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FAQ about 401(k)s

The stormy economy has taken a hefty bite out of millions of 401(k) accounts. Those double-digit gains of the '90s have been washed away, leaving some investors uncertain of what to do next. Given this volatility, our virtual mailbags have been bubbling with questions about 401(k) accounts. Here are some frequently asked questions with answers from our experts, Dr. Don and the Dollar Diva.

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  • Would it be wise to take money from my retirement plan to build a house in this sluggish economy?

  • We are considering a loan against my husband's 401(k) to pay off our credit card debt. Is this a smart thing to do?

  • I've changed jobs and am confused about what to do with my 401(k) account from my old job.

  • I'm twenty-something and have the opportunity to participate in my company's 401(k) plan with a 50 percent match. How should I allocate my money at this point in my life?

  • I want to diversify my 401(k) investments but I am confused by the descriptions for the types of mutual fund choices I have.
  • Would it be a good idea to take money from my retirement plan to build a house in this sluggish economy? I have lost about 40 percent over the past year or so. I know that there will be penalty and taxes of about 32 percent, but is getting out now worth it to invest in home equity?

    Watching your account balance decline in your 401(k), 403(b) or IRA account is a gut-wrenching experience. You think, if only I had been smart enough to see that the stock market was heading for a fall. If it helps, you weren't alone.

    Let's say you had $100,000 in a 401(k) account and you watched that account decline to $60,000. Paying income taxes plus a penalty tax of 10 percent for an early withdrawal, assuming that your 32 percent is correct, would result in you having $34,800 to invest in a home.

    I've put together an example that compares your investment in real estate to just holding on to your retirement account over the next 20 years. In it I assume that your home appreciates in value by 3 percent annually while a stock portfolio appreciates 9 percent a year.

    The stock appreciation value is quite conservative for a well-diversified portfolio of stocks. After all, the Standard & Poor's 500 Index, an index of the largest capitalization stocks in the U.S. market has averaged 12.7 percent annual returns in the 10 years ending Sept. 30, 2001.

    We'll assume that you would pay the same in rent ($903 a month) as you would pay in mortgage payments. Another assumption -- at the end of 20 years, you're in the 28 percent tax bracket and you'll have to pay taxes on the profits in your retirement portfolio (in this case, $94,154 in taxes).

    Now:

    Home

    Retirement

     

    Purchase price:

     $174,000

     $60,000

    Current value of retirement portfolio

    Down payment:

    $34,800

     

    Loan amount:

     $139,200

     

     

    Loan rate:

    6.75%

     

    30-year fixed mortgage

    Monthly payment:

    ($903)

    ($903)

     

    Twenty years later:

    Home

    Retirement

     

    Appraised value based on 3% annual appreciation:

     $314,263

     $336,265

    Loan balance:

     $78,168

     $(94,154)

    Home equity:

     $236,095

     $242,111

    I realize these figures are all pie-in-the-sky calculations. You don't know how your real estate investment will appreciate over time any more than you can know how the stock market will do over time.

    My point is that keeping that $25,200 working for you in your retirement account vs. paying it out to the IRS in taxes and penalties can mean a lot for your retirement. You have to weigh how close you are to your planned retirement, and how comfortable you are with the long-term prospects of real estate or the stock market before you decide which decision is right for you.

    Get professional help from a fee-only certified financial planner if you can't decide. The CFP Board of Standards can help you find and select a financial planner in your area.top of page

    We have a great deal of credit card debt and are able to borrow from my husband's retirement to pay some of it off. The loan will be for only five years and will be repaid through a payroll deduction. Is this wise?

    Yours is a common problem. You're saving for retirement, but not living within your means. Now you want to pay off your current debt by tapping your retirement savings.

    If your credit cards have an average rate of 17 percent and the loan from your retirement plan is at 8 percent, then it seems an easy decision to borrow from your retirement plan to pay off this debt. The chart below will help you frame the decision given the particulars of your situation.

    In most 401(k) plans you can borrow up to 50 percent of your vested balance, but not more than $50,000. You have to pay the money back with interest over five years (longer if the loan is for a principal residence).

    The good news is that the interest payments are going into your retirement account and not to the credit card company. The downside is that the original contributions to the account were made with pretax dollars, but the loan payments will be made with after-tax dollars.

    If you're in the 31 percent marginal federal income tax bracket, it will take $1.45 in wages or salary to replace each dollar you borrowed from the account -- plus interest. The interest payments aren't tax deductible and will be considered as earnings in the account. When you take qualified distributions in retirement, you'll pay income tax on the distributions including the interest expense you paid on the loan.

    If you don't repay the loan, you will owe both the income tax and a 10 percent penalty tax on the early distribution. If your husband's 401(k) plan is like most plans, the loan will become due immediately if he leaves the company.

    I've taken a hypothetical situation to show the savings associated with using the 401(k) loan at 8 percent and comparing it to paying off a credit card balance at 17 percent.

    You can put together your own table by using Bankrate's loan payment calculator to calculate the monthly payments and the savings calculator to determine the value of the loan payments reinvested over the next five years vs. how the account would grow if you didn't withdraw money to pay off your credit cards.

    401(k) loan vs. credit card repayment comparison
     
    401(k) loan at 8%
    Credit card at 17%
    Loan amount
    $25,000
    $25,000
    Monthly loan payment
    ($506.91)
    ($621.31)
    Total payments
    (monthly payment x 60 months)
    ($30,414.59)
    ($37,278.86)
    Interest expense
    (Total payments -- loan amount)
    $5,414.59
    $12,278.86
    401(k) loan payments reinvested @ 10% APR for 5 years
    $39,253.63
     
    $25,000 remains in 401(k) earning 10% APR for 5 years
     
    $41,132.72

    In this case it makes sense to borrow from the 401(k). You've saved almost $7,000 in interest expense and you've freed up $115 in your monthly budget that you could use to pay back the loan faster. Put in your own numbers to make the worksheet relevant to you.

    The three big concerns to avoid are: You take this as an opportunity to run up your credit card balances again; you stop making any contributions to your retirement accounts other than the loan payment; your husband leaves the company and is forced to pay the loan in full within 90 days of leaving the firm.

    Putting money aside for the future requires that you spend less than you make. If you're not doing that, you need to get to the point where you are. If you're spending like there's no tomorrow, then don't be surprised if tomorrow comes and you don't have any money to spend.top of page

     
     
    -- Posted: Aug. 31, 2004
       

     

     
     

     

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