Better Think Twice
by Robert Powell
Monday, July 7, 2008
provided by MarketWatch.com


Don't make these critical mistakes with your nest egg, even if times are tough

Recession or not, these are fast becoming hard times, and hard times can lead to bad decisions.

Recently, the Financial Industry Regulatory Authority warned investors to think twice before taking steps that might compromise their nest eggs, such as taking out a reverse mortgage, getting a 401(k) debit card, or cashing in life insurance policies to weather tough financial times.

"Each of these should be considered strategies of last resort," Mary Schapiro, chief executive of the Financial Industry Regulatory Authority said last week in a speech.

"They may raise cash quickly, but each also carries long-term consequences that can undermine financial security in retirement and pose the potential for losing a significant, and sometimes irreplaceable, asset," Schapiro said. FINRA is a nongovernmental organization that oversees U.S. security firms.

According to FINRA, Americans are faced with the perfect financial storm. Rising costs of fuel and food, declines and volatility in the housing and financial markets, and an ever-tightening credit crunch have gathered to form a storm that could lead some Americans to make poor financial decisions. "But tough financial times don't necessarily justify resorting to risky ways to make ends meet," Schapiro said.

Investors could be risking their most valuable assets when they use reverse mortgages, life settlements and 401(k) debit cards to tap much-needed cash.

Retirement Accounts

Don't cut back on or stop contributing your 401(k) and, even more importantly, don't cash in all or part of your 401(k). To be sure, plan providers do allow hardship withdrawals in certain situations -- if you face eviction from or foreclosure on your primary residence, for instance, or some other financial calamity. But if you are under age 59-1/2 and there is no hardship, you'll have to pay ordinary income tax on the withdrawal plus a 10% penalty tax. What's more, many employers will withhold 20% of the amount being withdrawn, so it's possible that a $20,000 withdrawal works out to less than $14,000 when all is said and done.

FINRA also warns that such withdrawals come with another cost - opportunity cost. If you're 40 years old with $40,000 in your 401(k) and it's growing at 6% percent year, excluding additional contributions that money would be worth $107,710 in 17 years. But if that same person withdraws $20,000, that remaining $20,000 would be worth just $53,855 in 17 years. In other words, a withdrawal of $20,000 now costs about $54,000 in future growth.

Worse yet, FINRA warns, creditors have access to any money taken out of a 401(k), be it a loan or hardship withdrawal, in ways they wouldn't if you left the money in a retirement account. Under the Bankruptcy Abuse Protection and Consumer Protection Act of 2005, creditors cannot touch your 401(k) balance or similar retirement savings account -- even if, as a last resort, you file for bankruptcy protection, FINRA said. Of note, balances in IRAs (Roth and traditional) are protected up to a limit of $1 million from creditors.

There are other benefits to maintaining contributions to your 401(k). Contributions reduce taxable income and lower your tax bill. Plus, 401(k) contributions often come with free money: Employers typically match a percentage of your contribution.

That said, if you really need the money from your 401(k), FINRA suggests taking out a loan rather than a withdrawal. You might be able to borrow money at a lower interest rate than a bank would offer. Plus, you won't have to pay taxes on the loan as you would with a withdrawal. Also, if your employer offers one, avoid using a 401(k) debit card, FINRA said.

Life Settlements

Don't cash in your life insurance policy using something called a life settlement, FINRA warns. With a life settlement, a third party will buy your life insurance policy from you, typically for more than the cash value but less than the death benefit. According to FINRA, life settlements can be a valuable source of liquidity if you would otherwise surrender your life insurance policy or allow it to lapse, or if your life insurance needs have changed. But life settlements are not for everyone, FINRA said.

For instance, life settlements can have high transaction costs and unintended consequences. You might be unable to buy a new insurance policy, plus you could lose state or federal benefits, such as Medicaid. Also, you will have to pay taxes on the life settlement.

If you really need the money from your life insurance and you still need the coverage, FINRA suggests you borrow against your policy, or check whether you are eligible for accelerated death benefits. If you have a long-term, catastrophic, or terminal illness you might be able get a reduced benefit prior to dying.

Reverse Mortgages

If you are over age 62 and have equity in your house, a reverse mortgage might sound intriguing. With a reverse mortgage, you get to convert the equity in your house to cash, plus you get to age in place, in your home. What's more, you don't have to make any interest or principal payments during the life of the loan.

But as with all things that sound too good to be true, especially something that sounds too good to be true for what could be your single largest asset and a future source of retirement income, there's a catch with reverse mortgages. For one thing, the loan costs can be steep. Also, interest is added to the principal, making reverse mortgages "rising debt" loans.

"The bottom line is that reverse mortgages are an expensive option that may prematurely deplete your home equity," FINRA said. "A reverse mortgage is a very serious decision."

Consider, for instance, some of the disadvantages FINRA outlined:

● The income or lump sum you receive could impact you or your spouse's eligibility for various state and federal benefits, including Medicaid.

● Depending on the laws of your state, a reverse mortgage may not enjoy the same home-equity protection that would otherwise apply against creditors, or if you have a health emergency and your spouse must liquidate assets to pay for nursing home care.

● A reverse mortgage is not the right choice if you want to leave your house to your heirs.

A reverse mortgage may be right for you. But you need to evaluate a number of factors, including your health, your spouse's health, other sources of income, the reason you're tapping your home equity, when to do it, and how wisely you use your loan proceeds - before deciding whether a reverse mortgage is right or not.

What are some alternatives to a reverse mortgage? According to FINRA, you could sell your house and then downsize or rent, or take out a home equity loan, or get help from your children or local government assistance program. Any of those tactics could unlock the equity in your home without the cost of a reverse mortgage.

See the FINRA statement for more information.

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