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December Newsletter

December Newsletter

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Published by Janet Barr

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Published by: Janet Barr on Dec 10, 2012
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Collaborative FinancialSolutions, LLC
CA Insurance License #0B33145Janet Barr, MS, ChFC, CLULPL Registered Principal206 E. Victoria StSanta Barbara, CA 93101805-965-0101
December 2012
The Economics of Borrowing from Your401(k)How to Give Wisely and WellLife Insurance Tax Traps for the UnwaryShould I be worried about recentmunicipal bankruptcies?
The Economics of Borrowing from Your 401(k)
See disclaimer on final page
From the Desk of Janet L. Barr,ChFC, CLU
When times are tough, that pool of dollarssitting in your 401(k) plan account may start tolook attractive. But before you decide to take aplan loan, be sure you understand the financialimpact. It's not as simple as you think.
The basics of borrowing
A 401(k) plan will usually let youborrow as much as 50% of yourvested account balance, up to$50,000. (Plans aren't required tolet you borrow, and may imposevarious restrictions, so check withyour plan administrator.) You paythe loan back, with interest, fromyour paycheck. Most plan loans carry afavorable interest rate, usually prime plus oneor two percentage points. Generally, you haveup to five years to repay your loan, longer if youuse the loan to purchase your principalresidence. Many plans let you apply for a loanonline, making the process quick and easy.
You pay the interest to yourself, but…
When you make payments of principal andinterest on the loan, the plan generally depositsthose payments back into your individual planaccount (in accordance with your latestinvestment direction). This means that you'renot only receiving back your loan principal, butyou're also paying the loan interest to yourselfinstead of to a financial institution. However, thebenefits of paying interest to yourself aresomewhat illusory. Here's why.To pay interest on a plan loan, you first need toearn money and pay income tax on thoseearnings. With what's left over after taxes, youpay the interest on your loan. That interest istreated as taxable earnings in your 401(k) planaccount. When you later withdraw those dollarsfrom the plan (at retirement, for example),they're taxed again because plan distributionsare treated as taxable income. In effect, you'repaying income tax twice on the funds you useto pay interest on the loan. (If you're borrowingfrom a Roth 401(k) account, the interest won'tbe taxed when paid out if your distribution is"qualified"--i.e., it's been at least 5 years sinceyou made your first Roth contribution to theplan, and you're 59½ or disabled.)
...consider the opportunity cost
When you take a loan from your 401(k) plan,the funds you borrow are removed from yourplan account until you repay the loan. Whileremoved from your account, the funds aren'tcontinuing to grow tax deferred within the plan.So the economics of a plan loan depend in parton how much those borrowed funds would haveearned if they were still inside the plan,compared to the amount of interest you'repaying yourself. This is known as theopportunity cost of a plan loan, because byborrowing you may miss out on the opportunityfor additional tax-deferred investment earnings.
Other factors
There are other factors to think about beforeborrowing from your 401(k) plan. If you take aloan, will you be able to afford to pay it backand continue to contribute to the plan at thesame time? If not, borrowing may be a very badidea in the long run, especially if you'll wind uplosing your employer's matching contribution.Also, if you leave your job, most plans providethat your loan becomes immediately payable. Ifyou don't have the funds to pay it off, theoutstanding balance will be taxed as if youreceived a distribution from the plan, and ifyou're not yet 55 years old, a 10% earlypayment penalty may also apply to the taxableportion of that "deemed distribution."Still, plan loans may make sense in certaincases (for example, to pay off high-interestcredit card debt or to purchase a home). Butmake sure you compare the cost of borrowingfrom your plan with other financing options,including loans from banks, credit unions,friends, and family. To do an adequatecomparison, you should consider:Interest rates applicable to each alternativeWhether the interest will be tax deductible (forexample, interest paid on home equity loansis usually deductible, but interest on planloans usually isn't)The amount of investment earnings you maymiss out on by removing funds from your401(k) plan
Page 1 of 4
How to Give Wisely and Well
Giving to charity has never been easier. Youcan donate the old-fashioned way--by mail--butyou can also donate online, by text, or throughsocial networking sites. According to theNational Center for Charitable Statistics, over1.4 million nonprofit organizations areregistered with the IRS. With so many charitiesto choose from, it's more important than ever toensure that your donation is well spent. Hereare some tips that can help you become both agenerous and wise donor.
Choose your charities
Choosing worthy organizations that support thecauses you care about can be tricky, but itdoesn't have to be time-consuming. There areseveral well-known organizations that rate andreview charities, and provide useful tips andinformation that can help you make wisechoices when giving to charity (see sidebar). Toget you started, here are some questions toask:
How will your gift be used? 
It should be easyto get information about the charity's mission,accomplishments, financial status, and futuregrowth by contacting the charity by phone orviewing online information.
How much does the charity spend on administrative costs? 
Charities withhigher-than-average administrative costs maybe spending less on programs and servicesthan they should, or may even be in seriousfinancial trouble. Some charities who usefor-profit telemarketers get very little of themoney they raise, so ask how much of yourdonation the charity will receive.
Is the charity legitimate? 
Ask for identificationwhen approached by a solicitor, and nevergive out your Social Security number, creditcard number, bank account number, accountpassword, or personal information over thephone or in response to an e-mail you didn'tinitiate. There's no rush--take time to checkout the charity before you donate.
How much can you afford to give? 
Stick toyour giving goals, and learn to say no.Legitimate fundraisers will not try to make youfeel guilty, and will be happy to send youinformation that can help you make aninformed decision rather than pressure you togive now.
Harness the power of matching gifts
Many employers offer matching gift programsthat will match charitable gifts made by theiremployees. You'll need to meet certainguidelines--for example, your employer mayonly match your gift up to a certain dollarlimit--and the charity may need to provideinformation. Check with your employer's humanresources department or the charity to find outhow you can maximize your donations througha matching gift program.
Put your gifts on autopilot
If you're looking for an easy way to donateregularly to a favorite charity, look into settingup automatic donations from a financialaccount. When donors contribute automatically,the charity benefits by potentially loweringfundraising costs and by establishing afoundation of regular donors. And you'll benefittoo, because spreading out your donationsthroughout the year may enable you to givemore, and will simplify your record keeping.
Look for new ways to give
Although cash donations are always welcome,charities also encourage other types of gifts.For example, if you meet certain requirements,you may be able to give stock, direct gifts fromyour IRA or other retirement account, realestate, or personal property (but check withyour financial professional to assess potentialincome and estate tax consequences based onyour individual circumstances). You can alsovolunteer your time, using your talents toimprove the lives of others in your community.And taking a "volunteer vacation" can be a funway to involve your family and meet otherpeople across the country or world who shareyour enthusiasm for a particular cause.
Use planned giving to leave a legacy
You can leave an enduring gift through yourestate. For example, you might leave a willbequest, give life insurance, or use a charitablegift annuity, charitable remainder annuity trust,or charitable unitrust that may help you giveaway the asset now, while retaining a lifetimeinterest--check with your financial or taxprofessional regarding any potential estate ortax benefits or consequences.
Keep good records
If you itemize when you file your taxes, you candeduct donations you've made to a tax-qualifiedcharity, but you may need documentation. Keepcopies of cancelled checks, bank statements,credit card statements, or receipts from thecharity showing the charity's name and the dateand amount of the contribution. For donationsor contributions of $250 or more, you'll need amore detailed written acknowledgment from thecharity. For more information and a list ofrequirements, see IRS Publication 526,Charitable Contributions.
These are a few of the organizations and agencies that publish reports and charity ratings, and/or give useful tips and information to consumers on choosing a charity and giving wisely: Better Business Bureau's BBB Wise Giving Alliance,www.bbb.org Charity Navigator,www.charitynavigator.org CharityWatch,www.charitywatch.org Federal Trade Commission,www.ftc.gov 
Page 2 of 4, see disclaimer on final page
Life Insurance Tax Traps for the Unwary
Life insurance has been recognized as a usefulway to provide for your heirs and loved oneswhen you die. Lawmakers have longrecognized the social significance of lifeinsurance as a source of funds for widowedspouses and children, and have offered liberaltax benefits as an incentive to those who puttheir hard-earned dollars into life insurancepolicies. However, there are a number ofsituations that can easily lead to unintendedand adverse tax consequences. Here are someof the life insurance tax traps you may want toavoid.
Policy loans
One area fraught with unintended taxramifications involves life insurance policyloans. A number of different scenarios involvingpolicy loans can result in unplanned taxes, butone of the most common situations arises whena policy is surrendered (cancelled) or lapseswith an outstanding policy loan.Generally, if a policy is surrendered or lapseswhile a loan is still outstanding, the loanbalance becomes taxable to the policyowner asordinary income to the extent the cash valueexceeds the owner's basis (net premiums paidless any tax-free distributions received) in thepolicy--it's as if cash from the policy isdistributed to pay off the loan.
You own a life insurance policy into which you paid premiums of $100,000 (your basis); the policy cash value is $200,000; and there is an outstanding policy loan of $150,000.You surrender the policy for $50,000 cash (the difference between your cash value and loan balance). However, much to your surprise,you'll have to include $100,000 as ordinary income for the tax year in which you surrender the policy ($150,000 loan balance+$50,000 cash - $100,000 premiums).
Modified endowment contract (MEC)
Since 1988, if the total premiums paid duringthe first seven years of the policy exceed amaximum amount based on the death benefit,then the policy becomes a MEC. The tax-freetreatment of the death benefit and thetax-deferred cash accumulation are generallythe same for MEC and non-MEC life insurance,although the tax consequences for pre-deathwithdrawals are different.For non-MEC policies, partial and fullsurrenders are taxed on a first-in, first-outbasis, meaning cash value withdrawals areconsidered first coming from your investment inthe policy (i.e., your premiums) then from anygain in the cash value (i.e., interest/earnings).Generally, policy loans from non-MECs are notsubject to income tax.But any withdrawals (including loans and partialor full surrenders) taken from the cash value ofa MEC are treated as coming from earningsfirst and are taxed as ordinary income to theextent the policy's cash value exceeds yourbasis. In addition, if the policyowner is underage 59½, a 10% tax penalty may be assessedon the amount withdrawn from a MEC that'sincludible as income unless an exceptionapplies.
You purchased a cash value life insurance policy with a single premium of $100,000, making the policy a MEC. The policy cash value has grown to $150,000. If you take out a loan of $75,000 against the cash value,you will have to include $50,000 of the loan amount as ordinary income ($50,000 of the total amount borrowed represents gain in the policy).
Estate planning
Generally, the life insurance death benefit isincludible in the estate of the policyowner andmay be subject to federal and/or state estatetax. Often, attempts to remove the policy fromthe owner's estate create problems. A quicksolution has the owner transferring ownershipof the policy to another person or an irrevocablelife insurance trust (ILIT), in an attempt toremove the policy from the estate. However, ifan insured owns a policy on his or her own lifeand gives the policy to another person, trust, orentity and then dies within three years of thetransfer, the death benefit will be included in theestate of the insured/transferor, subject topossible estate tax.Issues may arise when the policyowner,insured, and beneficiary are three differentparties. If the insured is the first to die, thepolicy proceeds are considered a gift from theowner to the beneficiary, subject to potential gifttax. Generally, the owner and insured shouldbe the same, or the owner and beneficiaryshould be the same party.Unintended ownership issues may result if theinsurance policyowner and insured are differentparties, and the owner is the first to die. If thepolicy owner did not name a successor owner,then the policy will be subject to probate,including possible creditors' claims andunnecessary costs. To avoid this scenario, theowner should name a successor owner.
If you take a loan against your cash value, the death benefit available to your survivors will be reduced by the amount of the loan. In addition, policy loans may reduce available cash value and can cause your policy to lapse. Finally, you could face tax consequences if you surrender the policy with an outstanding loan against it.
Page 3 of 4, see disclaimer on final page

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