Financial Ducks In A Row • Independent financial advice: IRA, Social Security, income tax, and all things financial

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high water pants by TimWilson With apologies to the writer and performers of the original “Sam, You Made The Pants Too Long!”… This article is about what happens when your IRA declines substantially in value and you’ve put a 72t Series Of Substantially Equal Periodic Payments plan (SOSEPP) into play – and the decline in value has brought your IRA to a point where the balance will no longer support your Equal Payments.

What Happens When Your IRA Will No Longer Support Your SOSEPP?

Here’s an example: You’ve set up a SOSEPP in your IRA, beginning at age 50. As we all know (see this post for details) you have to keep the payments going until you reach age 59½. During that time, many things can happen, both positive and negative. In this case, the IRA began with a balance of $100,000, and your annual payments are $3,000. Things go fine for the first few years, although your account doesn’t seem to be growing. So, you decide to take a leap and invest it all in a wild-eyed fund – some Madoff fellow’s running it. Then, lo and behold, one morning you wake up and find that your IRA balance has become – $12 total. You’re 56 years old, so you have three and a half more years that you are supposed to be taking this regular payment of $3,000 from your account! What do you do? You’ve read about the crazy penalties for busting a 72t payout plan – yikes!

Options

Calm down. Take a breath, it’s really not so bad. There are several options: You could rollover funds from another account into the IRA, either from another IRA account or a 401(k). You could also choose to make your one-time change to your SOSEPP plan. Or, you could choose to let it die, and go on with your life. The best option is probably the last one – it allows you to be as flexible as you can be.

If you chose the first option, it certainly would work – and your SOSEPP would just continue on as originally planned. But what if you have decided at this stage that you really don’t need that series of payments anyway? And it’s just a pain in the rear keeping up with the paperwork and remembering to take the payment each year…?

The same holds true for the one-time change to the RMD method. If you did that, now you’d have to re-calculate your payment each year on a very small balance. Once again, a pain in the rear – so why not just take the third option?

Let it die

If you go ahead and take the last payment out of your account (the remaining $12) and close the account – your SOSEPP is no longer in effect. You now have the option of starting a new SOSEPP from another IRA account, or just discontinuing the idea of the 72t payout. If you chose to start a new plan, you’d have to start over with a new five-year or (since in the example, you’re age 56) for three and a half more years until you reach age 59½.

What’s key to understand in this is that, for SOSEPP’s, the IRS considers each IRA account separately – yeah, I know, for everything else, all IRAs are considered as one. What can I say? They don’t want you to get too comfortable and start predicting how they’ll move – just when you think they’re gonna zig? They zag. So with that in mind, if one account (the one with the SOSEPP attached) runs dry, there’s no penalty if you just drop it and move on with your life.

That’s literally all there is to it. No penalty, no muss, no fuss.

Posted on Jul 22nd, 2019

by author: jblankenship.

Posted in: 72t, Early Distribution, IRA, retirement plan.
Tagged: IRA · retirement plan

Guaranteed Income (Annuitization)

Jul 19th, 2019

by sraskie.

3 comments

Annuities sometimes get a bad rap. The distaste people have for annuities may be based on a bad experience with a salesperson, the fear of “the insurance company getting all your money when you die”, or just plain misinformation.

Annuities can be a great choice for your retirement. That is, after annuitization an annuity provides a guaranteed income stream to you and or your spouse for the rest of your lives. Think of this as your own defined benefit pension. In fact, if you don’t have a defined benefit pension, you may consider the guaranteed income a private annuity provides. The guarantee comes from the insurance company providing the annuity. To date, no insurance company as ever defaulted on its annuity obligations.

So why can annuitization be a good thing for you? Let’s look at an example.

Let’s say you’ve determined when you retire that your annual expenses are $115,000. This sum includes your living expenses, taxes, and doing fun things in retirement (such as travel, dining out, and hobbies). You’ve determined that Social Security will provide $30,000 per year which leaves $85,000 to be covered with other retirement savings.

It’s safe to say that Social Security is providing $30,000 (inflation adjusted) per year in guaranteed income. In other words, you know that at the very least you’ll always have $30,000 per year for income, or $30,000 of expenses will always be covered. But maybe you’re uncomfortable with knowing only $30,000 is guaranteed. This is where the annuity can help.

Depending on the amount of money you have saved for retirement, you could purchase an annuity to provide a guaranteed income stream that meets 50, 75, or even 100 percent of your needed income – for the rest of your life! The amount you choose to annuitize will be dependent on several factors such as retirement savings, other income, RMDs, and estate goals (gifts and inheritances).

The flip side, however, is what can happen if you die before your life expectancy. It is true that in some circumstances the insurance company keeps your money (if you had a single life annuity) and this money goes back into the risk pool of other annuitants. But there are options to make sure that this doesn’t happen such as joint and survivor annuities, period certain annuities, and refund annuities.

Annuitizing a portion of your retirement income shouldn’t be readily dismissed. Guaranteeing some of your income can reduce stress, meet certain retirement expenses, and ensure you never run out of money. Should you need help navigating your options, consider working with a fiduciary – preferably one who doesn’t sell annuities.

Posted on Jul 19th, 2019

by author: sraskie.

3 comments already - add to the conversation!

Posted in: annuities, annuity, guaranteed income.

Your Account(?) at Social Security

Jul 17th, 2019

4 comments

One of the biggest misconceptions about Social Security is that each individual has a specific “account” which holds all the money you’ve had withheld from your paycheck over the years. Nothing could be further from the truth… as we’ve mentioned before on this blog, the Social Security system is a pay-as-you-go system (largely) where withholding today is used to pay benefits for current recipients.

It is for this reason that much consternation has been brought about in recent years with regard to the question of the Social Security system’s running out of money. You see, for quite a while the Social Security system has had a surplus over current expenses, with the surplus amounts being placed in the trust fund. In 2020 it is expected that current benefits being paid out will become greater than the payroll taxes are bringing in, so the difference will come from the trust fund.

No Pile of Money

The point is – there’s not a pile of money sitting somewhere with your name on it, although your “contributions” are tracked through the years, as a matter of adminis-trivia. There is no guarantee at any point in time that the money you’ve put into the system will ever be returned to you, but then again you may receive far more in benefits than you paid in.

For example, if you were single with no dependents and worked all your life paying in to the Social Security system but died just prior to starting to receive your Social Security retirement benefit, it would all be for naught (for your benefit). There’s no residual that goes to your estate.

On the other hand, to consider an extreme example at the other end of the spectrum: Ida May Fuller, the individual who received the first ever Social Security benefit check in January of 1940, had worked for only 3 years under the Social Security system, paying in a total of $22.54 in Social Security taxes during that time. Mrs. Fuller lived to age 100, and she received benefits in the amount of $22,888.92 over the course of the 35 years.

Posted on Jul 17th, 2019

by author: jblankenship.

4 comments already - add to the conversation!

Posted in: Social Security.
Tagged: Social Security

Inherited 401k plan

Jul 15th, 2019

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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:

You can leave the money in the 401k plan.
You can rollover the money from the 401k plan to an inherited IRA.
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.

Posted on Jul 15th, 2019

by author: jblankenship.

Posted in: #noTOP, 401 k 403 b, 401k, 403 b, inherited IRA, qrp.
Tagged: 401k · 403b · qrp

Deemed Filing

Jul 10th, 2019

6 comments

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.

Posted on Jul 10th, 2019

by author: jblankenship.

6 comments already - add to the conversation!

Posted in: social security benefits, social security retirement, Social Security spousal benefit, spousal benefits.
Tagged: social security benefits · spousal benefit

Turns Out You CAN Be A Little Bit Pregnant

Jul 8th, 2019

4 comments

Photo credit: jb

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.

Posted on Jul 8th, 2019

by author: jblankenship.

4 comments already - add to the conversation!

Posted in: IRA, retirement plan, Roth conversion, tax.
Tagged: IRA · retirement plan · tax

The Earnings Test is Specific to the Individual

Jul 3rd, 2019

5 comments

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).

Posted on Jul 3rd, 2019

by author: jblankenship.

5 comments already - add to the conversation!

Posted in: Earnings Limits, earnings test, reader questions, Social Security.
Tagged: Social Security

Roth Conversions for Inherited Retirement Plans

Jul 1st, 2019

1 comment

Photo credit: diedoe

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).

Posted on Jul 1st, 2019

by author: jblankenship.

Posted in: IRA, retirement plan, Roth conversion, tax.
Tagged: IRA · retirement plan · tax

Don’t Leave Money On The Table!

Jun 28th, 2019

by sraskie.

1 comment

Many 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.

Posted on Jun 28th, 2019

by author: sraskie.

Posted in: 401 k, 401 k 403 b, 401k, 403 b, 457, employer plan, match.
Tagged: employer match

Medicare is Not Automatic

Jun 24th, 2019

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If 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.

Timing

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.

Exception

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.

Posted on Jun 24th, 2019

by author: jblankenship.

Posted in: Medicare, Social Security.
Tagged: Social Security

Integrating Roth IRA With Social Security Benefits

Jun 18th, 2019

3 comments

There 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

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.

Summary

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).

Posted on Jun 18th, 2019

by author: jblankenship.

3 comments already - add to the conversation!

Posted in: financial planning, Roth conversion, Roth IRA, roth ira conversion, Social Security, tax.
Tagged: financial planning · Social Security · tax

Saving for College

Jun 7th, 2019

by sraskie.

1 comment

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.

Posted on Jun 7th, 2019

by author: sraskie.

Posted in: 529, 529 plan, college savings.
Tagged: 529 plan · college savongs

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

Jun 5th, 2019

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ira contributions can help pay for a barn

Photo credit: diedoe

If 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

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.
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.
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.
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

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.
Exempt students. If a student has exempt earnings from a job, that income can be used to make IRA or Roth IRA contributions.
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).

Posted on Jun 5th, 2019

by author: jblankenship.

Posted in: IRA, retirement plan, tax.
Tagged: IRA · retirement plan · tax

Are you leaving Social Security benefits on the table?

Jun 3rd, 2019

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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.

Posted on Jun 3rd, 2019

by author: jblankenship.

2 comments already - add to the conversation!

Posted in: restricted application, Social Security, social security benefits, Social Security spousal benefit, social security survivor benefits, Spousal Benefit, survivor benefits, widow.
Tagged: restricted application · Social Security

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

May 28th, 2019

13 comments

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?

Photo credit: jb

Wrong. 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.

Posted on May 28th, 2019

by author: jblankenship.

13 comments already - add to the conversation!

Posted in: 401k loan, retirement plan, tax.
Tagged: retirement plan · tax

Renter’s Insurance

May 24th, 2019

by sraskie.

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If 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.

Posted on May 24th, 2019

by author: sraskie.

Posted in: renters insurance.

Why is Index Investing a “No Brainer”?

May 20th, 2019

2 comments

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.

Photo credit: steelo

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.

7276279 The 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.

Bottom 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.

Posted on May 20th, 2019

by author: jblankenship.

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Posted in: index funds, investing.

How QDRO Impacts NUA

May 15th, 2019

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Photo credit: jb

Don’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.

QDRO and NUA

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.

Example

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.

Posted on May 15th, 2019

by author: jblankenship.

Posted in: IRA, net unrealized appreciation, NUA, qdro.
Tagged: IRA

Pension Payout: Annuitize or Rollover (Cash)?

May 8th, 2019