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Inherited 401k plan

An inherited 401k plan isn’t necessarily a different kind of retirement plan from a regular 401k plan in the hands of the original participant. However, the rules around an inherited 401k plan are unusual enough to warrant their own review.

When an individual inherits a 401k plan, generally this individual must begin taking minimum distributions from the plan, on a preset schedule. There are a few things to consider, the first of which is whether the beneficiary is the spouse of the original owner, or another person (non-spouse).

If the beneficiary is a spouse, special options are available for handling the inherited 401k plan. As a spouse-beneficiary, you have 3 primary options to choose from:

  1. You can leave the money in the 401k plan.
  2. You can rollover the money from the 401k plan to an inherited IRA.
  3. You can rollover the money from the 401k plan into an IRA in your own name (not the same as #2).

If you inherit a 401k plan from someone other than your spouse, you are limited to either #1 or #2 above. We’ll go over the three options in detail next.

Leave the money in the 401k plan

If you choose to leave your inherited 401k in the original account, you now have to figure out the Required Minimum Distribution for the account.

If the original owner was over age 70½ and already taking RMDs from the account, you must continue with those same distributions based on the lifetime of the original owner. You can choose to take out more each year, but you have to at least take out the minimum that applies as if the original owner were still living.

These same rules apply if the original owner was still employed past 70½ and not subject to RMDs. The RMDs must begin in the year following the original owner’s death, in this case, and will use the original owner’s age to determine the amount of each RMD.

If the original owner was younger than age 70½ at his or her death and therefore not subject to RMDs, the rule is different if you are the spouse or a non-spouse beneficiary.

If you are the spouse of the original owner you have the option of delaying until the original owner would have been 70½ years old before taking the RMDs. In this case, the RMDs would be based on the decedent’s assumed age (had he or she still been living) in each year of distribution.

If you are a non-spouse beneficiary, the default rule is that you must withdraw the entire amount of the 401k account by December 31 of the fifth year following the year that the original owner died. You can take some money out each year, or take it all at once, it just has to be withdrawn before the end of the fifth year.

Some plans (although these are relatively few) have another option for the non-spouse beneficiary: to stretch RMDs out based on the beneficiary’s lifetime. This is similar to the option described below in the case where you rollover the account to an inherited IRA. It’s more often the case that the rollover is undertaken to enable stretching payments, as few 401k plans include a stretch feature.

In all cases, you have the option of taking more than the minimum out of the account each year. In none of these cases will you have a 10% penalty applied for early distribution, but you will owe income tax on all pre-tax money withdrawn.

Rollover the inherited 401k to an inherited IRA

If you choose instead to rollover the inherited 401k to an inherited IRA, you have a bit more flexibility, but only a bit. Not all plans allow this rollover option – some plans are more restrictive and force only the 5-year complete payout option detailed previously.

As before when leaving the money in the 401k account, if the decedent original owner was already taking RMDs (or would have except for being still employed and over age 70½), you must at a minimum continue those RMDs based on the lifetime of the original owner.

However, if the original owner was under age 70½ and therefore not taking RMDs, by rolling over the account to an inherited IRA you have the option of “stretching” the IRA distributions. If you’re younger than the original owner was, you can start taking RMDs based on your age, which will result in a longer timeline for distribution of the funds as compared to using the original owner’s age.

Rollover the inherited 401k to your own IRA

This option is only available for a spouse beneficiary.

As a spouse, you have the option of rolling over the 401k plan to an IRA in your own name (not an inherited IRA). This action can cause restrictions that you may not want, but it could open up flexibility as well.

If you are under age 59½ and are the spouse beneficiary, rolling over the inherited 401k plan to your own IRA will eliminate your ability to withdraw funds from the account without penalty, unless you meet one of the exceptions. Once you reach age 59½ or an exception applies, you will be able to access the money without penalties. It’s important to note that this rollover action does completely eliminate your ability to withdraw funds without penalty before age 59½.

If you’re between 59½ and 70½ years old, rolling over the inherited 401k to your own IRA can give you more flexibility. By doing this action, if your late spouse was already subject to RMDs, you can delay RMDs now until you reach age 70½. This is because the account is no longer associated with your late spouse – it’s your IRA. You also can freely withdraw any amount for any purpose and only pay ordinary income tax on the distribution, no early withdrawal penalty will apply.

If you’re over age 70½ and you rollover the inherited 401k plan to your own IRA, you must take RMDs based on your lifetime and the account balance in your IRA.

As before, except for the case where you’re under age 59½ (when penalty-free withdrawals are not allowed), you are allowed to take more than the minimum distribution each year, but you must at least take the minimum.

Roth Conversion of Inherited 401k

One of the provisions that is available to the individual who inherits a 401k or other Qualified Retirement Plan (QRP) is the ability to convert the fund to a Roth IRA.

This gives the beneficiary of the original QRP the option of having all of the tax paid up front on the account, and then all growth in the account in the future is tax free, as with all Roth IRA accounts.

What’s a bit different about this kind of conversion is that, since it came from an inherited account, the beneficiary must immediately begin taking distribution of the account over his or her lifetime, according to the single life table. This means that, in order for this maneuver to be beneficial, the heir should be relatively young, such that there will be time for a lengthy growth period for the account – making the tax-free nature of the Roth account worthwhile.

A downside to this move is that the heir should also be in a position to pay the tax on the conversion from other funds, otherwise the tax pulled from the account (and therefore not converted to Roth) will reduce the funds that can grow tax-free over time.

If the heir has an IRA of his or her own that could be converted, and there are only enough other funds for paying tax to enable the conversion of one account or the other, the IRA should be converted rather than the 401(k). This is because the IRA has a much better chance for long-term growth than the inherited QRP due to the requirement for distribution of the account (as discussed above).

This is yet another reason that an individual might want to leave funds in a 401k plan rather than rolling it over to an IRA – since the heir does not have this Roth conversion option available if the money is in a traditional IRA. This option is only available for an inherited 401k.

Inherited Roth 401k

If the account that you’ve inherited is a Roth 401k, if you leave it in the original Roth 401k account, you’ll need to take RMDs from the account each year, based on your age and the account balance.

You could also rollover the Roth 401k to an inherited Roth IRA (similar to the conversion described previously). This is a tax-free event since the money is coming from an account that has already been treated as Roth with contributions.

As a spouse, you further have the option of rollover of the account to a Roth IRA in your own name (not an inherited Roth IRA). This would eliminate the RMD requirement during your lifetime.

Deemed Filing

Many times the question comes up – Since my spouse has filed for Social Security retirement benefits, can I file for only the Spousal Benefit?


This is a complicated question with two answers, depending on your date of birth. This is because there are two different rules: one that applies if you were born before 1954 and one if you were born in 1954 or after. These rules came into effect in 2016, after passage of the Bipartisan Budget Act of 2015.

It is certainly possible for the individual born before 1954 who is at or over Full Retirement Age (FRA). This is a common circumstance that many folks employ, although the number of people who can employ this is diminishing. One spouse files for benefits and the other, hoping to achieve the full Delayed Retirement Credits (DRCs) while still receiving a benefit, files for the Spousal Benefit only. This is a perfectly allowable method, but only for folks born on or before January 1, 1954.

If you’re under FRA (no matter when you were born), the option for filing solely for a spousal benefit is not available. This is because, prior to FRA, if you file for the Spousal Benefit, you are deemed to have filed for your own benefit as well. This is known as “deemed filing”, and it applies in all circumstances when you’re under FRA. The result of this action is that your own benefit will be permanently reduced, as will the Spousal Benefit that you’re filing for early as well. The reverse is true as well: if you file for your own benefit before FRA and you’re also eligible for a spousal benefit, you are deemed to have filed for both benefits at the same time. If you are not eligible for the spousal benefit at the time of your filing for your own benefit, as soon as you become eligible for the spousal benefit, deemed filing requires that you have automatically filed for the spousal benefit.

The group of people born before 1954 will all be at or older than FRA by January 1, 2020, so this group’s decision process is coming to an end. Let’s look at how deemed filing works for folks born in 1954 or later.

For anyone born on or after January 2, 1954, deemed filing has a very absolute application. In any case where you’re eligible for both a spousal benefit and your own retirement benefit, deemed filing will require that any application for benefits is an application for both benefits. No matter whether you’re over, under, or exactly at FRA, you can no longer separate these benefits.

If you are not eligible for a spousal benefit when you first file for your own retirement benefit, of course you’ll only be filing for the benefit that you’re currently eligible for. But as soon as you become eligible for a spousal benefit (because your spouse filed for his or her own benefit), you are deemed to have filed for the spousal benefit in the first month of your eligibility.

Deemed filing only applies to your own benefit and the spousal benefit. If you are eligible, for example, for both your own benefit and a survivor benefit, you can separate these two benefits in your filing, regardless of your age and date of birth. You could file for your own benefit at one age (perhaps before FRA) and delay the survivor benefit until you reach FRA (when it is maximized). The reverse is also true: If you’re eligible for a survivor benefit, you could file for the survivor benefit only and delay filing for your own benefit until as late as age 70, when your retirement benefit is maximized. The earlier filing for either benefit has no impact on the later filing for the other.

Turns Out You CAN Be A Little Bit Pregnant

surprise by PinkMoose Remember back in junior high (or whenever it was) during health class (or sex ed, or whatever they called it for you) – how it was explained that pregnancy is a black or white thing: “nobody gets just a little bit pregnant” was the story my health teacher gave us to remember. As it turns out, there are many other absolutes in life that are similar. However, in a totally characteristic move, the IRS gives us a way that takes something that you think would be absolute, and twists it so that you can, in fact, be a little bit pregnant (or rather, a little bit taxable, a little bit tax free, in this case).

Confused yet? Sorry, that wasn’t my intent… some people refer to this as the “cream in the coffee” rule. With this analogy, it is explained that once you put cream in your coffee, you can’t take out just some of the coffee or just cream, you have to take out both cream and coffee. Oh bother, with the analogies! Let’s get into this.

IRA Funds – Part Taxable, Part Tax-Free

If you’ve made after-tax contributions to your traditional (non-Roth) IRA, you’re likely expecting that at some point you can take those contributions out again, tax free. And you’re right to expect that, because that’s exactly what you can do. However (and there’s always a however in life, right?), if the after-tax money you have in your IRA isn’t the only money in ALL of your IRAs, any money that you take out will be partly taxable and partly tax-free. (this was where the “little bit pregnant” thing comes in)

Here’s how it works: Let’s say you have two IRAs, each worth $5,000. One is a traditional deducted (pre-tax) IRA, and the other is a traditional non-deducted (after-tax) IRA. If you wanted to take $100 out of either account, the IRS considers all of your IRAs as one account. Any money taken out of either account is considered pro rata, partly taxable and partly non-taxable. So in the $100 that you take out, $50 will be tax-free, and $50 will be taxed.

Let’s do another example, a little more real world:  You have two IRAs, one worth $5,000, which is made up exclusively of a $3,000 deducted contribution and $2,000 worth of growth and interest; the second is made up of a $4,000 deducted contribution, a $5,000 non-deducted contribution, and $1,000 worth of growth and interest, for a total of $10,000. You would like to take a distribution of $1,500 from one of the accounts. In the IRS’ eyes, you are taking out $500 which is non-taxed, and $1,000 which will be taxed. This is because, out of the total of $15,000 in the two accounts, only $5,000 was “after tax” funds. Everything else, the growth, interest and the deductible contributions, is considered taxable.

How To Get Around It (or How You Can NOT Be A Little Bit Pregnant)

Don’t lose faith, though, there is one way around this dilemma. The IRS allows you to roll over funds from your IRA into a Qualified Retirement Plan (QRP) such as a 401(k) – but ONLY the taxable portion may be rolled over to the QRP. If there are commingled funds in your account(s). So, in this case, the IRS goes along with the absolute (go figger – they treat the same money two different ways!) and requires that no after-tax contributions be rolled over into the QRP.

So, if you have a 401(k) plan at work, or an existing 401(k) that you haven’t rolled over into an IRA, you can use this account to split out your taxable IRA money from the non-taxable IRA money. Then you could do a tax-free conversion of the non-taxed IRA money into a Roth IRA if you wished, for example, as long as you fit all the other criteria.

Going back to our example above, you would rollover to your 401(k) plan the $10,000 from the two IRAs that represent the deductible contributions plus the growth and interest. This leaves you with $5,000 in non-deductible contributions from the one IRA. You could take a withdrawal as you had planned at this point, with no tax or penalty.

In addition, since your only IRA now only holds non-deductible contributions (no growth or deductible contributions), you could convert the IRA to a Roth IRA – also with no tax or penalty. This is a strategy that many have used to separate the cream from the coffee to make the Roth conversion painlessly.

The Earnings Test is Specific to the Individual

all thats left by adonis hunter ahptical

This topic comes from a reader, J., who asks the following question:

My wife is 62 and she works a part-time job earning around $23k per year. She is planning to retire in June, and so her total earnings for the year will be approximately $11,500. She would like to begin taking Social Security benefits right after her retirement.

The question is this:  will her earnings test be based upon her “individual” earnings, or on the higher combined earnings of the two of us (I am still working, earning in excess of the earnings test amount)? Since her earnings of approximately $11,500 are under the $17,640 earnings limit, her earnings would not be reduced – but if the earnings test is based upon both of our earnings combined, her earnings would definitely be reduced. How does this work?

My Response

Each person’s earnings record is specific to that individual – the only time the spouse enters into the equation is in calculating spousal or survivor’s benefits. Therefore, the only earnings considered for the “earnings test” for your wife – are those of your wife, and not the household (not including your income, in other words). Actually one other time that the household earnings are considered is when you file your tax return: at your household income level, her benefit might be included as taxable at as high as the 85% rate.

In addition, there is a special rule that applies to the first year of retirement, when a person retires mid-year: the retiree who retires in mid-year is eligible for a full benefit (however reduced by age, in your wife’s case) for any whole month that the person is considered retired, regardless of total yearly earnings.

“Considered retired” when at less than Full Retirement Age is defined as having earned $1,455 (monthly) or less and not performing substantial services in self-employment. “Substantial services in self-employment” is defined as more than 45 hours per month in a business or more than 15 hours to a business in a highly skilled occupation (e.g., brain surgery or writing a blog about Social Security and financial planning).

So, with this in mind, your wife would be eligible for her age-reduced benefit for the remainder of the year after her retirement, with no reductions due to earnings tests (as long as she doesn’t pick up another job).

Roth Conversions for Inherited Retirement Plans

monkey typing by pdimages-com If you have an IRA or a 401(k) that you’ve inherited, you may wonder if it is possible to convert that account over into a Roth IRA. After all, you’ve got to take RMD (Required Minimum Distributions) from the account since it’s inherited, why couldn’t you just pay all the tax upfront and roll it over?

Well, there are two answers to this question, one for inherited IRAs, and one for inherited qualified retirement plans (QRPs, such as 401(k) or 403(b) plans). And like many other things in this wonderful tax code of ours, the two kinds of plans are treated differently today, but may be subject to change in the future.

It should be noted that we’re talking about non-spouse beneficiaries here. A spouse has pretty much the same rights as the decedent (original owner, now deceased) had, so if the decedent was eligible for a Roth conversion, the spouse most likely is as well.

Inherited IRA

For an inherited IRA, current law does not allow you to convert the funds to a Roth IRA. This is pretty much cut-and-dried, with no interpretation necessary.

There is a great deal of conjecture about whether or not Congress will specifically change this ruling to match the QRP rule, although most of that discussion has dried up over the past several years. However, with recent proposed changes threatening to change the inherited retirement plan landscape, we may see a change in this rule sometime soon, you never know. Until a change is actually put in place, this rule will continue to apply.

Inherited QRP

If you’ve inherited a qualified retirement plan (QRP), this account IS eligible for conversion to a Roth IRA. The new Roth IRA (and it must be a new account) must be titled as inherited, just the same as if you were rolling over the QRP funds into a traditional inherited IRA. The new Roth IRA would continue to be subject to RMD, however tax would have been paid up front during the conversion, so future RMD would be tax-free.

In the year of the conversion, you still have to take your regular taxable RMD from the QRP, but the remainder of the account is eligible for Roth conversion. Keep in mind that this conversion has to be a direct (trustee-to-trustee) conversion, and also must be a direct conversion into the Roth IRA (without rolling over to a traditional IRA first, as was the former method for QRP to Roth conversion).

Don’t Leave Money On The Table!

social security benefits taxedMany individuals are offered an employer-sponsored savings plan though work such as a 401(k) or 403(b). Employers who offer these plans may provide a company match. This means that the employer will add money to the employee’s account, if the employee saves a certain percentage of income. Some employers will even provide money even if the employee is not saving.

If you’re employer offers a match on your contributions, take full advantage of it. Don’t leave money on the table! This is free money – and it’s unwise to not take it.

Let’s look at an example.

Sam and Betty (both age 45) have a 401(k) and their employer offers a 50% match on employee contributions up to 5% of their salary. They both earn $80,000 annually. Sam decides to save 1% of his salary and Betty decides to save the maximum she can for 2019 of $19,000. Since the match is 5% of their salary, they both qualify for a maximum employer match of $2,000 (50% of 5% of $80,000).

Sam’s contribution is $800, and his employer matches $400 for a total annual savings of $1,200. Betty’s contribution is $19,000, and her employer match is $2,000 for a total of $21,000. Sam has left $1,600 on the table. However, he’s leaving a lot more than that over time.

Assume that Sam and better will work another 20 years to age 65. Let’s also assume they invest in the same assets mix – a portfolio of 60% stocks and 40% bonds. Let’s also assume a return of 5% over 20 years.

In 20 years, Sam has a sum of $39,679. Betty has nearly eighteen times Sam’s amount at $694,385. Granted, Betty saved more – she’s smart. But what if Sam would have at least contributed to get the full employer match?

By saving 5% of his salary, Sam would have contributed $4,000, thereby qualifying him for the full employer match of $2,000 – saving a total of $6,000 annually. Over 20 years at 5% compounded Sam would have had $198,395. This is over $158,000 more than if Sam only saves 1% of his salary.

He left money on the table. A lot. We also assumed no raises, bonuses, etc. that would add to these amounts.

If you’re saving to a Roth 401(k) or 403(b), the match from your employer will be added to a pre-tax account. As you may know, contributions to Roth accounts are made with after-tax money, and qualified withdrawals are tax-free. Employer matches made with pre-tax money will be taxed when withdrawn at your ordinary income tax rate.

This shouldn’t discourage you from taking the full match. It’s still free money. Think of it this way. Would you rather be taxed on zero money, or a pre-tax amount given to you for free from your employer – allowed to grow and compound over time?

And, the employer match is added on top of employee contributions. Recall Betty’s scenario. Betty is maximizing her employee contributions this year at $19,000. Employer contributions are added to this amount. It’s possible to save even more than the employee maximums each year if you have an employer match.

Finally, many employers have strings attached to their matches via vesting schedules. This means that for the match to be completely yours, you must work for your employer for a certain length of time. Common vesting schedules include 2 to 6-year graded vesting (where a portion of the match becomes yours over the 2 to 6-year time frame), or 3-year cliff vesting where all the match becomes yours after three years of employment.

Your employer match is free money. Don’t leave any on the table.

IRA Trick – Eliminate Estimated Tax Payments

the old cat trick by wstryder Retirees: don’t you get tired of making those estimated tax payments? January, April, June and September, like clockwork, you have to hand over tax money, just because you’re receiving a pension, retirement funds, and/or Social Security benefits. What if there was a way to send this money off one time, and then you wouldn’t have to remember it every few months?

There is.

IRA Trick – Eliminating Estimated Tax Payments

When you receive money throughout the year, the IRS expects withholding payments or estimated payments to coincide with your receipt of the money. So when you receive a monthly pension check, you should either have some tax withheld out of each payment. On the other hand, you could send in an estimated tax payment, at four intervals throughout the year, which is treated equivalent to check-deducted withholding.

These estimated payments, often wrongly referred to as quarterly payments, are due each year on April 15, June 15, September 15, and January 15 of the following year. If you don’t make these payments in a timely fashion and you don’t have other withholding occurring with your receipt of money, the IRS may penalize you for underpayment of tax when you file your tax return.

A little-known fact about IRA distributions is that when you have taxes withheld from the distribution (which are then sent directly to the IRS), the withheld money is considered to have been received throughout the year – even if it is received late in December. Using this fact to your advantage, you could figure out how much your total estimated tax payments should be for the year sometime in early December, and then take a distribution from your IRA in that amount. Here’s the trick:  Instead of taking the distribution yourself, fill out a form W-4P (or use your custodian’s form) to direct the total amount of the withdrawal to be withheld and sent to the IRS. Voila! You’ve now made even payments to the IRS for each of the four quarters, on time with no penalties!

The downside to this plan is that, in the event of the taxpayer’s untimely death before the annual distribution is made, the estimated payments will be considered as unpaid up to the date of death, and therefore the estate will be responsible for paying the underpayment penalty. Other than that shortcoming, this trick could provide you with several months’ additional interest/return on your money, plus remove the hassle of the quarterly filings.

But Jim, what if I’m retired and under age 59½? Won’t there be a penalty?

There doesn’t have to be, although I’d place this particular move into the “higher degree of difficulty” category of tricks – not to be taken lightly.

Pre-59½ Retiree: How to Avoid Penalty?

Same situation as before, but now you must take another step:  once you’ve taken the distribution and properly filed the W-4P (or custodian form) to have the distribution withheld as tax – execute a 60-day rollover, placing the same amount of money either into the same IRA or another IRA… effectively, you’ve pulled the old switcheroo with the IRS on this: you’ve paid tax with a distribution that didn’t happen!

How can this be?  Well, the IRS allows you to replace (or rollover) money from any source back into your IRA, so it doesn’t matter that your original distribution was used for withholding. So you have made up for missing all those quarterly estimated payments (no underpayment penalty now) plus by rolling over the funds you’ve avoided the 10% early withdrawal penalty as well.


I mentioned that this last trick fits into the “higher degree of difficulty” category of tricks. The reason I say this is because using your account in this fashion (essentially a 60-day loan) can be hazardous – the primary reason is that 60 days is all you have, and 60 days can be a relatively short period of time. Plus, the IRS HAS NO SENSE OF HUMOR ABOUT THIS. If you miss the rollover period by one day, you’re outta luck.

In addition to the 60-day period, there is also the limitation of only one 60-day rollover per 12-month period. Again, remember: no sense of humor at the IRS. This is especially true if it’s clear that you’ve been pulling a fast one on them with a scheme like suggested above. It is for these reasons that this rollover trick should only be used in the most dire of circumstances – such as if you completely forgot to make quarterly payments and are facing a stiff underpayment penalty, for example. Otherwise, I’d suggest leaving this one alone. By all means, you should not try this trick year after year. It shouldn’t be a problem if you’re over age 59½, though.

Medicare is Not Automatic

automatic electric monophone 40 by alexkerheadIf you’re nearing age 65, there’s something you need to know: unless you’re currently receiving Social Security benefits (having filed early), you need to take action to make sure you receive your Medicare benefits in a timely fashion.


What this means is that you can sign up for Medicare up to three months prior to your 65th birthday. You must sign up within the period from three months before until four months after your 65th birthday, or you’ll face possible penalties. By signing up during that seven month period, your coverage will be on-time and you’ll begin being billed for Medicare Part B.

If you fail to sign up during that seven month window, you’ll have to wait until the next general enrollment period, which is January 1 through March 31, and your benefits won’t begin until the following July 1. Signing up late, you will be assessed a 10% penalty on your Part B premium for each year that you’ve delayed signup.


If you happen to still be employed and are receiving your medical coverage at least as good as Medicare (known as a creditable plan), you’re not required to enroll and won’t be penalized for delaying. After your employment ends (and thereby the medical coverage), you have a special eight month enrollment period when you can sign up for Part B without penalty.

If you sign up while still covered by the employer plan or in the first month after the coverage ends, your benefits will begin on the first day of the month that you enroll. If you enroll at any time after that but during the following seven months remaining in the special enrollment period, your coverage will begin on the first of the following month.

Just like the other enrollment period, if you delay until after it has expired you’ll need to wait until the next general enrollment period to enroll and your coverage won’t begin until July afterwards.

If you are actively receiving Social Security benefits when you reach age 65, you will be automatically enrolled in Medicare. But don’t leave it to chance: you should check with SSA in the 2 to 3 months before your 65th birthday to make sure you have coverage coming to you. In addition, you’ll want to check out the other coverage(s), such as Medigap, Medicare Advantage, and/or Medicare Part D, prescription drug coverage.

Integrating Roth IRA With Social Security Benefits

social security by Fabricator of Useless ArticlesThere are some great benefits to be had from converting funds from a traditional IRA or a 401k to a Roth IRA. But that doesn’t mean that everyone within earshot should just willy-nilly go off and convert their IRAs to Roth IRAs. One factor that many folks likely haven’t thought about is integrating Roth IRA with Social Security to reduce taxes.

Taxation of Social Security

As you may be aware, depending upon your “provisional income”, various amounts of your Social Security benefits may be taxable. At this time, for example, if your provisional income is more than $34,000 (or $44,000 for a married couple), then up to 85% of your benefits would be taxed. Less than $34,000 ($44,000 for a married couple) but more than $25,000 ($32,000 for marrieds), up to 50% of your Social Security benefit is taxable. Less than $25,000 ($32,000 for a married couple) and your Social Security benefit may be untaxed.

Provisional income is your adjusted gross income (AGI, the amount in line 7 of form 1040) plus tax-exempt interest earned for the year, plus ½ of the amount of your Social Security benefit. So the trick is to limit your AGI, in order to reduce the amount of Social Security benefits that are taxed, if possible. One way to do this is to generate income from a Roth IRA, which is not only tax-free, but isn’t counted toward the AGI.

A Tale of Two Taxpayers

Two taxpayers, Stevie and Christine, both age 62 and retired, have vastly different outcomes for their tax situations. For simplicity’s sake, we’ll say that both women are single, and are collecting identical Social Security benefits of $20,000, and that each has a total income requirement of $60,000 each year. In addition, each of the women has a pension available, which will either pay out a $40,000 payment each year, or is available as a lump sum for rollover at the amount of $600,000.


Stevie decides to take the pension payments of $40,000 per year. Come tax time, she learns that she will have to pay tax on 85% of her Social Security benefit ($17,000) because her provisional income adds up to $50,000, which is above the $34,000 limit mentioned above. So the tax on this amount ($40,000 pension plus 85% of SS, or $17,000) is $5,714, or roughly 9.5% of her total income. Assuming that nothing changes about the situation, Stevie can count on paying around 9.5% of her income in tax for the rest of her life.

Christine – Option 1

Christine, on the other hand, takes a look at the numbers and decides that it might make more sense to attack the situation differently. She takes the lump-sum payout from her pension plan and rolls the money over into an IRA. If Christine were to simply leave things this way and start taking a distribution of $40,000 each year, she would have exactly the same tax treatment that Stevie is getting. However, if Christine should decide to do a conversion of the IRA to a Roth IRA in 2019, she would be paying tax of approximately $188,000, leaving her with a net balance in the Roth account of roughly $412,000.

Now Christine pays no tax (under current laws) for the rest of her life! Given that her provisional income cannot be more than the limits, her Social Security benefit will never be taxed. And since all of her income comes from the Roth IRA, there is no tax owed at all. But this is a very high price to pay up front – roughly 1/3 of her IRA account. Christine would need to take this tax-free income for around 32 years, as long as income tax rates stay the same. If the income tax rates rise, the break-even time would be less, of course.

Christine – Option 2

But what if Christine instead took her income requirement each year (the same as Stevie), paying the roughly 9.5% tax, but then took an additional amount from the IRA and converted it to a Roth? If she converts $50,000 in the first two years, the additional tax would amount to roughly $11,200 each year. Having done this for two years, Christine can take (for example) $5,000 of her required income from the Roth. The result is to reduce the amount of her provisional income to only $45,000, thereby reducing the amount of her Social Security benefit that is taxed each year to approximately 70%. Now Christine’s annual tax would be reduced to $4,204, a savings of $1,500 per year in taxes.

Christine – Option 3

What if Christine did the conversion of $50,000 for five years in a row, paying a total of $56,000 in tax? Her provisional income is now only $40,000, reducing the amount of her Social Security benefit that is taxed each year to approximately 50%. The difference, $10,000 each year, is taken from the Roth IRA at no tax impact. Now Christine’s annual tax is reduced to $3,094, a savings of $2,700 per year in taxes.


There’s a lot of math going on in this article! The point was to show how this Roth IRA conversion activity isn’t just a question for the rich. It can have an impact on folks at all levels of income. It can be very costly to do nothing! On the other hand it can be quite lucrative to do some planning for integrating Roth IRA with Social Security. As always, talk to your financial professional before making any dramatic moves, just to make sure you’ve got it right.

Note – for the purpose of illustration, I used current tax rates throughout the examples. I realize that rates are likely to increase in years ahead. This will only make the illustrations I’ve done here look better for the Roth conversion early on at our historically low rates (in most cases).

Saving for College

If you’re a parent or plan to be one, chances are you are considering ways to pay for your child’s college education. You may have a goal of sending them to public or private school, with the hope of helping them graduate college with little, if any debt.

Whether or not your goal is to fully fund your child’s education or to help as best you can, there are some options to consider saving as much as you can to reach or education savings goal.

One option to consider is a 529 college savings plan. 529 plans allow money to be contributed specifically for many of the costs of higher education. Money that goes into the account grows tax-deferred, and money withdrawn for qualified college education expenses (tuition, room & board, books, fees) is tax-free.

Many states sponsor their own college savings plans, and some allow a state tax deduction for contributions. Currently, there are no federal tax deductions allowed for 529 contributions. 529 plans also have no income limits – meaning that regardless of income, anyone can contribute to a 529 plan.

Additionally, 529 plans have very high lifetime contribution limits ranging from about $300,000 to $400,000 in total, depending on the state plan. However, the maximum annual contribution limited is $15,000 which is the annual gift tax exclusion. This amount is $30,000 for couples who file jointly. States may also limit the amount of your state tax deduction on contributions.

There is an exception to the annual limit rule which is exclusive to 529 plans. Individuals can make a 5-year pro rata contribution totaling $75,000 (the $15,000 per year exemption multiplied by 5). For married couples filing jointly, the amount is $150,000 (the $30,000 per year exemption multiplied by 5). These numbers are for 2019 and are usually increased annually.

529 plans allow only one beneficiary per 529 plan. The beneficiary may be changed at any time. For example, parents with two children may own one 529 plan with the oldest child named as beneficiary, and then simply change beneficiaries to the younger child when the oldest graduates. Parent can also own one 529 plan for each child. If you’re not a parent yet but want to get started, you can open a 529 plan, name yourself beneficiary, and then simply change the beneficiary to your child when he or she is born.

The money in your 529 plan can be invested according to your risk tolerance or timeline. Many plans have predetermined portfolios of stock and bond mutual funds based on your child’s age, or they allow you to choose your own allocation based on the funds available.

If the money in a 529 plan is used for non-qualified education expenses the earnings become taxable at your ordinary income tax rates and are also subject to a 10% penalty. States may also recapture any tax deductions taken on contributions.

Exceptions to the 10% penalty include if the beneficiary dies, becomes disabled, or receives a scholarship. It’s important to note that in these exceptions, only the 10% penalty is waived. The earnings are still taxable when withdrawn.

Finally, when the time comes to apply for financial aid (grants or student loans) you will likely find yourself filling out the Free Application for Federal Student Aid (FAFSA®). This form essentially determines how much you can contribute toward the costs of college by determining your expected family contribution. 529 plans are considered an asset of the parent (assuming the parent owns it) and the percentage for inclusion in the expected family contribution is much less than assets owned by your child.

4 Ways You Can Make IRA Contributions – Without a Job!

this guy can make ira contributionsIf you know the rules, you must know that one of the main requirements for making contributions to an IRA is that you must have earned income. For most folks, that means you have a job… but it doesn’t have to. Below are four ways that you can have “earned income” without a job – plus a few ways to make contributions without having paid ordinary income tax on the wages. These exceptions are for either kind of IRA: traditional or Roth.

Four Ways to Contribute to an IRA Without a Job

  1. If your income is solely from exercising non-qualified stock options. When you exercise non-qualified stock options, the taxable component of the option exercise is considered taxable income, and therefore is eligible for contribution to an IRA.
  2. Alimony. If you receive alimony, it is taxable as ordinary income, which is eligible for IRA contribution. This only applies to alimony from a divorce that occurred before 2019 – alimony from a divorce in or after 2019 is not considered taxable income, and therefore could not be used to fund an IRA if that’s your only income.
  3. Scholarships and Fellowships. If these are taxable, reported in box 1 of a W2 form, they’re considered earned income for contribution to an IRA.
  4. Spousal contribution. If your spouse has earned income (and you have none or not enough to make a maximum contribution), you are eligible to make an IRA contribution based on your spouse’s income. The limit is that the total of all IRA contributions (yours and your spouse’s) cannot exceed the earned income of the working spouse.

A Few Ways to Make Contributions Without Paying Tax on the Income

  1. Non-taxable combat pay. If reported in box 12 of your W2 form, this no-tax money also eligible for contribution to an IRA or Roth IRA.
  2. Exempt students. If a student has exempt earnings from a job, that income can be used to make IRA or Roth IRA contributions.
  3. If your income is less than your deductions or the standard deduction. In this case, effectively you are not paying tax on the earnings – but the IRA contribution is based upon your Modified Adjusted Gross Income, so you can still make an IRA contribution with the non-taxed funds.

In the above 3 examples, unless circumstances dictate otherwise, you should strongly consider contributing the non-taxed income to a Roth IRA. In either case you wouldn’t likely have a need to deduct a traditional IRA contributions from your income (since none of your income is taxable), and so the Roth IRA makes the most sense. The contributions and any growth on them will always be tax free (under current law).

Are you leaving Social Security benefits on the table?


It happens more often than you think. Without a good understanding of the rules, you might make a move that results in leaving Social Security benefits on the table.

There are a couple of ways this can happen. Let’s start out by identifying the types of benefit we’ll be covering in this article: 

  • retirement benefits based on your own working record (RIB)
  • spousal benefits based on your spouse’s or ex-spouse’s working record (SRIB)
  • survivor benefits based on your late spouse’s or late ex-spouse’s working record (WIB)

Our first example of leaving Social Security benefits on the table relates to the interplay between the retirement benefit, which we’ll shorten to RIB, and the spousal benefit, which we’ll refer to as SRIB. (These acronyms stand for Retirement Insurance Benefit and Spousal Retirement Insurance Benefit, respectively.)

Ben and Anita are age 70 and 74 respectively. Anita has been collecting her RIB since she reached Full Retirement Age (FRA, age 66), but Ben has been delaying receipt of his benefit until he reaches age 70, which allows him to accrue the delayed retirement credits of 8% per year of delay.

The problem is that Ben and Anita didn’t know about the restricted application option available to folks born before 1954. Since Ben was born in 1949 (reaching 70 in 2019), he could have been collecting a SRIB (spousal benefit) from his FRA (also 66) while continuing to delay his own benefit to age 70. Because Anita had already filed for her own RIB at her age 66, when Ben reached age 66 he could have started collecting an SRIB equal to 50% of Anita’s benefit, with no affect on his future RIB.

Since they weren’t aware of this option, unfortunately it’s gone forever for them, now that Ben has reached age 70. It’s possible to retroactively file for the SRIB up to 6 months prior – which is something Ben should do ASAP. But that’s all the farther back he can go to correct this oversight. So he’s left 3 1/2 years’ worth of SRIB on the table.

If we go back in history to four or more years ago and educate Ben and Anita, we could ensure that Ben, having been born before 1954, files a restricted application for spousal benefits. Then he’ll begin to collect the SRIB, while still delaying his own RIB filing to age 70.

This same option is available to Ben if he and Anita were divorced, as long as their marriage lasted at least 10 years. 

Unfortunately, this type of restricted application is only available to folks who were born in 1954 or earlier – so if you (or your spouse) are not at least 65 in 2019, this example won’t apply to your situation.

The second example of leaving Social Security benefits on the table deals with the coordination of your own retirement benefit (RIB), with the survivor’s benefit, which we’ll refer to as WIB (WIB stands for Widow(er)’s Insurance Benefit).

Karen is a widow, her husband Leon died five years ago at the age of 63. Leon had not started collecting Social Security benefits at the time of his death. Karen will turn 62 in July of this year, and she’s planning to retire at that time. She called the local SSA office to set an appointment to find out about her benefits.

When Karen meets with the Social Security folks, they ask her about her marital status, and Karen provides Leon’s identifying information. It turns out that, if Karen was to file for the WIB (survivor benefit) based on Leon’s record, she could receive an additional $10 per month! Karen’s RIB at this point is $1,000, and the WIB is presently $1,010. Of course, Karen says yes, she’d like to receive that extra $10 (in the words of Geddy Lee, “Ten bucks is ten bucks!”).

The problem is that the Social Security folks didn’t tell Karen that she could have started receiving her own RIB at age 62, and then later, upon reaching Full Retirement Age she could switch over to the WIB, which would have increased by an additional $230 per month by that time! In the meantime, she’d be collecting the RIB (that was $10 less than the WIB at that point), but then later she could bump up her total monthly benefit by $230.

This is accomplished by another type of restricted application – an application restricted to retirement benefits only. In this case, Karen would tell the SSA folks that she only wants to file for her RIB, delaying filing for the WIB until later. 

This could also be deployed in the opposite manner – Karen could choose to restrict her application to only the WIB, and then later file for her own RIB. Assuming she waited until her FRA, using our fictitious example, her RIB would have increased to $1,333 by FRA. During the intervening four years, Karen would continue to receive the $1,010 WIB every month.

The critical point here is that Karen must know two things when she files for benefits: 1) which benefit will eventually be the larger, so that she can delay that one and collect on the other; and 2) that she must restrict her application at her present age to only the benefit she’s collecting at that point.

If Karen doesn’t take care to restrict her application, SSA will process the application as if she was applying for all available benefits at that point. You might think it’s a trivial thing, but the problem is that unless Karen restricts her application at that stage, she will be unable to apply for the other benefit later. In other words, upon reaching Full Retirement Age, Karen could not apply for the RIB (since she’s been collecting the larger WIB) if she did not restrict her application to only the WIB when she first applied. SSA will tell her that she cannot apply for RIB at this point because she applied for all available benefits back when she was 62. And there’s no “do-over” for this problem, much the same as in the first example.

SSA doesn’t tell you this – you have to know it on your own. SSA staff are famous for not providing advice when you are consulting with them. It seems that their primary objective is to get you the largest benefit possible at that given point in time – even if a greater benefit could be had later, by taking the time to restrict the application to only the benefit currently being received.

It’s up to you to know how this all works, and to be your own advocate as you go through the application process. Otherwise you may be leaving Social Security benefits on the table.


401k Loans Double-Taxed? Not so fast, conspiracy theory-breath

It has long been an urban myth that when you take out a loan from your 401k that you’re being double-taxed on the amount of your loan… but this isn’t so. This is a very pervasive myth – lots of folks will agree with it out of hand, but it’s not correct, when you work out the details. Let’s start with an explanation of why people believe that they’re being double taxed.

Double-Tax Scenario

You take out a loan from your 401k for $10,000. You make arrangements to pay this back in 10 monthly payments of $1,010, with the extra $10 representing the interest on the loan (the rate isn’t important to this example). As you pay this money back into the account, the payments are made with after-tax dollars. Fast forward to your retirement – you’re ready to start taking distributions from your 401k. All of those payments that you receive from your 401k will be taxed as ordinary income, including the $10,000 that you took out as a loan.  Double-taxation, right?

tony-shalhoubWrong. To borrow a phrase, here’s what happened:

The Real Story

You take out a loan from your 401k for $10,000. You use that money to buy something… let’s say it’s bubble gum. Normally when you buy bubble gum, you have to buy it with after-tax dollars. The 401k loan proceeds are not taxed when you take them out, but the dollars you’re paying it back with have been taxed. This is the same as if you had bought the bubble gum with your own money from your earnings, because that money is taxed when you earn it. So when you pay the money back into the account with after-tax dollars, you’re economically the same as if you had paid it with your after-tax savings.

Maybe the following examples will help… the assumed tax rate is 20% for simplicity.

No loan. You want to buy $10,000 worth of bubble gum. You must earn $12,500 in from your job in order to have $10,000 in take-home, or after-tax, money for the purchase. So, income tax included, it has cost you $12,500 to purchase the gum.

With a loan from the bank. You want to buy $10,000 worth of bubble gum. You take out a loan from the bank for $10,000 and make arrangements to pay it back in 10 installments of $1,010 per month. As you pay back the loan, you must earn gross income of $1,262.50 (at 20% tax) to make the $1,010 payments. In the end, it has cost you $12,625, tax and interest included, to purchase the gum.

With a loan from your 401k. You want to buy $10,000 worth of bubble gum. You take out a loan from your 401k for $10,000 and make arrangements to pay it back in 10 installments of $1,010 per month. As you pay back the loan, you must earn gross income of $1,262.50 (at 20% tax) to make the $1,010 payments.  In the end, it has cost you $12,625, tax and interest included, to purchase the gum, just the same cost as the bank loan. However, since you’re paying yourself the interest, your 401k account will have grown by $100 (the interest payments) with this activity.

End Result

So the end result is that you’re only taxed on your 401k funds upon distribution. If you don’t stop and think about how your money is treated for all other purposes, it might seem like an unfair situation – but economically, you’re no worse off with this loan versus any other loan (actually a bit better since you receive the interest in your 401k). And the interest is the only difference between taking this loan and just paying for it out of your regular take-home pay.

One last thing: When you took the loan from your 401k, that $10,000 was no longer invested in your account, right?  Well, it may not show up in your balance, but in effect, you have invested that money in a loan to yourself. After you’ve paid back the loan and the interest, you’ll have growth of that original $10,000 to a total of $10,100 (10x the $1,010 loan payments).

Note:  the foregoing explanation was not intended to be an endorsement of using a 401k loan. There can be detrimental consequences if you are unable to pay it back, or if you lose your job – in either case you’ll be taxed and penalized on the amount of the loan. You’re always best off to use all other sources of credit – and then count backwards from a million – before going ahead and taking a loan from your 401k.

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Renter’s Insurance

renters insurance policyIf you’re considering living in an apartment or currently reside in one, it’s important to make sure you have renter’s insurance. Renter’s insurance is an often-overlooked risk management tool for an overall financial plan, but it’s critical for protecting your assets and liability.

Renter’s insurance covers your personal property in your apartment. This includes clothes, furniture, electronics – pretty much all your stuff. It also provides liability coverage. This means that if you’re liable for damages to the apartment complex, someone’s injured in your apartment, or you’re liable for other damages, the liability coverage provides an amount to help pay for these damages. In other words, if you’re found liable or negligent it doesn’t come out of your pocket. The renter’s insurance pay for it.

A typical renter’s insurance policy can provide $15,000 of protection for your personal property (you can get more if needed) and $100,000 for liability coverage. However, consider $300,000 of liability coverage or higher, just to be safe. You may also consider an umbrella policy to provide liability coverage above and beyond your renter’s policy (for catastrophic losses).

The cost for renter’s insurance is relatively cheap. You can expect to pay about $150-$200 in annual premiums. This could differ depending on your location, personal property, etc. Bundling your renter’s policy with your auto insurance with the same company may also save you money with a multi-policy discount.

So, if you’re a recent graduate just starting out or currently renting an apartment, consider getting a renter’s insurance policy or reviewing your current policy for updates. For a small amount of money per year it will provide thousands of dollars in coverage.

Why is Index Investing a “No Brainer”?

For those of you who have read much of my writing on the subject, you’ll recall that I generally recommend working with index investments when we have them available. In this article I will do my best to help you understand some of the reasons why I recommend index investing.

What is Index Investing?

In order to understand why index investing is a good option, I need to explain first what I mean by an index. In general, an index investment is a representative investment covering a market, sector, or asset class. The S&P 500 is an index for example, representing the asset class of the 500 largest publicly-traded companies in the US marketplace. The Vanguard Total Market Index is an index that represents the entire spectrum of domestic (US) publicly-traded companies. There are many other examples, including the Lehman Brothers Aggregate Bond Market Index (all publicly-traded bonds in the US marketplace). The Morgan Stanley Capital International (MSCI) Europe, Australasia, and Far East (EAFE) index represents the entire markets of the following countries: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, The Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom. Since these indexes represent an entire marketplace, they are often used as the benchmark against which managed (non-index) funds are measured.

There are mutual funds and exchange-traded funds that track these various indexes. If you’ll recall, one of the first tenets of successful investing is to diversify – don’t put all of your eggs in one basket. By investing in one of these indexes, the investor is taking an ownership stake in all of those companies at once. What a great, simple way to diversify!

These indexes do not require a professional manager to oversee them, because they represent an entire marketplace. The makeup of the index only changes by an outside force (S&P replacing one company in the 500 with another, for example). Because of this, there is very little overhead (fees and expenses) to reduce your return within index investing. Also, since we aren’t changing investments by selling a company’s stock that is out of favor and buying one that we think might provide better returns in the future, transaction costs are limited, and excess taxation of capital gains is limited as well.

What Are Managed Investments?

On the other side of the coin from Index Investments is the group of mutual funds called Managed Investments. These are investment vehicles where a manager (or team of managers) chooses a group of companies (stocks or bonds) to invest in. Over time, this group of investments must be monitored to ensure that the individual companies are producing the expected results. If a company appears to be underperforming  or has changed intrinsically, that stock is sold and another company is chosen to replace it in the fund. All of this analysis requires lots and lots of research, review, and day-to-day management. That management costs a lot of money – often upwards of 1% of the fund’s holdings each year – as opposed to less than ¼% for many index funds.

7276279The idea is that the professional management team is a bunch of very smart guys and gals, and being very smart guys and gals, they can potentially get you a better return than you could get by just buying an index fund. Care to guess how often that happens, consistently? Less than 5% of the time, according to records, and that doesn’t include all of the funds that are eliminated or merged due to underperformance.

So – the first “wrong” with investing in managed mutual funds is that you’re taking a chance that your chosen smart guys and gals (the managers of the fund you’ve chosen) will happen to be in that top 5% that beats the index investment. And you’re paying something like four times (or more) in expenses to get there. But people still love a gamble, and so managed funds remain very popular. But why?

Under The Covers

Let’s take a look at why some managed mutual funds appear to be a good gamble.

Mutual fund companies introduce lots of funds every year. As an example let’s say a fund company introduces ten new funds in the year. Each fund has a fair-haired boy (or girl) managing the fund, and the manager does his or her level best to produce a good return. For the most part, since these funds haven’t been marketed to the public much, the fund company puts some of their own money in the fund;  this is called “incubation”, it’s a way for a fledgling fund to build a track record before investment of a lot of money in marketing. At the end of the year, nine of the ten new funds have poorly underperformed, but one of the funds outperformed the indexes by a wide margin – let’s say it’s by more than 20%.

The nine poor-performing funds’ monies are merged with the one winner fund (or some other fund), bolstering it’s asset size, and the marketing begins. Investors hoping for that “one in a million” investment are drawn to this new fair-haired investment manager because of the fantastic return that his or her guidance produced in the past year. Now is when it gets interesting…

The Interesting Part

I mentioned before about how less than 5% of all mutual funds consistently outperform the entire market index. That’s because it is very difficult to individually pick and choose 50 or 100 companies that will do better than the market (or index). The entire market has a track record of increasing in value over 80% of the time, year in and year out. Imagine trimming that 10,000+ group of investment choices to a manageable group of 50 to 100 stocks (or bonds) that will do better than everyone else! It’s very, very, difficult, indeed – and most managers do not do this – and certainly not consistently year after year.

So, what happens is that after the fund has had it’s initial “home run” season, where it outperformed the market by 20% or more, is that the fund attracts all kinds of attention and investors. In the second year, lots more money pours into the fund after the aggressive marketing, and the manager does his or her best to reproduce the result from the previous year. Amazingly enough, maybe she does it, but this time only by about 2% overall – and the expense ratio of the fund eats one percent right away. But look at her track record:  over the span of two years, she’s outperformed the index by an average of 11%! Why would you NOT invest in this fund??

After the second year where the manager just squeaked out a positive result, not wanting to lose investors’ funds, she becomes more conservative. Now she begins to more closely track the index against which her fund is compared, rather than whatever magic was used to produce the first year’s stellar results. At the end of this year, the fund doesn’t quite meet the index’s return, but it’s pretty close (until you take out the additional 1% of expenses). But again, the marketing points out that, over a three-year period, this manager has outperformed the index by almost 7%. Again – you’d be a dummy to not invest with that kind of result, right?

And so it goes… eventually this fund’s returns each year are always coming up just short of the index, and after a good run of five years, the fund is folded into the next best thing. Lather, rinse, repeat…

Backing Data

I wanted to give you some additional data on the above activity, so I ran some screens using readily available tools (like Yahoo! Finance, Morningstar, etc.). The results were quite interesting: on one screener I looked for mutual funds that performed in the top 20% in each of the previous five years, and 3 funds were the result, one of which was an index fund.

So next, I looked at all funds created during calendar year 2013, and took their rankings for 2014, 2015, 2016, 2017 and 2018.  Not one of the funds that was in the top 20% for 2014 repeated for all five years, and only a very small percentage of that top 20% ever showed up again in the top 20% for the succeeding four years.

Of course this isn’t definitive research and it doesn’t prove anything conclusively. I’ve found it doesn’t pay off to spend too much time checking these things out, because the result remains the same.

One other item that was not factored in is called survivorship bias.  This is the phenomenon that occurs because only the surviving funds, those that had good performance, are available for result comparison in subsequent years. From our example above, nine of the ten new funds created by our fictitious mutual fund company were shut down after the first year. So now, being non-existent, the poor results that those funds brought forth are not included in any screening reports, making the results (of only the surviving funds) look much better overall.

silver legacy casino hotel reno nevada by jimg944Bottom Line

At any rate, I wanted to provide you with this explanation of yet another problem seen in the investing world. I think it can best be summed up by comparing investing with gambling at a casino. Everyone knows that gambling odds are always in favor of the “house”. The individual gambler might hit it big once in a blue moon, but in general the gambler pretty much always comes out on the short end. On the other hand, with the odds in the favor of the casino, owning a casino (or casino stock) might be a pretty good way to make a lot of money.

In the investing world, it pays off to own the “casino” – that is, to own the entire marketplace – instead of playing the games of managed mutual funds. Owning the marketplace (via index investing) gives you the benefit of an 80% opportunity for an increase in your holding each and every year, for a very low expense ratio.

How QDRO Impacts NUA

choate buttonDon’t let the alphabet soup in the title put you off. If you’ve never come face-to-face with a QDRO you might not need to know this – but then again, the basic underlying premises are good information to understand…

First some definitions, just so we know what we’re talking about:

QDRO: Qualified Domestic Relations Order – this is a method for permitting distributions from a qualified retirement plan (not an IRA) in the event of a divorce. How a QDRO works is that, upon the decreed division of assets, if a retirement plan (such as a 401(k) or 403(b)) of one spouse is chosen as an asset to be divided and a portion given to the other spouse, a QDRO is issued. The QDRO allows the division to occur without penalty… otherwise, making a distribution from a qualified plan before age 59½ would result in penalty and possible taxation, as we all know. The QDRO provides a way (allowed by the IRS) for the receiving spouse to rollover the funds into an IRA of his or her own, without tax or penalty to either spouse.

NUA: Net Unrealized Appreciation – this is a special provision from qualified retirement plans that allows the employee to elect to treat company stock differently from all other assets in the plan when making a distribution from the plan. Essentially, you pay ordinary income tax on the basis, original cost, of the stock in your employer’s (actually former employer’s) company, and then place the stock in a taxable brokerage account. At this point, any gains on the stock are subject only to capital gains tax (rather than ordinary income tax, which is a much higher rate). The trick is that you can only do this maneuver one time, and the distribution must be in a lump sum of all your 401(k) account holdings. Everything in the account that is not company stock can be rolled over into an IRA and maintain tax deferral as usual. It’s critical to note that this can be the only distribution of funds from the account. If you were to distribute any amount, even a small amount from the employer plan in a previous year, you are no longer eligible to use the NUA provision on this employer account.


So the question comes up – if a QDRO distribution occurs for your account, and that distribution includes company stock: does this “bust” the original employee’s ability to later have the company stock treated with the NUA privilege, since the rule states that the distribution must be a one-time single lump-sum distribution?

(drum roll…) The answer is NO.  A QDRO is a division of the account, and though technically a distribution has occurred, this distribution does not impact the remaining account’s ability to take advantage of the NUA provision. The employee can go ahead and, upon separation from service, perform the lump-sum distribution of the stock and rollover the remainder into an IRA and get the NUA treatment for the stock.

Now, if you’re really astute, the last paragraph made you think of another question (it’s okay to admit it if you aren’t tax-geeky enough to have thought of this question): Can the ex-spouse (the one receiving a split of the employee’s plan) elect NUA treatment of any stock that was included in his portion of the account?

(drum roll…) The answer is a qualified YES. The qualification is this: As long as the rest of the account is eligible to be distributed (to include NUA treatment), the QDRO’d portion of the account can also take advantage of this provision.

In other words, although the ex-spouse of the employee could rollover the QDRO’d qualified retirement plan into an IRA at any time, if the account contains appreciated employer stock (stock of the former spouse’s employer) – it may be in the best interest of the receiving spouse to wait until the employee reaches age 59½ or leaves employment (termination or retirement), so that she can take advantage of the NUA provision. Otherwise, any rollover will squash this option forever.


Here’s a quick example to illustrate: Dick and Jane are divorcing.  Dick has a 401(k) plan with his employer, including some stock in his employer. Part of the divorce includes a QDRO to give Jane half of the 401(k) plan.

Once the QDRO is completed, Dick still has his original 401(k) account (albeit diminished by half), and Jane has an account in the plan of equal size. Jane can rollover those funds into an IRA at any time, if she chooses, without penalty. However, since the account holds highly appreciated company stock, in order to qualify for NUA treatment, she must maintain the account in the 401(k) plan until Dick terminates employment, retires, or reaches age 59½. At that time, she can pull the lump-sum distribution for NUA treatment and rollover the rest into an IRA. Dick can elect NUA treatment for his account when he terminates employment or retires.

Now you may be wondering about that picture… the button is the prize that a person gets when in a seminar with Natalie Choate, the renowned IRA expert – if you happen to ask a question that she is unable to answer. I asked the above questions of Mrs. Choate recently and received the button. No disrespect for her whatsoever – as an admirer of her work, I am proud of the button and wanted to share it here.

How To Turn $5,000 A Year Into a $33 Million Legacy

$5000 by AMagillWith a headline like that I bet you’re thinking this is one of those wild & crazy get rich schemes. However, it’s really just a hypothetical illustration of the great benefits of three factors that can work in your favor in building a legacy:

What follows is an example of how you can make those three factors work together to create this $33 million legacy.

How It All Started…

Once upon a time, there was this guy named Joe.  Joe is 20 years old, working part-time making decent money, finishing up college, just generally living large (by a 20-year-old’s definition). On the advice of his father (yes, some 20-year-olds do listen to their fathers!), he opened up a Roth IRA, funding it with $5,000. The account was invested in a fixed 5% yield instrument of some sort (not important what the investment is, just assume a 5% annual yield).

Using the Roth IRA is advantageous to Joe because his tax rate is very low at this stage of his life. And presumably tax rates will be increasing for him in the future. Any growth within this account is tax-deferred and most likely tax-free, as long as any future distributions are for qualified purposes.

Each year thereafter, Joe contributes an additional $5,000 to the Roth account. After he completes college, Joe starts working at an entry-level job. Not long after, he marries his high school sweetheart Jane, and Joe & Jane settle into their newlywed life. As life goes, they soon have children in their household, and even though money is tight, Joe continues to contribute the $5,000 each year into his Roth IRA. Life goes on like this for a while.

And then… 20 years pass

At age 40, Joe launches his own business. During this time in his life, tax deductibility becomes more important to him since he’s making a lot more money and is in a higher tax bracket. With this change to his tax circumstances, he stops contributing to the Roth IRA and starts investing in tax deductible retirement accounts.

All this time, his investments in the Roth account have been steadily growing at that fixed 5% rate. Now after 20 years the balance of Joe’s Roth IRA is now up to $165,329. Joe’s 20 years’ worth of $5,000 investments, makes a total of $100,000 contributed. Pretty nice, right?

Joe just sets the Roth IRA aside at this point, forgetting about it altogether for quite a while (other than those pesky quarterly statements). Not much of note happens in our story for a long, long time, other than compounding interest, time passing, and continued tax deferral.

… and another 50 years pass

Joe is now 90 years old. His business has flourished through the years, and his children are reaping the benefits of having worked there, and the children are now retiring. His grandchildren have taken over the business, and he and Jane are enjoying their great-grandchildren. A couple of years later, little Jolene is born, and this first great-granddaughter quickly becomes the apple of Joe’s eye.

It is along this time that Joe remembers that long lost Roth IRA account. To this point the Roth IRA has grown to over $2 million – from that original series of $5,000 contributions that amounted to a total of $100,000. Pretty amazing what can happen with compounding interest and time. Now, while doing his estate planning, Joe has plenty of other assets that he intends to eventually bequeath to his children: the business, other retirement and investment accounts, etc.. This Roth IRA though, he’s decided he’d like to really make a legacy out of it. So Joe decides to name his great-granddaughter Jolene, a newborn, the primary beneficiary of the Roth IRA account.

… and then, a couple of years later…

At age 95, with his family surrounding him, our protaganist Joe passes away.

little girl by ganessasLittle Jolene is now two years old, and as primary beneficiary of the Roth IRA (now worth over $2.4 million), Jolene must begin taking Required Minimum Distributions from the account, based on her age. Jolene’s Table I factor is 80.6, and so her first distribution is for just over $30,000. Her parents file the necessary paperwork and then they put this money away for Jolene’s college education fund.

And so on it goes, the account continuing to compound at 5% each year, Jolene receiving her RMD each year, and her parents putting that money away for college.

Fast forward some more…

Jolene has graduated from high school, and she’s planning to go off to college. Over the past 16 years since her beloved great-grandpa Joe passed away, she has received a total of over $650,000 in distributions from the Roth IRA that he left for her. This has made for a nice start on her college costs. (We won’t get into it now, but if we projected college costs out this far into the future, a year of college might cost more than $6 million at the 7% rate of increases we’ve seen recently.)

So Jolene finishes college, and she continues to receive the RMD payments from the wonderful gift from great-grandpa Joe throughout her life. She lives a long, full life, with a loving family and great success. At age 82, according to the original Table I factor, she has depleted the inherited Roth IRA. The total of all of the RMD distributions she received over those 80 years amounts to $33,069,557. Not too shabby for Joe’s $5,000-a-year commitment over 20 years.

Note: other than acknowledging the factors, income taxes, inflation, and other factors have not been calculated into this example. The example is only intended to illustrate the value of long-term investing, compounding of interest, and tax-deferral benefits of Roth IRAs, plus the stretch provisions. This example is not intended to represent real life situations, although it is certainly feasible. Bear in mind that this entire example’s activity takes place over the span of approximately 155 years.

Pension Payout: Annuitize or Rollover (Cash)?

cash by Franco FoliniIf you happen to be in one of those jobs (there can only be a handful left at this point, right?) that has a traditional pension plan, you may be faced with an important decision. When you’re ready to retire (did I just hear angels singing?) – you have to decide if you’ll take annuitized payments, or if you cash out the plan and roll it over to an IRA.

These “traditional” pension plans are referred to as defined benefit (or DB) plans – meaning that your benefit is defined as a determined amount. This benefit is usually based on a combination of your longevity in the job, plus your ending salary. You’re probably familiar with these computations: an example is a pension that is 2% per year of employment, multiplied by the average of your final five years of salary. So if you worked at a job for 25 years and your final five years’ salary average was $80,000, your annuity would equal $40,000 – which is $80,000 times 2% times 25 years. Often the calculations are more complicated, but that’s the gist of how they work.

In addition, your plan may also offer a cost of living adjustment, or COLA. With a COLA, each year the amount of your annuity payment is increased according to an inflation index such as the CPI, or a fixed rate such as 3%.

There are often other options to choose, such as the pension payout period. It might be for your lifetime (a “life annuity”), for you and your spouse’s lifetimes (a “joint and survivor annuity”), or over a set period of time, like 10 or 20 years (a “period certain annuity”). Quite often, unless there is a survivor option (such as a joint and survivor annuity) or a set period of time (like the period certain annuity), upon your death there will be no residual benefit from the plan. It is because of this that many folks look with favor upon the final option:  the cash-out and rollover.

Cash Out and Rollover

Most often these DB plans also offer an option to receive a cash value settlement for the plan. The amount of the settlement is a discounted value of the future cash flows (the pension payments) that you could expect to receive. For example, the pension mentioned above (the $40,000 per year payment, with no COLA) for a 62 year old retiree might have a cash-out value of $400,000. This may seem like a pretty nice amount of cash. However, this is where some folks act too quickly. (Actuaries, if you’re out there, I just picked some numbers out of the air.  I don’t know if they’re realistic or not. Forgive me!)

I get it – $400,000 in hand seems like it would be worth more than a future promise to pay $40,000 a year. Because, what happens if you die two years into the plan? As mentioned before, unless you have a survivor element in the pension plan, there will be nothing left for your heirs. There’s a lot more to consider than just the amount of the payout and your lifespan.

Things to Consider

It’s important to look at the provisions of the plan and all of the available options in order to determine what’s the best route to take. Each of the various payout options (life annuity, joint and survivor, period certain, etc.) needs to be examined to understand how the cash-out payment is calculated. (This is where it pays to know and work with a financial advisor.)

As you look at the various pension alternatives, consider them in comparison to one another. Sometimes the company subsidizes the survivor benefit to a degree, making a joint and survivor annuity more beneficial than either the single life or the cash-out option. In addition, sometimes for an early retirement option, the pension itself (over all payout options) is subsidized by the company, or “sweetened” to make retirement more attractive to the potential retiree.

As mentioned before, your health and the health of your spouse (as it impacts your lifespan), plus your other financial resources and lifestyle goals need to be considered as you look at the plan options. You also want to consider the financial strength of the company whose pension you’re considering, as well.


Going back to our example: the cash-out payment of $400,000 should be considered against the other pension payout options. The single-life payout was calculated at $40,000 per year for your life. What if the joint and survivor pension payout option was calculated at $36,000, and your spouse is also age 62? This means that you would instead receive $36,000 over your life and the life of your spouse if you predecease him or her. First of all, which option is a better deal? And secondly, is one or the other better than the lump sum cash payout?

We have to make some assumptions when calculating the values of these options. According to actuarial tables, using a joint and survivor option will statistically result in more years of payments, even if the two lives are the same age. Therefore, when comparing a single life annuity to a joint and survivor annuity, we assume that the joint and survivor annuity will be paid out for a longer period of time.

Using a 5% discount rate, the value of the joint and survivor payout is worth approximately 10.8% more (in present value) than the single life annuity. In other words, if you bypass the joint and survivor option, you’re giving up that potential 10.8% of extra value. Another way to look at it is that you’re giving your company a gift of the extra value by not choosing the J&S option.

Either of the pension options are also better than the cash payout – from a strictly financial standpoint, as long as you live to whatever the projected mortality age is for your plan (I used 82 for the example).  This is because the rate used to discount the present value of your future cash flows was 5%. This means that you’d need to get a return of something more than 5% from your lump-sum cash payout during that time frame in order to break even. Keep in mind that this 5% is a guaranteed rate – as long as you live long enough.

Of course, if your health is poor (or you have a family history of life-shortening health problems), you may benefit by taking the lump sum, for the “bird in the hand” benefit. However, if you happen to live longer than the actuarial tables project, you might be in the unenviable position of outliving your funds.

These are some of the issues you need to consider. This has been a very rough example but it should help you to understand the importance of looking before you leap.

It’s often very attractive to choose the cash-payout option since there are many inherent problems with the defined benefit pension plans. But you shouldn’t make the decision willy-nilly. It pays to examine the numbers closely, and if necessary hire someone to look at the numbers with you. You should know what you’re possibly giving up with each choice versus the alternatives.

Principles of Pollex – Saving 10% of Income

thumb xray by akeg(In case you are confused by the headline: a principle is a rule, and pollex is an obscure term for thumb.  Therefore, we’re talking about Rules of Thumb.)

I like rules of thumb, as a rule of thumb… I think we all generally want difficult issues in our lives to be boiled down to a simple, easy-to-understand statement.  These rules of thumb are everywhere, all around us. Heck, there’s even a whole website dedicated to rules of thumb, where you can find rules on all kinds of subjects, as diverse as how to outrun a crocodile to changing your answers on a test.

Save 10% of Your Income

Let’s start with one of the basics you might hear regularly: Save 10% of your income. Like most all rules of thumb, this one is very general in nature, but it provides a good starting point.

This starting point is best for someone starting the savings process at an early age – perhaps in your twenties or thirties. If you started to save 10% of your income at an early age and kept up the habit over your lifetime, you’d be bound to have a significant sum of money put aside when retirement comes. (You might be interested to note that this particular rule of thumb is one of the base recommendations in the book “The Richest Man in Babylon” which I wrote a summary of some time ago.)

The problem is that many folks don’t start early in life, and by the time they get around to saving in earnest (maybe in their forties), 10% savings will likely be woefully inadequate – 25% to 30% may be more appropriate.

The other, likely bigger problem with the 10% rule is that it doesn’t account for your timeline or the purpose or goal for the savings. The assumption of the rule of thumb is that you have a long timeline, meaning 30 or more years, and that your goal is retirement at some poorly-defined rate of income, such as 80% of pre-retirement income (see below). These two assumptions don’t fit everyone – although they could fit some people in general, your mileage may vary, quite a bit. If your timeline is shorter (say 10 to 15 years or less) or your goal is for a higher retirement income your percentage of savings should be higher, possibly much higher. If your goal is something altogether different, like a downpayment on a home (in a short timeline but of a specific, small-ish amount), 10% would be too much – although you will likely benefit on other goals by saving at least 10% starting at any time.

So, for a starting point, for someone with a relatively long timeline and a vague goal to aim for, 10% isn’t a bad place to start. Start with 10% (or however much you can afford) and adjust upward over time. It’s better than no rule at all, in my opinion.

When it Makes Sense to Take Social Security Early

fries with gravy by tweber1In this blog many times we’ve covered how beneficial it can be to delay receiving Social Security benefits as long as you can. An example of this discussion is in the article Ah, Sweet Procrastination – it makes good financial sense to delay receiving your benefit to age 70 in many cases, but of course not all.

The reason delayed filing can be such a great benefit is that this government-backed income stream is pretty much as good as you can get, in terms of longevity insurance. When you start receiving the benefit, you’ll continue to receive it through your entire life. When you start receiving your benefit impacts the amount that you will receive for your life. Plus, depending upon the amount of your spouse’s benefit, it will impact the amount that your spouse would receive as a Survivor’s Benefit as well.

But there are times when it may make more sense to begin receiving your benefit earlier…

Starting Early

Circumstances require it. If you’re in ill health, have a shortened life expectancy, or have very limited other resources, it may be necessary to start taking your Social Security benefit early. The financial calculations that we do that explain how delaying receipt of benefits is the better choice, always assume that the recipient will live to at least age 80 or beyond and can get along using other resources until filing at age 70. If one or the other (or both) of these circumstances is not the case for you, it likely makes more sense to begin taking your benefit earlier.

Spouse with a relatively small benefit. If the spouse with the lower wage base has earned a relatively small benefit and intends to switch over to a Spousal Benefit as soon as it makes financial sense, it might make more sense to start taking the smaller benefit early, even though it is reduced. In this case the financial impact of starting to take the benefit early doesn’t amount to a significant reduction in real dollars, so taking the benefit for several years is just extra “gravy on your french fries”, in a manner of speaking.

Social Security doesn’t matter to you. If you have more funds than you really need and the Social Security benefit is of very little real benefit to you – or if you consider the Social Security system a “safety net” for needy folks, you might want to start early. Or you may choose to not take the benefit at all.

Psychological impact. If you simply cannot stand the thought of leaving your Social Security benefit in the government’s hands any longer than necessary and you feel it’s to your best interest to start early (even in the face of facts to the contrary), then by all means start taking benefits early. If that’s what it takes to ease your mind, you should do it. Life’s too short to be wrought up over such matters.

Closing Thoughts

As stated before, in many cases it makes the most financial sense for the spouse with the higher earned benefit to delay benefits to age 70, but not in all cases. In order to really get a good handle on how these calculations would work for you, it may help to hire a professional advisor to run through the numbers with you.

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