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2018 Trust Fund Report Takeaways

Jul 2nd, 2018
by jblankenship.
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2018 trust fund reportRecently the Social Security Trustees released the 2018 Trust Fund Report. As has been the case over the past several years, the outlook for the Trust Fund is not good. As of 2018, the projection is that by the year 2034, the Trust Fund will be exhausted, and future benefit payments will have to be made solely from current tax receipts. If this is the case and no changes are made to the Social Security system, future benefits will have to be reduced by 23% going forward.

Please note that this article is only addressing the OASI (Old-Age and Survivors Insurance) Trust Fund, not the DI (Disability Insurance) Trust Fund. DI Fund is actually in better shape than the OASI Fund.

As usual, this report was met with a common response – one tweet effectively said “Name one annuity company that has published that they will cut payments by 25% on their annuities in 16 years?” Much drama to be found…

Of course, that rhetorical question was misguided and had the facts wrong, but it’s indicative of the kind of angst such reports cause. So let’s look at the facts. There are two types of fact that apply here – mathematical and policy. Let’s look at the math first.

The tweet mentioned above was made in defense of a strategy to take benefits as early as possible. The historical result for early filers is often less than optimal. The system is designed to deliver more-or-less equal benefits over your lifetime regardless of when you file, if you live to the average age. But, just between you and me, we know you’re above average – oddly enough, so am I. Because of that, you and I can expect to live longer than the projected approximation of ages 82-84. And when we live longer than that, we will be mathematically “in the black” if we delay Social Security benefits as long as possible.

I know that no argument in the world is likely to change the mind of someone who is dead set on filing for Social Security benefits early. By all means, go ahead if it makes you feel better. In the end, the more that choose to file early, the better off the Trust Fund will be, because you’re leaving money in the system by short-changing yourself and your family. More for the rest of us!  :-)

Keep in mind, this is not to say that there are not compelling circumstances in which early filing may be necessary. If you have no other (or not enough other) resources, or if you have ill health or an expectation that your lifetime would be shorter than the actuarial estimate, early filing may be your best option.

Facts from the Social Security 2018 Trust Fund Report

I mentioned previously that if no changes are made, the projection is that in 2034 benefits may have to be reduced by up to 23%. First of all, this is an improvement from recent years’ projections: as recently as 2013, the projected Trust Fund depletion was a year earlier (2033), and the required projected reduction thereafter was steeper at 25%. (This is likely where the Tweeter mentioned above got his information from.) So, although it’s not great news, the projections have actually improved in these intervening five years.

At the same time, the projected shortfall is based on nothing changing about the Social Security program. That’s extremely unlikely. But don’t expect any changes in the short term. Congress has a long, proud history of waiting until the last moment to avert crises.

To illustrate, here’s an excerpt from the 1980 Trust Fund Report (VIII. Conclusion):

Over the short term the OASI trust fund will face financial strains requiring policy actions. Without such actions, the OASI fund would be depleted in late 1981 or early 1982, depending on the course of the economy.

At that time, we were facing a depletion of the Trust Fund within one to two years! And guess what? Congress (promptly?) acted a little more than 2 years later (early 1983) by passing landmark legislation altering the Social Security program. This legislation augmented the input sources and outflows to produce a projection that in the 1984 Trust Fund Report (VII. Conclusion) indicated virtually no shortfall of trust fund amounts for the forseeable 75 year period. Of course, at that time no one could predict the kind of economy we’ve been seeing in the first two decades of the new millenium, which have (at least partly) been the blame for the accelerated projected exhaustion of the trust fund.

Something will be done, and of course it won’t be painless – but there will be action and the future of the Social Security program will be viable once again, at least for a while. There have been many efforts put forth as potential policy changes that could resolve this impending crisis – increase the wage base, means test the benefit payouts, and the like. Whatever it is, expect the changes to be unpopular, but effective to the extent that the program will continue paying benefits as promised.

Designated Roth Account (Roth 401k) Distributions

Jun 25th, 2018
by jblankenship.
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roth dune

Photo credit: diedoe

In a previous post we discussed the general information surrounding Designated Roth Accounts (also known as a Roth 401k) – eligibility, tax treatment, and contributions.  In this post we’ll go over the nuances involved in distributions from a Designated Roth Account under a 401k.  Distributions are a little different from most other retirement plans, as you’ll see…

Required Minimum Distributions

One of the first things that is different about Roth 401k distributions is that the Required Minimum Distribution (RMD) rules DO apply to these accounts.  This is different from the Roth IRA, as RMDs are not required by the original owner under present law.  RMD for a Roth 401k are the same as the RMD rules for all other accounts to which the RMD rules apply.

There is, however, a way to get around the RMD rule: if you roll over your Designated Roth 401k account balance to a Roth IRA, RMDs no longer apply.  Obviously this is a tax-free event, since both accounts are non-taxable in both contributions and earnings.  As long as this is done before the first year of RMD, these rolled over funds will never (under current law) be subject to RMD rules to the original owner of the account. When inherited, Roth IRA and Roth 401k funds are subject to RMDs as inherited accounts – but that’s a topic for another day.

Qualified Distributions

Another difference for the Designated Roth 401k account is in the definition of qualified distributions.  As with other retirement accounts, qualified distributions can occur when one of the following events occurs:

  • account owner reaches age 59½; or
  • account owner dies; or
  • account owner becomes disabled (per IRS definition).

In addition to one of those events, in order for the distribution to be qualified (and therefore tax-free), the account must have been in existence for at least 5 years.

Non-Qualified Distributions

A non-qualified distribution is, as you might guess, when the rules for a qualified distribution (above) have not been met.  Of course, there are complicated rules associated with any non-qualified distribution from a Designated Roth account.

Pro Rata Rule for Non-Qualified Distributions

A pro rata rule applies (instead of the ordering rules that apply to Roth IRA accounts) for non-qualified distributions from a Roth 401k.  For example, if the account had received contributions of $5,000 and had grown to $10,000, when a distribution occurs before the account has been in existence for 5 or more years, 50¢ of every dollar will be taxable.  This is different from the rule associated with a rollover, as you’ll see.

Ordering Rule

Just to confuse matters, when rolling over a portion of a Designated Roth 401k account to a Roth IRA in a non-qualified distribution, the ordering rules do apply, so that the first portion rolled over is the taxable amount (the earnings).  If the rollover was a qualified distribution, all amounts are considered basis in the new account, and therefore non-taxed upon a qualified distribution.

Rollovers

Now, let’s see how the IRS has really muddied the waters:  when rolling funds over from an existing employer to another employer’s Roth 401k – it’s a straightforward activity if you do a trustee-to-trustee transfer – same as for a transfer to a Roth IRA.  However (and there’s always a however in life, right?) if you do a non-qualified 60-day rollover things really get complicated.

Complications With a 60-Day Rollover

Here’s what happens with the 60-day rollover to a new employer’s Roth 401k plan:  first of all, only the growth (or earnings) from your old employer’s plan can be rolled over to your new employer’s Roth 401k plan.  In addition, the earnings portion of the account will be subject to mandatory 20% withholding, even if you roll the entire amount into the new employer’s plan, which should be a tax-free event.

Here’s an example:  your Roth 401k account has $20,000 in it, of which $5,000 is earnings.  You decide to roll over this account to your new employer’s Roth 401k plan.  If you don’t do a trustee-to-trustee transfer, you will only be allowed to put $5,000 (the earnings) into the new account.  When you take the distribution, you’d receive a check for $19,000, which is your $15,000 basis plus the $5,000 earnings minus 20% ($1,000) mandatory withholding tax.  You are allowed to put up to $5,000 into the new plan, plus up to $15,000 into your Roth IRA, all tax free, even though you were forced to have $1,000 withheld.

Of course, that amount that was withheld will be available to you as a credit against your tax obligation at the end of the year, or as a refund if it caused an overpayment.

If you did a trustee-to-trustee transfer, none of this withholding or earnings-only limitation would have applied, so it makes good sense to do the trustee-to-trustee transfer whenever possible, to avoid such a situation.

5-Year Rule

Rollover To Another Roth 401k or Roth 403b

The last nuance about Designated Roth 401k accounts covered here is the 5-year provision and how rollovers affect it.  If you do a trustee-to-trustee (either qualified or non-qualified) rollover of funds to a new employer’s Roth 401k account, the “5-year” starting date will follow from your original account – or rather, whichever account was established earlier will apply to those funds going forward.

On the other hand, if you do a 60-day (again, either qualified or non-qualified) rollover to a new Roth 401k, the age of the new account will apply, even if the funds had been in the old Roth 401k for a significant period of time.  Only the taxable or earnings component will be allowed to rollover in a 60-day rollover, so the age of the account is a moot point.

Rollover to a Roth IRA

For the same situations as in the paragraphs above, but the transfers are to a Roth IRA, no matter what kind of rollover is done, direct (trustee-to-trustee) or 60-day, qualified or non-qualified, the results are the same – the 5-year holding period will be that of the receiving Roth IRA account, no matter how long the funds had been held in the Roth 401k account.  However, each individual conversion or rollover to a Roth IRA has its own 5-year period, separate from the first 5-year period. See the article Two 5-year Rules for Roth IRAs for more details on this nuance. This is a good reason to establish a Roth IRA immediately, to have a vehicle to receive such transfers if the situation arises.

The one wrinkle with rollovers into Roth IRA accounts has to do with taxability of the rolled over funds:  If the distribution is qualified, then all of the funds rolled over are considered basis, and when distributed for any reason the basis is tax-free (no matter the holding period).  If the distribution is non-qualified, the funds retain their original characterization from before the rollover – part is contributions (basis) and part is earnings (taxable until qualified).

So you can see some of the great benefits of doing a trustee-to-trustee transfer over the 60-day transfer – especially if the rollover is to be non-qualified.  As always, consult your financial advisor before doing any of these, just to make sure you don’t make a mistake!

Calculating the Social Security Retirement Benefit

Jun 20th, 2018
by jblankenship.
1 comment

calculating the social security retirement benefitThere are three factors that go into calculating your Social Security retirement benefit – your PIA (Primary Insurance Amount), your FRA (Full Retirement Age), and the age you are when you start receiving benefits. Having these numbers, we need to determine if you are applying for early benefits, and therefore a reduced amount, or if you’re delaying receipt of benefits to increase the payment amount. If you file at exactly your FRA, your benefit will be the same as your PIA.

Applying Early for Reduced Benefit Amount

When you apply early (before your FRA), calculating the Social Security retirement benefit will determine how much your benefit will be reduced from the PIA. First, determine how many months there are between your FRA and the age at which you’ll start receiving benefits. The benefit will be reduced by a percentage based upon the number of months you come up with. The first 36 months are multiplied by 5/9 of 1%, and any months beyond 36 are multiplied by 5/12 of 1%.

So, if your FRA is age 66, and you intend to begin receiving benefits in the month that you are age 62 and 6 months, your PIA would be reduced by 20% for the first 36 months (36 * 5/9% = 20%) plus an additional 2½% for the remaining 6 months (6 * 5/12% = 2½%) for a total of 22½%. The maximum amount that the PIA can be reduced is 25% for folks with FRA of age 66, ranging up to 30% for those with FRA of age 67.

When you come up with this reduction factor, it is then applied to your PIA, and the result is your anticipated benefit amount. You can see in the table below how waiting a few months or years can make a big difference in the benefit amount. And this change can have a huge impact on your lifetime benefits – because once you start receiving your benefit, it won’t change other than with the annual COLA increases – unless you continue to work while receiving benefits, which could increase your PIA.

Delaying Receipt of Benefits to Increase the Amount

If you are delaying your retirement beyond FRA, you’ll increase the amount of benefit that you are eligible to receive. Depending upon your year of birth, this amount will be between 7% and 8% per year that you delay receiving benefits. The increase can be as much as 32% if you delay until age 70 and you were born between 1946 and 1954 – when your FRA is 66 and the increase amount is 8% per year at that age. See the table below for the increase amounts per year based upon birth year:

Birth Year FRA Delay Credit Minimum
(age 62)		 Maximum
(age 70)
1940 65 & 6 mos 7% 77½% 131½%
1941 65 & 8 mos 7½% 76⅔% 132½%
1942 65 & 10 mos 7½% 75⅚% 131¼%
1943-1954 66 8% 75% 132%
1955 66 & 2 mos 8% 74⅙% 130⅔%
1956 66 & 4 mos 8% 73⅓% 129⅓%
1957 66 & 6 mos 8% 72½% 128%
1958 66 & 8 mos 8% 71⅔% 126⅔%
1959 66 & 10 mos 8% 70⅚% 125⅓%
1960 & later 67 8% 70% 124%

Above you can see the impact of delaying receipt of retirement benefits. It can amount to more than 50% of the PIA, when you consider early benefits versus late benefits. Of course, by taking benefits later, you’re foregoing receipt of monthly benefit payments during the delay; given this, early in the game you’d be ahead in terms of total benefit received. This tends to go away as the break-even point is reached in your early-80’s in most cases.

The Spousal Benefit Option for Social Security Benefits

Jun 13th, 2018
by jblankenship.
7 comments

this bride is contemplating the spousal benefitThere is a provision in the Social Security system that many couples take advantage of – the spousal benefit.  This benefit is applicable when one spouse has had little or no working history, such as a stay at home mom or dad, and where the other spouse has had a working career covered by Social Security, that has provided enough quarters of earnings to make him or her eligible for Social Security retirement benefits.

Note – to simplify the explanations, from this point forward we’ll refer to the lower-earning member of the couple as “spouse” and the higher-earning spouse as “worker”.

This benefit option allows the spouse to receive a potentially greater benefit than the one based on his or her own earnings record – equal to ½ of the full benefit of the worker at his or her Full Retirement Age.  Specifically, if the spouse has earnings that represent a PIA (Primary Insurance Amount) that is less than ½ of the worker’s PIA, a spousal benefit amount is added to the spouse’s own benefit to increase the amount of the benefit to ½ of the worker’s PIA.

So, if the spouse has a PIA of $1,100 and the worker has a PIA of $2,450, an amount would be added to the spouse’s benefit to increase the PIA to $1,225, ½ of the worker’s PIA.  The ½ benefit is provided if the spouse has filed for benefits at FRA (Full Retirement Age).  If filing for the spousal benefit at age 62, the spousal benefit will be equal to 35% of the worker’s PIA.  At any age after 62 but before FRA, the amount will be pro-rated. After FRA, there is no increase to the spousal benefit.

Qualifications for spousal benefit

There are several qualifications and factoids that you need to understand about the spousal benefit:

  • the spouse and the worker must have been married for at least 12 months (continuously) immediately prior to applying for benefits.
  • the spouse must be age 62 or older.
  • the worker must be eligible for benefits, meaning that the worker must file for benefits with Social Security and is actually receiving them. Suspended benefits by the worker also suspends the spousal benefit.
  • the spousal benefit does not include any credits that the worker may be eligible for upon delaying receipt of benefits, as the spousal benefit is based upon the worker’s PIA, not the actual benefit the worker may receive.
  • there is no increase in spousal benefit by delaying application after FRA of the spouse.
  • if the spouse has reached FRA and would like to delay receiving his or her own retirement benefit, the full spousal benefit will be available to the spouse until he or she files for his or her own benefit.
  • if the spouse continues to work while receiving benefits, the same earnings limits apply to the spousal benefits as would apply to primary worker benefits. However, after FRA, earnings limits do not apply to spousal benefits, same as regular retirement benefits.

Things to Consider as You Set Up a SOSEPP

Jun 11th, 2018
by jblankenship.
1 comment

sosepp water bottle capsSo, you’ve decided that you’d like to begin taking distributions from your IRA funds – and you’re under age 59½, so you need to structure your distributions as a Series of Substantially Equal Periodic Payments (SOSEPP).  (For more background information on the SOSEPP, see this article.) It is important to do this right, because once you set up the plan, you’re pretty much stuck with it.

Steps to Set Up a SOSEPP

The first step in setting up a SOSEPP is to figure out just how much you’ll need to take each year. Working with a financial advisor or an actuary, you can figure out how much money is required to support the SOSEPP payments that you require.

Once an amount is determined, a new IRA can be opened and the money required rolled over into that account.  Other IRAs and 401(k) accounts will then hold the remainder of your funds – which provides your savings for future needs, once the SOSEPP is no longer in effect, or a “safety valve” for you to use in the event that you need additional funds at some point.  Of course, taking an additional amount from one of these other accounts would require payment of the 10% penalty (unless one of the other exceptions applies) – but this is much better than taking too much from your SOSEPP IRA and busting the plan, which carries some heavy penalties.

Keep in mind, especially if you’re setting up your SOSEPP early in your life, it is possible to set up another SOSEPP from a different account should the need arise.  You would just have two series’ going on at the same time, with different variables impacting each series.

In other cases, you may just want to take the greatest possible payment that you can from account, which can be easily determined when the span of the plan is understood, given your age and the amount in the IRAs.

Several choices are necessary to set up the plan:

  • Choose one of the three permitted methods – RMD, amortization, or annuitization
  • Choose a life expectancy table – single, joint, or uniform life expectancy
  • Choose an interest rate (if using amortization or annuitization)
  • Decide whether to use annual recalculation (if using amortization or annuitization)
  • Choose the account balance valuation date
  • Determine the “period” for your payments.  These can be monthly, quarterly or annually, but must at least be annual, and must be at the same regular interval each “period” once set up.

All of these details must be attended to when setting up the plan, and careful attention should be paid when making these decisions.  If you set up such a plan early in your life (say at age 50 or earlier) you will have to live with your choices for a considerable amount of time.  Understand what each choice means and can mean in the future as you make these decisions.

The Heartbreak of Withholding From Indirect Rollover

Jun 6th, 2018
by jblankenship.
1 comment

heart break of rollover by NDrewCTaking early withdrawals from your retirement plans is rarely a good idea, and should only be considered when it’s the last possible option available to you.  But this article is more about the pain you could experience if you don’t handle a rollover correctly – bypassing the trustee-to-trustee transfer option and going with an indirect rollover.

Withholding Rule For Indirect Rollovers

In general, if you take an early withdrawal (pre-age 59½) from a Qualified Retirement Plan (QRP) that includes pre-tax money, the custodian of the account is required to withhold and pay to the IRS 20% of the pre-tax amount withdrawn.  This can still be a tax-free transaction if you finish the indirect rollover process correctly and place the entire amount of the distribution in an IRA or other QRP (like a 401k) within 60 days.  However, if you don’t complete the indirect rollover, with the whole amount of the distribution, you’re likely to get a tax surprise…

A transaction like this is called an “indirect rollover”, as opposed to a direct or a trustee-to-trustee rollover.  In the event that you complete the indirect rollover within 60 days, you will need to come up with the 20% that was withheld in order to have a full rollover – otherwise you’ll have to pay tax and a penalty on the amount that was not rolled over. (It is important to note that this mandatory withholding is only for employer plans – 401k, 403b and the like. There is no mandatory withholding on an IRA distribution.)

An Example

For example, let’s say you’re 50 years of age, and you have a 401(k) from a former employer that you’d like to roll over into your IRA account.  The 401(k) is worth $50,000.  For whatever reason, you opted to have the 401(k) custodian send you a check for the amount, which you then plan on sending to the IRA custodian for deposit (within the allowable 60 day period, as an indirect rollover).

Lo and behold, when the check arrives, it’s only made out for $40,000!  This is because the custodian was required to withhold 20%… and now, since you don’t have any savings to speak of, you can only send the $40,000 over to the IRA custodian.  Guess what?  Come tax time, you will have to include that “missing” $10,000 as income, plus you’ll get to pay a 10% early withdrawal penalty as well.  So if you’re in the 25% tax bracket, you get to pay $3,500 in tax and penalties (25% times $10,000 plus 10% times $10,000).

Now, the original 401(k) that was worth $50,000 is reduced to an IRA worth $40,000 and a tax refund of $6,500 (since $10,000 was withheld and your tax and penalties were only $3,500).  This swift little maneuver has cost you 7% of your retirement plan!  Plus, you’ve lost tax-deferral on $10,000…

ALWAYS Do the Direct Rollover

It is for this reason that, whenever possible, you always should do a direct, or trustee-to-trustee transfer when rolling over IRA and QRP funds to a new account.  When you do a trustee-to-trustee rollover, no withholding applies, so you don’t have to make up any difference, and your tax-deferred amount remains intact.

It’s important to note that in our example above, if you had the $10,000 available to you in savings or elsewhere to make up the difference for the withholding, you could still complete the indirect rollover without tax or penalty by sending a total of $50,000 to the IRA custodian within 60 days.  Then when you file your taxes for the year, that $10,000 withheld would amount to either a refund to you or a reduction in the amount of tax that you had to pay for the year.

No Application Required

Jun 4th, 2018
by jblankenship.
9 comments

no application required to do somersaultsGenerally, in order to begin receiving Social Security benefits, you must submit an application to the Social Security Administration. Similarly, an application is required (in general) in order to receive Medicare benefits. But there are some circumstances where you can begin receiving Social Security benefits or Medicare without the need for an application.

In general, these cases are situations where you’re already receiving Social Security benefits on another program, such as Social Security Disability Income (SSDI), and you’ve reached Full Retirement Age (FRA).

When a Medicare application is not required

  • If you’re already receiving Social Security retirement benefits or SSDI and you reach age 65, you do not need to submit an application to enroll for Medicare. You are automatically enrolled for Medicare in these instances.
  • Additionally, if you’re receiving Disability Benefits (SSDI) and are under age 65, once you’ve been receiving SSDI for 24 months, you are automatically enrolled for Medicare benefits.
  • Also, if you’re signing up for Social Security retirement benefits and you’re over age 65, you are automatically enrolled for Medicare, no application required.

When an application for Social Security benefits is not required

  • If you are receiving SSDI benefits and reach your Full Retirement Age (FRA), you do not need to submit an application to continue your Social Security benefits as retirement benefits. This conversion is automatic.
  • Likewise, if a child is receiving benefits and reaches age 18, an application is not needed if the child will continue receiving benefits after his or her 18th birthday due to disability or contiuation of school attendance. The extension is automatic.
  • If you’re receiving SSDI and become ineligible for the benefits due to earnings above the substantial gainful activity (SGA) limit, and then later your earnings fall below the threshold, a new application is not required. This is applicable during the extended period of eligibility after a trial work period.
  • If a child is receiving an auxiliary (dependent) benefit based on the record of a living parent’s record and the parent dies, the conversion from dependent’s benefits to surviving dependent’s benefits is automatic as long as the child is otherwise eligible for the surviving dependent’s benefit.
  • The same goes for a conversion from a spousal benefit to survivor benefits when the spouse or ex-spouse dies – your benefit will convert to the surviving spouse’s benefit with no application needed. It’s important to note that this conversion can be avoided since deemed filing does not apply to survivor’s benefits; you can revert to your own retirement benefit alone (just remove the spousal excess benefit) and dely receipt of the survivor benefit to a later date if that would be advantageous to you.

This is not an exhaustive list of all situations where an application is not needed, so be sure to check with Social Security to see if an application is required for your specific circumstances.

IRAs Do Not Pass Through Your Will

May 31st, 2018
by jblankenship.
2 comments

gates of paradise by ConsciousVision willHere’s a little fact that you may not realize:  when you assign a beneficiary for your IRA account, you are effectively bypassing any outside action against that account, including your will – assuming that the beneficiary assigned is appropriate.

For most assets that you own, when you pass away, your last will and testament determines who will receive the assets. You may want to make sure that your daughter gets the heirloom china set, and your son receives the antique car, among other things – so you direct these wishes through your will.

If you don’t have a will, your state of residence, through the probate process, determines how your assets are distributed. Generally this will direct your estate to your living heirs in order, from your surviving spouse to your children and then grandchildren. It’s different in each state, so it really makes a lot of sense to get to know the rules in your state. It makes even more sense to set up at least a simple will to make sure everything is distributed per your wishes.

Back to the point: Your IRA does not go through the direction of your will or the probate process, as long as you’ve properly assigned a beneficiary or a group of beneficiaries. (These beneficiaries must also generally still be living at the time of your death.) The great thing about this is, since the assignment is cut-and-dried (i.e., beneficiaries are named specifically, so there are no questions), your heirs can immediately, upon your passing, access the funds in the IRA account if the need should arise.  See the article here to find out more about proper choices for beneficiaries of an IRA.

Photo by ConsciousVision

Index Funds: The Oatmeal of the Investing World

May 29th, 2018
by jblankenship.
6 comments

Wilfordbrimleyquakerad oatmealWe know it almost instinctively, from all the information we’ve seen about it: oatmeal is good for you.  For cryin’ out loud, Wilford Brimley made a living telling us “It’s the right thing to do, and a tasty way to do it.”  But in general, most folks look at oatmeal as a bland, tasteless, boring sort of food, and therefore choose much more exciting foods – often to our detriment.

There’s a similar story about index funds for investing:  it would be to the benefit of every investor to choose index funds as the core of his or her investment strategy.  In this case, the part of Wilford Brimley is being played by Burton Malkiel – venerable author of the classic book A Random Walk Down Wall Street.  And again most folks, especially those of us who deem ourselves too sophisticated for such a bland, tasteless, boring investment, choose to use much more exciting investment vehicles – often to our detriment as well.

According to Malkiel in his book – The Elements of Investing – while people of modest means are hurt most by not saving regularly, wealthy folks suffer the most damage by trying to find the “home run” sort of investments pushed by actively managed funds and stock-picking gurus.  “If I took all the mutual funds that existed in the early 1970s and asked the question of how many really beat the market through 2009, you can count them on the fingers of one hand”, says Malkiel.

Benefits of Oatmeal (and indexes)

From reports by the American Cancer Society, the great benefits of oatmeal in your diet include the fact that it’s a source of both soluble and insoluble fibers.  These two fibers give us diversification across these food “asset classes” that provide the benefits of reducing bile acid toxicity, reducing LDL cholesterol (that’s the bad kind), slowing digestion and absorption of starch, all the while providing us with vitamin E, zinc, selenium, copper, iron, manganese, magnesium and protein.  It’s almost as if oatmeal provides us with all the good things we need, and canceling out all the bad – and the diversity of providing all these good things in one package makes oatmeal the perfect food!

An index fund (or a group of index funds covering all asset classes) provides the investor with similar benefits – diversification across all possible investments, providing the average “good” returns while canceling out the bad or negative returns.

It’s safe to say that a diet consisting solely of oatmeal probably wouldn’t be good for you, and no one is suggesting that.  A proper diet requires many other things that just aren’t present in oatmeal.  If, however, you did include all of those other things – fruit, dairy, and the like – in your oatmeal, you actually could do far worse than choosing a steady diet of your “super oatmeal” all the time.  It’s kind of like choosing more than one type of index fund for investing – except that we humans need variety in our diet to keep us satisfied. There’s no inherent need for this satisfaction variety in our investments.

So if you started your investing diet with a blend of two oatmeals – the aggregate bond market index and the total domestic stock market – and then tossed in a portion of some fruits and veggies:  the aggregate Europe, Australasia and Far East equity markets, a dollop of emerging equity markets, plus a pinch or two of global equities, then a portion of domestic and global real estate (for that yummy crunch!).  Now you’ve got yourself a super oatmeal for investing – providing everything you need to balance your investment tastes.  Plus, you don’t have to pay a restaurant (managed fund company) to provide you with a menu, nor do you have to pay extra for a chef (mutual fund manager).

The good thing is that the appetite of our investment accounts doesn’t really need the “filet mignon” or “lobster” sort of investments to maintain proper balance.  The steady diet of our “oatmeal” index funds, properly diversified, is plenty for investors of all walks of life.

Disclaimer: I don’t personally eat oatmeal, but I do eat an oat-based cold cereal for breakfast every morning – pretty much the same thing, only a little more convenient for me.  Liken it to the difference between a no-load index fund and an ETF. 

Photo by Quaker Oats

Boost Your Social Security Benefit

May 23rd, 2018
by jblankenship.
1 comment

boost your Social Security benefitsAs we’ve discussed elsewhere, your Social Security benefit is calculated based on your highest 35 years of earnings over your career, indexed to the year you reach age 62.  So can continuing to work past age 62 (or later) boost your Social Security benefits?

Any year in your earnings history that had very little or no earnings covered by Social Security works against you. Since the calculation assumes 35 years of earnings, any zero years will reduce the average. If you only had, for example, 30 years of earnings on your record and five “zero” years, these years with no earnings will reduce your average earnings that are used for calculating your benefit amount. Continuing to work, even for a minimal amount, will gradually eliminate these zero years from your record for calculation and boost your benefit.

In addition, if you’re earning a higher salary relative to your earnings record, some of the lower years’ earnings can be eliminated from your calculation record as well. If you are earning more now than your indexed earnings from earlier, these higher income years will replace the lower income years, thereby boosting your Social Security benefit by increasing the overall average.

Lastly, when you get your annual statement from the Social Security Administration, a projected benefit amount is reported.  If you read the fine print, the projected benefit amount assumes that you continue to work up to the retirement age indicated, with your earnings remaining roughly the same as your most recent year. If you retire at age 62 with no further earnings and wait to age 66 to begin receiving benefits, the amount of benefit that was projected for you at age 62 will be lower because you will have added zero years to the end of your working career.  The estimate assumed that you continued working at (presumably) a high earnings rate relative to the rest of your record.

60-day Rollover Waivers

May 21st, 2018
by jblankenship.
1 comment
rollover-dorj

Photo credit: jb

There are all sorts of problems that can crop up when attempting to complete a 60-day rollover of qualified funds to an IRA. If you don’t complete the rollover within 60 days, the rollover is not allowed, and your distribution from the original source is subject to tax (and perhaps a penalty). Sometimes you can be granted automatic waivers of the 60-day rule, but only if all of the following apply:

  • The financial institution receives the funds on your behalf before the end of the 60-day rollover period, but for some reason the institution didn’t get the funds deposited into your eligible retirement plan;
  • You followed all the procedures set by the financial institution for depositing the funds into an eligible retirement plan within the 60-day period (including giving instructions to deposit the funds into an eligible retirement plan);
  • The funds are not deposited into an eligible retirement plan within the 60-day rollover period solely because of an error or delay on the part of the financial institution;
  • The funds are eventually deposited into an eligible retirement plan within 1 year from the beginning of the 60-day rollover period; AND
  • It would have been a valid rollover if the financial institution had deposited the funds as instructed within the time allotted.

Self certification waivers

There is another option available if the automatic waiver does not apply – called self certification. In order to self certify, you need to fill out a letter using the model at Revenue Procedure 2016-47, or a substantially similar letter. This letter is then presented to the custodian who is to receive your late rollover contribution.

You will be entitled to a waiver if ALL of the following are true:

  • The rollover contribution satisfies all of the other requirements for a valid rollover (except the 60-day requirement).
  • You can show that one or more of the reasons listed in the Model Letter prevented you from completing a rollover before the expiration of the 60-day period.
  • The distribution came from an IRA you established or from a retirement plan you participated in.
  • The IRS has not previously denied your request for a waiver.
  • The rollover contribution is made to the plan or IRA as soon as practicable (usually within 30 days) after the reason or reasons for the delay no longer prevent you from making the contribution.
  • The representations you make in the Model Letter are true.

Please note, a self-certification is not a waiver by the IRS of the 60-day rollover requirement. However, if you qualify for a waiver, you can use the Model Letter to make a late rollover contribution to another plan or IRA. If the IRS subsequently audits your income tax return, it may determine that you do not qualify for a waiver, in which case you may owe additional taxes and penalties. Also, If you have requested a PLR (below) and were not granted a waiver, you cannot self certify on this rollover.

Private Letter Ruling (PLR)

If the above conditions do not apply, you can still request a ruling from the IRS, called a Private Letter Ruling (PLR). You would take this route if you still think your circumstances merit the inclusion of your rollover even though it was beyond the 60-day period.  There is a $10,000 fee for requesting the PLR.

When making a determination on your request, the IRS will consider all of the following details:

  • Whether errors were made by the financial institution (other than those described under “Automatic waiver”, earlier),
  • Whether you were unable to complete the rollover due to death, disability, hospitalization, incarceration, restrictions imposed by a foreign country or postal error,
  • Whether you used the amount distributed (for example, in the case of payment by check, whether you cashed the check), and
  • How much time has passed since the date of distribution.

If you are planning to request a PLR, keep in mind that the costs can be quite high.  In addition to the earlier-listed $10,000 user fee, the cost for a tax attorney to prepare the request can be anywhere from $5,000 to $10,000 and more, depending upon the complexity.

Once again, the problems you find with the 60-day rollover highlight the benefit of doing the relatively painless trustee-to-trustee transfer.

Social Security for the Self-Employed

May 16th, 2018
by jblankenship.
1 comment

self-employed musicianAs a self-employed small business owner, you have lots of plates to keep spinning, and lots of additional costs that you never dreamed of when you were employed by someone else (if you ever were), like health insurance, for example.  Another cost that you have to deal with when self-employed is Self-Employment tax.

Self-Employment tax (SE tax) is essentially where you are paying both the employER and the employEE portion of the Social Security withholding tax.  This means that, for 2018, you are taxed at a rate of 12.4% on your first $128,700 of income (double the rate you’d have withheld if you were employed by someone else).  This doesn’t count the 2.9% that you also have to withhold for Medicare tax – which is another matter altogether.

With this in mind, you might wonder if there are ways that you could reduce the Self-Employed tax…?  One way might be to incorporate your business and reduce your income by taking dividends for a portion of the otherwise taxable income.  By doing this, you would eliminate the SE tax, and then pay employER withholding and employEE withholding only on each paycheck that you provide yourself.  The dividends would not be subject to Social Security tax, since they are not wages.

It’s important to note that such a strategy will have two important factors for you to consider:

  1. Your earnings record will reflect the new, reduced amounts for income, so your future Social Security benefit will be reduced as well
  2. You must be careful to pay yourself a reasonable wage, otherwise the IRS will consider your dividends to be taxable as wage income.  It might seem clever to reduce your wages to a very low amount (or eliminate them altogether), but this will come back to haunt you when the IRS gets ahold of your return.

Incorporating your business may be a valid strategy to help reduce your tax costs – for other reasons beyond Social Security tax.  But you’ll need to consider all of the consequences before you do this – one of the most important factors being that you will want to increase your retirement savings in order to make up for reduced future Social Security benefits.

The Benefit of a Budget

May 14th, 2018
by jblankenship.
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this guy started his budget sometime around 1972There are two important records that you need to keep if you’re planning to be successful in managing your finances – a budget and a net worth statement.  In this post we’ll talk about how to make a budget, and the benefits of having one. (I can almost hear you groan: Great, the financial guy says I need a budget.  I can’t stand the idea of a budget!)

It doesn’t have to be like that. It’s easy to imagine that a budget would be a constraint, but this is really just a fear of the unknown.  A budget is really just a spending plan, with priorities applied. There don’t have to be constraints at all – the process of monitoring is the most important part of it all, as you’ll see in a bit.

How to make a budget

Making a budget is much more simple than you think.  Track your spending over the past several months (if you can gather the records) and do the same for every expense you pay out from this point forward.  Organize these expenditures into categories (you make them up – have fun with it if you like) and begin to think about how your categories relate to your life and your values.  For example, you likely have a category for auto expenses, another for home or household expenses, maybe one for groceries, and another for restaurants.  You may also have categories for entertainment, gifts, and clothing.

Certain expenses are fixed – such as your mortgage, cable TV, and auto insurance (although each of these could be adjusted from their current amounts).  But other expenses can vary quite a bit, such as dining out, entertaining, and clothing.  And if you think about it, some of the fixed expenses might be more variable than you think – or at least they could be reduced.

What’s important about a budget is that you are now thinking about your expenditures as you make them.  As you track your spending, you’re going to notice that there are some categories that you spend a lot of your income on, while other categories may not have any expenditures in some months.

What you’re doing is prioritizing – even if you haven’t made a conscious effort to do so.  Those things that you spend a lot of money on are the things that are (presently) getting more of your attention, time, and money, while other areas are being short-changed.  Until you create a spending plan to track your expenses, you probably won’t realize what those priorities really are.  Now that you have your spending plan, you can understand the priorities – and you probably will make some changes.

For example, if it turns out that you’re spending exactly every penny that you earn or more (thus no savings), you may decide that savings for a rainy day is important to you (remember, no judgments here, we’re just reviewing the plan).  If that’s the case, then you need to figure out what categories of your spending plan are less important to you than saving for a rainy day.  Maybe it’s clothes.  Or your auto expenses.  Or gifts.  Whatever that category or categories may be, you are in control and can make wise decisions about what gets priority and what doesn’t, for your life.

Start with your “fixed” expenses – mortgage, homeowner’s insurance, utilities, etc..  Are these really fixed?  Is it possible to impact the cost of your homeowner’s insurance – maybe by choosing a higher deductible (for example)?  How about refinancing your mortgage to a lower rate?  Just be careful that you don’t draw out equity when you do this, or stretch out the payments beyond what’s reasonable – but this could free up some money each month.  Maybe you’ve been paying on your mortgage for several years now and have built up equity to a point where you don’t have to pay PMI any more if you refinanced.  What about your utilities?  Couldn’t you reduce the cost by bumping the thermostat up (or down, depending on the season) a degree or two?

There are a myriad ways to reduce or eliminate these “fixed” expenses – as well as to impact your more variable expenses.  Cut back on dining out.  There’s no shame in brown-bagging your lunch – if dining out isn’t a high priority for you.  The same goes for grocery costs (clip coupons, choose store brands), clothing (most folks have more clothes than they ever wear anyhow), automobile expenses (take the bus, or work out a telecommuting arrangement at your job), and so on.

The point is that unless you track your spending, you can only have a vague idea of what your spending priorities really are.  By tracking your spending, now you are fully conscious of where you are putting your money – and you can decide what categories get more of your hard earned dollars.

The benefit of a budget

As mentioned above, once you begin tracking your expenses you are now in a position to understand and take control of your spending.  Where before you thought that all these expenses were necessary, now you can begin thinking of where your priorities lie.  If you place a higher value on a particular category, let’s say it’s charitable giving, and that priority is higher than your priority for cable television, now you are in a position to consider how to reduce the one expense in order to put more toward the other.  Having organized your information you can plan out how your budget dollars will be spent.

The bottom line is this – if you’re going along merrily without any sort of plan or monitoring arrangement, two things are going to eventually happen:

  1. You’ll never achieve the balance of priorities that you hope to achieve in your life; and
  2. At some point, when your income is reduced either by a change in job situation or at retirement, you’re going to have to work out a budget because the expenses without a plan are greater than your income.

Most everyone comes to this point in their life – and those who have spent a bit of time working on understanding their outlays in advance are in a much better position to make changes and adjust to a reduced income when it occurs.

The psychology of a budget

It’s a ubiquitous message in the financial world – you should have a budget. (Perhaps the word “budget” is a turn-off for you, so please use “spending plan” or whatever term you’d like to apply to a system where you track your income and expenses.) For many, it seems like this budget thing is some sort of torture device or a method designed solely to punish you for your spending choices. But did you know that the simple act of tracking your expenses and income can begin to improve your financial situation – without guilt?

If you concentrate on the monitoring aspect of a budget (or spending plan), something interesting will occur. You’ll begin to notice where you’re spending money, and how much money you’re bringing in as income… and as you do this, you’ll automatically begin to make decisions that will help to improve the overall outcome. You’ll reduce expenses where they’re not as necessary, and perhaps bring in more income as opportunities arise.

Part of this may come about by virtue of a management principle known as the Hawthorne Effect – which was a study done in a factory that noted improvement to productivity any time the workers knew they were being monitored. The study leaders increased the lighting in the factory – and productivity increased. Then they reduced the lighting in the factory – and once again, productivity increased.

The Hawthorne Affect invokes the idea that if you’re paying attention to something, especially if you’re being accountable to someone else, it will likely improve. Your accountability can be to your spouse, a roommate, or anyone at all, such as an online community. You can also use software for accountability – such as Mint.com or Quicken software. You just have to get into the accountability mindset.

When you have something to compare to – either a goal expense amount or your historical averages – there is a tendency over time to push your self to improve what you’re monitoring to meet that comparison. This is another management principle known as the John Henry Effect. This principle was developed based on the folk story of John Henry’s competition with the steam engine, and how John Henry stopped at nothing, even death, to beat his competition (comparison). Of course you wouldn’t take your financial improvement to the point of your death – but it just might get you over the hump to improving your financial world. Having a competition, a sort of internal game-play, can be helpful to improve your financial situation.

Not So Fast! 9 Special Considerations Before Rolling Over Your 401(k)

Apr 23rd, 2018
by jblankenship.
1 comment
h dumpty

Photo credit: coop

Conventional wisdom has long told us that when you leave employment – either by taking another job, getting laid off, or retiring – it makes good sense to rollover your 401k plan to either an IRA or to your new employer’s 401k plan if that makes sense.

However – and if you read here much, you know there’s always a however in life – this decision isn’t as cut-and-dried as conventional wisdom leads us to believe.  As with just about every financial decision we make, it’s not wise to go off willy-nilly without considering all of the benefits that we’re giving up. (and if you’ve read much of my writings, you know I don’t cater much to the willy-nilly!)

9 Special Considerations Before You Rollover Your 401k

  1. If you are happy with your former employer’s plan, consider it well-managed, with low cost, and possibly with some investment options that are not readily available (such as desirable mutual funds that are closed to new investors), you may want to leave the plan right where it is. This is especially beneficial if you don’t have another employer plan to rollover your 401k into, or if you are squeamish about setting up an IRA.
  2. It is possible that maintaining a 401k account could garner you some employer-sponsored financial advice. Not all plans offer this, but if yours does, it could be a valuable option to keep. If you rollover your 401k, this benefit would be gone.
  3. If you have commingled deductible and non-deducted IRA contributions in your IRA account, having an active 401k plan can help you to separate the deductible IRA money from the non-deducted.  See this article about the pro-rata rule for more information. Essentially this benefit gives you a way to bypass the “little bit pregnant” rule which requires you to aggregate all IRA funds pro-rata when making distributions. This is a common issue when doing a Roth IRA conversion, for example. If you rollover your 401k, this option may be lost, unless you rollover into a new 401k.
  4. If you have an investment in your former employer’s stock in your 401k, you need to consider the ramifications of utilizing the Net Unrealized Appreciation (NUA) option – before doing a rollover. This article explains NUA, in case you need a refresher. The point is, if you’ve taken even a partial rollover of your 401k in a previous year, the NUA treatment is no longer available to you.
  5. capitol building by terren in Virginia If you think you may be returning to this employer, it might make sense to leave your funds where they are. This is especially true for government employers with section 457 plans – due to the nature of these plans’ ability to provide you with retirement income without penalty much earlier than an IRA or 401k can.  With the vagaries of governmental policy changes, if you’ve withdrawn and closed your account and come back to work for the same agency, the old plan may no longer be available to you since you’re a “new” participant.
  6. If you’re at or older than age 55 and are not moving to a new employer (or are undertaking self-employment), maintaining the 401(k) plan gives you an option to begin taking distributions prior to age 59½ without penalty.  If you rollover your 401k to an IRA or to a new employer’s 401k plan, this option is lost.
  7. On the off-chance that you might need a loan from your retirement funds, you should know that IRAs do not have this provision.  Retain at least some balance in the plan if you might need this option – but also you should check with your plan administrator to see if this option is available for non-employee plan participants, because it might not be (and actually, it likely is not).  But keeping in mind #5, if you’ve maintained a healthy balance in the plan and you return to work with this same employer, you’d have a much larger account to work with if you needed to borrow.
  8. Funds in a 401k account are protected by ERISA – and as such are generally not available to creditors in the event of a personal bankruptcy.  Depending upon the state you live in, IRA assets may be available to your creditors in the event of a bankruptcy.  If you’d like to bone up more on this, see this article.  At any rate, ERISA protection is pretty much an absolute, so this is yet another reason you might consider leaving funds in a former employer’s 401k plan.
  9. Take your after-tax contributions out first, if your plan happens to include these.  If you’ve made after-tax contributions, as some plans allow, it makes sense to separate these contributions from the pre-taxed amounts.  You can then convert this after-tax money directly over to a Roth IRA in most cases without tax. This is because the 401k isn’t subject to the “little bit pregnant” rule alluded to earlier.  Once you’ve removed the after-tax contributions and put them into a Roth IRA, you might want to rollover your 401k (the remaining money) if it makes sense.

I don’t imagine that this is an exhaustive list of all the reasons you need to stop and think about it before rolling over a 401k plan, but we’ve hit the high points.  If you have other good reasons to share, please leave a comment!

Converting Directly From a 401(k) to a Roth IRA

Apr 16th, 2018
by jblankenship.
2 comments
converting directly to MC2150

Photo credit: jb

Back in the olden days prior to 2008, it used to be against the rules to convert funds directly from a 401(k) plan (or other CODA plan, like a 403(b)) to a Roth IRA.  At that time, you were required to do the “conversion two-step” wherein you would first rollover or direct-transfer your funds from the 401(k) plan to a traditional IRA, then do a conversion from the trad IRA into your Roth IRA.  This was an unnecessarily complicated process, and the IRS logically waited until it got ridiculous and then relented listened to taxpayers, allowing taxpayers the option of converting directly from these qualified retirement accounts into a Roth IRA.

This earlier process was needlessly complicated, and it often introduced additional room for taxation, especially if you have after-tax money in your 401(k) plan.

The process is identical to the process for converting directly from a traditional IRA to a Roth IRA.  You can make this conversion from your:

  • Employer’s qualified pension, profit-sharing or stock bonus plan (including a 401(k) or other plan),
  • Annuity plan,
  • Tax-sheltered annuity plan (section 403(b) plan), or
  • Governmental deferred compensation plan (section 457 plan).

You are allowed to convert all or part of the account. Prior to 2010, there was an income limit on converting directly to a Roth IRA from any account, but that limitation was eliminated. Any pre-tax amount converted must be reported as income in the year of the conversion. If your account includes after-tax amounts, there may be some fancy footwork involved but you may be able to convert the after-tax monies without tax or penalty.

The conversion can be done either via a direct trustee-to-trustee transfer or a rollover.  In general, the trustee-to-trustee transfer is the preferred method since a rollover involves making a check payable to you, which requires the payor to withhold 20% of the rollover. If your 401(k) administrator has the option available, you can request a non-direct rollover (check made out to the new IRA account), which will allow you to bypass the withholding requirement.

Any amount that is not successfully converted (via an indirect rollover) within 60 days would be taxable AND subject to the 10% penalty unless other conditions apply. In other words, when you convert these funds over to your Roth account, in order to pay the tax on the withdrawal you’ll need to either hold out a portion and pay the 10% penalty on those funds, or pay the tax from another source.

The Importance of IRA Custodial Documents

Apr 11th, 2018
by jblankenship.
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custodial documents

Photo credit: jb

Remember when you opened your IRA account? And the broker or advisor handed you the 37-page custodial documents? Read that cover-to-cover, dintcha?

Unfortunately, too many of us don’t read these documents closely, and may end up getting a big surprise later on.  What sorts of surprises, you might ask…? Well, here are two major surprises that could await you:

Per Capita or Per Stirpes? If you have multiple beneficiaries of your IRA, how your IRA custodian determines between these two will be important to know. This difference will determine how your account will be distributed.  Here’s how – Per Capita means that, for example, if you have three equal beneficiaries designated on your account and one of the beneficiaries pre-deceases you, the account will then be split in two, between the two remaining beneficiaries.  If the account were to be split Per Stirpes, the two remaining beneficiaries would each receive a 1/3 share, and the beneficiaries (or the estate) of the deceased beneficiary would receive the remaining 1/3 share. Typically there is a check-box on the beneficiary form to help you designate your beneficiaries as you wish, and if not specified by you, ultimately the control comes down to the custodial documents.  This becomes even more important with the second consideration…

Divorced, but forgot to change beneficiary form? Depending upon the custodial agreement, the custodian could follow the court’s ruling, wherein the divorce decree may declare that all marital property is split as indicated and named in the document, with no other splitting to be done. Or, the custodian could go strictly “by the book”, where the beneficiary form indicates a specific individual as the primary beneficiary, regardless of any other outside document. And here is how the Per Stirpes/Per Capita issue becomes important in this case:  what happens if the former spouse is the only named beneficiary on the account (no secondary beneficiary(ies)), and the former spouse pre-deceases the account owner? If the custodian holds to the Per Stirpes definition, the former spouse’s heirs could reap the benefits of the account… scary huh?

So, in the end, it pays to know a little about the custodial documents on your IRA account, just so you don’t have any surprises.  If you don’t understand it or can’t follow what the document is telling you, make your advisor explain it to you – especially these two factors mentioned above.  That’s part of an advisor’s job – to advise you – and you’re paying them to do that sort of thing.

Who should do a mid-year tax checkup?

Apr 9th, 2018
by jblankenship.
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As a followup to my two posts last week on mid-year withholding checkup and estimated tax checkup, I found another notice from the IRS last week that pointed out there are certain groups of people really need to do amid-year checkup. This alert was part of the IRS’ communication IR-2018-80.

Special alert for key groups to check withholding

The IRS always recommends employees check their withholding at the beginning of each year or when their personal circumstances change to make sure they’re having the right amount of tax withheld from their paychecks.

Following the recent tax law changes, it’s especially important for certain people to use the Withholding Calculator on IRS.gov to check if they are having the right amount of withholding.

Among the groups, in particular, who should check their withholding are people who:

  • Belong to a two-income family.
  • Work two or more jobs or only work for part of the year.
  • Have children and claim credits such as the Child Tax Credit.
  • Have older dependents, including children age 17 or older.
  • Itemized deductions on their 2017 tax returns.
  • Earn high incomes and have more complex tax returns.
  • Received large tax refunds or had large tax bills for 2017.

“The IRS urges people in these groups to take a few minutes and review their withholding and tax situation,” Kautter said. “Taking this step will help avoid surprises next year at tax time. ”

The new law increased the standard deduction, removed personal exemptions, increased the child tax credit, limited or discontinued certain deductions, and changed the tax rates and brackets.

If you fit into one of those groups and need more information on how to do a mid-year withholding checkup, see the article at the link.

3 Ways to Do a Roth Conversion – Tax Free

Apr 4th, 2018
by jblankenship.
2 comments
tax

Photo credit: jb

If you have money in an IRA and you’d like to do a tax free Roth conversion, you may be wondering just how to do it. There are actually several ways to do a tax free Roth conversion, and three very common options are listed below.

After-Tax IRA Contributions

If your traditional IRA is composed only of after-tax (non-deducted) contributions, you can convert those funds over to a Roth IRA without tax consequence.  This is because the funds were taxed before you contributed them to the IRA, and so no tax is due when you convert the funds to a Roth IRA. This often is the case if you have no other traditional IRAs and you’ve made non-deductible contributions to the account (often from income limitations). You can convert these non-deductible contributions from the traditional IRA to a Roth IRA with no tax consequences. The only tax (if this is your only traditional IRA and it only contains non-deductible contributions) is if there is any growth on the contributed funds, such as interest earned or capital gains that have occurred.

The “gotcha” in this is that the IRA must be ONLY non-deducted, after-tax contributions.  Plus this must be the only IRA that you have – see the article: Turns Out You CAN Be A Little Bit Pregnant for more details, including a way around the “Pregnant” Rule.

If you happen to have other IRAs or other, deducted contributions in the traditional IRA, it’s not the end of the world. You’ll just have more tax to pay on the Roth Conversion.

After-Tax Qualified Retirement Plan Contributions

If you happen to have after-tax contributions to a Qualified Retirement Plan (QRP) such as a 401k plan, these can be used for a tax free Roth Conversion if you’ve terminated employment or the retirement plan has terminated. You can do this without having to worry about the “Pregnant” rule I mentioned above.  This is because QRP funds are treated differently, and as such you are allowed to move specific contribution money separate from other contribution money (e.g., pre-tax contributions separate from after-tax contributions).

Also, if you have money in a Roth 401k, it’s not actually considered a conversion but you can rollover your Roth 401k money into a Roth IRA with no tax consequences, as long as your plan allows. Generally this means you have either reached age 59½ (for some plans; many do not allow in-service distributions), or you must have left employment with that employer.

Zero Tax Bracket

If you have no or very low taxable income, that is, if you’re below the 10% tax bracket, any funds that you distribute from your traditional IRA up to the limit – which would be your AGI minus your exemptions and itemized or standard deductions and any tax credits – would be tax free.  Granted, this is likely to be a somewhat small amount for most people in this situation, but for others, such as business owners or farmers with carried-over Net Operating Losses, it could be sizeable.  See the linked article for more information on NOL carryovers and Roth IRA conversions.

Photo by Phillip

Mid-year estimated payments checkup

Apr 2nd, 2018
by jblankenship.
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estimated payments checkup calculatorAs a retiree, you may have a bit more difficulty determining if your withheld tax throughout the year is going to be enough. This is especially true in 2018, with the new tax tables and rules associated with the Tax Cuts and Jobs Act of 2017. For this reason, you may want to do a mid-year estimated payments checkup, to help ensure you’re having enough (but not too much) tax withheld.

If you’re not retired or are retired and still working part-time, you may want to check out the Mid-year withholding checkup article to help make sure you have enough tax withheld.

There are commercial programs available to help you figure this out (check with your tax preparer or tax software), or you can use the IRS Form 1040ES to help you work through an estimated payments checkup. I’ll briefly describe the process below using Form 1040ES.

Estimated payments checkup

Go to the IRS website (www.IRS.gov) and search for Form 1040ES. The form itself includes the instructions for filling out the form, as well as vouchers that you can use to make estimated payments (if needed). This will help you with your mid-year estimated payments checkup.

You’ll need to gather quite a bit of information together for this form. I’ll step you through the process (high level) below, so that you’ll have an idea of everything you’ll need when you start working through the form.

You need to estimate your income for the year. This may include pensions, annuities, required minimum distributions (RMDs) from IRAs, 401k’s and other plans, plus interest, dividends, any rental, partnership or corporate income, and your Social Security benefits. Go ahead and project the total amount that you’ll receive from each source through the end of the tax year. For most of these payments, if they occur monthly you can just multiply the monthly amount by 12. If it’s a quarterly payment, multiply by 4. If it only comes once a year, just project the total amount to the best of your knowledge (use last year’s tax return and documents to help you with this process). Make sure that you count the gross amount, not the net check that you receive after taxes and other deductions!

Next, if you’re having money withheld from any of these payments, go ahead and project that amount for the year as well – just the same as you did with the payments you receive.

You’ll also need to understand a few things about your tax return filing in order to fill out Form 1040ES properly:

  • Filing status
  • Can anyone else claim you as a dependent? Same for your spouse if filing jointly.
  • How many jobs have you worked (or will you work) in 2018? Same for your spouse.
  • Will you or your spouse receive a taxable scholarship or grant in 2018?
  • Are you or your spouse age 65 or older in 2018? Blind?
  • Number of dependents (not including spouse) to claim on your 2018 return.
  • Number of children that will be claimed for child-care expenses, child tax credit, and earned income credit

You’ll need to estimate your deductions next. If you’ve always used the standard deduction in the past, chances are you’ll continue to use the standard deduction in 2018. If you have had circumstances change, such as buying a house, moving to a higher-tax state, you’ve made significant contributions to charity, or you have significant medical expenses (beyond insurance coverage), then you’ll want to go through the exercise of calculating your itemized deductions. The calculator steps you through the process of estimating your taxes, medical expenses, interest paid on mortgages, charitable contributions and other itemized deductions.

When you have all of the above information together, you can work your way through Form 1040ES and calculate any shortfall that you will have in withheld tax. The form is designed to limit your withheld tax to the minimum before a penalty is applied. This means that you only have to withhold 90% of the current year’s tax, or 100% of the previous year’s tax, and your shortfall can be up to $1,000 before a penalty applies to your situation.

Understand that you may owe as much as $1,000 or more in tax when you file your tax return if you follow Form 1040ES to the letter!

Your result will help you to determine what the amount of estimated payments are that you may need to make for the year (if required). You can also make adjustments to withholding on any of your income sources to make up a withholding shortfall, by submitting a new W-4P form to your pension administrator, for example.

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