Dear Liz: Recently, someone from an insurance company proposed that I stop investing through my 401(k) at work and instead invest in his insurance company contract with after-tax dollars. He claims the funds would be guaranteed so that I would never lose principal, although there would be a cap on how much I could make in any given year. His claim is that it is better to forgo the tax deduction I would get from my 401(k) contributions so that I can take the money out of this contract tax-free in 20 or 30 years. I think I am too old for this program (I am 61 now) but I thought it might be appropriate for my daughter when she enters the workforce in a few years.
Answer: You may have been pitched an equity-indexed annuity. These are extremely complex investments that should not be purchased from someone who misrepresents how they work and who encourages you to forgo better methods of saving for retirement.
Withdrawals from annuities are not tax-free. You would not have to pay income tax on the portion of the withdrawal that represents your initial contributions, but any gain would be taxable at regular income tax rates.
Furthermore, most people fall into a lower tax bracket in retirement. That makes the tax break offered by 401(k) contributions especially valuable, because you’re getting the deduction when your tax rate is higher and paying the tax when your rate is lower.
The Financial Industry Regulatory Authority, which regulates securities firms, has warned that most investors consider equity-indexed annuities and other annuity products “only after they make the maximum contribution to their 401(k) and other before-tax retirement plans.”
Even then, you probably have better ways to save. Contributions to a Roth IRA would not be tax-deductible, but withdrawals in retirement would be tax-free. If you’re able to save still more, you could contribute to a regular, taxable brokerage account and hold your investments at least one year to qualify for long-term capital gains rates, which are lower than regular income tax rates.
The other possibility is that the insurance salesman was pitching a life insurance policy that would allow you to take out a tax-free loan. Although life insurance is sometimes pitched as a retirement savings vehicle, it’s an expensive way to go. In general, you should buy life insurance only if you need life insurance. To help ensure a policy is suitable for your situation, you should take it to a fee-only financial planner—one who does not make commissions from selling investments–for review.
In any case, you don’t want to do business with someone suggests you stop funding your workplace retirement plan, and you certainly don’t want to refer him to family members. What you should do instead is pick up the phone and report him to your state insurance department.
Dear Liz: I have a first mortgage with a current balance of $32,000 at 5.625% interest. This will be paid off in about 24 months, based on regular payments plus $200 a month extra I am paying on principal. I have a home equity line of credit with a balance of $200,000 at 3% interest on which I am paying interest only ($490) monthly with an occasional principal payment when I can afford it. Between the two mortgages I am making payments of about $1,950 per month.
I am about to retire and want to reduce my payments to a more manageable amount. I do not intend to move in the near future. Income is $145,000 annually now but will be reduced to about $76,000 annually upon retirement. Should I just hold on, pay off the first mortgage and then begin making interest plus principal payments on the credit line? Or should I refinance both mortgages now into a 30-year fixed mortgage?
Answer: Ideally, you would retire your mortgage debt before you retire from your job. That’s not possible in your case, so you should focus on making sure this debt doesn’t wreck your retirement.
A spike in interest rates could play havoc with your budget. Mortgage interest rates have been extremely low for some time, but that won’t continue indefinitely. Inflation may pick up as the economy improves, which means that 3% variable rate on your home equity line of credit could march considerably higher.
Consider locking in today’s low mortgage rates with a 30-year, fixed-rate mortgage. You could get an even lower rate on a 15-year mortgage, but the payment would be significantly higher — about $1,600 a month on a $232,000 mortgage, compared with about $1,000 a month for the 30-year loan. You may prefer the flexibility of the 30-year loan, which would still allow you to make extra principal payments to pay off the loan faster without locking you into a higher monthly payment.
Dear Liz: I’m in my 50s. My kids have college loan debts that might total more than $200,000. I allowed them to take out loans because I expected to inherit $300,000 to help them pay off the debt. Now that inheritance will not happen.
I have $250,000 saved for retirement. When I’m 58 1/2 years old, I would like to pull that money out and pay some or all of these debts. Or use home equity. I’ve recently been downsized in employment, but I am looking to increase my income so I can help with their debt. Advice?
Answer: If your goal is to impoverish yourself so your kids will have to take care of you in your old age, by all means proceed with your plan. Otherwise, you need to rethink this.
You’ve been laid off in the middle of what should be your peak earning years. Older workers often have a tougher time than younger ones finding replacement jobs, even in a better economy than this one. You may not be able to replace your former income, which means you may not be able to add much to the amount you’ve already saved. You should be conserving your resources, including your home equity, and not squandering it repaying debts that aren’t yours.
And “squandering” is the right word. You may be able to avoid paying federal and state tax penalties on withdrawals under certain conditions; distributions made after age 59 1/2 avoid the penalties, as do those made if you’re “separated from service” if the job termination occurred in or after the year you turn 55. But you’ll still owe income taxes on the withdrawal, and those can be considerable.
Your children are the ones who will benefit from their educations. Those educations should allow them to earn incomes to repay these loans. The amount of debt they’ve accrued might be excessive — you didn’t specify how many kids, or whether this debt is being incurred pursuing undergraduate or graduate degrees. Ultimately, though, they will be in a better position to pay the debt than you are.
If you promised them help you can’t deliver, sit down with them now to break the bad news and strategize on how they can finish their educations without incurring substantially more debt.
Your story also should serve as a cautionary tale for anyone counting on an inheritance to pay future bills. Until the money is in your bank account, it’s not yours and shouldn’t be part of your financial planning.
Dear Liz: I’m about to marry an active-duty military man. We’re in the process of marrying our finances, and I have several questions.
First, what is a good emergency fund for us? We run our household on his salary because I’m recently unemployed. I’ve always had a six-month emergency fund for myself, but because he’ll theoretically always be employed, should we have less savings in emergency funds and more in retirement and investments?
Second, along with my unemployment, I’m bringing about $15,000 in savings and $9,000 in student loan debt (at 4.5%). He has about $5,000 in savings and no debt at all. Neither of us has a retirement account or any other investments. I’m leaning toward paying off my debt so that we start on even ground, but I have a feeling that you’re going to tell me not to do that. What should I be considering at this time?
Answer: The military offers good benefits and generous pensions to people who make the armed services their career. But the pension probably won’t cover all your expenses in retirement. (Remember, if he retires after 20 years of service, he’ll get only 50% of his base pay.) Besides, there’s really no such thing as “guaranteed” employment, even in the armed services, so it’s smart to have a Plan B.
Your husband-to-be should be taking advantage of the federal Thrift Savings Plan, which works like a 401(k) for civilians, although there’s no employer match for service members. He can contribute up to $17,000 a year ($17,500 in 2013), his contributions are excluded from his taxable income, and the money grows tax-deferred until it’s withdrawn in retirement, at which point it’s taxed as regular income.
The Thrift Savings Plan also has a Roth option. Withdrawals from a Roth in retirement are tax-free, although contributions usually are included in taxable income. The exception: If your fiance is deployed, most or all of his income would be tax-free, so he would be able to make contributions to the Roth with tax-exempt income, said Joseph Montanaro, a certified financial planner with USAA. That’s a pretty great deal: no tax on the contributions going in, and no tax on the withdrawals coming out.
If your man isn’t deployed, he still might want to divide his contributions between the regular and Roth plans so that he would have different savings “buckets” to tap in retirement and thus more control over his tax bill.
He probably wouldn’t get a full military pension if he leaves or is forced out of the military before he has served 20 years. But he would be able to take his Thrift Savings Plan balance with him.
When you return to work, you also should start contributing to a retirement fund. If you don’t have access to a 401(k) or 403(b), you might contribute to an IRA or a Roth IRA.
Although you would be smart to pay off any high-rate debt, such as credit card balances, you need not be in a rush to pay off low-rate, tax-deductible debt such as student loans, especially if the rate you’re paying is fixed. Instead, focus on building up that emergency fund. The exact amount you need is more art than science, but a six-month fund would be prudent.
Dear Liz: I will be 61 in December. I have $15,000 in credit card debt at 9.9% and $41,000 in a certificate of deposit earning 3% per year. I have $590,000 in my 401(k) account. I want to pay off the credit card balance to redirect my income to paying off my $26,000 mortgage by the end of 2013. Which near-term option for paying off the credit card is better: close the CD and buy a new, lower-paying CD with the balance after paying the card off, or take a 401(k) distribution, leaving the $41,000 emergency fund untouched?
Answer: Since you’re older than 591/2, you would not have to pay penalties on any withdrawal from your 401(k). But a withdrawal would still be a bad idea for a number of reasons.
The most obvious is that you would have to pay taxes on any amount you take out. Typically 20% is withheld from any distribution, but your bill could well be higher depending on your federal and state tax brackets. In the 25% federal and 8% state brackets, you’d owe $3,750 in federal and $1,200 in state taxes on a $15,000 withdrawal. So even without penalties, you’d lose one-third of a withdrawal to taxes.
The money you take out also wouldn’t be able to earn any future tax-deferred returns for you. At 60, you have a life expectancy of a couple more decades. The money you plan to withdraw potentially could grow to more than $70,000, assuming 8% average annual returns, if you leave it alone.
So using 401(k) money to pay debt is almost as dumb for you as it would be for a younger person who would pay penalties and incur an even bigger potential loss of future tax-deferred money.
Use the CD money instead, and change your spending habits so you don’t incur any future credit card debt.
Dear Liz: My former employer is offering the one-time opportunity to receive the value of my pension benefit as a lump-sum payment. The other option is to leave the money where it is and get a guaranteed monthly check from a single life annuity when I reach retirement age. I am 40 and single, and I have been investing regularly in a 401(k) since graduating from college. I have minimal debt aside from a car payment. When does it make financial sense to take a lump sum now instead of an annuity check later?
Answer: Theoretically, you often could do better taking a lump sum and investing it rather than waiting for a payoff in retirement. That assumes that you invest wisely, that the markets cooperate, that you don’t pay too much in investing expenses and that you don’t do anything foolish, like raid the funds early.
That’s assuming a lot. Another factor to consider is that the annuity is designed to continue until you die. It’s a kind of “longevity insurance” that can help you pay your bills if you live a long life.
Some financial advisors will encourage you to take the lump sum, since they may be paid more if you invest it with them. Consider consulting instead a fee-only financial planner who charges by the hour — in other words, someone who doesn’t have a dog in this particular fight. The planner can walk you through the math of comparing a lump sum to a later annuity and help you understand the consequences of both paths. This is a big enough decision that it’s worth paying a few hundred bucks to get some expert advice.