Are 401(k) Loans A Good Solution?

According to Bankrate.com, 19% of Americans tapped their retirement savings last year to cover the cost of an emergency. Most people need to borrow money at some point, but is borrowing from a 401(k) plan the best solution?

Before you consider borrowing from a 401(k) plan, it’s a good idea to weigh the benefits versus the costs. Additionally, be aware that not all 401(k) plans allow employees to borrow from their accounts. Check with your H.R. department before you even begin to consider a loan.

On the surface it may look very attractive to borrow from your 401(k) plan. You can borrow up to 50% of your account value up to a maximum of $50,000. Further, borrowing from a 401k plan is unique in that you’re borrowing from yourself instead of from a third party. The interest and principal that you pay goes back into your plan.

Here’s a simple example that illustrates what you’re essentially doing by borrowing from your 401(k) plan. Assume that you place ten $10 bills in your right pocket. You then transfer the bills to your left pocket and place an IOU for $100 in your right pocket. Every month you return one $10 bill to your right pocket, and you utilize fifty cents from your piggy bank to pay the required interest.

As the example illustrates, the cost of borrowing from a 401(k) can be minimal. However, the individual in our example isn’t exactly getting ahead either. The problem is that you’re just shifting your own money around. You are missing the opportunity to build your 401(k) from an outside source in the form of new contributions, employer matches, growth, interest and dividends.

Taking a loan from your 401(k) has other costs. Most plan administrators charge a fee to prepare loan documents. A large administrator in Utah charges $75 to set up an employee loan. Worse, some employers won’t let you continue contributing to your 401(k) plan until the loan is fully repaid. Thus, you could forgo matching contributions – one of the greatest benefits of an employee retirement plan.

To pay back the money, you must set up a strict repayment schedule. The payback period cannot last more than five years (except for funds withdrawn for a home purchase), and you will typically make monthly payments using a reasonable interest rate – commonly the prime rate plus 1%. Many employers automatically deduct the loan repayment from the employee’s paycheck – with after tax dollars! Of course, this negates another one of the greatest benefits of a 401(k) plan in that you no longer get tax deferral.

If you leave an employer while you have a loan balance, you have to repay the entire outstanding loan balance. If you default on repayment, the IRS will treat the loan as a distribution. You will then be subject to income taxes and, if you are under 59 ½ years old, will have to pay a 10% penalty.

Before taking a loan from your 401(k), ask yourself why you want to borrow money. Reasons for borrowing money run the gamut from truly important things, such as medical expenses or buying a house, to things that merely feed our egos, such as hot new cars or exotic vacations. If you’re borrowing to buy something nonessential, you should consider a different source than a 401(k) plan. It’s not a good idea to replace appreciating assets (your 401(k)) with assets that depreciate.

Generally, I feel that a 401(k) loan should be considered only if it’s essential and all other financial resources have been exhausted. However, there are instances when a 401(k) loan can be a fantastic solution. For instance, I have a client who expects to receive an inheritance within the next few months. However, this client would like to purchase a new home immediately and needs funds for a down payment. It makes sense for this client to borrow from his 401(k) plan in order to cover the initial cost of the home loan and repay the loan in full once the inheritance is received. This enables this individual to borrow funds inexpensively but then not forfeit the great benefits provided by his retirement plan.

Stock Market Craziness

Dear Clients,

I wanted to share my thoughts given the craziness in the stock market over the past week and hopefully provide some perspective which the press fails to report. Let's look at the market drop from some other angles:

BONDS

Almost all of your portfolios have bonds in them. When you hear news that stocks are down remember that stocks only represent a piece of your portfolio. Further, if stocks are down, most likely bonds are up. This holds true during the past week -- bonds have been up.

STOCK MARKET PERFORMANCE

The stock market is up 8.59% as measured by the S&P 500 over the past 12-months (as of 8/4/11). So, while it's true that stocks have been beat up over the past week, they are still in positive territory for the past 12-months. Year-to-date the stock market is down 3.50%. Longer term the stock market is up significantly. Since March 9, 2009, just about two and a half years ago, the stock market is up 86.31%. Thus, even though the market is down recently it is up significantly over the past two and a half years.

BALANCED PORTFOLIO COMPARISON

By comparison, our portfolios that are comprised of 50% stocks and 50% bonds are up 8.29% over the past 12-months, and are up 0.53% year-to-date. Longer term our 50/50 mix portfolios are up 54.49% since March 9, 2009.

BUY LOW SELL HIGH

It's funny, if I were to ask you how to make money in stocks you'd likely say, "buy low and sell high." However, while this is easy to say it's very counterintuitive. If you buy low you are buying something that is down in price, that nobody wants, that CNBC is saying is awful. Buying low is buying stocks now. Buying high is buying gold now. The average person buys high once an investment has gone up in value and the investor feels good. They generally sell after an investment drops and the individual feels bad. Of course, this is the opposite of what they should do. This emotional investing is the ticket to poor returns.

REBALANCE - BUYING LOW

A good way to take advantage of the recent stock market drop is to rebalance your portfolio. Since stocks have done poorly recently your stock allocation may be lower and your bond allocation may be higher than the targets we've set. For example, a portfolio that was 50% stocks and 50% bonds in January may be 45% stocks and 55% bonds now. My recommendation is to rebalance. This means, in this example, to sell 5% of the bond portfolio and add the money to the stock portfolio, bringing the portfolio back to the target weighting of 50/50. Please let me know if you would like to rebalance your portfolio.

BUCKET INVESTING

We typically position portfolios using a bucket strategy. "Bucket One" consists of the money you'll spend in the next year or two. This money is in money markets or equivalents. "Bucket Two" consist of money that will be spent in years three to ten years. This is our bond money. "Bucket Three" contains the money that won't be spent for ten years or more. With this methodology the money you have invested in stocks is money that we won't begin spending for ten years. This means that if there is a stock market drop we have ten years to rebound. Time is on our side.

APPLE COMPUTER

Do you think Apple will be profitable over the next 1-3 years? In other words, do you think Apple will sell ipads, ipods, iphones, and computers? If the answer is yes and they are profitable, their stock will likely increase. Stock prices, while swayed by the noise of recent events, eventually reflect their true value based on a company's profitability/earnings. I believe companies will figure out a way to be profitable even given the current craziness. If this is true then stock values will go up.

EXPENSIVE WORDS

The most expensive words on Wall Street are, "This time it's different." When we have stock market drops people - even the pros on Wall Street - tend to let their emotions get the best of them, and begin to believe that this market drop is different from previous market drops. We have always rebounded from stock market losses. Corporations have figured out a way to be profitable even when economic conditions have seemed insurmountable. I believe that this will continue to be the case. I believe that capitalism works and will continue to do so. If this is the case, then stocks will increase over time.

HOLD THE COURSE

As you might expect by now, I am bullish on the long-term, and believe that the best action to take right now it to stay the course.

I hope this was helpful as you battle the negative sentiment created by illogical volatility and sensational news reporting.

Retiree's Healthcare and Medicare Basics

Finding affordable medical insurance is a critical part of your retirement planning. Most retirees ultimately receive health insurance through Medicare. However, early retirees don't have access to Medicare until the age of 65. Thus, individuals retiring early must temporarily obtain coverage either via a continuation of their employer-provided coverage or through private insurance.

Continued Group Coverage
In today's corporate world, you are fortunate if you have continued employer coverage when retiring before the age of 65. However, if you don't, there are legal requirements that prevent employers from completely eliminating health coverage for a period of time after an employee retires. Under the Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA), employers with twenty or more employees are required to provide access to continued health insurance coverage to former workers for up to 18 months.

Remember that COBRA only requires the employer to provide access to coverage; the cost of the coverage is assigned to the individual. Unfortunately, coverage under COBRA can be extremely expensive - in some cases as much as seven times what the employee paid for coverage while employed. Because coverage under COBRA must be identical to the coverage the employee had while working, a retiree is unable to choose a less-expensive plan to save money.

Private Insurance
Many early retirees will need private insurance, and it's a tough market for people ages 50 to 64. This age group is largely unprotected by government programs and is most likely to be denied coverage or hit with high premiums. If you have serious health problems, you may want to continue working to keep your employer-sponsored health coverage.

For healthy people ages 62 to 64, private health insurance costs $500 to $1,000 per month. If you are planning to retire before age 65, evaluate your health insurance options as soon as possible. Visit www.insure.com to get an instant online health insurance quote. If you can't obtain coverage, you may have no option other than to continue working until you qualify for Medicare.

Medicare
Last month, Steve Vernon put together some great information regarding Medicare. Following is a summary of Mr. Vernon's article, or you can view the full article here.

Enrolling and choosing a Medicare plan can most easily be thought of as a seven-step process. But first, you'll want to understand the four major parts of Medicare:

• Medicare Part A: Hospital Insurance - helps pay for inpatient hospital care, skilled nursing facilities, hospice care, and some home healthcare.
• Medicare Part B: Physician and Outpatient Coverage - helps pay for doctors' services, outpatient hospital care, and some other medical services such as blood work, lab tests, and preventive services.
• Medicare Part C: Medicare Advantage (MA) Plans - include Medicare Health Maintenance Organizations (HMOs), Preferred Provider Organizations (PPOs), Private Fee-for Service Plans, and Special Needs Plans. Coverage can also include prescription drugs. These plans include Medicare Part A and B.
• Medicare Part D: Prescription Drugs - necessary to obtain prescription drug coverage through Medicare. The coverage is offered through private health insurance companies.
  

Step 1: Check Your Eligibility
Eligibility for Medicare is similar to that of Social Security. You or your spouse must have worked 40 quarters (ten years) in Medicare-covered employment to receive free Medicare Part A coverage. Additionally, you must be 65 and a citizen or permanent resident of the United States. If you or your spouse hasn't worked 40 quarters, your monthly premium for Part A coverage could be as high as $450 per month.

Step 2: Determine When You Should Enroll
If you start your Social Security income benefits before age 65, you'll automatically be enrolled in Medicare Parts A and B upon turning 65. If you haven't started your Social Security benefits by age 65, you'll want to enroll in Parts A and B within three months of your 65th birthday. You'll also want to enroll in Part D at this time unless you're getting prescription drug coverage elsewhere.

If you delay signing up there might be a penalty applied to your premiums. Even if you're covered by an employer-sponsored plan, your employer may still require you to enroll in Medicare Part A at age 65. Ask your HR department for more information. If you don't enroll in Parts B and D because you're covered by your employer's plan, the late enrollment penalty won't apply.

If you decide you'd rather be covered by a Medicare Advantage (MA) plan than by Medicare Parts A and B separately, you'll want to enroll before your 65th birthday to avoid penalties. However, you won't want to elect a MA plan while you're covered by your employer's plan since you'd be duplicating coverage. In this instance, you may want to apply for Medicare Part A coverage at age 65 and then switch to a MA plan after retiring.

Step 3: Choose Between a Medicare Advantage (MA) Plan or Enrolling in Medicare Parts A and B
Medicare Advantage Plans combine Medicare Parts A and B, often cover Part D and may cover some of the amounts you might normally pay for Part A's deductibles and copayments.

The advantages of MA plans are:

• All coverage comes from one source.
• MA plans may have lower premiums when compared to premiums for Medicare Parts B, D and Medigap.
• Some MA plans provide benefits not covered by Medicare, such as dental, vision and wellness.
  

The disadvantages of MA plans are:

• You may be restricted to doctors in the plan's network.
• You may need to cover 100 percent of the cost to visit a doctor outside your network.
• You may need to pay a co-payment each visit.
  

Compare features and premiums of the MA plans in your area to enrolling in Medicare Parts A and B separately. Check to see if your preferred doctors or specialists participate in the MA plans you consider. Also, check out this tool offered by Medicare to help determine whether to take traditional Medicare Parts A and B, or enroll in a MA plan that offers coverage for both.

Step 4: Determine Whether You Should Purchase Parts B and D
The basic premium for Medicare Part B (generally $115.40 per month) only covers about one-fourth of the cost; the federal government pays for the rest. For high-income individuals, the monthly premium for Part B can be as high as $369.10. Part D benefits provide essential coverage since most retirees take prescription drugs. Monthly premiums generally range from $20 to $50. Both Parts B and D are good deals for most individuals.

Step 5: Shop For Part D Coverage
Medicare Part D, covering prescription drugs, is insurance you typically buy from an insurance company. You can select among many companies that offer Part D benefits. Mr. Vernon emphasizes that when choosing a provider, consider the plan's formulary - the list of drugs that the plan covers. There are plenty of tools offered by nonprofit organizations that can help you identify the provider that is right for you.

Be aware that Medicare Part D includes the dreaded donut hole. For example, if your total drug costs exceed $2,840 in 2011, you might be paying 100 percent of the costs until your total out-of-pocket costs for drugs reaches $4,550; at that point, you'll be eligible for catastrophic coverage and you'll only pay a small part of the remaining costs.

Step 6: Evaluate Medigap Insurance
Medicare has substantial deductibles and copayments which can lead to thousands of dollars each year in out-of-pocket expenses. Medigap insurance provides coverage for these gaps in your Medicare coverage. Monthly costs for Medigap plans generally range from $50 to several hundred dollars, depending on the type of Medigap coverage chosen.

Medigap plans come in 10 standardized policies, lettered A, B, C, all the way up to N. Each Medigap Plan A has the same features, each Medigap Plan B has the same features, and so on. Once you select the type of Medigap plan you need, you can easily compare the costs among different insurance companies. View a list of the different policies here.

Note: if you enroll in a MA plan you won't need Medigap insurance because that would duplicate coverage.

Step 7: Dealing With Expenses Not Covered By Medicare
Medicare Parts A and B and most Medigap plans don't typically pay for long-term care, vision, dental, hearing aids, or eyeglasses. If you need hearing aids or eyeglasses, you'll want to determine if either your Medigap or Medicare Advantage plan covers these expenses. This can be an item to consider when deciding between Medicare Parts A and B or a MA plan. If the plan you choose doesn't cover these expenses, you'll want to factor these costs into your budget.

Final Thoughts

Mr. Vernon estimates that by the time you add up all the costs involved, you should expect monthly expenditure of $500 or more per person for medical costs. Factoring these costs into your monthly budget can help you decide when you can afford to retire.

Finally, when you see how much money you could be spending on medical insurance and out-of-pocket costs, you might get really motivated to take care of your health to potentially reduce the amount of money needed. Wouldn't you rather spend your money doing fun things than on medicine or trips to the doctor?