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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…

Should The CFP® Board Require Recertification?

CFP Recertification Exam (just like doctors)

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I wanted to post this article to see if any of our readers, both planners have an opinion on the question of whether you think the CFP® Board should require CFP® professionals to get recertified in order to keep the prestigious CFP® designation.

In recent years the Board has been marketing the CFP® designation as the trusted mark and gold standard when it comes to clients seeking professional financial planning. As you may or may not know there are no laws dictating who can call themselves a financial planner. In other words, anyone can say they’re a financial planner regardless of expertise, experience, ethics, or education (the Board’s 4 E’s).

To be a CERTIFIED FINANCIAL PLANNER™ requires much more rigorous work, testing and education, among others.

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…

Emergency Fund vs. Credit Card

Credit Card

During moments in our lives we are faced with bad luck or simply things that go awry and inevitably cost us money. From a car needing repairs to the water heater going out, or an unexpected doctor bill we don’t plan for these to happen, but we can in place in case they do.

As financial planners we generally recommend that our clients have emergency funds in the event that such events are going to happen. On different occasions I will get the argument that an emergency fund isn’t necessary if one has a credit card to simply pay for the unplanned expenses when they happen.

Generally, in an emergency a credit card can come in handy as one may not have quick access to cash, etc. However, the flaw with thinking that a credit card can be used in place of an emergency lies here: How do you pay off the credit card?

The point is that the emergency may go away, but the credit card debt remains and the interest compounds not only the money used but the headache of the emergency the card was used to fund. Several emergencies in a small period of time can lead to high credit card debt – which is an emergency itself; only this emergency is preventable.

One thing folks can consider is to utilize both if necessary. In a pinch a credit card can come in handy if an unexpected emergency happens out of town, or as mentioned previously you don’t have immediate access to your emergency fund. The solution lies in once you have access to your emergency fund use that money to pay off the credit card that you just used for the emergency, and work on replenishing your fund.

The Designation Everybody Should Be Aware Of

We will stick tog...

At some point in your life you have probably started a new job, applied for life insurance, started an IRA or retirement account, or opened a bank account. You may remember when filling out the paperwork that the form asked for a beneficiary – both primary and contingent. This is simply telling the account’s custodian to whom you want your account to go to should you pass away.

Your primary beneficiary is the first (hence the name primary) that receives account balance or death benefit. The contingent is who receives the account balance in the event your primary beneficiary predeceases you. When choosing beneficiaries you had the choice of allocating a certain percentage to the primary and some to the contingent if needed. You may have even had two or more primary beneficiaries that you allocated a certain percent of your account to totaling 100%

Then you may have forgotten about the whole beneficiary thing. Until now.

It’s important to review and if necessary update your beneficiary designations ion your IRAs, 401(k), 403(b), life insurance and other savings and brokerage accounts.  This is especially important if you’ve recently had a divorce, or your primary beneficiary has passed away.

In the divorce example, a couple could have gone through a nasty divorce and perhaps many years have passed and both have remarried. If they haven’t updated their beneficiary designations on their accounts and policies, guess who gets the proceeds? Yep. The ex-spouse.

Some folks think that if they have a will they can forgo naming beneficiaries as their wishes will be carried out through the will – maybe and maybe not. Also, not only is proving a will (called probate) made public, wills can also be contested by family members.

For example, a couple may have family that disagrees with their relationship. If they both have wills, those will could potentially be contested by the family. Any directives in the will allocating money to the surviving partner can be challenged. This can be virtually eliminated by the couple naming each other as beneficiaries on their life insurance and retirement accounts. Now their money passes to the surviving partner by operation of contract – and avoids the publicity of probate.

It never hurts to review your beneficiaries and if necessary update them. It only takes a few minutes to check and that few minutes can save you (and your desired beneficiaries) hours, if not years of hassle, hurt, and financial hardship.

A Quick Trick to Reduce Your Tax Liability

Considering The Tax Shelter

Now that most folks are recovering from tax time there may be some individuals that paid an excessive amount of tax to Uncle Sam and are looking for ways to reduce their tax liability for next year. This post will be short and sweet, but hopefully it will drive a few points home.

The best way to explain this is through an example. Let’s say that Mary and her husband Paul both work and file their taxes jointly. Their tax liability for 2013 was $4,000 – meaning that’s the amount of the check they wrote to the IRS. Needless to say, they are both looking for a potential way to reduce that liability – at least in the here and now. In this case, their marginal tax rate is 25%.

The quick trick in this example is to take their tax rate which is 25% and divide it into their tax liability of $4,000. In this case it turns out to be $16,000. This magic number of $16,000 is what Mary or Paul or both of them combined could contribute to their pre-tax retirement plan such as a 401(k), 403(b), 457, etc. All else being equal, this significantly reduces their tax liability for 2014. The reason why is that the money deferred to their retirement accounts is taken from their paychecks before taxes are taken out, thus they have less money to take home that’s subject to taxation. And in this case – they’re paying themselves first!

Granted, they will eventually have to eventually pay tax on the amounts in their retirement plans, but what they are doing now is reducing their tax liability in the present, and paying for it later. This may work out for the both of them as their tax rate in the future may be lower than their current 25%. It could also work against them if their tax liability happens to be higher when they start taking money from their accounts.

This situation may apply to some folks reading this article. If it does and you have question feel free to contact us, or any competent financial professional.

Take Dave’s Advice With a Grain of Salt

Image courtesy of Stuart Miles at

Image courtesy of Stuart Miles at

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.

The Power of Endorsements

A White gold wedding ring and a single diamond...

Whether you rent or own your home chances are you have (or should consider having) renter’s or homeowner’s insurance. Generally these insurances cover you in the event of being liable for damages or if you suffer a loss of your own due to a fire, tornado, hurricane, etc.

What many polices do not cover or provide very limited coverage on is specific items such as jewelry, antiques, coins, firearms, etc. Generally if there is coverage for these items it’s for an aggregate amount not to exceed a certain dollar limit – such as $1,000 for the total amount lost.

For example, Herb has an extensive coin collection worth $50,000 and his wife Peaches has an engagement ring worth $10,000. Under their normal home policy, if there was a theft, fire or tornado causing a total loss of their coins and ring, they may only get up $2,000 (assuming the aggregate coverage amount was $1,000 respectively). This puts them at a $58,000 loss.

Both Peaches and Herb could have prevented this by adding an endorsement to their home policy. Think of an endorsement as an “insurance policy within the main policy”. Essentially an endorsement specifically covers an article of personal property that is either excluded or not fully covered in the main policy. With an endorsement, the owner can choose their own deductible for the loss and coverage is much more inclusive. This means that if the home policy deductible is $500, the endorsement can have a deductible for, say, Peaches’ ring for $100. So in this case, their loss would only be the deductible on the endorsement – a considerably smaller sum.

Additionally, many endorsements will cover mysterious disappearance. This means that should Peaches lose her ring washing dishes, it’s likely covered with the endorsement, something the home policy wouldn’t. Also, an endorsement supersedes and conflicting terminology in the main policy.

Generally, endorsements are an inexpensive way to broaden coverage under an existing policy. Should you have an extensive collection or an item of considerable value an endorsement may be worth considering.

File Now. Suspend Later.

Photo courtesy of Lacey Raper on

Photo courtesy of Lacey Raper on

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

Photo courtesy of Mario Calvo on

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.

New Advisor?

"Trust Me" and "The Woodman's D...

This article is geared mainly toward advisors and planners new to the business or considering changing careers to become a financial advisor or planner; but it can also be useful to folks considering working with an advisor.

As you start your new vocation it’s important to know what vocation you are actually in. What I mean by this is don’t be fooled by your future manager or company in to thinking that your job title is what you’ll be doing. For example, your job title might be financial advisor, insurance advisor, financial consultant, etc. You need to consider what it is you’re doing. If your main job (and the main method you get paid) is by selling a product, then your primary job title is salesperson, not financial advisor. This isn’t necessarily a bad thing (unless you don’t like doing it) but it’s important to understand what you’re really doing.

Your main job may be to gather as many client assets as you can – in which case you’re not an advisor, but an asset gatherer. I can remember early in my career interviewing with a company that had all these fancy titles, offices, and industry jargon but when we got down to brass tacks, my main job was going to be hunting and gathering assets. Even though this wasn’t for me, it doesn’t mean it’s wrong. You simply need to be aware of what it is you’re doing.

Granted, we are all in sales – selling folks on our products, ideas, way of thinking (my daughters are extraordinary salespeople). Dan Pink’s book To Sell is Human talks about this in great detail.

Next, consider the vocation you want. In other words, picture yourself in 5, 10, even 20 years in the future. What type of business do you want to be involved in? Do you want to be in management, sales, running your own company, or working for a firm? The good news about this is you can start planning early and start doing the things you need to do today, to get you to your goals in the future.

Also consider the company you will work for. How will you be paid? Will you have quotas? What type of contract will you have? Contracts come in all shapes and sizes but mainly you want to see what you can and can’t do. Some companies prohibit you from working in the best interest of your clients. This means you have to put the company first and your clients second. It may also mean you cannot attain certain degrees and designations that require you to work in a fiduciary relationship with your clients. Put yourself in your clients’ shoes. If you were the client is there any reason you wouldn’t want the advisor acting in your best interest? A few hundred dollars to have an attorney review and interpret your contract may be priceless.

Additionally, consider how the company you’re going to work for acquires its clients. For some this means cold calling, direct mail, going after your friends and family and even going door to door in the neighborhood. Most of these strategies (if you can call them that) are frivolous at best and what business is gained is quickly lost or relationships ruined. Again, put yourself in your prospective clients’ shoes. Would you invest your hard-earned and carefully incubating nest egg with someone who called you out of the blue or rang your doorbell without an appointment? (Note to readers: generally if this happens to you the advisor is brand spanking new). If you want to keep cold-calling, and door knocking, maintain the status quo and stop reading here.

Still reading? Good!

So what steps can you take given that you’re new and have to start somewhere?

  1. Never stop learning. Continue to educate yourself through books (not sales books, but financial/finance books). Take college classes in financial planning, finance, tax, etc. Earn designations like the CFP®, CFA® or other designations that are difficult to achieve. Consider a degree in financial planning. Learning can make up for months, if not years of pounding the pavement and having a phone glued to your ear. It’s also much more productive and effective.
  1. Talk with others in the profession (aside from the person interviewing you or company recruiting you). See what experiences they’ve had. What do they enjoy? What mistakes did they learn from? What are they currently doing? What designations do they have? How do they get paid?
  1. Consider working another job. What? Yes, you read that correctly. Having another income to support you and or your family will make your decision on which company to work for or start on your own less stressful and can make the small or non-existent paychecks easier to deal with starting out. It will also help you avoid the temptation to not act in a client’s best interest because you need the money. Many highly successful financial planning professionals have other jobs as consultants, educators, etc.
  1. Picture yourself in the future. What are you doing? Who are your clients? How are you acquiring them? What designations do you have? Are you happy? Start doing those things today.
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Investment Allocation in Your 401(k) Plan

Photo courtesy of Jacob Aguilar-Friend on

Photo courtesy of Jacob Aguilar-Friend on

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

Image courtesy of Stuart Miles at

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

Photo courtesy of Sonja Langford on

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.

Book Review – Entrepreneurial Finance

9780071825399_p0_v3_s260x420This book is a fantastic introduction to any would-be or current entrepreneur looking to understand the numbers and money behind what it takes to succeed. Steven Rogers approaches the subject of entrepreneurial finance in a way that makes sense to the reader and allows then to understand how the finance concepts work for and potentially against the entrepreneur. Mr. Rogers has taught at the Northwestern Kellogg School and is currently a senior lecturer at Harvard University.

Pulling from an extraordinary amount of personal experience Mr. Rogers guides the reader through reading and interpreting different financial statements as well as gives real life examples of companies, personal experience and the experience of a former student considering changing jobs and what the cost analysis of the change would be.

Not surprisingly, Mr. Rogers’ concepts can be applied to personal finance – a plus for anyone who reads the book. As some of our readers know I teach finance classes and will be using this book to augment the lessons I deliver to students.

It’s easy to read and straight to the point. Mr. Rogers wastes no time in telling it like it is and how things are and what to expect as readers journey into the world of starting, acquiring and running businesses – which is what many budding entrepreneurs need, but seldom get except from personal trials and tribulations.

Are Target Date Funds Off Target?


On Target

It seems that an easy fix for saving for retirement for many folks is to simply choose a target date fund. Generally how target date funds work is a fund company will have a set of different funds for an investor to pick from depending on a best guess estimate of when the investor wants to retire.

For example, an investor who’s 30 years old and wants to retire at age 65 may choose a 2045 fund or a 2050 fund. In this example since the investor is age 30 in the year 2014, 30 more years gets him to 2044. Most target date funds are dated in 5 year increments. If the investor was age 60 and wanting to retire at age 65, then he may choose a 2020 fund to correspond to his timeline.

Generally, the goal of target date funds is to follow a glide path that allocates the investor’s assets more conservatively as the investor approaches retirement. Then at the target retirement year, remain fixed in a more conservative allocation. The problem lies in the fact that of all the target dates funds out there, there is little conformity among glide paths – that is, different target date funds from different companies may have the same target year to retire, but may have significantly different asset allocations.

In addition, recent research has shown that target date funds’ approach in moving to more conservative assets such as bonds when investors are nearing retirement may be counterproductive. Since as an investor’s portfolio is at its largest and can therefore take advantage of compounding more efficiently, moving to conservative assets can actually hinder performance in the years right before the investor retires.

So what does an investor do? First, determine what options you have available from different target date funds. Some are better than others – especially when it comes to expenses. Next, research the fund you plan on investing in. You can also find a competent financial planner that can do the leg work for you.

Finally, determine if a target date fund is right for you. For many folks it’s a simple way to start saving for retirement in their 401(k), as well as in many company plans it’s the default option if an investor doesn’t pick a fund outright. You don’t have to have a target date fund in order to retire with a decent nest egg. There are many competent planners that can have an excellent discussion with you to determine which funds and which allocations are appropriate for you.

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

Photo courtesy of Paula Borowska on

Photo courtesy of Paula Borowska on

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.