Every 401(k) plan is supposed to serve a specific purpose. It’s a retirement account that can give you a source of income when you leave the workforce. As a result, a 401(k) isn’t technically designed with early withdrawals in mind. However, that doesn’t mean you can’t pull some of the money. If you are wondering whether that’s a smart move, here are the pros and cons of an early 401(k) withdrawal.
The outbreak of COVID-19 across the globe has impacted the stock market, employment rates, and people’s everyday lives in a huge way. Millions of Americans watched their nest eggs disappear. For those nearing retirement, it is enough to send you into a panic. Thankfully, government officials are proposing changes in law during the coronavirus outbreak to help.
Changes in Law During the Coronavirus to Help People
As the virus swept across the world, the stock market collapsed. Because many retirement accounts rely on investments, people watched their savings for their golden years dwindle down to nothing.
Additionally, individuals who have been laid off during this time no longer have an income to contribute to their retirement. There is good news though. Officials are putting some changes in law into place to help.
1. RMDs Will Be Put on Hold
Required minimum distribution (RMD) refers to the minimum amount an investor must withdraw from their account after reaching age 72. This is common with many 401(k) and IRA plans. If you do not take the minimum, a fine will be placed on your account. However, during the coronavirus outbreak, the government has put a hold on minimum required withdrawals.
This will be the case for the entire year. Ed Slott, a certified public accountant, said: “Now, clients can sit out a year and avoid the tax bill on their 2020 RMDs if they wish.”
2. Penalties Are Being Eased
Individuals with IRAs and 401(k) accounts that have been financially impacted by the virus are also able to withdraw up to $100,000 from their retirement account without penalty. Typically if an accountholder withdraws early, they are required to pay a 10% early withdrawal fee.
It is important to note that this only applies to people who have been diagnosed with the coronavirus, been laid off due to the virus, had reduced work hours, or have otherwise been impacted.
3. You Can Get Larger 401(K) Loans
As mentioned in the point above, people with 401(k) accounts are able to take $100,000 out without a penalty. This is more than the typical $50,000 limit for 401(k) loans.
Other retirement plans will only allow you to take out up to a percentage of your balance. These limits will also be lifted for the rest of 2020.
Other Changes in Law and Policy
Policymakers are also pushing to make other changes to help Americans get through this time financially. For instance, Navient, a major federal student loan lender, has waived all interest and allowed borrowers to be granted forbearance until September. This means no payments will be required during this time.
On top of that, many mortgage companies and other businesses are offering payment relief at this time to assist people through the coronavirus outbreak. If you need assistance or are unable to make a payment at this time, the best thing to do is give the company a call and ask what your options are.
Readers, what do you think about the changes in law during the coronavirus outbreak? Are they helping you in any way?
Many people want to make sure that they are financially secure during their golden years. As a result, they stash money away in various retirement savings vehicles. Thus, allowing them to have a nest egg for when they leave the workforce. However, many savers accidentally overlook a critical part of the equation: taxation of retirement vehicles. This can lead to trouble. Particularly if you aren’t prepared for what you’ll owe.
The Taxation of Retirement Vehicles
Taxation levels for retirement accounts vary. Not all sources of retirement income are subject to the same rules. It isn’t uncommon for that to lead to some confusion. Causing some to make unwise choices as they try to plan for retirement.
If you want to plan for retirement successfully. You should understand how various post-retirement income sources can be taxed is critical. Otherwise, you may find yourself with an unexpected federal tax bill at the end of the year that you’ll struggle to pay. Alternatively, you could overestimate your tax burden. This could cause you to make withdrawals or spend differently than you otherwise would. If you want to make sure that you are ready to handle retirement. Here’s a look at how four different retirement vehicles are typically taxed.
1. Social Security
Before 1983, Social Security benefits were universally tax-free. However, that isn’t the case today. While many who receive Social Security income don’t pay taxes on it, others do. If the person’s “provisional income” is high enough. They could owe federal taxes on as much as 85 percent of their Social Security benefits.
According to the IRS, a beneficiary’s provisional income has to be below $25,000 ($32,000 for married couples who file jointly) for their Social Security to go fully untaxed. From $25,000 to $34,000 (or $32,000 to $40,000 for married filing jointly), up to 50 percent of the Social Security benefit is taxable. Once you cross $34,000 ($44,000 for married filing jointly), up to 85 percent is subject to taxation.
2. 401(k)s and Traditional IRAs
Both 401(k) plans and traditional IRAs are tax-deferred. Contributions are potentially deductible the year they are made. Therefore, allowing a person to lower their taxable income by increasing their retirement savings.
However, once it comes time to make withdrawals, it’s tax time. Every withdrawal is taxed based on the person’s ordinary tax rate. This happens regardless of whether the money is from your original contributions, employer-matching funds, or gains.
In many cases, a pension is funded with pre-tax income, so you don’t pay taxes on the contributions. However, like a 401(k) or traditional IRA. You’ll have to pay taxes once you start making withdrawals. In most cases, pensions are taxed by the federal government at your ordinary tax rate.
The only time that may not occur is if there are after-tax pension contributions. When that happens, the pension withdrawals that connect to that money can be tax-free. However, relatively speaking, this is a rare scenario.
4. Roth IRAs
When it comes to long-term tax advantages, Roth IRAs offer a big benefit. The contributions themselves aren’t deductible when they are made, so taxes are paid when during the year that money is earned. However, when it’s time to make qualifying withdrawals during retirement, that cash is probably going to be tax-free, including the value of your account gains.
There are some instances where a person might have to pay taxes on Roth IRA gains withdrawals. First, if you make a withdrawal of any gains before you are 59 ½ years old, you’ll be subject to taxation and early-withdrawal penalties. Second, if your account isn’t at least five years old, you aren’t eligible for tax-free withdrawals until you hit the five-year mark.
Otherwise, once you hit 59 ½ and the account is old enough, you don’t have to worry about taxes on that money. It’s that simple.
Did you consider taxation of retirement vehicles when planning to retire? Why or why not? Share your thoughts in the comments below.
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The Internal Revenue Service (IRS) released updates for 2020 earlier this week. Amongst those updates, the agency announced changes to the retirement contribution limits that will take effect during the 2020 tax year.
Changes to the Retirement Contribution Limits
And, for once, the IRS is giving people a break. Starting in 2020, the IRS has increased the retirement plan contribution limit to $19,500 (up from $19,000). This includes 401(k), 403(b), and 457 plans. Catch up contributions will also be increased from $6,000 to $6,500.
That’s just the basics though. If you’d like to learn more about the ins-and-outs of the changes recently announced, head over to the IRS website. You can also read a quick summary of the changes taking effect in 2020 in the IRS news bulletin.
The best part of the IRS announcing the increase in limits is contributing more to your retirement accounts will help you build wealth. Not to mention, retirement contributions are not typically taxed. Your money will be put to work in the stock market while you effortlessly get ready to retire.
Readers, what do you think about the latest changes to the retirement contribution limits?
The Secure Act recently passed unanimously through the House Ways and Means Committee. It is a small bill in some ways. Nevertheless, it represents the biggest change to private retirement plans that we’ve seen in quite some time. More and more people are reaching retirement age without adequate savings, so it’s important that we take steps like these.
What is the SECURE Act?
The Secure Act is a bill that recently passed through the House Ways and Means Committee. SECURE is actually an acronym. It stands for the Setting Every Community Up for Retirement Enhancement Act of 2019. It’s also known as H.R. 1994.
The primary aim of the bill is to make it easier for people to sign up for 401(k) retirement plans. In particular, it helps ease the difficulty of those working for small businesses to access this crucial component for security in retirement.
3 Ways the Secure Act Helps with Small Business Retirement
If you work for a small business then you might not currently have access to a good 401(k) plan through your employer. The Secure Act should change that. It has three key components to that end:
1. Encourages Benefits
More than anything else, the Secure Act encourages small businesses to offer 401(k) benefits to their employees. Of course, people can get social security after retirement, but it’s not enough to support the average person. Therefore, we each need to have other retirement savings plans. The 401(k) is the most popular of those plans. However, small businesses often don’t offer those benefits. A series of details in the Secure Act should entice small businesses to change that around. Moreover, there are provisions that will make it easier for employees to understand and harness the benefits of these plans.
2. Offers Businesses a Tax Incentive
In order to further motivate small businesses to make those changes, the Secure Act has a built-in incentive. Any small business that creates a 401(k) plan or begins offering automatic enrollment for one may qualify for a brand new tax credit. They’ll get $500 back just for creating that plan, a credit that applies for three years.
Plus, there are a variety of details that make it easier for businesses to offer these plans. For one thing, small businesses are allowed to join together in groups to offer these plans. This makes it easier for the business to deal with their own costs and hassles.
3. Requires Certain Benefits for PT Workers
Of course, like many bills, this one has a carrot and a stick. Hopefully, small businesses will be inspired by the tax incentives to offer 401(k) plans to employees. However, in case they aren’t, some specific new rules are in place. The big one is that any small business that has part-time workers who are long-time employees much allow them to participate in the 401(k) plans that they set up. This is a protection for part-time workers who need retirement income as much as, if not more than, full-time employees.
Will the Secure Act Help You in Your Retirement?
Ultimately, you are responsible for your own retirement savings. If you don’t have a private retirement savings plan, then you should remedy that as quickly as possible. For some people, that’s just a matter of ease of access. Those are the people who will benefit most from the Secure Act. People who are already saving for retirement through 401(k) plans or other means will not likely see any change as a result of this bill. However, those people on the margins, particularly long-term part-time employees, can definitely benefit from what this bill has to offer.
That said, some of the provisions in the bill could benefit anyone interested in saving for retirement through 401(k) plans. Such details include:
- Currently, employers can auto-escalate their employees’ 401(k) contributions to 10% of their pay. The new bill increases that amount to 15% which can mean significantly more retirement savings for those people.
- Graduate students and post-doctoral students will both be able to include their stipends and fellowships as a means for saving for retirement, something that was not previously available.
- Home healthcare workers will also see benefits that allow them to save more than previously allowed.
- Loans based on credit cards will be prohibited, which is important because they tend to ultimately result in less money in the accounts.
- Even though you’ve set that money into a retirement account, you will be able to withdraw some penalty-free if you need money to cover the cost of the birth or adoption of a child. This is an incentive to encourage more young people to start contributing to their own retirement. The earlier you start, the better off you will be.
2 Other Things the Secure Act Does
The thrust of this new bill is all about what it does to help small business employees save for retirement through 401(k) plans. However, there are a couple of extra things in the bill as well. After all, the 401(k) might be the most popular retirement savings plan, but it’s not the only one. Here are two more things that the new bill does:
1. Changes IRA Age Rules
The IRA is another popular retirement plan. The bill has two components that affect it:
- Takes away the maximum age for IRA contributions. You can keep contributing to your IRA for longer. That’s important because people who are working later into retirement can set aside more money. Then when they need their retirement income, there’s more to access.
- Increases the age for required mandatory distributions. It used to be that you had to start taking money out of your IRA by age 70.5. The new bill increases that to age 72. Again, this allows people who are working later into retirement age to benefit more from their IRA.
In addition to working longer, people are living longer. They need that retirement money into their 80s, 90s, and even past age 100. Therefore, these small changes can actually make a big impact for some retirees.
2. Expands 529 Savings Plans
The 529 savings plan isn’t for retirement per se. Instead, it’s tax-friendly savings account for future education costs. If you have children, you should set one up. Oftentimes, parents are looking towards retirement as their kids reach college age, so it does help ease the mind around retirement in that way. In any case, the new expansions from this bill will help some people reap more benefit from 529 savings plans.
Previously, the money in those savings accounts had to be used for college costs. However, the new bill changes that. For one thing, it allows the money to be used for homeschooling and apprenticeships. Perhaps even more powerfully, it allows the money to go towards paying off student loans. With student loan debt so incredibly high these days, that can mean a big change. Therefore, the Secure Act gives parents more reason to start setting aside money in those savings plans.
What’s Next for the Secure Act?
This act passed a critical committee in the House. It goes to the full House floor in May. The bill has a good chance of full Congress approval.
One of the biggest killers for investment performance over time is high fees. It used to be that many mutual funds would charge a fee for buying, an annual fee based on the balance invested, and a fee when the fund is sold. For most investors, those days are thankfully long gone. Vanguard started the push for lower fee funds, and nearly every online broker has followed suit.
But the lowering of fees is mostly seen in taxable and IRA accounts. In the world of 401(k) plans, this is not always the case. Many 401(k) plans still have investments with fees that are three to four times higher than what one would see when investing in an IRA.
Not only do many employees pay a high annual fee on the funds they invest in with their 410(k) plan, they also pay an annual administrative fee. Most people have no idea they are paying such an administrative fee, and many have no idea what the annual fees on their funds are inside their 401(k) plan.
Finding Your Fees
The administrative fee on a 401(k) plan can be difficult to find, which means you would need to ask your Human Resources director or person in charge of the plan for that information. But the annual fund fee, known as the expense ratio, is now easier than ever to find thanks to all of the great financial planning software and tools available to the public. I used WealthTrace’s financial planning application to view the fees on several ETFs.
Not only can I see the expense ratio for each fund, but I can also view the total dollars I pay each year in fees along with the fund turnover. For taxable investment accounts, the turnover can really make a big difference in taxes. The higher the turnover, the more in capital gains one usually pays.
How High 401k Fees Can Crush a Portfolio
Most of us know that investment gains compound over time as more money is reinvested. But fees work the opposite way. They are a negative and therefore compound negatively over time. I looked at a portfolio that has a balance of $700,000. I ran a fee what-if scenario where the annual fees on all investments were increased by 0.5%.
The portfolio value was reduced by over $655,000 over 30 years. This value does not even take into account inflation over that time frame either. The result is in today’s dollar terms. This just shows how even a small increase in fees can have a huge impact on retirement investments. A hit like this can mean that even $1 million might not be enough to retire on.
What You Can Do
If you have an IRA or taxable investments, make sure you are not paying too much in annual fees. Look for the expense ratio for your funds. For most funds that are not actively managed, you should not be paying more than 0.15% per year. Vanguard is usually the best in terms of fund fees so I always recommend starting there.
For 401(k) plans you should look for your expense ratios. Make sure your company offers index funds with fees that are at least below 0.4%. They should also offer a target date retirement fund that reallocated your investments towards a more conservative approach as you get older. These types of funds are great for those who do not want to worry about reallocating their investments over time. The fund does it for you!
You should also ask the person in charge of your 401(k) plan what the administrative fees are. If they are more than 0.5% per year, you should ask if they can change 401(k) providers. The 401(k) provider industry is becoming more competitive, and more and more companies are moving to Vanguard, which as mentioned earlier, is always a great place to start when trying to lower fees.
Lastly, it is a good idea to roll over a 401(k) to an IRA if you leave a company or retire. This way you will have access to thousands of funds with lower fees. You also will get rid of any administrative fee you are currently paying.