Early Withdrawals Less Attractive Than Loans
One alternative to a 401 loan is a hardship distribution as part of an early withdrawal, but that comes with all kinds of taxes and penalties. If you withdraw the funds before retirement age youll typically be hit with income taxes on any gains and may be assessed a 10 percent bonus penalty, depending on the nature of the hardship.
You can also claim a hardship distribution with an early withdrawal.
The IRS defines a hardship distribution as an immediate and heavy financial need of the employee, adding that the amount must be necessary to satisfy the financial need. This type of early withdrawal doesnt require you to pay it back, nor does it come with any penalties.
A hardship distribution through an early withdrawal covers a few different circumstances, including:
- Certain medical expenses
- Some costs for buying a principal home
- Tuition, fees and education expenses
- Costs to prevent getting evicted or foreclosed
- Funeral or burial expenses
How Much You Need
As a general rule of thumb, many financial advisors recommend having enough saved in retirement funds plus other sources of income, such as social security or a pension, to replace 80% of your income before retirement. If you have determined how much you will receive from other sources of income, you can use a conservative estimate of roughly 56% in annual returns from your 401 to figure out what sort of balance you will need to generate the additional income to achieve 80%.
Another quick and simple way to estimate the amount you will need to have saved is to take your pre-retirement income and multiply it by 12. So, for example, if you were making $50,000 a year and were considering retirement, you should have about $600,000 saved in your 401.
A more comprehensive approach would be to use a “retirement calculator.” Many financial institutions that manage 401 plans offer online, interactive retirement calculator tools that will allow you to use different assumptions and automatically calculate the required savings amount needed to achieve your goals. They typically also have knowledgeable representatives that will walk you through the process. You should take advantage of these resources if they are available, assuming you don’t already have a financial advisor.
Essential 401 Startup Steps
Youll have to follow an exact protocol to take advantage of the ROBS plan and use 401 funds for your business startup, tax- and penalty-free. First, youll need to create a C corporation and set up a retirement plan for it. After these two fundamentals are in place, youll roll over your existing 401 funds to the new retirement plan youve just set up for your new company. With these newly rolled-over 401 funds, youll then purchase stock in your own new company to capitalize its financial needs.
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Establishing The New 401 Plan
ROBS plans have all the same features and benefits of a traditional 401 plan, profit-sharing plan, or defined benefit plan, except they also have special features that allow the plan to invest plan assets in the privately held C-Corp.
You need to work with a firm that knows these plans well because not all custodians will allow you to hold shares of a privately held corporation in a qualified retirement account. For many investment firms and custodians, this is considered either a private placement or an alternative investment. There is typically a special approval process that you must go through with the custodian before they allow your 401 account to purchase the shares of stock in your new company. Be ready, there are a lot of mainstream 401 providers that will not only not know what a ROBS plan is, but they often times limit the plan investment options to mutual funds to avoid this, make sure you are aligning yourself with the right provider.
Robs Frequently Asked Questions
Do I have to quit my job to start or buy a business with ROBS?
The answer is that it depends. Some ROBS-eligible retirement plans prevent performing a ROBS when the plan is tied to an active employee, in which case you would need to leave your job. However, there are a few carve-outs:
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You have a retirement plan from a previous employer that has enough funds for a ROBS
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Your current retirement plan allows an in-service rollover
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You’re more than 59 1/2 years old
Do I need to invest my entire retirement plan when using ROBS?
No, you can use as much of your retirement savings as you want. In fact, you’re able to do an Additional Rollover Capital transaction if you decide that you need to roll over additional funds after the initial transaction.
Is ROBS limited to only assets in 401s?
No, nearly any retirement plan can be used with a ROBS. The distinction is that the retirement plan needs to be rolled over into a 401 at the new company. Think of it as the “starting point” and “destination.” The “destination” is always a 401 at the new C-Corp. The “starting point” can be a Traditional IRA, SEP-IRA, SIMPLE IRA, 401, etc.
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Option : Early 401 Withdrawal
In an emergency situation, taking an early 401 withdrawal can make sense. You will pay significant penalties for doing so, and it can have a noticeable effect on your retirement accounts and long-term investment returns. If you are looking to buy a business using your 401, this is the least desirable of the financing options covered in this article.
Typical reasons to make an early 401 withdrawal are if you need to make a payment immediately in order to avoid repossession, to cover a costly emergency vehicle repair, or in other emergency situations that require access to money you just dont have. If you have an accountant, they will probably advise you that taking an early withdrawal should only be seen as a last resort.
There are, however, some circumstances where you may not have to pay the early withdrawal fee. If you lose your job and are 55 years old or older, you wont have to pay the 10% tax penalty. There are sections in the CARES Act, specifically section 2202, that allows favorable tax treatment for up to $100,000 of coronavirus-related distributions from eligible retirement plans. These include individual retirement accounts , 403 plans, and 401 plans.
That being said, you need to be considered a qualified individual under the section. The list of what makes you a qualified individual can be found here. There are also adjustments to loan relief and if you qualify, may be able to take a higher loan amount if you borrow against your 401.
Can You Pay Off A 401 Loan Early
Yes, loans from a 401 plan can be repaid early with no prepayment penalty. Many plans offer the option of repaying loans through regular payroll deductions, which can be increased to pay off the loan sooner than the five-year requirement. Remember that those payments are made with after-tax dollars, unlike contributions, which are made before taxes.
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Complications If You Have Employees
For start-up companies or established companies that have employees that would otherwise be eligible for the 401 plan, there are special issues that need to be addressed. The rules within the 401 world state that all investment options available within the plan must be made available to all eligible employees. That means if the business owner is able to purchase shares of the company within the retirement plan, the other eligible employees must also be given the same investment opportunity. You can see immediately where this would pose a challenge to the ROBS plan if you have eligible employees.
However, investment options can be changed which is why ROBS plans are the most common in start-ups where there are no employees yet, allowing the 401 plan to setup the only eligible plan participant, the business owner, allowing them to buy shares of the company. Once the share purchases are complete, the business owner can then remove those shares as an investment option in the plan going forward.
What Is A 401 Plan
A 401 plan is a retirement savings plan offered by many American employers that has tax advantages for the saver. It is named after a section of the U.S. Internal Revenue Code .
The employee who signs up for a 401 agrees to have a percentage of each paycheck paid directly into an investment account. The employer may match part or all of that contribution. The employee gets to choose among a number of investment options, usually mutual funds.
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What Are The Benefits Of A 401
There are two main benefits to a 401. First, companies usually match at least a portion of the money you put into your 401. Second, there are tax benefits for these accounts. If your contributions to your 401 are pre-tax, you don’t have to pay taxes on the gains you earn over time when it comes time to withdraw money for retirement. If your contributions are post-tax, you get to deduct your contributions on your federal income tax return.
What To Look For
Among your choices, avoid funds that charge the biggest management fees and sales charges. Actively managed funds are those that hire analysts to conduct securities research. This research is expensive and drives up management fees.
Index funds generally have the lowest fees because they require little or no hands-on management by a professional. These funds are automatically invested in shares of the companies that make up a stock index, like the S& P 500 or the Russell 2000, and change only when those indexes change. If you opt for well-run index funds, you should look to pay no more than 0.25% in annual fees. By comparison, a relatively frugal actively-managed fund could charge you 1% a year.
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Your Plan May Allow You To But That Doesnt Mean You Should
One of the biggest disadvantages of 401s is that youre usually limited to a few investment options that have been selected by your employer and may or may not fit your needs. Historically, most workers had no other choice if they wanted to contribute to their 401s, but the rising popularity of 401 self-directed brokerage accounts is changing this.
More options arent always better, though, especially if youre new to investing and are unsure what to choose. Below, I explain 401 brokerage accounts in more detail, along with who may want to consider them and who is better off staying away.
After Establishing The Plan
Once your portfolio is in place, monitor its performance. Keep in mind that various stock market sectors do not always move in lockstep. For example, if your portfolio contains both large-cap and small-cap stocks, the small-cap portion of the portfolio will likely grow more quickly than the large-cap portion. If this occurs, it may be time to rebalance your portfolio by selling some of your small-cap holdings and reinvesting the proceeds in large-cap stocks.
While it may seem counter-intuitive to sell the best-performing asset in your portfolio and replace it with an asset that has not performed as well, keep in mind that your goal is to maintain your chosen asset allocation. When one portion of your portfolio grows more rapidly than another, your asset allocation is skewed toward the best-performing asset. If nothing about your financial goals has changed, rebalancing to maintain your desired asset allocation is a sound investment strategy.
Try not to borrow from your plan. Borrowing against 401 assets can be tempting if times get tight. However, doing this effectively nullifies the tax benefits of investing in a defined-benefit plan since you’ll have to repay the loan in after-tax dollars. On top of that, you will be assessed interest and possibly fees on the loan. Plus, you will often be unable to make 401 contributions until the loan has been paid off.
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What Is 401 Business Financing
401 business financing, also known as Rollovers for Business Startups , is a small business and franchise funding method. ROBS allows you to draw money from your retirement account in order to start or buy a business without incurring an early withdrawal fee or tax penalty. This is not a loan ROBS gives you access to your own money so you can build the life you want without going into debt.
Leave Your 401 With The Old Employer
In many cases, employers will permit a departing employee to keep a 401 account in their old plan indefinitely, though the employee can’t make any further contributions to it. This generally applies to accounts worth at least $5,000. In the case of smaller accounts, the employer may give the employee no choice but to move the money elsewhere.
Leaving 401 money where it is can make sense if the old employer’s plan is well managed and you are satisfied with the investment choices it offers. The danger is that employees who change jobs over the course of their careers can leave a trail of old 401 plans and may forget about one or more of them. Their heirs might also be unaware of the existence of the accounts.
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Can You Invest In Real Estate Through Your 401k
If you have a 401k plan through your employer, the answer is probably no at least not directly. I have yet to find an employer-sponsored retirement plan that allows participants to buy investment properties or participate in crowdfunded real estate investments.
The only possibility of even putting money to work in real estate indirectly in an employer-sponsored 401k would be if theres a real estate investment fund on the plans menu of investment options. For example, the Vanguard Real Estate Index Fund might be one of the funds offered by your plan.
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Most People Have Two Options:
Whether youre considering a loan or a withdrawal, a financial advisor can help you make an informed decision that considers the long-term impacts on your financial goals and retirement.
Here are some common questions and concerns about borrowing or withdrawing money from your 401 before retirement.
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What Is A 401 Loan
A 401 loan allows you to borrow money youve saved up in your retirement account with the intent to pay yourself back. Even though youre lending money to yourself, its still treated like a normal loan by charging interest that youre on the hook for.
When you take out a loan from your 401 plan, youll get terms like you would with any other type of loan: Theres a repayment plan based on how much you borrow and the interest rate you lock in. According to IRS rules, you have five years to pay back the loan, unless the funds are used to buy your main home, in which case you have more time to repay.
A 401 loan has some key disadvantages, however. While youll pay yourself back, one major drawback is youre still removing money from your retirement account that is growing tax-free. And the less money in your plan, the less money that grows over time. Even when you pay the money back, it has less time to fully grow.
In addition, if you have a traditional 401 plan, youll be repaying the pre-tax funds in the account with your after-tax earnings, so it takes even more time in terms of working hours to repay the loan.
The Millionacres Bottom Line
To sum it up, you cant purchase real estate directly with funds in an employer-sponsored 401k plan if youre still an active participant in the plan. However, if you have money in a former employers 401k plan or are self-employed, there are some good options that can allow you to put your retirement savings to work in investment properties and other types of real estate investments.
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Traditional 401 Vs Roth 401
When 401 plans became available in 1978, companies and their employees had just one choice: the traditional 401. Then in 2006, Roth 401s arrived. Roths are named for former U.S. Senator William Roth of Delaware, the primary sponsor of the 1997 legislation that made the Roth IRA possible.
While Roth 401s were a little slow to catch on, many employers now offer them. So the first decision employees often have to make is choosing between a Roth and a traditional .
As a general rule, employees who expect to be in a lower after they retire might want to opt for a traditional 401 and take advantage of the immediate tax break.
On the other hand, employees who expect to be in a higher bracket after retiring might opt for the Roth so that they can avoid taxes on their savings later. Also importantespecially if the Roth has years to growis that, since there is no tax on withdrawals, all the money that the contributions earn over decades of being in the account is tax free.
As a practical matter, the Roth reduces your immediate spending power more than a traditional 401 plan. That matters if your budget is tight.
Since no one can predict what tax rates will be decades from now, neither type of 401 is a sure thing. For that reason, many financial advisors suggest that people hedge their bets, putting some of their money into each.
