Why The Traditional 401(k) Is Underrated

August 31, 2017

Do you like paying “hefty tax bills?” According to this article titled, “If you like paying hefty tax bills, stick with your regular 401(k),” you’re likely to be better off contributing to a Roth 401(k) since required minimum distributions from a traditional 401(k) can keep you at the same or a higher tax bracket in retirement. That sounds pretty cut and dry but as with most universal financial recommendations, it’s a bit oversimplified.

Let’s take a look at some reasons why you might want to contribute to a traditional 401(k) even if you don’t like paying “hefty tax bills:”

1. Lowering your taxable income now can make you eligible for other tax breaks. One of the main differences between a traditional and Roth 401(k) is that the former lowers your taxable income now, while the latter can lower your taxable income in retirement. In other words, would you rather pay the tax now or later? One way to answer that is to compare your tax rate now with the one may pay in retirement.

However, there’s another factor to keep in mind. There are a number of tax breaks that phase-out based on your taxable income. Since almost all of them involve working, having children, saving or paying for education expenses, or saving for retirement, you’re much more likely to be eligible for them now than when you’re retired…assuming your taxable income doesn’t disqualify you. Before switching to a Roth 401(k), see if traditional 401(k) contributions can help you qualify for other tax breaks.

2. Your effective tax rate in retirement may be lower than you think. First, don’t forget that not all your income will be taxable in retirement. Even if you have no other tax breaks, you’ll still likely be eligible for at least the personal exemption and standard deduction and your Social Security will at most be partially taxable depending on your “combined income.” Any withdrawals from Roth accounts may be tax-free and only earnings on outside savings and investments are taxable (as opposed to any principal that you sell or withdraw).

More importantly, we need to examine what we mean by “tax rate.” For example, let’s say you currently earn a joint taxable income of $100,000. That would put you in the 25% tax bracket. If you contribute $18,000 pre-tax to your 401(k), all $18,000 would otherwise have been taxed at that 25% rate.

You then retire with the equivalent of $80,000 of taxable income (including RMDs) and are still in the 25% tax bracket. However, only the taxable income above $75,900 (in today’s dollars but the brackets are adjusted for inflation) or about 5% of your taxable income is taxed at that 25% rate. This means your average or effective tax rate is only 14.35%, despite still being in the 25% tax bracket. Would you rather pay a tax rate of 25% now or 14.35% later?

3. You can always convert to a Roth IRA later. If you make pre-tax contributions, you always have the option to later roll them into a traditional IRA and then convert them into a Roth IRA. You’ll have to pay taxes on the amount you convert, but if you plan to take time off from work to go back to school or take care of a child or elderly parent or even start a business that takes time to ramp up, you may be able to convert at that time and pay a lower tax rate. If your taxable income is low enough in retirement, you may even decide to convert then so your Roth account can grow tax-free for your heirs. However, if you make Roth contributions, you don’t have the same option to convert them to traditional.

None of this is to say that the traditional 401(k) is better for everyone either. In fact, there are some very good reasons to make Roth contributions such as if you’re maxing out your 401(k) contributions, you want to have tax-free income in retirement to qualify for higher health insurance subsidies under the Affordable Care Act, or you expect your tax rate to be the same or higher in retirement. If you’re not sure what the best option for you is, consult a qualified and unbiased financial professional.

Don’t just rely on one article’s headline. If it sounds too simple to be true, it probably is.

This post was originally published on Forbes, July 26.

Are Self-Directed IRAs a Good Idea?

April 18, 2016

If you could buy a private business, a rental property or racehorses in your Individual Retirement Account (IRA), would you do so? Even if you could, would that be a wise choice? Self-directed IRAs (SD-IRA) offering non-traditional investments have become increasingly popular and more broadly available.

The self-directed IRA is a traditional or Roth IRA in which the custodian, the financial institution which keeps records and reports to the IRS, permits the full range of investments allowed by law in retirement accounts. Many types of investments are permitted in IRAs, but there are certain things you can’t do, like buy collectibles (such as art and coins) and life insurance, as well as investment strategies that require borrowing, such as shorting stock or certain options strategies. However, the reality is the vast majority of financial institutions limit retirement account investments to the more traditional ones like stocks, bonds, mutual funds, CDs and exchange-traded funds.

“Self-Directed” Really Means “Alternative Investments Accepted”

The term “self-directed” is a bit off base. What it means is that alternative investments are accepted or offered by the IRA custodian. Technically, at most financial institutions, IRAs default to the more literal interpretation of “self-directed,” in that the account owner makes the final decisions on what investments to buy or sell, unless they have given discretion in writing to an investment advisor.

A custodian who offers self-directed IRAs agrees to keep required records of your non-traditional investments in the IRA and report them to the IRS. The custodian may or may not offer physical custody of the investment, depending on type, or may just house the records of investment activity and valuation. Common alternative investments available in SD-IRAs are precious metals, real estate, loans, and private equity.  Certain custodians of self-directed IRA accounts will accept just about anything allowed by the IRS, including tax lien certificates and dairy cows.

Very High Risk

Many alternative investments available in SD-IRAs carry a high risk of losing all or most of your money due to lack of diversification or the inherent risk of the investment itself. You may not be able to sell the investment later (lack of liquidity), meaning that you won’t be able to access the value of it to make distributions in retirement. Keep in mind that the entire burden of investigating the investment (doing your “due diligence”) is on you, the account holder. This could be a benefit when you are investing in an area of your professional expertise (e.g., the experienced real estate investor). However, it can also lead to fraud, when investors are duped into Ponzi schemes or other types of investment scams through slick offerings and piles of legal paperwork.

Beware of investing in anything you don’t understand and can’t explain easily to others. If you are considering an investment within an SD-IRA, read this pamphlet from the SEC first and do your homework. Use the checklist at the end of this post. Remember, if it sounds too good to be true, it probably is.

High Fees

Fees in self-directed IRAs are generally much higher than more traditional types of IRAs. Expect to pay set up fees, custodial fees and annual fees to value the investment. Many of the types of alternative investments offered in SD-IRAs are hard to value, so this can get quite pricey.

Keep in mind that the IRA or Roth IRA is the owner of the investment, so you don’t have direct control over it. With investments like real estate or a business, for example, that means you have to pay the custodian to do things like collect rents or business income. (Per this Bankrate article, some custodians propose that you set up a an IRA LLC to address this issue, which may give you checkbook control but is costly to establish and has legal risk.) No matter what, make sure you do some comparison shopping for a custodian who specializes in the type of investment you want to own in your SD-IRA.

Potential Tax Problems

Investors often get tripped up by unexpected tax consequences in SD-IRAs. Most importantly, in a traditional IRA, distributions in retirement are taxed as income, not the lower capital gains rate. The investor may have been better off holding the asset outside of a retirement account. Additionally, investors miss out on the ongoing favorable tax treatments for some common types of investments, such as real estate.

Depending on the type of investment income, a self-directed IRA may not be completely tax-deferred and a Roth IRA may not be completely tax-free. For example, if the investment generates Unrelated Business Income, the IRA or Roth IRA would be taxed at the high trust rates for the tax year in which it occurs. Those taxes must be paid by the IRA, not the account owner separately.

Can’t Invest in Yourself or Your Family

Don’t get too excited about selling the family business to your IRA! Certain transactions are prohibited in retirement accounts to prevent self-dealing, including transactions with people within your linear family, such as your spouse, your parents, your children, your grandchildren and their spouses. Most of your family could not work in or on behalf of the investment or live in a property held by the IRA.

When to Consider a Self Directed IRA?

SD-IRAs are not suitable for many people. Use this checklist to see if you might be a good candidate for self-directed IRA accounts: (Aim for at least 4 out of 6.)

  • I am an accredited investor. (If you don’t know what it is, you probably aren’t.) While you don’t need to be an accredited investor to open an SD-IRA, being one means you have the income and net worth to consider alternative investments.
  • I don’t need my IRA or Roth IRA for future retirement income. Either:
    • I am fully on track to completely fund my retirement with my employer-sponsored retirement plan, e.g., 401(k), 403(b), etc.
    • I have a pension or other investments (e.g., rental income) which will fully cover my retirement income needs.
  • I have well-diversified traditional investments in my work-sponsored and non-retirement brokerage accounts that can be liquidated to pay future living expenses if needed.
  • I have professional expertise and experience in the SD-IRA investment which I am considering.
  • I want to add a target percentage of precious metals to my retirement portfolio for diversification.
  • I am considering making a small private equity investment that might pay off big (a possible strategy in a Roth SD-IRA) but could also go bust.

What The New Fiduciary Rule Could Mean For You

April 07, 2016

You may have heard by now that the Department of Labor announced a new rule requiring any advisor of a retirement account like a 401(k), IRA, and even an HSA to act as a fiduciary, putting their clients’ interest above their own. The good news is that this will drive out many glorified salespeople selling high-priced investments for a commission from “advising” people on their retirement accounts. The bad news is that many people who need advice may not be able to meet the asset minimums required by many fiduciary advisors or may not be willing to pay their asset management fees. If you’re in one of those camps, here are some options for you:

Target Date Funds

Since these funds aren’t providing personalized advice, they aren’t affected by the new rule but they can substitute for an investment advisor in many ways. All you need to do is pick the fund with the year closest to when you plan to retire. You can put all of your money into that one fund (in fact, they’re designed for that so adding more funds can actually throw off the balance of the fund) and set it and forget it. That’s because they are designed to be fully-diversified “one stop shops” that automatically become more conservative as you get closer to the target retirement date.

This doesn’t mean that all target date funds are the same. While they each have slightly different investment mixes, it’s been found that low fees are actually more important than getting the best mix (which no one can know in advance anyway). To minimize your costs, look for target date funds made up of low cost index funds.

Robo-Advisors

If you want a portfolio more customized to your particular risk tolerance, consider a “robo-advisor,” a new breed of automated online investment advisors that design a portfolio for you based on a questionnaire you answer. They already act as fiduciaries so they won’t be negatively impacted by the new rule. However, they tend to have much lower minimums and fees than human advisors.

Flat Fee Advisors

If you’re looking for more comprehensive financial advice or just prefer to work with a human being, another option is an advisor that charges fees that aren’t based on how much they’re managing. Instead, they may charge an hourly, monthly, or annual fee. However, these advisors are relatively rare so the number of local options may be limited.

There will be lots of changes as a result of the new fiduciary rule. Many investors will pay less in fees but if you’re currently working with a non-fiduciary advisor for your retirement account(s), you may have to find a new one. Fortunately, there are a lot of good alternatives if you know where to look.

 

The F Word In Financial Services – And Why You Need To Know It

April 04, 2016

Should financial advisors have to act in the best interest of their clients? Absolutely yes, according to the U.S. Department of Labor. The Office of Management and Budget will soon release the final version of the DOL’s fiduciary rule, which will require more of those who provide retirement investment advice to put their clients’ best interests first by expanding the type of retirement investment advice covered by fiduciary protections. What does this mean, and how will it impact employees saving for retirement?

The term “fiduciary” comes from the Latin word, “fiducia,” meaning trust. A fiduciary must act for the benefit of another person in a financial relationship and not for their own personal gain. Fiduciaries must disclose all conflicts of interest, and have a legal obligation to take into account the beneficiary’s circumstances, goals, risk tolerance, time horizon and investment experience. In other words, when you hire a fiduciary, he or she is legally and ethically required to act in your best interests.

The practical implication of this is that when choosing between two otherwise very similar investments, a fiduciary would choose the one with the lower costs. This is very helpful as the structure of much of the financial services industry is full of inherent conflicts of interest that don’t always favor consumers. A fiduciary can’t charge you ridiculously high commissions on an investment just because they have a mortgage to pay on their second home or their broker-dealer has a current sales promotion with a favored mutual fund company.

But wait…Aren’t all financial advisors supposed to do that anyway? Not to the same extent.

Many financial advisors operate under something called the “suitability standard,” which states that the advisor must have a “reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through reasonable diligence.”  This is why a financial advisor can sell you a mutual fund with a 4% up front sales charge, recommend investment strategies with lagging performance or encourage you to roll over your 401(k) into a higher fee account when you leave a job. Fellow Financial Finesse planner Erik Carter wrote about this conundrum for financial advisors recently in his Forbes column.

Thankfully, there are some financial advisors already follow the fiduciary standard, such as registered investment advisors (RIAs) and certain retirement plan advisors under ERISA, the law that governs employer-sponsored retirement plans. Fee-only financial advisors who are members of the National Association of Personal Financial Advisors sign a Fiduciary Oath as part of their membership. According to the CFP Board, “CERTIFIED FINANCIAL PLANNER™ professionals providing financial planning services also must abide by the fiduciary standard,” acting “solely in the client’s best interest when offering personal financial planning advice,” and the Board has been very active in promoting adoption of the DOL rule and a uniform standard. However, some CFP® professionals work for big financial services firms who have not yet adopted the standard. So what is the new DOL rule likely to mean for retirement savers?

Lower fees

More types of retirement investment advice are covered, including for IRAs and individual work-sponsored retirement plan accounts. This could mean that certain types of investments are less easy to justify selling to retirement investors, such as high fee mutual funds, and may put downward pressure on fees overall. The DOL estimates that expanding who must provide fiduciary advice will save investors up to $40 billion in fees over the next ten years.

Less pressure to rollover your retirement plan to an IRA

According to a recent Wall Street Journal article, the new DOL rule will make it harder for advisers to recommend a rollover of your work-sponsored retirement plan if you leave your job, “as they will have to clearly document why it is in a client’s best interest. Additionally, once the money is in an IRA, advisers would generally have to avoid payments, including commissions, that create incentives for them to select one product over another.”

Rebuilds trust and confidence

The most consumer-friendly aspect of the expanded fiduciary rule is that it aligns the interests of retirement financial advisors and their clients. This eliminates conflicts of interest and gets financial advisors and clients on the same side of the table when it comes to retirement investing. If you know that your advisor is legally looking out for your best interest and not just looking to make a sale, this makes it more likely that you’ll consider his/her advice carefully.

More transparency should rebuild trust and confidence in financial advice. That is good for investors and good for financial services. The DOL rule has prompted the SEC to begin looking at adopting a Uniform Fiduciary Standard for all investment advice, not just retirement advice.

 

 

5 Areas That May Need Some Financial Spring Cleaning

March 31, 2016

With Easter weekend behind us and spring officially in the air, it’s time for some spring cleaning. Don’t forget about cleaning your financial life too. While it’s much easier to see the clutter in your home, the clutter in your finances could have much bigger consequences. Here are several areas that may need some cleaning up:

Your expenses. If you’ve never taken a look at what you spend money on, it can be a real eye-opener. Start by gathering at least 3 months’ of bank and credit card statements and record each expense. You can also use a tool like Mint or Yodlee MoneyCenter to track your spending online for free.

Then go through your expenses and see what areas of waste you can cut. Are there things you’re spending money on that you don’t really need? If you do need it, can you get it in a way that costs less? You can get some ideas for savings here.

Your credit report. It’s been estimated that about 70% of credit reports have errors that could be hurting your score. If you haven’t done so in the last 12 months, you can order a free copy of each of your 3 credit reports (TransUnion, Equifax, and Experian) at the official site: annualcreditreport.com and report any discrepancies. You can also improve your score by getting current on your bills and paying down debt. Just be aware that old debt falls off your credit report after 7 years and making a partial payment or even acknowledging the debt to the creditor can restart that clock so if it’s getting close and you’re past your state’s statute of limitations for being sued by a creditor, you may just want to wait it out.

Your retirement account. Do you have retirement accounts that you left at previous jobs? If so, your overall retirement portfolio may not be properly diversified or you may be paying more than you need to in fees. Unless you have employer stock or are taking advantage of some unique investment option in the plan, you might want to roll those accounts to your current employer’s plan or into an IRA to make them easier to manage.

Your savings and investment portfolio. Many people have accounts they’ve opened or investments they’ve bought for different reasons over the years and now their savings and investments are a cluttered mess. Having 10 different bank accounts or 5 US stock funds isn’t diversification. Here are some simple ways to make sure you’re properly diversified.

Your legal documents. Tax documents only need to be kept for 7 years at the most. After that, you might as well just shred them. Estate planning documents should be checked to make sure they’re still up-to-date. Once your spouse finds out that your ex is still listed as your beneficiary or your youngest child wasn’t included, it may be too late.

How about you? Have you spring cleaned any of your finances? If so, share your experiences in the comments section below.

 

Roth IRA or Roth 401(k)?

February 18, 2016

We’ve recently received several calls on our Financial Helpline from people who entered their Roth 401(k) contributions as Roth IRA contributions in tax software and were told that they had over-contributed. Since Roth 401(k) plans are relatively new, it’s easy to get these mixed up but the differences are important and not just when filing your taxes. Let’s start with the similarities. Both accounts allow you to contribute after-tax dollars that can grow to be tax-free after age 59 ½ as long as you’ve had the account for at least 5 years. Now let’s look at the differences: Continue reading “Roth IRA or Roth 401(k)?”

10 End-of-Year Tax Tips

December 03, 2014

Are you worried about paying too much in taxes this year? If you wait until you file next year, it will be too late to do much about it. As the 2014 year winds down, you’ll want to note some simple things you can do to reduce the amount of income tax you owe Uncle Sam this year, while planning for the year to come.  Continue reading “10 End-of-Year Tax Tips”

Using Retirement Plan Assets for Education

June 04, 2014

As the school year winds down, many graduating high-school seniors are looking ahead to the promise of a new day come next fall, but for many parents, that day is fraught with mixed emotions—and a handful of college bills. To help pay for college, some parents will set aside money using more traditional ways to save for college expenses. Each has its own set of pros and cons and seldom are parents able to save enough to pay for their student’s entire education. As such, many students will require student loans in order to continue their education. The result is an average student loan debt of just under $30,000. Continue reading “Using Retirement Plan Assets for Education”

What Should You Do With Your Tax Refund?

April 17, 2014

If you’re like the average American, you’re getting a tax refund of about $3k this year. So what should you do with that nice windfall? Here are some things to consider before blowing it all on a random shopping spree. Continue reading “What Should You Do With Your Tax Refund?”

Could Asset Location Make Your Investments More Tax Efficient?

September 20, 2013

What happens when you get a group together that consists of financial planners, CPAs, estate planning attorneys and investment managers? Usually when that happens for me, it means that a bunch of my friends are getting together to go watch one of our friend’s bands play or we’re playing poker. And, it also means that the topic is eventually going to become a financial one and inevitably there will be people on opposite sides of an issue so debate is a certainty.  The great thing about the debate is no matter what side you’re on, you learn something you didn’t know before the debate. One of our recent debates was about asset location.  Continue reading “Could Asset Location Make Your Investments More Tax Efficient?”

8 Home Buying Mistakes to Avoid

May 20, 2013

Exactly one year ago, our family completed a crosstown move in Charleston, South Carolina to get closer to family, my wife’s business, and our children’s schools, and thankfully, within a short little drive to Folly Beach. Any planned major purchase can add significant joy (and stress) as well as some expected and unexpected financial challenges and this was one was no different. Our new home was purchased through a short sale and although it was left structurally sound when we moved in there, there was a long to-do list related to cosmetic repairs, appliances in need of replacement, and an exterior in need of pretty significant landscaping and TLC. Continue reading “8 Home Buying Mistakes to Avoid”

How Is Your Retirement Income Taxed?

May 15, 2013

Last month I took a phone call from a gentleman who is in the process of preparing for retirement. He has done a good job saving and now that he is getting ready to take distributions from his retirement accounts, he is concerned about taxes. We are often lead to believe that taxes will be less in retirement and for many taxpayers, that will be true not because of a change in the way things are taxed but rather because many retirees will be able to enjoy retirement on less income.  Income sources are taxed no differently in retirement than they are while we are working.  Sure, we receive an additional deduction once we turn 65, but the primary difference between our working and retired years is not how our sources of income are taxed, but the “sources” of income themselves. Continue reading “How Is Your Retirement Income Taxed?”

5 Potential Changes That Could Affect Your Retirement

February 07, 2013

The more I think about the funding shortfalls with Social Security and Medicare, the disappearance of traditional defined benefit pension plans, and the lack of Americans’ saving for retirement, the more I realize that there will likely be some major changes in the future of retirement and retirement planning. Everyone talks about entitlement reforms like raising the Social Security retirement age and reducing Medicare benefits. But here are 5 other possible changes affecting retirement that you may not have heard as much about and some things you can to prepare: Continue reading “5 Potential Changes That Could Affect Your Retirement”

What Your Employees Don’t Know About Target Date Funds Could Hurt Them

June 12, 2012

Some of the most common questions that I’ve been receiving from employees during recent retirement planning workshops relate to confusion around the proper use of target-date funds. Ironically, these investment options are designed to simplify rather than complicate the process of saving for retirement. When used correctly, target date funds can help employees allocate and re-balance their investment assets appropriately to achieve their retirement goals with one stop diversification.  In fact, more than three-quarters of all 401(k) plans now offer target-date fund options for plan participants and in many plans, they serve as the default investment for automatic enrollment. Continue reading “What Your Employees Don’t Know About Target Date Funds Could Hurt Them”

The Proposed Retirement Security Project: Could Retirement Plan Deductions Get Cut?

May 01, 2012

A recent tax reform proposal may bring the end to the cherished tax shelter of a retirement plan deduction.  During testimony to the U.S. Senate Committee on Finance last September, William Gale discussed a proposal to eliminate the current tax deduction on retirement savings plans and suggested replacing it with a flat-rate refundable credit that would be deposited directly into the saver’s account.  Gale, who is the Director of the Retirement Security Project at the Brookings Institution, wants to see a new incentive structure for contributions to retirement savings accounts by changing the treatment of retirement savings in three ways: Continue reading “The Proposed Retirement Security Project: Could Retirement Plan Deductions Get Cut?”

A Workplace Twist on Balance Transfer Day

December 20, 2011

In case you missed it, two Sunday’s ago was designated as Balance Transfer Day, based on a Facebook-led protest against big banks that encouraged consumers to switch their high interest credit cards for cards with lower rates or 0% teaser rates.  The December 11th protest was meant  to “beat the banks at their own game and demand the same 0% interest rate that they receive from the federal government,” the protest’s organizers said.  Hopefully, this put the spotlight on the high cost of finance charges that some consumers are facing with their credit card debt.  So where can you shine your own spotlight? Continue reading “A Workplace Twist on Balance Transfer Day”

GUEST BLOG POST: The 6 Reasons Why the 401(k) Is the Best Way to Save for Retirement

June 30, 2011

401(k)s have gotten some negative press due to the market downturn during the recession, which took a big toll financially on many employees. Even so, as someone who has dedicated my whole working life to retirement planning, specifically to the 401(k), I wanted to share six important points on why 401(k) are still a better vehicle for saving for retirement.

  1. The matching contribution. The vast majority of companies who sponsor 401(k) plans match your contribution into the plan. You can’t get that with any other savings vehicle. For example if you’re going to put money into an IRA nobody is going to come in and give you $0.50 for every dollar that you put into that IRA. Continue reading “GUEST BLOG POST: The 6 Reasons Why the 401(k) Is the Best Way to Save for Retirement”

What Should I Consider When Taking My RMD?

May 05, 2011

I was doing some workshops for a group of pre-retirees (talk about envy!) and we were going over a lot of the basic questions that group often has, how do I know if I have enough money, how do I plan for medical costs, what should I do about my investment allocations, etc.  But the question that seemed to generate a lot of interest was if there were any strategies surrounding taking the Required Minimum Distribution (RMD).  The strategies listed below can help you be more efficient in deciding which dollars you should consider using to pay your RMD. Continue reading “What Should I Consider When Taking My RMD?”

Financial Planning: When a Spouse Passes – How to Stay Out of the Dark

March 17, 2011

Well you knew I would be broaching this topic at some point.  In many years of financial planning I have seen numerous situations which made me sad, and which inevitably led to me becoming a financial educator.  Some of the most searing memories, and sad to say happened all too frequently, were of widows who were in the dark as to what their financial condition was. Continue reading “Financial Planning: When a Spouse Passes – How to Stay Out of the Dark”