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Early Withdrawal of an IRA or 401k – Medical Expenses

medical expensesThere are several ways to get at your IRA funds before age 59½ without having to pay the 10% penalty. In this post we’ll cover the Medical Expenses which allow for a penalty-free distribution.

There are three different Medical reasons that can be used to qualify for an early withdrawal: high unreimbursed medical expenses, paying the cost of medical insurance, and disability. Disability and high unreimbursed medical expenses are also applicable reasons allowing for early withdrawal of 401k funds without penalty. We’ll cover each of these topics separately below.

High Unreimbursed Medical Expenses

If you are faced with high medical expenses for yourself, your spouse, or a qualified dependent, you may be eligible to withdraw some funds from your IRA or 401k penalty-free to pay for those expenses. The amount that you can withdraw is limited to the actual amount of the medical expenses you paid during the calendar year, minus 10% (7.5% if you or your spouse is age 65 or older during 2016) of your Adjusted Gross Income, or AGI.  Your AGI is the amount on your Form 1040, line 38, or Form 1040A line 22.

You can only count medical expenses that are otherwise deductible as medical expenses on Schedule A of Form 1040 – but, you don’t have to itemize your deductions in order to take advantage of this exception to the 10% penalty.

For this exception to apply to withdrawals from a 401k, often you are also required to have left the employer.

Medical Insurance Premiums

You may be able to take a penalty-free distribution from your IRA (but not your 401k) to help pay for medical insurance premiums for yourself, your spouse, and your dependents, as long as the amount you withdraw does not exceed the amount you actually paid for medical insurance premiums, and all of the following apply:

  • You lost your job.
  • You received unemployment compensation paid under any federal or state law for 12 consecutive weeks because you lost your job.
  • You receive the distributions during either the year you received the unemployment compensation or the following year.
  • You receive the distributions no later than 60 days after you have been reemployed.

There is no income limitation on this provision.

Disability

If you become disabled prior to age 59½, distributions in any amount from your IRA or 401k are not subject to the 10% penalty. Your disability must be considered of a long duration (greater than one year) or expected to result in death. The disability (physical or mental) must be determined by a physician.

Keep in mind, as we mentioned previously, these avenues provide a way to withdraw funds from your IRA penalty-free, but not tax-free. You will still be liable for ordinary income tax on any distributions that you take from your deductible IRA or 401k. In addition, you will need to check with your 401k administrator to find out about the rules and limitations that are specific to your particular plan.

5 Things to Check on Your Homeowners Policy

2016-05-22-17_19_35-1024x576Just because an individual has a homeowners policy or renters insurance doesn’t mean that they are covered for everything. Sometimes individuals assume that because they have insurance, they don’t need to worry about checking into specifics. However, without understanding what may or may not be covered, in the event of a claim, it’s better to know beforehand rather than adding insult to injury and finding out there wasn’t coverage.

  1. Flood coverage. In most cases this is excluded on a homeowners policy. Coverage can be obtained separately through a broker found here. Additionally, many policies exclude water or sewer back-up. Individuals concerned about water/sewer back-up can generally get an endorsement for this coverage added to their policy.
  1. Trampolines and pools. Individuals that have a trampoline or a pool (or recently acquired these items) should notify their insurance carrier immediately. Some carriers will specifically exclude any liability claims resulting from injury or death related to pools or trampolines. Other carriers may deny a claim if they weren’t notified the items existed. Carriers that do allow them generally have rules that include proper fencing, locking gates and safety apparatuses to prevent or reduce the risk of injury or death. Parents should consider whom they let swim or jump. Neighbors can be great friends until one of their kids is hurt. Then all bets are off.
  1. Jewelry, antiques, collections. Generally, most insurance policies provide limited coverage for these items. The good news is that for a few dollars more, these items can be endorsed and have their own coverage amounts and deductibles. If an individual owns expensive jewelry, has firearms, coin collections, or expensive musical instruments (say, a grand piano in the living room) chances are these need to be endorsed on your homeowners policy.
  1. Insurance is for catastrophic loss. If an individual has a low deductible on their home or renters policy they should consider raising it. This is especially true if they rarely, if ever make claims. Consider a deductible of at least $2,500 and up to $5,000. This money should be set aside in the emergency fund.
  1. Many homeowners add to their home, upgrade kitchens, finish basements or make other home improvements. It’s important to notify the insurance company of these changes. Yes, the premium may increase, but in the event of loss, the homeowner will want replacement coverage for the upgraded material, not what was replaced. This is also true if a policyholder starts a business run from the home. Some carriers provide coverage for home businesses with property and liability extending from the personal policy to the business. However, when in doubt, ask your carrier. They will let an individual know if their home policy covers them, or if they need separate business insurance.

Early Withdrawal of an IRA – First Time Homebuyer

Early stage of a developing white-capped mushroom 2When you have money in an IRA, you are allowed to begin taking withdrawals once you’ve reached age 59½. But sometimes you’d like to take your money out earlier… and you’ve probably already discovered that there is a 10% penalty for taking funds out of your IRA early, right? So – is there a way to avoid that penalty? Perhaps as a first time homebuyer.

There are several ways to withdraw IRA funds without penalty, as a matter of fact. There are several sections of the Internal Revenue Code that deal with these early distributions – including 72(t) which includes the first time homebuyer exception. We’ll explain the first time homebuyer exception in this post.

First Time Homebuyer

If you are buying, building, or re-building your first home (defined later), you are allowed to take a distribution of up to $10,000 (or $20,000 for a married couple) from your IRA to fund a portion of your costs, without paying the 10% penalty. There are a few restrictions, though – here is the official wording from the IRS:

  1. It must be used to pay qualified acquisition costs (defined later) before the close of the 120th day after the day you received it.
  2. It must be used to pay qualified acquisition costs for the main home of a first time homebuyer (defined later) who is any of the following.
    1. Yourself.
    2. Your spouse.
    3. Your or your spouse’s child.
    4. Your or your spouse’s grandchild.
    5. Your or your spouse’s parent or other ancestor.
  3. When added to all your prior qualified first-time homebuyer distributions, if any, total qualifying distributions cannot be more than $10,000.

If both you and your spouse are first time homebuyers (defined later), each of you can receive distributions up to $10,000 for a first home without having to pay the 10% additional tax.

Qualified acquisition costs. Qualified acquisition costs include the following items.

  • Costs of buying, building, or rebuilding a home.
  • Any usual or reasonable settlement, financing, or other closing costs.
First time homebuyer. Generally, you are a first time homebuyer if you had no present interest in a main home during the 2-year period ending on the date of acquisition of the home which the distribution is being used to buy, build, or rebuild. NOTE: If you are married, your spouse must also meet this no-ownership requirement. This provision might cause you to re-think the timing of a purchase of a home if you are about to get married and your soon-to-be spouse has had ownership within the past 2 years.

Date of acquisition. The date of acquisition is the date that:

  • You enter into a binding contract to buy the main home for which the distribution is being used, or
  • The building or rebuilding of the main home for which the distribution is being used begins.

The keys here are to make sure that you qualify as a first time homebuyer (by the IRS’ definition above), that you use the funds in time (before 120 days has passed since the distribution), and that you haven’t taken this option previously (or previous distributions were less than $10,000). For many folks this can be very helpful when buying a home.

Another important point to note is that although you do not have to pay the 10% penalty on the distribution, you WILL be required to pay ordinary income tax on any money taken from your IRA. This can be a surprise to some folks who weren’t expecting it. However, if you have post-tax (non-deductible) contributions in your IRA, these will be non-taxable, but pro rata in this distribution.

Sometimes it’s Not a Good Fit

puzzle-piecesWhether you’re the prospective client working with a financial planner or the planner working with a prospective client, sometimes for whatever reason the relationship doesn’t make sense. The purpose of this post is to help prospective clients and planners in deciding whether or not a client/planner relationship is worth pursuing or maintaining.

First, let me start from the perspective of the client looking for a financial planner. Initially, as the client you’re going to want to look for some of the minimums every financial planner should be doing. The first is the CFP® designation. This means that the planner has at least a minimal amount of financial planning education and had passed a rigorous exam. Next, make sure the planner is a fiduciary. This is not optional. This means that the planner is legally required to act in your best interests always. Additionally, make sure they are fee-only. This means they are compensated only by you the client, not commissions from product sales.

Once those minimums are met, find out if you like them. Personalities sometimes clash and life’s too short to work with a planner you don’t like. In addition, find out what value you’ll be receiving and if you’re currently the planner’s client, what value (or lack thereof) you are receiving. A higher price doesn’t necessarily equate to a good value and vice versa.

If you’re the planner, it’s important to interview your prospective clients as well to see if they will be a good fit. Sometimes, you have to assess your current clientele to see if the relationship still makes sense.

For example, if a prospective client asks a lot of questions about your background, history, beliefs, and firm in general, this is a good thing. They are doing their due diligence. However, pay attention to how they’re asking. If the tone is in an aggressive or condescending manner, they may act this way after they’ve become clients.

In another example, a current client may have come aboard initially agreeing with your firm’s investment approach and philosophy. Let’s say that their portfolio allocation is set up in a way to achieve long term rates of return. Initially, the client may have agreed with this. But, after just a few short years they may be constantly wondering why they haven’t experienced returns like their friends or relatives or the Dow. These folks may need some reassurance or education that their holdings are for the long run. However, if they just aren’t happy with their returns despite the short term thinking and your attempt to educate, they may be better off elsewhere.

Another point to consider is if you work on commissions or fee-only. It becomes much easier to work with people you like when you know your compensation doesn’t depend on selling them something, even if they’re not a good fit.

Lastly, whether current or prospective client, no one has the right to belittle you or be vulgar towards you. Show them the door immediately. Life’s too short.

The hope is that occurrences like these are very few and far between. But it’s good to know that should they arise, clients and advisors have a choice.

A Social Security Hat Trick for $24,000

hat trickDid you know that even with the new Social Security rules, it’s possible to work out a strategy to maximize your Social Security benefits? There are options still available (if you were born before 1954) that can provide you with some vestiges of the old “get some now, get more later” option.

Since the restricted application option is still open for those born on or before January 1, 1954, a married couple can still work this strategy to their advantage to maximize benefits.

Here’s how it works:

Jessica and Robert are both age 66 this year. Robert’s Primary Insurance Amount, or PIA, is $1,000 per month. This is the amount of benefits he’d receive if he files for his Social Security benefit upon reaching age 66. Jessica’s PIA is $2,600 per month.

Robert files for his benefit when he turns 66 in June. Jessica reaches age 66 on her birthday in August. At that time, since Robert has filed for his Social Security benefit, Jessica is eligible to file a restricted application for spousal benefits, receiving $500 per month, 50% of Robert’s PIA. So Robert and Jessica are receiving a total of $1,500 per month at this point, and they continue to do so for the next four years.

When Jessica reaches age 70, her Social Security benefit has maximized due to the earned delay credits. When she files, she’s eligible for $3,432 per month, a 32% increase from her PIA. At the same time, now that Jessica has filed, Robert is eligible for a spousal benefit based on Jessica’s record. This means that Robert can file for the spousal “excess” benefit – which is calculated as:

50% of Jessica’s PIA ($1,300) minus Robert’s PIA ($1,000) = $300

This $300 is then added to Robert’s current benefit, and he now can receive a monthly benefit of $1,300. So together, Robert and Jessica will now receive a total of $4,732 per month.

Regardless of which of the two dies first, the smaller benefit (Robert’s) will cease, and the larger benefit (Jessica’s) will continue. So the benefit that was maximized by delaying will be paid out for the longest period of time – to the death of the second-to-die of the couple.

While maximizing the larger benefit, Robert and Jessica were able to receive four years’ worth of benefits at $1,500 per month. Then upon maximizing Jessica’s benefit, Robert received a step-up for spousal excess benefits. This strategy results in $24,000 more benefits for the couple.

5 Secrets About Your 401k Plan

401k plan secretMany folks have a 401k plan – it’s the most common sort of retirement savings vehicle that employers offer these days. But there are things about your 401k plan that you probably don’t know – and these secrets can be important to know!

The 401k plan is, for many, the only retirement savings you’ll have when you reach your golden years. Used properly, with steady contributions over time, a 401k plan can generate a much-needed addition to your Social Security benefits. But you have to make contributions to the 401k plan for it to work, and invest those contributions wisely.

So how much do you know about your 401k plan? Below are 5 secrets that you probably don’t know about your 401k plan. Check with your 401k plan administrator to see if these provisions are available – some plans are more restrictive than others.

Secrets You Don’t Know About Your 401k Plan

1. You can take a loan. You may not realize it, but you have a source of ready cash available for any purpose you need, in the form of a 401k loan. Of course, once you take the money out you have to pay it back, which can make your already small take-home pay even smaller. But if you have no other source for cash and a true crisis is ahead of you, a 401k loan could be the answer. For more details on 401k loans, see the article How to Take a Loan from Your 401k, and check with your 401k plan administrator for information.

2. You may have access to the money in your plan before you retire. Not all 401k plans allow this, but many do: once you’ve reached age 59½ (for some plans it’s 55), you may be eligible to take an “in-service distribution” from the plan while you’re still employed. This can be a way to make up for a spouse who has retired before you, and who is waiting for other retirement funds such as Social Security or a pension. As mentioned before, check with your 401k plan administrator to see if this option is available to you.

3. You can start with very small contributions, and grow the amount over time. Many times, especially early in our careers, the thought of trimming our already meager take-home pay with a contribution to a 401k plan is scary. The problem is that you’re faced with peers and bosses who tell you things like “If you don’t put in up to the company match amount, you’re throwing money away!” – which doesn’t help if you can’t hardly afford to set aside even 1%.

There is no rule that says you must put aside the amount to take advantage of the company match (often 6% or so) – you can start with a small amount, such as 1%, and see how it goes. My experience with folks who’ve done this is that they learn to budget around the smaller paycheck, and they’re happy they’ve done so. Then when you have an increase to your pay, figure out how much your increase is and put aside a portion of that in additional 401k plan contributions. Over time, you’ll build your contributions up to a point where you’re taking full advantage of the employer match, and then some!

4. You can stop and restart your contributions. Bad things happen to good people all the time. Unexpected expenses arise that we’re not prepared to deal with (hence the name “unexpected”!) and so it sure would be handy to put the 401k plan contributions on pause for a while. Most 401k plans will allow you to stop your contributions (or simply reduce the amount), although some may limit the frequency of making such changes. Just don’t get too comfy with the reduced or eliminated contribution level – set a time for yourself to bump it back up so that you keep putting money away for retirement!

5. Making contributions is very smart – in several ways. As mentioned above, your 401k plan may be your only source of money in retirement (besides Social Security) – and making contributions is the only way to build up this account. This by itself is smart, but there are xx other really smart things about making 401k plan contributions:

Employer Match – when you make a contribution to your 401k plan, many times your employer will match a portion of your contribution. If you don’t contribute, the employer won’t either, in most cases. So if you’re making $30,000 and your employer will match 50¢ for every dollar up to 5% for example, if you contribute the full 5% you’ll have credit for $2,250 in your account. That’s 7.5% – which only cost you 5%. Or $2,250 in your account that only cost you $1,500. Pretty sweet, right?

Payroll Deduction – making contributions to your 401k plan via payroll deduction is, for most folks, a relatively painless way to save money. If you don’t see the money in your checking account, you won’t miss it. And the tax treatment of 401k plan contributions helps out more (see the next point).

Tax Treatment – since traditional 401k plan contributions are taken out before income tax, the amount of reduction to your paycheck will be less than the amount you’re putting into the 401k plan. Think about that for a moment, because it’s a bit confusing…

What happens is when you make a contribution to the 401k plan, that money isn’t counted toward income taxes. So as a result, fewer dollars are withheld from your remaining paycheck to cover the tax bite. I have a good example over in the article How a 401(k) Contribution Affects Your Paycheck that works through the numbers for you.

Making contributions to your 401k plan is a smart move for you, tax-wise and savings-wise. Check with your 401k plan administrator to see what provisions are available to you.

Canceled debt and your taxes

canceled debtWhen you have a canceled debt, you may think you’re done with that old nuisance. Unfortunately, the IRS sees it otherwise. Technically, since you owed money beforehand and now you don’t, your financial situation is increased by the amount of canceled debt. When you have an increase to your financial situation, this is known as income. And income, as you know, is quite often taxable – but sometimes there are ways to exclude the canceled debt from your income for tax purposes.

The IRS recently issued a Tax Tip (Tax Tip 2016-30) which details some important information that you need to know about canceled debt, including HAMP modifications and other items. The actual text of the Tip follows:

Top 10 Tax Tips about Debt Cancellation

If your lender cancels part or all of your debt, it is usually considered income and you normally must pay tax on that amount. However, the law allows an exclusion that may apply to homeowners who had their mortgage debt canceled. Here are 10 tips about debt cancellation:

1. Main Home. If the canceled debt was a loan on your main home, you may be able to exclude the canceled amount from your income. You must have used the loan to buy, build or substantially improve your main home to qualify. Your main home must also secure the mortgage.

2. Loan Modification. If your lender canceled part of your mortgage through a loan modification or ‘workout,’ you may be able to exclude that amount from your income. You may also be able to exclude debt discharged as part of the Home Affordable Modification Program, or HAMP. The exclusion may also apply to the amount of debt canceled in a foreclosure.

3. Refinanced Mortgage. The exclusion may apply to amounts canceled on a refinanced mortgage. This applies only if you used proceeds from the refinancing to buy, build or substantially improve your main home and only up to the amount of the old mortgage principal just before refinancing. Amounts used for other purposes do not qualify.

4. Other Canceled Debt. Other types of canceled debt such as second homes, rental and business property, credit card debt or car loans do not qualify for this special exclusion. On the other hand, there are other rules that may allow those types of canceled debts to be nontaxable.

5. Form 1099-C. If your lender reduced or canceled at least $600 of your debt, you should receive Form 1099-C, Cancellation of Debt, by Feb. 1. This form shows the amount of canceled debt and other information.

6. Form 982. If you qualify, report the excluded debt on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. File the form with your federal income tax return.

7. IRS.gov Tool. Use the Interactive Tax Assistant tool on IRS.gov to find out if your canceled mortgage debt is taxable.

8. Exclusion Extended. The law that authorized the exclusion of canceled debt from income was extended through Dec. 31, 2016.

9. IRS Free File. IRS e-file is fastest, safest and easiest way to file. You can use IRS Free File to e-file your tax return for free. If you earned $62,000 or less, you can use brand name tax software. The software does the math and completes the right forms for you. If you earned more than $62,000, use Free File Fillable Forms. This option uses electronic versions of IRS paper forms. It is best for people who are used to doing their own taxes. Free File is available only on IRS.gov/freefile.

10. More Information. For more on this topic see Publication 4681, Canceled Debts, Foreclosures, Repossessions and Abandonments.

Each and every taxpayer has a set of fundamental rights they should be aware of when dealing with the IRS. These are your Taxpayer Bill of Rights. Explore your rights and our obligations to protect them on IRS.gov.

Additional IRS Resources:

Information on 457(b) Plans

Bees 003

457 bees – photo by sraskie

The 457(b) plan, sometimes known as a deferred compensation plan is a retirement plan that is generally set up by states, municipalities, colleges and universities for their employees. These plans have some similarities to their 401(k) and 403(b) counterparts, but they also have some differences that individuals with access to these plans may find advantageous.

First, let’s look at the similarities. The 457(b) allows the same deferral limits as a 401(k) or 403(b). These limits for 2016 are $18,000 annually for those under age 50. For those age 50 and over, the deferral limit is $18,000 plus an additional $6,000 catch-up for a total of $24,000 annually. 457(b) plans may allow for pre-tax or Roth contributions. Individuals can choose among a variety of funds that the plan offers. At age 70 ½ the plans will require RMDs (unless still employed). At retirement or separation from service, individuals are generally allowed to roll the money from their 457(b) to a traditional or Roth IRA. For a simple rollover chart from the IRS, click here.

Now let’s look at some of the differences. Unlike their 401(k) and 403(b) counterparts, 457(b) plans allow access to the individual’s money, without penalty, at any age, as long as the individual is separated from service. For example, if an individual who worked for a university for 10 years and saved to a 457(b) plan then retired at age 45, they would have access to their 457(b) plan money without incurring the 10% early withdrawal penalty. Taxes may be owed depending on whether contributions were made pre-tax or Roth. Additionally, in-service distributions are generally stricter in 457(b) plans.

One of the major differences with 457(b) plans is that they bypass the aggregation rules that apply to 401(k)s and 403(b)s. This means that individuals with both a 401(k) and a 403(b) are still limited to contributing a total of $18,000 or $24,000 (if age 50 or older) combined for both plans. An individual in this situation could elect to put the maximum in the 401(k) but then could not contribute to the 403(b). Or, they could contribute to both, but could not exceed their maximum based on age.

If an individual has both a 401(k) and 457(b), or a 403(b) and 457(b) they are allowed to contribute the maximum employee deferral to each plan. This means that someone aged 50 or older could contribute a maximum of $24,000 to each plan for a total of $48,000 – annually.

These are some of similarities and differences the 457(b) plan has compared to other retirement plans. If you find that you work for a state, municipality, or are a state university or college employee and would like more information on your 457(b) plan, don’t hesitate to reach out to us.

The Madoff Scam: What Can We Learn?

scandalNote: This is a re-publish of an article from early 2009 – but the lessons are still very useful in today’s world.

You’d have to be living under a rock to not know about the scandal of Bernie Madoff’s firm – wherein the supposedly legitimate Madoff bilked some of the most sophisticated investors in the world out of something like $50 billion. The Ponzi scheme has been around forever, for the very fact that it works – much to the chagrin of those caught in its web.

The bright spot for all of us (as long as you weren’t caught in the Madoff scheme) is that the losses we’ve all seen in the the stock market pale in comparison to the losses by Madoff investers. Plus, we have the opportunity to make it back (eventually). These folks lost literally everything invested there, in some cases entire life savings. The vexing part is that many of those folks should have known better. Included in the ranks of people who lost money with Madoff were big banks, Wall Street economists, and, surprisingly, Stephen Greenspan, an emeritus psychology professor who just published a book titled Annals of Gullibility: Why We Get Duped and How to Avoid It.

So How Did This Happen? The way folks were fooled into believing this scheme is that Madoff had a reputation as a forthright and above-board individual. Why, he had once been the chairman of the Nasdaq stock exchange! Most of the large institutions victimized had personal relationships with Madoff and his marketing team, in part owing to the scammer’s earlier position on Wall Street. It is this kind of personal relationship that evokes trust and, in the wrong kind of individual, exploitation of that trust.

But the real enticement came from the consistency of the returns – not earth-shattering in scope, these were relatively modest returns of approximately 1% a month. Considered one month at a time, that’s pretty minimal, but even the average investor should have begun to ask questions when that return continued through up markets and down, with nary a change. Had Madoff offered 10% per month, he wouldn’t have even gotten off the ground, but with this smaller return folks came in by the busload, checkbooks in hand.

And lastly, he came across as an independently-wealthy individual. What motive would someone of his means have for stealing even a dime from someone else? As it turns out, he had every motive in the world, and appearances were quite deceiving.

Lesson #1 from Madoff: If it looks too good to be true, it probably is too good to be true.

Lesson #2 from Madoff: No one can deliver a 1% return per month, every month, in up markets and down. It just doesn’t happen.

What Else Can We Learn? One of the easiest ways to keep something like this from happening is to keep your investing simple. It seems that when complex investment activity is added to an investor’s portfolio, bad things can begin to happen. By complexity I mean getting involved in frequent trading, playing with options, shorting positions, fooling with derivatives, and things along those lines. These are the sorts of investments at the root of today’s financial crisis. While the products in question (mortgage derivatives) are not new to the scene, the history of these products was shaky at best even before September of last year – and we saw what happens when the “perfect storm” of risks comes together. With little forewarning, the entire house of cards comes falling down.

When asked his investment strategy, Madoff touted a complex “split-strike conversion” methodology. That was all the explanation given, and all that the investors (apparently) required. Whatever he was doing seemed to be working, and that was fine with anyone who cared to wonder. It’s unknown if Madoff ever invested a single dollar, or if he just churned the new money back out the door to the earlier investors, in the classic Ponzi style.

It is a common belief that there is a group of folks (the “smart money”) who can beat the market all the time. It’s my opinion that no such group or individual exists. Just look around you: if there was any “smart money” around, you’d have seen those companies or mutual funds faring well during the meltdown last quarter. Unfortunately there is no crystal ball – and given the firehose of information available to us these days, very little can escape notice.

This is not to say that no one ever beats the stock market averages. On the contrary, there are some mutual fund managers every year who beat the average, and some do it consistently (although not many). As I have mentioned on these pages in the past, less than 3% of all fund choices in a particular category will beat the index for an extended period. With odds like that, why not stick with the simple, tried and true index strategy?

Lesson #3 from Madoff: Keep it simple. Understand your investments, and why they make money.

In addition, Madoff acted not only as advisor, but also as brokerage for his client-victims. In other words, when making an investment, clients would just hand over the money to Madoff, rather than a third-party brokerage. With everything under one roof, Madoff was free to do whatever he wanted (and he did) with no checks and balances.

Lesson #4 from Madoff: Know where your money is going, and check on it regularly. Utilize a third-party between you and your advisor so that you can independently verify that your money is invested as you desire.

It’s a terrible thing that the folks who trusted Madoff have nothing to show for their lifetime of investing. Knowing what we know today, he probably still would have suckered in quite a few folks. But if we pay close attention to the lessons that we can learn from this scam, hopefully you and I will avoid being pulled in to the next scheme like this that comes along.

A Note for New Advisors

Businessman juggling fruit

Businessman juggling fruit

This post is for an advisor just starting out in their career. Their work could range from working for a large broker-dealer, to a small financial planning firm with a few employees. The main point of this post is to give the advisor reading it some hope and inspiration. Having had experience working for both a large broker-dealer and a small firm (here at BFP) my hope is to give some advice thoughts as the advisor shapes their career.

  1. First, you are in one of the greatest positions in your career. You have the choice of determining how you want your career path to look. Determine the path and what type of financial professional you want to be moving forward.
  1. Identify if you are a hunter or a farmer. If you decide to be a hunter, you will spend the rest of your career “going for the kill”. This means you will find yourself going after new clients almost always and it will likely be a byproduct of how you’re paid – on commission and likely with quotas. Often, clients don’t appreciate being “prey”. If you’re a farmer, you’ll spend a lot of time cultivating and nurturing relationships. The income may seem low at first (more on this in a bit) but after time, your relationships will bear fruit and your income will grow.
  1. If you take care of your clients, the money will follow. It can be difficult when we are so prone to short-term thinking, but giving up an immediate “sure thing” transaction for the benefit of the client will reap you huge rewards – both professionally and financially. When your clients see you care about them, and not your bottom line (or the company’s) they will trust you more and more, and trust you with their referrals. And by the way, don’t ask for referrals. If you’ve done your job, the referrals will come.
  1. Keep educating yourself. I’m not talking about the required CE that your licensing requires. I’m talking about taking continuing education because you want to learn. Think of it this way. Would you want to work with the person who only did CE at the 11th hour or the professional who took CE because he wanted to learn regardless of requirements? At a minimum, study and earn the CFP® designation. From there, pursue other designations such as the ChFC®, CLU®, etc.
  1. Are you a generalist or specialist? Some advisors choose to be generalists. This means that they can help clients in a number of areas and are qualified to provide general comprehensive financial planning. Specialists may hold themselves out to be an expert in a particular area, such as a specific retirement plan, Social Security, taxation, or estate planning. They may choose additional designations besides the CFP®. There are many successful financial professionals in either category.
  1. Find a mentor. Be proactive about finding an individual that reflects your beliefs, work ethic, and integrity (hopefully, all positive). They can help cut years in trial and error off of your learning curve. This can also tie into the second point above. Be willing to farm and cultivate this relationship. Don’t be afraid to accept a smaller wage in exchange for the mentor’s wisdom. Additionally, be willing to do “grunt” work without complaining or hesitation. You may not realize it now, but if you’re with the right mentor, your professional career will be greatly enriched.

My hope is that this can be beneficial for a new advisor or someone thinking about financial planning as a career. Please don’t hesitate to reach out to us if you have any questions. We promise to be candid.

New Rules for File and Suspend

file and suspendSo the heyday is over, file and suspend under the old rules is gone forever as of April 30, 2016. Those were the days, my friend. We thought they’d never end. We’d file and suspend forever and a day. But not any more…

Or, may we still file and suspend?

Of course we can still file and suspend, the rules are just more restrictive now. When you suspend your benefits these days, all benefits that are payable based upon your record are suspended as well. For example, if you have a child who is eligible for benefits based on your record, when you suspend your benefits the child’s benefits will be suspended as well.  The same goes for spousal benefits based on your record.

To be clear, the rules about suspending benefits are:

  • You must be at least Full Retirement Age
  • When you suspend benefits, your own benefit will not be paid to you
  • Since you are not receiving benefits, you will earn delay credits at the rate of 8% for every year of delay
  • ALL OTHER BENEFITS based on your record will also be suspended, including spousal benefits and child’s benefits

File and Suspend

Before the rules changed, it was common to file and suspend at the same time. Now, with the new rules, it would likely not make much sense to file and suspend at the same time.

The action of filing for benefits is enough to enable benefits for others (spouse or child) to receive benefits based on your record. Under the old rules, if you suspended your benefits, these auxiliary benefits could continue – so, file and suspend at the same time made a lot of sense. By doing so, you would enable others to receive the auxiliary benefits, while at the same time delaying your own actual filing to some later date, receiving the delay credits for the delay.

With today’s rules, file and suspend at the same time doesn’t actually accomplish anything for you, other than establish a filing date.

What you might do though, is file for benefits at one point, and then later suspend them. For example, if you are 62 years old and you have a child who is under 18 (for example’s sake we’ll say 12 years old), you could file for your own benefits and enable your child to receive benefits based on your record. When the child reaches age 18, he will no longer be eligible to receive the benefits – so you could suspend your benefits at this point (you’d be 68 by now) and receive an 8% increase to your benefits for each year that you delay.

The strategy above would be important to you to provide some benefits to the auxiliary dependents (such as a child or spouse) for a short period of time, while allowing you to then enhance your benefits later by suspending.

If the concept isn’t thrilling to you, you’re not alone. Suspending benefits just isn’t what it used to be.

401k Loan versus Early Withdrawal

loaned motorcycleWhen you have a 401k and you need some money from the account, you have a couple of options. Depending upon your 401k plan’s options, you may be able to take a 401k loan. With some plans you also have the option to take an early, in-service withdrawal from the plan.

These two options have very different outcomes for you, in terms of taxes and possible penalties. Let’s explore the differences.

401k Loan

If your plan allows for a 401k loan, this can be a good option to get access to the money, for virtually any purpose. Being a loan, there is no tax impact when you take out a 401k loan. Plus you can use the money for any purpose that you need, at any age.

As a loan, it must be paid back over the a five-year period (at most). You’ll pay interest on the loan, but since it is from your own account, you’re paying interest to yourself.

There is a limit of $50,000 for a 401k loan, or 50% of your account balance if that amount is less.

If you leave the employer (retirement or otherwise) and there is still a balance outstanding on your 401k loan, the outstanding balance will be considered a withdrawal from the 401k account – which is taxable as ordinary income and possibly subject to the 10% early withdrawal penalty (unless you meet one of the exceptions, see below).

If you are not currently employed by the sponsoring employer, a 401k loan is generally not available.

401k Withdrawal

If you’re still employed by the company and want to take a withdrawal from your 401k, the 401k plan must have an option to allow for in-service withdrawals. Often there are restrictions on the availability of an in-service withdrawal. For many plans it’s necessary to be above a certain age (such as 59½ years of age), or that a particular requirement is met, such as hardship by the employee, defined by the plan administrator.

In addition, if you’re taking a withdrawal from the plan instead of a 401k loan, the money withdrawn from the 401k plan will be taxable to you as ordinary income. Plus if you’re under age 59½ your withdrawal could be subject to an early withdrawal penalty unless you meet one of the exceptions. See the article 16 Ways to Withdraw Money From Your 401k Without Penalty to see the exceptions to the 10% penalty.

The good news is that you won’t have to pay the money back to the plan when you make a withdrawal as you would with a 401k loan.

A Risk Management Checklist

checklistAlthough many individuals have various risk management policies in place, sometimes those policies get brushed aside and every once in a while the dust needs to be wiped off of them and perhaps some updating needed. Here’s a checklist to consider the next time you review your risk management strategies.

  1. Auto Insurance – Review your coverage to make sure it’s still adequate. Liability limits of at least $250,000 should be the norm. Limits of $500,000 up to $1 million are better. If you drive an older car, consider raising your comp and collision deductibles or eliminating them altogether to save on premiums. Upside down on your car loan? Consider gap insurance. Better yet, don’t have a car loan.
  1. Home Insurance – Make sure your home is insured to its reconstruction cost. This is the cost to rebuild your home using today’s prices for materials, labor, etc. It is NOT the fair market value. Often these numbers are vastly different. Liability limits should be at least $250,000, but higher amounts up to $1 million are better. Have a collection, jewelry, or other unique items? Consider endorsing them specifically. Endorsements provide specific coverage and deductibles for the covered items and override any limits in the original policy. If you recently acquired a pool or trampoline talk to your company. These items may have special requirements or not be covered at all.
  1. Life Insurance – Review your beneficiaries. Life happens and you need to consider if they need to be updated, or in the case of a divorce or other life event, changed. What type of policy do you have? Are you paying too much? Do you need more coverage? Do you need less? If you have coverage through your employer, is it enough (chances are it’s not)? It pays to spend some time reviewing these questions. If you’re confused, call a competent financial professional.
  1. Umbrella Insurance – This often overlooked coverage is extremely important to your risk management plan. Often the least expensive insurance coverage (as it rarely is needed) it’s still important if the worst happens. Generally, it’s coverage that’s in place if an individual exceeds their liability limits in an auto or home claim. Policies with $1 million limits can be obtained for as little as a few hundred dollars annually.
  1. Disability Insurance – The odds of an individual becoming disabled during their working lifetime are greater than dying prematurely. Many employers offer group disability. This is a great benefit. Individuals without access to group disability should consider purchasing a policy outright to protect their income. Be sure to review the definition of disability in the policy. Generally, cheaper premiums mean stricter definitions of disability. This means that while the premium may be less, it may be very difficult to file a claim if the definition of disability is strict – such as any occupation. Review the elimination period (time deductible) of the policy. Generally, the longer them elimination period (how long you wait until the benefits pay) the lower the premium and vice versa.
  1. Health Insurance – Review your policy to see if the coverage still makes sense. Review how often you’ve used the policy. If you’ve seldom gone to the doctor or made claims, consider a policy with higher deductibles. This will save on premiums. If you have a high deductible policy, consider utilizing an HSA.
  1. Emergency Fund – Generally, make sure you have three to six month of non-discretionary income set aside. Personally, I like a year’s worth. To each their own. Having an emergency fund can help pay for higher deductibles in any of the policies mentioned above. The higher the emergency fund, the higher your deductibles can be. The more you save on premiums. Additionally, an emergency fund can help you avoid making a costly mistake by funding deductibles or emergencies with credit cards.

Finally, don’t wait for a claim to see what your coverage is. Or worse, let the loss be the impetus to get coverage in place. Insurance is meant to be preemptive, with the hope that you never need it. But if you and when you do, your entire wealth management plan isn’t destroyed. Risk management ensures that if the worst happens, you have a bad day or two, not a bad life.

Focus on the Things You Can Control

Left a good job in the city, workin’ for the man every night and day. But I never lost one minute of sleepin’ worryin’ ’bout the way things might have been.

— John Fogerty

heathrowSometimes the answer to our stresses in life is to get back to basics and figure out what’s important to us, as well as what things we can control in our life. In the song quoted above, Fogerty’s writing was most likely tempered by his recent discharge from the Army Reserve (1967), after which the protagonist explores an awakening to a simpler side of life, and what turns out to be important to him.

We are often faced with similar situations – maybe we’ve been laid off or some financial calamity strikes us, and from that perspective we often discover what’s really important to us. Other times we just come to realize that our life seems out of control, and we’re searching for a way to get our comfort level back. Most importantly we can learn to not “worry ’bout the way things might have been”, and instead focus on the things about our lives that we can control.

At times we worry about interest rates, inflation, overseas unrest, the current political cycle, whether stocks are going up or down, and the baggage retrieval system they’ve got at Heathrow*. None of these things are items that you can control – for example, stocks are going to go either up or down, and no amount of worry on your part will affect the end result. The same goes with obsessing over the interest rate or inflation. Nothing you can do will change the course of these things. It’s best just to let them go, and don’t worry about them.

Now, I’m not advocating a “don’t worry, be happy” attitude, at least not completely. But there is something to be said for not letting things get you down. This can be more easily understood if you think about your life resources that you have available to you as similar in that there is a finite amount of each that is yours to use as you please:

  1. Money
  2. Time
  3. Talent
  4. Energy

In our lives we’re always making choices about how to “spend” these resources. Setting aside money for the moment, the other three (time, talent and energy) can be exchanged for money, and you can use the money to provide yourself with more time (sometimes) and more talent. Energy is one that can’t be expanded easily – and this one is where you lose out by worrying too much.

You only have so much energy available to accomplish things in your life. Whatever amount of that energy that you spend worrying about whatever is on the business news channel, then you have that much less energy to teach your son to play catch. And the end result for your financial well-being is likely to be the same whether you’re playing catch or watching the business news circus.

In addition, we often allow “the way things might have been” to dig at us over time. This stress that we put upon ourselves has no purpose – as the saying goes, “don’t cry over spilled milk”. Learn from the bad things that have happened to you, for sure. But don’t let the bad things that happened to you in the past define your future.

You have control over certain things, and it’s different for everyone. Instead of worrying about the stock market, shut off the tv, play catch with your son (or daughter), and then use your extra energy to figure out a way to maximize your IRA contributions. You’ll be far better off in the long run.

* That line is from a Monty Python routine called I’m So Worried – not their best work, but if you’re amused by the Python, I recommend giving it a listen.

Changing Your SOSEPP – Once, just once

sosepp-carIf you’re taking (or planning to take) early distributions from an IRA using the 72(t) provision with a Series of Substantially Equal Periodic Payments, also known as a SOSEPP, you need to know a few things about this arrangement. For more information on SOSEPPs in general, see the article Early Withdrawal of an IRA or 401(k) – SOSEPP for more details.

Generally when you establish a SOSEPP you have to stick with your plan for the longer of five years or until you reach age 59½ years of age. However, the IRS allows changing your SOSEPP one time, and only one time. And then, the rules only allow changing your SOSEPP from either the fixed annuitization method or the fixed amortization method to the Required Minimum Distribution method.

This is the only exception allowed for changing your SOSEPP during its enforcement period, which is the later of five years after you started the SOSEPP or when you turn age 59½. The exception is documented in Rev. Ruling 2002-62, 2.03(b).

If you’re planning on changing your SOSEPP in a manner other than the above-described methods, you will effectively “break” the plan, meaning that the SOSEPP is no longer in place. Doesn’t sound like such a bad thing, right? That’s where you’re wrong though… because if you break a SOSEPP, there are some very nasty ways that the IRS will get back at you.

This can be as simple as increasing or decreasing the amount you withdraw slightly, or forgetting to make a withdrawal altogether, or possibly taking two distributions (a double-dip) in one year. There’s not much room for “forgive and forget” on this from the IRS. For more on the consequences of breaking a SOSEPP, see the article Penalties for Changing a SOSEPP.

There is no specific provision in the Internal Revenue Code for relief from the penalty if you have broken your SOSEPP.  On the other hand, the IRS has in some cases granted relief in several private letter rulings by determining that a change in the series of payments did not materially modify the series for purposes of the rules.

If the series is broken due to an error by an advisor (for example), some prior PLRs have been issued in favor of the taxpayer.  PLR 201051025 and PLR 200503036 each address the situation of an advisor making an error and the distributions were allowed to be made up in the subsequent year.  Bear in mind that PLRs are not valid for any other circumstances other than the specific one in the ruling, and cannot be used to establish precedence for subsequent cases.

But in reality, the likelihood of your getting a favorable PLR for your case of a broken SOSEPP is small – unfortunately, breaking the series usually results in application of the penalty for previous payments received, and the SOSEPP is eliminated.  If you wish to restart the series you can do so, but you are starting with a new five-year calendar (the series must exist for at least five years, or until you reach age 59½, whichever is later).

Don’t Forget to Make Your IRA Contribution by April 18!

forgetmenotsWhen filling out your tax return, it’s allowable to deduct the amount of your regular IRA contribution when filing even though you may not have already made the contribution.

You’re allowed to make an IRA contribution for tax year 2015 up to the original filing deadline of your tax return. This year, that date is April 18, 2016.

The problem is that sometimes we file the tax return way early in the year, and then we forget about the IRA contribution. As of the posting of this article, you have 1 week to make your contribution to your IRA to have it counted for tax year 2015.

What To Do If You Miss the Deadline

If you don’t make the contribution on time, you’re in for some nasty surprises unless you take some corrective actions.

If you find yourself on April 19, 2016 without having made your IRA contribution and you had deducted one from your taxes for 2015, you need to amend your return. This means that you’ll fill out a Form 1040X and eliminate the IRA contribution that you originally deducted from your income. This will (most likely) result in additional taxes that you’ll owe, so when you send in the amendment you’ll have to send an additional tax payment.

Failure to amend your return in a timely fashion will result in the IRS contacting you later, requiring you to pay the additional tax plus interest. In addition, since your tax return was erroneous, the IRS will consider this to be “under-reporting of income” and “under payment of tax” – both of which carry penalties. Even if it was an honest mistake, you’ll owe these penalties.

You may even owe some penalties and interest if you file your amendment right away, since technically you’ve under-reported and underpaid. But if you amend as soon as you can, these penalties and interest should be minimized.

Should I Pay Off My Student Loans or Start Investing?

Businessman juggling fruit

Businessman juggling fruit

I had an interesting question come my way from a student the other day and I thought I’d expand on my answer that I gave to the student. The question was whether he should pay off his student loans and then start investing, or if he should start investing first and pay off the student loans gradually.

If we really look at it, paying down any type of debt is very similar to making an investment in a guaranteed account paying interest on the equivalent of the interest rate on the debt. This student’s interest rate on his debt was approximately 7%. Paying this off would not be unwise and would be a great way to earn 7% risk free – only this method keeps the 7% out of the lender’s pocket and puts it into the borrower’s.

However, if we completely ignore investing and saving for retirement we can miss out on some of the crucial, early years of investing where a young investor can take advantage of time, and compounding. Even a small amount set aside on a regular basis can reap huge rewards and returns over time through the value of compounding.

So here was my answer to the student. Depending on his risk tolerance, if he thought he could earn a return higher than 7% (subject to much more risk) than he could consider investing now and simply paying down the debt through the regular monthly repayments. I advised that deferring the repaying was not recommended.

If he thought he was a more conservative investor then he could consider paying a much larger amount monthly to reduce the debt even more, then, when the debt is paid off, use the free cash flow to enhance retirement savings.

Additionally, I told the student if he was participating in a 401(k) with a match, to definitely save into the 401(k) at least up to the employer match. This is free money from the employer and everyone should take advantage of this. Furthermore, the student should be aware that his student loan interest paid is deductible up to $2,500 every year as an adjustment to income (above the line deduction).

While I had no blanket answer for this student, it hopefully gave him an idea as to how he should think about his retirement savings and debt. The good news is that he was at least thinking about these things, which feels good. Sometime you wonder if you’re making a difference.

Taxes and Your Child

childrenWhen a child has unearned income from investments in his or her own name, taxes can be a bit tricky. Depending on how much the unearned income is, part of it may be taxed at the child’s parent’s tax rate, for example.

Recently the IRS published their Tax Tip 2016-52, which details What You Should Know about Children with Investment Income. The text of the Tip is below:

What You Should Know about Children with Investment Income

Special tax rules may apply to some children who receive investment income. The rules may affect the amount of tax and how to report the income. Here are five important points to keep in mind if your child has investment income:

  1. Investment Income. Investment income generally includes interest, dividends and capital gains. It also includes other unearned income, such as from a trust.
  2. Parent’s Tax Rate. If your child’s total investment income is more than $2,100 then your tax rate may apply to part of that income instead of your child’s tax rate. See the instructions for Form 8615, Tax for Certain Children Who Have Unearned Income.
  3. Parent’s Return. You may be able to include your child’s investment income on your tax return if it was less than $10,500 for the year. If you make this choice, then your child will not have to file his or her own return. See Form 8814, Parents’ Election to Report Child’s Interest and Dividends, for more.
  4. Child’s Return. If your child’s investment income was $10,500 or more in 2015 then the child must file their own return. File Form 8615 with the child’s federal tax return.
  5. Net Investment Income Tax. Your child may be subject to the Net Investment Income Tax if they must file Form 8615. Use Form 8960, Net Investment Income Tax, to figure this tax.

Refer to IRS Publication 929, Tax Rules for Children and Dependents. You can get related forms and publications on IRS.gov.

Each and every taxpayer has a set of fundamental rights they should be aware of when dealing with the IRS. These are your Taxpayer Bill of Rights. Explore your rights and our obligations to protect them on IRS.gov.