Retirement Withdrawal Rates

Posted On August 28, 2014 By Admin In Retirement Planning /

If you’re close to retirement, a key planning question is How much can I withdraw from my portfolio annually? Or in financial planning terms, what is a safe withdrawal rate? It’s a challenging question because we don’t know future rates of return. But what we do know is that you can’t just project “average” or historical returns in a straight line and use that as your basis for withdrawals.

Unlike a portfolio in accumulation, a portfolio under distribution is greatly dependent on the order of returns. We might have a 7% average return over 30 years, but in certain rare circumstances, a portfolio under distribution could be wiped out if there were negative returns in the first handful of years. This is known as sequence of returns risk.

Today, we have several reasons to believe that future returns may be lower than historical returns. This impacts the level of withdrawal that we can safely achieve in a retirement portfolio. In my planning process, I use projected returns rather than historical returns, because I am concerned that historical returns may over-estimate the likelihood of success.

This issue is too complex to address in the space of a blog post, but I want to educate as many people as possible about the challenges of funding a retirement in a lower return environment. I have written a whitepaper on this subject and strongly encourage anyone interested in their retirement to read more:

Five Reasons Your Retirement Withdrawals are Too High

If you’re not close to retirement, this is still a relevant issue because the amount you need to accumulate is determined on your future retirement withdrawal rate. A simple way to calculate your finish line is by multiplying the reciprocal of your withdrawal rate times your annual need.

For example, a 4% withdrawal rate (1/25), gives us a multiplier of 25. A 5% withdrawal rate equals a multiplier of 20. If your annual need is $100,000, your portfolio target would be $2,500,000 under a 4% withdrawal program. Decreasing the withdrawal rate from 5% to 4% would increase your portfolio target from $2 million to $2.5 million. And that’s why the safe withdrawal rate matters to everyone seeking financial independence.

Socially Responsible Investing

Posted On August 18, 2014 By Admin In Portfolio Management / 1 Comment

Socially Responsible Investing (SRI) has taken off in recent years as many investors want to align their portfolio to reflect their personal beliefs. Fortunately, it is becoming easier to access high quality SRI investments and we are happy to incorporate our clients’ wishes whenever possible. This year, the amount invested in SRI funds surpassed $100 Billion and I think it’s safe to say that SRI has moved from being a small niche to a mainstream approach.

I want to emphasize two very important considerations for anyone contemplating adopting SRI principles for their portfolio. First, you may want to support an idea or sector, such as Solar Energy. You might think that by buying stock in a solar company, you are supporting that company, but you’re not actually providing new capital. Other than in an Initial Public Offering (IPO), trading shares is just buying and selling between investors in the open market. Although solar power is a great idea, many investors suffered losses in recent years when the stock market eventually recognized that solar panels had become a commoditized product with low profit margins. If you want to buy individual stocks, be sure that you buy the company based on its investment fundamentals and not just because you believe in the idea or think it will be “the next big thing”. Otherwise, you’d be better off investing in regular funds and using your profits to make donations to the causes you want to support.

For most investors, I suggest you avoid individual stocks altogether and instead choose from the many Socially Responsible funds and ETFs that are available today. This brings me to my second recommendation: when selecting an SRI Fund, always look at its holdings, weightings, and diversification. SRI guidelines limit which stocks a fund manager can select. For example, they may be prohibited from owning alcohol, tobacco, nuclear power, or defense companies. As a result, SRI funds are often heavily weighted in just two or three sectors of the economy. Today, many (if not most) SRI funds have their largest holdings in the technology industry. Concentrated funds can look attractive when those sectors are performing well, but often perform very poorly when their top sectors tumble. Make sure your funds are well diversified and that you are not buying a sector fund in disguise.

For a core US equity holding, consider the iShares KLD 400 Social Equity (ticker: DSI). This is an index Exchange Traded Fund (ETF) that holds the 400 largest US companies that have been screened for positive environmental, social, and governance qualities. If you currently have a large cap mutual fund in your portfolio, you could use DSI as a replacement to add an overlay of socially responsibility, while maintaining a liquid and diversified portfolio. With an expense ratio of 0.50%, it is a relatively cheap way to build a core SRI equity position compared to most actively managed mutual funds.

I would, of course, use several other SRI funds to build out a more complete portfolio. While equity investing tends to get most of the attention in SRI, investors should also consider their fixed income holdings. When you own the bond of a company or government, you are in fact a lender who has provided capital and receives interest from that entity. So if you decide to embrace the Socially Responsible Investing approach, don’t forget to also include your bond funds. Alternatively, you could work with an advisor such as myself to help select individual bonds and build a bond ladder for your portfolio.

Unfortunately, I do not expect an SRI portfolio to outperform a traditional asset allocation, and anticipate it may even lag over time. SRI reduces sector diversification, but also SRI funds tend to have a higher expense ratio than the ETFs we use for our core equity positions. Still, I admire what SRI aims to accomplish, which is to tell corporate management that as owners, shareholders demand companies do the right thing for the environment, human rights, and society. It’s clear that corporate lapses can contribute to increased risks for our economy, not to mention for the company itself. Too many mutual funds and ETFs are not proactively using their capacity as the largest shareholders to advocate for improved corporate governance. That’s a bigger issue than I can tackle as an advisor and investor, but my hope is that SRI will help apply pressure to corporate boards to do better.

Health Savings Accounts: 220,000 Reasons Why You Need One

Posted On August 11, 2014 By Admin In Retirement Planning / 2 Comments

The Health Savings Account (HSA) is one of the best savings vehicles, yet remains underutilized by many investors. Used properly, you can get a tax deduction for your contributions, like a Traditional IRA, and be able to take your money out tax-free, like a Roth IRA. No other account has this remarkable benefit! And that’s why I’ve been telling clients about the HSA every chance I get, as well as contributing the maximum to my own HSA for the past 8 years.

Most people know that you can use your HSA to pay for co-pays, deductibles, prescriptions and other medical expenses not covered by your health insurance, including expenses for dental and vision care. But fewer people are aware of some of the longer-term benefits of an HSA which make it a very attractive tool to help fund your retirement.

In addition to IRS-qualified medical expenses, after age 65, you can take tax-free withdrawals from your HSA to pay for Medicare premiums for parts A, B, D, and a Medicare HMA. You can also use your HSA to pay for long-term care insurance premiums. If you’re still working after age 65, you can even use your HSA to pay (or reimburse) the employee costs of your employer health plan.

But why do you need an HSA? According to a 2014 study by Fidelity, the estimated cost of health care for a 65-year old couple is $220,000 in today’s dollars. This is the amount not covered by Medicare, and by the way, assumes zero nursing home expenses. Having tax-free dollars available in an HSA can fund these costs while helping retirees reduce their need for withdrawals from taxable sources such as their 401(k) or IRA to pay for medical expenses or insurance premiums.

If you are healthy today, you might not be thinking about an HSA, but it is still a valuable idea to accumulate pre-tax dollars in your HSA now to pay for your health insurance or LTC premiums in retirement. Many families were familiar with Flexible Spending Accounts, which were “use it or lose it”, so when HSAs became available, a lot of participants were still in the mode of contributing only their expected annual expenses. HSAs have no expiration date on contributions, yet I still hear some people say that they “don’t want to have too much money in their HSA”.

Prior to age 65, there is a 20% penalty for non-qualified withdrawals from an HSA. After age 65, the penalty is waived, but you will have to pay tax on any withdrawal for a non-qualified expense. It would obviously be preferable to take a tax-free withdrawal for a qualified expense, but if you were to need the funds for other purposes, then the account would be treated the same as a 401(k) or Traditional IRA. And that’s still a benefit, because you had an upfront tax-deduction followed by years of tax deferred growth. Unlike a Traditional IRA, however, there are no income restrictions on contributing to an HSA, so this is a tax deduction that many high income families miss. And there are no Required Minimum Distributions on an HSA.

The only negative is that the contribution limits are relatively low. For 2014, the maximum contribution is $3,300 for a single plan or $6,550 for a family plan. Account holders who are over age 55 but not enrolled in Medicare can contribute an additional $1,000 catch-up. Once you’re enrolled in Medicare (Part A or B), you are ineligible to fund an HSA. Not all high deductible health plans are HSA eligible, so please do not open an HSA until you have confirmed you can participate.

A high deductible plan is generally a good deal if you have few medical and prescription expenses and primarily want coverage in case of a major illness. On the other hand, if you have a lot of on going medical bills for your family, a high deductible plan may be more expensive if you will hit the annual out of pocket maximum each year.

Given the significant size of medical expenses in retirement, the high inflation rate of medical care, and the troubling state of future Medicare funding, starting an HSA early makes sense. Looking at the remarkable long-term tax benefits of an HSA, I suggest clients consider an HSA on equal ground with funding a Roth or Traditional IRA.

Student Loan Strategies: Maximizing Net Worth

Posted On August 11, 2014 By Admin In Financial Planning /

For today’s young professionals, student loans have grown to become a significant financial obstacle. A common question is if it makes sense to pay off these loans early.

First, before considering making additional payments, I’d counsel investors to:
1) have paid off any credit card balances;
2) establish an emergency fund of at least 6 months reserves, and 12 months if their income is unknown or employment is in any way tentative; and
3) save up for a house down payment, if home ownership is a goal.

Having the cash available to pay off a loan is terrific, but I caution people to not forgo their retirement savings in lieu of their student loans. I know that for many recent graduates it seems appealing to get out from under those loans as quickly as possible, so they think they should wait on contributing to their 401(k) and put as much as possible towards the loans. When you look at the effects of compounding, however, the money you invest in your 20’s and 30’s into your retirement accounts is much more valuable than the same dollars invested in your 40’s and 50’s. Often times your net worth will be higher by starting to invest earlier and taking your time with the loan repayment. And of course, you can test this projection with most financial planning software programs or a spreadsheet.

Another factor to consider on the decision to repay is the tax deduction. For 2014, you can deduct up to $2,500 in student loan interest from your federal tax return. This deduction is limited, however, based on your modified adjusted gross income (MAGI).

Single taxpayer: full deduction below $65,000 MAGI, phaseout $65,000 – $80,000
Married filing jointly: full deduction below $130,000 MAGI, phaseout $130,000 – $160,000

I would note that student loan rates are variable and have crept up in the past couple of years. Additionally, as your career progresses and income increases, many families lose their eligibility to take advantage of this tax deduction. I point this out because another important question is: Which is better to pre-pay, student loans or your home mortgage? The mortgage interest deduction does not have an income limit and is not capped at $2,500. Also, most mortgages are fixed, not variable. That’s why I suggest most borrowers make extra payments towards student loans rather than their home mortgage.

For those who can receive the student loan interest tax deduction, it lowers your cost of borrowing, so I would consider the after-tax cost of borrowing when deciding if early loan repayment makes sense. Most borrowers I counsel have multiple loans at various interest rates, so it is often best to send extra payments towards the student loan with the highest interest rate and make only the minimum payments on the other loans. Over time, we will pay off the highest rate loan first. Then that monthly payment can be applied towards other loans. Additionally, paying off one loan first will reduce your total monthly minimum payments, which is highly valuable should you have any sort of temporary setback like a job loss.

The earlier you can make extra payments, the better. If your interest rate is 5%, paying an extra $1,000 today will mean that you are saving $50 in interest in every year going forward. Early principal payments will shorten the length of the loan more dramatically than extra payments made in future years. If you scrimp a bit now and make extra payments, you will reduce your total interest payments over the life of the loan.

Be careful about consolidating loans. Most people consolidate to lower their monthly payment amount, but inadvertently add years to their loans and thousands in interest payments. Additionally, if you are consolidating Federal loans, such as Stafford Loans, into private loans, you will be giving up access to Federal loans benefits such as forbearance, income-based payments, or loan forgiveness. Before consolidating, make sure you are not going to lose any pre-paid interest if you are ahead on your payment schedule.

Many people think a financial plan deals only with the Asset side of your balance sheet, but some of the most important choices are about how to manage your Liabilities. Student loans are an investment in yourself, so make sure your subsequent cash flow decisions are helping to maximize your net worth in the long run.

Catching Up for Retirement

Posted On July 28, 2014 By Admin In Retirement Planning /

A common rule of thumb is to save 10% of your income each year for retirement. If you started in your 20’s and invested for 30-40 years, this may well be adequate. But if you currently aren’t saving at this level, 10% can seem like a daunting amount. And if you got a late start or had some financial set-backs along the way, you may need to save even more.

What can a late starter do to get caught up on their retirement goals? Here are 5 ideas to help you take positive steps forward.

1) Save half your raise. When you get a raise, before you receive your next paycheck, increase your 401(k) contribution by 50% of the raise. You’ll still see an increase in your paycheck, but have a better chance of keeping the money which is automatically withheld, rather than taking the cash and hoping to have some left over to invest at the end of the year. This strategy works well for careers which have predictable, steady raises.

2) Downsize. If your kids are out of the house, you may not be needing all the space in your current home. By downsizing to a smaller home, you may be able to free up some home equity and invest those proceeds into investments with a potentially higher return. Additionally, a smaller home will have much lower expenses, including utilities, insurance, and property taxes.

If you really want to make a big impact on your finances, you have to look at the big expenses. For someone in their 50’s or 60’s, cutting out a daily latte just isn’t going to make enough of a difference. Many people have an emotional attachment to their home, which is completely understandable. However, if downsizing makes sense for you, you should try to make that change as soon as possible. Your home is one of your largest expenses and you want to make sure that it isn’t holding you back from achieving other important goals.

3) Spousal IRAs. Most people are aware of the catch-up provisions available after age 50 in their 401(k) or 403(b) plans at work, but many couples aren’t aware of their eligibility to fund an IRA for a spouse who doesn’t work or who doesn’t have a retirement plan. For 2014, the IRA contribution limits are $5,500 or $6,500 if over age 50. Here are the rules for some common scenarios:

– If neither spouse is covered by an employer plan at work, then both can contribute to a Traditional IRA and deduct the contribution, with no income restrictions. Both can contribute to an IRA, even if only one spouse works.
– If only one spouse is covered by an employer retirement plan, then the other spouse can contribute to a deductible Traditional IRA, if their joint MAGI is below $181,000 (2014).
– My personal favorite: if either spouse does not have any IRAs, that spouse can contribute to a Back-Door Roth IRA. There are no income restrictions to this strategy.

4) Social Security for divorcees. A common reason why individuals are behind in their retirement saving is divorce. If you were married for at least 10 years, you are eligible for a Social Security benefit based on your ex-spouse’s earnings. Many divorcees are not aware of this because spousal benefits are never listed on your Social Security statement.

The spousal benefit does not impact your ex-spouse in any way and they will not know you are receiving a spousal benefit. You do not have to wait for (or even know if) your ex-spouse has started to receive their benefits. We’ve often found that someone who was out of the workforce to raise a family or had a limited earnings history will have a very small Social Security benefit based on their own earnings and isn’t aware they are eligible for a benefit from a high-earning ex-spouse.

Details: you must be at least 62, unmarried, and the spousal benefit will only apply if greater than your own benefit. To apply, you will need your ex-spouse’s name, date of birth, social security number, beginning/ending dates of marriage, and place of marriage.
See: http://www.ssa.gov/retire2/divspouse.htm

5) Don’t get aggressive. For many investors, the temptation is to try to eke out extra return from their investment portfolio to make up for the fact that they are behind. They take a very aggressive approach or try to day trade. This is very risky and the results can be devastating. Invest appropriately for your risk tolerance, objectives, and time horizon, but stay diversified and don’t gamble your nest egg.

A Young Family’s Guide to Life Insurance

Posted On July 21, 2014 By Admin In Financial Planning /

Life insurance isn’t for you – you really purchase life insurance to protect someone else. If you have a spouse, children, parents, or even a business that is depending on your future work and income then you should consider if a life insurance policy makes sense for you. Life insurance is an essential piece in the financial planning process that is often overlooked by many young families. It is not always easy to discuss the reality of our own mortality, but most people feel more secure once they have a life insurance policy in place.

Life Insurance premiums are based on your age and health, so the best time to get a policy is when you are young and healthy; you will be able to get the best price from an insurer and lock in your cost and coverage. If you later develop health issues, such as diabetes, high blood pressure, or a more serious condition, you may find that you are now uninsurable or that adequate coverage is prohibitively expensive.

A young professional is probably not thinking about life insurance, but with decades of earnings ahead of them, actually has the greatest amount of future income that would require replacing in the event of their unexpectedly passing. An older individual, say with grown children, does not have the same liabilities or as many years of future income that would require replacing for their family.

As a Financial Planner, my recommendation is to use Term Life insurance for young families. Many individuals can buy a policy for under $1000 a year and that may be the last policy they will ever need to own. With Term Life, you lock in a low cost that is guaranteed to not increase over the life of the policy. We look at 15, 20, and 30 year policies and try to match the duration of your future needs, as well as to make sure that the policy will be in force through your children’s college years. To decide on a benefit amount, we look at a number of factors including your income, liabilities, and children’s needs. However, as a rule of thumb, a benefit of 8-12 times your annual income is often adequate. Rather than thinking about life insurance in terms of mortality, it helps to frame the conversation around looking at your family’s potential need for income replacement.

You may hear about other types of life insurance, but insurance is not the most efficient tool for investing, so I typically steer clients away from policies that have a cash value or are used as an investment vehicle. “Buy Term and Invest the Difference” is my approach and the philosophy embraced by many financial professionals. In planning for clients for a period of decades, our goal is for them to become self-insured by their 50’s, so that they have enough in assets that life insurance is not a necessity. When their Term Life insurance policy reaches the end of its term period, they may not need to purchase another policy.

There are some reasons to buy a permanent policy, such as Universal Life or Whole Life, if you have a specific requirement to leave money at your passing. This might be for charitable purposes, for business requirements, to fund a special needs trust, or to pay for estate taxes. Outside of very specific needs like these, most individuals will be well served with a term policy instead.

Two other thoughts on buying life insurance:

1) Don’t rely on a group life policy with your employer. Employer life insurance benefits are generally not portable if you change jobs, do not have fixed premiums, and may be dropped if your company amends their benefit programs. You’re not in control with a group policy. If you are in relatively good health, buying an individual policy is typically a better solution. However, if you have some health concerns, a group policy may be affordable and the only coverage you can obtain.

2) Term Life is largely a “commodity” product today, so it pays to shop around or use an independent agent, such as myself, who can get quotes from multiple companies. Each year, when I send in my check for $350 for my annual premium, I think how glad I am to have my term policy in place. Term insurance can be incredibly cheap for a significant amount of coverage.

I hope that none of my clients will ever need to make a claim on their Term Life policies, but I have to say that it has been very satisfying to know that I have protected quite a few families over the past 10 years with this vital program. It may not be the most interesting or significant part of a financial plan, but if a claim did occur, it would be the only part of the plan that mattered. If life insurance is something that you haven’t gotten around to, please give me a call, and we will get it done for you. And your spouse will sleep easier, rather than wondering, What if?

How to Maximize Your Social Security

Posted On July 14, 2014 By Admin In Retirement Planning /

When should I start my Social Security benefits? I am asked this question frequently and find that many otherwise rational individuals don’t actually look at any data or analysis when making this important decision. As a financial planner, I have the tools to help you take a closer look at all your options to make an informed choice, rather than relying on heuristic biases. The first step, though, is to understand what happens when you start at age 62, 66, or 70. And that’s what today’s post aims to accomplish.

74% of Americans start their Social Security benefits early, before the Full Retirement Age (FRA) of 66 (for individuals born between 1943-1954). Starting at age 62 will result in a reduction in benefits to 75% of your primary insurance amount (PIA). If you wait past age 66, you will receive Delayed Retirement Credits (DRCs), equal to 8% a year, or a 32% increase for individuals who wait until age 70. Many of the individuals who wait until age 70 do so because they are still working. However, even for individuals who retire at age 62, it may make sense to delay benefits to age 66 or 70 and live off other sources of income, in order to receive a higher future Social Security benefit.

Delaying from age 62 to 70 offers a 76% increase in benefits. For example, someone with a PIA of $1000 a month would receive this amount at age 66, but would receive $750 at 62 or $1320 at 70. While COLAs or additional earnings will increase your benefits regardless of when you start, a 2% COLA is obviously going to produce a higher dollar increase if your benefit amount is $1320 rather than $750. So in nominal dollars, the difference between 62 and 70 typically exceeds 76%.

For single individuals, the decision is relatively straightforward. Social Security was designed so that a person with average life expectancy will receive the same benefits regardless of whether they start at age 62, 66, or 70. On an individual level, if your life expectancy is above average, you will receive greater total lifetime payments by delaying benefits until age 70. And if your life expectancy is below average, you will not have enough years of higher benefits to make up for the lost years, so you should start benefits earlier. The breakeven for delaying from age 66 to age 70 is between age 83 and 84. Delaying from 62 to 70 creates a breakeven between age 80 and 81.

Since 74% of recipients start benefits early, the behavioral bias is that people are underestimating their life expectancy. It should be 50% – half of us will live shorter than average and half will live longer. Unfortunately, many of the 74% will live longer than average and their choice means they will receive lower lifetime benefits than if they had delayed to age 66 or 70.

In addition to life expectancy, the other consideration for a single individual is if they have other sources of income. If he or she can get by with withdrawals of 4% or less from their portfolio from age 62 or 66 to age 70, then I would encourage them to delay the Social Security benefits.

Delaying benefits will reduce the future withdrawals required from their portfolio and increase the likelihood that their portfolio will be able to provide lifetime income. When I run Monte Carlo analyses for clients, those who fund a larger percentage of their needs from guaranteed payments like Social Security (or a Pension) have a greater probability of success than retirees who are more dependent on portfolio withdrawals. A larger Social Security benefit reduces the impact from poor potential outcomes in the stock and bond markets, or from an initial drop in the market, called Sequence of Returns Risk.

For married couples, the decision to delay benefits becomes more complex. Neither your Social Security statements nor the calculators on the SSA.gov website help with coordinating spousal benefits. Often, it may make sense to delay for one spouse but not for the other.

A general rule for couples is that you should consider maximizing the higher earning spouse’s SS benefit amount by delaying to age 70. The larger benefit will become the survivor’s benefit, so in effect, the higher earner can consider his or her benefit to be a joint and survivor benefit. And if the spouse is younger or has a high life expectancy, than delaying to age 70 for the higher earner may be an even better idea, in terms of actuarial odds.

Social Security is a good hedge for portfolio performance and an 8% guaranteed increase for delaying one year is a valuable benefit. I looked at quotes this month for immediate single-life annuities and for a 66-yr old male versus a 67-yr old, the rate increase was only 2.2%. Delaying from 66 to age 70 increased the annuity benefit by 12.2%. That gives you an idea of how exceptionally valuable the 8% annual increase is (or 32% for waiting four years), given the low interest rate environment we face today.

Aside from the principle of delaying the higher earning spouse, it is difficult to make other generalizations about delaying to age 70 as the details of a couple’s specific situation typically determine the best course of action. I use financial planning software to analyze your options and suggest an approach to coordinate your benefits into your overall financial plan. There are two tools which married couples might consider to provide some often-missed benefits as one or both defer to age 70.

The first tool is the ability to file and suspend. At full retirement age (66), you can file for benefits but immediately suspend the payments. This enables your spouse to be eligible to receive a spousal benefit, while you can continue to receive deferred credits for delaying to age 70. This is typically used if the spouse does not have any SS benefit based on their own earnings, or if the spouse’s individual benefit is less than the spousal benefit amount (half of the first spouse’s PIA, if the second spouse is at FRA).

If a spousal benefit applies, it is important to know that DRCs are not added to a spousal benefit. While the primary spouse will receive the 8% increase after age 66, the spousal benefit does not increase. So, if the spouse is the same age or older than the higher earning spouse, it is important to not delay the spousal benefit once both are age 66.

The second tool is a restricted application. At FRA, a spouse may restrict their application to receive only their spousal benefit amount and still earn Deferred Retirement Credits on their own benefit. Then they can switch to their own benefit at age 70. However, to receive any spousal benefit, the other spouse must be currently receiving benefits. This works if you want to delay from age 66 to 70 and if your spouse is already receiving benefits (or has filed and suspended).

These two tools provide a benefit from age 66-70 which many people miss. Both techniques will allow one spouse to defer their individual benefit to age 70 to maximize their payment amount (and potentially, the survivor’s benefit amount), while receiving an additional benefit for those four years. If you might benefit from either of those tools, don’t expect the Social Security Administration to tell you. And if you miss those benefits, you’ll lose free money that you can’t get later.

10 Questions Grandparents Ask About 529 Plans

Posted On July 7, 2014 By Admin In College Savings / 1 Comment

It’s summer break and your little grandchildren are one year closer to college. Still haven’t set aside any funds for their college expenses? For grandparents who have the means to help with future college expenses, the 529 College Savings Plan is a tremendous tool. Here are the Top 10 questions grandparents ask about 529 plans.

1) What are the tax benefits of 529 Plans?

Many states offer a state income tax deduction for contributions to a 529 plan. There are no federal tax deductions for 529 contributions, however, withdrawals for qualified higher educational expenses are tax free, so any future gains would be tax-free. The earlier you establish a 529, the greater potential growth you may have in the account. And the greater the potential tax savings!

2) Which 529 plan should I choose?

The first step in choosing a 529 College Savings Plan is to determine if there is any benefit or incentive to using the “in-state” plan. For example, if you are a New York resident, you can deduct up to $5,000 off your NY state income tax return if you participate in the New York 529 plan. For married couples, you can deduct up to $10,000 per year. The NY deduction is per tax-payer, not per beneficiary. However, in other states, the tax deduction may be per beneficiary and may even carry forward to future years.

In states without an Income Tax, such as Texas and Florida, there are no tax benefits or credits for using the in-state plan, so you can choose from any plan in the country. You might choose a plan with very low costs and a good selection of investments. The rules vary by state, so you will want to look up this information on www.savingforcollege.com.

3) What expenses can you use a 529 Plan for?

529 plan distributions for Qualified higher educational expenses are tax-free. These qualified expenses include tuition, fees, books, lab supplies, computers, and room and board. If your student lives off campus, you are limited to the same amount of expenses that they would have had for living on-campus. You cannot take a qualified 529 Plan distribution for transportation, student loan costs, health insurance, sports/clubs, or other expenses.

4) Are there limits to 529 contributions?

Contributions to a 529 Plan are considered a gift by the IRS and are subject to gift tax rules. For 2023, the annual gift tax exclusion is $17,000 per beneficiary. However, 529 Plans have a special exception to this rule which allows you to fund five years of contributions in one year, or $85,000 per beneficiary ($170,000 per beneficiary if funded by a married couple).

Most parents and grandparents try to keep 529 contributions within the Gift Tax exclusion amounts. However, you can contribute more than this amount if you want. But, you will have to file a gift tax return and use up a portion of your unified lifetime exemption.

5) How do assets in a 529 plan impact my estate planning and eligibility for Medicaid?

Assets in a 529 plan are excluded from your taxable estate. If you are likely to be subject to the estate tax, 529 plans are a terrific tool to shelter assets from the estate tax while maintaining control of those funds. If you have funded five years in advance, and do not survive the five years, the donor’s estate will have to add back a pro-rata portion of the 529 contribution to the taxable estate.

Medicaid rules vary by state. 529s may be counted as assets in some states and may be subject to “look back” provisions by Medicaid. If you are thinking you will become so impoverished to qualify for Medicaid (not Medicare), you might not be the best candidate to be giving money to a 529 Plan.

6) How do 529 plans affect students’ eligibility for financial aid?

Grandparents’ assets are not disclosed on the Federal financial aid application (the FAFSA), so student financial aid eligibility is actually improved compared to having those same funds held in either the parents’ or student’s name. Taking a distribution, however, from the 529 plan is considered reportable income on the FAFSA, so the best time to use the grandparents’ 529 is in the student’s final year of college. The CSS has different rules, so you also have to know which process your university will use for determining financial aid.

7) What if my student doesn’t need the 529 Plan?

If your student doesn’t use the full 529 plan, you have a lot of options. Thankfully, there is no expiration date or time restriction on a 529 account. You can change the beneficiary to another relative, or even save it for future grandchildren. Your beneficiary can also use $10,000 (lifetime) from the 529 to repay student loans. These options all retain the full tax benefits of the 529 Plan.

There are several exceptions to the 10% Penalty. This means you could take a withdrawal, and the gains would be taxable income, but the 10% Penalty would be waived. These situations include: receiving a scholarship, attending a US Military Academy, or the disability or death of the beneficiary.

8) Can 529 plans be used to help pay for private high schools?

Yes, after the Tax Cuts and Jobs Act (TCJA) 529 plans were expanded to be usable for private elementary and high school tuition. This is limited to $10,000 per year. But be careful, a handful of states will consider this use a taxable distribution (including CA, CO, HI, IL, MI, MN, MT, NE, NY, OR, and VT).

9) What if I end up needing the money in a 529 plan for my own expenses?

Since you control the assets in a 529 Plan, you can make a withdrawal at any time. A 529 plan is revocable by the owner. However, if the withdrawal is taken for a reason other than a qualified higher educational expense, any gains would be subject to income tax and a 10% penalty. Note that the tax and penalty apply only to the gains, not to your principal. If you have multiple 529 accounts, select the one with the lowest gains if you need a withdrawal, and then you can change the beneficiaries on the remaining accounts as needed. Otherwise, all non-qualified distributions are considered a pro-rata distribution consisting of both principal and earnings (like an IRA, there is no FIFO or principal first rules).

10) When does it make sense to pay for college tuition directly or give the money to my child or grandchild to pay for tuition instead of opening a 529 plan?

If a student is within a year or two of college, you may not see sufficient growth in a 529 account to receive much of any tax benefit. 529s are much more attractive when funded at an early age to allow for many years of growth.

While 529 contributions are subject to the gift tax rules, those limitations do not apply to payments made directly for education or medical expenses. If the expenses are greater than the gift tax exclusion amounts, it may make sense to pay college expenses directly, rather than choosing to file a gift tax return and use up part of your lifetime unified exemption. Money given directly to your children or grandchildren will be reported on the FAFSA, which could increase their expected family contribution and potentially reduce their eligibility for other sources of financial aid. It would be preferable to pay the college tuition bill directly rather than giving money to your children or grandchildren.

If you have questions on 529s or college planning, feel free to drop me an email. I am here to help.

Why Alan Didn’t Rollover his 401(k)

Posted On July 1, 2014 By Admin In Retirement Planning /

Alan and Lois began investing in the 1990’s when their tax preparer suggested the young couple establish a Roth IRA to begin saving for retirement. They each deposited $2,000 into a Roth, the maximum contribution back then. As the contribution limits increased, they continued to fund their Roth IRAs, and as their careers flourished, they were able to contribute to their 401(k) plans at work as well.

This worked for more than a decade, until 2006, when their joint income exceeded the income limitations to contribute to a Roth IRA. At that point, they ceased making contributions. They could have funded a Traditional IRA, but it would have been non-deductible. Luckily, I met Alan and Lois two years ago and I was able to determine they were eligible for a Back Door Roth IRA.

Prior to 2010, in order to convert a Traditional IRA into a Roth, you had to have a joint income under $100,000. When this income restriction was abolished in 2010, it created a new opportunity. Now, anyone can contribute to a Traditional IRA – which does not have income limits – and convert those funds into a Roth IRA. If you fund the Traditional IRA with a non-deductible contribution and immediately convert the account, you will have zero taxable gains and the conversion will be tax-free. The strategy is called the “Back Door Roth” since it bypasses the Roth’s income restrictions.

Here’s the crucial piece to understand: the IRS considers you to have one Traditional IRA, regardless of the number of accounts or types of IRAs you own (Traditional, Rollover, SEP, or SIMPLE). This means that you cannot convert just the new non-deductible contributions. If you have multiple accounts or multiple contributions, the IRS will consider any conversion to bepro rata, meaning proportional from all sources.

Luckily for Alan and Lois, their retirement accounts consisted solely of 401(k) accounts and Roth IRAs, so they were eligible fund the “Back Door Roth IRAs” and pay no taxes. We deposited $5,500 into a Traditional IRA for each of them and converted the account into their existing Roth IRA. It’s a great way to add $11,000 a year to tax-free account, and yet many people don’t realize they are eligible for the Back Door account.

This spring, Alan changed jobs and asked me about rolling over his 401(k) into an IRA. If we did rollover his $350,000 account into an IRA, he would be giving up the ability to do the tax-free Roth conversion in the future. The IRS will look at his accounts as of December 31, so if he did rollover his 401(k) this year, the Roth conversion we did in January would now be more than 95% taxable.

After explaining this to Alan and Lois, we decided that it did not make sense to rollover the 401(k) into his IRA and give up the opportunity to fund the Back Door Roth for the next 15 to 20 years. He could leave his 401(k) in its current location or roll it to his new 401(k), which is acceptable because it is not going to an IRA. The rules on Roth conversions apply only to your IRAs, and not to 401(k), 403(b), 457, or other ERISA-type plans. Alan’s new 401(k) plan had extremely low fees and access to institutional share classes of mutual funds. So, we rolled his old 401(k) to the new plan and will still be able to take advantage of the Back Door Roth IRA each year.

There are a number of reasons to not roll a 401(k) into an IRA, and that’s why it can be highly valuable to have a financial planner who is completely familiar with your individual situation. If you’re looking for this kind of personalized advice, please give me a call.

Who’s Going to Pay for Your Retirement, Freelancer?

Posted On June 26, 2014 By Admin In Retirement Planning /

A regular employee has a steady paycheck which makes planning and budgeting easy. For a freelancer, your income may fluctuate greatly from month to month and be very difficult to predict from year to year. You may not know what work you will be doing six months from now and that’s likely to be a more immediate concern than retirement which could be 20 or 30 years away.

It’s often impractical for a freelancer to save up a large lump sum investment each year. What does work for freelancers is to “pay yourself first” by setting up a monthly automatic investment program into an Individual Retirement Account (IRA). This forces you to budget for retirement savings just as you would do for any other bill, such as your car payment or rent. It is easier to plan for smaller monthly contributions and this creates the same regular investment plan as an employee who is participating in a 401(k).

The maximum annual contribution for an IRA in 2014 is $5,500, which works out to $458 per month. If you aren’t able to contribute the maximum, that’s okay, there are mutual funds that will let you invest with as little as $100 a month. The most important thing is to get started and not put it off for another year. You can always increase your contributions in the future as you are able. If you are over the age of 50, you can contribute an additional $1,000 a year into an IRA, a total of $6,500 a year, or $541 per month.

If you can use a tax deduction, open a Traditional IRA. If you don’t need the tax deduction, and meet the income limitations, select a Roth IRA. Additionally, there is another reason the Roth IRA is very popular with freelancers. Many freelancers worry about hitting a slow patch in their business and needing to tap into their savings. A nice benefit of the Roth IRA – which may help you sleep well at night – is that you can access your principal without tax or penalty at any time. So if you do have an emergency in the future, you would be able to withdraw funds from your Roth IRA. (Principal is the amount you contributed; if you withdraw your earnings (the gains), the earnings portion would be subject to income tax and a 10% penalty if you are under age 59 1/2.)

If you are able to contribute more than $5,500 (or $6,500 if over age 50), the SEP-IRA is your best choice. You could contribute as much as $52,000 into a SEP this year, if your net income is over $260,000. The contribution for a SEP is roughly 20% of your net profit each year, so it works great for freelancers who want to save as much as possible. Why not just recommend a SEP for all freelancers? The challenge with a SEP is that it is impossible to know the exact dollar amount you can contribute until you actually prepare your tax return each year. That’s why most SEP contributions are not made until March or April of the following year. For freelancers who are getting started with saving for retirement, your best bet is to first maximize your contributions to a Traditional or Roth IRA through automatic monthly deposits. Then if you want to make an additional investment, you can also fund a SEP at tax time. A lot of investors assume that you cannot do a SEP if you do a Roth or Traditional IRA, but that is not the case, you can do both.

Being a freelancer can be very rewarding and fulfilling, but it does carry some additional financial responsibilities. You don’t have an employer to pay half of your social security taxes or to provide any retirement or insurance benefits. Unlike traditional employees, however, many freelancers don’t go from working full-time one day to completely retired the next day. What I often see is that many freelancers choose to keep working but reduce their schedule and select only the projects which really interest them. In this manner, they are never fully retired, but still stay active and have multiple sources of income. Regardless of your plans or intentions for retirement, my job is to help you become financially independent, so you work because you want to and not because you have to.