After the recent economic meltdown in the US, many people have incurred insurmountable amount of debt. In such situation, debt consolidation programs can help you pay off the debts. Due to poor credit report you might face problem of getting debt consolidation loan. Therefore, you can borrow against 401k to consolidate your debts. Once you pay off your debt you can regain control over your financial situation and again start making contribution to your 401(k) plan.

1. You can approach the human resource department of your company to know whether there is a possibility of getting loan against your 401k instead of withdrawing from the plan. The IRS will not impose tax penalty if you do not withdraw money from your account. You are required to pay interest rate on the loan amount that you borrow from the 401k plan.

2. You can consult your 401k administrator regarding the evaluation of the Summary Plan Description (SPD). You will be given the terms and clauses under which you are allowed to withdraw money from your 401k account. You are eligible to take out money from 401k if you are facing severe financial hardship.

3. Make sure that you withdraw the amount you require to pay off your debts otherwise you might put your retirement savings plan at risk. You need to pay penalty if you withdraw money from 401k before your retirement. You can avoid this kind of penalties by taking out the money in annual installments. But it might not be beneficial to people withdrawing money for paying off their debts.

4. Once you get the money from your retirement account make sure you immediately use it for paying off your owed amount. Once you eliminate your debt then promptly start working on rebuilding your credit rating.

5. After you pay off your debt start your 401k contribution for long term growth. If you borrow money from your company then you are required to repay the loan and it will be deducted from your monthly paycheck.

Therefore, if you take out money against 401k then you can pay off your owed amount without damaging your credit report.

Financial advisors will never advise you to borrow money from your 401(k) retirement plan, after all this is the nest egg that you will need when you stop working upon retirement.

Other financial advisors will tell you borrowing a 401k loan from your own retirement account is more like an act of robbery! While it is encouraged not to ever borrow from your 401(k), there are advantages of doing so on the flip side; this is what we will explore in this article. In fact, according to a study conducted by the Employee Benefits Research Institute (EBRI), 18% of all 401(k) investors had outstanding loan balances at the end of 2006. Since 18% is a significant number, there must be some advantages to borrowing 401(k) loans that these people saw. Let’s look at some advantages of borrowing 401k loans, and how not to dig a deep hole in your retirement savings. The diagram on the left describes 401(k) loans in a nutshell. In the left side of the diagram, you are borrowing a loan from your local bank, that gets its funds from investors in the stock/commodities markets. This money in the stock market ultimately comes from mutual funds that hold 401(k) retirement money of millions of employed Americans. On the right side of the diagram, you are borrowing directly from your own 401(k) plan thereby eliminating the need for borrowing from your bank and the financial markets.

When Should You Borrow a 401(k) Loan?

When you need liquid cash urgently for a serious short-term need, a 401(k) loan from your retirement savings would sound probable. Short-term need is defined as less than 12 months. Also, a serious cash need is something that is really urgent, and not the purchase of a 47-inch Panasonic television. A 401(k) loan from your retirement savings is a quick, cost-effective way of borrowing, and it does not create a taxable event unless the limits placed on the loan are violated and the loan is not repaid on time. Also, if you pay back the short-term 401(k) loan on time, it will not significantly impact the total growth of your nest egg upon retirement. In fact, sometimes it may even have a positive impact on your total nest egg.

Basics of 401(k) Loan Borrowing

401k loans are not actually loans because there is no lender, and there is no examination of your credit rating. A 401(k) loan is the ability to reach in to your retirement nest egg and withdraw up to $50,000 or 50% of your total retirement savings, whichever is lesser. After that, you must pay back this money within 1 year to restore your 401(k) to its original level. The feature that really stands out in this transaction is that this whole process is tax-free, thus when you withdraw the $50,000, you will not be taxed on it, thus treating it as a tax-free cash withdrawal! Another cool feature of 401(k) loans is the Interest. For the 1 year period that you borrow the loan, you will have to pay interest fees, however these interest fees are added back to your original 401(k) nest egg. Thus, this is not a borrowing cost, in fact you are paying yourself back. This feature is a lot more attractive than having to borrow money from banks and paying their outrageous 10%+ interest rates.

4 Reasons to Borrow from Your 401(k) Plan

i) Repayment Flexibility: Most 401(k) plans allow a 5 year amortization repayment schedule, however your loan can be paid off faster with no prepayment penalties. You can setup automatic payroll deductions from your check with a percentage of it being taken off to repay your loan. After every biweekly payroll deduction, be sure to take a look at your month statements to make sure you have been credited for the deductions.

ii) Speed of Loan Request: Borrowing a loan from your 401(k) retirement savings requires no credit check to be done on you, nor is your credit rating checked. Your employer usually should have an online application form requesting funds from your 401k plan. If the management of your company’s 401(k) plans are outsourced to a financial services company such as JP Morgan, Manulife Financial or ICICI, then you should visit that bank’s website and log in to your account.

iii) Save on Fees: When you borrow from your 401k(k) plan, there are no costs associated other than the interest that you repay yourself. You do not have to pay the extremely high Credit Card APRs, late payment fees, overdraft interest, etc. When you log in to your financial services company’s website you specify from which investment you want to withdraw money from, and that investment is liquidated for your specified amount. Thus, you will be losing any positive gains you would have made if you had left your money intact in the investment, this is the disadvantage. However, you also avoid any losses that that investment might have made. You will realize there is an opportunity cost associated here. The cost of borrowing from your 401(k) plan versus borrowing from a credit card is:

For instance, if you borrow a loan from your credit card company at 15% APR, versus if you borrow from your 401k plan where you are currently returning 9% a year, the cost advantage is:

401(k) Loan Cost Advantage = 15% – 9% = 6%

Thus, you are saving 6% in interest fees and costs if you borrow from your 401k plan versus if you borrow from your credit card.

iv) Time for Payback: When you repay your 401(k) loan, you will have to pay slightly more than what you borrowed. This is the interest charged on your borrowing, and the best advantage of it is that instead of paying a credit card company, you are repaying yourself.

Media & Their Say on 401(k) Loans

The media always criticizes borrowing from your 401(k) loan as a legal “robbery” or “raid” on your retirement savings. They say this assuming:

i) The investment returns you gain from your 401(k) funds invested in the stock market generate strong returns. With the recession of 2009 in hand, and the Dow Jones hitting below 6000 points, you can actually forget about generating any returns on your investment! In fact, you should be worried about strong negative returns on your 401k funds.

ii) They do not take into account the extremely high Annual Percentage Rate (APRs) that banks and credit card companies charge on money borrowed from credit cards. Thus, if you refrain from borrowing 401(k) loans but rack up credit card debt and pay the extremely enormous interest rates, then it is time to think about a change.

In this article, we will look at the advantages of making salary deferral 401k contributions to employer sponsored retirement programs.

1) Reduces Your Current Taxable Income

Contributions towards an employer sponsored 401k retirement plan are made in before-tax dollars. This means your current taxable income for the year is reduced by the total amount of contribution you have made. For example, you might be single and earn $50,000 this fiscal year. However, if you make a $4000 contribution towards a 401k retirement plan this year, your current taxable income for the year will be reduced to $50,000 – $4000 = $46,000. Say hypothetically, you are in the 25% tax bracket. Here are the results:

• Before Making 401k Contributions $50,000 x 25% = $12,500 Tax Owing
  After Making 401k Contribution of $4000. $46,000 x 25% = $11,500 Tax Owing
• After making 401k contributions of $4000, you have lowered your current tax owing from $12,500 to $11,500.
• Note: This is only a hypothetical example. Individual results are based on current taxable income, amount of 401k contributions and what tax bracket you fall into.

Note also that you will eventually be taxed on this $4000 you contribute towards a 401k plan. However, if you do this at the age of 65 (when you are not working and are in a lower tax bracket), you will pay a much lower tax at the age of 65, as opposed to now. Make sense?

2) No Taxes Owing on Earnings

Another advantage of contributing towards a qualified 401k retirement plan is the fact that any earnings you make on your contributions are also tax-deferred up until you retire or withdraw your money. For example, consider this hypothetical example:

• Annual 401k Contributions $4000
• # of Years of 401k Contributions 10 Years
• Interest Rate (Compounded Annually) 8%
• Future Value of 401k Investment 62,581.95
• Original Principal $4000 / year x 10 Years = $40,000
• Earnings $62,581.95 – $40,000 = $22,581.95

Until the time you make 401k withdrawals or turn 65 (upon retirement), you will NOT be taxed on this earnings amount of $22,581.95. Say you are in a tax bracket of 25% at the moment earning $50,000 a year. However when you retire, you will be in a tax bracket of only 10%. This means when you withdraw this earnings amount of $22,581.95 at the age of 65, you will be taxed only 10%, as opposed to getting taxed at your current tax bracket of 25%. Make sense?

3) Employer Match 401k Contributions

Most employers will match your 401k contributions up to a certain percentage amount. You should at least make salary deferral 401k contributions up to the percentage amount of 401k contributions your employer is willing to pay for you. Consider this hypothetical example:

James works for Coco Corporation and has an annual gross salary of $40,000. His employer said he will make employer matched contributions of $0.55 per every dollar that James contributes, up to 5% of his salary. Here’s what’s going on:

• John’s Annual Wage $40,000
• 5% of John’s Annual Wage $2000
• John Contributes $3000 this year to 401k Plan $3000
• Employer Matched 401k Contribution = $3000 x 0.55 = $1650

Therefore, what is the total sum of 401k contributions that John and his employer are making together?

• Total 401k Contributions $3000 + $1650 = $4650

What will the nest egg of John be after 10 years? Using a table similar to the one we used above, here are the results:

• Annual 401k Contributions $4650
• # of Years of 401k Contributions 10 Years
• Interest Rate (Compounded Annually) 8%
• Future Value of 401k Investment $72,751.52
• Original Contribution $3000 / year x 10 Years = $30,000
• Earnings $72,751.52 – $30,000 = $42,751.52

John contributing solely to the 401k plan would have resulted in a nest egg of $46,936.46 in 10 years. However, John and his employer matched contributions combined would result in a nest egg of $72,751.52 The difference is huge:

• Difference = $72,751.52 – $46,936.46 = $25,815.16

Understand 401k Hardship Withdrawals

The Internal Revenue Service (IRS) allows 401k investors to take out 401k hardship withdrawals in the form of loans only if these 6 criteria are met:

i) the withdrawal is due to an immediate and important financial need
ii) the withdrawal must be necessary to satisfy that need
iii) You have no other way to fulfill that need or no other sources of money
iv) the withdrawal should not exceed the total amount needed by you
v) You cannot contribute to your 401k plan for up to 6 months after your withdrawal date
vi) You must have first received all non-taxable distributions or loans available under your 401k

401k Hardship withdrawals are permitted by some large companies, but due to the high costs of administering them, they may not be readily available in smaller companies. Check with your Human Resources department to see if 401k hardship withdrawals are permitted in your 401k program.

The following are reasons acceptable by the IRS for a hardship withdrawal

i) Repairs of primary residences
ii) Funeral expenses
iii) Payments necessary to prevent you from being forced out of your home
iv) Home foreclosures
v) Payments of college tuition & other educational costs such as room & board, transportation, food, etc.
vi) Purchase of principal residence
vii) Unexpected or un-reimbursed medical expenses

401k hardship withdrawals are subject to a 10% early withdrawal penalty as well as income taxes due. For example if you withdraw $10,000 as hardship withdrawal, you will owe $1000 in penalty, as well as be taxed on the $9000. There are some hardship withdrawals however that are not subject to the 10% penalty, they are:

i) You stop working, get laid off, quit or retire in the year you turn 55 or after
ii) Court orders you to give money to a divorced spouse or dependent
iii) Unexpected medical debts that exceed 7.5% of your Adjusted Gross Income
iv) Permanent disabilities
v) You stop working and begin taking regular payments based on a schedule that will make equal payments for the rest of your expected life; this must last for 5 years or until you turn 59 and 1/2, whichever is longer.

A Simple 401k plan is less well known than its counterparts Simple IRA and a traditional 401k but actually combines the best of benefits provided by both plans into 1 single plan, the Simple 401k. In this article, we explore some of the features provided by Simple 401k plans and advantages/disadvantages.

Advantages of Simple 401k Plans

i) No Testing – Traditional 401k plans require intensive testing to make sure the plan works in compliance with regulatory requirements set out by law. Such testing must be done by 401k professionals and can be very costly. On the other hand, Simple 401k plans do not require such testing and can be very appealing to small business owners who do not have the capital to expense to all the heavy testing that traditional 401k plans require.

ii) Borrow Loans - Simple 401k plans make it easier to borrow loans from one’s 401k and pay it back in the form of principal and interest payments.

Disadvantages of Simple 401k

i) Immediate Vesting – With traditional 401k plans, new employees may be required to work a minimum # of years or months before they can make contributions to the company’s 401k plan. This can work in the form of a contribution vesting schedule. With Simple 401k, contributions are vested 100% immediately. This means employees who meet the eligibility of taking distributions from their retirement accounts may do so at any time, even if it means withdrawing their entire savings account.

ii) Lower Contribution Limits – The contribution limits for Simple 401k plans are lower than those of traditional 401k plans. Here’s a comparison of salary deferral limits for both plans.

iii) Limited Employer Matched Contributions – Employer matched contributions are limited to 3% of the employee’s compensation while this is up to 25% for traditional 401k plans.

iv) One Plan Limitation – An employer who participates in a Simple 401k plan cannot maintain any other retirement program for any of its employees that are eligible for Simple 401k contributions. On the other hand, an employer who maintains a 401k retirement program for its employees may also administer and have other defined-contribution plans, SEP IRAs, profit sharing and Roth IRA plans.

Eligibility for Participation

i) Every employer who is eligible to run a traditional 401k program for its employees is also eligible to administer Simple 401k. Examples include sole proprietors, partnerships and corporations. However, Simple 401k plans are limited to employers who have a maximum of 100 employees, each receiving compensation in excess of $5000 annual.

ii) Employees who have worked for their current employers for at least 1 year and who are 21 years or older must be allowed to participate in the Simple 401k plan.

Deadline?

A Simple 401k plan must be established between January 1st – September 30th of any year. This rule is waived for any businesses or corporations that go in to business after October 1st of the current year.

While there are many similarities between simple IRAs and Simple 401k plans, there are many differences as well. In this article, we compare and contract between Simple IRAs and Simple 401k plans.

Eligibility:

i) Employers – For both the Simple 401k and Simple IRA plans, employers must have a maximum of 100 employees or less who receive at least $5000 in annual compensation. Also, employers cannot maintain any other retirement plan for their employees who are eligible for the Simple 401k other than the Simple 401k. The employers can however run another retirement plan for employees who do not qualify for making contributions into the Simple 401k.

By contrast, an employer who runs a Simple IRA for his employees is not permitted to run any other retirement program no matter what. Therefore if an employee does not qualify for making contributions to a Simple IRA while his employer only administers a Simple IRA, then too bad for that employee!

ii) Employees – Employees are normally required to perform at least 1 year of service before they are eligible to participate in an employer’s Simple 401k plan. They must also be at least 21 years of age. By contrast, there is no age requirement for Simple IRA and no minimum 1 year service. Any employee who has earned at least $5000 in annual compensation in the last 2 years, and is reasonably expected to earn $5000 annual compensation this year is permitted to contribute to a Simple IRA plan.

The deadline to establish a Simple 401k or a Simple IRA is January 1st to October 1st of any given year. If a new business or corporation is formed after October 1st, then they are permitted to set up a Simple 401k or a Simple IRA. This deadline allows employees to make salary deferral contributions before the year end.

Also, because a Simple IRA is part of Individual Retirement Accounts, no loans are allowed to be withdrawn. By contrast, a hardship withdrawal or loan is permitted under the Simple 401k. Go here to learn more about 401k hardship withdrawals. Also, all contributions to a Simple 401k or a Simple IRA are 100% immediately vested.

Making Contributions to Simple 401k or Simple IRA

Employees are eligible to make salary deferral contributions to these retirement plans while employers can make matching contributions. For matching contributions, employers can make contributions of up to 3% of the employee’s total annual compensation. Here are the deferral limits for both the Simple 401k and Simple IRA programs:

Investors who are 50 years of age or older can make 401k catch up contributions. Also, the matching contributions that employers can make varies from the Simple 401k to the Simple IRA. All employer matching contributions to the Simple 401k are subject to a compensation cap of $245,000 for 2009 and $245,000 for 2010. Here’s an example to illustrate this concept:

Wood Corp. established a Simple 401k for its 95 employees. The company has elected to make matching contributions to each employee’s 401k for the year 2007. Joe who is the Chief Financial Officer of the company is eligible to receive $250,000 in annual compensation from the company. Joe decides to make his salary deferral contribution to the maximum limit of $10,500 for 2007. The amount of matching contribution that Joe receives from his employer depends on whether it is a Simple 401k or a Simple IRA.

i) Simple IRA – Joe would receive a matching contribution of 3% x $250,000 = $7500

ii) Simple 401k – Joe would receive a matching contribution of 3% x $225,000 = $6750
Note how only $225,000 out of Joe’s total compensation of $250,000 is taken into account. This is because under a Simple 401k, the employer would consider no more than $225,000 on which to make matching contributions.

3% Matching Contributions?

For the Simple IRA, an employer that decides to make matching contributions may reduce the percentage from 3% to 1% or more, for 2 out of every 5 years. The matching contribution percentage cannot be reduced to less than 1%

Further Readings

For further readings, go to IRS Publication 560 – http://www.irs.gov/publications/p560/index.html It gives very useful information on setting up Simple 401k or Simple IRA plans, contribution limits, notification requirements, tax treatment of contributions, minimum funding requirements, due dates and more!

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Many plan sponsors want to know how their 401k plan stacks up to the typical or average plan. This is often the first question asked when attempting to determine whether an effort should be made to upgrade the features and benefits of the plan.

Eligibility: Short service requirements (less than three months of service) are now common for participant contributions. In 1998, only 24 percent of plans allowed employees to begin contributing to their 401k plans immediately upon employment. Now, 60.3 percent of all plans permit immediate participation in their 401k programs. Short service requirements are even more common at large companies — 74.2 percent of companies with 1,000 or more employees provide immediate eligibility and 89.7 percent provide eligibility within three months.

• Immediate (one month or less)   60.3%
• 3 months or 90 days        15.3%
• 6 months or 1000 hours                 9.8%
• 1 year    11.2%
• Other    3.3%

Minimum Age Requirements: The common minimum age requirements for participation are:

• None     43.1%
• 18 Years Old       20.1%
• 21 Years Old       35.4%
• Other Minimum Age      1.5%

Vesting Schedules: Thirty-nine point five percent (39.5%) of plans provide immediate vesting for matching contributions, while 23.0 percent provide immediate vesting for profit sharing contributions. Among plans that do not have immediate vesting, graduated vesting is the most common arrangement for all plan types.

Automatic Enrollment: Thirty-eight point four percent (38.4%) of plans have an automatic enrollment feature. Automatic enrollment is most common in large plans — 53.7 percent of plans with 5,000 or more participants report having automatic enrollment. The most common default deferral is 3 percent of pay, present in 58.0 percent of plans. 53.1 percent of plans automatically increase the default deferral percentage over time.

Seventy-two percent of plan sponsors use a life-cycle or target date fund (TDF) as the default investment option, and 13% use a balanced or lifestyle fund. Sponsors of smaller plans are more likely to use TDFs — 78% of plans with $10 million to $99 million in assets use TDFs compared with 68% of plans with $1 billion or more.

Employer Contributions: Company contributions average 2.1% of payroll.

Numerous formulas are used to determine company contributions. The most common type of fixed match, reported by 27% of employers, is $1.00 per $1.00 up to a specified percentage of pay (commonly 6%). Twenty-three (23%) of all plans match $0.50 per $1.00 up to a specified percentage of pay (most commonly 6%).

Company Stock as Match: Only 17% of employers invest the employer matching contribution exclusively in company stock. Of those that do default the match exclusively to employer stock, there are fewer restrictions associated. Currently, 84% of these plans allow employees to diversify or transfer employer matching contributions at any time.

Employee Participation Rate: Eighty-nine percent (89%) of U.S. employees at companies offering a 401k program are eligible to participate. On average, 87.3 percent of eligible employees have a balance in the plan. Twenty-two point four percent (22.4%) of plan participants are no longer actively employed by the plan-sponsoring company.

Investment Options: The number of funds offered to plan participants appears to be leveling out after many years of steady increase. Plans offer an average of 18 funds for both participant and company contributions. The funds most commonly offered are actively managed domestic equity funds (87.3 percent of plans), actively managed international equity funds (86.0 percent of plans), and indexed domestic equity funds (82.4 percent of plans). The availability and use of target-date funds continues to grow. 62.3 percent of plans now offer them.

Investment Committee: Thirty-three percent of plan sponsors have no investment committee, though it varies heavily by plan size. More than half the plans with less than $5 million in assets did not. Fewer than one in 10 of plans with more than $5 million in assets did not have such a body.

Investment Policy Statement: Ninety percent of all plans have a written investment policy statement, but only about half of those with less than $5 million in assets do.

Investment Advisors: Sixty-six point seven percent (66.7%) of companies retain an independent investment advisor to assist with fiduciary responsibility. For 54.2 percent of those companies, the fee is a fixed amount and for 36.1 percent the fee is percentage of plan assets.

Investment Advice: Advice is offered in 60.1 percent of plans. Twenty-one point six percent (21.6%) of participants used advice when it was offered. Participant usage tends to be greatest in small plans.

Roth 401k: Among plans that permit participant contributions, 41.3 percent allow participants to make Roth after-tax contributions. Only 13.0 percent of participants make Roth contributions when offered the opportunity.

Catch-up Contribution: Catch-up contributions for participants aged 50 and older are permitted in 98.0% of plans. Thirty-one percent (31.0%) of these plans offer a match on the catch-up contributions.

Self-directed Brokerage Accounts: Self-directed brokerage accounts are offered in 15.5 percent of plans, while open mutual fund windows are offered in 8.3 percent of plans. On average, plans invest 2.2 percent of plan assets through brokerage windows and 1.5 percent through mutual fund windows.

Loans: Sixty-one percent of the 401k plans offer a plan loan provision to participants. The loan feature is more commonly associated with large plans (as measured by the number of participants in the plan). Ninety-four percent of plans with more than 10,000 participants included a loan provision, compared with 35 percent of plans with 10 or fewer participants. There is modest variation in participant loan activity by plan size, ranging from 17 percent of participants with loans outstanding in 401k plans with 26-100 participants to 23 percent of participants in 401k plans with more than 5,000 participants. Loan ratios vary only slightly when participants are grouped based on the size of their 401k plans (as measured by the number of plan participants). Among participants in plans with 100 or fewer participants, the loan ratio was 18 percent of the remaining assets, while in plans with more than 10,000 participants, the loan ratio was 15 percent.

Hardship Withdrawals: Hardship withdrawals are permitted in 85.6 percent of plans. The most common reasons for permitting hardship withdrawals include purchase of a primary residence or to prevent eviction or foreclosure (97.9 percent), medical expenses (97.2 percent), and post-secondary education expenses (93.5 percent). 1.9 percent of participants took a hardship withdrawal, when permitted.

Safe Harbor Plan Design: Thirty-four point two percent (34.2%) of plans have a Safe Harbor plan design in lieu of ADP/ACP testing.