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Posts Tagged ‘401K’

What to do with your Cash Balance Account

March 6th, 2010 No comments

Do you have a Cash Balance Account (CBA)? A CBA is an account hybrid between a pension and a tax deferred savings account. Most employers today do not offer traditional pensions anymore they offer some version of a tax deferred contribution account (401K, SEP IRA, Roth 401K, and others).

About 10 years ago, I left an employer who previously had offered both a traditional pension as well as a 401K account. The creation of the CBA enabled the employer to hand off the pension obligation to me.

There are some upsides and downside to this kind of arrangement depending on your point of view.

  • First, it moves the management of the pension risk from the employer to the employee (not unlike a 401K).
  • The CBA severs the pension obligation from the balance sheet of the employer. So, the pension is not tied to the future success of the employer the way many traditional pensions are because it is funded independently in a separate account.
  • The CBA offers the opportunity for the employee to roll the money over to an IRA providing additional investing opportunities.
  • The CBA provides more transparency about pension value and the investment rate of return.

If you have one of these accounts these are some of your options.

Do Nothing

The CBA can be left in the original account that was setup with the employer. Over the past 10 years this has been a good strategy for me because it has earned a fixed positive return that has performed better than other retirement accounts I have. Even when retirement starts the money can still stay there and I can start to draw a pension from it without moving it.

Roll Over to an IRA

Because the CBA has a cash value, it can be rolled over to an IRA, either one you already have or in a new account. Whenever you roll over an account be cautious about how this is done. What you want to do is have the administrator cut the check to the new IRA and not to you. This will prevent the rollover from being viewed as an early distribution from the IRS. (If this does happen, it can be fixed, but it is an unnecessary hassle).

Roll Over to a 401(k)

It may be possible to roll the money over to an existing account (401(k), SEP IRA, etc.) that you have with your employer. Check with your account administrator as to whether or not they will accept the rollover. In general this option may not offer the range of investment opportunities that a roll over to an IRA would.

Draw from the CSA

If you decide to retire early, or even if you don’t, you can start drawing a pension at anytime (it does still keep the benefits of a pension account) . There is an advantage here over an IRA, which are not by default setup to draw a pension (particularly for early retirement). You can do the same thing in an IRA but you need to file paperwork to do this – I will cover this option in a future article.

The downside to this option is that you need to keep the money in the CSA, which will typically offer a lower return on investment than other options you would have in an IRA (stocks, bonds).

Managing 401K Expenses

February 28th, 2010 No comments

In the news today is a proposal by the Labor Department requiring employers to increase disclosure of 401K investment fees. After reading this article, I decided to take a closer look at my own 401K plans, all three of them.

You might ask why I even have (3) plans, and have not yet rolled them over to an IRA. All of them offer two key investments that I require: an S&P500 index fund, and a short term money market fund, or equivalent. These two investments offer a low cost method to split your investments between cash and stocks. At some point these accounts will be moved to an IRA.

First, a word about finding the “cash” investment option in your 401K: be careful not to select a bond fund. Bond funds do not necessarily keep your principal safe, and in fact most bond funds are very much like stock funds in that they can lose and gain value separate from the income that they provide. Find the investment in your plan that indicates in its prospectus something like “invests in stable value contracts”.  Most of these investments also contain the words “stable value” in their name. If not, it may be named something like “money market fund”.

Since I invest in only two vehicles at this time which are presumed to be low cost, I thought that I did not need to consider fees. But as I discovered upon further investigation, there is some room to improve my returns by managing costs a little more. All funds are required to provide a prospectus that gives you detailed information about the fund, including fees. If you cannot find this information on your 401K providers site, contact them to get copies of these documents. First, here is what I found out about the fees for each of my 401K plans:

 Plan A, Expense Rate

    S&P500 Index Fund:   0.15%

    Stable Value Fund:   0.12% 

 Plan B, Expense Rate

    S&P500 Index Fund:   0.24%

    Stable Value Fund:   0.80% 

 Plan C, Expense Rate

    S&P500 Index Fund:   0.27%

    Stable Value Fund:   0.25%

In order to understand your fees completely, find out who manages your funds. If your 401K is a cafeteria style plan (funds from different providers managed by another provider), you may find that there can be two sets of fees. The S&P500 index fund in Plan C is setup that way, and as I discovered only by contacting the 401K manager, there is an extra 2 basis point charge on top of the 0.25% expenses that came along with the fund.

So far so good. All of my current investments charge annual expenses of less than 1%. Not all funds that charge more than 1% fees should be avoided, but investigate them ahead of time before buying them. Don’t unknowingly pay high investment fees particularly since lower cost options are usually available.

 The fund that stands out is the Stable Value fund in Plan B. Given that the expected investment return is about 4-5%/year for typical stable value funds, an expense rate of %0.80 is a real drag. I made the following change: moved all the money out of that fund into the S&P500 Fund in Plan B. An equivalent amount was then moved from the Stable Value Fund into the S&P500 fund in Plan A. This change kept my overall ratio of cash/stock the same, but lowered my costs by more than 1/2% for the portion that is invested in “cash”.

Finding the Cash in your 401K

February 3rd, 2010 No comments

If you have investments in a regular taxable brokerage account, it’s easy to find your cash. When you fund your account, the cash is deposited in some form of cash investment such as a money market fund. In your 401K account, where is the cash?

It’s not where you may think it is and it usually has a different name.

Look at your 401K, the investment choices usually fall into the following categories:

  • Stock Investments: Large Cap, Mid Cap, Small Cap, International
  • Bond Investments: High Yield, Bond, Stable Value
  • Mixed Investments: Blend, Equity Income
  • Lifestyle Investments: Target Date funds.

Here’s the Cash

There will likely be different names depending on your 401K account brokerage company. But, the ‘cash’ investment will be named with some variation of ‘Stable Value’ or ‘Money Market Fund’. The term ‘Stable Value’ means that the investment tries to keep its par value (never lose principal).  If you are unsure if your investment is  stable value, check the prospectus and look for this wording.

The Stable Value investment is similar to money market funds that you would find at your bank or in your taxable investment account.

Where the Cash Isn’t

In one of my 401K accounts, the stable value fund is lumped in with other ‘Bond Investments’. Don’t make the mistake of putting your money in a bond fund thinking that it’s cash. It isn’t. Bond funds are not created to maintain par value, they can lose principal.

Bond funds are more like stock investments, you should treat them the same way. Bond funds trade bonds. It is possible to make and lose money trading bonds, just like with stocks. 

Move Into Cash

Now that you know where the cash is, move some money over there, either with an exchange or perhaps in your allocation of new money. It’s a good idea to have some cash in your portfolio to take advantage of market downturns. 


Categories: Investing Tags: ,

Get Tax Deferral Without an IRA

February 13th, 2009 No comments

Is it possible to earn passive income today and defer the taxes on the income for years? Yes, read on to find out.

You may be thinking that I am referring to tax free municipal bonds, but these investments don’t give you tax deferral they eliminate taxes. 

There is a class of investments called Master Limited Partnerships (MLP) that are partnerships that trade like stocks. When you buy into these investments you are not a stock holder but a unit holder, a partner. This distinction comes with addition issues that you should know about before you buy.  Don’t worry too much, for most people these investments won’t be more trouble than regular stocks if you follow some guidelines. 

First, Investment Quality

By design in law, MLPs are limited to specific businesses, including primarily energy extraction, storage and transportation (there are a few financial companies such as REITs and investment manager companies that also have this structure). These investments are not well known due to a lack of Wall Street interest and low institutional ownership.

Even without the special advantages that they offer due to their structure, high quality partnerships offer stable and predictable returns, while also offering growth potential in earnings and distributions. This article on SeekingAlpha talks more about MLPs and how they earn their income.

Structure Advantages

Under a normal corporate structure, the company pays corporate taxes (up to 35%) on its earnings. Then, if dividends are distributed to shareholders, they are responsible for paying taxes at a lower rate (up to 15%).   Even though the shareholder gets a break on the dividend tax the income is still taxed twice.

Under the MLP structure, the company does not pay corporate taxes, the taxes are the responsibility of the unit holder when distributions are made. So, the double taxation problem is eliminated. Also, most of the income distributed (perhaps 80% or more) is considered a return of capital (ROC). The tax on the ROC is deferred until you sell the units. For a more detailed explanation and example, read the following Investopedia article.

By owning these investments, you can earn 8-10% per year (or more) in stable income and defer the income tax on 80% or more of the income.

Some Guidelines

  • The primary reason why these investments are complicated to handle at tax time is that you need to keep track of all the money you get in income over the years and account for it when you sell the security. 
  • MLPs may distribute some cash that is considered ‘unrelated’ to its primary tax exempt status. If you own an MLP in a tax deferred account (IRA), there may be tax due on this unrelated income (UBTI) in the same year. Solution: Don’t own an MLP in your IRA. Even if you do, most likely tax wouldn’t be due unless you have a very large position.
  • As the Investopedia article talks about, the income tax on ROC can be due before you sell if the money you get in distributions exceeds the cost of the unit. If hold these units long enough you will earn more in distributions than you paid.

More Information