There are many opportunities for leveraging the power of a 401(k) plan. Financial advisors discussed some of the smartest ways and dumbest things they have seen with CNBC.com.
Smartest
● Paying off a credit card. Helen M. Ngo, certified financial planner and principal of Capital Benchmark Partners, recalled a client who took a loan from her 401(k) to pay back her credit card balance. "The interest rate on the credit card was two times greater than the interest rate on the 401(k)," she said. "She saved a significant amount in interest by doing this.
"The one catch that I tell clients is that when you take a loan from your 401(k), you cannot miss a payment," Ngo added. "If you do, the [Internal Revenue Service] will count the entire loan amount as a distribution that year and you will be taxed on it."
● Funding a retraining sabbatical. Michael Haubrich, CFP and president of the Financial Service Group, cited a middle-aged client who borrowed from her 401(k) plan to pursue a different career path that required retraining. He mapped out a two-year plan with her that included working with a career coach, taking assessments, developing new skills and actively networking. She has started her career search, confident of her success.
"We planned on her withdrawing only the amount that used up the 15 percent federal income tax bracket so adding the 10 percent early withdrawal penalty did not exceed 25 percent effective tax rate," Haubrich said.
● Converting to a Roth. "We had a client with a significant loss from a business who was able to do an in-plan Roth conversion of their 401(k)," said Marianela Collado, CPA and CFP with Tobias Financial Advisors. The business owner converted the full balance of his 401(k) to a Roth account and, while this would normally be a taxable event, the taxes were offset by the business loss. Now his Roth account will continue to grow and provide future distributions tax-free.
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The power of compounding. "When [my client] first came in to meet with me three years ago, he told me that he had been a forklift operator for Budweiser for the last 35 years," said Trent D. Porter, CPA and CFP with Priority Financial Partners. "I jumped to conclusions until he showed me his 401(k) statement, with just over $2 million in a target retirement date fund.
"Shocked, I asked what his secret was and he said he had been religiously putting away 15 percent of his paychecks since the day he started," Porter added. "It was a powerful lesson in not making assumptions, as well as the power of compound interest."