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Annuity in an IRA? Maybe, now

Annuities can produce mountains of fees

Photo courtesy of Martin Staněk on unsplash.com.

Forever and a day, the rule of thumb has been that you should not use IRA funds to purchase an annuity – primarily because traditional annuities had the primary feature of tax deferral. Since an IRA is already tax-deferred, it’s duplication of effort plus a not insignificant additional cost to include an annuity in an IRA.  This hasn’t stopped enthusiastic sales approaches by annuity companies – plus new features may make it a more realistic approach.

Changes in the annuity landscape have made some inroads against this rule of thumb – including guaranteed living benefit riders, death benefits, and other options.  Recently the IRS made a change to its rules regarding IRAs and annuities that will likely make the use of annuities even more popular in IRAs: The use of the lesser of 25% or $125,000 of the IRA balance (also applies to 401(k) and other qualified retirement plans) for the purchase of “longevity insurance”, which is another term for a deferred annuity. Keep reading…

Resurrecting the Qualified Charitable Distribution?

You could use your computer to make a qualified charitable distribution

Photo courtesy of Rayi Christian W on unsplash.com.

This past week the US House of Representatives passed a bill (HR 4719, known as the America Gives More Act) which would re-instate the Qualified Charitable Distribution from IRAs and make the provision permanent.  This provision expired at the end of 2013, as it has multiple times in the past, only to be re-instated temporarily time and again.

A Qualified Charitable Distribution (QCD) is when a person who is at least age 70½ years of age and subject to Required Minimum Distributions from an IRA is allowed to make a distribution from the IRA and direct the distribution to a qualified charitable organization without having to recognize the income for taxable purposes.  This has been a popular option for many taxpayers, especially since the QCD can also be recognized as the Required Minimum Distribution for the year from the IRA. Keep reading…

How to Compute Your Monthly Social Security Benefit

steps to compute your monthly social security benefit

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So you’ve seen your statement from Social Security, showing what your benefit might be at various stages in your life.  But not everyone files for benefits at exactly age 62 or 66 – quite often there are months or years that pass before you actually file.  This article will show you how to compute your monthly Social Security benefit, no matter when you file.

Computing your monthly Social Security benefit

First of all, in order to compute your monthly Social Security benefit, you need to know two things: your Primary Insurance Amount (PIA) and your Full Retirement Age (FRA).  The PIA is rather complicated to define, but for a shorthand version of this figure, you might use the figure that is on your statement from Social Security as payable to you on your Full Retirement Age (or “normal” retirement age).  Keep reading…

The Dog Ate My Tax Receipts Bill

dog ate my tax receiptsNow here’s some legislation that I could get behind!

Recently, House Representative Steve Stockman (R-TX) introduced a bill in response to the IRS’ lame excuse of a “computer glitch” that purportedly erased all of the incriminating evidence from the agency’s computers.  This was part of the testimony offered by former IRS Exempt Organizations Division director Lois Lerner in response to the accusation that her division targeted organizations critical of the current administration.

Stockman’s bill provides that if the IRS can use lame, flimsy excuses to avoid prosecution, taxpayers should be allowed to use similar excuses.  The actual text of the bill follows below: Keep reading…

QDRO vs Transfer Incident to a Divorce

sometimes people discuss transfer incident to a divorce in tall buildings in big cities

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Divorcing couples often face the need to split up some retirement account assets.  This can be done from a retirement plan such as a 401(k) or 403(b), or from an IRA.  Depending on which type of account you’re splitting, the rules are very similar but are referred to by different names.  For a qualified retirement plan (401(k) or 403(b) plan), the operative term is Qualified Domestic Relations Order or QDRO (cue-DRO).  For an IRA, the action is known as a transfer incident to a divorce.

We discussed the QDRO in several other articles, so we’ll focus on the transfer incident to a divorce in this article.

Keep reading…

Starting a new job in the middle of the year? Use the part year withholding method to avoid excess tax withheld

part year withholding works for cab drivers too

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When you file your W4 form with a new employer, this instructs the employer how much tax to withhold from your pay, based on a full year’s pay rate.  There is a strategy you can employ that will reduce the amount of tax withheld from your pay – known as the part year withholding method.  This method of tax withholding calculation takes into account that you are only working and earning for a part of the year, so your overall income will be less, and there would be less tax required.

If you start working in the middle of the year (or worse, late in the year) the normal rate of withholding would result in significant over-payment of tax withheld.  The standard tables used to calculate withholding make the assumption on each pay that you are earning at this rate over the entire period.

Keep reading…

Why You Should Participate in a 401(k)

2559353875_e08d93e193_m1We all know that we should save money for a rainy day, a message we’ve received since we were little ones, but this article covers some more reasons why you should participate in a 401(k) plan, if you have one available.

It’s on you

Back in the olden days when the earth was still cooling, employees could count on (or at least thought they could count on) a pension benefit from their employer upon retirement.  This pension plan provided a safety net that allowed the employee to go into retirement with relatively little concern about whether there would be enough money to live on. Keep reading…

Roth 401(k) In-Plan Conversions

As of the beginning of 2013, a new provision became available for participants in 401(k), 403(b) and 457 deferred compensation retirement plans: the Roth 401(k) In-Plan Conversion.  This provision allows current employees participating in one of these Qualified Retirement Plans to convert funds from the traditional 401(k) (or other) account into the Designated Roth Account (DRAC) that is part of the plan.

This is new and different because previously the only way to convert funds from the 401(k) plan to a Roth-like account was to have left employment by the sponsoring employer. Keep reading…

Take Dave’s Advice With a Grain of Salt

Image courtesy of Stuart Miles at FreeDigitalPhotos.net

Image courtesy of Stuart Miles at FreeDigitalPhotos.net

Dave Ramsey hands out advice to millions of people every day, and much of the time he’s right on track – or at least relatively so.  However, like all purveyors of financial advice to the masses, his advice should be taken with a grain of salt.

There are two reasons for this: First, your circumstances are very likely to be very different from the individual to whom the “vending machine” advice is rendered.  A subtle change to the circumstances can make a major difference as to whether the recommendation applies to you the same as the asker.  Dig deeper than just taking the recommendation verbatim, making a decision based on your own circumstances.

Second, the very nature of the forum that Dave (and Suze, Malcom, and others) use, that of mass-produced financial advice, is oriented toward the sound bite.  Take the recommendation Dave makes in this recent column as an example.  In the first question, Dave’s got no idea what the tax situation is for Jennifer, her income, her age (several years before retirement could be 5 or 50!), if she has other accounts, not even if she’s married.  Yet his response is unequivocal: a Roth 401(k) is best – presumably (at least in part) because that’s what Dave has chosen for himself.  Dave’s financial circumstances are bound to be drastically different from Jennifer’s, but the sound bite wins out.  Millions of followers now have the idea that in all circumstances, if you have a Roth 401(k) available, you should utilize it.  That’s not exactly poor advice, but it’s very generalized and incomplete at the very least.

A proper answer would require more information about Jennifer, much more.  For example, if it turns out that Jennifer has a very high income now and expected future income will be much lower, the traditional 401(k) could be the best for her.

Another problem with this answer is Dave’s calculation of the tax hit on distribution.  He says it could be $300k to $400k on a million-dollar account.  That could be the case if Jennifer withdrew the entire $1 million in one tax year (makes for a great sound bite!). However, if she takes that money out over a 20-year timeframe at $50,000 per year, is married, and that’s the only income that Jennifer and Mr. Jennifer receive, at today’s tax rates they’d pay less than $64,000 in tax during that period.  Not such a juicy sound bite, but likely a lot closer to reality.

My point is not that you should disregard what Dave Ramsey (or any of the other financial “gurus” out there) has to say.  Much of the time, as I stated before, he gives good guidance (notwithstanding his irrational fear of debt and his expectation of a 12% return from the stock market). I like a lot of what he has to say, helping folks via his Financial Peace University and whatnot.  Plus, how can you not like a guy whose offices are right next door to a Cracker Barrel and a Krispy Kreme, all right across the street from a swanky Galleria Mall??? No, my point is to understand the nature of the recommendations given, and that your circumstances are most likely very different from the seeker of wisdom from the mount.

File Now. Suspend Later.

Photo courtesy of Lacey Raper on unsplash.com.

Photo courtesy of Lacey Raper on unsplash.com.

Suspending benefits is a facet of Social Security filing that usually only gets written about in connection with filing – File and Suspend is often referred to as a single act, but it’s actually two things.  First you file for your benefits, which is a definite action with the Social Security Administration, establishing a filed application on your record.  Then, you voluntarily suspend receiving benefits.  If this happens all at once, the end result is that you have an application filed with SSA, but you’re not receiving benefits.  Since you have an application filed (in SSA parlance, you’re entitled to benefits), your spouse and/or dependents may be eligible for a benefit based on your record.

Since you are not receiving benefits, your record earns delayed retirement credits (DRCs) of 2/3% per month that you delay receipt of benefits past your Full Retirement Age (FRA).  (Note: you can only suspend receipt of benefits when you are at or older than FRA, age 66 for folks born before 1955.)

It doesn’t have to happen all at once though.  You could file for benefits and receive them for a few months or a long period of time, and then suspend benefits later in order to receive delayed retirement credits to increase your benefit later.

For example, Tim started receiving his Social Security benefit at age 62, because he figured he couldn’t count on the government to make the funds available for him in the future, and by gum he was going to get what was coming to him.  By starting early, Tim has reduced his benefit from a possible $2,000 (had he waited until FRA to file) to $1,500 per month.  The crazy thing is that Tim has a pension that covers his and his wife Janice’s monthly expenses completely, so he doesn’t really need the SS benefit for living expenses.

A couple years later, Janice explained (tactfully of course) to Tim how he had unnecessarily thrown money away by filing so early.  Since more than 12 months had passed, he couldn’t do anything about it, right?

Wrong – once Tim reaches FRA, he has the option of suspending his benefits, which will provide the ability for his benefit record to begin accruing the Delayed Retirement Credits at the rate of 2/3% per month, or 8% per year.  After four years, Tim’s benefit could be increased by 32%, up to a new monthly benefit of $1,980 per month – almost as much as what his original benefit would have been. (Cost of Living Adjustments have not been factored into the equation.)

Roth 401(k) Rules

Photo courtesy of Mario Calvo on unsplash.com.

Photo courtesy of Mario Calvo on unsplash.com.

If your employer has a 401(k) plan available for you to participate in, you may also have a Roth 401(k) option available as a part of the plan. (We’re referring to 401(k) plans by name here, but unless noted the rules we’re discussing also apply to other Qualified Retirement Plans (QRPs) such as 403(b) or 457 plans.)  Roth 401(k) plans are not required when a 401(k) plan is offered, but many employers offer this option these days.

The Roth 401(k) option, also known as a Designated Roth Account or DRAC, first became available with the passage of the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001, with the first accounts available effective January 1, 2006.  The Roth 401(k) was designed to provide similar features present in a Roth IRA to the employer-provided 401(k)-type plans.

Similar to traditional 401(k)

Certain features of the Roth 401(k) are similar to the traditional 401(k) plan – since the Roth 401(k) is just an extension of the traditional 401(k), in practice.  For example, the employee-participant has the option to elect to defer a portion of her income into the account, and the employer may provide matching contributions based upon the elected deferrals.

The deferred funds are held in a separate account, and the funds invested in selected investment options.  While the funds are in the plan (before distribution) the growth of the funds occurs without taxation.  Upon reaching retirement age (59½ years of age, usually), the funds can be distributed without penalty to the employee-participant.

Funds can also be rolled over into another employer’s plan or a like-ruled IRA (Roth IRA) without tax or penalty.  If the funds remain in the Roth 401(k) plan and the employee-participant has reached age 70½ years of age, and is no longer employed by the plan sponsor (or is still employed and is a 5% or greater owner), the employee-participant must begin taking Required Minimum Distributions from the plan.

Different from traditional 401(k)

Some very important features about the Roth 401(k) are different from the traditional 401(k), but very similar to features of the Roth IRA.  If not, what’s the point of the separate account, right?

First of all, unlike the traditional 401(k), funds deferred into the Roth 401(k) plan are subject to ordinary income tax.Once contributed, growth in the account is tax-deferred – and if taken out after age 59½, the distributions are not subject to income tax.  This is the same treatment that funds contributed to a Roth IRA receive.

When the employer provides matching funds, those funds are contributed to a traditional 401(k) account rather than the Roth 401(k) account.  Vesting rules apply just like with the traditional 401(k) plan, and these only apply to the matching funds.

In addition, when money has been contributed to the Roth 401(k) plan, in order for the distributions to be fully tax-free, the account must have been established at least five years prior to the distribution, and the account owner must be at least 59½ years of age.

Combined Rules

In total, the employee-participant’s contributions for any tax year to ALL 401(k) plans, traditional or Roth, for all employers, cannot exceed the annual deferral limit – which is $17,500 for 2014, plus a $5,500 catch-up for folks who are over age 50.

Rollovers from the plan to an outside plan (Roth IRA or another employer’s Roth 401(k) plan) are generally not allowed until the employee has ceased employment with the plan sponsor.

Although the traditional and Roth 401(k) plans are likely reported on the same statement to the employee-participant, they are always kept in separate accounts, totally segregated from one another.  This simplifies the application of future tax treatment of the funds in the two types of accounts.  When you have deferred funds into the Roth 401(k) account this action is irreversible – in other words, you cannot move the funds into your traditional account or take them in cash after you’ve deferred into the Roth 401(k) without consequences.

It is possible for the employer to allow in-service rollovers (conversions) from the traditional 401(k) to the Roth 401(k) account – paying ordinary income tax on the converted funds in the tax year of the conversion.  These conversions are an allowed, non-penalized distribution from the 401(k) plan.

Investment Allocation in Your 401(k) Plan

Photo courtesy of Jacob Aguilar-Friend on unsplash.com.

Photo courtesy of Jacob Aguilar-Friend on unsplash.com.

When you participate in your employer-sponsored 401(k) plan (or any type of Qualified Retirement Plan, including 403(b), 457, etc.), the first step is to determine how much money you will defer into the plan.  We discussed this previously in an article about contributions to your 401(k) plan.

Once you’ve determined the amount you’ll contribute, the next step is to allocate your funds within the account.  This starts with an overall plan for your investment allocation – which you should take time to plan in advance.  For the purposes of our illustration here, we’ll say that you have a plan to split your account 75% to stocks and 25% to bonds.  Within the stock allocation, you want to split this as 1/3 each to large cap stock, small cap stock, and international stock.  In the bond category you want to split this to 80% domestic bonds and 20% international bonds.

Now you need to review your 401(k)’s investment options.   Generally you will have anywhere from five to 15 or more investment choices, and sometimes you have an open brokerage option (we’ll talk about this more later).  Within the investment options you’ll likely have at least one (if not more) of the following: large cap stock, small cap stock, international stock, fixed interest (like a money market), and domestic bonds.

Sometimes there will be more than one choice in each asset classification, and it often doesn’t make a lot of sense to invest in more than one mutual fund within the same asset class.  This is due to the fact that, unless one of the fund choices is limited in its investment choices (versus the other funds in the group), they are likely to be very closely correlated in their performance and returns.  By “limited in its investment choices” I mean that the fund is sector-specific (such as a healthcare fund) or valuation-specific (such as a growth or value fund).

When you have two or more funds within the same asset class that are indistinguishable from one another other than by name, it’s time to dig a bit deeper.  Your plan administrator should provide you with access to data about the investment choices to help with the selection process.  One of the first things you should look at and compare between the two (or more) choices is the expense ratio of the funds.  This factor is one of the simple factors that you can control, and which can have a significant impact on your life-long results.  Other factors to compare include the recent and long-term investment results (which should be similar for similar funds), turnover ratio, manager tenure, and the like.

If the expense ratios you’re seeing are all above 1% – don’t feel like you’re alone.  A 1% mutual fund expense ratio is ridiculously high these days when you can get exchange-traded funds or indexed mutual funds with expense ratios in ranges at 1/3 of that rate or less.

This is when you need to review all of your portfolio allocations and consider how you’re splitting things up across the board.  Perhaps you have a 401(k) plan at an old employer, an IRA, a taxable brokerage account and/or possibly a Roth IRA.  When you have other investment accounts to choose from, it can help you to limit exposure to some of the higher-expense funds like your employer’s 401(k) plan.

Let’s say for example that your 401(k) has six funds available for allocation: Large Cap Fund A (expense ratio 1.15%), Large Cap Fund B (expense ratio 0.95%), Small Cap Fund C (expense ratio 0.54%), International Stock Fund D (expense ratio 1.05%), Domestic Bond Fund E (expense ratio 0.75%) and a Money Market Fund F (0.10% expense ratio).  Earlier we indicated that we wanted to break out our allocation as 25% Large Cap, 25% Small Cap, 25% International, 15% Domestic Bonds and 10% International Bonds.  Your allocation choices make the first four allocations simple: choose Fund B for 25% (because it’s the lowest cost), Fund C – 25%, Fund D – 25% and Fund E – 15%.  The remainder of your allocation could be handled via outside accounts (IRAs, taxable accounts, and the like).

In your IRA you have access to a large-cap stock fund with an expense ratio of 0.19%.  Instead of choosing to allocate your Large Cap 25% to your 401(k) high-expense Fund A or Fund B, it makes a lot more sense to allocate this portion to the very low cost option in your IRA.

In addition, your 401(k) doesn’t have an International Bond option at all – so you will need to pick that allocation up within your non-401(k) account(s) as well.

The point is that you don’t have to set your allocation separately within each type of account – look at all of them in aggregate and choose the lowest-cost options across all accounts.  (You could allocate each account separately but your simplification would come at an unnecessarily-high expense.)

Another point to understand is that the expense ratio is not the only factor to use in your investment choices – but it is (I believe) the most important factor that you have control over which can improve your investment results significantly in the long run.  You should review all of your fund choices in context with your available accounts, and make intelligent decisions about which funds to use based on your review.

The last thing to understand is that – especially when you’re just starting out – your allocation percentages won’t be exactly what you planned for until you’ve been contributing for a while.  Say for example that you have an IRA with $50,000 invested in it and you’re just starting to contribute to the company 401(k) plan.  You’ll be investing $2,000 per year in deferred income, and the company matches an extra $1,000 per year.  Your allocation is as we described above in your IRA, and you wonder what makes the most sense for your new $3 grand a year.

In this case, you might choose to put that extra $3,000 all in your Small Cap Fund C, since it has a relatively low expense ratio.  As this money builds up over time, look at all of your investment allocations in the aggregate and choose your future investments based on the new present balances.  Gradually your funds will build up (at least you hope they will!) and you’ll want to split the money among other funds in the plan, again, in context with your overall investment plan.

Mechanics of 401(k) Plans – Loans

Image courtesy of Stuart Miles at FreeDigitalPhotos.net

Image courtesy of Stuart Miles at FreeDigitalPhotos.net

Continuing our series of articles on the mechanics of 401(k) plans, today we’ll talk about loans from the account.  As with all of these articles, we’ll refer generically to the plans as 401(k) plans, although they could be just about any Qualified Retirement Plans (QRPs), including 403(b), 457, and other plans.

Unlike IRAs, 401(k) plans allow for the employee-participant to take a loan from the plan.  There are restrictions on these loans, but they can be useful if you need funds for a short-term period and have no other sources.

401(k) Loans

If you have a balance in your 401(k) account, often your plan administrator will have a provision allowing you to take a loan of some of the funds in the account. (Not all plans allow loans – this is an optional provision, not a requirement.)  Sometimes the plan administrator will place restrictions on the use of the loan – such as for education expenses, medical expenses, or certain housing costs.

These loans are limited to the lesser of 50% of your vested balance or $50,000.  If your vested account balance is less than $20,000, you are allowed to take a loan up to $10,000 or 100% of your vested balance.  It is allowed to have more than one loan from your 401(k) plan at a time, but the limits mentioned above apply to the aggregation of all loans at any time.

Loans from your 401(k) plan must be paid back over a specific period of time, not to exceed 5 years from the loan origination.  If the loan is for purchase of the participant’s primary residence, the plan administrator may extend the repayment period of the loan.  In addition, loan payments must be on a set schedule of substantially equal payments, including both interest and principal – and payments must at least be quarterly.  Loan payments are not considered to be plan contributions (when considering annual contribution limits).

If the loan is not repaid according to the schedule, any unpaid balance is considered to be a taxable distribution from the plan – but not a usurpment of rules regarding in-plan distributions.  In other words, if a plan only allows in-plan distributions to employee-participants who are over age 59½ and an employee under that age defaults on a loan, the deemed distribution is not outside the rules of an in-plan distribution.

Loan payments can be suspended for up to one year for a period of absence by the employee-participant, but the original loan repayment period still applies.  In other words, if an employee with a 401(k) loan in repayment status takes a leave of absence and payments are suspended, upon the shorter of his return to work or 1 year, the suspended payments have to be made up.  This is done via either increased payments for the remainder of the loan period, or a lump-sum payment at the end of the period.

Loan payments can also be suspended for employees performing military service – such as called-up reserves.  The time limit of 1 year (as above) doesn’t apply to these suspensions.

Interest on the loan can vary by the 401(k) plan, but most common is to use a rate such as “Prime plus 2%”.

Unless you default on the loan, the proceeds are not taxable, since you’ve only borrowed them and are paying back the funds, usually via payroll deduction.  The payments back into the plan are taxable income, since they are not considered to be “regular” contributions to the account.

Mechanics of 401(k) Plans – Distribution

Photo courtesy of Sonja Langford on unsplash.com.

Photo courtesy of Sonja Langford on unsplash.com.

For the next in our series of articles regarding the mechanics of 401(k) plans, we’ll review distributions from the plan.  As with our other articles in this series, we’re referring to all sorts of qualified retirement plans (QRPs) – including 401(k), 403(b), 457, and others – generically as 401(k) plans throughout.

There are several types of distributions from 401(k) plans to consider.  Distributions before retirement age and after retirement age are the two primary categories which we’ll review below.  Another type of distribution is a loan – which will be covered in a subsequent article.

But first, we need to define retirement age.  Generally speaking, retirement age for your 401(k) plan is 59½, just the same as with an IRA.  However, if you leave employment at or after age 55, the operative age is 55.  If you have left employment before age 55, retirement age is 59½. This means that when you have reached retirement age you have access to the funds in your account without the early distribution penalty. (For government jobs with a 457 plan, retirement age is whenever you leave employment – no set age is defined. If you move your funds from the 457 plan to any other type of plan, such as an IRA or 401(k) you lose this provision and must abide by the retirement age for your new plan.)

Distributions before retirement age

When you take a distribution from your 401(k) account before you have reached retirement age (as defined above) – you will possibly owe ordinary income tax and a penalty for early distribution from the account.  This is if you take the distribution without rolling it over into some other sort of tax-deferral vehicle, such as an IRA or 401(k) plan.

If you withdraw funds or securities from your 401(k) plan and put the money into a non-deferred account (or just spend it), it is considered taxable income to you.  Ordinary income tax will apply to the pre-tax amounts distributed from your account.

The one exception: If you happen to have post-tax funds in your account – that is, if you have contributed funds that were taxable prior to your contribution to the account – when these funds are distributed there will be no tax on the distribution.  Any growth of the funds (interest received, capital gains, dividends, etc.) would be taxable, but the post-tax contributions are free from additional tax.  All other funds in your 401(k) account are taxable upon distribution.

The other exception: If the funds are rolled over into another tax-deferred account such as an IRA, another 401(k), or any other QRP, there should be no tax on this distribution.

The 10% penalty will apply to funds withdrawn prior to retirement age if one of the 72(t) exceptions does not apply. Some of these exceptions include (with limits): first-time home purchase, medical expenses, and education expenses, among other things.  See the article at this link for a complete list of 72(t) exceptions.

Distributions after retirement age

Withdrawals after retirement age are the same as withdrawals before retirement age, except for the 10% penalty.  If you are older than retirement age (defined above) you will not be subject to the 10% penalty on funds withdrawn from the account – because this is one of the 72(t) exceptions, the most common one used.

So pre-tax contributions and growth in the account will be taxed as ordinary income unless rolled over into another tax-deferred account.  Post-tax contributions to the account will be tax-free upon distribution.

Distributions including partly pre-tax and partly post-tax

If your account includes some after-tax money in addition to pre-tax money, the general rule is that any distribution from the account includes pro-rata amounts of some pre-tax and some post-tax money.  For example, if a 401(k) account contains $100,000 in total, of which $10,000 is post-tax contributions, for every dollar withdrawn from the account, 10¢ is tax-free, and 90¢ is taxable.  This is known in the industry as the “cream in the coffee” rule – as in, once you have cream (post-tax money) in your coffee (your 401(k) plan), every sip (distribution) contains some cream along with the coffee.

There are ways to separate the cream from the coffee, all controversial and subject to significant restrictions.  We’ll cover that in a later article.

Types of Rollovers Not Subject to the Once-Per-Year Rule

Photo courtesy of Paula Borowska on unsplash.com.

Photo courtesy of Paula Borowska on unsplash.com.

In a previous article we discussed the changes to the IRA One-Rollover-Per-Year rule.  There are certain types of rollovers that are not included in that restriction, detailed below.

As mentioned in the earlier article, trustee-to-trustee transfers are not considered “rollovers” by the IRS regarding this rule.  So you are allowed to make as many trustee-to-trustee transfers in a year as you like – no restrictions on these kinds of transfers at all.  This includes trustee-to-trustee transfers from or to IRAs, 401(k)s, 403(b)s, or any eligible plan.

In addition, a rollover from an IRA into a 401(k) or other Qualified Retirement Plan (QRP) is not impacted by this rule.  This means that you can roll funds out of your IRA and into your employer’s 401(k) plan with no restriction – regardless of whether or not you have already made an IRA-to-IRA rollover in the previous 12 months.

Similarly, a rollover from a 401(k) or other QRP into an IRA is also not covered by the once-per-year rule.  Just like going the other direction, you could rollover funds from your 401(k) plan into an IRA (via a non-direct transfer) and it will not count against the one-rollover-per year restriction.

Roth IRA conversions do not count toward the one-rollover-per-year rule either.  This could be a method for moving funds around if you’ve been otherwise restricted by a prior indirect or 60-day rollover.  Even though moving money from a traditional IRA (or QRP) to a Roth IRA via a conversion is technically termed a rollover, these conversions are not counted toward the once-per-year rollover restriction.

Mechanics of 401(k) Plans – Vesting

Image courtesy of vectorolie at FreeDigitalPhotos.net

Image courtesy of vectorolie at FreeDigitalPhotos.net

In this article in our series on the mechanics of 401(k) plans, we’ll be covering the concept of vesting.  As with the other articles in the series, we’ll refer specifically to 401(k) plans throughout, but most of the provisions apply to all types of Qualified Retirement Plans (QRPs), which go by many names: 401(k), 403(b), 457, etc..

Vesting refers to the process by which the employer-contributed amounts in the 401(k) plan become the unencumbered property of the employee-participant in the plan.  Vesting is based upon the tenure of the participant as an employee of the employer-sponsor of the plan.

Generally, when an employee first begins employment there is a period of time when the employer wishes to protect itself from the circumstance of the new employee’s leaving employment within a relatively short period of time.  Vesting is one way that the employer can protect itself from handing over employer-matching funds from the 401(k) plan if the employee leaves the job very soon.  Vesting can also apply to other employer-provided benefits such as a pension, profit-sharing plan, or stock purchase plan.

It is important to note that you are ALWAYS vested in the funds that you have deferred into the 401(k) plan.  Vesting refers to employer-provided benefits.

Vesting can be done in three ways: immediate, cliff, or graded.  Immediate vesting is just as the name implies – the employee is 100% vested in employer-provided amounts immediately, with no limitations.  In this case, if the employee left the company immediately after his or her first paycheck where 401(k) amounts were contributed on his or her behalf, those amounts would be available to rollover into an IRA or other QRP right away.

Cliff vesting refers to a process where a specific period of time must pass, and after that time has passed the employee is 100% vested in the employer-provided amounts.  Until that time period has passed, the employee has a zero percent claim to the employer-provided amounts in the plan.  Federal law prescribes a 3-year limit on cliff vesting schedules for QRPs – any length of time less than or equal to 3 years can be an applicable cliff vesting schedule.

Graded vesting refers to a process where a series of time periods pass, and after each of these periods of time a portion of the employer-provided amounts in the 401(k) plan becomes the property of the employee.  Gradually the employee gains 100% vesting (access) to the employer-provided amounts.  An example of a 4-year vesting schedule would provide vesting of 25% per year at the end of each of the four years.  After the end of the first year of employment, 25% of the employer-matching funds are vested.  After two years, 50%; after three years, 75%; and after the fourth year the funds are 100% vested with the employee.  Federal law puts a limit of 6 years as the maximum number of years a vesting schedule can run.

Social Security Spousal Benefits After a Divorce

Photo courtesy of danka peter on unsplash.com.

Photo courtesy of danka peter on unsplash.com.

We’ve discussed many different factors about Social Security Spousal Benefits, but what happens to Spousal Benefits after the couple has divorced?

We know that a divorcee can file for Spousal Benefits if the marriage lasted for at least 10 years – but only after a 2-year period has passed if the ex-spouse has not already filed for benefits.  The only other factors that must be in place are for the ex-spouse to be at least 62 years of age, and of course the ex must have a benefit record to calculate Spousal Benefits from.

On the other hand, if a couple is divorcing and one of the spouses (soon to be ex-spouses) has already filed for his or her own Social Security benefits, the other spouse can file for Spousal Benefits either before or after the divorce is finalized with no waiting period, as long as they were married for one year or longer.

This differs from the usual explanation of divorcee Spousal Benefits in a couple of ways: first off, if the other spouse has not already filed, there is a two year waiting period after the divorce to allow the person to file for Spousal Benefits.  Secondly, if the benefits have not already started, the marriage must have been in existence for 10 years (before the divorce) for the ex-spouse to be eligible for Spousal Benefits.

A planning point can be illustrated by the following example:  A couple, Jan and Dean, who were married for 30 years and are going through a divorce.  Dean is 66 years old, and Jan is 62.  Dean has not filed for his Social Security benefits, preferring to delay until age 70.  Jan has also not filed for benefits, however, after the divorce she feels that she may need the benefits to augment her income.

Jan could file for her own benefit either before or after the divorce, that event won’t have an impact on her own retirement benefit.  However, if she needs the Spousal Benefit in addition to her own benefit, she would have to wait until two years have passed after the divorce in order to be eligible.  The limiting factor is that Dean has not filed for his own benefit.

Now, if Dean was to file and suspend his benefit, there is no negative for him – file and suspend has no downside for him.  On the other hand, by Dean’s filing and suspending his own benefit, he has enabled Jan to file for Spousal Benefits, either before or after the divorce is finalized.  Otherwise Jan would have to wait until two years after the divorce is final to be eligible for Spousal Benefits.

It’s important to note that deemed filing would apply to Jan if Dean has filed for his benefits – meaning that if Dean files or files and suspends before Jan files for her own benefit, she is required to filed for both her own benefit and the Spousal Benefit at the same time.  This is because she is under full retirement age, and is eligible for a Spousal Benefit in addition to her own benefit, so she is deemed to have filed for both in these circumstances.

Mechanics of 401(k) Plans – Employer Contributions

Photo courtesy of Lumen Bigott on unsplash.com.

Photo courtesy of Lumen Bigott on unsplash.com.

This is the second post in a series of posts that explain the mechanics of a 401(k) plan.  As mentioned previously, there are many types of Qualified Retirement Plans (collectively called QRPs) that share common characteristics.  Some of these plans are called 401(k), 403(b), and 457.  In these articles we’ll simply refer to 401(k) plans to address common characteristics of all of these QRPs.

Employer Contributions

Many companies provide a matching contribution to the 401(k) plan – and sometimes there is a contribution made to a QRP on your behalf no matter if you have contributed your own deferred salary or not.

Most of the time these matching contributions are stated as x% of the first y% of contributions to the account.  An example would be “50% of the first 6%”, meaning if you contribute 6% of your salary to the plan, the company will match that contribution with 3% (50% of your contribution).  This matching rate is up to the company, but it must be applied without discrimination for all employee-participants in the plan.

Sometimes the company designates that your contribution must be invested solely in company stock – this is less common these days, but it still occurs.  Otherwise, once you’re vested in the plan, this matching contribution is your money. (We’ll cover vesting later.)

Matching

As mentioned previously, most often employer contributions are in the form of matching contributions – dependent upon employee-participants’ making deferrals into the program in order for the company to make a contribution to your account.

In a 50% of the first 6% match plan (as an example), if your salary is $30,000 and you defer 5% or $1,500 into the plan, your employer would match that with a $750 contribution.  As mentioned in the earlier post on saving/contributing to your 401(k) plan, this deferral could result in a tax savings of approximately $225 in these circumstances.

When you balance it out, you wind up with $2,250 in your 401(k) account and a tax bill that’s $225 lower.

Spontaneous Contributions

In some cases, the employer makes contributions to your 401(k) plan regardless of whether you defer salary into the plan.  In these cases, called Safe Harbor plans, the employer wants to ensure that there are contributions made on behalf of all employees (to encourage saving and participation) and to ensure that there is no discrimination toward higher-salaried employees.  If there were discrimination in favor of higher salaried employees the plan itself could become disqualified by the IRS and all tax benefits would be eliminated.

Mechanics of 401(k) Plans – Saving/Contributing

Image courtesy of Ppiboon at FreeDigitalPhotos.net

Image courtesy of Ppiboon at FreeDigitalPhotos.net

Many folks have a 401(k) plan or other similar Qualified Retirement Plan (QRP) available from their employer.  These plans have many names, including 403(b), 457, and other plans, but for clarity’s sake we’ll refer to them all as 401(k) plans in this article.  This sort of retirement savings plan can be very confusing if you’re unfamiliar, but it’s a relatively straightforward savings vehicle.

This is the first in a series of articles about the mechanics of your 401(k) plan – Saving/Contributing.

Saving/Contributing

You are allowed to make contributions to the 401(k) plan, primarily in the form of pre-tax salary deferrals.  You fill out a form (online most of the time these days) to designate a particular portion of your salary to be deferred into the 401(k) plan.  Then, each payday you’ll see a deduction from your paycheck showing the 401(k) plan contribution.  The deduction is before income tax withholding is applied to the paycheck, since these contributions are “pre-tax”.  However, Social Security and Medicare taxes are applied to these deferrals.

Because of this pre-tax nature of your deferrals into the 401(k) plan, putting money in the plan will reduce your income taxes in the year of the deferral.  For example, if your income is $30,000 per year and you defer 5% of your income into the plan, your reported taxable wages would be 5% less, or $28,500.  As a result, your possible tax bill could reduce from $2,553.75 to $2,328.75, a reduction of $225. (This is an example only, using 2013 tax tables.)

Once your money is deferred into the plan you will be eligible to invest those funds as you see fit (we’ll get to the investments in a later post).

The deferred funds are your money.  You earned it, just the same as your take-home pay. The only way you lose this money is by investing in a security that loses money, such as a stock that goes bankrupt.  Otherwise, no one can take this money away from you.  When money is deferred to the plan you have an increase to the balance in your 401(k) plan just the same as your checking account increases with the direct-deposit of your take-home pay.

Roth 401(k)

Depending on your company’s plan, you may have a Roth 401(k) component available to you.  The mechanics are similar to the garden-variety traditional 401(k) plan – except that your contributions are post-tax, rather than pre-tax.  So the changes to your tax mentioned above do not apply to contribution made to a Roth 401(k) plan.  Then, when you take the money out of the Roth 401(k) account at retirement (as long as you’re at least age 59 1/2 years of age) there is no tax on those withdrawals.  We’ll provide more detail on withdrawals in a later post.

If you have a Roth 401(k) plan available to you, it is simply another component of the overall 401(k) plan.  You have a choice as to whether or not your deferrals to the plan are made to the traditional 401(k) plan or the Roth 401(k) plan, and you can contribute any amount (up to the maximum) to the combination of these two plans in the tax year.

Annual Maximum Contributions

Each year the IRS provides guidance about the maximum annual contribution that can be made to a 401(k) plan.  For 2014, this maximum contribution is $17,500, and if the employee-participant is over age 50, an additional $5,500 “catch-up” contribution can be made for the tax year.  This could be as much as 100% of your annual contribution, if you wish.

If you are employed by more than one employer, this annual limit applies across the board to all plans that you might contribute to collectively (with one exception, below).  So if you have a second job where you can contribute to a 401(k) plan in addition to your primary job, you can only contribute up to $17,500 in total to all plans for 2014 (plus the $5,500 catch-up if over age 50).

Exception

Earlier, I mentioned that we were referring to all QRPs as 401(k) plans because they are much the same.  One difference comes about with annual contributions: 457 plans have the same limit as 401(k) plans, but are not subject to the “collective” limit mentioned above.  So if your employer provides both a 457 plan and a 403(b) plan, for instance, you could defer up to double the annual maximum contribution to these two plans – $35,000 (plus $11,000 if over age 50) for 2014.

Book Review: Facing the Finish–A Roadmap for Aging Parents and Adult Children

facingthefinishOne of life’s only sureties, we all will eventually come face-to-face with the end of our life.  Sometimes it comes quickly with no warning, and sometimes end of life comes more slowly, over the course of many months or years.  In either case, after life there are many things to deal with (for those that remain) – and in the cases where the final chapter of our life is a lengthy one, there are many more decisions to make and situations to deal with. Regardless of how swiftly or drawn out the event is, we can all benefit from planning out many of the inevitable decisions in advance.

This book is an excellent guide for folks who are either nearing that final transition in life (referred to by the author as Older Adults), or who are helping our parents or grandparents with this transition (referred to as Adult Children).  Most everything that you need to consider about this transition is covered here, from decisions about your personal and financial affairs, involving your family in decision-making (where appropriate), decisions about care and housing, as well as how to finance your final chapter of life.

The book was written by Sheri L. Samotin, who is a life transitions coach, National Certified Guardian, and certified Professional Daily Money Manager and the founder of LifeBridge Solutions LLC.  Ms. Samotin brings her wealth of knowledge and experience in helping Older Adults and their Adult Children deal with the challenges of aging.  With these insights Samotin provides many real life examples to illustrate her points, which help to personalize the lessons.

I believe that all persons, whether Older Adults or Adult Children, can get a great deal of benefit from this book. The author brings to the fore many salient points that you might not otherwise have considered as you face this transition, from either point of view (Older Adult or Adult Child).  It’s a relatively short read (roughly 200 pages) and is written in an easy, conversational style (not full of technical jargon!).  I will recommend this book for clients in either situation who are looking for just such a roadmap (and even if they don’t know they’re looking for such a roadmap!).