Should I borrow from my 401(k) plan? When it Works

Borrowing from a 401(k) plan can make sense when cash is needed for a serious SHORT-TERM liquidity need.  “Short-term” is roughly a year or less.  “Serious liquidity need” does NOT include a sudden yearning for a flat-screen TV.

The best time to take a loan is when the stock market might be vulnerable or weakening (such as during recessions). Coincidentally, many people find that they need short-term liquidity during such periods.

When a borrower takes a 401(k) loan for appropriate amounts of money for the right SHORT-TERM reasons, these loans can be simple, convenient and low-cost. Before taking any loan, a borrower should always have a clear plan in mind for repaying these amounts on schedule or earlier.

Posted in Tips

Should I borrow from my 401(k) plan? Purchase a Primary Residence

Regulations require 401(k) plan loans to be repaid on an amortizing basis over not more than five years, unless the loan is used to purchase a primary residence. Longer payback periods are allowed for these particular loans.

Evaluating the use of 401(k) plan loans for home purchases is complex, and plan loans may not be as attractive as mortgage loans. Plan loans do not offer tax deductions for interest payments as do most types of mortgages, home-equity loans and home-equity lines of credit. The impact on retirement progress for a loan paid back over many years can be significant. It is best to consult personal tax and financial advisors before taking such loans.

Posted in Tips

Should I borrow from my 401(k) plan? The upside

Sometimes it may make sense to borrow from your 401(k) plan.  The upsides are:

–401(k) loans can be a quick, simple, lowest-cost way to get cash needed.

–In most 401(k) plans, requesting a loan requires no lengthy applications or credit checks nor does it affect credit rating.

–If the loan is short-term loan and paid back on schedule, it usually will have little impact on retirement savings progress. In some cases, it can have a positive impact.

–Borrowers avoid any investment losses on this money.  A loan can be neutral, or even positive, in sideways or down markets.  If the interest paid in exceeds any lost investment earnings, taking a 401(k) loan actually can increase retirement progress.

–Receiving a loan is not a taxable event unless the loan limits and repayment rules are violated.

–Many 401(k)s allow loan requests to be made through a website with the amount received in a few days with total privacy.

–Some plans now offer a debit card through which multiple loans can be made instantly in small amounts.

–Most 401(k) loans can be repaid faster than the loan schedule with no prepayment penalty.

— Most plans allow loan repayments to be made through payroll deductions (using after-tax dollars).

Posted in Tips

Should I borrow from my 401(k) plan? The Pitfalls

The pitfalls of borrowing from a 401(k) plan are the following opportunity costs:

–Borrowers lose any positive earnings that would have been produced by those investments in the market.  In other words, the impact is negative in strong ‘up’ markets.

–Many borrowers either stop contributing to their 401(k) or reduce their contribution for the duration of their loan, so they also miss out on the company match.

–Unless the money is repaid quickly, the loan represents a permanent setback to retirement planning.

–Borrowers lose out on tax efficiency. Loans are repaid with after-tax dollars. In other words, someone in the 25% tax bracket would need to earn $125 to repay $100 of the loan. The 401(k) money is taxed again when withdrawn in retirement, so those who take out a loan are subjected to double taxation.

— Double taxation of 401(k) loan interest becomes a meaningful cost when large amounts are borrowed and then repaid over multiyear periods.

–The first 401(k) loan can act as a “gateway” to serial borrowing.

–The interest borrowers save by choosing a 401(k) loan over a bank loan still might not be enough to make up for the loss of earnings from taking the money out of the 401(k) account.

–There may be a loan origination or administration fee to tap into a borrower’s own 401(k) money.

–A 401(k) loan can become a serious problem without having the intent or ability to repay it on schedule. In this case, the unpaid loan balance is treated similarly to a hardship withdrawal with negative tax consequences and perhaps also an unfavorable impact on plan participation rights.

Posted in Tips

Should I borrow from my 401(k) plan? The Basics

According to a study by the Employee Benefits Research Institute (EBRI), nearly 20% of all 401(k) participants had plan loans outstanding. This statistic has held true since the early 2000s.  These loans can be appropriate in some situations.  However, borrowing from a 401(k) plan exacts a big opportunity cost.  Let’s first look at what borrowing from a 401(k) plan means and how it works.

Technically, 401(k) loans are more accurately described as the ability to access a portion of retirement plan money on a tax-free basis. A borrower then must repay the money accessed to restore the 401(k) plan to its original state.

Borrowers specify the investment account(s) from which to borrow money. Those investments are liquidated for the duration of the loan.

As loan repayments are made to the 401(k) account, they usually are allocated back into the investments originally chosen. The account is repaid more than what was borrowed from it, and the difference is called interest.

Any interest charged on the outstanding loan balance is repaid by the participant into the participant’s own 401(k) account, so technically this is a transfer from one pocket to another, not a borrowing cost.

Regulations specify a five-year amortizing repayment schedule.  Repayment plan statements show credits to the loan account and remaining principal balance, just like a regular bank loan statement.

If a 401(k) is invested in stocks, the impact of the loan on retirement progress depends on the market environment.

Posted in Tips

Ever-Changing Tax Law

There were about 4,430 changes to the tax code from 2001 through 2010, an average of more than one a day.

Posted in IRS

Charitable Donations of Services

Americans have used charitable donations to lower their taxable income since World War I when the federal government introduced the charitable tax deduction.

Not all nonprofit organizations qualify as beneficiaries for tax-lowering gifts, nor do all gifts to eligible charities qualify. Knowing what you can and can’t claim helps you maximize the potential tax savings that the charitable tax deduction offers.

Charitable Donations of services:

If you donate your services to a 501(c)(3) organization, you have no deduction whatsoever. Doesn’t seem fair, does it? Unfortunately the IRS places no value on your time or expertise. While you are not allowed to deduct the value of your time at the rate you would normally charge, you can still deduct mileage to and from the charitable organization and the cost of all supplies and materials used in the performance of the service.

By the same token, if you donate your services to an individual who needs help, you are not be able to write off the donation. This is because the IRS does not allow the deduction of gifts to individuals.

Posted in Deductions

Charitable Donations of Money or Goods

Americans have used charitable donations to lower their taxable income since World War I when the federal government introduced the charitable tax deduction.

Not all nonprofit organizations qualify as beneficiaries for tax-lowering gifts, nor do all gifts to eligible charities qualify. Knowing what you can and can’t claim helps you maximize the potential tax savings that the charitable tax deduction offers.

Charitable Donations of money or goods:

Businesses in general are not allowed to deduct charitable contributions; however, payments to a charitable organization may be deducted as an expense to the business.

For example: If the business received ad space or marketing for the payment, it may be deducted as an advertising business expense.   Another example: The business paid $20 to a church for an ad in a program for a concert it is sponsoring. The payment is not a charitable contribution but rather a business advertising expense.  A third example:  The business made a $100,000 donation to a committee organized by the Chamber of Commerce to bring a convention to your city, intended to increase business activity.  The payment is not a charitable contribution but rather a business expense.

If an S-corp makes a charitable contribution, the contribution is not deductible on the S-corp tax return but is instead taken as a deduction by the corporation’s shareholder(s).

For example, you are the sole shareholder of his S-corporation. The corporation’s gross income was $100,000 with deductible expenses totaling $60,000. The corporation also mad $1,000 contribution to a 501(c)(3) charity during the year. That $1,000 contribution is not included in the $60,000 of expenses. Instead, it’s shown on the K-1 you receive from the corporation.  On your personal return, you will claim $40,000 of pass-through income from the corporation ($100,000 income minus $60,000 of expenses). The $1,000 of charitable contributions will be taken as an itemized deduction on your personal return if you itemize.

Why is it like this?

Charitable contributions in an S-corp don’t reduce a shareholder’s AGI; instead the contributions are taken as an itemized deduction. If the shareholder takes the standard deduction instead of itemizing, they receive no tax benefit at all from the charitable contribution.

Posted in Deductions

Teaching Kids About Taxes

“If you are truly serious about preparing your child for the future, don’t teach him to subtract – teach him to deduct.”  Fran Lebowitz

Posted in Quotes

Teaching Kids About Taxes

“The best way to teach your kids about taxes is by eating 30 percent of their ice cream.” Actor and comedian Bill Murray

Posted in Humor