Calculating How Much Money You Need for Retirement

Every so often I receive questions from readers. I try to answer them all directly, but occasionally a question comes up that is very broad and is one that more people are thinking about but not asking. Everybody wants to know how much they should be saving and how large their account should be once they reach retirement, so I wanted to tackle that question for everyone today.

When it comes down to it there are two methods to help guide you. Some basic rules of thumb that anyone can quickly use to get an estimate and then the process of creating a detailed estimate of retirement expenses and income.

1. Retirement Rules of Thumb

The most common method is simply by using one of the general rules of thumb about retirement income. For years people have been told that you need to generate 75-80% of your pre-retirement income during retirement to maintain your current lifestyle. This is a fine place to start, but there are simply too many problems with this method.

First, we can’t predict the future. We can make some assumptions as to why we will need less income during retirement such as not having a mortgage payment or no longer commute to work, but nothing is certain Epecially if you have a number of years yet before retirement. Another huge factor is health. While you may not have a mortgage payment during retirement you could find that you replace that with high insurance premiums or medical care that wasn’t expected.

2. Creating a Detailed Estimate

A better way to determine how much you should save up for retirement would be to create a detailed estimate based on your specific situation. This means sitting down and taking a look at exactly what expenses you will or won’t have in retirement, what sources of income you will gain or lose, and any lifestyle changes you may have.

Some people will still carry a mortgage while others won’t. Some people may choose to buy a second home or move to a new location in retirement. And depending on what you do during retirement will have a huge impact on your income needs. Maybe you want to travel overseas frequently or maybe you want to join that private golf club you’ve always dreamed of, or maybe you plan on starting a business. You may find you can live comfortably on 25% of your pre-retirement income or you may find you need 150% of that income to reach your goals. Your plans will ultimately dictate how much money you need.

The problem with this method is that this really works best for those who are approaching retirement within maybe the next 5 to 10 years at the most. Beyond that it is difficult to get a real grasp on your financial needs because your situation may still change, tax laws are sure to change, and we obviously have no idea what the state of the economy will be a few decades from now. For those of us in our 20s, 30s, or even 40s, we have to rely on a lot of assumptions for the most part. We really don’t know where our careers might take us, how our income grow, and what our plans are 30 years down the road. Even if we can develop a detailed retirement income and expense plan there’s a good chance it will be completely wrong in thirty years. And nobody wants to retire broke and unhappy.

What The Experts Say

A relatively new study done by a few experts was published in the Journal of Financial Planning to tackle this exact topic. The study aims to address the following:

1. The annual cash flow needed in retirement
2. The capital needed to generate this lifetime retirement cash flow
3. The annual savings needed to build the capital that will provide the retirement cash flow

An interesting note as to why this study is a bit different can be summed up with this:

We used a more sophisticated approach by using the retirement ratio of 80 percent based on pre-retirement net income as defined as gross income less retirement savings. We used net income because someone who saves for retirement has reduced their pre-retirement living expenses and, for most, it typically follows that they also reduce their post-retirement expenses. For individuals who are saving a lot, this can be significant. Lower retirement expenses means less needed capital. You could say the more one saves, the less one needs to save.

In the past the assumption was simply based on gross income. If you earned $50,000 just before retirement then you need to have $40,000 coming in during retirement. This study factors in savings because if you are saving money each year for retirement, once in retirement you won’t be saving and instead withdrawing so that shouldn’t count towards your required income. For example, let’s say you make $50,000 a year and you are putting $6,000 into your 401(k) each year. Instead of just taking 80% of $50,000 you would take 80% of $44,000 ($50,000 – $6,000), or therefore  a retirement income of $35,200.

Capital Required to Generate Income

While it is fine to make estimates about how much money you need in retirement, whether it is based off 75%, 80%, 120% of your income, the other big question people have is how much money does it take to generate that stream of income? When I meet with clients they are often quite distressed. They hear things in the media about how they should have over a million dollars saved up and with $150,000 in their account and 5 years until retirement they think it is the end of the world.

The same study talks about how to estimate how much capital will be required to generate this stream of income. It goes into detail using mortality rates, social security, the Monte Carlo simulation and so on. Since it is complex I won’t go into detail here but I encourage you to check out the study and take a look at some of the tables they have provided that give some sample income levels you can use to compare with your own situation.

What This Means For You

After all of this discussion you are probably just as confused as before. Making general assumptions only goes so far, yet if you’re getting close to retirement and put together a detailed estimate you’ve already missed out on a lot of time needed to save, so what should you do? Ultimately you shouldn’t get hung up on some of the numbers out there. Just because some talking head on TV says you should have a million dollar portfolio by age 65 doesn’t mean that is what you should strive for, just as the rule of thumb saying you need to save 10% of your income or have 80% of your income during retirement might not be appropriate for you. People are unique and everyone’s situation is different.

Use these guidelines as a starting point. Read the study and go over some of the examples they provide. While in the end they are still general assumptions they are a great place to start, it is then up to you to monitor your progress and make changes as things in your life change. It is hard to say where life will take you so your actual savings goals may change significantly. If you start saving early and find out you’re saving more than you need to that is a good problem to have. It doesn’t hurt to overestimate because you can do even more in retirement or leave more to your heirs or charity, but if you realize at age 50 that you haven’t saved nearly enough you can’t go back in time and fix it. In the meantime, be sure you’re maxing out those IRAs and not hurting your retirement chances by taking a 401k loan.

Resource: National Savings Rate Guidelines for Individuals

About the Author: Jeremy is a retirement planning specialist and founder of Generation X Finance and the guide to Financial Planning at About.com. To learn more, follow Jeremy on Twitter.

How Much Money Do I Need to Save For Retirement?

As a Chartered Retirement Planning Counselor and someone who deals specifically with retirement issues I spend a lot of time helping participants with their retirement plans. One of the most common reasons participants would meet with me is because they say need money and they are looking to take it out of their retirement plan. Unfortunately, this conversation almost never goes over too well since they are usually upset with the fact that they cannot cash out their entire account while an active employee or can’t tap into the company match. It’s just as bad when I explain to those who are eligible for a distribution that they are likely going to lose 30% or more of their money to taxes.

What is probably more shocking is that many of the people coming in looking to take money out of their retirement plan only need a small amount (generally under $1,000) to cover some unexpected expenses and I’ve even seen people take out $500 loans on three year terms. With so many people tapping into their employer plans for minor emergencies I think this highlights the importance for keeping a cash emergency fund available even if it isn’t significant.

Congratulations on Saving for Retirement, but Your Responsibilities Don’t Stop There

I have to applaud those who actually take the time to enroll and begin contributing to their plan, especially if money is tight. Generally, the people who need to borrow against their 401(k) are earning modest incomes and are just able to make ends meet. There is a lot to be said for someone in such a situation. They understand the importance of saving and have learned to make due without that little extra money coming home in their paycheck.

Taking the step to actually save for retirement is only the first step. That money doesn’t do any good if you’re constantly tapping into your nest egg via 401k loans or distributions instead of rolling it over. Saving is good, but not managing those funds properly can be just as bad as not saving anything at all.

Taking the Next Step

While participating in the plan is a great initial step it is often the only savings many people are taking part in. It is automatically taken out through payroll so it is simple to set up and easy to forget about. The problem is that people stop there and don’t apply the same technique for other savings. If you can spare $10 every two weeks from your paycheck for retirement you should strive to save at least $10 as well for your emergency savings so you don’t have to treat your retirement plan as an emergency fund.

The problem is that this takes additional work and you either need to change your direct deposit to put money into a savings account or you need to manually set up the transfer or deposit. The other big problem is how easy the money can be to access. Most people simply set up their savings account where they do the rest of their banking and more often than not the savings account is linked to the checking or even their ATM card. The ease in accessing this money can make it difficult for some people to keep the money in savings where it belongs and occasionally tap into it. The benefit of a retirement plan is that the money isn’t as easy to access, so after a few years of constant contributions and no withdrawals people are surprised at how much they have saved and see that as money that can be used for other things.

So, if you can manage to get by saving automatically in your retirement plan, you can just as easily set up an automatic savings plan with a savings account. The best thing to do is to open up a high-yield online savings account at an online bank. The rates are probably better than you’ll get at the bank, and the money will physically be separated from your other cash. Then, all you have to do is establish a regular and automatic transfer to fund the account. Maybe you set the transfer up for payday so you don’t even miss the money. Whatever you do, it has to be automatic and require little action from you. If you have to force yourself to remember to make a deposit every two weeks we know how long that will last.

Loans Should Be Your Last Resort

If your plan allows you to take a loan it should be treated as a last resort. Some people argue that taking a 401k loan isn’t all that bad of an idea because it is your money and you are simply paying yourself back the interest. While that is true, you are still hurting yourself over the long run. Money that you take out of your plan can no longer earn interest or see capital gains. For some loans this could be a period of five years of foregone compounding interest. Second, most people who take a loan end up stopping their regular contributions so that they can make the loan payments. This just compounds the problem of foregone gains and what is even worse are those who end up forgetting to begin contributing again once the loan has been repaid.

Another thing to consider are the tax consequences on the loan. Money you borrow from your plan is pre-tax money, but your loan payments are from after-tax dollars.  This means you are effectively going to be taxed twice on some of the money that you borrowed. If that isn’t a raw deal I don’t know what is. Finally, in the event you default on your loan because you change jobs and stop making loan payments the IRS will treat that as a premature withdrawal resulting in taxes owed on the distribution with a 10% penalty on top if you were under the age of 59 and a half. You say to yourself it won’t happen, but I have seen people take out $10,000 loans only to find themselves out of work a month later, fail to repay the loan in time, and get hammered with a $10,000 early distribution and all of the taxes that go with it.

Check to See if Your Employer Offers an After-Tax Retirement Account or Christmas Club

If you find it difficult to save money the traditional way and want to avoid the pitfalls of tapping into your qualified retirement account there may be another option available to you in the form of an after-tax portion of your 401(k) or 403(b). Some employers actually offer the option to also contribute after-tax dollars into your retirement account, either within your current plan or through a separate account like a Christmas Club program.

The benefits of doing this are that you can begin saving money easily through payroll deduction just like your current retirement plan and yet you have access to 100% of this money without needing to take a loan or worry about IRS early withdrawal penalties. While you won’t receive the tax benefits of a qualified plan you can at least create a cushion of money that is available without excess penalties or taxes. Most plans allow this money to go into a savings type account or in some sort of fixed fund so your money is usually not at risk.

About the Author: Jeremy is a retirement planning specialist and founder of Generation X Finance and the guide to Financial Planning at About.com. To learn more, follow Jeremy on Twitter.

Don’t Treat Your 401(k) Like a Savings Account

There has been increasing discussion lately about new ways to help lower income employees who may not have access to more traditional retirement savings to begin saving for retirement. We already have a number of retirement vehicles available for most people, but there are still millions of people who simply don’t save anything for retirement. One of the less talked about ideas is the automatic IRA. Would this new savings product really help level the playing field?

I have not really given these new IRAs much thought until I saw a very brief piece in an old issue of Newsweek. Jane Bryant Quinn addresses the topic with a fairly hasty comment:

Funny–We pay a bundle to the rich to get them to save more money, but we pay almost nothing to the poor. When I say “pay,” I’m talking about the tax breaks offered for savings in retirement plans…the fatter your earnings, the bigger the government subsidy (deductions are always worth more in higher tax brackets).

Right away I see the obvious argument that yes, clearly people who make more money have to pay more taxes, so any tax breaks they receive will have a greater benefit than those who don’t make much money and are paying little or no taxes. She goes on to criticize the fact that people who earn more receive a benefit from saving whereas lower earners receive nothing. She claims that only the well-to-do are able to save for retirement and receive investment advice. It is a “privileged realm” she calls it.

Quinn’s article was before the new Obama administration’s new proposal which throws another wrench into the mix by defaulting to a Roth IRA as the automatic enrollment vehicle. Now there’s little tax break up front but a tax break in the future. For lower income individuals I think they would see more value of an immediate tax break. A Roth still probably makes more sense for them financially, but the idea is to encourage people to save, period. If they can’t envision the tax break 30 years down the road they may see little benefit to contributing at all, and the whole premise of the automatic IRA has been wasted.

Here’s how the automatic IRA would work in a nutshell:

• Employers without retirement plans and have 10 or more employees and have been in business for at least two years would be required to make the new IRAs available.
• Workers could contribute on a percentage or fixed dollar amount basis just like the 401(k) counterpart directly through payroll deduction, but the automatic enrollment would default to 3%.
• Employers would have no obligations to this account, no requirement for matching money or any liability.
• They would receive a small tax credit to offset the start-up costs.

So the goal is to get lower income employees to save right? I guess if you’re creating an opt-out plan instead of an opt-in plan you will get a lot of people to enroll and never opt out. It could be just due to apathy, but at least there would be people saving who otherwise might not be. But there is one issue that bothers me, and that’s the details around liability and fiduciary duty.

If the employer isn’t responsible, who is? Who do they select for the IRA provider? Will the government select a dedicated investment provider? Will they be responsible? No. Remember, these are Individual Retirement Accounts. Everything falls on the individual for making decisions. Who is going to provide them with investment advice? Who is going to help them understand the importance of saving? Who is going to guide them when an employee gets fired or quits their job and wants to cash out all this “found money” they now have access to? And what about help with roll overs? I’m sure a lot of employers would love to wash their hands of any fiduciary responsibility, but this isn’t doing the common employee any favors.

A Good Idea on Paper

On paper this idea sounds great. You provide an easy way for employees to make contributions to an IRA directly through payroll deduction. Why wouldn’t that help people save? Well, I think it would help a few, but it is taking on the problem of our inability for people with lower incomes to save in the wrong way.

I’ve worked with retirement plans and my sole job was to educate employees and encourage them to sign up to the employer sponsored plan. The biggest problem I see is that even with a very generous company match, institutional funds with very low fees and a dedicated investment representative on-site 5 days a week the lower income employees still generally don’t enroll. If you can’t attract low income employees with a 100% match and professional investment advice that the high-paid executives in the same company are utilizing how on Earth will you ever get these people to stay enrolled in an IRA that has no match and comes with virtually no guidance?

We still don’t have standardized automatic 401(k) enrollment, which would help millions more people and is an infrastructure that is already in place, so why don’t we start there?

The Real Problem

If companies providing these so-called “privileged” retirement accounts aren’t even able to enroll their lower income employees I just don’t see how the automatic IRA would be any different other than making it an opt-out account. The real problem is that these employees are generally just able to make ends meet and don’t think they can afford to save. In some cases that may be true. Just because their employer lets them save easily and automatically doesn’t mean they will by any means. Some may obviously not realize they are saving or never get around to opting out, but for people who are literally living on every last penny of their paycheck will likely just opt out so they can get more money, especially if they aren’t seeing any financial incentive for saving.

The real way to get lower income workers to save is to give them free money. Those earning more money obviously get a nice tax deduction by saving in pre-tax retirement accounts, but when you have someone that isn’t paying any tax as it is there’s not much incentive. That’s where the saver’s tax credit comes in. This is a credit for those those who contribute to an retirement account with low incomes. Again, this is a great incentive for lower income workers, yet very few actually take advantage of it. It’s a tax break specifically for the working poor and it usually goes to waste. At least if the IRA became an automatic enrollment you could find a way to show these savers how much of a credit they would receive in order to encourage them to stay enrolled, but I usually find that trying to manipulate financial behaviors of those who make little money is not very effective.

You can decide for yourself, but while the thought of an automatic IRA sounds like it would help these people save I think it is only a tiny improvement for this situation. Much more has to be done in the way of educating people, and for those who truly do not make enough money to save I don’t see what can be done to encourage them to save with a plan like this. The majority of employers already offer a retirement plan and most companies struggle to get employee participation over 70%. So, why not start with automatic 401(k) enrollment? I wish I had the solution to the problem, but I don’t. I just don’t think a plan like this is ultimately very helpful or addresses the real problems.

About the Author: Jeremy is a retirement planning specialist and founder of Generation X Finance and the guide to Financial Planning at About.com. To learn more, follow Jeremy on Twitter.

Are Automatic IRAs the Answer for Low Income Workers Saving for Retirement?

Have you heard of The American Workers, State and Business Relief Bill of 2010 that’s been floating through Congress this year? Don’t worry, you’re not alone. It hasn’t received much press, but there was one little tidbit that caught my attention since it has to do with Roth 401(k)s and conversions. The idea is to make it easier for 401(k) plan participants to be able to convert their pre-tax contributions to a Roth 401(k) within their existing plan. Sounds good, right?

The bill would authorize a 401(k) plan to allow plan participants experiencing a distributable event to directly roll over the distribution to a Roth 401(k) account maintained under the 401(k) plan for the benefit of the individual to whom the distribution is made. The provision would effectively keep the participant’s money in the plan, thereby potentially reducing “leakage” from the participant’s account.

You Still Need a Distributable Event

This is where the bill falls flat. In order to take advantage of a Roth conversion you still need a distributable event. This means you need to terminate employment, retire, and so on before you can do this. The problem is that these distributable events already allow you take your money out of the plan and do what you want with it, either roll it into a Traditional IRA, convert to a Roth IRA, cash some out, etc.

Usually when people have a distributable event the first thing they want to do is roll over their 401(k) so they can take more control over their money. All this bill is doing is making it easier for someone with a distributable event to obtain Roth status by keeping the funds with the 401(k) provider. How does this help the investor? Seems to me it’s only helping the plan providers and fund companies by making it easier for them to retain assets.

Not Many Plans Will Be Able to Take Advantage

Finally, according to the bill this Roth conversion provision is going to basically be limited to 401(k)s that already have a Roth account. I don’t know the stats, but I’m fairly certain that Roth 401(k)s are quite uncommon as it is, so the vast majority of people will not have access to this new rule.

A plan that does not otherwise maintain a designated Roth program may not establish a designated Roth account solely to accept rollover contributions. The distribution to be rolled over to the Roth 401(k) must be otherwise allowed under the plan. Thus, distributions subject to restriction (i.e., in-service distributions and other pre-retirement age distributions) may not be rolled over to the Roth account.

A plan must be amended (within a prescribed remedial amendment period) in order to allow for the rollover of 401(k) funds to the Roth 401(k). However, a 401(k) plan that includes a Roth program is not required to allow employees (and surviving spouses) to execute the Roth conversion.

If I understand this correctly, the bill says the conversions are only allowed by 401(k) plans that have an existing Roth account option, and even if they do they are not required to allow the conversion. I have to wonder just how many plans are even going to be bothered with the trouble of amending their plan to take advantage of the changes.

So, What’s the Point?

When I see legislation like this I have to just scratch my head and wonder what the point of it is. If you’re selling it as a way to help investors and give them more opportunities to take advantage of the tax-free benefits of a Roth why is it so limited that hardly anyone will actually be able to do it? Not only that, but why limit it to distributable events and actually create a mechanism for fund companies and plan sponsors to retain assets instead? That’s not helping investors, but the already expensive funds that are making a lot off of the fees participants are paying.

So, what’s your take on this? Does this Roth conversion part of the bill have any merit or is it all just fluff?

About the Author: Jeremy is a retirement planning specialist and founder of Generation X Finance and the guide to Financial Planning at About.com. To learn more, follow Jeremy on Twitter.

The American Workers, State, and Business Relief Bill of 2010 to Expand Roth 401(k) Conversions

The 401k Loan May Have Benefits, but it Isn’t Without Pitfalls

Roughly 75% of 401(k) plans have a loan provision. This is good news for participants who find themselves in a bind and need quick access to some cash, but it also potentially puts a lot of retirement nest eggs at risk. In fact, about 30% of employees who have the ability to take a loan from their 401(k) plan have done so and currently have an outstanding loan balance. This number picked up a bit during the economic downturn as people found themselves in difficult situations and in need of a little extra money.

In an ideal world we’d leave our retirement plans alone and rely on our emergency fund in a time of need. But let’s face it, life happens. As much as we try to plan ahead and put money aside for that very reason there are times when that just isn’t possible or those funds aren’t sufficient to cover a major crisis. So, having the ability to tap into your 401(k) a little early may be your saving grace. Unfortunately, it isn’t all sunshine and rainbows. Taking a loan against your 401(k) may have devastating consequences if you’re not careful and the decision to borrow from your retirement nest egg should not be taken lightly.

401k Loan Basics

While each plan may set their own specific loan features and restrictions there are a number of similarities. Even so, if you are considering a loan, be sure to check with your plan provider to see what the requirements are for you.

• Most plans have a minimum loan amount which is often $500 or $1,000. The good news is that this keeps people from taking small and frequent loans for things they can probably find the cash for elsewhere, but it also means you may need some time to repay the loan if it’s more than you actually need.
• Plans typically allow you to borrow up to 50% of your vested balance up to $50,000. Keep in mind that not all plans will allow you to borrow from the vested company match and it may restrict you to your personal vested balance. On the other hand, the available vested balance typically does include amounts rolled over into the 401(k) from an outside account.
• Personal loans have a maximum repayment term of five years, but most plans also allow home loans to be taken for the purchase of a new primary residence. Additional documentation may be required to prove the home purchase, but those loans generally have a 15-year term.
• In most cases your loan must be paid with equal installments taken directly from your paycheck over the life of the loan. Once the loan has been issued you usually can’t change the payment terms, although some plans do allow you to pay off the loan in full early.
• The interest rate is often set as the prime rate plus 1%. The loans use a fixed rate and will be set on the day the loan is issued.
• Loan origination fees may exist and you can expect to pay anywhere from $25 to $100 just to process the loan.
• Loans proceeds are not taxed at the time of the distribution, but would be taxed in the event of a default.

The Advantages of a 401(k) Loan

Don’t get me wrong, there are far worse things you can do in a time of need than borrow some money from your retirement account. Racking up credit card bills, getting your vehicle repossessed, home foreclosed upon, or resorting to payday loans are very bad alternatives. So, there are some situations in which a 401(k) loan has an advantage.

One of the best benefits is that there’s very little paperwork to fill out and most loans are issued regardless of your needs. With many plans it can be as easy as logging into your account online and clicking a few buttons to have a loan issued. It can then be sent in a few days via check or possibly even deposited directly into your checking account. And unless you’re requesting a loan for the purchase of a home, most plans don’t care why you’re asking for the money and you are under no obligation to tell them. Try getting a loan at the bank without filling out a mountain of paperwork or running a credit check. It won’t happen, so because of this simplicity the 401(k) loan has an advantage.

Let’s talk about interest. When you borrow money from a bank or charge something on a credit card you need to repay the loan plus interest. In these cases you pay the bank the interest. So, you may need to borrow $2,000 but after all said and done you may have shelled out $3,000 to pay off the balance. The bank just made off with $1,000 of your money. With a 401(k) loan you pay yourself the interest. If you borrow $2,000 from your account and interest charges over the life of the loan totaled $1,000 you actually put that extra $1,000 back into your 401(k). Keep in mind that some of that money was paid back in with after-tax money, but the net result is far better than giving those finance charges to a bank or credit card company.

The Disadvantages of a 401(k) Loan

While a 401(k) loan clearly has some advantages over traditional borrowing, let’s not forget that there are plenty of disadvantages that should have you thinking twice before borrowing from your retirement nest egg.

• Don’t ignore fees. These loans usually aren’t free, and as mentioned above there is typically a loan origination fee of anywhere up to $100. In addition, there may be an annual maintenance fee. If you are borrowing $1,000 and they charge you a $75 origination fee that’s 7.5% of the loan. If there’s an additional $25 annual maintenance fee and you require three years to repay the loan you just spent another 7.5%. That $1,000 loan that seemed like a good idea actually cost you $150 in fees, or 15%.
• If you default on your loan it won’t hurt your credit score, but it could be even more damaging to your finances. Defaults are treated as a distribution, which means your money is then taxed and you must also pay the 10% early withdrawal penalty if you’re under age 59.5. If you already spent the loan proceeds and wasn’t planning on having a major taxable event this could lead to big problems come April 15th.
• There’s also a significant opportunity cost when taking a loan. If you pull money out of your retirement account you’re pulling money out of the market and/or safe fixed accounts as well as temporarily eliminating the tax-deferred growth that money would have otherwise been earning.
• The market can also move between when you take a loan and when you repay it. If you’re unfortunate enough to take a loan while the market is at a bottom and then begins going back up you’ve done even more damage to your retirement account as you’ve cashed out some money at a low point and will be buying back in over the coming years while the market is high. Of course the opposite is also true, but this is a game you shouldn’t be playing with your nest egg.
• You are also repaying part of the loan with money that has already been taxed. As you know, one of the benefits of contributing to a 401(k) is the fact that the money is invested pre-tax. When you take a loan you aren’t taxed on the proceeds, but the money used to repay the loan has already been taxed so your additional interest going into the account will effectively be taxed twice–at the time of contribution and again when eventually withdrawn from the account in retirement.

Choosing Which Investments to Borrow Against

Some loans do not give you a choice and they will simply take an equal portion out of each investment to cover the loan proceeds. This means if you have 80% in stocks and 20% in a fixed account and request a $10,000 loan they will pull $8,000 from your stock holdings and 20% from your fixed account. If you don’t have a say in this matter there isn’t much you can do.

If you can choose where to pull the money from the loan there is a strategy you can use that may minimize the negative impact on your investments. If at all possible, you should consider pulling your loan from the fixed income portion of your portfolio. This is especially true in a low rate environment where your fixed income allocation may be earning just a few percent each year. The thing about this strategy is that you know exactly what your opportunity cost is if you pull money out of a fixed account.

If your fixed account is earning 2.5% currently you know that if you borrow $10,000 from that part of your portfolio you’re only giving up a 2.5% return on that money in the first year, and probably not much more in subsequent years. On a one year loan that’s like giving up $250. When you factor in the extra money you pay into your 401(k) while repaying the loan you’ll probably still come out ahead. Compare that to borrowing from the stock portion of your portfolio. Here, the opportunity cost cannot be determined until after the fact. What happens if you pull $10,000 out of your stock funds for the loan and the market sees a 12% gain that first year? Not that you could have predicted it, but that loan just cost you $1,200. Sure, one can argue that the market could have gone down 12% and you saved yourself from losing money, but there’s no way to predict that ahead of time. A calculated risk is better than rolling the dice.

The Dangers of Default

While it was already mentioned earlier, it is worth discussing the dangers of defaulting on your loan one more time. As long as you’re an active employee with the company that maintains your 401(k) you have nothing to worry about since your loan payments will be made via payroll deduction. But what happens if you quit your job or get fired? In most cases, that means you only have 60 days to pay the outstanding balance of your loan before you default. When you default, your employer then reports to the IRS that you were unable to pay the loan, and they will then treat the defaulted amount as a hardship distribution. As a distribution you’ll then be required to pay taxes on the outstanding balance plus an additional 10% if you’re under age 59.5.

Let’s think about that for a minute. Say you borrow $10,000 from your 401(k) and you get laid off eight months later. Maybe you’ve repaid about $2,000 of the balance so far, but that means there’s still $8,000 that needs to be paid. You’re now given just 60 days to come up with $8,000 in cash or else it will be treated as a default. If you were in a difficult financial position to begin with that required you to take the loan do you really think coming up with that cash is going to be possible?

Assuming you can’t repay the loan in full and you do default that $8,000 will then get reported to the IRS as a early distribution from your retirement plan. So, come tax time you’re going to owe regular taxes on that amount plus the 10% penalty if you’re taking the distribution early. If you’re at the 25% tax rate that means your federal tax liability will be somewhere around $2,200.  Again, if you’re experiencing financial difficulties which made you take out the loan in the first place what kind of trouble might this put you in with the IRS?

Finally, don’t forget that the defaulted amount is treated as taxable income, which increases your total taxable income that determines things like tax rates and phase out limits for other tax deductions and credits. If this distribution puts you over the limit for claiming additional tax deductions or credits you’re used to it could create a massive tax liability. As you can see, defaulting on your 401(k) loan may have far-reaching effects.

In rare cases, some plans will give you the option to continue making your loan payments after termination via a coupon book, but even that doesn’t come without its drawbacks. Making these payments may keep you from going into default, but as long as there is a loan balance outstanding you’ll be unable to roll over your 401(k) to an IRA or another qualified retirement plan. This means you’re still tied to your old 401(k) even after termination until your loan is repaid or you default.

Other Options Before Taking a Loan

Borrowing against your 401(k) may be better than some alternatives, but as you can see it’s by far the best option if not done properly. And some things are completely out of your control such as losing your job after taking out the loan. We’d all like to think we’ll remain employed, but if that doesn’t happen you’re then on the hook for the remaining loan balance. So, before taking that loan there are a few things you may consider first.

Above all else, you need to create an emergency fund. If you haven’t started one already, just start small and put a little money away each week. It might not be a lot, but after you have a few hundred saved up it is going to help provide you with a little safety net that can keep you from having to resort to high-interest credit cards or taking a 401(k) loan for just a small and temporary emergency. I’d recommend opening a high-interest savings account online that will put your money to work, won’t burden you with fees, and keeps the money just out of arm’s reach so you don’t spend it unless you really need it.

You should also consider opening a Roth IRA. Not only is this a good idea for generating tax-free income in retirement, but these accounts also provide you a little more flexibility and let you take control of your money. One major benefit of the Roth IRA is that you are allowed to take your contributions out at any time without being taxed or paying a penalty. It still has the drawback of opportunity cost, but you have the option to take the money out of an IRA as you need it. No loan fees, no interest to repay, and you can work with your tax preparer or CPA to minimize the tax burden.

Finally, don’t underestimate the benefits of a 0% APR or low-interest credit card in a pinch. This isn’t recommended if you’re already up to your eyeballs in debt, but having a credit card on hand can still be better than taking a loan from your retirement plan. For example, say your hot water heater or other major appliance breaks and you need to spend $1,000 to get everything back to normal. You might take a 401(k) loan, but that will likely cost you between $50-$100 in fees plus any lost opportunity if you pull money out of an investment that increases in value. Compare that to a 0% credit card. You could put the $1,000 on there and possibly have up to a year to repay it without incurring a single fee or penny of interest. Even if you do have an interest rate of say 15%, if you schedule regular payments to have it paid off in a timely manner it may end up still costing less than taking the loan.

About the Author: Jeremy is a retirement planning specialist and founder of Generation X Finance and the guide to Financial Planning at About.com. To learn more, follow Jeremy on Twitter.

The 401k Loan: How to Borrow Money From Your Retirement Plan and What You Need to Know

Social Security Benefits and You

Social Security is a sore topic for many people. The system is flawed, it’s in significant financial trouble, and the younger generations aren’t expecting to see a penny from it when they retire. While it’s true that Social Security has its problems, it still pays out benefits to tens of millions of Americans each year and will continue to pay out benefits for years to come. How the system and benefits may change in the future is anyone’s guess, but as it stands now it’s still a key source of retirement income for many.

There’s some bad news for younger generations, which include many in Generation X. Unfortunately, younger workers have a great deal to worry about. Even though their parents’ and grandparents’ benefits are safe, theirs are not. Any worker born after 1974 will reach full retirement age after the trust fund is exhausted. Unless Congress acts soon, younger workers can look forward to paying full Social Security taxes throughout their careers but only receiving 78 percent or less of the benefits that have been promised to them. In addition, they will have to repay the Social Security trust fund, an expense that will total almost $6 trillion by the time the trust fund is exhausted in 2041.

More Than Just Retirement

When most people think of Social Security it simply means a monthly retirement check. While that may make up the bulk of the benefits, Social Security covers much more. Social Security as a whole consists of:

• Old-Age Benefits
• Survivor’s Benefits
• Disability Benefits
• Medicare

The old-age benefits are what most people consider retirement benefits. This is the monthly check a retiree receives once they are age 62 or older. As important as this is, you also need to consider the survivor benefits, disability benefits, and Medicare. Even though Medicare is technically part of the Social Security program, that’s such a big topic it deserves its own post. So for now we’re going to focus on the other three benefits.

Normal Retirement Age (NRA)

The normal retirement age is the age at which full retirement benefits are available. The NRA doesn’t remain constant and those born between 1937 and 1960 will have different normal retirement ages. For those of us born after 1960 it’s pretty easy to remember that our NRA is a flat 67. Keep in mind that although this information currently applies, there could be changes made that affect you in the future as the government looks for ways to solve the Social Security funding problems. But for now, here is the current Social Security NRA breakdown with some examples of how much benefits are reduced by taking an early retirement at age 62.
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Early Retirement

Those who are eligible for a Social Security old-age benefit can begin receiving them at age 62, but with a reduction from what would otherwise be received at NRA. The current formula for figuring the benefit reduction is five-ninths of 1% per month for each of the first 36 months prior to normal retirement age, plus five-twelfths of 1% for each month in excess of 36 months. This reduced level of payments continues for the life of an early retiree. Benefits do not increase to 100% when the retiree reaches NRA.

Could that calculation be any more confusing? Odd fractions of a single percent for a certain number of months. It sounds like a math question that would be on the SAT. Don’t worry about calculating it yourself. If you really want to know you can use the Social Security Administration’s online benefit calculator.

Late Retirement

Someone who does not want to start receiving benefits at their Social Security NRA but continues working can earn delayed retirement credits, which can eventually increase the worker’s benefit by up to 8% per year. Keep in mind the worker’s spouse will not see any increase in their benefits as a result. The decision to delay receiving benefits can be complicated and one must take into account many different factors such as the amount of the benefit, other sources of income, and life expectancy.

Spousal Benefits

In addition to receiving benefits as a Social Security recipient the spouse of a recipient is also entitled to 50% of their primary insurance amount (PIA), subject to a family maximum, as long as the spouse is of normal retirement age. If the spouse is entitled to a larger Social Security benefit of their own, they will receive that benefit and no additional spousal benefit will be paid. Also, the family maximum does not reduce the benefit if both spouses receive their own Social Security benefits. Instead, the family maximum applies when one or more dependents receive benefits based upon the earnings record of one worker.

Earnings Limitation

The Senior Citizens’ Freedom to Work Act of 2000 eliminated the retirement earnings test for people who have attained Social Security’s normal retirement age. Excess earned income by Social Security beneficiaries who are under Social Security’s NRA results in a partial or full loss of benefits, depending on the age of the person, the amount of their benefit, and the amount of earned income.  For the sake of this test earned income generally includes wages and salary. Investment income is not included in this definition.

For people attaining NRA after 2010, the annual exempt amount in 2010 is $14,160. For people attaining NRA in 2010, the annual exempt amount is $37,680. This higher exempt amount applies only to earnings made in months prior to the month of NRA attainment. $1 in benefits is withheld for every $2 of earnings in excess of the lower exempt amount. $1 in benefits is withheld for every $3 of earnings in excess of the higher exempt amount. Earnings in or after the month you reach NRA do not count toward the retirement test.

Taxation of Benefits

As if it wasn’t bad enough that Social Security benefits are rather small, many people are surprised to find that some or all of their Social Security benefits may be taxed. Whether or not your benefits are taxed are a result of two things:

• The total amount of Social Security benefits received, and
• The amount of the recipient’s other income

The higher the amount of Social Security benefits received during the tax year and the higher the income from other sources (even including tax-exempt income), the more likely it is that your benefits will have to include a portion of Social Security benefits as taxable income. The portion is defined by a set of calculations that, in essence, determines how much of the taxpayer’s income is in excess of certain thresholds. Because tax-exempt income is one factor in this calculation it may have an ironic effect of pushing some of the benefits over the thresholds to a point where they are subject to taxation.

If a taxpayer’s modified adjusted gross income (MAGI) for the tax year plus one-half of Social Security benefits received (let’s call this provisional income) during the tax year exceed the base amount, then according to the general rule the lesser of the following two amounts must be included in gross income:

1. one-half of the Social Security benefits received during the year, or
2. one-half of the amount by which the provisional income exceeds the base amount

The base amount is determined by the recipient’s filing status. Notwithstanding the preceding general rule, if a taxpayer’s provisional income exceeds certain levels, more than one-half of their Social Security benefits must be included in gross income.

Are you confused yet? Don’t worry, it is kind of complicated. This is a situation where it certainly makes sense to get professional tax advice. But if you have plenty of time before collecting Social Security, don’t fret about it. Just realize that there are tax considerations when you reach that point.

Indexing for Inflation

Social Security benefits are indexed annually to the cost of living. This is one bright spot the current system. The idea is that your Social Security benefits will increase alongside everything else. The bad news is that not all things increase in price at the same rate. Your benefits may generally increase according to some things, but it may fall well short of covering for the price increases in other areas. So, it’s good that benefits will generally increase over time, but don’t be fooled in thinking that the increases will easily cover everything as you age through retirement.

What You Need to Know

Fortunately (or unfortunately, depending on how you look at it), Social Security is largely out of our hands. During your working years you simply have to work and pay into the system. Little can be done in terms of increasing your benefit other than make more money so that you pay more into the system or work longer. Where the real decisions come into play are those years leading up to retirement. You’re then faced with choices such as deciding if you want to receive your benefits early, wait until NRA, or keep working longer and building up a larger benefit. In addition, you then need to begin thinking about your other income and how taxes will affect your benefits.

Whether or not Social Security will be around for the younger generation is debatable, but the best thing you can do is to plan for retirement as if it won’t be. This means putting money into your 401(k), opening an IRA, and saving what you can for retirement so that you will have something to live off of in the event Social Security is nowhere to be found. In reality, there will probably always be some sort of benefit to protect our retired individuals, but the amount you receive will almost certainly not provide you with the retirement that you want.

About the Author: Jeremy is a retirement planning specialist and founder of Generation X Finance and the guide to Financial Planning at About.com. To learn more, follow Jeremy on Twitter.

Social Security – What You Need to Know About Benefits, Coverage, and Eligibility