Suppose you believe that the market is going to go down, what would you do? The normal answer is sell what you have and get out. However, what if you have nothing to sell? Until a couple of years ago, the answer would have been “Stay on the sidelines” for simple investors. The sophisticated investors always had plenty of avenues - shorting the stock, buying puts, selling naked calls, etc.

However, the gap was narrowed with the arrival of Inverse ETFs that allow even novice investors to short the market in a less risky way (you cannot lose more than what you put in the ETF, while in shorts your loss is theoretically unlimited and this can be psychologically unsettling for some). However, the power and pitfalls of these instruments are poorly understood by many, particularly by the long term investors. The power is obvious - you can go 1/X or 2/X of the market pretty easily, leaving all the pesky details of achieving them to the ETF managers. Here are the pitfalls.

1. Inverse and Leveraged ETFs lose money over the long term

Here is the chart from Yahoo Finance of DUG (Double inverse of petroleum companies) and DIG (Goes 2X in the direction of petroleum companies). Basically they are the yin and yang of Oil industry. Regardless of what happens in the market surely one of them must win, right? But, look deeply at the cart - both of these funds lost 45% in the last 20 months.

So, even if you had predicted the correct direction, you would have lost half your money in just 1.5 years.

2. Inverse ETFs can track the underlying for only one time period

Mathematically, leveraged and inverse ETFs can track their underlying index exactly for one time period only. If they track their index accurately for hourly, then it can’t track for daily, weekly, monthly and so on. This is due to the way compounding works. Let us say your underlying went 1% down everyday for 1 month. The underlying will go down 26% [(1-0.01)^30], while your inverse would have gone up 35% [(1+0.01)^30]. Most inverse funds plan to track daily, so for other time periods you will see an error.

3. Tracking error increases with time

Here is the comparison chart between XLF (Financial Sector Index) and its double Inverse SKF. SKF is supposed to go 2X in the opposite direction of XLF, and though it was good in maintaining the direction, it was not very good in exact tracking. XLF fell 62% in the period from February 2007, while SKF has gone up only 90%, instead of 124% as would have been expected.

4. Degenerative decay and relationship to volatility

Leveraged ETFs’ efficiency goes down with volatility. The problem is even more so with inverse ETFs. Let us say the Dow went from 10K to 8K and back to 10K. An inverse ETF tracking accurately will go up from 100 to 120 (20% gain to equal 20% loss in Dow) and then from 120 to 90 (25% loss because Dow gained 25%). So, from period t1 to t2, the Dow stayed the same, while its inverse ETF fell by 10% from 100 to 90. Repeat the same process x number of times, and you will find the inverse ETFs totally wiped out of the value, while underlying has not moved much. If the Dow goes up to 10000 from 9900 and back to 10000, the inverse would be reasonably accurate. However, we are at a historically high volatility - the highest in the last 20 years. Here is the movement of volatility Index [VIX] over the last 18 years.

5. Constant Leverage Trap

Constant Leverage Trap is a well know problem in financial modeling and affects the performance of inverse ETFs. Here is a simple scenario explained by Tyates in a financial forum:

Proshares has $1m of investor money and borrows $1m of additional money to invest $2m in the S&P 500 index. After six months, the index appreciates 10%, and then the fund has $2.2m in assets and $1.2m of equity. (Let’s ignore interest on debt for now).

The problem is that the fund now has a lower debt to equity ratio than advertised. It is supposed to be a 2x fund, but now only has $1m of debt paired with its $1.2m of equity, making it a 1.67x fund. In order to get back to its target leverage it has to borrow $200,000 and invest in the index. Now the fund has $2.4m in assets and $1.2m in debt. Six more months go by, and the index falls 10%. The fund now has $2.16m in assets and $1.2m in debt, leaving the investors with $960k in equity. This 4% loss surprises investors who thought that the index was down 1% for the year (+10% and -10% = -1%).

But what happens next is even worse. Because the leverage ratio is out of balance again - total assets are 2.25x the equity, not 2x - the fund has to sell its shares in order to reduce its leverage back down to 2x. It sells $240k worth of shares, and applies all of this cash to reducing the debt to $960k. The fund is now smaller than when it started. Yes, you read that correctly, to maintain constant leverage, this index fund is constantly buying and selling, incurring short-term gains, and doing the worst possible market timing - buying more on margin when prices are high and selling when they’re lower.

6. Regulatory Actions:

When the SEC comes up with a short ban as it did in September, it can substantially screw up the market. For a couple of weeks SKF was affected due to its inability to find appropriate counterparties for its trade. Typically, governments tend to go more after bears than bulls in a mistaken fear that bears are causing the problems instead of being the messenger of problem information. Thus regulatory actions can be more unfavorable to bearish strategies than bullish strategies.

http://biz.yahoo.com/ms/080919/253823.html

7. Counterparty risk

Inverse ETFs achieve their strategies through swaps and futures contracts with various counterparties. There are troubles when the counterparties don’t honor their contract.  When these parties fail, then the ETF could lose money.

Here is some good information on this, written by Paul Amery.

8. Other factors to consider

Can you stomach the volatility? Double Inverse and Leverage ETFs tend to move enormously by definition, particularly in troubled times like these - you could see your portfolio going up or down 50 or 75% - even if it too heavily weighted in such ETFs. Will you have trouble sleeping well in such roller coaster activity? If so, you should not play.
High Management Expense - given that these ETFs are not plain vanilla - buy a bunch of stock types, management expenses of maintaining leverage is pretty high. Sometimes the expense ratios can be up to 5X more than popular index ETFs.
Summary:

Inverse and leveraged ETFs are great tools that democratized bear strategies. However it should not be used for anything other than short term trading purposes. And when you use it, understand its risks and don’t be surprised when you find the results are not as promised.

Deposits at FDIC-insured institutions are now insured up to at least $250,000 per depositor through December 31, 2013. On January 1, 2014, the standard insurance amount will return to $100,000 per depositor for all account categories except for IRAs and other certain retirement accounts which will remain at $250,000 per depositor. (This supersedes the October 3, 2008 changes.)

May 20, 2009

WASHINGTON — U.S. lawmakers will scrutinize the Pension Benefit Guaranty Corp.’s ability to continue paying monthly annuities to retirees amid news that the agency’s deficit has tripled to roughly $33.5 billion in the last six months.

The financial update comes at the request of Congress as lawmakers plan to discuss PBGC’s solvency and concern of mismanagement at a Wednesday afternoon hearing held by the Senate Special Committee on Aging.

The $33.5 billion shortfall, up from $11 billion shortfall reported at the close of fiscal year 2008, is a record high for the agency and comes on the backdrop of controversy surrounding former PBGC director Charles Millard, who may have crossed the line with communication he had with potential investment partners.

According to testimony submitted to the committee, PBGC’s Acting Director Vincent Snowbarger attributed the lose to additional pension plans terminations, investment losses, administrative fees and a decrease in the agency’s interest factor — which is a method PBGC uses to value liabilities.

“Economic turmoil poses issues we have never before confronted and that do not lead to easy solutions,” Snowbarger said in written testimony. Snowbarger is expected to reassure committee members that despite the inflating deficit, “PBGC has sufficient funds to meet its benefit obligations for many years’ because the monthly annuity payments are not lump sums.

Still, the agency makes more than $350 million in annuity payments monthly to workers or retirees who are eligible.

The agency receives its funding primarily from insurance premiums that companies pay and from returns on its investment portfolio, which has been scrutinized as well.

The agency’s investment portfolio, as of April 30, had 30% allocation for equities, 68% bonds and less than 2% with alternative investments, such as private equity and real estate. All of PBGC’s alternative investments have been inherited from failed pension plans.

Snowbarger is scheduled to testify alongside PBGC’s inspector general, a representative from the Government Accountability Office, and possibly Millard, the former PBGC head.

The committee hearing will address to some extent Millard’s improper contact with financial firms and the structure of PBGC’s board of directors, which hasn’t met in roughly 15 months, according to written testimony submitted by GAO Associate Director Barbara Bovbjerg.

Apprehension about PBGC’s operational structure and which industries and sectors agency officials believe could pose great fiscal risk are among the other topics expected to be discussed at the hearing.

The agency is closely monitoring financially distressed businesses related to automotive, retail, financial services and health-care industries. Of particular concern is the automotive industry; PBGC estimates that pension underfunding in the entire auto sector is $77 billion, of which $42 billion would be guaranteed.

By Darrell A. Hughes
Of DOW JONES NEWSWIRES

NEW YORK — The option of a lump sum on retirement is likely to disappear for a lot more workers this fall.

Lump sums used to be a fairly common option for workers enrolled in pension plans. It is becoming more rare, however, as dramatic declines in stock values have sent pension assets plunging just as they have to meet more stringent funding requirements. (Pensions themselves, of course, are being offered to fewer workers.)

Some employees may slip through before Oct. 1, the deadline for businesses to update the funding status of their pensions. More companies are expected to be underfunded when the 2009 numbers are run.

The 100 largest pension plans ended 2008 with $217 billion in liabilities, compared to an $86 billion surplus at the end of 2007. The funding status dropped from about 106% at the end of 2007 to less than 80% at the end of 2008.

The Pension Protection Act begins to restrict lump sum payouts when a plan is less than 80% funded, says Judith F. Mazo, senior vice president, director of research at the Segal Co., a consulting firm. At that point, workers can only receive half of the amount in a lump sum and other half as an annuity. Plans that are less than 60% funded are forced to freeze and provide only an annuity.

The limits are designed to prevent participants from draining badly needed cash from the plans. They also give employers an incentive to keep funding at appropriate levels.

But as the markets have plummeted, credit has tightened, making it difficult for companies to add cash to underfunded plans.

While the majority of workers typically choose a lump sum rather than an annuity if the plan offers a choice, Rebecca Davis, staff attorney at the Pension Rights Center, says people need to carefully consider their choice. No one should make any decision before finding out exactly how much the lump sum would be, the center says.

Some people think they can manage the money better on their own, but as last year’s market losses illustrate, there’s no guarantee. A lump sum may be a lot of money, but a big advantage of an annuity is that it’s guaranteed for life, she says.

One disadvantage to an annuity is that many are not adjusted to reflect increases in the cost of living.

It also might be worth taking the lump sum if the Pension Benefit Guaranty Corp. (PBGC) has to take over the plan. About 84% of participants get their full benefits even if the PBGC steps in, but the limit is currently $54,000 a year.

By Jilian Mincer
A DOW JONES NEWSWIRES COLUMN

NEW YORK — Now is a good time to give stock to family members who can hold onto the gift until the shares are worth more. A parent or grandparent can give away more for less.

Federal gift and income taxes should get serious thought, though, before choosing which shares to give or how to give them. Taxes may make it smarter to sell a stock and give the cash instead, or to set up a trust to hold the shares.

It is especially important now, when many stocks have lost value, to weigh the tax consequences of giving.

Many people who make gifts ignore taxes until they sit down with an accountant at the end of the year, says Stefan F. Tucker, a partner in the Washington, D.C., office at Venable LLP. Instead, clients should “think about taxes early and often.”

The key is to analyze the interplay between gift, estate and income taxes, according to Tucker.

Federal gift tax rules currently let an individual give an unlimited number of gifts up to $13,000 ($26,000 for couples) per recipient, free of gift tax.

Separate from the $13,000 gifts, each person can give away up to $1 million free of gift tax during a lifetime. This may be a good time to use up some of that lifetime exemption, according to estate planners.

When is it smarter to sell shares and give the cash instead? Often, it’s when the stock has lost value since the owner bought it. The idea is for the donor to take a tax loss rather than passing shares to someone who can’t use it at all.

When shares are sold at a loss, the tax cost is the lower of the donor’s tax cost or the value at the time of the gift. So, if shares cost $100,000 but are worth $50,000 at the time of the gift and are later sold by the recipient for $50,000, no loss can be taken.

The donor can benefit by taking the loss. Here’s an example provided by Tucker: A man gives $50,000 from the sale of stock that he bought at $100,000 to his daughter and takes a capital loss of $50,000; the loss yields a federal income tax savings of $7,500 (15% — the current top capital gains rate — times $50,000) when used to offset a capital gain.

This leaves $7,500 in the man’s pocket after he gives away the $50,000. If the man and his daughter decide the sold stock is a good long-term investment, they can buy more. The amount of the gift over $13,000 would go against the man’s $1 million lifetime exemption.

Understanding how cost basis works is important in figuring out the tax aspects of a gift of stock.

The person who gets a gift of stock gets the donor’s cost basis in the shares. (The exception is when the gift is big enough to generate gift tax; then, a portion of the gift tax is factored into the new cost basis.)

The donor also passes his or her holding period for the shares along. So, if he or she held it for 36 months, the recipient is also considered to have held it that long.

The idea of gifting while stocks are priced cheaply is generally for the recipient to hold the stock and get the gains. Current low capital gains tax rates can benefit a family member who ends up selling a gift soon, however.

Rande Spiegelman, vice president of financial planning at the Schwab Center for Financial Research notes that a person who sells a gift of stock soon after receiving it could end up paying tax at a much lower rate (as low as 0%, depending on the bracket) than the donor would owe.

Many wealthy people set up special trusts to reduce the tax hit on gifts. A common vehicle for this is the grantor trust for income tax purposes.

The donor gives stock to the trust, and pays all the income tax on income it generates. This way, the property given to the trust isn’t diminished by taxes paid when the stock is sold.

A parent who just wants to make a $13,000 gift to a child would probably not bother with the trust for a single gift of that size, says Dan Schrauth, a wealth adviser in the San Francisco office at J.P. Morgan Private Bank.

However, setting up a trust isn’t particularly complicated or expensive, so it can pay to have one to receive gifts of stock over the years, says Schrauth.

By Arden Dale
A DOW JONES NEWSWIRES COLUMN

NEW YORK — Spooked by shrunken savings, even some wealthy retirees are going back to work. One way to boost income further over the long term: Reset the clock on Social Security benefits.

Retirees who collect Social Security can start over — provided they pay back all benefits received so far. Individuals can start collecting Social Security at age 62, but they earn an extra 7% to 8% for each year they defer until age 70.

“By pushing back the start date, retirees can collect a higher benefit for the remainder of their lives,” says Chuck Roberson, a certified financial planner at Modera Wealth Management in Old Tappan, N.J.

The oldest of the baby boomers turned 62 last year, and many began claiming Social Security — believing that government benefits, 401(k)s and other money invested in the market would allow them to retire in comfort.

But the market meltdown changed all that. Now some retirees are returning to work not out of financial necessity, but to more quickly recoup investment losses.

“They’re looking to create a bigger financial cushion,” says Brett Horowitz, a wealth manager at Evensky & Katz LLC, in Miami. He is flagging resetting Social Security benefits as an option to clients.

Retirees who begin collecting Social Security benefits at 62 typically receive benefits that are about 25% lower than if they had waited until full retirement age. (The age of eligibility to receive full Social Security benefits is 65 for those born in 1937 or earlier. The eligibility age increases for retirees born in 1938 or later; full retirement age is 67 for those born in 1960 or later.)

The monthly payment is even higher for those who wait a few years beyond the eligibility age for full benefits to start collecting, “If you can wait from 62 to 70, you can almost double the initial benefit,” says Christine Fahlund, senior financial planner at T. Rowe Price in Baltimore.

The maximum pretax benefits at 62 are $21,228, compared with $26,064 at 65 and $36,648 at 70, when maximum benefits are available (in current dollar values). Payments are adjusted for each year for the cost of living.

For retirees to reset their Social Security payment schedule, all benefits received must be repaid, using a form SSA-521. (For more information, visit

www.socialsecurity.gov/retire2/withdrawal.htm
 

Individuals in poor health should take the retirement benefit as soon as they can to maximize how much they’ll receive over the rest of their lives. Waiting longer, and then getting bigger monthly payments, is beneficial for those who live to a ripe age.

If he or she lives to 85, someone who waited until 70 to get Social Security would have received $76,896 more in current pretax dollars than the person who took the benefit at 62. If he or she lives to 95, the advantage would be $231,096, according to research from T. Rowe Price.

Because a claimant is required to return only the nominal amount of collected benefits in a reset, he or she could in theory use it as a no-interest loan, investing the money and keeping the interest.

“In essence, the claimant is a ‘borrower” who is required to pay back only the ‘principal” on a loan,” says Alex Golub-Sass, a research associate at the Center for Retirement Research at Boston College, who co-authored a recent paper on this topic.

Commenting on this strategy, Cynthia Edwards, a spokeswoman for the Social Security Administration, says: “This is legal to do under current law, but our Commissioner has some concerns. It’s an issue we intend to raise with the Office of Management and Budget.”

Before doing a reset, investors should talk to their tax adviser.

Married couples in particular need to think carefully about the mortality risk. If the higher earner in the couple takes Social Security at age 62, for example, and dies before doing a reset, the survivor benefits could be reduced.

By Victoria E. Knight
A DOW JONES NEWSWIRES COLUMN

WASHINGTON — Social Security and Medicare trust funds are expected to run out of money sooner than expected, a report released Tuesday shows.

The report, from the programs’ trustees, shows that expenses will exceed tax revenues for Medicare’s hospital insurance fund in 2017, two years earlier than was estimated in a similar report in 2008.

Social Security’s trust fund is expected to be exhausted in 2037, four years earlier than last year’s estimate.

The report “once again reminds us that the longer we wait to address the long-term solvency of Medicare and Social Security the sooner those challenges will be upon us and the harder the options will be,” U.S. Treasury Secretary Timothy Geithner said in response to the data.

The data shows Medicare’s financial problems are larger and more imminent than Social Security’s. Medicare has been hit hard as demand for public health programs increases alongside rising health-care costs.

President Barack Obama has in recent days been lobbying the health-care industry to find ways to cut costs, measures that could make funds held in trust for Medicare go further.

Social Security’s challenges have been exacerbated by the ongoing recession. Still, the fund is expected to continue paying full benefits for almost 30 years while funding about 75% of benefits thereafter.

Last year, the trustees projected Social Security’s trust fund would run dry by 2041, Medicare’s by 2019.

By Meena Thiruvengadam
Of DOW JONES NEWSWIRES

President Obama’s budget proposes to hike the marginal tax rates of the wealthy to 36% and 39.6% beginning in fiscal 2011, and to increase by 5% the capital gains and dividends tax rate for the wealthy - tax changes that market participants say could lead to higher demand for tax-exempt bonds.

“The Obama tax hike [on the marginal rates] would mean that muni investors could buy bonds about 40 basis points richer in yield to achieve the same after-tax yield,” said Matt Fabian, a managing director at Municipal Market Advisors.

Wealthy would be defined as married couples earning over $250,000 and individuals earning $200,000 or more.

However, the administration has abandoned a proposal aired in a budget outline released in February that would have capped the amount of deductions taxpayers could take at 28%, another move that may have pushed wealthier investors into the muni market.

The most recent budget document also shows an even smaller estimate for how much the federal government will pay for the new Build America Bonds program than a document released Thursday.

However, market participants said the discrepancy does not really matter since the higher numbers were already underestimating the amount of payments that will be made under the program.

In an appendix to the budget released last week, the administration estimated that the Treasury Department would spend $91 million in fiscal 2009 and $340 million in fiscal 2010 on BABs, which it said included Recovery Zone Economic Development Bonds

But the Analytical Perspectives document released yesterday estimated just $50 million and $192 million for BABs during those years. Neither administration officials nor market participants could explain the differences in the estimates.

Treasury officials say roughly $9 billion of BABs have been issued during the past two months since the program started. Clifford Gannett, the director of the Internal Revenue Service’s tax-exempt bond office, which is charged with processing the direct payments for those bonds, said Friday that doing “very conservative” math on those numbers indicates $90 million of payments on just those issuances.

It is possible that the budget numbers stem from revenue estimates put together when the BAB legislation was being drafted, well before anyone knew how popular they would become, sources said.

The BAB program, created by the stimulus law, allows governmental issuers to sell an unlimited amount of taxable debt and either receive a cash payment from the federal government or provide investors with a tax credit equal to 35% of the interest rate.

The Recovery Zone Bonds, $10 billion of which were authorized under the stimulus law, also would provide issuers with a cash subsidy, but that payment is equal to 45% of the interest rate, and there is no option to provide a tax credit to investors. The bonds are to be allocated to areas hit hard by unemployment in 2008.

The budget documents also provide some fresh details for the administration’s estimated savings of phasing out the Federal Family Education Loan student loan program and moving to a system in which all federally guaranteed student loans are originated directly by the Department of Education. Many state-level FFEL lenders, who are opposed to the switch, issue municipal bonds backed by their student loans.

By ending “subsidies” paid to FFEL lenders, the budget documents estimate savings of $24 billion over five years and $48 billion over 10 years.

But an appendix to the budget proposal shows that the federal government has historically overestimated the costs of subsidies for FFEL while underestimating the costs of the direct loan program.

For the roughly $811.7 billion of FFEL loans originated since 1992, the cost of each loan averaged about 8.2 cents per dollar, compared to original estimates of about 10 cents. Issuance costs for the roughly $249.8 billion of direct loans were about 4.5 cents for each dollar loaned, compared to estimates of about 0.6 cents.

Almost three quarters of the budget’s proposed $100.5 billion of grants to state and local governments would be used for transportation infrastructure, mostly highways.

The budget proposed some modest changes to transportation and infrastructure funding, including a new user fee that would fund the air traffic control system beginning in 2011.

The administration argued that the current excise tax that is levied on users based mostly on airline ticket prices should be replaced by a tax related to the cost of services provided by the Federal Aviation Administration. If such a measure is taken, it will generate $9.6 billion in 2011 and existing aviation excise taxes could be reduced, according to the budget.

The administration also confirmed in its budget that it hopes Congress will create a national infrastructure bank and fund it at $5 billion in fiscal 2010. However, only a portion of that would be spent in 2010, the budget said.

The budget estimated that the federal government will provide $73.4 billion of transportation in grants to state and local governments in fiscal 2010, up about $11 billion from this fiscal year. Federal transportation grants would reach $102.3 billion in fiscal 2019 under current policy, according to budget documents.

The administration also proposes a five-year, $5 billion high-speed rail state grant program that would add on to the stimulus funding provided for high-speed rail development.

In addition, the budget includes $3.9 billion for the clean and drinking water state revolving funds.

By Peter Schroeder, Audrey Dutton and Andrew Ackerman, Bond Buyer
May 12, 2009

Americans say that despite daunting circumstances, they have developed a more practical attitude toward money and retirement since last year, according to a study by San Francisco-based Age Wave. And that’s good news for financial planners, says Ken Dychtwald, CEO of Age Wave, because Americans know they need planners’ help.

In a new study, Age Wave, a research firm, found that only 4% of respondents strongly agree that Americans behave in a financially responsible manner. An overwhelming 95% of respondents said financial management should be a standard part of high school curricula. Eighty-one percent said that to live within ones means was the most important financial advice that parents could pass on to their children. That figure jumped from 69% a year ago, when the survey was last conducted.

All of these responses underscore the need for guidance and education among financial services clients, and financial planners are positioned to provide those services, said industry professionals. “There has not been a moment in history when more people need to be coached, guided and educated about how to create a long-term plan,” Dychtwald said. “What you’ve got is a population of people who have been spooked. They don’t know who to trust, who’s lying, or what people’s intentions are.”

The study, called “Retirement at the Tipping Point: The Year that Changed Everything,” gathered opinions from more than 2,000 Americans from four generations. The study was conducted with Harris Interactive.

Nearly 60% of Americans lost money in mutual funds, 401(k) plans or the stock market. Respondents believe that it will take about seven years, on average, to recover losses. Among respondents 55 and older, 46% say that medical expenses not covered by insurance is a top financial worry for their retirement phase. Four out of ten respondents said they believe they will have to help support their parents, in-laws or siblings eventually. In light of their financial situations, respondents believe, they might need to postpone retirement by 4.2 years, on average.

Clients might find that they have other reasons for optimism, especially when it comes to the timeline for earning back financial losses. Financial markets typically recover very quickly from recessions, so the U.S. would have to be in a prolonged recession for recovery to take as long as seven years, said Russell Diachok, president and chief executive officer of Centennial, Colo.–based Geneos Wealth Management, Inc., an independent broker dealer. 

“Personally, I think it would be a shorter recovery time, more like three to five years,” Diachok said. Of course, he acknowledged, “that is a significant amount of time if you were planning to retire in two years.”

In the survey, some Americans did express optimistic attitudes about retirement, and even saw working during their retirement years in a positive way. Sixty percent of Americans say that they view retirement as “a new, exciting chapter in life.” That is an increase from the 52% who felt that last year, according to the study. Seventy percent say that working in retirement is a way to remain stimulated and pay bills.    

By Donna Mitchell

NEW YORK — Cracking into retirement savings early is the tax equivalent of standing on a street corner burning $10 bills.

Hard times have more people doing it anyway.

Early withdrawals from Individual Retirement Accounts and 401(k) plans trigger taxes and penalties that can really add up. There are exceptions, but only for some people who use the money to buy a first home, or pay for higher education or other items.

Many people have at least a vague understanding of all this, but that isn’t stopping them.

The number of companies reporting early withdrawals for hardship from 401(k) and 403(b) plans (the non-profit version of 401(k)s) rose from 15% in October 2008 to 44% last month, according to a recent Watson Wyatt study that polled executives at 141 U.S.-based companies using an online questionnaire.

Many more clients than usual asked about early withdrawals from retirement savings this tax season, according to Michael Eisenberg, a certified public accountant at Eisenberg Financial Advisers in Los Angeles, who is a member of the AICPA’s Financial Literacy Commission.

Eisenberg advises strongly against early withdrawals; none of his clients ended up taking money out, he says.

The federal tax penalty for taking money out of a 401(k) or IRA before age 59 1/2 is 10% of the amount of the distribution. That levy goes on top of any tax owed on the amount. State taxes and penalties may also apply, and they vary.

So, an early withdrawal of $1,000 from a 401(k) or IRA would generate tax on that amount, plus a federal penalty of $100, plus possible state taxes and penalties.

There are exceptions that allow penalty-free early withdrawals from retirement savings, though they differ depending on whether it’s an IRA or 401(k).

For IRAs, the taxpayer may be able to avoid a penalty (but not tax) if he or she uses the money for one of several reasons, including:

*To buy a home (if qualified as a first-time homebuyer under IRS rules).

*To pay for higher education for the immediate family.

*To pay for unreimbursed medical expenses over 7.5% of adjusted gross income.

*To pay for health insurance if the taxpayer has been unemployed for a certain period.

For 401(k)s, the taxpayer can make an early withdrawal without a penalty in several cases, including if he or she:

*Leaves the employer in the year he or she turns 55 or older.

*Uses the money to pay unreimbursed medical expenses over 7.5% of adjusted gross income.

Knowing the exceptions can save people from making common mistakes, according to Ed Slott, an IRA expert and author of numerous books including “Your Complete Retirement Planning Road Map.”

For example, the laid-off often use 401(k) money to foot the bill to go back to school; they assume wrongly that the education exception that applies for IRAs carries over to 401(k)s. The 10% penalty then applies;

“That’s a mistake a lot of people make, and actually go to court to argue a case they can’t possibly win,” says Slott.

Instead, the smart thing to do would have been to roll the money into an IRA and pay for education from there, he adds.

Rande Spiegelman, vice president of financial planning at the Schwab Center for Financial Research, says making an early withdrawal should be a last resort, “somewhere right before homelessneess and/or starvation.”

Early withdrawal deletes all potential for future tax-deferred compounding, to say nothing of the taxes and penalties that can wipe out more than half of the amount withdrawn.

“Better to borrow or beg (but not steal) before raiding your retirement,” says Spiegelman.

Eisenberg advises clients who are thinking about hitting up a 401(k) to consider a loan from the 401(k) instead. A caveat here is that if the employee leaves the company with the loan outstanding, it is considered income and tax will be due on it.

By Arden Dale
A DOW JONES NEWSWIRES COLUMN