Borrowing from Your 401(k)

While every 401(k) plan is different, most will let you borrow as much as 50% of your vested balance up to $50,000. The loan is paid back through your paycheck, with interest. Most plans have competitive interest rates and the loans can be carried for up to 5 years. If you use the proceeds of the loan to purchase a primary residence, that pay-off term may be extended.

When you are making payments back into the loan, you are paying yourself interest on the money you borrowed. This is where it gets a bit foggy. First, when you draw your paycheck, you pay taxes on the earnings. Then you pay the interest on the loan out of what remains. At a later date, say retirement, you begin drawing from the plan. Those distributions are taxable income, therefore taxed again. You are paying income taxes twice on the funds you use to pay interest on the loans. (Special tax rules apply to Roth 401(k) contributions).

There is an opportunity cost with taking a loan from your 401(k) as well. If those funds are not invested, they are not continuing to grow tax deferred. So, what is the opportunity cost? Well, you need to compare the interest you are paying yourself and the future tax implications previously discussed with the lost opportunities of tax deferred investment returns.

There are other considerations as well. For instance, if there is a separation from employment, the plan may require that the loan be immediately repaid. If you don’t have the funds to repay the loan, it is treated as a taxable distribution. If you are not age 59 ½ or more, a 10% early withdrawal penalty may also apply to the taxable balance.

Whether or not you can afford to pay back the loan and still make contributions to the plan should be carefully considered. Would the circumstances that have lead you to look at borrowing the funds as an option impair your ability to repay the loan? If so, this might not be considered a viable option.

The interest you pay on alternative financing options may be tax deductible. For example, the interest on a home mortgage often qualifies for a tax deduction. However, the interest on a plan loan repayment often is not. Be sure to weigh the comparisons of tax deductibility for both alternatives before making a decision.

Every plan is different and will have various restrictions. Consult with your plan administrator before deciding to borrow from your 401(k).

Posted on October 1, 2010 Read More

Is Your Mental Accounting Adding Up?

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The faulty stock market perception can be illustrated with the following equations.
If you were to ask people what the average of 3 and 5 is, they typically respond as follows: (3 + 5 = 8)/2=4. The average is 4.

If you were then to ask them for the average of a negative 50 and a positive 50 they would do the equation the same way. So the typical investors assume that if they are getting positive returns and negative returns that they are still doing fine.

So what if you were then to ask them, “What is the impact of losing 50 percent one year and gaining 50 percent the following year? Back to your starting amount, right?” Actually, that would work out like this:

• $10,000 down 50 percent is $5,000
• Then up 50 percent is $7,500
• This is a 25 percent loss (13 percent annualized) after “offsetting” years.

Let’s look at an example in which the gaining percentage is greater than the losing one. A return of +66 percent followed by -50 percent would seem to add up to an 8 percent return. But actually:

• $10,000 up 66 percent is $16,600
• Then down 50 percent is $8,300
• +66 percent followed by -50 percent produces a negative 9 percent annualized return.

But look at the compounding gain of two 8 percent years:
$10,000 x 1.08 = $10,800 x 1.08 = $11,664

So, many people wrongly think that if they are getting a greater return than a loss, then they are doing well. But obviously that’s not true. Another misperception is just how deep a hole is created by losses. A 100 percent return would be necessary to offset a 50 percent loss. But a 300 percent return is required to offset a 66 percent loss. And then 400 percent for a 75 percent loss.

So, the next time you’re thinking about taking a risk, make sure you are doing an accurate mental accounting.

Posted on September 1, 2010 Read More

How Do Fees Affect Mutual Fund Performance?

A mutual fund’s fees and expenses may be more important than an investor might realize. Ads, rankings and ratings will often emphasize how well a fund has performed in the past. But according to the Securities and Exchange Commission (SEC), studies show that the future often is different. Fees and expenses can be a reliable predictor of mutual fund performance.
When considering a mutual fund, one of the most important numbers is the expense ratio, which tells you how much the fund costs. The ratio shows how much of the fund’s assets are paid to the portfolio manager and for other operating expenses. Typically, a fund pays an average of 1.5 percent of assets annually.
Three things typically figure into this ratio. The investment advisory fee pays the managers of the fund, which accounts for .50 to 1 percent. Then, administrative costs cover services such as record keeping, mailing and maintaining a customer service line, which can range from .20 to .40 percent. And often a fund will charge a 12b-1 distribution fee, which covers marketing, advertising and distribution services. This ranges from .25 percent to 1 percent of assets.
The upper range of these fees shows how high an expense ratio can be. And even though the fee seems to be just a few percentage points, it is charged in down years, when it can represent a significant slice of the return. Also, over time, the fee can cut the ultimate return by nearly 50 percent, according to one analysis. With an initial $10,000 invested after 30 years of 10 percent returns (a bit optimistic, perhaps), the fund has made $174,494, but with a 2.5 percent expense ratio, it has lost $86,944, according to an analysis by Moolanomy.com.
But even that isn’t the bottom line. There are still transaction fees incurred by the buying and selling of assets in the fund that go unreported, and that can double or triple the cost, according to Richard Kopcke of the Center for Retirement Research at Boston College.
Of the 100 largest stock funds held in defined contribution plans as of December 2007, trading costs averaged from 0.11 percent of assets annually in the quintile with the lowest costs to 1.99 percent of assets in the quintile with the highest costs, with a median of 0.66 percent, Kopcke found. But it is difficult for average investors to determine this percentage, he said.
The SEC has not been able to develop ways to report this percentage in the same way an expense ratio is reported, partly because fund managers say the number is too difficult to determine. One way to get an indication of the percentage is the fund’s turnover. The percentage of turnover shows at what rate stocks in the fund have been replaced. A high turnover rate would mean more fees.
The SEC last year required fund managers to disclose one year of turnover at the front of a prospectus in addition to the already required five years of turnover disclosed in the financial highlights section, according to a March 1 Wall Street Journal article. Turnover of more than 100 percent can indicate trading costs may be high, the Journal reported.

Posted on August 1, 2010 Read More

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