5. As the old saying goes “some restrictions apply.” Our friends in Congress and the IRS don’t want this to be too good a deal, even if it’s our own money. After all, Congress thinks they did us a really big favor with 401k accounts by making it easier to save for retirement. Maybe they did, but like many good deals, this one comes with strings attached. First there’s the $50,000 limit. Even if your have $200,000 in your 401k account, and the general rule is you can borrow up to 50% of your 401k account balance, you are limited to borrowing $50,000 at any one time. In addition most plans usually limit the number of loans you can have at any one time to 1 or 2. For example, if you borrow 50% of your 401k account balance of $50,000 on a 5 year loan, and the $25,000 left in your account triples over the next 3 years from savings and increases in the value of the investment to $75,000, you cannot borrow another $37,500. First you are limited to a total outstanding balance of $50,000. Second, if your plan restricts you to 1 loan at a time, you will not be about the borrow 50% of the new value in your account until the first loan is paid off. Even if your plan allows for 2 loans at a time, most plans have another restriction that says the amount you can borrow on the second loan will be reduced by the highest outstanding balance on the first loan during the previous 12 months.

6. If you switch to a new company, you may have to pay off your loan immediately. In many cases, this can be avoided by rolling over your 401k account, but if you can’t do that, the outstanding balance of your loan will be considered an “early distribution” from you retirement savings account and will be deducted from what you have available. You won’t have to pay the money back, but you will have to pay taxes on the balance of the loan as ordinary income. And if you’re less than 59 ½ yeas old, you will also have to pay a 10% early withdrawal penalty.

Thinking about paying extra taxes is stressful, so we’ll end here today. Tomorrow, I’ll post 2 other reasons to think twice about borrowing against your retirement account.

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Most of us have our 401k account or IRA in a plan that allows us to borrow a portion of the money. This can be a great idea and a ready source of money, but there are positives and negatives to borrowing from your retirement savings account. Here’s a list of 8 things to consider before taking out a loan from your retirement account. Since the list is long, I’ll post it over 4 days. Let’s start with 4 good reasons:

1. Most plans allow you to borrow up to 50% of the vested balance in your account, up to $50,000.

2. Interest rates are usually competitive and are often lower than your could get from a bank on a signature loan. Borrowing your own money is not technically a signature loan, because you are pledging the money in the account to back up the loan, but because it’s so quick and simple, it’s more like getting a signature loan on a note at the bank than the longer process of pledging assets for a loan guarantee.

3. Because your are borrowing your own money, you don’t have to “qualify” for a loan, like you would for a signature or other loan from a bank, so you don’t have to worry about your credit rating.

4. Since you’re borrowing your own money, the interest you pay on the loan goes back into your own pocket and not the banker’s, since it goes into your account. If your 401k account is primarily invested in your company stock or even in a mutual fund that has a low or falling rate of return at the moment, you might actually earn more money from the interest you pay on your loan, even if it’s only 5 or 6%.

So – 4 good reasons to consider borrowing from your retirement account when you need some extra money. Tomorrow, we’ll look at 2 reasons you might want to reconsider.

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Step 3 - Determine how much you need to save. Let’s say you currently earn $86,000 per year and have determined you can live on 70% of that or $60,000. To determine the amount of money you need in your retirement savings account by the time you retire, calculate how much it would take to earn $60,000 a year in interest at 8%. The math is simple. $60,000/8 x 100 = $750,000. Next determine how much you will have to save over the years between now and the age you plan to retire to reach your $750,000 goal.

If you don’t have a financial calculator handy, you can go to one on the website of the good folks at FinAid.org. Just click on the handy calculator at www.finaid.org. This particular calculator says it was designed to calculate how much money to save for college, but you can use it to calculate how much you need to save for any financial goal. For the sake of this example, I plugged in $750,000 as the goal and 25 years left before retirement and 8% return. In this situation, it says we would need to save $783 per month. That’s a hefty sum. Let’s see if there are ways to reduce that monthly savings amount.

Step 4 - Adjust for company or other retirement or pension plan payments. You need to adjust the amount you will have to save each month by taking into consideration any retirement or company pension plan payments you may be entitled to. Fewer and fewer companies are offering a defined benefit plan, where you are guaranteed a certain monthly payment. However many still do, usually tied to your number of years of service.

Let’s assume for this example that you qualify to receive 1.2% of your final salary, and that you will be on the job for 30 years when you retire. That’s 1.2% x 30 x $86,000 = $30,960 per year. That means you will have to cover the difference between $60,000 and $30,960 or $29,040 yourself. Applying the same math at 8%, that’s $29,040/8 x 100 = $363,000. Using the calculator on FinAid.org, that’s $379 a month in savings to reach that goal in 25 years.

Tomorrow in Part 3, we will look at adjusting for Social Security and inflation.

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In these steps, I’ve kept the math in the example simple to make the process easy to follow. Some folks have written entire books on this subject, and they make excellent reading when you’re ready to get into the process in detail. First step through the process in this simple example and then go into greater detail by doing a little research on your own when you are ready to set up your own retirement savings plan. The important point is - don’t delay getting started until you understand every complex twist and turn of the tax laws and all the investment options. That’s what the pro’s are for. Begin by understanding the basics and then get started. As a friend of mine says about any worthwhile project “It’s more important to get it going than to get it perfect”. So in the famous words of Nike - “just do it”.

Step 1 - Determine how much income you will need to have a comfortable retirement lifestyle. The old rule of thumb many investment advisors recommended was 80% of your current income. However, that’s a very general guideline. You really need to examine your own situation for a better number. Is your home paid for, or will it be paid for when you retire? Then you won’t need money to cover a mortgage payment. If you and your spouse are driving 2 cars now, will you cut back to one car? That’s one less car to maintain or eventually replace. If you currently live in a large house, will you be moving to a smaller house? That’s less for utilities, and the proceeds from the sale of the larger house can go into your retirement account. You’ll also have to factor in that you will have new expenses you didn’t have before. You may need to buy more medicines as you get older. If you have a health plan from your current employer, your share of the cost may go up. You will also probably want to buy Medicare insurance to cover your share of medical costs not covered by Medicare.

Step 2 - Determine what rate of return you believe you can get on your retirement savings. There are many references out there on what rate of return to use for retirement planning. Let’s try to keep the math simple. According to a research report prepared for the Social Security Advisory Board in 2001, the average real rate of return for stocks from 1946 to 1998 was 7.8% after inflation. That seems like a good time period to use because it avoids the Internet boom and bust between 1998 and 2002. This is 7.8% in real, not inflated dollars.

Of course, 7.8% is truly an average over time. In some years the stock market has done very well. In other years, it has taken a big slide. It can be very hard to predict a rate of return over a short period of time. So for the sake of simplicity, let’s round the 7.8% up to 8%. For your own planning, if you want to be more conservative, you can always use an even lower rate.

Tomorrow in Part 2, we’ll walk through some simple calculation to determine how much you need to save to provide the monthly income you need.

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