’ll have a tax consequence. However, if your former employer issues you a check, you have 60 days (and no more than 60 days) to establish a rollover IRA account. If you don’t follow the 60-day rule, the entire amount will be considered taxable income. That could be quite costly, considering how much money you may have parked in your 401(k) plan.
Sometimes we find it necessary to cash out our 401(k) plans. Financially, this is usually the worst possible choice. If you cash out, the entire balance becomes taxable. If you are under 59-1/2 years old, you are subject to a 10 percent penalty tax on top of the income tax. So if you’re in the 25 percent tax bracket, you will incur a 35 percent tax on your 401(k) plan. If you had $20,000 in your account, at cash out it would be worth a mere $13,000. That’s without any fluctuation it’s purely federal tax (and your resident state gets its share as well). So, which is worse, a credit card at 19 percent interest, or income tax approaching 40 percent? The IRS does require 20 percent federal tax withholding when you cash out a 401(k) plan or IRA. Very often, when clients show us 1099 forms at tax time, they tell us that they’ve already paid the tax on this. Wrong. They’ve already paid some of the tax on the withdrawal. Unless you project the tax implication before withdrawal, you have no way of knowing whether the 20 percent is sufficient or not.
Finally, make sure you have a handle on where your money is and what type of accounts you have your investments in. It’s a good idea to use a trusted financial adviser, who can help you consolidate your accounts and keep an inventory of what you have. We would be happy to set up a meeting with one of our referral partners who would be glad to evaluate your portfolio.