Q&A: Why tapping retirement cash early shouldn’t be done lightly

Dear Liz: I’m reaching out on behalf of my father, who does not know how to write emails. He was wondering if he pulls his money out of his IRA, how much will he get charged? Also, how much would he be able to give to his granddaughters without being charged?

Answer: Withdrawals from IRAs and most other retirement accounts are taxable. The tax bill will depend on his tax bracket and whether his contributions were pre-tax (deductible) or after-tax (non-deductible). If he withdraws money before age 59 1/2, he also may face tax penalties. A premature withdrawal can easily trigger a tax bill of 25% to 50%. Once the money is withdrawn, it also loses all the future tax-deferred returns it could have earned.

If he gives the money to his granddaughters, it’s unlikely he would face an additional tax bill. He would be required to file a gift tax return if the amount exceeded $14,000 per recipient in a year, but he would only have to pay gift taxes if the total amount he gives away in his lifetime over that limit exceeds $5.49 million.

Clearly, taking money out of a retirement account is a big deal and something that shouldn’t be done lightly. At the very least, your dad should consult a tax pro who can estimate the bill he’s likely to face. He’d be smart to consult a fee-only financial planner as well so he understands the potential effect this withdrawal could have on his future standard of living.

Wednesday’s need-to-know money news

Today’s top story: Don’t get taken by government grant scams. Also in the news: When you should and shouldn’t tap your Roth IRA, using your credit cards to pay for child care, and a report that finds many American teens lack basic financial skills.

Don’t Get Taken by Government Grant Scams
The government doesn’t want to give you money.

When You Should — and Shouldn’t — Tap Your Roth IRA
Let your interest rate be your guide.

Should You Use Credit Cards to Pay for Child Care?
Depends on the card.

Report finds many American teens lack basic financial skills
Not a good sign.

Make your teen a millionaire this summer

Gary Sidder set up Roth IRAs for his sons when they turned 13. Each year, the Littleton, Colorado, certified financial planner and his wife, Francie Steinzeig, a school psychologist, contributed an amount equal to whatever the two boys earned cutting lawns, shoveling snow and doing odd jobs. As the sons’ earnings increased, so did the parental contributions.

“Initially we started with $400, and now we do $5,500 for each,” the annual maximum allowable contribution, says Sidder, whose sons are 32 and 27. “Now that their accounts are worth more than $100,000 and $65,000, respectively, they do see the value of saving and starting early.”

Even if no further contributions are made, both sons could see their accounts top $1 million by retirement age, assuming conservative 7 percent average annual returns.

In my latest for the Associated Press, how setting up your kids with an IRA could pay off big dividends for their future.

Thursday’s need-to-know money news

Today’s top story: 6 myths about IRAs you can’t afford to believe. Also in the news: New loan modifications from Fannie and Freddie, tax refund loans, and what the Consumer Financial Protection Bureau offers consumers.

6 Myths About IRAs You Can’t Afford to Believe
IRA mythbusting.

New Loan Modification From Fannie, Freddie: What to Know
Keeping your home out of foreclosure.

Tax Refund Loans Offer Fast Cash for Early Filers
But pay close attention to the fees.

What Is the CFPB and What Does It Offer Consumers?
And why it’s in danger.

Friday’s need-to-know money news

mortgage2Today’s top story: Why you should front-load your IRA in January. Also in the news: Rideshare insurance for drivers, why January is the best time to buy a home, and how fifteen minutes a day can get your finances in order.

Front-Load Your IRA in January for a Bigger Payoff
It’s all about compound interest.

Rideshare Insurance for Drivers: Where to Buy, What It Covers
What Uber and Lyft drivers need to know.

Why January Is the Best Time to Buy a Home
Timing is everything.

Commit to Fifteen Minutes of Financial Literacy a Day to Get Your Finances in Order
Make it a daily habit.

Tuesday’s need-to-know money news

Life InsuranceToday’s top story: Life insurance questions you’re too embarrassed to ask. Also in the news: what to do with an IRA when you leave a job, when a debt collector calls to collect money you don’t owe, and the profitable business of lending to subprime borrowers.

5 Life Insurance Questions You’re Too Embarrassed to Ask
There are no dumb questions!

Why to Do an IRA Rollover When You Leave Your Job
Don’t leave money behind.

When a Collector Calls About a Debt You (Possibly) Don’t Owe
Get all the information you possibly can.

The profitable business of lending to subprime borrowers
Subprime borrowers bring in lots of extra money.

Q&A: Retirement account bears close scrutiny

Dear Liz: About five years ago, I transferred a 401(k) account to an IRA with a financial advisor recommended by a friend. I receive monthly statements, but like most people, I am busy and do not study them, which is my fault. The statements are very confusing, even though I am a college graduate with a business degree. I recently realized that the account has not grown at all, even though it’s invested in stock mutual funds. The Standard & Poor’s 500 has been up about 10% each year on average, so I feel that I should have a much better return. How do I best go about finding out why I am not making any money? Approaching this financial advisor is useless.

Answer: It appears your advisor is worse than useless; he or she is a hazard to your financial health.

A properly diversified retirement portfolio may not grow at exactly the same rate as a stock benchmark such as the S&P 500, but it certainly should have grown significantly in the past five years. It could be that the advisor has been trying to “beat the market” with actively managed funds, which typically fall far short of the mark and do little other than cost investors too much. Or the advisor could be pushing high-cost funds that pay fat commissions and benefit the firm far more than they benefit you.

The Department of Labor recently instituted regulations that should stop many of these shenanigans by requiring advisors giving retirement advice to put their clients’ interests ahead of their own. You shouldn’t wait for those changes to be implemented, though, because you’ve already lost enough ground. Transfer your IRA to a low-cost provider such as Vanguard, Fidelity or T. Rowe Price and consider investing in a target-date retirement fund that will take care of asset allocation and rebalancing for you.

Q&A: Cashing out an IRA to pay off credit card debt

Dear Liz: I owe about $49,000 on my credit cards and now have the money to pay them off in full. Should I? Or should I slowly pay them in large amounts?

Answer:
There’s typically no reason to delay paying off credit card debt. Carrying balances costs you money and doesn’t help your credit scores. You’ll see the fastest improvement if you pay them off in one fell swoop.

The only excuse for delaying would be if this windfall comes from a retirement fund. Cashing out a 401(k) account or IRA to pay off debt is not wise, since you’ll trigger huge taxes and penalties. Add in the future tax-deferred compounding you lose and the total cost is far more than you’ll save in interest.

Q&A: IRA maintenance fees

Dear Liz: My son has an IRA at his credit union. He puts in small amounts when he can. Recently they lowered the interest rate and started charging a $25 yearly maintenance fee, which now is taking all the interest back. Is this legal?

Answer: Yes. It’s also a good reason to move the account elsewhere.

Your son’s retirement account was shrinking in real terms even before the fee ate up all his interest. Even though rates are now on the rise, they’re still lower than inflation, which means the money’s buying power is being eroded every day.

Your son needs to invest in stocks if he wants his savings to grow faster than inflation. A few discount brokerages, including ETrade, Fidelity and TD Ameritrade, have no account minimums or annual fees.

Your son also should consider making automatic contributions to his retirement account. This is known as “paying yourself first,” and it ensures that those contributions actually get made. Waiting until he sees what’s left over is paying himself last, and the result will be a much smaller retirement fund than he’s likely to need.

Q&A: 401(k) followup

Dear Liz: Your reply about what to do with a 401(k) after someone leaves a job was off base, in my opinion.

You advised the questioner to leave the 401(k) with the former employer until it could be rolled over to a new 401(k) with a new employer. Wouldn’t it be better to roll over the old 401(k) to an IRA? An IRA offers more control and better investment options than a 401(k).

Answer: More is not necessarily better. Some people appreciate the chance to diversify their investments by using a rollover IRA. Many others, however, have no need for thousands of investment options and in fact could be paralyzed by so many choices.

The investment options available for IRAs also can be more expensive than what’s typically available in large company plans. These 401(k)s often offer institutional funds with low expense ratios that are unavailable to retail investors.

Finally, 401(k)s have better protection from creditors than IRAs if the worker is sued or files for bankruptcy, although that won’t be an issue for the vast majority of savers.

People can protect an unlimited amount of money in a 401(k), while IRA protection is limited to $1,245,475.

Keeping an account with an old employer, or rolling it over to a new one, won’t be the right solution for everyone. But neither is an IRA rollover—despite what brokerage houses that profit from IRA rollovers may tell you.