Beating Broke

Personal Finance from the Broke Perspective

Reader Question: IRAs, 401(k)s, and Dividends

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Reader David left a comment with the following question in it:

Every other mutual fund I have ever owned has at one time or another paid out dividend distributions.This includes funds that I have held on my own, and some that were held in Traditional and Roth IRA’S. Not so with any funds I have had in two 401k plans over the years. Going all the way back in my annual statements I cannot find a single entry for dividend distributions. Do you have any ideas why this might be so and whether or not I would be better off making contributions to an IRA that go above and beyond the company match??

There are several ways that I’ll attempt to answer this.  Keep in mind, I’m not a financial planner, or a financial adviser, so take what I say with a grain of salt.  Perhaps a few of my adviser readers will have slightly better advice, we’ll see. I think there are really two questions there though (I won’t charge you extra.), so let’s break it down a bit.

Dividend Distributions in 401(k) and IRA accounts

401K
Several things could be happening here, but here are the most likely scenarios.  Because of the difference in how a 401(k) and an IRA are handled for taxes, (401(k) is pre-payroll tax while IRA is post-payroll tax) the tax that you would normally pay on a dividend distribution is deferred in a 401(k).  What that means is that the dividend income in a 401(k) doesn’t have to be reported and is usually automatically reinvested.  Depending on the 401(k) provider, dividend income might just be being shown as a capital gain on the fund since that’s what it becomes in this tax scenario.  Another possibility (although somewhat unlikely) is that, like stocks, not all funds will pay a dividend.  The only way to figure that out is to do some research into the individual funds that you own in your 401(k) and determine if they pay a dividend or not.  I like finance.google.com for quick lookups, but the best place would be the website of the fund, or the prospectus for the fund.

Make Contributions to an IRA that go above and beyond the company match

I wanted to tackle this question separately.  First, you should, absolutely, take advantage of your company match to it’s full extent.  If your company will match x% up to y% of your income, you should contribute y% at a minimum.  It’s free money, and I guarantee you the company looks at it as a part of your compensation package.  You wouldn’t leave a paycheck un-cashed would you?  Once you’ve met that amount, several things come into play.  I think the biggest of these is your personal tax situation.  A 401(k) acts as a deferred tax account.  You don’t pay any taxes on your contributions, and then pay taxes (at your then tax rate), on the withdrawals.  With a Roth IRA, you pay taxes on the contributions, but not on the withdrawals.  Let’s say you make a lot of money now, and your tax rate is 35%.  When you retire, you’re no longer making those fat stacks of cash, and your tax rate drops to 25% or less.  You’ll now pay 10% less in taxes on those withdrawals.  Keep in mind that those withdrawals will include any capital gains that the account has accrued over your working career.  In the Roth IRA, you’ve already paid the taxes on contributions at 35%, and you don’t pay any taxes on the withdrawals.  In this scenario (10% drop in tax rate), you’ll need to have managed gains of 10% above your contributions by the time you retire to realize any significant difference.

Another thing to look at, is whether you are able to contribute to the limits.  In 2012, the 401(k) contribution limit is 17,000.  If you’re 50 or older, you can also make an additional “catch-up” contribution of $5,000, for a total of $22,000.  There’s an additional overall limit of $50,000 for employee plus employer contributions.  So, if you make the max contribution, your employer can only contribute the additional amount to $50,000.  For the IRA, the maximum annual contribution is $5,000 (or $6,000 if you’re 50 or older).  There are also some restrictions on how much of the contribution is tax deductible, and how much can be contributed based on income.

The simple suggestion here is that you should contribute to your 401(k) up to the % that the company will match to take full advantage of that added compensation.  Once you’ve hit that %, contribute to an IRA up to the full amount you’re allowed.  Once you’ve hit that contribution limit, invest any additional contributions into your 401(k).  Obviously, it takes a bit of math to figure all of that out, since you won’t likely know whether you’ve hit the max on the IRA without some pre-planning.  But, if you can manage to sock away the $5,000 (or $6,000 if you’re older than 50) into a savings, you can write one check at the beginning of the year as your current year contribution to your IRA, and then take whatever you’re comfortable with out of your paycheck for your 401(k).  Using a tax refund as a boost to the IRA contribution can be helpful (if you get a refund).

That’s a very high level overview of the IRA vs. 401(k) question though, and you really should consult your accountant or a financial adviser on the subject.  There are lots of factors that go into the the tax ramifications of both, and you really want to know as much as you can so that you can adjust your retirement planning accordingly.

I’m sure many of my personal finance friends who know more about the subject than I do will offer their wisdom in the comments, so be sure to check back and see what nuggets they have to offer. 😉

photo credit: urban_data

The Lending Club IRA : Peer-to-Peer Enters the Retirement Realm

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You already know that I like Lending Club as an investment vehicle.  The returns are good (or great, depending on your default rate), and I like the idea that my money isn’t going to line the pockets of some corporation, but is being used to help someone who needs a loan get a better rate than they might get at a financial institution or through credit card usage.

Recently, Lending Club started offering IRA accounts to the lenders.  My first thought, was something along the lines of “that sounds kinda cool”.  But, then I got to thinking about it.  Many of us struggle to put money away for our retirements.  Do we really want what little money we have put away in an investment that carries as much risk as Lending Club notes carry?  I like risky investments, but even I don’t think I’d want all of my retirement money in these notes.

One use that could redeem it is using it as a supplemental IRA.  If you’ve already got a 401(k) and an IRA that you use to invest in more traditional, lower risk, investments, you could use a Lending Club IRA as a way to diversify further and add a little more risk to your portfolio.  That would also allow for keeping a higher percentage of your 401(k) and standard IRA in investments that are a little less risky.  Of course, that would also mean balancing your investment portfolio over several accounts.

I tried to figure out some of the finer details of the Lending Club IRA through their site, but either it isn’t all that clear, or I’m just a bit dense.  😉  So, I emailed them to get a few questions answered.  Here’s what I found out.  The accounts are administered through a company called Self Directed IRAs.  I’m not all that familiar with what a self directed IRA is, but it basically looks like an IRA account that you can use to invest in just about anything.  They offer several different IRA “types”, so it will depend on which the LC IRA falls under to determine what other investments you can add to your account besides the LC notes.  It doesn’t seem out of the question to assume that you would be able to invest in stocks and such as well.  (I’ve replied to the email I got to try and determine this for sure)  Based on what I was seeing on the administrators website, it was looking like the account might be pretty heavy in fees.  The email from Lending Club managed to answer that question as well.

There are no fees associated with a Lending Club IRA with a balance of at least $5,000 in the first year (you have all year to reach this), or $10,000 in the second year and beyond.

If you don’t meet those requirements, the account carries a $100 annual fee.  Pretty hefty if you don’t meet the requirements.  There’s two ways to look at that, however.  If you’re IRA is large enough, it shouldn’t be a problem to keep $10,000 in Lending Club notes and still keep your risk diversification.  If you’re IRA is smaller though, you’d be automatically raising the risk of the account my meeting the requirements.

Anyway you look at it, I don’t think it will be the most popular IRA account around.  But, it’s nice that they offer it for those of their customers who want a tax sheltered way to take advantage of peer-to-peer investing.  You can read more over on their site: Lending Club IRA.

What are your thoughts on the Lending Club IRA?  Too risky for retirement funds?  Good as a part of the retirement portfolio?

Bye, Bye Pension; Your Opinion Needed

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We were recently told that our defined benefits plan was being taken away.  For those that are confused, a defined benefits plan is what is normally called a pension.  For me, I haven’t been around long enough for it to really affect me.  Some, who have been around for a very long time and are nearing retirement, it will mean a rather significant chunk of the money that they thought they would have for retirement will be gone.  To their credit, our employer is doing it the right way.

Rather than just declaring the fund bankrupt, or letting it run until it was bankrupt, they’ve decided to shut it down gracefully.  What that means is that those of us who are vested in the plan will receive a payout of the amount we have vested.  And, as part of that, we need to decide what to do with that money.  We have four options:

  1. Buy an Annuity.  Annuities basically work like this: You give them a lump sum of money, and they agree to pay you a monthly amount back.  The total of the payments is equal to some amount greater than the amount that you gave them.  It’s usually based on current interest rates.
  2. Roll the money into the company 401(k).  I’m already participating in the 401(k), so this would be a logical place to go with it.
  3. Roll the money into an IRA.  Also a logical way to use the money.  Could be rolled over into a Roth IRA as well.  Either way, I have far more control of the money than I would in my 401(k).  Also, I don’t believe I’d have to worry about IRA Contribution Limits if I roll it over.
  4. Take a cash payout.  They’d just write me a check, minus the 10% early withdrawal penalty from the IRS.

I’ve ruled out option 1 as it doesn’t make any sense to do with the interest rates where they are.  Most likely, I’ll be using option 2.  But, I just can’t come to a concrete solution.  If I take option 2, I add a significant amount of money to my 401(k).  More is always better.  But, I have no more control of that money than I do with the current money that’s in there. Wall Street's Cut of Your 401(k) Pie If I take option 3, I still retain the same amount of money in a retirement account, plus I have far more control of where the money is invested than I do in the 401(k).  That’s also the con of this option though.  I’m no investment expert.  I could look to invest in a stocks and shares ISA but as a general rule, most of the investments I’ve made aren’t all that great.  Which means it would have to be limited to EFTs and Mutuals which doesn’t afford that much more control than in the 401(k).  The final option would be to take the money in a check.  The big downside there is that the IRS takes 10% off the top as a penalty.  Then, it’s counted as income which gets taxed as income.  In our tax bracket, that could mean an extra 15% in tax liability.  If it bumps us up into a new bracket, it could mean some of it could be 25% in tax liability.  So, I’d pay an instant (or nearly so) 25-35% if I took a check.  But, that still means I would receive a lump sum of several thousand dollars.  That money could be used to pay off at least one credit card, if not two, and alleviate some of the monthly burden that our debt gives us.

I know that the safest (rightest) answer is to put it into one of the retirement accounts, but having the cash to dump some of our debt would also be very advantageous.

What would you do?  If you were in my situation, would you play it safe and roll the money into your 401(k)?  Would you take the cash and pay something off to reduce your monthly expenses?  Tell me how you would handle this!

photo credit: House Committee on Education and Labor