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The 401(k) follies: The right and wrong way to save

  • Paying off credit card debt is always a good idea.
  • Understand the power of compounding, even with the smallest of contributions.
  • Oddball investments such as alpacas and luxury cars are a big no-no.

There are many opportunities for leveraging the power of a 401(k) plan. Financial advisors discussed with CNBC.com some of the smartest ways and dumbest things they have seen.

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."

Financial advisors have seen clients make very smart, and pretty dumb, 401(k) plan decisions.
FatCamera | Getty Images
Financial advisors have seen clients make very smart, and pretty dumb, 401(k) plan decisions.

● Funding a retraining sabbatical. Michael Haubrich, CFP and president of the Financial Service Group, cited a middle-age 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 the 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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Using 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."

Dumbest

● Investing in alpacas. On the subject of not making judgments, Frank Armstrong III, CFP and president and founder of Investor Solutions, described an airline pilot client who withdrew all his individual retirement account rollover to purchase an alpaca farm. The fleece-producing animals — similar to llamas — promptly died, and he went bankrupt.

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"The story sounds funny on the surface but was actually tragic," he said. "The events leading up to the demise of Eastern Airlines [in 1991] cut short many pilot careers. In desperation, some of them rolled the dice looking for giant returns because they had insufficient capital to sustain them during their forced early retirement and severely limited job prospects," Armstrong added.

● Buying a luxury car. "I had a client recently who took a loan from his 401(k) to fund the purchase of a luxury car," said Vid Ponnapalli, CFP and founder of Unique Financial Advisors. "Six months into the loan, he moved to a new job. The loan is still outstanding, and he was given 60 days to pay the balance."

The client did not have the money to pay it back, said Ponnapalli, and consequently the outstanding balance on the loan was considered an early distribution from his 401(k) and he was forced to pay taxes and penalties on the withdrawal.

"Some people are highly concerned and wonder, 'Can the business take my money if it gets in trouble?' We have to explain to them that the employer has no access to their accounts." -Kevin J. Meehan, regional president of the Wealth Enhancement Group

● Fearing employer access. A lot of employees don't invest in 401(k) plans, because they don't have a trusted relationship with their employers, said Kevin J. Meehan, CFP and regional president of the Wealth Enhancement Group. "Some people are highly concerned and wonder, 'Can the business take my money if it gets in trouble?' or 'Is my employer making money with my investments?'" he said. "We have to explain to them that the employer has no access to their accounts."

● Drowning in consumer debt. Sometimes it actually doesn't make sense to contribute to a 401(k). Shawn Tydlaska, CFP and founder and CEO of Ballast Point Financial Planning, had a client contributing to her 401(k) while she had a personal line of credit with a 96 percent interest rate. "She was saving in her 401(k), but she was not making payments toward her consumer debt," he said. "She said she felt helpless."

What was she thinking? "She heard the message 'Pay yourself first,'" he said. "People simply don't know the possibilities regarding their financial options."

— By Deborah Nason, special to CNBC.com

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