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The Pros, Cons and Complexities of Early Retirement Account Withdrawals

Posted by admin on 03/01/2020 12:00 am  

The temptation to dip into retirement assets early can be powerful, especially during financially stressful circumstances. Unexpected job (and income) loss. A huge college tuition bill. A disability or health issue that cuts into earning power and brings unanticipated medical expenses. These are among many reasons that people might consider tapping into their retirement accounts — IRAs, 401(k)s and the like.

These types of accounts were designed to be treated much like a produce crop. Plant seeds. Provide light, water and fertilizer consistently. Let grow. Harvest when ripe. With retirement accounts as with crops, there are opportunities to harvest prematurely but also, potentially, consequences for doing so.

“Generally speaking, tapping into your retirement accounts early is a bad idea,” says FPA member and CERTIFIED FINANCIAL PLANNER™ professional Jonathan P. Bednar of Paradigm Wealth Partners in Knoxville, TN. “There is a reason Albert Einstein called compounding the eighth wonder of the world. Letting your money grow for you for the long-term and avoiding the temptation to access that money early can [pay] extraordinary dividends.”

“When you see how much money one dollar can turn into over 30 years, it’s easy to justify leaving those assets alone until retirement,” adds FPA member Leon LaBrecque, CFP® of Sequoia Financial in Troy, MI.

Under federal rules, people with a qualified retirement account such as a 401(k) or a traditional IRA (Individual Retirement Account) can start withdrawing funds from their account at age 59½ and must take distributions from their account starting at age 72. Withdrawing money from a qualified retirement account prior to age 59½ means the account holder not only will likely have to pay state and federal income tax on the amount withdrawn, they also will be subject to a 10% tax penalty, unless the money is used for certain “excluded” purposes. Those exclusions include:

  • When the funds are used by the account holder or a qualified family member to purchase or rebuild a first home (limited to $10,000 per lifetime).
  • When the funds are used to cover medical expenses that were not reimbursed, or to pay for medical insurance if the account holder loses his or her employer’s insurance.
  • When the funds are used to cover higher education expenses.
  • When the funds are used to cover expenses related to the birth or adoption of a child (a new exclusion as of 2020).
  • When an employee, after separating from employment, withdraws the funds systematically in a series of at least five installments, known as Substantially Equal Periodic Payments, or SEPPs.
  • When the funds are withdrawn from a 401(k) (but not an IRA, for which different rules apply) by an employee who separates from employment (retires, quits or is fired) at age 55 or later.

The drawbacks to withdrawing money early from a retirement account extend well beyond tax penalties. For one, an early withdrawal sacrifices the growth potential of the assets that are withdrawn. Taking money out of a retirement account prematurely means losing out on the compound growth potential associated with those assets. The assets held in a retirement account have the potential to compound in value, without taxes eroding that value. Over time, earnings can compound upon earnings, providing the growth engine that people rely upon to build a large enough asset base to last through retirement.

For 401(k) account holders, early withdrawals must come out in the form of a loan that must be repaid over time. So the withdrawal comes with a payback obligation as well as a tax obligation and a penalty.

An early withdrawal also amounts to a reduction in the size of a retirement nest egg. It means using money now that likely will be needed later, during retirement, notes LaBrecque. “You need to make sure you are keeping a sustainable amount for the future, taking into account inflation and expectations of future expenses.”

“Your 401(k) [or other type of retirement account] is not a bank,” he adds. Instead, he suggests treating it as an untouchable asset in the vast majority of circumstances.

In certain rare situations, however, a retirement account could be a person’s last financial resort — their only means of covering basic living expenses (or dealing with an unexpected severe financial challenge). In those situations, says LaBrecque, “survival is more important than retirement,” and a premature withdrawal could be warranted.

There also are rare situations where making a series of early withdrawals — SEPPs — under Rule 72(t) in the federal tax code may make sense, according to LaBrecque.  The rule exempts taxpayers from early penalties provided they take account withdrawals in at least five installments over five years. This could be an option for people who retire prior to age 59½.

Before deciding to tap a retirement account early and live with the consequences, seek advice from a financial professional to discuss other potential options, suggests New York City-based FPA member Sallie Mullins Thompson, CFP®. Often, there’s another, better alternative. “It is imperative to look at all other options first.”

During situations in which early retirement account withdrawals are a consideration, “there is no one-size-fits all strategy,” says FPA member Sean M. Pearson, CFP® based in Conshohocken, Pa. “But working with a financial planner will help find the best solution for your unique situation.”

To find a CERTIFIED FINANCIAL PLANNER™ professional in your area, use the Financial Planning Association’s national searchable database, accessible at www.PlannerSearch.org.

 

March 2020 — This column is provided by the Financial Planning Association® (FPA®) and FPA of Nebraska, the principal membership organization for Certified Financial PlannerTM professionals.

FPA seeks to elevate a profession that transforms lives through the power of financial planning. Through a collaborative effort to provide members with tools and resources for professional education, business support, advocacy and community, FPA advances financial planning practitioners through every phase of their careers, from novice to master to leader of the profession. Please credit FPA of Nebraska if you use this column in whole or in part. The Financial Planning Association is the owner of trademark, service mark and collective membership mark rights in: FPA, FPA/Logo and FINANCIAL PLANNING ASSOCIATION.  The marks may not be used without written permission from the Financial Planning Association.

 


A Financial Readiness Guide for First-Time Home Buyers

Posted by admin on 03/01/2020 12:00 am  

Part 2 in a series of articles about home ownership. Click here to read part 1.

You’ve been a renter, a tenant, for long enough. Now you’re ready to say goodbye to the landlord and become a homeowner yourself for the first time.

You are not alone. The credit bureau TransUnion projects at least 8.3 million first-time homebuyers will enter the housing market between 2020 and 2022, up significantly from 7.6 million during the 2016-2018 period.

For many people, buying that first home is the single largest purchase, and, perhaps, the most important investment, they have made to this point in their lives. Given the financial magnitude of a first home purchase, the nuances of the purchasing process and the far-reaching ramifications it’s likely to have on a person’s (or a couple’s) life, the better prepared you are, the more positive the outcome is likely to be.

Here in the second in a series of articles from the Financial Planning Association® (FPA®) about home ownership, CERTIFIED FINANCIAL PLANNER™ professionals provide potential first-time home-buyers with advice and guidance to help prepare for and navigate the purchase experience.

So, you’re considering purchasing your first home. Having never been down this road before, you have questions: How does the process work? What should I do to prepare in advance? Are there steps I can take to put myself in a better financial position leading up to and after the purchase?

The answer to the latter question is, of course, “Yes!”

“Planning ahead is a great way to get ready for owning a home for the first time,” says FPA member and CERTIFIED FINANCIAL PLANNER™ professional Amy F. Merrill of True Wealth Management in Atlanta, GA.

Here’s a closer look at some of the key planning steps first-time home-buyers should consider taking prior to the purchase, along with other important details about the process.

Check your credit score, and if possible, do what you can in the short-term to improve it. Unless you have a significant lump sum of cash available and a willingness to spend it, you likely will need to secure a mortgage loan to cover a large portion of the home purchase. Generally speaking, the better your credit score (as calculated by the major credit bureaus, TransUnion, Experian and Equifax), the better terms you should be able to secure for a mortgage (greater borrowing power at a lower interest rate).

So check your credit score first. You can do so free of charge via websites such as Credit Karma and freecreditscore.com. Besides seeing where you stand, you also should look carefully through your credit report to see if there are any errors that could lower your score, says FPA member Michelle A. Fait, CFP®, who heads Satori Financial LLC in Seattle, WA.

While improving your credit score tends to take time, she notes, it’s possible to make short-term improvements in your score by paying all your bills on time, and by ensuring you make at least minimum monthly payments on all your credit cards.

  • Set aside money for a down-payment, keeping it hands-off in in a separate savings account. The larger the cash amount you pay upfront, the lower the amount you’ll need to borrow and pay interest on. The key word here is interest. The longer the term (length) and the amount of the loan, the larger the overall amount of interest you’ll pay on the loan. Say a person buys a $250,000 home, for which their down-payment is $50,000. That means they’ll need a mortgage of $200,000. If it’s a 30-year mortgage with an interest rate of 5%, they’ll end up owing the lender a total of about $386,500 over the life of the loan, including $200,000 in principal (the original loan amount) and $186,500 in interest.

 

Those figures underscore the importance of focusing on saving toward a down-payment. To do so, set aside money in a high-interest savings account that you establish exclusively for the home purchase (find the best interest rate at a site like www.bankrate.com). To take guesswork out of the equation, automate contributions to the account. And be sure you commit to leaving the money in the account until you’re ready to pull it out for the purchase.

  • Factor in your priorities as well as your financial wherewithal in determining how much to spend on a home. One of the first things mortgage lenders do with potential borrowers is to determine how much of a mortgage they would qualify for, based on a formula that accounts for household income, debt and other factors. Use that figure as a guide only, recommends FPA member Marisa Bradbury, CFP® of Sigma Investment Counselors in Lake Mary, FL. “Mortgage companies will approve you for a much higher amount than you typically should be spending. Just because you’re approved for that amount, doesn’t mean you should spend that amount.

 

Be sure to look beyond the numbers, too, giving adequate weight to other important big-picture factors, Fait suggests. “One of the biggest drivers of both happiness and grief in your personal financial life is where you live. If you buy as much house as you can afford and love everything related to it, super. If you do this and your housing costs crowd out every other thing you might want to do (eating out, movies, travel, etc.) you might do better to buy less house and have more flexibility.”

“Think about your take-home pay every month, allocate it out to your priorities (food, travel, student loans, anything else that’s important to you) and then see what you can afford without sacrificing other things that are important to you. It’s all a trade-off,” adds FPA member Tess Zigo, CFP®, of Waddell & Reed Financial Advisors in Overland Park, KS. “Think about what’s really important in a home, location, size, style, etc., …and so instead of spending the extra money on a bigger mortgage…I choose to spend the extra money I have on experiences — traveling, nights out with friends and ultimately being able to reach financial independence in my 50s. It’s really important to look in the mirror and decide what’s important to you and makes you happy, not what society often tells us to view as success — the big house, for example — but what brings you the most joy.”

  • Comparison-shop for a mortgage. Approach at least three lenders for a quote, including a bank with which you have a relationship, as well as an independent mortgage broker and a third institution such as a credit union or an online lender, suggests Fait. Then compare annual percentage rates, not just interest rates. “The APR gives you a true comparison of loan interest rates and costs.”

 

  • Look for tax breaks and other perks for first-time home-buyers. Many states provide financial incentives and tax credits to first-time home buyers.Nerd Wallet offers an overview of those perks here.

 

  • Budget for more than just a mortgage payment. The mortgage payment is merely one line item (albeit a large one) in the overall tab for home ownership. There’s also state and local taxes and homeowner’s insurance, which a mortgage lender typically will wrap into the cost of monthly payments (as escrow).

 

Then there are the other expenses that come out of the homeowner’s pocket: utilities, maintenance on the home and yard, repair and replacement of appliances, roof, etc., and perhaps other costs such as homeowner association fees, home improvement projects and the like. “We always recommend that clients have a 'house fund' with $10,000 to $15,000 to handle the ‘joys of home ownership’ issues,” explains Merrill.

Also budget for new furnishings, Fait suggests. “You might want or need a few new items for the new house, but plan for them, rather than allow the new house to encourage lifestyle creep.”

  • Take your budget for a test drive. “Before you buy the house, definitely practice living with the new monthly expenses to see how it feels before you jump in,” Merrill recommends.

 

  • Put payments on autopilot. Automate your mortgage payment and your utility bill payments. Paying on time every time helps to build a better credit score, a positive for the next time you buy a home!

 


March 2020 — This column is provided by the Financial Planning Association® (FPA®) and FPA of Nebraska, the principal membership organization for Certified Financial PlannerTM professionals.

FPA seeks to elevate a profession that transforms lives through the power of financial planning. Through a collaborative effort to provide members with tools and resources for professional education, business support, advocacy and community, FPA advances financial planning practitioners through every phase of their careers, from novice to master to leader of the profession. Please credit FPA of Nebraska if you use this column in whole or in part. The Financial Planning Association is the owner of trademark, service mark and collective membership mark rights in: FPA, FPA/Logo and FINANCIAL PLANNING ASSOCIATION.  The marks may not be used without written permission from the Financial Planning Association.