What I’m Watching This Week – 20 July 2014

The Markets

In a week that saw mostly mixed economic data and generally positive earnings reports, markets posted mixed results as well. While tech and international stocks posted slight gains, the Dow Jones Industrial Average lost a little less than 1% after Friday’s 123-point drop. Small caps continued their slump, and the S&P 500 finished the week flat despite hitting new records mid-week.

Market/Index 2013 Close Prior Week As of 7/25 Weekly Change YTD Change
DJIA 16576.66 17100.18 16960.57 -.82% 2.32%
Nasdaq 4176.59 4432.15 4449.56 .39% 6.54%
S&P 500 1848.36 1978.22 1978.34 .01% 7.03%
Russell 2000 1163.64 1151.61 1144.72 -.60% -1.63%
Global Dow 2484.10 2622.25 2630.48 .31% 5.89%
Fed. Funds .25% .25% .25% 0 bps 0 bps
10-year Treasuries 3.04% 2.50% 2.48% -2 bps -56 bps

Chart reflects price changes, not total return. Because it does not include dividends or splits, it should not be used to benchmark performance of specific investments.

Last Week’s Headlines

  • Consumer prices rose 0.3% in June. According to the Bureau of Labor Statistics, the increase was driven largely by higher gas prices, which rose 3.3% and accounted for two-thirds of the increase. By comparison, last month’s rise in inflation was more broad-based. Energy prices were mixed in June: electricity prices rose, while natural gas and fuel oil prices fell. Food prices rose modestly, while the index for all items except food and energy rose by a slight 0.1%. For the 12 months ended in June, inflation rose 2.1%.
  • Existing-home sales climbed 2.6% in June, reported the National Association of Realtors® (NAR). At a seasonally adjusted annual rate of more than 5 million, sales are at their highest rate since October 2013. Inventories rose 2.2% to 2.3 million homes, indicating a 5.5-month supply at the current rate of sales. Lawrence Yun, NAR chief economist, said, “Inventories are at their highest level in over a year and price gains have slowed to much more welcoming levels in many parts of the country. This bodes well for rising home sales in the upcoming months as consumers are provided with more choices.”
  • On the other hand, sales of new single-family homes plummeted by more than 8% in June from May, according to a report issued jointly by the U.S. Census Bureau and the Department of Housing and Urban Development. The seasonally adjusted rate of 406,000 homes was 11.5% lower than the June 2013 estimated figure.
  • The Securities and Exchange Commission (SEC) announced amendments to the rules that govern money market mutual funds. According to a press release issued by the SEC, the amendments are intended to guard against a run on such funds in times of crisis, “while preserving the benefits of the funds.” The rules require a floating net asset value for prime money market funds serving an institutional client base. Prime money market funds serving individual investors will continue to strive for a stable $1 share price, although there can be no guarantees that such a price will be maintained. The new regulations also allow non-governmental money market funds to charge fees or impose other restrictions on investors attempting to withdraw funds during trying times. “This strong reform package will make our markets more resilient and enhance transparency and fairness of these products for America’s investor,” said Mary Jo White, SEC chairperson.
  • In a move that surprised many observers, the Bank of Russia raised its key interest rate for the third time in five months. The central bank lifted the rate by 0.5% to 8% in a move intended to curb inflation, respond to continued geopolitical unrest, and perhaps stymie additional flight of capital resulting from any further economic sanctions.
  • Unemployment insurance weekly claims (i.e., weekly jobless claims), were 284,000 for the week ending July 19. That was a decrease of 19,000 from the previous week and, more notable, the lowest level for initial claims since February 2006.

Eye on the Week Ahead

Next week, market watchers will keep an eye on manufacturing data, home prices, comments from the Fed, and the government’s initial estimates for second-quarter growth figures.


How does divorce affect estate planning?

Wills for both spouses are often drawn up sometime during the marriage–particularly if there are children involved. When divorce is contemplated, the selection of beneficiaries and executors will likely be revised to reflect the absence of your former spouse. Additionally, you will need to re-examine the gift and estate tax aspects of your estate plan. For these reasons, many divorcing couples revise their estate planning documents during the period of separation or soon after the divorce has been finalized.

What should you be concerned about during the separation period?

If divorce proceedings have begun, it’s important to draft a formal separation agreement as soon as possible, establishing the spouses’ rights regarding property, debts, temporary alimony, child support, and child custody. When drafting the provisions, you (or your attorney) will want to consider the possibility of your spouse dying prior to entry of the final divorce decree. You may wish to make the agreement binding on heirs and assigns so that the obligations will continue if one party dies.

If you expect to receive alimony and child support from your spouse, you may want to require (in the separation agreement) that your spouse buy a life insurance policy (or keep the existing one in force), naming you as the beneficiary. The policy should be in an amount sufficient to cover the sum of support obligations and property distribution payments contemplated. You could even be named as the owner of the policy insuring your spouse’s life.

Similarly, your agreement might require your spouse to maintain minimum will provisions in favor of you (and/or your children). Often, the parties to a separation agreement include a provision that both waive the right to elect a share of the estate of the other in the event that one party dies before the divorce decree is entered.

When revising your estate plan, which areas require particular note?

First of all, you should make the necessary changes in your will or other estate planning documents to ensure that your former spouse isn’t named as your personal representative, successor trustee, beneficiary, or holder of the power of attorney. A new will will likely be drafted during the separation period. Note that in some states, wills drawn up during a marriage are considered void after a divorce unless specifically ratified after the divorce. This means that intestacy rules would apply, instead of the will being controlling.

Next, consider gift tax implications if funding your children’s education is required by your property settlement. Although your direct tuition payments (even for adult children) are exempt from gift tax when required by a property settlement agreement, be aware that your payments for related educational expenses (e.g., books and room and board) may be subject to gift tax.

Example(s): Liz and Frank have a daughter, Carol. Carol has reached the age of majority under state law. When the couple divorced, Frank agreed (as part of the settlement) to pay for Carol’s college tuition, books, room, and board. During the year, Frank pays $20,000 tuition directly to Carol’s university, and he gives Carol $15,000 in cash for living expenses. The tuition isn’t a taxable gift, but the $15,000 in cash will be treated as a taxable gift.

Finally, consider the absence of the unlimited marital deduction. A deduction is allowed for qualifying transfers to one’s spouse during lifetime or at death. Because this gift and estate tax deduction is one of the most important estate planning tools for married couples, your loss of this tool at divorce can affect your tax situation adversely when you die.

What I’m Watching This Week – 21 July 2014

The Markets

U.S. stocks dropped sharply Thursday in response to the downing of a Malaysia Airlines commercial jet over Ukraine and the Israeli ground invasion of Gaza. However, most indexes bounced back Friday to end another week in positive territory. The exception was the Russell 2000 Index, which continued its decline perhaps aided by Fed Chairman Janet Yellen’s comments earlier in the week indicating that valuations in some small-cap sectors appear “substantially stretched.” Treasury yields dropped last week, while gold ended the week about 2% lower.

Market/Index 2013 Close Prior Week As of 7/18 Weekly Change YTD Change
DJIA 16576.66 16943.81 17100.18 .92% 3.16%
Nasdaq 4176.59 4415.49 4432.15 .38% 6.12%
S&P 500 1848.36 1967.57 1978.22 .54% 7.03%
Russell 2000 1163.64 1159.93 1151.61 -.72% -1.03%
Global Dow 2484.10 2599.40 2622.25 .88% 5.56%
Fed. Funds .25% .25% .25% 0 bps 0 bps
10-year Treasuries 3.04% 2.53% 2.50% -.03 bps -.54 bps

Chart reflects price changes, not total return. Because it does not include dividends or splits, it should not be used to benchmark performance of specific investments.

Last Week’s Headlines

  • Stocks tumbled Thursday in response to two major geopolitical events, the downing of Malaysia Airlines Flight 17 over Ukraine and Israel’s ground invasion of the Gaza Strip. Treasuries yields dropped and gold futures rose as investors sought safer havens.
  • Retail and food sales rose 0.2% in June and were 4.3% higher than a year earlier. However, the Commerce Department does not adjust the numbers for price increases such as those seen in food costs in the last several months; not counting autos, which were down 0.3%, other retail sales were up 0.4% for the month.
  • The Federal Reserve’s “beige book” report said most districts expect a continuation of generally steady growth seen at the end of last year. All districts reported year-over-year gains in manufacturing, and most also said retail sales had increased since the last report.
  • Wholesale prices rose 0.4% in June, putting the wholesale inflation rate for the last 12 months at 1.9%. The Bureau of Labor Statistics said almost all of the monthly increase was the result of a 2.1% jump in energy costs resulting mostly from higher gas prices.
  • Housing starts dropped by 9.3% in June from the previous month, according to a joint release issued by the U.S. Census Bureau and the U.S. Department of Housing and Urban Development. The decrease stemmed from a nearly 30% drop in the South, where unusually wet weather hampered construction efforts. Other regions reported increases, including the Northeast, which was up 14.1%, and the Midwest, which rose 28.1%. Year-over-year, the index is up 7.5%.
  • Manufacturing data was generally positive. The Federal Reserve said U.S. manufacturing output was up for the fifth straight month, while a 0.2% gain in industrial production meant production was up an annualized 5.5% during Q2 2014. Also, the Federal Reserve’s Empire State manufacturing survey rose for the third straight month, hitting its highest level in more than four years (25.6). The Philadelphia Fed Survey reported similar results. The index rose to 23.9 this month, its highest point since March 2011.
  • The Conference Board Leading Economic Index rose 0.3% in June. Ataman Ozyildirim, a Conference Board economist, noted that increases over the last six months indicate an improving economy, which might even accelerate a bit in the second half. “Housing permits, the weakest indicator during this period, reflects some risk to this improving outlook. But favorable financial conditions, generally positive trends in the labor markets and the outlook for new orders in manufacturing have offset the housing market weaknesses over the past six months,” he said.
  • The Justice Department announced that Citigroup had agreed to provide $200 million worth of financing for new affordable rental housing as part of a $7 billion settlement for misrepresenting mortgage-backed securities it packaged and sold leading up to the 2008 financial crisis. The agreement also includes a $4 billion civil penalty that the Department of Justice said represents the largest settlement under a federal law enacted as a result of actions by thrifts and savings and loan institutions in the 1980s.

Eye on the Week Ahead

This week, investors will likely keep a close eye on continuing geopolitical developments, as well as domestic reports on consumer inflation, existing and new home sales, and durable goods.

Retirement Myths and Realities

We all have some preconceived notions about what retirement will be like. But how do those notions compare with the reality of retirement? Here are four common retirement myths to consider.

1. My retirement won’t last that long

The good news is that we’re living longer lives. The bad news is that this generally translates into a longer period of time that you’ll need your retirement income to last. Life expectancy for individuals who reach age 65 has been steadily increasing. According to the National Center for Health Statistics, life expectancy for older individuals improved mainly in the latter half of the 20th century, due largely to advances in medicine, better access to health care, and healthier lifestyles. Someone reaching age 65 in 1950 could expect to live approximately 14 years longer (until about age 79), while the average 65-year-old American today can expect to live about another 19 years (to age 84) (Source: National Vital Statistics Report, Volume 61, Number 4, May 2013). So when considering how much retirement income you’ll need, it’s not unreasonable to plan for a retirement that will last for 25 years or more.

2. I’ll spend less money after I retire

Consider this–Do you spend more money on days you’re working or on days you’re not working? One of the biggest retirement planning mistakes you can make is to underestimate the amount you’ll spend in retirement. One often hears that you’ll need 70% to 80% of your preretirement income after you retire. However, depending on your lifestyle and individual circumstances, it’s not inconceivable that you may need to replace 100% or more of your preretirement income.

In order to estimate how much you’ll need to accumulate, you need to estimate the expenses you’re likely to incur in retirement. Do you intend to travel? Will your mortgage be paid off? Might you have significant health-care expenses not covered by insurance or Medicare? Try thinking about your current expenses and how they might change between now and the time you retire.

3. Medicare will pay all my medical bills

You may presume that when you reach age 65, Medicare will cover most health-care costs. But Medicare doesn’t cover everything. Examples of services generally not covered by traditional Medicare include most chiropractic, dental, and vision care. And don’t forget the cost of long-term care–Medicare doesn’t pay for custodial (nonskilled) long-term care services, and Medicaid pays only if you and your spouse meet certain income and asset criteria. Without proper planning, health-care costs can sap retirement income in a hurry, leaving you financially strapped.

Plus there’s the cost of the Medicare coverage itself. While Medicare Part A (hospital insurance) is free for most Americans, you’ll pay at least $104.90 each month in 2014 if you choose Medicare Part B (medical insurance), plus an average of $31 per month if you also want Medicare Part D (prescription coverage). In addition, there are co-pays and deductibles to consider–unless you pay an additional premium for a Medigap policy that covers all or some of those out-of-pocket expenses. (As an alternative to traditional Medicare, you can enroll in a Medicare Advantage (Part C) managed care plan; costs and coverages vary.)

4. I’ll use my newfound leisure hours to ______ (fill in the blank)

According to the Bureau of Labor Statistics 2012 American Time Use Survey, retirees age 65 and older spent an average of 8 hours per day in leisure activities. (Leisure activities include sports, reading, watching television, socializing, relaxing and thinking, playing cards, using the computer, and attending arts, entertainment, and cultural events.) This compares to an average of 5.4 hours per day for those age 65 and older who were still working.

So how did retirees use their additional 2.6 hours of leisure time? Well, they spent most of it (1.6 hours) watching television. In fact, according to the survey, retirees actually spent 4.5 of their total 8 leisure hours per day watching TV.

And despite the fact that many workers cite a desire to travel when they retire, retirees actually spent only 18 more minutes, on average, per day than their working counterparts engaged in “other leisure activities,” which includes travel.

401(k) Frequently Asked Questions

How much money can I put into my 401(k) account?

The maximum pre-tax contribution dollar amount is set by law and adjusted for inflation annually. The 2008 pre-tax contribution limit is $17,500. If you are age 50 or older you may also make an additional catch-up contribution of $6,500 per year. Some plans may offer you the option to contribute on an after-tax basis which is not included in the $17,500 limit. Note that plans may restrict employee contributions to an amount less than $17,500, and may also choose not to permit catch-up contributions.

What is the difference between investing pre-tax and after-tax contributions?

The difference between the two types of contributions is when you are taxed. Pre-tax contributions and earnings are taxed only when you withdraw it. Since the money that would normally be paid in taxes goes directly into the plan, pre-tax contributions can accumulate quickly. However, if you need to withdraw money prior to age 59½ you may incur a 10% withdrawal penalty, in addition to owing current income taxes. After-tax contributions are taxed before they are put into the plan. Although you won’t owe taxes on your contributions when you take a withdrawal, you will be taxed on the earnings and may be subject to an early withdrawal penalty on the interest earned if you do so before age 59½.

What pre-tax percentage should I invest when I am starting out?

Any savings is better than nothing and the sooner you get started, the better!! You should maximize your company’s match. For example, if your company matches 50 cents on the dollar up to 6%, you should contribute at least 6%. Simply defer as much as you can afford to budget and take full advantage of the tax deferral.

Is it legal for my employer to move my 401(k) account balances to similar investment funds and change investment fund managers?

It is legal. It is your company’s responsibility to provide competitively performing funds.

What can I do if I do not like the investment funds that my company offers.

Talk to your human resources representative. Your employer has implemented a retirement savings plan for the employees to utilize and appreciate. It is your employer’s fiduciary responsibility to provide competitively performing funds.

Can I withdraw money from my account while I am still working?

Some plans offer loans allowing you to borrow money from your 401(k) account, but you have to pay yourself back with interest. If you fail to pay back the loan it is treated as a withdrawal and the outstanding loan balance will be subject to current income taxes as well as a 10% early withdraw penalty. If your plan doesn’t offer loans, you may be able to qualify for a severe financial hardship withdrawal if no other resources are available to you. According to the IRS a hardship withdrawal includes the following:

  • down payment of primary residence
  • college tuition for you or your dependents
  • unreimbursed medical expenses
  • prevent eviction or foreclosure from your home

Some companies are more lenient than others. Because of the complexity surrounding this issue and varying plan designs, you need to reference your plan document or ask your Human Resources representative for further information regarding plan withdrawals.

How is my company match determined?

There are several different methods used to determine the amount your company may contribute to the plan. Some of the more common employee matches include:

  • fixed percentage – company contribution 25% up to 6% participant deferral.
  • guaranteed percentage – company contributes a pre-determined percentage of participants’ pay.
  • discretionary percentage – company contributes a percentage of participants’ pay generally based on company profits and subject to change year to year.

Can I stop contributing if I feel I cannot afford to?

Most plans allow you to stop contributing at any time though employers are not required by law to do so. Some plans may require specific percentage contribution for a full plan year so be sure to check your plan rules.

What happens to my 401(k) account balance if I choose to leave or am fired from the company?

Your distribution options are the same whether you voluntarily leave or are terminated. If your account balance is more than $5,000, you can leave your money in the plan. If you want to take your money with you, your vested account balance can be rolled into another 401(k) plan with your employer or put into an IRA to avoid early withdrawal penalties.

How long can my former company hold my account balance from my date of termination?

There is no quick, general answer. There are four factors that affect the timing of your distribution:

  • The plan itself may provide a time frame which should be documented in your plan documentation or summary plan description. In some rare cases, distributions are not made until the participant has reached retirement age, usually defined as age 65, even if the participant terminated employment much earlier.
  • Your distribution cannot be processed until after the next valuation date when the plan determines the account balances of participants. Companies can determine account balances daily, monthly, quarterly, semiannually or even annually.
  • How your money is invested can affect how long it will take for you to get your distribution. While most investments can be liquidated quickly, a few, such as some real estate investments, may take longer.
  • Processing your paperwork after the valuation date can take a few days or a few weeks depending on how your plan is managed.

It is important for you to know that your company wants you to have your money just as soon as you do. The company is responsible for and must pay fees on your account balance for as long as your money remains in the plan.

What information and reports is my employer required to provide me with on my 401(k) plan?

Your employer must provide you with a Summary Plan Description and an annual statement of your account information. You have a legal right to ask the plan administrator for a copy of the plan’s latest Form 5500 or Form 5500-C/R, the summary plan description, the plan document, the trust agreement setting up the plan, if separate from the plan, and any collective bargaining contract, if appropriate, and any other instrument under which the plan was established or is operated. In addition, you will often be provided a prospectus for every fund offered in the plan, but this is not legally required. If your company’s stock is offered in the plan you are required to receive a prospectus on the company stock fund.

How soon does my employer have to deposit my contributions deducted from my pay into my 401(k) account?

Government regulations require that participant contributions to a 401(k) be deposited to the plan on the earliest date that they can be reasonably segregated from the employer’s general assets, but in no event may they be deposited later than the 15th business day of the month following the month in which the participant contributions are deducted from their pay. Please note that your employer can not wait until the 15th business day of the month following the month in which your contribution was deducted just for the convenience of doing so. If they can deposit the funds sooner, they must do so.

I still have a 401(k) account with my former employer. I would like to transfer this account into my IRA. Can this be done? If so, are there any penalties?

Yes, this can be done and is referred to as a trustee to trustee transfer. You need to request the distribution forms from your former employer. Make sure you open your new IRA before the transfer so that you can provide the account information on the required forms. There are no penalties with a trustee to trustee transfer, but if you allow your former employer to send the funds directly to you and not to your new IRA, they will be required to deduct and remit 20% of the total to the IRS.

What are the rules regarding hardship withdrawals from my 401(k)?

Hardship withdrawals are allowed by law but your employer is not required to provide this option in your plan. The cost of administering such a program can be prohibitive for many small companies. Your summary plan description (SPD) will state whether or not your employer allows withdrawals in your plan.The IRS code that governs 401(k) plans provides for hardship withdrawals only if: (1) the withdrawal is due to an immediate and heavy financial need; (2) the withdrawal must be necessary to satisfy that need (i.e. you have no other funds or way to meet the need); (3) the withdrawal must not exceed the amount needed by you; (4) you must have first obtained all distribution or nontaxable loans available under the 401k plan; and (5) you can’t contribute to the 401(k) plan for 6 months following the withdrawal.The following four items are considered by the IRS as acceptable reasons for a hardship withdrawal:

  • Un-reimbrused medical expenses for you, your spouse, or dependents.
  • Purchase of an employee’s principal residence.
  • Payment of college tuition and related educational costs such as room and board for the next 12 months for you, your spouse, dependents, or children who are no longer dependents.
  • Payments necessary to prevent eviction of you from your home, or foreclosure on the mortgage of your principal residence.

Hardship withdrawals are subject to income tax, and if you are not at least 59½ years of age, the 10% withdrawal penalty. You do not have to pay the withdrawal amount back.

What are the general rules regarding loans from a 401(k)?

The rules governing 401(k) plans allow plans to provide loans, but do not mandate that an employer make it a plan feature. Your summary plan description (SPD) will state whether or not your employer allows loans in your plan.Most of the time loans are only allowed for the following reasons: (1) to pay education expenses for yourself, spouse, or child; (2) to prevent eviction from your home; (3) to pay un-reimbursed medical expenses; or (4) to buy a first-time residence. You must pay the loan back within five years, although this can be extended for the first-time home purchase.Usually you are allowed to borrow up to 50% of your vested account balance to a maximum of $50,000 (set by law). Because of the cost, many plans will also set a minimum amount and restrict the number of loans you can have outstanding at any one time. Loan payments will generally be deducted from your payroll checks and, if married, you may need your spouse to consent to the loan. Funds obtained from a loan are not subject to income tax or the 10% early withdrawal penalty. If you should terminate your employment, often any unpaid loan will be distributed to you. This distribution will be subject to income tax and, if you are not at least 59½ years of age, the 10% withdrawal penalty.

I am currently working in the U.S. on a Visa. If I choose to leave the U.S. when my Visa expires, what will happen wiht my 401(k) account?

To avoid early withdrawal penalties and payment of taxes you can do one of two things: (1) If your account balance is over $5,000, you can leave your 401(k) money in your former employer’s plan. (2) You can roll your account balance into an IRA. You can also request a distribution from the 401(k) plan and take the lump-sum payment. You will have to pay taxes and early withdrawal penalties with the lump sum payment.

Disclaimer: I am not engaged in rendering legal advice. I am providing you with general 401(k) information. For plan specific information, you need to refer to your employer’s summary plan description.

What I’m Watching This Week – 14 July 2014

The Markets

After Alcoa’s strong report unofficially kicked off the Q2 earnings season, domestic equities rebounded from two down days. However, investors decided to take advantage of equities’ recent record levels and take some profits after revelations about a banking problem in Portugal revived concerns about Europe’s financial sector. Meanwhile, the spot price of oil, which had spiked to $107 two weeks ago, ended the week just over $100 a barrel.

Market/Index 2013 Close Prior Week As of 7/11 Weekly Change YTD Change
DJIA 16576.66 17068.26 16943.81 -.73% 2.21%
Nasdaq 4176.59 4485.93 4415.49 -1.57% 5.72%
S&P 500 1848.36 1985.44 1967.57 -0.90% 6.45%
Russell 2000 1163.64 1208.15 1159.93 -3.99% -.32%
Global Dow 2484.10 2638.59 2599.40 -1.49% 4.64%
Fed. Funds .25% .25% .25% 0 bps 0 bps
10-year Treasuries 3.04% 2.65% 2.53% -12 bps -51 bps

Chart reflects price changes, not total return. Because it does not include dividends or splits, it should not be used to benchmark performance of specific investments.

Last Week’s Headlines

  • The Federal Reserve currently expects its bond purchases to end in October, according to minutes of the most recent Federal Open Market Committee meeting. However, the minutes also reiterated that the end of bond-buying won’t automatically mean higher interest rates, at least not for a “considerable time.” The Fed also will continue to reinvest the proceeds of maturing bonds it already holds until after it acts on rates.
  • Talks aimed at trying to address U.S.-China differences over Chinese currency policies began. The United States contends that those policies have kept the yuan artificially low, giving Chinese companies an unfair pricing advantage. Meanwhile, Chinese exports were up 7.2% in June from a year earlier, according to China’s General Administration of Customs.
  • A major Portuguese lender’s failure to make payments on some of its short-term debt raised concerns once again about the stability of European banks and the possibility of contagion. Banco Espirito Santo has been known to be struggling since December, but investor reaction to the disclosure caused several other European companies to postpone bond offerings.

Eye on the Week Ahead

Q2 earnings reports from some major financial and tech companies, due next week, could influence investor thinking about whether Q1’s discouraging GDP really has given way to renewed growth. Housing and inflation data also are likely to be closely watched.

Should I Divert Unmatched 401(k) Contributions to a Roth IRA?

By Leslie E. Papke, Professor of Economics at Michigan State University

Note: A participant’s first priority should be to contribute enough to their 401(k) plan to obtain the entire employer match.

In most cases, no. 401(k) contributions and contributions to a Roth IRA benefit from identical favored tax treatment over the life of the investment. (See examples below.) Since the tax benefits of the two saving schemes are identical, an investor should be indifferent between the two types of saving on tax grounds. Plus, the Roth IRA is capped at $5,500 after-tax, while most 401(k) participants can invest much more than that before reaching the current 401(k) cap of $17,500 before-tax. Since the tax treatments are identical, and the limit on the 401(k) contributions is much higher, you should continue to make unmatched contributions to your 401(k) until the maximum is reached. Diverting unmatched 401(k) contributions to a Roth will not give you additional tax saving, but will increase your transaction costs, and possibly management fees as well.

There may be non-tax reasons to prefer a Roth IRA. Say, for example, that you are not happy with the investments available in your 401(k) plan. If your asset choices are restricted in your 401(k), then since the tax treatments are the same, you may prefer to choose your own investments for the $5,500 after-tax that you are allowed to invest in a Roth.

The examples below illustrate that the tax liabilities of comparable 401(k) and Roth IRA contributions are equivalent. In general, the 401(k) contribution is made in pre-tax dollars, and while you pay taxes on the value of the account at withdrawal, you are essentially only paying taxes on the contributions, earnings are effectively tax-free. A Roth contribution is made in after-tax dollars, you pay taxes on the contribution up-front, and its earnings are also tax-free. The key to comparing after-tax returns on a 401(k) investment to a Roth is to be sure that the contributions you are comparing involve the same amount of pre-tax income.

To illustrate with a simple example, suppose I face a 30 percent marginal tax rate and I want to save my next $1,000 of salary in either my 401(k) plan or a Roth. If I invest in the 401(k) plan, since the contribution is not taxed (deducted from your paycheck before taxes), I put the entire $1,000 into the account. Contributions to a Roth are made after-tax, however, so if I receive the $1,000 as salary today, I can contribute only $700 ($1,000-$300 tax) to a Roth.

Ignoring penalties, suppose I want to withdraw from the accounts the following year. My tax rate is still 30 percent and the pre-tax interest rate is five percent. I withdraw $735 ($700 x 1.05) from the Roth and pay no additional taxes. Or, I withdraw $1050 ($1000 x 1.05) from my 401(k), pay my 30 percent tax of $315 ($1050 x .3), and have $735 left. The tax liabilities of the Roth and the 401(k) plan are identical. This is true for an investment of any time horizon.

I make these comparisons assuming that my tax rate today is the same as the tax rate I face when I withdraw the funds. If my tax rate were lower in the future (due to lower retirement income, for example) then the 401(k) plan would have a higher after-tax return than the Roth. But if my tax bracket increases after retirement, then the 401(k) plan would have a lower after-tax return than the Roth IRA.

Changes in my future tax rate will not affect the after-tax return from the Roth, since taxes are paid before the contribution. The Roth would still return $735 in the example above. But, if my tax rate is 20 percent at withdrawal, when I withdraw the $1050 from my 401(k) plan, I pay $210 ($1050 x .2) in taxes and have $840 left. When my tax rate is lower at withdrawal, the 401(k) plan beats the Roth.

But, if my tax rate at withdrawal is 40 percent, when I withdraw the $1050 from the 401(k) plan, I pay $420 in taxes, and have $630 left over. When my tax rate is higher at withdrawal, the Roth after-tax returns are higher than those from my 401(k) plan.

A comparison between a 401(k) contribution and a Roth IRA contribution may also be framed in terms of a $1,000 after-tax contribution to a Roth. Suppose I want to compare an investment of $1,000 in a Roth to the equivalent investment in my 401(k) plan. The right question to ask is: How much pre-tax income would I need to make the $1,000 Roth contribution? That is the amount I could invest in my 401(k) instead. Since Roth contributions are made after-tax, I need $1,430 in income ($1,000=$1,430 x (1-.3)) to contribute $1,000 to a Roth. The after-tax $1,000 contribution to the Roth grows to $1050 next year with no additional liability. If, instead, I save the $1,430 in the 401(k) plan, it grows to $1,500 ($1,430 x 1.05) in one year, leaving $1,050 ($1,500 x (1-.3)) after-tax.

No matter how you argue it, from the point of view of tax liability, the 401(k) plan without matching and the Roth IRA are equivalent forms of saving. Of course, if you can afford to save more after you have maximized your 401(k) contributions, you might invest an additional $4,000 after-tax in a Roth IRA. Some investors may also be eligible for a conventional IRA. The conventional IRA is capped at $ 5,500 before- tax, so if you’re going to invest up to $5,500 before taxes, the two IRAs are equivalent (assuming that you are eligible for both). If you can afford the larger investment of $5,500 after-tax, then you should invest in the Roth IRA.

What I’m Watching This Week – 7 July 2014

The Markets

After generally positive economic data once again suggested that the economy really did begin to rebound this spring, the Dow industrials surpassed 17,000 for the first time, while the S&P 500 hit three new all-time records during the week. And as investors embraced stocks, worries about the potential impact of a strong economy on potential Fed rate increases also sent the benchmark 10-year Treasury yield up and the price down.

Market/Index 2013 Close Prior Week As of 7/4 Weekly Change YTD Change
DJIA 16576.66 16851.84 17068.26 1.28% 2.97%
Nasdaq 4176.59 4397.93 4485.93 2.00% 7.41%
S&P 500 1848.36 1960.97 1985.44 1.25% 7.42%
Russell 2000 1163.64 1189.49 1208.15 1.57% 3.83%
Global Dow 2484.10 2603.77 2638.59 1.34% 6.22%
Fed. Funds .25% .25% .25% 0 bps 0 bps
10-year Treasuries 3.04% 2.54% 2.65% 11 bps -39 bps

Chart reflects price changes, not total return. Because it does not include dividends or splits, it should not be used to benchmark performance of specific investments.

Last Week’s Headlines

    • The unemployment rate fell to 6.1% in June; that’s 1.4% lower than a year earlier and the lowest level in almost six years. The economy added 288,000 new jobs during the month, higher than the 272,000 monthly average since March. The data, coupled with upward revisions to payroll figures for April and May, suggested possible acceleration in job growth. The Bureau of Labor Statistics said the widespread job gains were led by professional/business services, retail, restaurants/bars, and health care.
    • A 2% increase in new orders placed with U.S. manufacturers put orders at their highest level since late 2013. Even though the Institute for Supply Management’s index showed that manufacturing growth didn’t accelerate in June, it still remained at a healthy 55.3% reading (any number above 50 represents expansion). The ISM’s measure of the services sector also showed slightly slower growth than the previous month, though the reading remained at a robust 56.3%.
    • After three straight monthly increases, new orders for U.S. manufactured goods slipped 0.5% in May, though most of the decline was in the volatile transportation sector. The Commerce Department also said inventories were at their highest level on record and have increased 18 of the last 19 months.
    • Commercial construction spending rose 1.1% in May, but the Commerce Department said that was largely offset by a 1.4% drop in the value of new home projects. The 0.1% overall increase in construction spending was weaker than April’s 0.8% gain, but the annual rate was 6.6% higher than a year ago.
    • As expected, the European Central Bank left two key interest rates unchanged, hoping that measures taken last month will be enough to help stimulate the economy.
    • Higher auto-related exports and less spending on imported oil and consumer goods helped cut the U.S. trade deficit by 5.5% in May to $44.4 billion, according to the Bureau of Economic Analysis.
    • The U.S. Supreme Court ruled that closely held, for-profit companies can choose to opt out of a provision of the Affordable Care Act that requires that employees’ insurance include coverage for birth control. The court also ruled that workers who aren’t full-fledged public employees cannot be required to pay fees to a union even if they benefit from its collective bargaining efforts.
    • Two separate assessments suggested that China’s sluggish manufacturing sector may be rebounding. The reading on the Chinese government’s purchasing managers’ index nudged up slightly to 51 in May. Meanwhile, HSBC/Markit’s Manufacturing PMI was basically flat but stayed in expansion territory, apparently responding to small steps taken by the government to stimulate economic growth.

Eye on the Week Ahead

In a week that’s light on fresh economic reports, investors may begin to focus on the Q2 earnings season, which has its unofficial start on Tuesday when Alcoa reports. Minutes of the most recent Federal Open Market Committee meeting could shed new light on the debate over whether the Fed should be concerned yet about inflation.




401(k) Loans

When You Need Your Money NOW

Ideally, you will never touch your retirement funds, allowing them to grow continuously until you retire. But we don’t live in an ideal world! In case of emergency, the funds in your 401(k) may be available to you in the form of a Loan.

One of the benefits of many 401(k) plans is being able to borrow against your retirement savings in times of need. Currently, about 20 percent of employees eligible for a plan loan have one, and the average outstanding loan balance is approximately $7,600. If your plan has a loan program you have the security of knowing that your money is available “just in case,” which means you can comfortably make a sizable commitment to retirement savings in your plan. Also, if you need money from your plan because of a financial emergency and your plan has a loan program you will be required in most cases to take a loan first. Now, let’s assume you have an unexpected crisis and you need your money – what should you know?

Loan Basics

  • Plans typically allow you to borrow 50 percent of the amount in your plan, up to $50,000.
  • In nearly all cases you must repay the loan in 60 equal monthly payment over a five-year repayment period. The one exception is for a loan that is a mortgage for your primary residence, then the repayment period may be longer.
  • The interest rate you pay will be determined on the day you take the loan. While interest rates vary by plan, the rate most often used is what is termed the “prime rate” plus one percent. You can find the current “prime rate” in the business section of your newspaper.
  • In nearly all cases you will repay your loan through payroll deduction. Only a few companies will allow you to repay in any other way.
  • You can always repay your loan at any time with no penalties.
  • Many plans will permit you to have more than one plan loan.
  • Plan loans usually have a minimum amount requirement, typically $1,000.

Pros and Cons

Plan loans are convenient, but they are not always the right solution. Consider both the positives and negatives to determine if a plan loan is best for you. And always compare the overall cost of a plan loan with other possible loans.

Plan Loan Advantages


Less Paperwork: No credit checks or long credit application forms. You may be able to obtain a plan loan simply by visiting your benefits office, calling your plan’s 800 number or going online.
No Restrictions: Most plans let you borrow for any reason. Check your plan.
Fast: You could receive a loan in mere days, depending on how often your plan processes transactions.
Good Rates: The prime rate is the interest rate that banks charge their best customers. The prime rate plus one percent is a very good rate of interest for an individual borrower.
Higher Return: The rate of repayment for your loan may be greater than the rate of return you were receiving on the fixed investments in your plan. For example, if you were to replace assets from your money market fund paying four percent with your plan loan paying seven percent you would be earning a higher rate of return.


Plan Loan Disadvantages


Loan Default: The consequences of a plan loan default are different than for the default of other types of loans. If you fail to repay the plan loan, you will have to pay both regular federal and state income taxes and if you are under age 59 1/2 an additional federal income tax equal to 10 percent of the outstanding balance.
Fees: 70 percent of all plans charge a one-time loan fee, ranging from $3 to $100. Another 25 percent of plans also charge a yearly service fee, ranging from $3 to $75.
Alters Financial Plan: You’ve done the work to determine your retirement goal and pick the right investment mix. But when you take a plan loan, money must be removed from your plan investments. If plan loan amounts must be taken money from your equity investments this could diminish your overall plan return.
Market Cost: Cash for your loan from selling shares from your stock funds when the market is down, may force you to sell your stock at a loss reducing your long term plan investment return.
Spousal Consent: Some plans require that you get your spouse’s permission for a plan loan.
Lower Returns: The rate of repayment for your loan may be lower than the rate of return you were receiving from the investments in stock in your plan. For example, if you were to replace assets from your diversified equity fund returning ten percent with your plan loan paying seven percent you would be earning a lower rate of return.


There is a popular misconception that paying back a plan loan is like “paying yourself.” Unfortunately, this is not true. When you take a loan from your plan, you are withdrawing money from your account balance and replacing it with an IOU. That IOU continues to generate interest from your repayments, but generates no special investment return.

In a sense, all fixed investments are a kind of loan. You are lending money to the government or a corporation through the stable value, money market or bond funds in your plan. However, the return (or interest) generated from these loans comes from a borrowing party. When you loan yourself the money you are simply replacing the interest you would already be receiving with interest payments from yourself.

Plan Loans and Your Investments

To preserve your asset allocation plan when taking a plan loan, you should withdraw the funds for the loan from the fixed income allocation side of your portfolio. Let’s assume you have 50 percent of your money invested in equities and 50 percent invested in fixed income. When you borrow 50 percent of the money in your plan, you want to take the funds entirely from the fixed income side and maintain all the equities. Some plans will ask you to make that determination, others will reduce all of your investments proportionally by the amount of your plan loan. In that event, you need to go back and rebalance the remaining investments to the proper equity and fixed allocation ratios. In others words be sure to take money for your plan loan from your lowest returning investment option.

Warning: Do Not Default on Your Loans

This is crucial: if you leave your current employer, have no outstanding plan loans. Whether you find a new position or you are laid off, in most cases your plan loan will come due when employment ends. You will be given a limited amount of time to pay off your loan, and if you cannot repay it will be placed in default. “In default” means your employer will report to the government that you were unable to pay the loan, and the government will then treat the defaulted amount of your loan as a distribution. This most likely will lead to regular taxes on the defaulted amount plus for those under 59½ the ten percent additional federal income tax penalty. Depending on your tax bracket and the tax rate of your state, you could be forced to pay the government as much as half of the defaulted amount. Some people take a cash advance on their credit card to pay off their plan loan when they change jobs, because 18 percent interest is still better than a 50 percent tax liability.

401(k) and Divorce

You have saved and invested for the long term in your 401(k) plan, accumulating a sizable nest egg. But what happens if you become divorced? In a divorce, your former spouse and any dependents may be entitled to a portion of you 401(k) assets. If this is the case, the court will issue a qualified domestic relations order (QDRO) as part of your divorce settlement that will define the what, when, and how of the division of your 401(k) or other retirement plan account.

A QDRO is a court judgement, decree, or order that names someone other than you as a recipient of you 401(k) assets. This other person, known as the alternate payee, may only be your spouse, your former spouse, your child, or other dependent. The QDRO is used in the division of assets in a divorce settlement for alimony payments, child support payments, or property rights payments. If you are involved in a divorce proceeding, be sure to ask your company’s plan administrator if there is a model QDRO form for your plan. Doing so early on in the process will save you time and expense.

There is one piece of good news in this situation. The money removed from your account for a properly processed QDRO is not subject to the 10 percent early withdrawal federal income tax penalty-even if you and your alternate payee are both younger that age 59 ½. Unfortunately, if the QDRO is not properly established, you will be subject to the 10 percent early withdrawal federal income tax penalty. In the midst of divorce and the distribution of your account to other parties, the last thing you want to face is a tax on money that is no longer yours.

Ensuring the Validity of a QDRO

In order for a QDRO to be valid, it must meet two legal requirements: It must be correctly created and it must be correctly verified. Checking the status of your QDRO at both stages is wise to ensure that your QDRO is acceptable under the law. If this seems like a lot of trouble, keep in mind that aside from preventing undo taxation, the other reason why such checking and double-checking takes place is to prevent someone from illegally accessing your 401(k) assets.

Creation of the QDRO

To be considered a QDRO, the division of your assets must first and foremost be directed by a court order issued in compliance with state laws. However, the QDRO must also include the following information to be valid:

  • Your name and your last known mailing address.
  • The name and address of your alternate payee.
  • The amount of percentage of your account to be given to your alternate payee.
  • The manner in which the amount or percentage is to be determined.
  • The number of payments or period to which the order applies.
  • The plan to which the order applies.

Verification of the QDRO

If your 401(k) plan assets are subject to a QDRO, you must provide your plan administrator with either the original court order or a court-certified copy of your QDRO document. Your plan administrator will then follow formal procedures to establish the legality of the QDRO and put it into motion. These procedures are part of the rules set down in your 401(k) summary plan description (SPD), and by law they must include:

  • Notifying you and the alternate payee that the order was received, and detailing the procedures that will be followed to verify the order.
  • Determining within a reasonable period of time (no longer than 18 months after the order is issued) whether the order is valid QDRO.
  • Accounting separately for any amount payable to your alternate payee during the evaluation period.
  • Notifying you and your alternate payee whether the QDRO is valid.

A QDRO Case Study

In a famous case, a man paid out $1 millions dollars from his retirement plan as part of his divorce settlement. The man assumed that the order was a QDRO, but missed several key elements that caused the order to be invalid. First, the man’s former wife was not identified as the alternate payee. Second, the order did not include the name or address of the alternate payee. Third, the man did not follow proper procedure for verifying the order.

Because the man was the administrator of the retirement plan in question, he argued that he did not need to file forms with himself, and that the order did not need to include the name and address of the alternate payee because he was personally aware of the details. The IRS did not agree, and deemed the settlement payment an early distribution and, therefore, subject to the 10 percent early withdrawal federal income tax penalty. This error cost him $100,000.

The Division of Funds in a Divorce

How your funds are divided relies in part on the state in which you live. In most states, your assets are subject to equitable distribution during a divorce settlement. This means that 401(k) assets accumulated during your marriage probably, but not necessarily, will be divided 50-50. Other factors, such as the division of the rest of your marital assets, the length of your marriage, or what each of you contributed to the marriage will also play a part in the decision. However, if you live in a state with a community property law, you may face an equal split in your 401(k) assets regardless of the other division of marital assets. Following is a list of states that include the community property law:

  • Arizona
  • California
  • Idaho
  • Louisiana
  • Nevada
  • New Mexico
  • Texas
  • Washington
  • Wisconsin

What to Do with QDRO Assets

If you have recently gone through a divorce and will receive money from your former spouse’s 401(k) plan a result of a QDRO, you have several options. Taking the money in cash can be useful to get through the rough divorce period, but keeping the assets within a tax-sheltered plan could be far more beneficial. If you receive a lump-sum distribution you will have to pay taxes on the entire amount immediately and you will lose the investing and earning power of that money for the future.

Instead, consider leaving the money in your former spouse’s 401(k) plan or rolling it over into an IRA. If you would like to leave it in the 401(k) plan, you can make this stipulation part of the QDRO agreement. When the money is divided, the plan’s administrator will create a separate account for you. You may not be able to add to this account or withdraw from it until your former spouse withdraws his or her money at retirement, but you will be able to mange the investments of this money yourself and keep it safely tax-sheltered. If you would instead prefer an account to which you can make contributions, rolling the money into an IRA is the best option. Rolling the money into an account not connected with your former spouse also provides you with more freedom as you are allowed to withdraw the money at your own discretion.