401k Distribution Rules – Everything You need to Know

Posted on by Ryan

401k Distribution Rules

As you read thru this article keep something in mind………the IRS has permitted tax benefits to families by way of the 401k for many years. Primarily intended to permit individuals to salt away extra cash for their own retirement, participants have responded. 401k plans now make up the largest employer-sponsored retirement account type in existence. Knowing the 401k distribution rules will help you decide the best path for you.

But, you’re reading this because it is now time to retire or it is time to tap the 401k for some much needed cash.

Whatever the reason, care must be taken to abide by the 401k distribution rules. Otherwise, Uncle Sam may become more involved in your life than you ever believed he could be.

In an attempt to simplify the concepts of 401k withdrawals, I have boiled them down to two types.

1. Early 401k withdrawals and,
2. Withdrawals made at the age 59½ or older.

Let’s start with……

Early 401k Withdrawal

An early 401k withdrawal has the likelihood of creating two taxable situations on your tax return.

401k Calculator That Allows You See The Impact of Changes

In addition to paying Federal income tax on the amount withdrawn, 401k early withdrawal penalties at a rate of 10% on the distribution amount will generally be required of you as well.

Congress had enough foresight (I can’t believe I actually wrote that) in the early years to understand that if participants were going to contribute to their own 401k account, they should have some access to their money.

So Congress put in a 401k hardship rule (this hardship rule also exists for 403b plans and 457 plans). These rules make allowances for early 401k withdrawals in a limited number of situations. Here are the exceptions:

Expenses for medical care for an immediate family member.
Costs directly related to the purchase of a principal residence.
Payments of directly related educational fees, including room and board, for the next 12 months of post-secondary education for the employee or an immediate family member.
Payments necessary to prevent the eviction of the employee from his/her residence.
Funeral expenses.
Certain expenses relating to the repair or damage of an employee’s principal residence.

“It’s important to note that the above exceptions simply specify conditions when a participant may have access to 401k funds. They are not exceptions to penalties or tax.”

401k withdrawal penalties will not apply if distributions before age 59½ are made in any of the following circumstances:

Payments made to the beneficiary after the death of the participant.
Disability of the participant.
Substantially Equal Periodic Payments after separation from service.
Payments made to a participant after separation from service if the separation occurred during or after the calendar year in which the participant reached age 55. More on this below.
Payments made to an alternate payee under a qualified domestic relations order.
Distributions to a participant for medical care up to the amount allowable as a medical expense deduction.
Distributions to correct excess contributions, match, or deferral.

Although the IRS makes provisions for early distributions, your employer’s plan does not have to allow those distributions. Many employers do not allow premature distributions because of the added administration costs incurred.

Stock Profit Calculator That Allows You To See Changes Profits

As briefly noted above, a 401k withdrawal penalty does not apply to employees who separate service from their employer in or after the year they have reached the age of 55 (for qualified public safety employees that age gets moved back to age 50!)

Let’s re-phrase this exception. The 401k distribution rules state that you can begin taking a 401k early withdrawal in the year you turn 55 or later from your current employer only. Therefore, it may make good financial sense to roll older 401k’s into your current employer before you retire.

Distributions at age 59½ or Older

If your intent is to withdraw 401k assets at retirement, 401k withdrawal laws allow for these three options. Each item assumes that you’re at least 59½ and you are no longer employed by your employer.

Take a lump sum. Your provider will write you a check after holding out 20% of the balance. This 20% is simply a required tax deposit on the 401k distribution. As you file your taxes the following year, the withdrawal will be included in your total income via a 1099 tax form. Whether the 20% Federal tax withheld is enough or too much depends on your particular tax situation for that year.
Do nothing. Leave your plan assets with your employer. There is no tax consequence as no money is withdrawn.
Rollover 401k to IRA. There is no tax implication of this is done correctly.

401k withdrawal rules can be extremely complicated. Contact your financial advisor or CPA for more help.

Difference Between Financial Planner and Advisor

Posted on by Ryan

Let me start off by saying that I truly like most financial planners. After all, they are like cousins to my own field of investment banking. I also believe they can be extremely helpful, even indispensable when planning your financial future. So, please use them. However, like most tools, they are only useful when used correctly and backed up by a certain amount of knowledge. After reading this article you’ll have a better understanding about the difference between financial planner and advisor.

A Personal Story

A few years back, a relative of mine inherited a sum of money from her late great aunt. Being an investment banker, everyone in my family assumes that I know all things financial. It’s funny, but I can invest a large amount of my own money and sleep well at night knowing that I have done my homework and calculated the risks and the rewards. But when it comes to investing family money, I get all tied up in knots and really fearful of making a mistake. My bravado and self-confidence go right out the window.

So, in the case of my relative’s request for help with her inheritance, naturally I sought help. I set up appointments with several well-established financial planners in hopes of helping my relative choose one to help her invest her newly found nest egg. It was a very enlightening experience and not what I expected.

Having gone through this process like most people trying to figure out and develop their personal investment strategy and financial plan, I would like to share my insights with you.

What’s The Difference Between Financial Planner and Advisor?

First, let’s get some definitions straight. In the world of investment, there are investment advisors and there are financial planners. Most financial planners are also investment advisors, but not all investment advisors are financial planners. Both investment advisors and financial planners sell investments. However, financial planners also evaluate financial resources and situations to develop investment strategies or financial plans for their clients–all with the intent of achieving their client’s financial and life goals.

I cannot stress enough the importance of having well-defined financial and life goals. How can anyone arrive at their final destination without knowing where they are going? The guidance of a good financial planner can help you define these goals and get you on the path to success.

Salesmen in Disguise

Difference Between Financial Planner and Advisor Commission

Some investment advisors are captive–meaning that they work for a firm that only sells a certain type of investment and therefore are limited in what they may offer you. These “salesmen” may also be known as financial representatives, financial specialists, annuity specialists, life insurance specialists and a whole host of other names used to disguise the fact that they are usually paid lucrative commissions or bonuses to sell specific product or service to their clients.

Commissions and bonuses are not bad things in and of themselves. After all, we should not expect anyone to work for free. However, it is very important when choosing investments to understand the motivation of anyone offering you advice.

As you search for an investment advisor or a financial planner, you are going to hear the phrase “fiduciary responsibility”–meaning that the planner or the advisor has an ethical and, in some cases, legal responsibility to represent the best interests of their client. But hang on a minute…can an educated professional with a list of impressive acronyms following their name really be impartial and do what is right for their client when they know that selling one financial product to their client earns a higher commission than another financial product?

Call me “cynical”, but come on…it’s human nature. Even in the best case scenario of both products being relatively close in quality and price, they’re going to pick the one that pays the highest commission! And I don’t blame them. I would do it. Gandhi would do it.

Okay, maybe not Gandhi…or Mother Teresa. The point is that there is an inherent conflict of interest in the world of investment and you should be aware of it whenever you invest. It is interesting to note that there are by far more commission-based advisors than fee-based advisors.

Fiduciary Responsibility…Not

So what’s the difference between financial planner and advisor, well, let’s get back to my story. With my relative in tow, I visited with several financial planners. During each interview I would ask the financial planner their opinion of “Vanguard Funds”. There was purpose in my question. Vanguard funds are index funds that can be purchased directly from Vanguard through their website. This means that the financial planner would not get a commission. Every single one of the financial planners that I met with suggested reasons why the Vanguard funds might not be suitable for my relative.

Coincidence? I also asked if they would consider being paid a fee by my relative and forgoing any commissions they might receive by selling my relative a financial product. To my surprise, several of them actually got a bit irate, stating that they had a fiduciary responsibility to represent their clients fairly and that they were perfectly capable of distinguishing which financial products were best for their clients while not giving weight to their potential commission on that product. They were insulted that I would question their integrity. We left their office.

Difference Between Financial Planner and Advisor – Which Is Cheaper?

Okay, another knowledge tidbit for the uninitiated. There are two types of investment advisors, including financial planners–commission-based advisors and fee-based advisors. Both should be registered with FINRA, a self- governing organization for financial advisors whose membership in most cases is required by the Securities and Exchange Commission to work in certain parts of the investment industry.

Difference Between Financial Planner and Advisor Saving Money

Commission-based advisors receive commissions on the financial products that they sell. Fee-based advisors are paid a fee directly from the clients that they serve. From the outset, a commission-based advisor is going to be cheaper than the fee-based advisor. After all, the commission-based advisor doesn’t usually charge you any fees on the investments they sell you, because their fee is built into the cost of the investment. On the other hand, the fee-based advisor is charging you their fees over and above the cost of the investment. So, naturally, the fee-based advisor looks more expensive… at least in the short run.

In my experience, the better the investment, the lower the commission and visa-versa. Certain types of life insurance pay very high commissions over long periods of time. High-risk, venture capital or business startup type investments also tend to pay very high fees to the advisors that sell them. I have seen commissions as high as 10% of capital raised paid out to advisors that brought in the investors. Vanguard, the funds I mentioned earlier (and recommended by Warren Buffett), pay little to no commission to the advisors that sell them. Quality investments don’t need to pay high fees to attract investment. The product speaks for itself.

Human Nature & Investment Advice

So, now ask yourself…what would human nature dictate to a commissioned investment advisor when they could earn 1% on one investment and 10% on another investment? Which would they recommend? Would the quality of the investment even come into play? I am sure there are many investment advisors that take the long view and value their reputation for finding good investments for their clients. But I am equally sure there are investment advisors that would sell the product that makes them the most money regardless of the product’s quality. The real question is…how do you tell the difference between the good advisor and the greedy advisor?

The Difference Between Good and Greedy Advisors

The only way is to take money out of the equation. If you pay your advisor a direct fee in lieu of them receiving commissions, you eliminate the conflict of interest and you can count on their advice being fair and unbiased. It is not easy to find a good investment advisor or financial planner willing to work based on a fee, but it is well worth the effort. You can start by looking on the NAPFA website. NAPFA (National Association of Personal Financial Advisors) is an organization of fee-only financial planners. The fee charged by a fee-only financial planner will be meniscal compared to a bad investment. Investing is one of those areas in life where you really don’t want to be penny wise and pound foolish. Now you should be able to the difference between financial planner and advisor. You next step is to determine, which if any is right for you.

Early Retirement Advice

Posted on by Ryan

Early Departures……

The most recent economic situation is making it increasingly difficult to even discuss the idea planning for an early retirement. Much less, actually doing it. Still, it’s always a good time to plan for retirement no matter what the age.

First things first. The key to making sure that retiring early actually works (and lasts) is to have an early retirement plan.

Retirement planning strategies will generally revolve around these major concepts. We will discuss each of these in further detail as we go thru this article.

Total Retirement Assets Available.
Spending Order of Available Assets.
Retirement Account Withdrawal Rules.
Income Needed from Available Assets.
Investment Options at Retirement.

Total Retirement Assets Available

This would include almost all of your assets with the exception of the house, vehicles, or any other assets that would be difficult to convert to cash pretty quickly. Annuities, 401k accounts, 403b accounts, 457 accounts, profit sharing plan accounts, traditional and Roth IRA’s, checking accounts, savings accounts, and all brokerage accounts should be identified and scheduled. These will be considered the assets you have at your disposal to finance your retirement.

Small businesses and rent houses should be considered, if you plan to sell these and finance retirement expenditures with them. Gold or coin collections might even be considered as assets available for retirement spending. Many times they can be converted to cash as easily as mutual funds.

Spending Order of Available Assets

Now that you have your assets identified, you should arrange those assets in a way that makes the most sense. There will often be a preferred sequence of how you withdraw your funds in retirement.

Generally, you will want to consider grouping your assets based upon the tax status of the assets available. For example, savings accounts, certificates of deposit, and general brokerage accounts should be spent first (as long as they are not in IRA’s or other qualified accounts). This is true because these funds have been taxed already, and withdrawals of these accounts do not cause a taxable situation to the retiree.

Later, not-yet-taxed accounts such as IRA’s, 403b’s and 401k’s should be considered for withdrawal.

This ordering usually makes more sense for a couple of reasons. For obvious reasons, the tax levied on withdrawals from qualified accounts such as IRA’s and 401k’s should be postponed for as long as possible. Also, delaying withdrawals from qualified accounts allows further tax-deferred growth to take place.

Moreover, consider capital gains tax issues when selling raw land, small businesses, rent houses or gold coins used to fund your retirement. Think about selling assets with embedded long-term capital gains instead of short-term. Short-term capital gains are presently taxed at higher ordinary income tax rates, whereas the long-term capital gains tax rate is currently set at 15%.

The ordering of assets is up to you. Just remember that there is usually an ideal process of liquidating your assets. You just have to find it.

Retirement Account Withdrawal Rules

An early 401k withdrawal is a withdrawal made prior to the age of 59½. Generally, not only are these type of withdrawals taxable, but a 10% penalty applies as well.

However, an interesting exception exists for individuals interested in planning for an early retirement. 401k withdrawal rules state that you can begin taking an early 401k withdrawal in the year you turn 55 or later from your current employer only. These withdrawals are taxed of course, but the 10% penalty is not applied.

Therefore, it may be a good idea to roll older 401k’s into your current employer’s plan before you retire. This process could give you additional funds available to access. Taxes will still apply to withdrawals of course, but penalties will not be applied.

This 401k strategy is quite a boon for near-retirees whose primary source of early retirement income is their employer’s retirement plan.

Income Needed From Available Assets

A withdrawal rate is the amount of income taken from available assets divided by available assets. A popular rule of thumb heard repeatedly is that a 5% withdrawal rate is relatively safe. Depending on inflation factors, portfolio performance and the standard of living adjustments during retirement, this rate may or may not be safe. Always remember, a rule of thumb should be no substitute for good judgment.

If I were asked to identify the single greatest risk while considering early retirement planning, it would be inflation risk.

Inflation is the systematic, silent killer of the best of plans (Related Article: How To Combat Inflation). Even when the best portfolios have their problematic years of soft returns (if not downright lousy), inflation continues without sleep. And it almost always goes up.

An example may help to illustrate the problem of inflation. Let’s say you’re 50 years old. You want to retire at the age of 65. You currently need $50,000 to fund your basic living expenses. Inflation numbers are at steady 5%. For your first year in retirement, you will need $100,000 in your first year of retirement assuming your standard of living stays the same.

Can your portfolio keep up with inflation without exposing itself to unnecessary risk?

That brings us to the next section.

Investment Options at Retirement

As stated earlier, inflation is the dragon. How do we slay it? With proper planning and risk management, of course.

Early retirees have a unique problem. First, the forces of inflation should be a greater concern because early retirees have even more years to battle against it. Second, there are no employment wages or salary income to battle with. This puts the portfolio assets in the position of having to grow to keep up with inflation and the withdrawals being taken against them. Bad portfolio years turn out to be unacceptable to the “just-retired” folks because there is no safety net of wages or salaries to catch the retiree when things get dicey in the markets.

So often, portfolios crumble against the weight of inflation and withdrawals. Couple that with a poorly-designed portfolio and you’ve got a recipe for disaster. A poorly designed portfolio generally includes too much or too little risk for the portfolio owner. Either mistake can cost a retiree.

So, always remember that there are two entirely different phases in an individual’s investment life.

Accumulation phase. This is the stage of life in which an individual is simply interested in growing his/her portfolio. If small losses occur, an individual in the accumulation phase has plenty of years to make up for them. If you are doing some early retirement planning, this phase is history.
Distribution phase. Now you have worked very hard for your money and you have very little margin for error in your investment accounts. You should be invested far more conservatively than you were in the accumulation phase. In the distribution phase, the number one goal is to never lose money.

Closing Thoughts On Early Retirement

Finally, early retirement planning can be both exciting and daunting. Begin to work in these five areas. This summarized short list is not to be construed as exhaustive, but you will be well on your way to a secure early retirement plan.

Identify assets.
Order assets based upon tax issues.
Learn Retirement Account Withdraw Rules.
Determine Income Needed From Available Assets.
Invest According to Your Phase in Life!

Small Business SEP IRA Rules

Posted on by Ryan

Is an SEP IRA plan right for you?

A SEP Plan is a small business retirement plan that allows employees to save for their retirement. It is designed to give employers of companies with few or no employees an easy alternative to building for retirement. Any business may establish a SEP Retirement Plan. Knowing the SEP IRA Rules will help you decide if the SEP IRA plan is right for you!

What are the benefits of a SEP?

SEP Contributions. An employer may make contributions to an employee’s Plan up to the lesser of 25% of compensation, or $49,000 for 2009 (and subject to annual cost-of-living adjustments for 2010 and thereafter).
Tax Deductions. The above qualified contributions generally allow for tax deductions of contributed amounts.
Tax Deferral. Tax deferral on all growth, income, dividends and interest while funds remain in the SEP account.
Flexibility on Contributions. SEP IRA rules state that contributions do not have to be made every year. Also, amounts may be adjusted from year to year.
SEP Contribution Deadlines. Contributions do not have to be made until tax filing date (including extensions) of the following year. A SEP Plan can be set up as late as the due date (including extensions) of the business’s income tax return for that year.
SEP IRA’s are Extremely Easy to Set Up and Maintain. An online brokerage company such as the Vanguard Group or Fidelity offer paperwork and a little personal assistance as you go. (Disclaimer: I am in no way affiliated with either Vanguard or Fidelity and do not profit from either of these companies)
SEP’s can be terminated at any time. The employer can stop funding the SEP IRA account once the plan is terminated.
Portability. SEP funds may be rolled over into a traditional IRA, 401k, or a profit sharing plan. Note: Employers do not have to receive rollovers from a SEP IRA, even though the law allows for it.

“For More Information on SEP IRA Rules Visit www.irs.gov”

What are the Drawbacks of a SEP IRA?

Potentially Large Contributions to Employees. This item is a drawback for employers, but a boon for employees. SEP plans require that contributions to employees’ SEP-IRA’s be proportional to their salary/wages. For example if an owner contributes 10% of his/her salary to their SEP account, he/she must make contributions at 10% for each employee as well.
Catch-Up Contributions are not Allowed for SEP’s.
Taxable upon Withdrawal. Like all “pre-tax” retirement plans, qualified distributions after the age of 59.5 are taxed at ordinary income tax rates.
Early Withdrawals are Penalized. SEP IRA’s early withdrawals are not only taxed, they are also subject to a 10% penalty with the following exceptions. Keep in mind that the ordinary income tax may not be excused if one of the following exceptions applies….only the penalty.
- Certain Unreimbursed Medical Expenses.
- Certain Medical Insurance Payments.
- Disability.
- Death.
- Withdrawals as Part of a SEPP Program. SEPP stands for “substantially equal periodic payments”. The payments must last five years or until the IRA owner reaches age 59.5 – whichever is longer – and the payments must also follow certain IRS-approved processes.
- Certain Qualified Higher Education Expenses.
- Certain First-Time Homebuyers Costs.

Plan Investments

Remember employees, SEP IRA’s are only accounts. They are not the investment themselves. The investments will be held inside the SEP IRA accounts.

Eligible investments may include money market accounts, mutual funds, exchange-traded funds, stocks and bonds.

SEP IRA rules, like traditional IRA rules, state that SEP accounts may not hold collectibles such as artwork, antiques, rugs, gems, metals, stamps, coins and other tangible personal property.

If your SEP Retirement Plan invests in collectibles, the amount invested is considered distributed to you in the year invested.