Q I have an idea that I think is terrific. I want to borrow $25,000 to $35,000 against my 401(k) and use the proceeds to invest in the stock market. My thinking is that I will be paying myself back on the loan and be making 10% on my money from the loan interest. And I think I can make decent returns by investing in a high-quality mutual fund. Is there anything wrong with this plan?
A Federal law permits taxpayers to take as many as two loans against their 401(k) plans. The first of these loans may be for as much as $50,000 or 50% of the 401(k) balance, whichever amount is less. The second loan can be up to 50% of the remainder minus the largest loan balance of the previous 12 months.
Further, federal law requires that loans for general purposes be repaid within five years. Loans made for a home purchase may be repaid over 30 years. However, your employer's rules may be more restrictive than these, so be sure to check before you proceed.
Rules aside, let's examine whether your plan makes sense. There are several unknowns here, such as your tax rate, the performance history and outlook of your 401(k) plan and the likely performance of the mutual fund in which you want to invest.
Even so, the plain fact is that you want to take money out of an account that is generating compounded tax-deferred income and put it into an account that will generate compounded taxable income. Is is worth the gamble, not to mention the hassle?
Let's see. If your 401(k) plan is generating annual tax-deferred returns of 14%, you would have to earn at least 19% in a taxable account to match that performance, assuming you're
in the 28% federal tax bracket. And this doesn't even consider your state tax obligation. (To arrive at this figure, we divided the rate of return of the tax deferred account, 14%, by 1 minus your marginal tax bracket, 28%, or 0.72.)
Of course, there is the issue of favorable capital gains treatment of any profit you might make in your taxable investment account compared with mandatory treatment as ordinary income of all withdrawals from your 401(k) account.
But you would have to consider as well the present value of the capital gains tax you would pay versus the income tax you would pay sometime in the future when you withdraw your 401(k) funds.
Glendale certified public accountant Gregory Kling says that at the end of the day, he usually advises clients raising your question to leave the money in their 401(k) plans if they have any confidence at all in the plan's administration and investment strategy.
"This isn't a numbers analysis but one based on practical experience," Kling says. "You can try to chase the last penny with your investment strategy, but my experience is that it generally doesn't work, and it generally isn't worth the risk or the effort."
Q In a recent column, you outlined the operations of dependent or health-care spending accounts that so many employers offer to their workers. You said these plans, often called "flexible spending" or "tax saver" programs, allow taxpayers to set aside a predetermined amount of a worker's salary--before federal and state taxes--to pay child-care, elder-care or unreimbursed medical costs during the year.
You also said that under most plans, any money that's unspent at the end of the year is forfeited. To whom or to what is the money forfeited?
A Any payroll deductions that are not claimed by a taxpayer by the end of the calendar year, or by the deadline imposed by the employer, become the property of the federal government.
Here's how these plans work and where the money goes if the taxpayer doesn't reclaim it. Under these plans, employees of the sponsoring company may elect to have withheld from their paychecks on a pretax basis an amount they expect to spend each year out of pocket for unreimbursable medical expenses, such as an insurance deductible.
Once the bill is paid, you may then submit a claim for that amount to your company's plan administrator and be reimbursed from the money that has been withheld from your paychecks.
At this point, you've paid for your medical expenses with pretax money, an automatic savings to you of the usual federal and state tax bite.
Some companies also provide flexible spending accounts for people with family day-care expenses. With these accounts, participants are permitted to set aside up to $5,000 to cover certain child-care or elder-care expenses for which they can be reimbursed.
However, you must estimate your costs carefully when you enroll in one of these plans, because under most of them, any money that's unspent at the end of the year is forfeited to the federal government.
No refunds are permitted, and most plans do not allow you to adjust the amount of money you have withheld from your paychecks during the year.
Q I invested in a mutual fund early last year and didn't touch my holdings throughout the year. Any income generated was reinvested back into the fund. Do I need to pay any taxes on those dividends and capital gains?
A You must report the dividends and capital gains on your income tax return. By now your mutual fund should have sent you a fairly detailed 1099 showing what portion of the total distributions generated by the fund were ordinary dividends and what portion were capital gains.
Some funds are even taking the extra step of breaking down the capital gains between those generated by long-term holdings of the fund and those generated by short-term holdings.
If you have any questions about the nature of your fund distribution, don't hesitate to call your fund. Most have toll-free numbers listed on their investor correspondence.
Carla Lazzareschi cannot answer mail individually but will respond in this column to financial questions of general interest. Write to Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053, or e-mail firstname.lastname@example.org