401(K) Cash Distributions: Understanding The Taxes & Penalties

When an employee unexpectedly loses their job and needs access to cash to continue to pay their bills, it’s not uncommon for them to elect a cash distribution from their 401(K) account. Still, they may regret that decision when the tax bill shows up the following year and then they owe thousands of dollars to the IRS in taxes and penalties that they don’t have.   But I get it; if it’s a choice between working a few more years or losing your house because you don’t have the money to make the mortgage payments, taking a cash distribution from your 401(k) seems like a necessary evil.  If you go this route, I want you to be aware of a few strategies that may help you lessen the tax burden and avoid tax surprises after the 401(k) distribution is processed. In this article, I will cover:

• How much tax do you pay on a 401(K) withdrawal?

• The 10% early withdrawal penalty

• The 401(k) 20% mandatory fed tax withholding

• When do you remit the taxes and penalties to the IRS?

• The 401(k) loan default issue

• Strategies to help reduce the tax liability

• Pre-tax vs. Roth sources

Taxes on 401(k) Withdrawals

When your employment terminates with a company, that triggers a “distributable event,” which gives you access to your 401(k) account with the company.   You typically have the option to:

1. Leave your balance in the current 401(k) plan (if the balance is over $5,000)

2. Take a cash distribution

3. Rollover the balance to an IRA or another 401(k) plan

4. Some combination of options 1, 2, and 3

We are going to assume you need the cash and plan to take a total cash distribution from your 401(k) account. When you take cash distributions from a 401(k), the amount distributed is subject to:

• Federal income tax

• State income tax

• 10% early withdrawal penalty

I’m going to assume your 401(k) account consists of 100% of pre-tax sources; if you have Roth contributions, I will cover that later on.  When you take distributions from a 401(k) account, the amount distributed is subject to ordinary income tax rates, the same tax rates you pay on your regular wages.  The most common question I get is, “how much tax am I going to owe on the 401(K) withdrawal?”.  The answer is that it varies from person to person because it depends on your personal income level for the year.  Here are the federal income tax brackets for 2022:

Using the chart above, if you are married and file a joint tax return, and your regular AGI (adjusted gross income) before factoring in the 401(K) distribution is $150,000, if you take a $20,000 distribution from your 401(k) account, it would be subject to a Fed tax rate of 24%, resulting in a Fed tax liability of $4,800.  

If instead, you are a single filer that makes $170,000 in AGI and you take a $20,000 distribution from your 401(k) account, it would be subject to a 32% fed tax rate resulting in a federal tax liability of $6,400.

20% Mandatory Fed Tax Withholding Requirement

When you take a cash distribution directly from a 401(k) account, they are required by law to withhold 20% of the cash distribution amount for federal income tax.  This is not a penalty; it’s federal tax withholding that will be applied toward your total federal tax liability in the year that the 401(k) distribution was processed.   For example, if you take a $100,000 cash distribution from your 401(K) when they process the distribution, they will automatically withhold $20,000 (20%) for fed taxes and then send you a check or ACH for the remaining $80,000.  Again, this 20% federal tax withholding is not optional; it’s mandatory.

Here's where people get into trouble.  People make the mistake of thinking that since taxes were already withheld from the 401(k) distribution, they will not owe more.  That is often an incorrect assumption.  In our earlier example, the single filer was in a 32% tax bracket. Yes, they withheld 20% in federal income tax when the distribution was processed, but that tax filer would still owe another 12% in federal taxes when they file their taxes since their federal tax bracket is higher than 20%.   If that single(k) tax filer took a $100,000 401(k) distribution, they could own an additional $12,000+ when they file their taxes.

State Income Taxes

If you live in a state with a state income tax, you should also plan to pay state tax on the amount distributed from your 401(k) account.  Some states have mandatory state tax withholding similar to the required 20% federal tax withholding, but most do not. If you live in New York, you take a $100,000 401(k) distribution, and you are in the 6% NYS tax bracket, you would need to have a plan to pay the $6,000 NYS tax liability when you file your taxes.

 10% Early Withdrawal Penalty

If you request a cash distribution from a 401(k) account before reaching a certain age, in addition to paying tax on the distribution, the IRS also hits you with a 10% early withdrawal penalty on the gross distribution amount.  

Under the age of 55: If you are under the age of 55, in the year that you terminate employment, the 10% early withdrawal penalty will apply.

Between Ages 55 and 59½:   If you are between the ages of 55 and 59½ when you terminate employment and take a cash distribution from your current employer’s 401(k) plan, the 10% early withdrawal penalty is waived.   This is an exception to the 59½ rule that only applies to qualified retirement accounts like 401(k)s, 403(b)s, etc.   But the distribution must come from the employer’s plan that you just terminated employment with; it cannot be from a previous employer's 401(k) plan.   

Note: If you rollover your balance to a Traditional IRA and then try to take a distribution from the IRA, you lose this exception, and the under age 59½ 10% early withdrawal penalty would apply.  The distribution has to come directly from the 401(k) account.

Age 59½ and older:  Once you reach 59½, you can take cash distributions from your 401(k) account, and the 10% penalty no longer applies.    

When Do You Pay The 10% Early Withdrawal Penalty?  

If you are subject to the 10% early withdrawal penalty, it is assessed when you file your taxes; they do not withhold it from the distribution amount, so you must be prepared to pay it come tax time.  The taxes and penalties add up quickly; let’s say you take a $50,000 distribution from your 401(k), age 45, in a 24% Fed tax bracket and a 6% state tax bracket.  Here is the total tax and penalty hit:

Gross 401K Distribution:                $50,000

Fed Tax Withholding (24%)          ($12,000)

State Tax Withholding (6%)          ($3,000)

10% Penalty                                       ($5,000)

Net Amount:                                      $30,000

In the example above, you lost 40% to taxes and penalties. Also, remember that when the 401(k) platform processed the distribution, they probably only withheld the mandatory 20% for Fed taxes ($10,000), meaning another $10,000 would be due when you filed your taxes.

Strategies To Reduce The Tax Liability

There are a few strategies that you may be able to utilize to reduce the taxes and penalties assessed on your 401(k) cash distribution.

The first strategy involves splitting the distribution between two tax years. If it’s toward the end of the year and you have the option of taking a partial cash distribution in December and then the rest in January, that would split the income tax liability into two separate tax years, which could reduce the overall tax liability compared to realizing the total distribution amount in a single tax year. 

Note: Some 401(k) plans only allow “lump sum distributions,” which means you can’t request partial withdrawals; it’s an all or none decision. In these cases, you may have to either request a partial withdrawal and partial rollover to an IRA, or you may have to rollover 100% of the account balance to an IRA and then request the distributions from there.

The second strategy is called “only take what you need.”  If your 401(k) balance is $50,000, and you only need a $20,000 cash distribution, it may make sense to rollover the entire balance to an IRA, which is a non-taxable event, and then withdraw the $20,000 from your IRA account. The same taxes and penalties apply to the IRA distribution that applies to the 401(k) distribution (except the age 55 rule), but it allows the $30,000 that stays in the IRA to avoid taxes and penalties.

Strategy three strategy involved avoiding the mandatory 20% federal tax withholding in the same tax year as the distribution.  Remember, the 401(K) distribution is subject to the 20% mandatory federal tax withholding. Even though they're sending that money directly to the federal government on your behalf, it actually counts as taxable income.  For example, if you request a $100,000 distribution from your 401(k), they withhold $20,000 (20%) for fed taxes and send you a check for $80,000, even though you only received $80,000, the total $100,000 counts as taxable income.

IRA distributions do not have the 20% mandatory federal tax withholding, so you could rollover 100% of your 401(k) balance to your IRA, take the $80,000 out of your IRA this year, which will be subject to taxes and penalties, and then in January next year, process a second $20,000 distribution from your IRA which is the equivalent of the 20% fed tax withholding. However, by doing it this way, you pushed $20,000 of the income into the following tax year, which may be taxed at a lower rate, and you have more time to pay the taxes on the $20,000 because the tax would not be due until the tax filing deadline for the following year.

Building on this example, if your federal tax liability is going to be below 20%, by taking the distribution from the 401K you are subject to the 20% mandatory fed tax withholding, so you are essentially over withholding what you need to satisfy the tax liability which creates more taxable income for you.   By rolling over the money to an IRA, you can determine the exact amount of your tax liability in the spring, and distribute just that amount for your IRA to pay the tax bill.

Loan Default

If you took a 401K loan and still have an outstanding loan balance in the plan, requesting any type of distribution or rollover typically triggers a loan default which means the outstanding loan balance becomes fully taxable to you even though no additional money is sent to you.   For example, if You have an $80,000 balance in the 401K plan, but you took a loan two years ago and still have a $20,000 outstanding loan balance within the plan, if you terminate employment and request a cash distribution, the total amount subject to taxes and penalties is $100,000, not $80,000 because you have to take the outstanding loan balance into account.  This is also true when they assess the 20% mandatory fed tax withholding. The mandatory withholding is based on the balance plus the outstanding loan balance.  I mention this because some people are surprised when their check is for less than expected due to the mandatory 20% federal tax withholding on the outstanding loan balance. 

Roth 401(k) Early Withdrawal Penalty

401(k) plans commonly allow Roth deferrals which are after-tax contributions to the plan. If you request a cash distribution from a Roth 401(k) source, the portion of the account balance that you actually contributed to the plan is returned to you tax and penalty-free; however, the earnings that have accumulated on that Roth source you have to pay tax and potentially the 10% early withdrawal penalty on.   This is different from pre-tax sources which the total amount is subject to taxes and penalties.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

$7,500 EV Tax Credit: Use It or Lose It

Claiming the $7,500 tax credit for buying an EV (electric vehicle) or hybrid vehicle may not be as easy as you think.  First, it’s a “use it or lose it credit” meaning if you do not have a federal tax liability of at least $7,500 in the year that you buy your electric vehicle, you cannot claim the full $7,500 credit and it does not carryforward to future tax years.   Normally, most individuals and business owners adopt tax strategies to reduce their tax liability but this use it or lose it EV tax credit could cause some taxpayers to do the opposite, to intentionally create a larger federal tax liability, if they think their federal tax liability will be below the $7,500 credit threshold. 

There are several other factors that you also have to consider to qualify for this EV tax credit which include:

• New income limitations for claiming the credit

• Limits on the purchase price of the car

• The type of EV / hybrid vehicles that qualify for the credit

• Inflation Reduction Act (August 2022) changes to the EV tax credit rules

• Buying an EV in 2022 vs 2023+

• Tax documents that you need to file with your tax return

• State EV tax credits that may be available

Inflation Reduction Act Changes To EV Tax Credits

On August 16, 2022, the Inflation Reduction Act was signed into law, which changed the $7,500 EV Tax Credits that were previously available. The new law expanded and limited the EV tax credits depending on your income level, what type of EV car you want, and when you plan to buy the car.   Most of the changes do not take place until 2023 and 2024, so depending on your financial situation it may be better to purchase an EV in 2022 or it may be beneficial to wait until 2023+.

$7,500 EV Tax Credit

If you purchase an electronic vehicle or hybrid that qualifies for the EV tax credit, you may be eligible to claim a tax credit of up to $7,500 in the tax year that you purchased the car.  This is the government’s way of incentivizing consumers to buy electric vehicles.   The Inflation Reduction Act also opened up a new $4,000 tax credit for used EVs.

New Income Limits for EV Tax Credits

Starting in 2023, your income (modified AGI) will need to be below the following thresholds to qualify for the federal EV tax credits on a new EV or hybrid:

• Single Filers:                                 $150,000

• Married Filing Joint:                     $300,000

• Single Head of Household:           $225,000

There are lower income thresholds to be eligible for the used EV tax credit which is as follows:

• Single Filers:                                       $75,000

• Married Filing Joint:                        $150,000

• Single Head of Household:           $112,500

Before the passage of the Income Reduction Act, there were no income limitations to claim the $7,500 Tax Credit.  Taxpayers with incomes level above the new thresholds may have an incentive to purchase their new EV before December 31, 2022, before the income limitations take effect in 2023.

Restriction on EV Cars That Qualify

Not all EV or hybrid vehicles will qualify for the EV tax credit. The passage of the Inflation Reduction Act made several changes in this category. 

Removal of the Manufacturers Cap

On the positive side, Tesla and GM cars will once again be eligible for the EV tax credit.  Under the old EV tax credit rules, once a car manufacturer sold over 200,000 EVs, vehicles made by that manufacturer were no longer eligible for the $7,500 tax credit.  The new legislation that just passed eliminated those caps making Tesla, GM, and Toyota vehicles once again eligible for the credit.   The removal of the cap does not take place until January 1, 2023.

Purchase Price Limit

Adding restrictions, the Inflation Reduction Act introduced a cap on the purchase price of new EVs and hybrids that qualify for the $7,500 EV tax credit. The limit on the manufacturer’s suggested retail price is as follows:

• Sedans:                              $55,000

• SUV / Trucks / Vans:       $80,000

If the MSRP is above those prices, the vehicle no longer qualified for the EV tax credit.

Assembly & Battery Requirements

Another change was made to the EV tax credit under the new legislation that will most likely limit the number of vehicles that are eligible for the credit. The new law introduced a final assembly and battery component requirement. First, to be eligible for the credit, the final assembly of the vehicle needs to take place in North America. Second, the battery used to power the vehicle must be made up of key materials and consist of components that are either manufactured or assembled in North America.

Leases Do Not Qualify

If you lease a car, that does not qualify toward the EV tax credit because you technically do not own the vehicle, the manufacturer does. You have to buy the vehicle to be eligible for the $7,500 EV tax credit.

Are You Eligible For The EV Tax Credit?

Bringing everything together, starting in 2023, to determine whether or not you will be eligible for the $7,500 EV Tax Credit, you will have to make sure that:

1.  Your income is below the EV tax credit limits

2. The purchase price of the vehicle is below the EV tax credit limit

3. The vehicles assembly and battery components meet the new requirement

Once there is more clarification around the assembly and components piece of the new legislation there will undoubtedly be a website that lists all of the vehicles that are eligible for the $7,500 tax credit that you will be able to use to determine which vehicles qualify.

Timing of The Tax Credit

Under the current EV tax credit rule, you purchase the vehicle now, but you do not receive the tax credit until you file your taxes for that calendar year.   Starting in 2024, the tax credit will be allowed to occur at the point of sale which is more favorable for consumers.  Logistically, it would seem that an individual would assign the credit to the car dealer, and then the car dealer would receive an advance payment from the US Department of Treasury to apply the discount or potentially allow the car buyer to use the credit toward the down payment on the vehicle.

However, car buyers will have to be careful here.  Since your eligibility for the tax credit is income based, if you apply for the credit in advance, but then your income for the year is over the MAGI threshold, you may owe that money back to the IRS when you file your taxes. It will be interesting to see how this is handled since the credits are being awarded in advance.

A Use It or Lose It Tax Credit

There are going to be some challenges with the new EV tax credit rule beyond limiting the number of people that qualify and the number of cars that qualify.  The primary one is that the $7,500 EV federal tax credit is not a “refundable tax credit.”  A refundable tax credit means if your total federal tax liability is less than the credit, the government gives you a refund of the remaining amount, so you receive the full amount as long as you qualify.  The EV tax credit is still a “non-refundable tax credit” meaning if you do not have a federal tax liability of at least $7,500 in the year that you purchase the new EV vehicle, you may lose all or a portion of the $7,500 that you thought you were going to receive.

For example, let’s say you are a single tax filer, and you make $50,000 per year.   If you just take the standard deduction, with no other tax deductions, your federal tax liability may be around $4,200 in 2023.  You buy a new EV in 2023, you meet the income qualifications, and the vehicle meets all of the manufacturing qualifications, so you expect to receive $7,500 when you file your taxes for 2023.  However, since your federal tax liability was only $4,200 and the EV tax credit is not refundable, you would only receive a tax credit of $4,200, not the full $7,500.

No EV Tax Credit Carryforward

With some tax deductions, there is something called tax carryforward, meaning if you do not use the tax deduction in the current tax year, you can “carry it forward” to be used in future tax years to offset future income. The EV tax credit does not allow carryforward, if you can’t use all of it in the year of the EV purchase, you lose it.

Intentionally Creating Federal Tax Liability

If you are in this scenario where you purchase an EV but you expect your federal tax liability to be below the full $7,500 credit threshold, you may have to do what I call “opposite tax planning”. Normally you are trying to find ways to reduce your tax bill, but in these cases, you are trying to find ways to increase your tax liability to get the maximum refund from the government.  But how do you intentionally increase your tax liability? Here are a few ideas:

1. Stop or reduce the contributions being made to your pre-tax retirement accounts.   When you make pretax contributions to retirement accounts it reduces your tax liability.  But you have to be careful here, if your company offers an employer match, you could be leaving free money on the table, so you have to conduct some analysis here.  In many cases, 401(k) / 403(b) allows either pre-tax or Roth contributions.  If you are making pre-tax contributions, you may be able to just switch to Roth contributions, which are after-tax contributions, and still take advantage of the employer match.

2. Push more income into the current tax year. If you are a small business owner, you may want to push more income into the current tax year. If you are a W2 employee, you are expecting to receive a bonus payment, and you have a good working relationship with your employer, you may be able to request that they pay the bonus to you this year as opposed to the spring of next year.

3. Delay tax-deductible expenses into the following tax year. Again, if you are a small business owner and have control over when you realize expenses, you could push those into the following year.  For W2 employees, if you have enough tax deductions to itemize, you may want to push some of the itemized deductions into the following tax year.

4. Delay getting married until the following tax year. Kidding but not kidding. Nothing says I love you like a full $7,500 tax credit. Use it toward the wedding.  You may not qualify under the single file income limit but maybe you would qualify under the joint filer limit.  

State EV Tax Credit

The $7,500 EV tax credit is a federal tax credit but some states also have EV tax credits in addition to the federal tax credit and those credits could have different criteria to qualify. It’s worth looking into before purchasing your new or used EV.

EV Tax Credit Tax Forms

In 2022, you apply for the federal EV tax credit when you file your tax return.  You will have to file Form 8936 with your tax return.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

401K Loans: Pros vs Cons

There are a number of pros and cons associated with taking a loan from your 401K plan.  There are definitely situations where taking a 401(k) loan makes sense but there are also number of situations where it should be avoided.  Before taking a loan from your 401(k), you should understand:

• How 401(k) loans work

• How much you are allowed to borrow

• Duration of the loans

• What is the interest rate that is charged

• How the loans are paid back to your 401(k) account

• Penalties and taxes on the loan balance if you are laid off or resign

• How it will impact your retirement

Sometimes Taking A 401(k) Loan Makes Sense

People are often surprised when I say “taking a 401(k) loan could be the right move”.  Most people think a financial planner would advise NEVER touch your retirement accounts for any reasons.  However, it really depends on what you are using the 401(k) loan for.  There are a number of scenarios that I have encountered with 401(k) plan participants where taking a loan has made sense including the following:

• Need capital to start a business (caution with this one)

• Resolve a short-term cash crunch

• Down payment on a house

• Payoff high interest rate credit cards

• Unexpected health expenses or financial emergency 

I will go into more detail regarding each of these scenarios but let’s do a quick run through of how 401(k) loans work.

How Do 401(k) Loans Work?

First, not all 401(k) plans allow loans. Your employer has to voluntary allow plan participants to take loans against their 401(k) balance. Similar to other loans, 401(k) loans charge interest and have a structured payment schedule but there are some differences.  Here is a quick breakout of how 401(k) loans work:

How Much Can You Borrow?

The maximum 401(k) loan amount that you can take is the LESSER of 50% of your vested balance or $50,000.  Simple example, you have a $20,000 vested balance in the plan, you can take a 401(K) loan up to $10,000.   The $50,000 limit is for plan participants that have balances over $100,000 in the plan.  If you have a 401(k) balance of $500,000, you are still limited to a $50,000 loan.

Does A 401(k) Loan Charge Interest?

Yes, 401(k) loans charge interest BUT you pay the interest back to your own 401(k) account, so technically it’s an interest free loan even though there is interest built into the amortization schedule.  The interest rate charged by most 401(k) platforms is the Prime Rate + 1%. 

How Long Do You Have To Repay The 401(k) Loan?

For most 401(k) loans, you get to choose the loan duration between 1 and 5 years. If you are using the loan to purchase your primary residence, the loan policy may allow you to stretch the loan duration to match the duration of your mortgage but be careful with this option.  If you leave the employer before you payoff the loan, it could trigger unexpected taxes and penalties which we will cover later on.

How Do You Repay The 401(k) Loan?

Loan payments are deducted from your paycheck in accordance with the loan amortization schedule and they will continue until the loan is paid in full.  If you are self employed without payroll, you will have to upload payments to the 401(k) platform to avoid a loan default.

Also, most 401(K) platforms provide you with the option of paying off the loan early via a personal check or ACH.

Not A Taxable Event

Taking a 401(k) loan does not trigger a taxable event like a 401(k) distribution does.  This also gives 401(k)’s a tax advantage over an IRA because IRA’s do not allow loans.

Scenarios Where Taking A 401(k) Loans Makes Sense

I’ll start off on the positive side of the coin by providing you with some real life scenarios where taking a 401(k) loan makes sense, but understand that all of the these scenarios assume that you do not have idle cash set aside that could be used to meet these expenses.  Taking a 401(k) loan will rarely win over using idle cash because you lose the benefits of compounded tax deferred interest as soon as you remove the money from your account in the form of a 401(k) loan.  

Payoff High Interest Rate Credit Cards

If you have credit cards that are charging you 12%+ in interest and you are only able to make the minimum payment, this may be a situation where it makes sense to take a loan from your 401(k) and payoff the credit cards.  But………but…….this is only a wise decision if you are not going to run up those credit card balances again.  If you are in a really bad financial situation and you may be headed for bankruptcy, it’s actually better NOT to take money out of your 401(k) because your 401(k) account is protected from your creditors.

Bridge A Short-Term Cash Crunch

If you run into a short-term cash crunch where you have a large expense but the money needed to cover the expense is delayed, a 401(k) loan may be a way to bridge the gap.  A hypothetical example would be buying and selling a house simultaneously.  If you need $30,000 for the down payment on your new house and you were expecting to get that money from the proceeds from the sale of the current house but the closing on your current house gets pushed back by a month, you might decide to take a $30,000 loan from your 401(k), close on the new house, and then use the proceeds from the sale of your current house to payoff the 401(k) loan. 

Using a 401(k) Loan To Purchase A House

Frequently, the largest hurdle for first time homebuyers when planning to buy a house is finding the cash to satisfy the down payment.  If you have been contributing to your 401(k) since you started working, it’s not uncommon that the balance in your 401(k) plan might be your largest asset.  If the right opportunity comes along to buy a house, it may makes sense to take a 401(k) loan to come up with the down payment, instead of waiting the additional years that it would take to build up a down payment outside of your 401(k) account.  

Caution with this option.  Once you take a loan from your 401(k), your take home pay will be reduced by the amount of the 401(k) loan payments over the duration of the loan, and then you will a have new mortgage payment on top of that after you close on the new house.  Doing a formal budget in advance of this decision is highly recommended.

Capital To Start A Business

 We have had clients that decided to leave the corporate world and start their own business but there is usually a time gap between when they started the business and when the business actually starts making money.  It is for this reason that one of the primary challenges for entrepreneurs is trying to find the capital to get the business off the ground and get cash positive as soon as possible.  Instead of going to a bank for a loan or raising money from friends and family, if they had a 401(k) with their former employer, they may be able to setup a Solo(K) plan through their new company, rollover their balance into their new Solo(K) plan, take a 401(k) loan from their new Solo(k) plan, and use that capital to operate the business and pay their personal expenses.

Again, word of caution, starting a business is risky, and this strategy involves spending money that was set aside for the retirement years.

Reasons To Avoid Taking A 401(k) Loan

We have covered some Pro side examples, now let’s look at the Con side of the 401(k) loan equation. 

Your Money Is Out of The Market

When you take a loan from your 401(k) account, that money is removed for your 401(k) account, and then slowly paid back over the duration of the loan.  The money that was lent out is no longer earning investment return in your retirement account.  Even though you are repaying that amount over time it can have a sizable impact on the balance that is in your account at retirement. How much?  Let’s look at a Steve & Sarah example:

• Steve & Sarah are both 30 years old

• Both plan to retire age 65

• Both experience an 8% annualize rate of return

• Both have a 401(K) balance of $150,000

• Steve takes a $50,000 loan for 5 years at age 30 but Sarah does not

Since Sarah did not take a $50,000 loan from her 401(k) account, how much more does Sarah have in her 401(k) account at age 65?  Answer: approximately $102,000!!!   Even though Steve was paying himself all of the loan interest, in hindsight, that was an expensive loan to take since taking out $50,000 cost him $100,000 in missed accumulation.

401(k) Loan Default Risk

If you have an outstanding balance on a 401(k) loan and the loan “defaults”, it becomes a taxable event subject to both taxes and if you are under the age of 59½, a 10% early withdrawal penalty.  Here are the most common situations that lead to a 401(k) loan defaults:

1. Your Employment Ends:  If you have an outstanding 401(K) loan and you are laid off, fired, or you voluntarily resign, it could cause your loan to default if payments are not made to keep the loan current.  Remember, when you were employed, the loan payments were being made via payroll deduction, now there are no paychecks coming from that employer, so no loan payment are being remitted toward your loan.  Some 401(k) platforms may allow you to keep making loan payments after your employment ends but others may not past a specified date.  Also, if you request a distribution or rollover from the plan after your have terminated employment, that will frequently automatically trigger a loan default if there is an outstanding balance on the loan at that time. 

2. Your Employer Terminates The 401(k) Plan: If your employer decides to terminate their 401(k) plan and you have an outstanding loan balance, the plan sponsor may require you to repay the full amount otherwise the loan will default when your balance is forced out of the plan in conjunction with the plan termination.   There is one IRS relief option in the instance of a plan termination that buys the plan participants more time.   If you rollover your 401(k) balance to an IRA, you have until the due date of your tax return in the year of the rollover to deposit the amount of the outstanding loan to your IRA account. If you do that, it will be considered a rollover, and you will avoid the taxes and penalties of the default but you will need to come up with the cash needed to make the rollover deposit to your IRA.

3. Loan Payments Are Not Started In Error:  If loan payments are not made within the safe harbor time frame set forth by the DOL rules, the loan could default, and the outstanding balance would be subject to taxes and penalties.  A special note to employees on this one, if you take a 401(k) loan, make sure you begin to see deductions in your paycheck for the 401(k) loan payments, and you can see the loan payments being made to your account online.  Every now and then things fall through the cracks, the loan is issued, the loan deductions are never entered into payroll, the employee doesn’t say anything because they enjoy not having the loan payments deducted from their pay, but the employee could be on the hook for the taxes and penalties associated with the loan default if payments are not being applied.  It’s a bad day when an employee finds out they have to pay taxes and penalties on their full outstanding loan balance.

Double Taxation Issue

You will hear 401(k) advisors warn employees about the “double taxation” issue associated with 401(k) loans.  For employees that have pre-tax dollars within their 401(k) plans, when you take a loan, it is not a taxable event, but the 401(k) loan payments are made with AFTER TAX dollars, so as you make those loan payments you are essentially paying taxes on the full amount of the loan over time, then once the money is back in your 401(k) account, it goes back into that pre-tax source, which means when you retire and take distributions, you have to pay tax on that money again.  Thus, the double taxation issue, taxed once when you repay the loan, and then taxed again when you distribute the money in retirement.

This double taxation issue should be a deterrent from taking a 401(k) loan if you have access to cash elsewhere, but if a 401(k) loan is your only access to cash, and the reason for taking the loan is justified financially, it may be worth the double taxation of those 401(k) dollars.   

I’ll illustrate this in an example.  Let’s say you have credit card debt of $15,000 with a 16% interest rate and you are making minimum payments.  That means you are paying the credit card company $2,400 per year in interest and that will probably continue with only minimum payments for a number of years. After 5 or 6 years you may have paid the credit card company $10,000+ in interest on that $15,000 credit card balance.

Instead, you take a 401(k) loan for $15,000, payoff your credit cards, and then pay back the loan over the 5-year period, you will essentially have paid tax on the $15,000 as you make the loan payments back to the plan BUT if you are in a 25% tax bracket, the tax bill will only be $3,755 spread over 5 years versus paying $2,000 - $2,500 in interest to the credit card company EVERY YEAR.   Yes, you are going to pay tax on that $15,000 again when you retire but that was true even if you never took the loan.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Avoid Taking Auto Loans For More Than 5 Years – The Negative Equity Wave

There is a negative equity problem building within the U.S. auto industry.  Negative equity is when you go to trade in your car for a new one but the outstanding balance on your car loan is GREATER than the value of your car.  You have the option to either write a check for the remaining balance on the loan or “roll” the negative equity into your new car loan.  More and more consumers are getting caught in this negative equity trap. Below is a chart of the negative equity trend over the past 10 years.

In 2010, 22% of new car buyers with trade-ins had negative equity when they went to go purchase a new car.  In 2020, that number doubled to 44% (source Edmunds.com).  The dollar amount of the negative equity also grew from an average of $3,746 in 2010 to $5,571 in 2020. 

 Your Car Is A Depreciating Asset

The first factor that is contributing to this trend is the simple fact that a car is a depreciating asset, meaning, it decreases in value over time. Since most people take a loan to buy a car, if the value of your car drops at a faster pace than the loan amount, when you go to trade in your car, you may find out that your car has a trade-in value of $5,000 but you still owe the bank $8,000 for the outstanding balance on your car loan.  In these cases, you either have to come out of pocket for the $3,000 to payoff the car loan or some borrowers can roll the $3,000 into their new car loan which right out of gates put them in the same situation over the life of the next car.

Compare this to a mortgage on a house.  A house, historically, appreciates in value over time, so you are paying down the loan, while at the same time, your house is increasing in value a little each year.  The gap between the value of the asset and what you owe on the loan is called “wealth”.  You are building wealth in that asset over time versus the downward spiral horse race between the value of your car and the amount due on the loan.

How Long Should You Take A Car Loan For?

When I’m consulting with younger professionals, I often advise them to stick to a 5-year car loan and not be tempted into a 6 or 7 year loan.  The longer you stretch out the payments, the more “affordable” your car payment will be, but you also increase the risk of ending up in a negative equity situation when you go to turn in your car for a new one.  In my opinion, one of the greatest contributors to this negative equity issue is the rise in popularity of 6 and 7 year car loan.  Can’t afford the car payment on the car you want over a 5 year loan, no worries, just stretch out the term to 6 or 7 years so you can afford the monthly payment.    

Let’s say the car you want to buy costs $40,000 and the interest rate on the auto loan is 3%.  Here is the monthly loan payment on a 5 year loan versus a 7 year loan:

• 5 Year Loan Monthly Payment:  $718.75

• 7 Year Loan Monthly Payment: $528.53

A good size difference in the payment but what happens if you decide to trade in your car anytime within the next 7 years, it increases your chances of ending up in a negative equity situation when you go to trade in your car.  Also, when comparing the total interest that you would pay on the 5-year loan versus the 7 year loan, the 7 year car loan costs you another $1,271 in interest.

But Cars Last Longer Now……

The primary objection I get to this is “well cars last longer now than they did 10 years ago so it justifies taking out a 6 or 7 year car loan versus the traditional 5 year loan.”  My response?  I agree, cars do last longer than what they used to 10 years ago BUT you are forgetting the following life events which can put you in a negative equity scenario:

1.  Not everyone keeps their car for 7+ years.  It’s not uncommon for car owners to get bored with the car they have and want another one 3 – 5 years later. Within the first 3 years of buying your car that is when you have the greatest negative equity because your car depreciates by a lot within those first few years, and the loan balance does not decrease by a proportionate amount because a larger portion of your payments are going toward interest at the onset of the loan.

2. Something breaks on the car, you are out of the warrantee period, and you worry that new problems are going to continue to surface, so you decide to buy a new car earlier than expected.

3. Change in the size of your family (more kids)

4. You move to a different climate. You need a car for snow or would prefer a convertible for down south

5. You move to a major city and no longer need a car

6. You get in an accident and total your car before the loan is paid off 

The moral of the story is this, it’s difficult to determine what is going to happen next year, let alone what’s going to happen over the next 7 years, the longer the car loan, the greater the risk that a life event will take place that will put you in a negative equity position.

The Negative Equity Snowball

A common solution to the negative equity problem is just to roll the negative equity into your next car loan.  If that negative equity keeps building up car, after car, after car, at some point you hit a wall, and the bank will no longer lend you the amount needed to buy the new car and absorb the negative equity amount within the new car loan. 

Payoff Your Car Loan

Too many people think it’s normal to just always have a car loan, so they dismiss the benefit of taking a 5-year car loan, paying it off in 5 years, and then owning the car for another 2 to 3 years without a car payment, not only did you save a bunch of interest but now you have extra income to pay down debt, increase retirement savings, or build up your savings.    

Short Term Pain for Long Term Gain

Rarely is the best financial decision, the easiest one to make.  Taking a 5-year car loan instead of a 6-year loan will result in a higher monthly car payment which will eat into your take home pay, but you will thank yourself down the road when you go to trade in your current car and you have equity in your current car to use toward the next down payment as opposed to having to deal with headaches that negative equity brings to the table.  

Post COVID Problem

Unfortunately, we could see this problem get worse over the next 7 years due to the rapid rise in the price of automobiles in the U.S. post COVID due to the supply shortages.  When people trade in their cars they are getting a higher value for their trade in which is helping them to avoid a negative equity situation now but they are simultaneously purchasing a new car at an inflated price, which could cause more people to end up in a negative equity event when the price of cars normalizes, the car is worth far less than what they paid for it, and they still have a sizable outstanding loan against the vehicle.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Government Savings Bonds (I Bonds) Are Paying A 9.62% Interest Rate

There are U.S. Government Savings Bonds, called “I Bonds”, that are currently paying a 9.62% interest rate as of August 2022, you can continue to buy the bonds at that interest rate until October 2022, and then the rate resets.  Before you buy these bonds, you should know the 9.62% interest rate is only for the first 6 months that you own the bonds and there are restrictions as to when you can redeem the bonds.  In this article I will cover:

• How do I Bonds works?

• Are they safe investments?

• Purchase limits

• Why does the interest rate vary over the life of the bond?

• How do you purchase an I Bond?

• Redemption restrictions

• Tax considerations

How do I Bonds Work?

I Bonds are issued directly from the U.S. Treasury.  These bonds earn interest that compounds every six months but the interest is not paid to the bondholder until the bond is either redeemed or when the bond matures (30 years from the issue date). 

Variable Interest Rate

Unlike a bank CD that pays the same interest rate until it matures, an I Bond has a variable interest rate the fluctuates every 6 months based on the rate of inflation.  There are two components that make up the I Bond’s interest rate:

1. The Fixed Rate

2. The Inflation Rate

The fixed rate, as the name suggests, stays the same over the life of the bond.  The fixed rate on the I Bonds that are being issued until October 31, 2022 is 0%. 

The inflation rate portion of the bond interest usually varies every 6 months. A new inflation rate is set by the Treasury in May and in November.  The inflation rate is based on the non-seasonally adjusted Consumer Price Index for all Urban Consumers (CPI-U) for all items, excluding food and energy.  You can find the rates that the bonds are currently paying via this link:  I Bond Rates

The total initial interest rate ends up being the Fixed Rate + the Inflation Rate which is currently 9.62%.  But that initial interest rate only lasts for the first 6 months that you own the bond, after the first 6 months, the new inflation rate is used to determine what interest rate your bond will pay for the next 6 months.  Your 6 month cycle is based on when you purchased your bond, here is the chart:

For example, if you purchase an I Bond in September 2022 at a current rate of 9.62%, that bond will accumulate 4.81% in interest over the next 6 months (50% of the annual 9.62% rate) and then on March 1, 2023, you will receive the new rate based on the new inflation rate. Between March 2023 – August 2023, you will receive that new rate, and then it will be recalculated again on September 1, 2023.  This pattern continues until you redeem the bond.

Was The Fixed Rate Ever Higher Than 0%?

Yes, in May 2019, the fixed rate was 0.50% but the last time it was above 1% was November 2007.

Can These Bonds Lose Value?

To keep my compliance department happy, I’m going to quote this directly from the U.S. Treasury Direct website:

“No. The interest rate can’t go below zero and the redemption value of your I bond can’t decline” (Source www.treasurydirect.com)

These bonds are viewed as very safe investments.

Purchase Restrictions $10,000 - $15,000 Per Year

There are purchase restrictions on these bonds but it’s not income based.  They restrict purchases to $10,000 - $15,000 each calendar year PER tax ID.  Why the $10,000 to $15,000 range? Most taxpayers are restricted to purchasing $10,000 per calendar year but if you are due a federal tax refund, they allow you to buy up to an additional $5,000 with your tax refund, so an individual with a large enough federal tax return, could purchase up to $15,000 in a given calendar year. 

If your married, you can purchase $10,000 for your spouse and $10,000 for yourself. 

Self Employed Individuals

If you are self employed and your company has an EIN, your company would be allowed to purchase $10,000 in the EIN number.

Trusts Can Purchase I Bonds

If you have a trust that has an EIN number, your trust may be eligible to purchase $10,000 worth of I Bonds each year.

Gift An I Bond

You can buy a bond in the name and social security number of someone else, this is common when parents purchase a bond for their child, or grandparents for their grandchildren.

$80,000 Worth of I Bonds In A Single Year

Let’s look at an extreme hypothetical example of how someone could make an $80,000 purchase of I Bonds in a single year.  You have a family that is comprised of two parents and three children, one of the parents owns an accounting firm setup as an S-Corp, and the parents each have a trust with a Tax ID. 

• Parent 1:              $10,000

• Parent 2:              $10,000

• Child 1:                 $10,000

• Child 2:                 $10,000

• Child 3:                 $10,000

• S-Corp:                 $10,000

• Parent 1 Trust:  $10,000

• Parent 2 Trust:  $10,000

Total:                     $80,000

The $80,000 is just for one calendar year. If this structure stays the same, they could keep purchasing $80,000 worth of I Bonds each year.  Given what’s happened with the markets this year, investors may welcome a guaranteed 4.61% rate of return over the next 6 months.

Restrictions on Selling Your I Bonds

You are not allowed to sell your I Bond within 12 months of the issue date. If you decide to sell your bond after 1 year but before 5 years, you will lose the last three months of interest earned by the bond. Once you are past the 5-year holding period, there is no interest penalty for selling the bond. 

When Do You Pay Tax On The I Bond Interest?

The interest that you earn on I Bonds is subject to federal income tax but not state or local income tax but you have a choice as to when you want to realize the interest for tax purposes. You can either report the interest each year that is accumulated within the bond or you can wait to realize all of the interest for tax purposes when the bond is redeemed, gifted to another person, or it matures. 

Warning: If you elect to realize the interest each year for tax purposes, you must continue to do so every year after for ALL of your saving bonds, and any I Bonds that you acquire in the future.

How Do You Purchase An I Bond?

I Bonds are issued electronically from the Treasury Direct website. You have to establish an online account and purchase the bonds within your account. Paper bonds are not available unless you are purchasing them with your federal tax refund.  If you are purchasing I bonds with your federal tax refund, you can elect to take either electronic or paper delivery.

I Bond Minimum Purchase Amount

The minimum purchase amount for an electronic I Bond is $25.  Over that threshold, you can purchase any amount you want to the penny. If you wanted to you could purchase an I Bond for $81.53.  If you elect to receive paper bonds from a fed tax refund, those are issued in increments of $50, $100, $200, $500, and $1,000. 

How Do You Redeem Your I Bonds

If you own the bonds electronically, you can redeem them by logging into your online account at Treasury Direct and click the link for “cashing securities” within the Manage Direct menu.

If you own paper bonds, you can ask your local bank if they cash I Bonds.  If they don’t, you will have to mail them to the Treasury Retail Securities Services with FP Form 1522.  The mailing address is listed on the form. You DO NOT need to sign the back of the bonds before mailing them in.

What Are Your Savings Bonds Worth?

If you want to know how much your savings bonds are worth before cashing them in, for electronic bonds you can log into to your online account to see the value.  If you have paper bonds, you can use the Savings Bond Calculator provided by the Treasury.

DISCLOSURE:  This article is for educational purposes only and is not a recommendation to buy I Bonds. Please consult your financial professional for investment advice.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

This Market Rally Could Be A Bear Trap!! Here’s why……

After a really tough first 6 months of the year, the stock market has been in rally mode, rising over 9% within the last 30 days.  It’s left investors anxious to participate in the rally to recapture the losses that were incurred in the first half of the year.  Our guidance to clients, while there are plenty of bobbing heads on TV talking about “buying the dip” and trying to call the “bottom” in the market, this could very well be what we call a “bear trap”.   A bear trap is a short-term rally that baits investors into thinking the market has bottomed only to find out that they fell for the trap, and experience big losses when the market retreats to new lows.

The 4th Bear Trap In 2022

 If the current rally ends up being a bear trap, it would actually be the 4th bear trap so far in 2022.   

The green boxes in the chart show when the rallies occurred and the magnitude.  Notice how the market moved to a new lower level after each rally, this is a common pattern when you are in a prolonged bear market environment.

So how do you know when the bear market is over and the new sustainable bull market rally has begun?  It’s actually pretty simple. Ask yourself, what were the issues that drove the market lower in the first place?  Next question, “Is the economy making MEANINGFUL progress to resolve those issues?” If the answer is yes, you may in fact be at the beginning of the rally off of the bottom; if the answer is no, you should resist the temptation to begin loading up on risk assets.

It's Not A Secret

 It’s not a secret to anyone that inflation is the main issue plaguing not just the U.S. economy but economies around the world.  Everyone is trying to call the “peak” but we did a whole video on why the peak doesn’t matter.

 The market cheered the July inflation report showing that headline year over year inflation dropped from 9.1% in June to 8.5% in July.   While progress is always a good thing, if the inflation rate keeps dropping by only 0.60% per month, we are going to be in a lot of trouble heading into 2023.  Why? As long as the inflation rate (the amount prices are going up) is higher than the wage growth rate (how much more people are making), it will continue to eat away at consumer spending which is the bedrock of the U.S. economy.  As of July, wages are growing at only 6.2% year over year.  That’s still a big gap until we get to that safety zone.

Understand The Math Behind The CPI Data

While it’s great that the CPI (Consumer Price Index) is dropping, the main CPI number that hits the headlines is the year-over-year change, comparing where prices were 12 months ago to the prices on those same goods today. Let me explain why that is an issue as we look at the CPI data going forward.   If I told you I will sell you my coffee mug today for $100, you would say “No way, that’s too expensive.”  But a year from now I try and sell you that same coffee mug for $102 and I tell you that the cost of this mug has only risen by 2% over the past year, does that make you more likely to buy it?  No, it doesn’t because the price was already too high to begin with.

In August 2021, inflation was already heating up.  The CPI headline number for August 2021 was 5.4%, already running above the Fed’s comfort level of 3%.  Similar to the example I just gave you above with the coffee mug, if the price of everything was ALREADY at elevated levels a year ago, and it went up another 8.5% on top of that elevated level, why is the market celebrating?

Probability of A 2023 Recession

Even though no single source of data is an accurate predicator as to whether or not we will end up in a recession in 2023, the chart that I am about to show you is being weighted heavily in the investment decisions that we are making for our clients.

Historically an “inverted” yield curve has been a fairly accurate predicator of a coming recession.  Without going into all of the details of what causes a yield curve inversion, in its simplest form, it’s the bond market basically telling the stock market that a recession could be on the horizon.  The chart below shows all of the yield curve inversions going back to 1970.  The red arrows are where the inversion happened and the gray shaded areas are where recession occurred.

Look at where we are right now on the far right-hand side of the chart. There is no question that the yield curve is currently inverted and not just by a little bit.  There are two main takeaways from this chart, first, there has been a yield curve inversion prior to every recession going back to 1970, an accurate data point.  Second, there is typically a 6 – 18 month delay between the time the yield curve inverts and when the recession actually begins.

Playing The Gap

I want to build off of that last point about the yield curve.  Investors will sometimes ask, “if there is historically a 6 – 18 month delay between the inversion and the recession, why would you not take advantage of the market rally and then go to cash before the recession hits?”  My answer, if someone could accurately do that on a consistent basis, I would be out of a job, because they would manage all of the money in the world. 

Recession Lessons

I have been in the investment industry since 2002.  I experienced the end of the tech bubble bust, the Great Recession of 2008/2009, Eurozone Crisis, and 2020 COVID recession. I have learned a number of valuable lessons with regard to managing money prior to and during those recessions that I’m going to share with you now:

1.  It’s very very difficult to time the market.  By the time most investors realize we are on the verge of a recession, the market losses have already piled up.

2. Something typically breaks during the recession that no one expects.  For example, in the 2008 Housing Crisis, on the surface it was just an issue with inflated housing prices, but it manifested into a leverage issue that almost took down our entire financial system.   The questions becomes if we end up in a recession in 2023, will something break that is not on the surface?

3. Do not underestimate the power of monetary and fiscal policy.

The Power of Monetary & Fiscal Policy

I want to spend some time elaborating on that third lesson.  The Fed is in control of monetary policy which allows them to use interest rates and bond activity to either speed up or slow down the growth rate of the economy.   The Fed’s primary tool is the Fed Funds Rate, when they want to stimulate the economy, they lower rates, and when they want to slow the economy down (like they are now), they raise rates.   

Fiscal policy uses tax policy to either stimulate or slow down the economy.  Similar to what happened during COVID, the government authorized stimulus payments, enhanced tax credits, and created new programs like the PPP to help the economy begin growing again.  

Many investors severely underestimate the power of monetary and fiscal stimulus. COVID was a perfect example.  The whole world economy came to a standstill for the first time in history, but the Fed stepped in, lowered rates to zero, injected liquidity into the system via bond purchases, and Congress injected close to $7 Trillion dollars in the U.S. economy via all of the stimulus policies.  Even though the stock market dropped by 34% within two months at the onset of the COVID crisis in 2020, the S&P 500 ended up posting a return of 16% in 2020. 

Now those same powerful forces that allowed the market to rally against unsurmountable odds are now working against the economy.  The Fed is raising rates and decreasing liquidity assistance.  Since the Fed has control over short term interest rates but not long-term rates, that is what causes the yield curve inversion.  Every time the Fed hikes interest rates, it takes time for the impact of those rate hikes to make their way through the economy. Some economists estimate that the delay between the rate hike and the full impact on the economy is 6 – 12 months.

The Fed Is Raising More Aggressively

The Fed right now is not just raising interest rates but raising them at a pace and magnitude that is greater than anything we have seen since the 1970’s.  A chart below shows historical data of the Fed Fund Rate going back to 2000. 

Look at 2004 and 2016, it looks like a staircase. Historically the Fed has raised rates in small steps of 0.25% - 0.50%. This gives the economy the time that it needs to digest the rate hikes.  If you look at where we are now in 2022, the line shoots up like a rocket because they have been raising rates in 0.75% increments and another hike of 0.50% - 0.75% is expected at the next Fed meeting in September.  When the Fed hikes rates bigger and faster than it ever has in recent history, it increases the chances that something could “break” unexpectedly 6 to 12 months from now.  

Don’t Fight The Fed

You will frequently hear the phrase “Don’t Fight The Fed”.   When you look back at history, when the Fed is lowering interest rates in an effort to jump start the economy, it usually works.  Conversely, when the Fed is raising rates to slow down the economy to fight inflation, it usually works but it’s a double edged sword.  While they may successfully slow down inflation, to do so, they have to slow down the economy, which is traditionally not great news for the stock market.

I have to credit Rob Mangold in our office with this next data point that was eye opening to me, when you look back in history, the Fed has NEVER been able to reduce the inflation rate by more than 2% without causing a recession.  Reminder, the inflation rate is at 8.5% right now and they are trying to get the year over year inflation rate back down to the 2% - 3% range.  That’s a reduction of a lot more than 2%.

Stimulus Packages Don’t Work

In the 1970’s, when we had hyperinflation, the government made the error of issuing stimulus payments and subsidies to taxpayers to help them pay the higher prices.  They discovered very quickly that it was a grave mistake. If there is inflation and the people have more money to spend, it allows them to keep paying those higher prices which creates MORE inflation. That is why in the late 70’s and early 80’s, interest rates rose well above 10%, and it was a horrible decade for the stock market.

In the U.S. we have become accustomed to recessions that are painful but short.  The COVID Recession and 2008/2009 Housing Crisis were both painful but short because the government stepped in, lowered interest rates, printed a bunch of money, and got the economy growing again. However, when inflation is the root cause of our pain, unless the government repeats their mistakes from the 1970’s, there is very little the government can do to help until the economy has contracted by enough to curb inflation. 

Is This The Anomaly?

Investors have to be very careful over the next 12 months.  If by some chance, the economy is able to escape a recession in 2023, based on the historical data, that would be an “anomaly” as opposed to the rule.   Over my 20 year career in the industry, I have heard the phrase “well this time it’s different because of X, Y, and Z” but I have found that it rarely is.  Invest wisely.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Medicare Is Projected To Be Insolvent In 2028

The trustees of the Medicare program just released their 2022 annual report and it came with some really bad news.  The Medicare Part A Hospital Insurance (HI) Trust is expected to be insolvent in 2028 which currently provides health benefits to over 63 million Americans.  The U.S. has been kicking the can down the road for the past 40 years and we have finally run out of road. In this article I will be covering:

• What benefits Medicare Part A provides that are at risk

• The difference between the Medicare HI Trust & Medicare SMI Trust

• If Medicare does become insolvent in 2028, what happens?

• Changes that Congress could make to prevent insolvency

• Actions that retirees can take to manage the risk of a Medicare insolvency

Medicare HI Trust vs. Medicare SMI Trust  

The Medicare program provides health insurance benefits to U.S. citizens once they have reached age 65, or if they become disabled.  Medicare is made up of a few parts: Part A, Part B, Part C, and Part D. 

Part A covers services such as hospitalization, hospice care, skilled nursing facilities, and some home health service.  Medicare is made up of two trusts, the Hospital Insurance (HI) Trust and the Supplemental Medical Insurance (SMI) Trust.   The HI Trust supports the Medicare Part A benefits and that is the trust that is in jeopardy of becoming insolvent in 2028.   This trust is funded primarily through the 2.9% payroll tax that is split between employees and employers.

Medicare Part B, C, and D cover the following:

Part B:  Physician visits, outpatient services, and preventative services

Part C:  Medicare Advantage Programs

Part D:  Prescription drug coverage

Part B and Part D are funded through a combination of general tax revenues and premiums paid by U.S. citizens that are deducted from their social security benefits.  Most of the funding though comes from the tax revenue portion, in 2021, about 73% of Part B and 74% of Part D were funded through income taxes (CNBC).   Even though they are supported by the SMI Trust, it would be very difficult for these sections of Medicare to go insolvent because they can always raise the premiums charged to retirees, which they did in 2022 by 14%, or increase taxes.

Part C is Medicare Advantage plans which are partially supported by both the HI and SMI Trust, and depending on the plan selected, premiums from the policyholder.

What Happens If Medicare Part A Becomes Insolvent in 2028?

The trustees of the Medicare trusts issue a report every year providing the public the funding status of the HI and SMI trusts.  Based on the 2022 report, if no changes are made, there would not be enough money in the HI trust that supports all of the Part A health benefits to U.S. citizen.  The system does not completely implode but there would only be enough money in the trust to pay about 90% of the promised benefits starting in 2029. 

This mean that Medicare would not have the funds needed to fully pay hospitals and skilled nursing facilities for the services covered by Medicare.  It could force these hospital and healthcare providers to accept a lower reimbursement from the service provider or it could delay when the reimbursement payments are received.  In response, hospitals may have to cut cost, layoff workers, stop providing certain services, and certain practices may choose not to accept patients with Medicare coverage, limiting access to certain doctors. 

Possible Solutions To Avoid Medicare Insolvency

The natural question is: If this is expected to happen in 2028, shouldn’t they make changes now to prevent the insolvency from taking place 6 years from now?”  The definitely should but Medicare is a political football. When you have a government program that is at risk of going insolvent, there are really only three solutions:

1. Raise taxes

2. Cut Benefits

3. Restructure the Medicare Program

As a politician, whatever weapon you choose to combat the issue, you are going to tick off a large portion of the voting population which is why there probably have been no changes even though the warning bells has been ringing for years.  The reality is that the longer they wait to implement changes, the larger, and more painful those changes need to be.

Some relatively small changes could go a long way if they act now.  It’s estimated that if Congress raises the payroll tax that funds the HI Trust from 2.9% to 3.6% that would bump out the insolvency date of the HI Trust by about 75 years.  If you go to the spending side, it’s estimated that if Part A were to cut its annual expenses by about 15% per year starting in 2022, it would have a similar positive impact (Source: Senate RPC). 

Another possible fix, they could restructure the Medicare system, and move some of the Part A services to Part B.   But this is not a great solution because even though it helps the Part A Trust insolvency issue, it pushes more of the cost to Part B which is funded be general tax revenues and premiums charged to retirees. 

A third solution, Medicare could more aggressively negotiate the reimbursement rates paid to healthcare providers but that would of course have the adverse effect of putting revenue pressure on the hospitals and potentially jeopardize the quality of care provided.

The fourth, and in my opinion, the most likely outcome, no changes will be made between now and 2028, we will be on the doorstep of insolvency, and then Congress will pass legislation for an emergency bailout out package for the Medicare Part A HI Trust.  This may buy them more time but it doesn’t solve the problem, and it will add a sizable amount to debt to the U.S. deficit.  

What Should Retirees Do To Prepare For This?

Even though the government may try to issue more debt to bailout the Medicare Part A trust, as a retiree, you have to ask yourself the question, what if by the time we reach 2028, the U.S. can’t finance the amount a debt needed to stave off the insolvency?  The Medicare Part A HI Trust is not the only government program facing insolvency over the next 15 years. One of the PBGC trusts that provides pension payments to workers that were once covered by a bankrupt pension plan is expected to be insolvent within the next 10 years.  Social Security is expected to be insolvent in 2035 (2022 Trustees Report). 

The solution may be to build a large expense cushion within your annual retirement budget so if the cost for your healthcare increases substantially in future years, you will already have a plan to handle those large expenses. This may mean paying down debt, not taking on new debt, cutting back on expenses, taking on some part-time income to build a large nest egg, or some combination of these planning strategies.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Social Security Income Penalties Are Refunded To You When You Reach Fully Retirement Age

If you decide to turn on your Social Security payments before your full retirement age, the IRS has something called the Social Security Earnings Test where they assess a penalty if you make over a specified amount during that tax year.  For 2022, that amount is $19,560 and the penalty is $1 for every $2 you earn over that threshold, but not many taxpayers realize that Social Security actually refunds you the penalty amounts once you reach full retirement age.  In this article, I will walk you through:

•  Social Security Full Retirement Age Based on Date of Birth

• Social Security Earnings Test

• How they assess the Social Security earnings penalty

• How does Social Security refund you the penalties paid when you reach full retirement age

• Other social security filing considerations

Social Security Full Retirement Age

As I mentioned in the intro, if you turn on Social Security PRIOR to your Full Retirement Age (“FRA”) and you continue to work, you are subject to the SS earnings test and possible penalties.  Your SS full retirement age varies based on your date of birth:

The final column in the chart above shows the permanent reduction in your social security benefit if you turn on your SS benefit at age 62.  If you plan to turn on your social security prior to your full retirement age and you plan to continue to work, you have to be careful with this decision.  Not only are you permanently reducing your SS benefit, but you are also subject to the Social Security earnings test.

Once you reach Full Retirement Age, the SS earnings test goes away, you can make as much money as you want, and social security does not assess a penalty.

Social Security Earnings Test

Here’s how the social security earnings test works. If you turn on your SS benefit prior to full retirement age and you make more than $19,560 in 2022, SS will assess a penalty of $1 for every $2 you earn over that limit (50% penalty).  The IRS increases the income threshold a little each year.  Let’s look at the example below:

•  You are age 63

• Your monthly social security benefit is $1,000 ($12,000 annually)

• You made $23,560 in earned income in 2022

In the example above, you earned $4,000 in income above the limit ($23,560 - $19,560 = $4,000).    Social Security will assess a penalty of $2,000 ($4,000 x 50%). 

How Do You Pay The Social Security Earned Income Penalty?

Let’s keep building on the previous example, you failed the earnings test, and you owe the $2,000 penalty, how do you pay it?  The good news is you don’t have to write a check for it, instead social security will withhold your social security payments the following year until you have satisfied the penalty.  In the example above, your monthly SS benefit was $1,000 and you had a $2,000 penalty. Social security will withhold two of your monthly SS payments the following year and then your monthly social security payment will resume as normal.    

The math for this example came out easy, 2 months exactly, but what if your monthly benefit is $1,000 and the penalty is $2,400, which would be 2.4 months of benefit payments.  Social security rounds UP all fractional months, so they would withhold 3 full months of your social security payments even though that means they are withholding $3,000 to pay back a $2,400 penalty. The additional $600 that they withheld will be refunded back to you when they process the refund of the earned income penalty at your full retirement age.

Social Security Does Refund You The Penalties At Full Retirement Age

If social security withheld some of your monthly payments due to a failed earnings test prior to reaching your FRA, the good news is, once you reach full retirement age, social security refunds those penalties back to you.  Unfortunately, they do not just send you a check for the dollar amount of all of those missed payments, instead, upon reaching full retirement age, they recalculate you monthly social security payment taking into account those missed payments. 

The easiest why to explain the refund calculation is via an example:

• Your SS full retirement age is 67

• You turned on your SS payment at age 62

• Your monthly SS benefit payments are $2,000

• Every year you made $8,000 over the SS earnings test limit

• This resulted in a $4,000 earned income penalty each year

• SS withheld 2 months of your benefit payments each year to assess the penalty

• 2 months x 5 years of SS payments = 10 months of missed payments  

Between age 62 and reaching age 67 social security withheld a total of 10 months of your social security payments.  Upon reaching FRA 67, instead of continuing your monthly benefit at $2,000, they credit you back those 10 months of payments, by recalculating your social security benefit assuming you originally turned on your SS benefit at age 62 & 10 months instead of age 62 & 0 months.  This reduces the amount of the permanent penalty that you incurred for turning on your social security benefit prior to full retirement age, and you will receive a slightly higher social security benefit for the rest of your life to repay you for those earned income penalties that were assessed prior to full retirement age. It may take you a number of years to recoup those penalty payments but how long you live will ultimately determine whether this refund calculation benefits you or the social security system.

Other Considerations Before Turning on Your SS Benefit Early

After reading this article, it may seem like a no-brainer to turn on your SS benefit early, if you earn to much in a given year, and get assess a penalty, so what, you just get the money back later, but it’s important to understand that there are other factors that you need to take into consideration before turning on your social security benefits early which include:

• The impact on the survivor benefits for your spouse

• The breakeven age of turning on the benefits early versus waiting

• How social security benefits are taxed

• Taking advantage of the automatic increase in the amount of the benefit each year

• The 50% spousal benefit

• Your life expectancy

Here is our article on Social Security Filing Strategies covering these other considerations.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Removing Excess Contributions From A Roth IRA

You discovered that you contributed too much to your Roth IRA, now it’s time to fix it. This most commonly happens when individuals make more than they expected which causes them to phaseout of their ability to make a contribution to their Roth IRA for a particular tax year. In 2022, the phase out ranges for Roth IRA contributions are:

• Single Filer: $129,000 - $144,000

• Married Filing Joint:  $204,000 - $214,000

The good news is there are a few options available to you to fix the problem but it’s important to act quickly because as time passes, certain options for removing those excess IRA contributions will be eliminated.

You Discover The Error Before You File Your Taxes

If you discover the contribution error prior to filing your tax return, the most common fix is to withdraw the excess contribution amount plus EARNINGS by your tax filing deadline, April 18th.   Custodians typically have a special form for removing excess contributions from your Roth IRA that you will need to complete.

If you withdraw the excess contribution before the tax deadline, you will avoid having to pay the IRS 6% excise penalty on the contribution, but you will still have to pay income tax on the earnings generated by the excess contribution.  In addition, if you are under the age of 59½, you will also have to pay the 10% early withdrawal penalty on just the earnings portion of the excess contribution.

Example, you contribute $6,000 to your Roth IRA in September 2022 but you find out in March 2023 that your income level only allows you to make a $2,000 contribution to your Roth IRA for 2022 so you have a $4,000 excess contribution.  You will have to withdraw not just the $4,000 but also the earnings produced by the $4,000 while it was in the account, for purposes of this example let’s assume that’s $400.   The $4,000 is returned to you tax and penalty free but when the $400 in earnings is distributed from the account, you will have to pay tax on the earnings, and if under age 59½, a 10% withdrawal penalty on the $400.  

October 15th Deadline

If you have already filed your taxes and you discover that you have an excess contribution to a Roth IRA, but it’s still before October 15th, you can avoid having to pay the 6% penalty by filing an amended tax return.  You still have pay taxes and possibly the 10% early withdrawal penalty on the earnings but you avoid the 6% penalty on the excess contribution amount.   This is only available until October 15th following the tax year that the excess contribution was made.

You Discover The Mistake After The October 15th Extension Deadline

If you already filed your taxes and you did not file an amended tax return by October 15th, the IRS 6% excess contribution penalty applies.   If you contributed $6,000 to Roth IRA but your income precluded you from contributing anything to a Roth IRA in that tax year, it would result in a $360 (6%) penalty.  But it’s important to understand that this is not a one-time 6% penalty but rather a 6% PER YEAR penalty on the excess amount UNTIL the excess amount is withdrawn from the Roth IRA.  If you discovered that 5 years ago you made a $5,000 excess contribution to your Roth IRA but you never removed the excess contributions, it would result in a $1,500 penalty.  

6% x 5 Years = 30% Total Penalty x $5,000 Excess Contribution = $1,500 IRS Penalty

A 6% Penalty But No Earnings Refund

Here’s a little known fact about the IRS excess contribution rules, if you are subject to the 6% penalty because you did not withdraw the excess contributions out of your Roth IRA prior to the tax deadline, when you go to remove the excess contribution, you are no longer required to remove the earnings generated by the excess contribution. 

Reminder: If you remove the excess contribution prior to the initial tax deadline, you AVOID the 6% penalty on the excess contribution amount but you have to pay taxes and possibly the 10% early withdrawal penalty on just the earnings portion of the excess contribution. 

If you remove the excess contribution AFTER the tax deadline, you do not have to pay taxes or penalties on the EARNINGS portion because you are not required to distribute the earnings, but you pay a flat 6% penalty per year based on the actual excess contribution amount.

Example:  You contributed $6,000 to your Roth IRA in 2022, your income ended up being too high to allow any Roth IRA contributions in 2022, you discover this error in November 2023.  You will have to withdraw the $6,000 excess contribution, pay the 6% penalty of $360, but you do not have to distribute any of the earnings associated with the excess contribution.

Why does it work this way?  This is only a guess but since most taxpayers probably try to remove the excess contributions as soon as possible, maybe the 6% IRS penalty represents an assumed wipeout of a modest rate of return generated by those excess contributions while they were in the IRA.

Advanced Tax Strategy

There is an advanced tax strategy that involves evaluating the difference between the flat 6% penalty on the excess contribution amount and paying tax and possibly the 10% penalty on the earnings. Before I explain the strategy, I strongly advise that you consult with your tax advisor before executing this strategy.

I’ll show you how this works in an example.  You make a $6,000 contribution to your Roth IRA in 2022 but then find out in March 2023 that based on your income, you are not allowed to make a Roth contribution for 2022.  Your Roth IRA experienced a 50% investment return between the time you made the $6,000 contribution and now. You are 35 years old. So now you have a choice:

Option A: Prior to your 2022 tax filing, withdraw the $6,000 tax and penalty free, and also withdraw the $3,000 in earnings which will be subject to ordinary income tax and a 10% penalty. Assuming you are in a 32% Fed bracket, 6% State Bracket, that would cost you 48% in taxes and penalties on the $3,000 in earnings.

Total Taxes and Penalties = $1,440

Option B: Waiting until November 2023, pull out the $6,000 excess contribution, and pay the 6% penalty, but you get to leave the $3,000 in earnings in your Roth IRA.  $6,000 x 6% = $360

Total Taxes and Penalties = $360

PLUS you have an additional $3,000 that gets to stay in your Roth IRA, compound returns, and then be withdrawn tax and penalty free after age 59½. 

FINANCIAL NERD NOTE:  If the only balance in your Roth IRA is from earnings that originated from excess contributions, it’s does not start the 5-year holding period required to receive the Roth IRA earnings tax free after age 59½ because they are considered ineligible contributions retained within the Roth IRA. 

Losses Within The Roth IRA

Since I’m writing this in July 2022 and most of the equity indexes are down year-to-date, I’ll explain how losses within a Roth IRA impact the excess contribution calculation.  If your Roth IRA has lost value between the time you made the excess contribution and the withdrawal date, it does reduce the amount that you have to withdraw from the IRA.  If your excess contribution amount is $3,000 but the Roth IRA dropped 20% in value, you would only have to withdraw $2,400 from the Roth IRA to satisfy the removal of the excess contributions.  If withdrawn prior to your tax filing deadline, no taxes or penalties would be due because there were no earnings.

Other Options Besides Cash Withdrawals

Up until now we have just talked about withdrawing the excess contribution from your IRA by taking the cash back but there are a few other options that are available to satisfy the excess contribution rules. 

The first is “recharacterizing” your excess Roth contribution as a traditional IRA contribution. If your income allows, you may be able to transfer the excess Roth contribution amount and earnings from your Roth IRA to your Traditional IRA but this must be done in the same tax year to avoid the 6% penalty.

Second option, if you are eligible to make a Roth IRA contribution the following year, the excess contribution can be used to offset the Roth contribution amount for the following tax year. Example, if you had an excess Roth IRA contribution of $1,000 in 2022 and your income will allow you to make a $6,000 Roth IRA contribution in 2023, you can reduce the Roth contribution limit by $1,000 in 2023, leave the excess in the account, and just deposit the remaining $5,000.  You would still have to pay the 6% penalty on the $1,000 because you never withdrew it from the Roth IRA but it’s $60 penalty versus having to take the time to go through the excess withdrawal process.   

Which Contributions Get Pulled Out First

It’s not uncommon for investors to make monthly contributions to their Roth IRA accounts but when it comes to an excess contribution scenario, you don’t get to choose which contributions are entered into the earning calculation.   The IRS follows the LIFO (last-in-first-out) method for determining which contributions should be removed to satisfy the excess refund.  

You Have Multiple IRA’s

If you have multiple Roth IRA’s and there is an excess contribution, you have to remove the excess contribution from the same Roth IRA that the contribution was made to, you can’t take it from a different Roth IRA to satisfy the removal of the excess.  

If you have both a Traditional IRA and a Roth IRA and you exceed the aggregate contribution limit for the year, by default, the IRS assumes the excess contribution was made to the Roth IRA, so you have to begin taking corrective withdrawals from your Roth IRA first.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

How Much Should You Have In An Emergency Fund?

Establishing an emergency fund is an important step in achieving financial stability and growth. Not only does it help protect you when big expenses arise or when a spouse loses a job but it also helps keep your other financial goals on track. When we educate clients on emergency funds, the follow questions typically arise:   

• How much should you have in an emergency fund?

• Does the amount vary if you are retired versus still working?

• Should your emergency fund be held in a savings account or invested?

• When is your emergency fund too large?

• How do you coordinate this with your other financial goals?

Emergency Fund Amount

In general, your emergency fund should typically be 4 to 6 months of your total monthly expenses.  To calculate this, you will have to complete a monthly budget listing all of your expenses.  Here is a link to an excel spreadsheet that we provide to our clients to assist them with this budgeting exercise: GFG Expense Planner. 

Big unforeseen expenses come in all shapes and sizes but frequently include:

• You or your spouse lose a job

• Medical expenses

• Unexpected tax bill

• Household expenses (storm, flooding, roof, furnace, fire)

• Major car expenses

• Increase in childcare expenses

• Family member has an emergency and needs financial support

Without a cash reserve, surprise financial events like these can set you back a year, 5 years, 10 years, or worse, force you into bankruptcy, require you to move, or to sell your house.   Having the discipline to establish an emergency fund will help to insulate you and your family from these unfortunate events.

Cash Is King

We usually advise clients to keep their emergency fund in a savings account that is liquid and readily available.  That will usually prompt the question: “But my savings account is earning minimal interest, isn’t it a waste to have that much sitting in cash earning nothing?”   The purpose of the emergency fund it to be able write a check on the spot in the event of a financial emergency.  If your emergency fund is invested in the stock market and the stock market drops by 20%, it may be an inopportune time to liquidate that investment, or your emergency fund amount may no longer be the adequate amount.

Even though that cash is just sitting in your savings account earning little to no interest, it prevents you from having to go into debt, take a 401(k) loan, or liquidate investments at an inopportune time to meet the unforeseen expense.

Cash Reserve When You Retire

I will receive the question from retirees: “Should your cash reserve be larger once you are retired because you are no longer receiving a paycheck?”  In general, my answer is “no”, as long as you have your 4 months of living expenses in cash, that should be sufficient.  I will explain why in the next section.

Your Cash Reserve Is Too Large

There is such a thing as having too much cash.  Cash can provide financial security but beyond that, holding cash does not provide a lot of financial benefits.  If 4 months of your living expenses is $20,000 and you are holding $100,000 in cash in your savings account, whether you are retired or not, that additional $80,000 in cash over and above your emergency fund amount could probably be working harder for you doing something else.  There is a long list of options, but it could include:

•  Paying down debt (including the mortgage)

• Making contributions to retirement accounts to lower your income tax liability

• Roth conversions

• College savings accounts for your kids or grandchildren\

• Gifting strategies

• Investing the money in an effort to hedge inflation and receive a higher long-term return

Emergency Fund & Other Financial Goals

It’s not uncommon for individuals and families to find it difficult to accumulate 4 months worth of savings when they have so many other bills.  If you are living paycheck to paycheck right now and you have debt such as credit cards or student loans, you may first have to focus on a plan for paying down your debt to increase the amount of extra money you have left over to begin working toward your emergency fund goal. If you find yourself in this situation, a great book to read is “The Total Money Makeover” by Dave Ramsey.

The probability of achieving your various financial goals in life increases dramatically once you have an emergency fund in place.  If you plan to retire at a certain age, pay for your children to go college, be mortgage and debt free, purchase a second house, whatever the goal may be, large unexpected expenses can either derail those financial goals completely, or set you back years from achieving them.

Remember, life is full of surprises and usually those surprises end up costing you money. Having that emergency fund in place allows you to handle those surprise expenses without causing stress or jeopardizing your financial future.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.