DON'T DO IT!

Many first-time home-buyers take a distribution from their company’s 401(k) retirement plan to help fund the down payment for the purchase of the home.  And, unfortunately, they tell their tax professional about it AFTER it has been done.

This is a bad idea.  The distribution is included in the federal and probably also state taxable income of the taxpayer – at a cost of 25% to perhaps as much as 40% of the distribution.  In addition, if the taxpayer is under age 59½ he or she must pay an additional 10% penalty for early withdrawal – bringing the cost of the distribution up to as much as 50%.  So, a distribution of $20,000 only puts $10,000 to $13,000 in the taxpayer’s pocket.

The overall tax and other financial benefits of home ownership may eventually outweigh the tax cost of a 401(k) withdrawal, but I still say this is still not a good idea.

If there is no other source of funds for the down payment consider taking a loan from the 401(k) plan, if allowable, instead of an outright distribution.  The interest rate on 401(k) loans is usually low, and you are actually probably paying the interest to yourself.  This loan must eventually be paid back, or the outstanding balance will be treated as a distribution when employment with the company ends.  FYI, the interest charged on the 401(k) loan is NOT deductible on Schedule A.

One way to avoid the 10% premature withdrawal penalty when a loan from the plan is not an option is to rollover a 401(k) distribution of up to $10,000 into an IRA account and then take a $10,000 distribution from the IRA account.  Or just take $10,000 from an existing IRA account instead of the 401(k) plan.  One of the exceptions to the 10% penalty for premature withdrawals from an IRA account is a distribution for first-time purchases.  A purchase qualifies as “first time” if the taxpayer did not own a home in the two years prior to the withdrawal.  This exception DOES NOT apply to premature withdrawals from a qualified plan such as a 401(k).

So, if you are thinking about buying a home your 401(k) plan should be the last place you turn to for funding the down payment.  And you should discuss it with your tax professional BEFORE you do anything.

TTFN

DON'T TOUCH THAT 401(K)!

Over the years I have seen many clients who have, without first consulting me, taken money from their 401(k) plans, while still employed, to assist in paying for excessive medical expenses, college tuition, or a downpayment on a home.

This is a very expensive way to get money.  A loan shark might be cheaper!

Money taken from a 401(k) plan will be fully taxed on a federal and state level and, if you are under age 59 ½ when you take the money, as has been the case in most of what I have seen among clients, you will also be subject to the 10% premature withdrawal penalty.

In most cases 40% or more of the amount taken from the account will be eaten up by federal and state taxes and penalties!  So if you take $10,000 from your 401(k) you will end up in pocket with less than $6,000.

It is similar with premature withdrawals from a traditional IRA, but with an IRA you might have a “basis” in your traditional IRA investment based on non-deductible contributions so the entire amount of the withdrawal may not be taxable.  With a ROTH IRA you can withdraw your contributions at any time without tax or penalty.

There are a limited number of exceptions that could allow you to avoid the 10% premature withdrawal penalty – but you would still need to pay federal and state income tax on the withdrawal.  Some exceptions apply to withdrawals from both 401(k) plans and traditional IRA accounts, and some apply only to premature IRA distributions.

You can avoid the 10% penalty if you take money out of a 401(k) plan, or a traditional IRA, “to the extent unreimbursed medical expenses exceed 10% (or 7½% if the lower threshold is reinstated) of AGI”.  So you can avoid the penalty on the amount of medical expenses that would be deductible on Schedule A.

If you take $10,000 from your 401(k) to pay for an excessive medical bill not fully covered by insurance (this would NOT include elective cosmetic surgery) and when you sit down to prepare your tax return you determine that your total allowable medical expenses for the year are $20,000 and your AGI is $110,000, you can avoid the 10% penalty on $9,000 of the withdrawal ($20,000 – $11,000 = $9,000).  You would still pay $100 in premature withdrawal penalty.

But in most cases of client 401(k) distributions the money has been used either to pay for college or for a downpayment on a house.  Money taken directly from a 401(k) plan for these purposes will be subject to the full 10% penalty.

However money taken from an IRA account and used for either of these two purposes is exempt from the penalty.  In the case of a downpayment on a home, the exemption is limited to $10,000 withdrawn and only applies for “first-time” home purchases (no home ownership in prior two years). 

According to the IRS, expenses that qualify under the college exception include –

“ . . . tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution. They also include expenses for special needs services incurred by or for special needs students in connection with their enrollment or attendance.  In addition, if the student is at least a half-time student, room and board are qualified education expenses.”

The amount of expenses allowed must be reduced by any tax-free educational assistance.

So if you want to invade your 401(k) plan for college expenses or a home downpayment first check with the plan to see if you can have the amount of the withdrawal transferred (rolled over) trustee to trustee from the employer plan directly to your traditional IRA account.  Or take the distribution from the 401(k) and immediately rollover the amount yourself into the IRA account.  When that has been done take the amount of the transfer as a distribution from the IRA account and use the IRA money to make the college or home purchase payments. 

Instead of taking an actual withdrawal from your 401(k) you may be able to take a loan from the account.  Taking a loan from a 401(k) plan is not a taxable event.  However be aware that you must pay the money back to the plan, perhaps with some interest, before you leave the company.  If your employment is terminated you must pay back any outstanding 401(k) plan loan balance within a short period of time or the unpaid balance will be treated as a distribution, subject to income tax and penalty at that time.

The best advice I can give you is do not take the money from your 401(k) plan, or second best that if you are thinking about taking money from your 401(k) plan to pay for anything talk to your tax professional first!  If my clients had come to me they would have saved a lot of money.

TTFN

 

 

 

 

 

 

 

 

 

 

 

THE 1% MORE BLOGGING PROJECT

Jim Blankenship of GETTING YOUR FINANCIAL DUCKS IN A ROW has asked all “financially-oriented bloggers” to “sharpen up their electronic pencils and write a column to encourage folks to increase their 401(k) savings by at least 1% more than last year” in his post “Call All Bloggers! 2nd Annual 1% More Blogging Project”.

Jim explains the idea behind the project -

“I’m sure that I’m not alone in the financial planning world with my concern about the rate of saving toward retirement across this great land.  Recent figures have shown that we Americans are not doing as good this year as last, at a 4.6% rate versus 5% last year when we started this project. This is a dismal figure when you consider how most folks are coming up way short when they want to retire.  Just like last year in November, I thought maybe something could be done to encourage an increase in savings – if only by 1%, this can be a significant step for lots of folks.  November is the perfect time to do this, as most corporations are going through the annual benefit election cycle, so the 401(k) (or 403(b), 457, or other savings plan) is right at the forefront for many folks.”

One of the benefits of a “traditional” 401(k), 453(b) or 457 plan is that your contributions are considered to be “pre-tax” for federal, and often state, income tax purposes.

If your gross salary is $60,000, and you contribute $5,000 to a 401(k) plan, the “taxable wages” reported on your Form W-2 for the year is $55,000.  If you are in the 15% tax bracket this $5,000 savings has cost you only $4,250.  You are getting a 17.65% “match” for your actual out of pocket contribution from the government!  The cost is only $3,750 if you are in the 25% bracket.  Here the government “match” is 33.33%!  The actual costs may be even less when factoring in any state tax savings.

But the tax savings does not stop there.  Because they are considered to be “pre-tax your contributions reduce your Adjusted Gross Income (AGI).  This can increase a multitude of deductions and credits that are affected by AGI or Modified AGI, and further increase your tax refund or balance due. 

So contributing an additional 1% of your income to your employer retirement savings account will really cost you less than 1%.

Here is one way that I save.  Every Friday I put $10.00 from my weekly "take-home pay" in a “piggy bank”.  If at any point during the year I need to use any of this money for a cash-flow emergency I always put the money I have used back when cash flow allows.  At the end of the year I have $520.00 which I add to savings.

You can choose to put the weekly equivalent of 1% of your gross income into a piggy bank each Monday or Friday.  At the end of the year contribute the accumulation to a ROTH IRA account.  The contribution will not provide a current tax savings, but done year after year will grow to a substantial source of tax-free income at retirement.

The below chart from 360 FINANCIAL LITERACY shows how investing $200 per month in a ROTH IRA can grow over the years –

Contribute $200/month to age 65 at different hypothetical earnings rates:
	Start at age 20	Start at age 30	Start at age 40	Start at age 50
2%	$174,931	$121,510	$77,764	$41,943
4%	$301,894	$182,746	$102,826	$49,218
6%	$551,199	$284,942	$138,599	$58,164
8%	$1,054,908	$458,776	$190,205	$69,208

An advantage of putting this money into a ROTH IRA instead of your 401(k) plan is that if you need money for an emergency at any point you can always withdraw your contributions to the ROTH tax and penalty free.

So, Jim, how did I do?

TTFN