If you contribute to a 401(k) retirement account, you may be able to take a loan from the plan. The maximum amount you can borrow is limited to the lower of $50,000 or up to 50% of your vested account balance. However, some plans may impose lower limits or not offer loans at all. In addition to these restrictions, borrowing from your 401(k) calls for taking into account some significant additional limitations and considerations. A financial advisor can help you save for retirement.
401(k) Loan Basics
You can access funds in your 401(k) by withdrawing money or, in many cases, by taking out a 401(k) loan. If you withdraw money early, before reaching age 59.5, you may have to pay a 10% penalty as well as owe any taxes due. Borrowing against the balance in your plan lets you tap that money at a younger age without having to pay these costs, which makes a loan look more attractive. In order to avoid penalties, however, you’ll have to pay back the loan, including interest.
While IRS rules and federal law allow 401(k) loans, plans are not required to offer them. Some don’t, while others but only with additional restrictions. In all cases, if you borrow the money you have to pay it back, with interest, like a regular installment loan. If you don’t pay on time, your loan may be treated as a withdrawal, activating the penalties and taxes that would be due on a withdrawal.
How Much You Can Borrow
Government rules allow for loans of up to $50,000 or 50% of the vested assets in your account. The lower of these two amounts set the limit. So, for example, if you have $75,000 in fully vested funds in your 401(k), your maximum loan amount would be 50% of that or $37,500.
If 50% of the vested assets in your account come to less than $10,000, you can borrow up to $10,000. Individual plans may have lower limits, however, and some don’t allow loans at all. The only way to be sure you can borrow or how much you can borrow, is to review your plan’s terms.
Multiple 401(k) Loan Limits
You can take out more than one loan at a time from your 401(k). However, that won’t let you get around these limits. If you add up the total balance of all your 401(k) loans, they must not exceed the plan limit. Time is also a factor. According to IRS rules, to calculate the effective cap on what you can borrow if you already have one loan, determine the highest outstanding balance of all your 401(k) loans during the previous 12 months.
Next, determine the outstanding loan balance on the day the proposed new loan would be taken out. Subtract the current outstanding balance from the average of the previous year. Now subtract this figure from the absolute maximum loan amount. This figure represents the largest allowable total loan balance, including previous loans as well as the new loan.
For example, say you can borrow up to $50,000 from your plan and one year previously took out a $40,000 loan that you have since paid down to $32,500. The difference between these amounts is $7,500. Subtracting $75,000 from $50,000 gives $42,500. That is the maximum allowed amount for all loan balances at this time. Since you already owe $32,500, you can borrow up to another $10,000, which will put your total outstanding loan balance at $42,500.
Practical 401(k) Loan Limits
The fact that you can take out a loan of up to $50,000 from your 401(k) doesn’t mean that you should. This financing technique comes with some potential minuses that require careful consideration. Opportunity cost is one. When you borrow from your 401(k), the money you borrow is temporarily removed from your investment portfolio. This means you miss out on potential market gains. The more you borrow, the more you could miss.
Failure to repay a 401(k) loan is another. If you don’t make all your payments within the loan’s time frame, usually five years, the outstanding balance will be treated as a taxable distribution. You’ll owe on it then plus, if you’re under age 59.5, a 10% early withdrawal penalty. Borrowing more than you can really pay back could be a costly error.
If you lose or change your job, whether voluntarily or involuntarily, the outstanding loan balance becomes due, typically within 60 days. If you don’t pay, again it will be treated as an early withdrawal and subject to penalties and taxes. If your employment situation is uncertain, a 401(k) loan may not be the best idea.
Finally, if you have taken out a loan, depending on the plan you may not be able to contribute to your account until you have paid it all back. This could cause you to lose out on employer matches as well as the benefits of current income tax deductions. If it takes longer to pay back a bigger loan, you could miss out on more valuable matches.
The Bottom Line
Borrowing from your 401(k) can provide a convenient and cost-effective source of funds in some situations. Legal, regulatory and specific plan rules limit the maximum amount you can borrow, with either $50,000 or 50% of your vested account assets as the absolute cap. Some plans impose lower limits. Other considerations including opportunity costs and repayment challenges may suggest borrowing less than the rules allow.
Tips for Retirement Planning
Before making a decision about borrowing from your 401(k), consider consulting with a financial advisor who can help you assess whether a 401(k) loan aligns with your long-term plans. Finding a financial advisor doesn’t need to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
SmartAsset’s 401(k) Calculator can tell you whether your retirement saving plan is on track.
Mark Henricks
Mark Henricks has reported on personal finance, investing, retirement, entrepreneurship and other topics for more than 30 years. His freelance byline has appeared on CNBC.com and in The Wall Street Journal, The New York Times, The Washington Post, Kiplinger’s Personal Finance and other leading publications. Mark has written books including, “Not Just A Living: The Complete Guide to Creating a Business That Gives You A Life.” His favorite reporting is the kind that helps ordinary people increase their personal wealth and life satisfaction. A graduate of the University of Texas journalism program, he lives in Austin, Texas. In his spare time he enjoys reading, volunteering, performing in an acoustic music duo, whitewater kayaking, wilderness backpacking and competing in triathlons.
Your employer technically will always know when you borrow money from your 401(k). One of the tricky parts about managing a 401(k) loan is that, even though this money belongs to you, your employer can set terms and conditions around taking the loan. The employer may even disallow loans completely. Here’s how 401(k) loans work and what you should keep in mind if you’re thinking about taking one. A financial advisor can help guide you through the process of taking a 401(k) loan or recommend alternatives.
What Is a 401(k) Loan?
A 401(k) is a tax-advantaged retirement account that your employer provides. Money is deducted from your paycheck and saved in the account on a pretax basis. This lets you invest a full dollar for every dollar you earn, unlike the rest of your income on which you pay taxes and only keep a portion of those earnings.
This tax-advantaged status means that you ordinarily cannot sell assets and withdraw money from your 401(k) until you near retirement age or meet the qualifying criteria for a hardship withdrawal. If you do, the IRS will require you to pay the taxes you would have paid on the income you invested along with a 10% early withdrawal penalty.
If your 401(k) provider allows it, you can borrow money from the account with a 401(k) loan. Unlike a hardship withdrawal, you must repay this money back into the portfolio. If you make regular payments and repay the money on time, often within five years, you do not have to pay any taxes or penalties on the loan. But if you fail to repay the loan on time, the IRS will consider it an early distribution and you’ll owe taxes and penalties on the money you borrowed.
A 401(k) loan can be a good way to solve pressing financial problems, such as unexpected job loss or a sudden emergency. While it’s sometimes referred to as an interest-free loan from yourself, this is not accurate. When you take money from your 401(k) you lose out on any growth that this money would have had during the loan period. This is a real loss, one that grows the longer you take to put the money back in.
Your Employer and a 401(k) Loan
The rules governing 401(k) loans aren’t universal – they can vary from plan to plan, employer to employer. Unlike hardship withdrawals, which are generally defined and governed by the IRS, the terms of 401(k) loans are set by your employer when the program is established.
This means that your employer can decide:
If their 401(k) program will allow loans at all;
If their 401(k) program will allow loans freely, or only under certain conditions;
If there are conditions, what those conditions are;
The maximum amount of a loan (up to 50% of the account’s value);
Some repayment terms
As part of running and managing the 401(k) program, your employer will have an officer or agent who monitors all contributions, withdrawals and other aspects of the plan. This person is known as the “record keeper.” He or she may be an employee of the company or work for an external firm that the company hires to run the 401(k) program on its behalf.
On an institutional level, your employer has access to these records. This means that every withdrawal from an employee 401(k), including loans and hardship withdrawals, can be known by certain company employees.
However, it’s important to note that this does not mean your immediate supervisor or any specific colleagues will have access to this information. The details of a 401(k) plan are generally considered confidential financial information, so it’s likely that your company will have rules around who can see those records. The smaller your firm, the more likely it is that a close colleague will have access to 401(k) records. At a larger company, though, it’s likely that only finance or human resources personnel, along with upper management, will have the right to see those records.
In either case, the answer is the same though. Yes, your employer as an institution will know if you take out a loan from your 401(k) portfolio. However, that information is not necessarily available to any specific colleague.
Bottom Line
Your employer sets the rules for taking loans out of its 401(k) program, which means that as an institution certain employees will have the ability to know every withdrawal and loan that someone makes. However, that does not mean that any individual manager or coworker will have access to this information.
Retirement Savings Tips
Keep the IRS contribution limits in mind each year and max out your retirement accounts when you can. If you have a 401(k), 403(b) or 457 plan, you can contribute up to $22,500 to your account in 2023, plus another $7,500 if you’re 50 or older. You can save another $6,500 in an IRA ($7,500 if you’re 50 or older).
A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Eric Reed
Eric Reed is a freelance journalist who specializes in economics, policy and global issues, with substantial coverage of finance and personal finance. He has contributed to outlets including The Street, CNBC, Glassdoor and Consumer Reports. Eric’s work focuses on the human impact of abstract issues, emphasizing analytical journalism that helps readers more fully understand their world and their money. He has reported from more than a dozen countries, with datelines that include Sao Paolo, Brazil; Phnom Penh, Cambodia; and Athens, Greece. A former attorney, before becoming a journalist Eric worked in securities litigation and white collar criminal defense with a pro bono specialty in human trafficking issues. He graduated from the University of Michigan Law School and can be found any given Saturday in the fall cheering on his Wolverines.
Employer-sponsored 401(k) plans are a popular way for workers to save for retirement, but they’re not the only way. If you’re self-employed or your employer doesn’t offer a 401(k), there are retirement savings vehicles out there that will work for you. Let’s take a look at both solo 401(k) plans and IRAs. If you’d like personalized advice about planning for retirement, consider working with a financial advisor.
What Is a 401(k)?
A 401(k) is an employer-sponsored retirement account that offers tax benefits. A traditional 401(k) will be withdrawn from your paycheck pretax and will only be taxed when you withdraw from it in retirement. A Roth 401(k) is similar, but the money that goes into it is already taxed, so it won’t be taxed when you withdraw from it in retirement. You can withdraw from your 401(k) penalty-free beginning at age 59 ½.
Once you deposit money into a 401(k), it’s invested according to your choices—you’ll be presented with investment options when you complete the paperwork. That money will grow not just through contributions, but through interest and earnings on those investments.
These plans were specifically created to incentivize workers to save for retirement. If you contribute to a traditional 401(k), your taxable income is reduced due to the 401(k) withholdings. If you’re contributing 6% of your income to a 401(k), you don’t owe taxes on that 6% of your income. With a Roth 401(k), instead of saving on taxes in the year, you contribute money to your 401(k) and you’ll enjoy the savings when you withdraw it in retirement.
Can You Open a 401(k) Plan Without an Employer?
As a 401(k) plan is an employer-sponsored retirement account, there’s an option for a self-employed person with no employees to open one with themselves as the sponsor. This is called a solo or one-participant 401(k) plan.
A solo 401(k) works exactly like a traditional 401(k) plan you would get with an employer—you’re just the employer and the account holder. Just like a 401(k) plan with an employer, there are contribution limits, but they’re much higher because you are serving as both employee and employer. We’ll cover those contribution limits later.
If you’re not a self-employed person, your best option is likely an individual retirement account (IRA). Whether you opt for a traditional IRA or a Roth IRA, both are tax-advantaged savings vehicles that will help you prepare for the future and have similar benefits to 401(k) plans.
Some traditional IRAs will also allow you to deposit pretax income and only pay taxes upon withdrawal in retirement. IRAs offer a great deal of freedom because, outside of income thresholds, they are not related to your employment status and you can open one anytime. Roth IRAs are funded with taxed income, but withdrawals aren’t taxed unless you withdraw before the age of 59 1/2.
You’ll need an employer identification number (EIN) to open a solo 401(k), but you can easily find a provider for the retirement accounts mentioned. Compare reviews and choose one with the benefits and features that work for you.
How Much You Can Contribute to Your Retirement Account
Understand how much you can contribute to your retirement accounts, without an HR department to help you, you could run into trouble. The IRS sets contribution limits that often change. Here are the limits for 2023:
Solo 401(k): Solo 401(k) limits are a bit more complicated because you are serving as both the employee and employer. These are divided into elective deferrals, of up to $22,500—or $30,000 if you’re 50 or older—and employer nonelective contributions of up to 25% of compensation as defined by your plan. Total contributions cannot exceed $66,000. The IRS recommends using the worksheets in Chapter 5 of Publication 560, Retirement Plans for Small Business to figure out your allowable contribution rate and tax deduction for your 401(k) plan contributions.
Traditional and Roth IRAs: Both types of IRAs have the same annual contribution limit of $6,500—$7,500 if you’re 50 or older—or your taxable compensation for the year if it’s less than those numbers
The Bottom Line
While your options are a little different without an employer-sponsored 401(k), there are fantastic retirement savings options available for self-employed workers or those that don’t have plans available through their employer.
Do some research to see which one is right for you, then open a retirement account to prepare for the future while unlocking tax savings.
Retirement Planning Tips
Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Use SmartAsset’s free retirement calculator to see if you’re on track to meet your retirement goals.
Inside: Are you confused about how gross pay and net pay are calculated? This guide will clear everything up. Learn about the different deductions that are taken from your paycheck, as well as the tax rates that apply to your gross pay.
This is one of the most confusing questions for many people.
So, if you are wondering what the difference between gross pay and net pay, you are in the right place.
In order to become financially stable, you need to have a tiny amount of financial literacy.
If you’re like most people, you probably think of your “gross pay” as the amount of money you make before taxes are taken out. But in reality, gross pay is your total compensation from your employer before any deductions are made.
So what is “net pay,” then? Net pay is the amount of money that actually goes into your bank account or paycheck after all of those deductions are made.
Now you want to which one is more important between gross pay and net pay.
The answer is: it depends! If you’re trying to save money or make a budget, then net pay is probably more important to you. But if you’re trying to figure out how much taxes you’ll owe at the
We will dive into all of the details, you will not ever be confused again.
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What is gross pay?
Gross pay is the total amount of money earned by an employee before any taxes or deductions are taken out. It’s important to know your gross pay as it determines your overall income and can impact your taxes and benefits.
This is the total amount paid by your employer.
Knowing your gross pay is crucial for financial planning and paying taxes.
How can I calculate my gross pay?
To calculate gross pay, you need to know your hourly wage or salary, any overtime pay, bonuses, and additional reimbursements for work-related expenses.
For hourly workers, multiply the hourly wage by the number of regular hours worked within a pay period and include the overtime pay rate for any extra hours.
For salaried workers, multiply the gross monthly income by 12 to find the annual gross salary.
To calculate a paycheck, start with the annual salary amount and divide it by the number of pay periods in the year.
Find out 5000 a month is how much a year.
What deductions are taken out of gross pay?
Gross pay refers to the total amount of money an employee earns before any deductions are taken out.
As such, there are no deductions.
Learn what is annual income.
How are taxes calculated on gross pay?
Gross pay is the amount an employee earns before taxes and deductions are taken out by their employer.
Understanding taxes on gross pay is essential, as it affects an employee’s take-home pay and tax liability.
Taxes that are deducted from gross pay include FICA payroll taxes, federal and state income tax withholding, along with any state-mandated programs like this Colorado Paid Sick Leave.
To calculate taxes on gross pay, an employer uses a formula that subtracts all taxes and deductions from the gross pay amount. Learn how much you should withhold on your taxes.
Common issues that may arise during tax calculation include incorrect tax withholding and not considering voluntary pre-tax deductions. Understand why do I owe taxes this year.
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What is net pay?
Net pay refers to the amount of money an employee takes home after all deductions and taxes have been taken out of their gross pay.
This is the money left over that you can spend, save, and invest.
Thus, you will be able to budget by paycheck like a pro!
How to calculate net pay?
Calculating net pay is crucial for accurate and compliant payroll management.
Here is a step-by-step guide on how to calculate net pay:
Determine the gross pay based on hours worked or salary divided by the number of pay periods in the year.
Subtract mandatory deductions, including health insurance premiums, federal, state, and local income taxes, payroll taxes, and court-ordered wage attachments.
Subtract voluntary deductions, such as employee contributions to a 401(k) or other retirement plan as well as any flexible spending account.
The resulting amount is the employee’s net pay.
Learn about annual net income.
What deductions are taken out of net pay?
Net pay refers to the amount of money an individual receives after taxes and other necessary deductions have been subtracted from their gross pay.
It is a crucial factor in determining an individual’s income, as it represents the actual amount of money they take home.
There are various deductions that are commonly taken out of net pay, including mandatory and voluntary deductions.
Mandatory deductions are made in accordance with the law, while voluntary deductions are ones that employees have the freedom to opt out of.
The mandatory deductions include:
Federal, state, and local income taxes
Social security taxes
Medicare taxes
Local state or municipal taxes
Other common voluntary deductions from gross pay include:
Health insurance premiums (if signed up on a company plan)
Retirement contributions
Health savings account contributions
Flexible spending account contributions
Dependent Care FSA
Is gross before or after taxes?
Gross pay is BEFORE taxes.
Gross pay is the amount earned before taxes and other deductions are taken out. Taxes are then calculated based on the gross pay amount and deducted to arrive at the net pay. This means that gross pay is always before taxes.
Understanding the difference between gross pay and net pay is important to effectively manage finances.
Gross pay may seem like a large amount, but it is important to consider the impact of taxes and other deductions on the final amount received.
What is the difference between gross pay and net pay?
Gross pay and net pay are two important terms that employers and employees should understand.
Gross pay refers to an employee’s total earnings before any deductions are taken out, while net pay is the amount an employee takes home after deductions such as taxes, benefits, and garnishments have been subtracted.
Here are some key differences between gross pay and net pay:
Gross pay includes all earnings, such as wages, salary, reimbursements, commissions, and bonuses, while net pay is the actual amount of the paycheck after deductions.
Employers are responsible for deducting necessary expenses from an employee’s paycheck and making payments to the appropriate accounts before issuing the check or depositing the net pay into the employee’s bank account.
Gross income determines an individual’s federal income tax bracket and borrowing capacity, while net pay presents disposable income.
When budgeting for the year, starting with gross wages requires subtracting the total of taxes and other deductions to compute the actual amount left to spend from each paycheck.
Understanding the difference between gross pay and net pay is crucial for effective budgeting and financial planning.
Employers must ensure proper employee taxes are collected and paid to the government, while employees need to know their take-home pay to manage their expenses.
How do gross pay and net pay work?
Gross pay and net pay are two important terms in the payroll world that employees should understand to manage their finances effectively.
Gross pay is the total amount of pay while net pay is the amount of money you have to spend each month.
Understanding the difference between gross and net pay can help employees and employers avoid confusion and manage their finances better.
What is better gross pay or net pay?
One term is not “better” than the other as they each have different meanings.
When you increase your gross pay, your net pay will rise as well.
Here is how to use gross pay to your advantage:
Provides a clear understanding of the employee’s total compensation
Helps employees plan for future expenses
Can be used as a basis for negotiating salary increases
Figure out the amount of taxes you are required to pay.
Here is how to use net pay to your advantage:
Reflects the employee’s actual take-home pay
Helps employees budget for their expenses
Provides a clear understanding of the impact of deductions on their pay
Can be difficult to compare with other job offers that list gross pay
Overall, net pay is better for employees as it reflects their actual take-home pay and helps them budget for their expenses.
However, it’s important for employees to understand both gross pay and net pay to make informed decisions about their compensation.
Why do you receive more gross pay than net pay in your paycheck?
Employees receive more gross pay than net pay in their paychecks because gross pay is the total amount of money an employee earns before any deductions are taken out.
This includes an employee’s salary, wages, commissions, and bonuses.
On the other hand, net pay is the actual amount of money an employee takes home after taxes, benefits, and other mandatory deductions have been subtracted from their gross pay. These deductions can include federal and state taxes, Social Security contributions, health insurance premiums, and retirement plan contributions.
Therefore, employees receive more gross pay than net pay.
Learn is social security disability income taxable.
FAQs
Overtime wages are included in gross pay when an employee works more than their regular hours and earns additional compensation for the extra hours worked.
This is the case for nonexempt employees who are entitled to overtime pay under federal or state law.
Net income is the take-home pay or the money that you earn on payday, which is why it may be best to focus on that number when creating a budget.
This number helps you determine how much you have to spend, save, or invest.
By tracking your expenses and using budgeting techniques like budgeting with percentages or the 50/30/20 rule, you can manage your finances effectively and make the most out of your net income.
Remember, creating a budget is about being realistic and disciplined with your spending habits, so make sure to adjust your budget accordingly as your income or expenses change.
The tax rates for gross pay depend on the specific taxes being withheld, such as federal income tax, Social Security tax, and Medicare tax.
Federal income tax rates vary depending on the employee’s income level and filing status, with higher earners generally paying a higher percentage of their gross pay in taxes. Click here for the latest federal income tax brackets.
Social Security tax is a flat rate of 6.2% for the employee on the first $$160,200 of gross pay earned. Your employer must match the same contribution. (source)
Medicare tax is a flat rate of 1.45% on all gross pay with the employer matching the same percentage, with an additional 0.9% tax for high earners. (source)
Employees need to understand their tax liability based on their gross pay to accurately calculate their net pay and avoid any surprises come tax time.
Now, you Know the Difference between Gross and Net Pay
Understanding deductions and their impact on net pay is crucial for employees to accurately budget and plan their finances.
Since you know the difference between gross and net pay, you can make sure that you are getting the right amount of money in your paycheck.
Be sure to check your pay stubs carefully to make sure that all of the deductions are correct. If you have any questions, be sure to ask your human resources department.
Know someone else that needs this, too? Then, please share!!
Digitalization is still on the rise, and technology has revolutionized countless aspects of our daily lives. The property management industry has benefited greatly from today’s technological advancements – developments in automation and cloud-based computing have paved the way for property managers, landlords and investors to streamline operations and maximize profits. Across the board, technology like this is becoming more accessible and affordable to the average person, but it isn’t without its own issues.
Security concerns have plagued the technology industry for years, and I foresee data breaches continuing to be an obstacle in the years to come. This should be top of mind for those of us in the property management industry, as we are entrusted not only with personal and employee data, but with data from property owners and tenants as well. Unfortunately, this kind of information makes property managers ideal targets for identity theft, data breaches, and other scams designed to steal personal details.
In this line of business, we are given access to a high amount of private information and it is our responsibility as property managers and business owners to protect the information of our employees, clients and tenants.
Prevention for property managers
The best place to start when it comes to data security is basic knowledge – create strong, unique passwords for each online account related to your property. Many experts recommend a minimum of 10 characters, using a variety of numbers, letters and special characters, and using a different password for each account you have (use a password manager or app if necessary). Avoid using personal information in your passwords that could easily be learned through your social media channels (birthdates, names of siblings, children, pets, etc.).
Two-factor authentication may seem like a pain, but it works. Take advantage wherever two-factor authentication is offered on financial sites, email and any other accounts with login information. Don’t do business on any public, unsecured Wi-Fi networks in airports, restaurants and other similar locations. Public Wi-Fi is the same thing as being in public – don’t share anything on the network that you wouldn’t share with the stranger sitting next to you.
Be aware of phishing scams and never click on links or attachments from unknown email addresses. In the property management industry, phishing scams commonly happen around tax season and involve offenders posing as IRS representatives or other authoritative sources and requesting personal information. Please note that the IRS will not initiate contact with taxpayers by email or phone to request personal or financial information and will always begin with contact by mail.
Prevention for small businesses
Owning and managing your own property is one realm and involves data security strategies that are similar to those used to protect your day-to-day personal information. When you begin managing multiple properties or managing properties on behalf of clients, a whole new level of responsibility is on your shoulders when it comes to data storage and protection. In addition to all of the best practices advised for individuals, you’ll want to ensure your business and your employees are practicing the same tactics.
Always protect your employer identification numbers and immediately report any suspected data loss or data breach to the IRS and state tax agencies.
If a data breach occurs
If you are facing a data breach as a property manager or property management business, act quickly in order to mitigate your risk. Research to determine exactly what information was compromised – was it your email or password that was acquired, or was more sensitive information like social security numbers accessed?
Utilize credit monitoring services to keep an eye out for activity or charges that you don’t recognize and place a fraud alert on any credit accounts with suspicious activity.
Without cloud-based technology, our devices would quickly run out of space and the only alternative would be to purchase expensive physical memory storage. Because of the cloud, large companies, small businesses and individuals alike can store and protect their digital information on the cloud. In the years to come, leaders in the technology space will continue to develop more innovative and effective tools to protect consumers and businesses from these situations.
One of the biggest wealth transfers in history is about to unfold.
That is, it’s estimated that more than $68 trillion in wealth – involving 45 million households across the U.S. – will be transferred through inheritance in the next 25 years.
Will you be one of them?
If you’re a Millennial or a Gen Zer, chances are you may be in the group of Americans most likely to benefit from this massive transfer.
If so, you’ll need to know how to plan for an anticipated inheritance, even if you’re not sure of the details.
What’s Ahead:
1. Have a rough idea of the amount that you are set to inherit
Though this seems like a simple step, it often isn’t.
Not all parents or grandparents are open about their personal net worth (it’s a generational thing). And asking how much you can expect to inherit – or, if you’ll be inheriting anything at all – can seem presumptuous at best, and greedy at worst.
Some parents and grandparents will be open to this question. Some may even provide the information without you asking. But if that’s not your situation, you’ll need to proceed carefully and delicately.
How do I find out how much I will inherit?
You probably already have an idea of your parents’ approximate net worth, but if you don’t, don’t beat yourself up. After all, it isn’t always that obvious on the surface.
The best way to find out?
Just ask.
If your parents aren’t forthcoming about their finances, you’ll need to step back. That doesn’t mean giving up, however. You can let some time pass, then approach the subject later. Just be sure to frame it in such a way that you’re interested in protecting all they’ve worked so hard to accumulate.
2. Learn what makes up the inheritance
Some estates are very simple, while others can be incredibly complicated. The best scenario is a parent who rents his or her home (no house to sell) and has nearly all wealth sitting in financial assets, like bank and brokerage accounts.
Things get way more complicated when a large share of the estate is held in real estate, and especially investment real estate. More complicated still is business equity.
Collectibles, like jewelry and artwork, can also be problematic. You’ll first need to get a ballpark estimate of the value. But before they can be sold, they may need to be formally appraised.
Just as important, your parents may prefer to pass real estate, business interests, or collectibles to specific individuals. That may or may not include you, which is something you need to know before you plan to inherit them.
3. Know if there are other beneficiaries
This is as delicate an issue as requesting the value of your parents’ estate. If you are the sole beneficiary, it’s a non-problem. But if there are siblings, or others your parents may want to distribute assets to, the waters can get a bit muddy.
In a perfect world, your parents will set up an equal distribution for you and your siblings. But real life isn’t always so simple.
For reasons known or unknown to you, your parents may choose unequal distributions. This can be due to family politics, like one sibling being favored over the others, or one sibling being closer to your parents than others. In some situations, parents may choose to give a larger share to a child who provides for their direct care in their later years.
There may still be other situations where your parents want to make special provisions for one of your siblings or even a grandchild.
Yes, it can get worse!
But those aren’t even the most complicated beneficiary situations.
Given that divorce is common, and often involves a second set of children, there may be issues and limitations.
In some extreme situations, parents may disown one or more children, and exclude them from the inheritance. If that might be you, you’ll need to know.
Finally, complicated family situations can result in probate. That’s where the estate has to go before a judge prior to distribution. This can happen because of the nature of the family situation, or because one or more potential beneficiaries (or even an excluded party) challenge the distribution of the estate proceeds.
If that situation seems likely, it’s one that should be discussed with your parents. They may need to set up a trust to ensure each beneficiary gets the intended distribution so the estate can avoid probate.
4. Understand the intended distribution process
This primarily has to do with the timing of inheritance distributions. While the conventional distribution method is to distribute all beneficiary shares on a common date when the estate is settled, that’s not always the case.
Parents sometimes arrange to have estate assets distributed gradually.
For example: if one or more beneficiaries is considered to be irresponsible with money, the parents may set up a staggered distribution over a period of several years.
A staggered distribution is often accomplished through a trust. If your parents have set up a trust, either for part or all of the estate, you’ll need to know of its existence, as well as the intended distribution.
Some trusts are even more specific
For example, they may include provisions that will distribute funds based on certain milestones. Common examples include holding distributions until the beneficiary turns 30 (or some other age), or gets married (or divorced, if the marriage is shaky).
Trusts can be amazingly specific, which is why people set them up. That’s also why you’ll need to know any distribution method that will be used.
Some estates may also have provisions to make staggered distributions based on asset types.
For example: cash-type assets may be distributed early in the estate process. But real estate and business interests may not be distributed until they have been liquidated.
5. Estimate your personal finances at the anticipated time the inheritance happen
A big part of how you handle an inheritance will be determined by your own financial situation.
If you already have a sizable personal estate, you may be able to simply fold the inheritance into your existing plan. But if your finances are limited, you may need to be more intentional and figure out what you’re going to do with the inheritance when it arrives (ya know, so you don’t blow it all on a bright red Mustang).
The point is, only when you have a clear picture of your own finances can you make the best use of an inheritance. And to get the greatest benefit, it can help to improve your finances before you receive the money. The better positioned you will be when the inheritance comes in, the more flexibility you’ll have in choosing where to allocate the money.
If you’ve not been investing up to this point, you may want to begin before the inheritance comes in. It’s best to get investment experience with a small amount of money, so you don’t risk losing your windfall through poor investment choices.
Read more: Best Investment Accounts For Young Investors
6. Design a plan (aka what to do with the inheritance)
If you already have your own personal financial plan, planning for an inheritance will be much easier. But even if you do, you should have at least a loose plan for what to do with the new money. The worst choice is holding off until the inheritance is received. Without a solid plan, you may quickly draw down the new money, financing a series of wants.
Having a plan for the inheritance will ensure the money will provide for a better future. To learn how to set up a financial plan, check out our article: What Is A Financial Plan And Why Do You Need One?
Decide what your priorities are
The main purpose of a plan is to set up a series of priorities.
For example: if your retirement planning isn’t where you want to be, you can make it a priority to fix that with the inheritance. You can either use the new money to enable you to make larger retirement plan contributions or plan to set up an annuity specifically for retirement.
Take advantage of annuities
One of the advantages ofannuitiesis that they can be used to shore up an adequate retirement plan.
Read more: What Is An Annuity And Should You Consider One?
The investment earnings on annuities accumulate on a tax-deferred basis, like retirement plans. But the major advantage is that there are no limits to your contributions. You can make a single, large lump sum contribution to an annuity and let it grow tax-free until retirement. You can set a date that distributions will begin, which can even cover the rest of your life.
In addition, Dr. Guy Baker, CFP and founder of Wealth Teams Alliance, also points out:
“Annuities are a fixed-income alternative. The opportunity to get a market return with no downside risk can be dramatically better than the income from an investment-grade bond of comparable risk. The amount to put into an annuity should coordinate with the age of the beneficiary and the investment objectives. In general, an indexed annuity can provide significant benefits for no additional risk.”
However, since annuities are complicated instruments themselves, you’ll need time to do research and evaluate the best one to take. That’s best done in advance of receiving an inheritance.
Consider starting your own business
In a different direction, maybe you’ve been dreaming of starting your own business. If you lack the capital to do that up to this point, the inheritance can make it happen.
In the meantime, you can make preliminary plans for the business, andeven get it up and running as a side hustle. When the inheritance arrives, you’ll have an established business to grow, rather than starting a new one from the ground up.
Starting a business is always risky, though, so make sure you carefully consider such a big move if/when you do receive an inheritance.
Read more: How To Start Your Own Business – A Complete Step-By-Step Guide
7. Find out if there will be tax consequences
You’ve undoubtedly heard the saying,
“the only things certain in life are death and taxes.”
Well, guess what? Sometimes the two happen at the same time.
Officially, they’re called inheritance taxes. Because estates can contain a lot of money, governments view them as rich revenue sources. Just like they tax your income, your home, your utility bills, and even your purchases, there are taxes designed to snatch a part of an inheritance before you receive it.
There’s good news and bad news here.
Let’s start with the good news…
There is a federal inheritance tax, but the good news is that it only applies to very large estates.
Under current IRS regulations, estates that transfer from one spouse to another are generally tax exempt. But even when they pass to other beneficiaries, like children and grandchildren, there’s a federal estate tax exemption of $11.7 million, for 2021.
That means if the total value of the estate (before distribution) doesn’t exceed $11.7 million, there’ll be no federal tax on the inheritance.
Now for the bad news…
18 states impose some type of state-level inheritance tax. And while some of those states match the federal estate exemption, there are no fewer than 13 with lower exemptions.
On the low-end, Massachusetts and Oregon can tax estates as low as $1 million. Rhode Island sets the threshold at $1,595,156.
Not many Americans have a net worth of over $11.7 million. But there are many millions with estates of $1 million or more. Even if you’re not affected by the federal estate tax, you may be subject to it at the state level.
If any of the estate tax thresholds may apply in your situation, whether at the state or federal level, you’ll need to be prepared for this outcome.
So make sure you estimate for a lower inheritance
The best strategy is to estimate a lower inheritance, based on applicable estate tax rates. Fortunately, the estate will pay the inheritance tax before the money is distributed. But you still need to be prepared for a lower distribution amount.
If your parents are open about your inheritance, you may even be able to discuss the tax consequences with them. That way they’ll be in a position to take action to minimize them before the fact.
8. Decide if you’ll need a financial planner
If you believe your net worth is too small to justify a financial planner right now, you may change your mind when you receive a large inheritance. But you don’t have to wait until the inheritance arrives to at least consult a financial planner.
If you know the approximate size of your inheritance, paying for a meeting with a financial planner may be money well spent. The financial planner can help you to make decisions to both set up your current finances in anticipation of the inheritance, as well as to make intelligent decisions when it actually comes.
The financial planner may also provide ideas you may want to convey to your parents. They’re often unaware of strategies that will minimize inheritance taxes, or create a strategic plan for a more successful distribution of the estate.
In addition, if there may be questions surrounding the estate, perhaps involving the children of a previous or subsequent marriage, the financial planner may recommend consulting with an estate attorney.
The more you can do in advance, the less likely it is you’ll be blindsided when the inheritance arrives and the stakes are higher.
Read more: Are Certified Financial Planners Worth The Money?
9. Decide if you’ll need a trust
If you don’t have one now, receiving a large inheritance might make a trust advisable. It may even be completely necessary if the inheritance is particularly large, or if you yourself have children from a previous marriage.
A trust is a way to protect your assets, and to ensure the money is distributed as you wish upon your death.
Shawn Plummer, CEO of The Annuity Expert, explains further:
“You may need a trust if you want to specify how your assets will be distributed without a probate court getting involved. While a will can achieve a similar purpose, wills have to be authenticated by a probate court and can require more time and money.”
Just as important, a trust has the potential to protect your assets from seizure by creditors, or from litigation. With the larger personal estate the inheritance will create, you may need just that kind of protection.
And don’t worry, you won’t need to pay an arm and a leg to get these documents drawn up. Trust & Will offers estate planning help with plans starting at just $39. This can help you avoid racking up a high bill with an estate planner.
Summary
You’ve probably known of situations where someone came into a large windfall, only to be broke a few short years later. Unfortunately, it’s not an uncommon outcome.
The sudden arrival of a large amount of money can cause an unprepared recipient to blow what could be a life-changing opportunity. It could have the potential to dramatically improve your finances and your life.
You’ll need a plan to make that happen, and it’s never too early to start drawing one up.
In the world of personal finance, offshore bank accounts have long been a source of intrigue, often associated with high-net-worth individuals, multinational corporations, and even cinematic tales of mystery and suspense.
However, they’re not just tools for the James Bonds of the world. From asset protection to currency diversification, offshore bank accounts can offer a wide range of benefits.
What is offshore banking?
Offshore banking refers to the process of keeping money in a financial institution located outside the depositor’s home country. This foreign financial institution could be in a country halfway across the world or in a neighboring nation, depending on the account holder’s needs and preferences.
Despite the name, an offshore bank account functions much like your local bank account, providing similar services such as savings accounts, debit cards, credit cards, and online banking.
How to Open an Offshore Bank Account Legally
Opening an offshore bank account can be a relatively straightforward process, albeit with more documentation involved than opening a domestic account. To open a foreign bank account, you need to conduct research on countries that offer offshore banking services and the offshore banks that operate within these jurisdictions.
Typically, the account opening process involves providing your identification documents, proof of address, and, in some cases, proof of income or wealth, to the foreign bank. Some foreign banks may also request a bank reference, which usually comes in the form of bank statements from your current bank.
Advantages of Offshore Banking
When considering an offshore bank account, it’s essential to weigh the potential advantages it offers. These benefits can be quite compelling, depending on your specific financial situation and needs.
Asset Protection
One significant advantage of offshore banking is asset protection. This benefit is of particular interest to high-net-worth individuals and business owners, but it can be equally beneficial for anyone interested in safeguarding their assets from legal disputes or economic instability.
Offshore bank accounts can serve as a secure and central location for assets. By keeping part of your wealth in a jurisdiction other than your home country, you’re diversifying the risks associated with potential economic downturns or changes in governmental policies. For instance, if your domestic economy takes a downturn, having a portion of your assets abroad could provide a financial buffer.
Moreover, certain offshore accounts offer a level of legal protection, potentially shielding your assets from legal proceedings such as lawsuits or bankruptcy filings.
Currency Diversification
Currency diversification is another advantage of offshore bank accounts. When you hold money in an offshore bank account, you’re not restricted to a single currency. Instead, you can hold deposits in multiple currencies, providing a hedge against currency risk.
For example, if your home country’s currency significantly depreciates, it could lead to a relative decrease in your wealth. However, if you hold funds in other currencies through your offshore account, you might be shielded from this depreciation. This multi-currency feature can also be beneficial for frequent travelers or individuals conducting business across different countries.
Tax Benefits
Lastly, it’s worth noting the potential tax advantages of offshore banking. Certain offshore banks are located in tax havens, or countries known for their low or no taxes on certain types of income. These jurisdictions might offer favorable tax conditions compared to your home country.
While these potential tax benefits should never be used to avoid paying taxes unlawfully, they can be part of an effective wealth management strategy when used correctly. For instance, some offshore jurisdictions don’t tax interest income, which could be beneficial for those with a substantial amount of money in their savings or investment accounts.
It’s important to always disclose these accounts and income to your home country’s tax authority, to stay in compliance with all tax laws.
Disadvantages of Offshore Banking
While offshore bank accounts can offer several benefits, they also come with challenges that potential account holders need to be aware of.
Cost
Some of the best offshore bank accounts are often associated with various costs. To start, there might be a substantial minimum deposit requirement. This can put some of the more premium offshore accounts out of reach for individuals without a high level of wealth.
Furthermore, offshore banking can involve monthly maintenance fees and transaction fees that are often higher than those of a domestic bank. These fees can add up over time, potentially eroding the benefits gained from lower taxes or higher interest rates.
Accessibility
Physical and technological accessibility can be a concern when banking offshore. Depending on the location of the bank, accessing your funds when you need them can be more challenging than with a domestic account. For instance, differences in time zones can make real-time banking difficult, and language barriers could potentially complicate communication with customer service.
Regulation and Stability
Lastly, not all countries that offer offshore banking have the same level of political and economic stability. While places like the Cayman Islands and Switzerland are known for their stability, this is not a universal trait among all jurisdictions offering offshore accounts.
Moreover, the level of consumer protection offered by offshore banks may not be as comprehensive as what you would find in your home country. For instance, some countries might lack deposit insurance schemes, leaving your funds vulnerable if the bank were to fail.
The Legal Landscape of Offshore Accounts
While offshore bank accounts have unfortunately been linked to money laundering and tax evasion, it’s essential to underscore that having an offshore account is completely legal. However, account holders must adhere to tax laws and regulations in their home country, and not use these accounts for illegal purposes.
This includes reporting your offshore accounts to the relevant tax authorities and paying any taxes owed on interest or other income earned from these accounts. Failure to do so could lead to severe penalties, including charges of tax fraud.
The Role of Offshore Banking in Investment and Savings
Offshore banking can also be an effective tool for managing your savings and investments. Many offshore banks offer a variety of financial services, including investment accounts and high-yield savings accounts, allowing individuals to invest money in a range of assets across different markets.
This makes offshore banking particularly appealing to expatriates, international businesspeople, and globe-trotters, as it provides a level of flexibility that is often unmatched by domestic accounts. However, it’s important to note that these potential benefits should always be balanced against any associated costs, such as monthly fees or transaction charges.
Myths and Misconceptions About Offshore Banking
Offshore banking is often misunderstood, thanks to a slew of myths and misconceptions. The truth is, you don’t have to be a billionaire or an international spy to open an offshore bank account. Many people, from expatriates to retirees, can benefit from foreign currency holdings, potential tax benefits, and other financial advantages that come with having an account with a foreign bank.
Bottom Line: Is Offshore Banking Right for You?
Offshore banking can offer a host of benefits, from asset protection to potential tax advantages. However, it’s not a decision to be taken lightly. It’s crucial to understand the legal implications, costs, and potential risks before deciding to bank offshore.
Whether to open an offshore bank account will largely depend on your individual circumstances. If you’re considering banking offshore, it’s always a good idea to consult with a financial advisor or tax professional to understand all the implications.
After all, navigating the world of offshore accounts can be tricky, but with the right guidance and knowledge, you can make an informed decision that aligns with your financial goals.
Frequently Asked Questions
Can I open an offshore bank account online?
Yes, many offshore banks offer the option to open an account online, but the process can vary depending on the bank. Some banks may require a notarized copy of your passport, proof of address, and a reference from your current bank. Others may need more or less, depending on their internal policies and the regulations of the country where they’re located.
Can U.S. citizens open offshore bank accounts?
Yes, U.S. citizens can legally open an offshore bank account. However, it’s important to note that U.S. citizens must report these accounts to the IRS and the U.S. Treasury Department if the total value of their foreign financial accounts exceeds a certain threshold.
How can I access the money in my offshore account?
There are several ways to access your money in an offshore account. You can use a debit or credit card issued by your offshore bank, make electronic transfers, or write checks. The exact methods will depend on the services your offshore bank provides.
What happens to my offshore account if I die?
In the event of your death, your offshore account would be handled based on the local laws of the country where the bank is located and any instructions you may have left with the bank. Some offshore jurisdictions are notoriously complex when it comes to probate laws, so it’s essential to discuss this aspect with your bank when opening an account.
Can I open an offshore account anonymously?
While some offshore jurisdictions used to allow anonymous accounts, this is no longer the case due to global efforts to increase transparency and fight against illicit activities like money laundering and tax evasion. Today, every bank is required to know its customers (KYC regulations) and will need your personal information when you open an account.
Can offshore banking help with my retirement planning?
Yes, offshore banking can be a part of your retirement planning, especially if you plan to retire abroad or travel frequently during your retirement. Some offshore banks offer specific services for retirees, including access to medical insurance and investment products.
A House panel has passed a bill that would temporarily expand the standard tax deduction used by the majority of taxpayers by $2,000 per person for the next two years.
The Tax Cuts for Working Families Act (H.R.3936) recently approved by the tax-writing House Ways and Means Committee would temporarily boost the standard deduction by $2,000 for single filers and $4,000 for married filers for 2024 and 2025. The deduction would start to phase out for single taxpayers with $200,000 in income, or $400,000 for joint filers. A financial advisor can help you optimize your tax strategy and make sense of tax code changes.
“The vast, vast majority of my constituents use the standard deduction on their taxes every year,” said Rep. Carol Miller, R-West Virginia, adding that the measure will increase economic activity in local economies. “The bonus $4,000 deduction is a $100 billion tax cut for the working families and will go a long way to make sure that my constituents can make ends meet.”
Potential Impact of Standard Deduction Increase
Nearly two-thirds of households would get a tax cut in 2024 under the proposal, according to research from the nonpartisan Penn Wharton Budget Model. However, since the standard deduction lowers the amount of income subject to tax, the deduction isn’t refundable and wouldn’t provide cash to lower-income taxpayers. In fact, only a small percentage of the bottom 20% of households have enough income to get a tax cut under the proposal, the researchers from Penn concluded.
But those at the very top of the income ladder also wouldn’t see significant tax savings if the bill becomes law. Not only does the higher deduction phase out for incomes of $200,000 or more (or $400,000 for married couples), but a larger proportion of high-income households use itemized deductions.
“The poorest fifth of Americans would receive just 2% of the benefits of this provision, and on average, that means a tax break of just $30 next year,” said Rep. Richard Neal of Massachusetts, the committee’s ranking Democrat.
The change would also cost approximately $96 billion over 10 years, the Penn researchers found.
The standard deduction for 2023 will be $13,850 for singles and $27,700 for couples. The deduction nearly doubled as part of the 2017 Tax Cuts and Jobs Act, which expires in 2026. An increasing number of taxpayers have opted to claim the standard deduction, rather than itemize deductions for mortgage interest, charitable donations, medical costs and a host of other deductible expenses. According to the IRS, 90% of taxpayers opted for the standard deduction for their 2021 taxes.
Will it Help Ease Inflation or Make it Worse?
Sponsors of the temporary increase said the measure was intended to provide relief from inflation, which soared to 9.1% last June before dropping to 4% in May. The target inflation rate for the Federal Reserve is 2%, which mirrors the historical average.
That reasoning was criticized in an analysis by the conservative-leaning American Enterprise Institute, which pointed out that increasing the disposable income of so many Americans tends to make inflation worse, and would contradict efforts by the Federal Reserve to slow consumer spending by raising interest rates.
Bottom Line
An increase in the standard deduction on federal income tax would benefit most U.S. households but only a small amount of lower-income taxpayers would see any cut to their tax bills. Since the increase of the standard deduction in 2017, fewer taxpayers have been itemizing deductions on their returns.
Tax Optimization Tips
When it comes to saving and investing for retirement, taxes are a significant and complicated consideration. Saving in a traditional IRA or 401(k) gives you an immediate tax break since contributions are made on a pre-tax basis. A Roth account, on the other hand, is funded with after-tax dollars so your money grows tax-free. Here’s some additional guidance for late-career savers deciding whether to switch to Roth contributions.
A financial advisor with tax expertise can help you optimize your tax strategy. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
There’s no denying that exchange-traded funds (ETFs) are popular. According to the New York Stock Exchange’s most recent quarterly ETF report , as of December 31, 2020 there were 2,391 ETF listed in the U.S. Those funds hold a total of $5.49 trillion in assets, with an average of $111.5 billion transactional daily value.
Investors primarily turn to ETFs because of the returns. The average annual 10-year return for the benchmark SPDR S&P 500 ETF stands at above 14% at the end of 2020. (That said, as always past performance is not a guarantee of future success.)
There is another major benefit of ETFs—they’re a good tax-limitation tool.
In a 2019 Morningstar report on investment funds and taxes, analysts conclude that 84% of all ETF portfolio assets were steered toward specially-focused funds that closely follow market-cap weighted indexes. Such funds historically have low investor turnover, which in turn curbs capital gains and fund distributions, and thus reduces excess “taxable events.”
ETFs & Mutual Funds: How They Differ
When it comes to understanding ETFs vs mutual funds, it’s often best to start with a simple explanation for each.
Both mutual funds and ETFs invest in a group or “basket” of underlying stocks, bonds, commodities, and other financial assets, on behalf of fund shareholders. But ETFs trade on a daily basis much like stocks and bonds. Mutual funds do not.
Mutual funds offer investors a menu of various share classes where they can invest their money. Given the wider assets selection options available, a mutual fund investor may see more fund fees to compensate for that expanded menu. Given their low trading structure, ETF fees are usually lower than mutual funds, resulting in a lower expense ratio.
ETF Tax Advantages Over Mutual Funds
Tax-wise, The IRS treats ETFs and mutual funds the same. When either fund model sells securities that have appreciated in value, it creates a capital gain—or capital appreciation on the investment—which is taxable under U.S. law.
ETF fund managers make trades for a variety of reasons. For example, an asset can be bought and sold for strategic reasons (i.e. to properly allocate assets or to avoid “style drift” when a fund slides away from its target strategy.) Trades also must be made upon shareholder redemptions—when they redeem some or all of the assets they’ve invested in the fund.
The more trades made by ETF fund managers, the more taxable events occur. Consequently, for fund managers and investors, the goal is to find ways to keep those taxes from accumulating.
An ETF’s structure can help curb the negative impact of taxes, in the following ways.
Lower Capital Gains Impact
Since the IRS considers capital gains a taxable event, a major goal with any fund investment is to reduce the impact of capital gain payouts to shareholders at year end.
ETFs typically accumulate fewer capital gains than mutual funds. When a mutual fund has to redeem assets back to shareholders, it must sell assets to create the money needed to pay out those redemptions, resulting in capital gains. But when an ETF shareholder wants to sell shares, they can easily do so by trading the ETF to another investor—just like a stock transaction. That, in turn, creates no capital gains impact for the ETF—and adds a major tax advantage for ETF investors.
Index Tracking Tax Benefits
Since many ETFs are structured to track a particular index, trades are made only when there are changes in the underlying index (like when the S&P 500 or the Russell 2000 index experience significant fluctuations that require some ETF stabilization.) Fewer transactions generally means lower taxes.
The Use of “Creation Units”
ETFs are built to trade differently than mutual funds. With ETFs, fund managers can leverage so-called “creation units”—blocks of shares—to buy and sell fund securities. These units enable fund managers to buy or sell assets collectively, instead of individually. That means fewer trades and fewer taxable trade execution events.
Downsides of ETFs and Taxes
Though ETF tax efficiency is generally better than that of mutual funds, that doesn’t mean ETFs come with no tax risks. There are a few taxable events that bear watching for investors.
Distributions and dividends
Just like any investment vehicle, ETFs can come with regular distributions and dividends, which are usually taxable.
Increased Trade Activity on Actively Managed Funds
Though most ETFs simply follow an investment index, there are some actively managed ETFs. With actively-managed funds, more trades are made, which may lead directly to a more onerous tax bill.
High Trading Costs
Since ETFs are traded like stocks, the fees that come with buying and selling ETF assets usually trigger trading costs that are akin to trading stocks—and those fees can be high. Historically, brokerage trading fees are among the highest fees in the investment industry, which isn’t great news for ETF investors. Even if investors do save on taxes, those savings can potentially be mitigated or even wiped out by high ETF trading costs.
The Takeaway
Exchange traded funds offer ample potential tax benefits to savings-minded investors—especially in key areas like capital gains, expense ratios, redemptions, and trading frequency.
SoFi Invest® offers investors an easy, low-cost way to diversify their portfolio with ETFs. Investors can choose from a variety of ETFs designed specifically for ambitious investors with long-term goals for their investments.
Find out how SoFi Invest ETFs can be a part of your financial portfolio.
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An IRA is a simple little thing. It’s a common, garden-variety retirement vehicle, basically nothing more than a savings account with initials — right? Wrong.
The rules regulating IRAs are varied and vexing; IRS Publication 590 [PDF], the definitive source for Uncle Sam’s shalls and shan’ts regarding IRAs, weighs in at a hefty 108 pages. And then there are all the guidelines about employer-sponsored plans — e.g., 401(k)s and 403(b)s. Whew! Seems like all this would be enough to fill a two-day conference focusing on nothing but retirement accounts.
Actually, it is. I know, because I attended one — Ed Slott’s two-day IRA workshop (fun!). Slott, a CPA and the operator of IRAHelp.com, is recognized as one of America’s foremost authorities on individual retirement arrangements (yep, that’s what the “A” in “IRA” actually stands for). At the conference, he and his team led 100 financial-services pros (and one Fool) through a 430-page manual that described the care and feeding of retirement accounts, as well as several real-life examples of people who made mistakes that cost them thousands of dollars.
Some examples:
A teacher withdrew $67,553 from her 403(b) to pay her daughter’s college expenses. She paid the income taxes, but thought she’d be exempt from the 10% penalty since the money was used for higher-education expenses. Sadly, that exemption applies only to IRAs, not 403(b)s or 401(k)s. Oops.
A widow inherited a $2,646,798 retirement account from her deceased husband. She transferred it to her own IRA, then withdrew $977,888. She wasn’t yet 59-1/2 but figured she’d be spared the 10% early withdrawal penalty since she inherited the account. Indeed, distributions from inherited accounts are exempt from the 10% penalty. However, since she transferred the account to her own IRA, she owed Uncle Sam $97,789. Bigger oops.
It would be the ultimate in stinkiness if you spent years — nay, decades — saving in a retirement account, only to lose thousands due to one simple mistake. Here are just some of the guidelines you must follow to prevent just such a mistake from happening to you.
Stuffing It The maximum you can contribute to an IRA in 2011 is $5,000 — or $6,000 if you’re 50 or older. Granted, the biggest source of your IRA’s funds is likely a transfer from a 401(k) or other employer plan, but contributing $5,000 annually is nothing to sneeze at. For one thing, sneezing at something is rude — but more importantly, contributing $5,000 a year to an account that earns 8% annually would result in $78,227 after 10 years and $247,115 after 20 years. Not shabby at all.
While contributing to an IRA can pay off over the long term, most people first contribute to their employer’s retirement plan, especially if the boss matches contributions. After that, you may want to contribute additional savings to an IRA; if you have money in a retirement plan with a former employer, moving that to an IRA also makes sense.
Here are the advantages of an IRA over a 401(k) or other plan:
More investment options. The typical 401(k) offers a menu of five to 15 mutual funds, whereas an IRA with a discount brokerage allows the owner to choose from among thousands of stocks, exchange-traded funds (ETFs), mutual funds, individual bonds, CDs, and, if approved, alternative strategies such as options.
Lower costs. This depends on the plan and the IRA provider, but the cost-conscious investor will have more ways to limit fees in an IRA, such as investing in index funds, ETFs, or stocks that you hold for many years (avoiding the annual expenses of funds).
There are two reasons not to transfer an employer plan to an IRA:
If you retire between the ages of 55 and 59-1/2, you can take money out of the plan from your last employer penalty-free, whereas withdrawals from an IRA before age 59-1/2 might result in a 10% penalty.
If you own stock in your employer, you’re likely better off transferring it to a taxable account to take advantage of net unrealized appreciation (NUA).
Getting It There From Here The easiest and best way to move money from one retirement account to another is with a “trustee-to-trustee transfer.” Contact the company to which you wish to move the money, complete the paperwork they send you, and they’ll handle the rest.
You want to avoid being sent a check payable to you alone. If that happens, you’ll generally have 60 days to get the money into the new account. Wait any longer and it may be considered a distribution from your previous plan, subject to taxes and possible penalties. In addition, 20% of the distribution may be withheld; you’ll have to cover that gap with personal funds when you move the money to a new account, but you’ll get a refund when you file your taxes. If you don’t make up that 20%, it, too, will be considered a distribution subject to taxes and penalties. This is all very bad.
If your current account provider insists on sending you a check, request that it be made payable to the new financial institution — for example, “XYZ Bank as trustee of IRA of John Doe” or “ABC Firm FBO Jane Smith” (FBO means “for benefit of”).
Spending It As mentioned earlier, you generally have to wait until age 59-1/2 before tapping retirement accounts, whether IRAs or 401(k)s — if you don’t, you’ll be charged a 10% early-distribution penalty. However, there are several exceptions. Some apply to both IRA and employer-sponsored plans, others to just one. (Any exceptions apply just to the 10% penalty; regular taxation will still apply.)
The chart below lists the possible exceptions. If you find yourself in any of these situations, take the time to know all the details before you make a withdrawal. Most exceptions are restricted to certain groups, but Substantially Equal Periodic Payments are available to everyone; they’re explained in IRS Code 72(t), but they’re complicated and can trigger the penalty if not done properly. For all the details, visit www.72t.net.
Note: The very first exception listed is also available to everyone, but it’s a large price to pay to avoid an IRS penalty.
Medical expenses that exceed 7.5% of adjusted gross income
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IRS levy
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Active reservists
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Distributions from inherited accounts
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Higher education, for self or qualified relatives
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“First-time” home buyer, up to $10,000 per account owner (can be used for qualified relatives, or for yourself if you didn’t own a home in the previous two years)
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Health insurance if unemployed
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Age 55
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Age 50 for public safety employees
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457 plans
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Dividends from employee stock ownership plans
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Qualified Domestic Relations Order
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Totally insane prices on flat-screen TVs at an after-Christmas sale
Contributions to a Roth IRA can be withdrawn tax- and penalty-free at any time, while earnings will be subject to the age 59-1/2 rule (as well as the five-year rule, which is a whole other complicated ball of wax). A Roth 401(k) is a different matter; all withdrawals are a proportional mix of contributions and earnings, with any taxes and penalties being assessed against the earnings only.
When You Gotta Take It Owners of traditional IRAs as well as traditional and Roth employer plans must begin taking annual required minimum distributions (RMDs) the year they turn 70-1/2. Alternately, they can wait until the following year but take two distributions in that year. Otherwise, they’ll pay a 50% penalty. Yes, even a Roth 401(k) has RMDs, but they can be avoided by transferring the money to a Roth IRA — the only account not subject to forced liquidation.
Surprisingly, beneficiaries of inherited retirement accounts must also take RMDs beginning in the year following the death of the original owner. This is true regardless of age — even if the account is a Roth IRA. The only exception: a surviving spouse who elects to make the inherited account her own (i.e., has it re-titled in her name) or rolls over the inherited account to her own existing account.
While non-spouse beneficiaries can roll an inherited 401(k) to an inherited IRA, they can’t avoid the RMDs. The account must remain titled something along the lines of “Joe Smith, deceased, IRA for the benefit of Joe Smith Jr. as beneficiary.”
Bequeathing It If you’re interested in passing on wealth to your family, you probably want as little to go to taxes and lawyers as possible. Start by naming living, breathing human beings on your account beneficiary forms. Doing this means the account bypasses your will and probate (which can cost time and money), and the beneficiary or beneficiaries can “stretch” the account over their lifetimes. If the form is blank, or the listed beneficiaries are themselves deceased, the money will go to the estate. In that case, the account may have to be liquidated within five years, and it will lose all the tax advantages of an IRA or 401(k).
Keep in mind that the beneficiary form often trumps other legal documents, such as wills and prenuptial agreements. If your beneficiary form says your IRA should be split between your son and daughter, but your will says it should just go to your daughter (because your son has turned out to be an irresponsible spendthrift — or a banker), the account may end up being split. And to minimize the risk of lost or messed-up beneficiary forms (it does happen!), keep copies in your own records.
It’s important to name primary beneficiaries as well as contingent beneficiaries (the people who will inherit your accounts if the primaries are deceased, or if they’d rather the contingent beneficiaries get the money). If you’ve inherited an IRA, make sure you name new beneficiaries.
Protecting It Finally, here are three other considerations for protecting your retirement accounts, during this life and beyond:
Creditors and bankruptcy. The money in your employer-sponsored retirement account most likely can’t be lost to bankruptcies, creditors, or lawsuits. IRAs receive bankruptcy protection up to $1 million. However, the amount of protection from other creditors varies by state.
IRA fees paid with non-IRA money. Many IRA providers charge an annual account fee, which is automatically taken from your account assets. However, you can instead send a check to the custodian and leave more money in the IRA to grow. This also applies to annual “wrap” fees, though not to commissions and mutual fund expenses.
Estate taxes. Retirement accounts, including Roths, are included in a gross estate for tax purposes. Recent laws increased the federal estate tax exemption to $5 million per person and $10 million per couple, but the limits drop in 2013. Twenty states also impose estate taxes, with exemptions as low as $338,333. If your estate is or will be worth a few million dollars or more, see a local, qualified estate-planning attorney.
Remember: Get help if you need it. If you’re going to make a significant change to your retirement accounts, you might want a little professional help to make sure you’re doing everything right. IRAHelp.com features a listing of advisors in your area who have taken extra training about IRAs and 401(k)s. Also, the fee-only financial advisors at the Garrett Planning Network charge by the hour (among other methods), which makes it easier to get your questions answered without having to turn over your entire financial life.