Deferral Rates Trump Fund Performance, Rebalancing as Key to Retirement Plan Success

Posted On March 16, 2015 By Admin In Retirement Planning /

A study by the Putnam Institute, “Defined Contribution Plans: Missing the forest for the trees?” contends that while a number of variables, such as fund selection, asset allocation, portfolio rebalancing, and deferral rates all contribute to a defined contribution plan’s effectiveness — or lack thereof — it is deferral rates that should be placed near the top of the hierarchy when considering ways to boost retirement saving success.¹

As part of its analysis, the research team created a hypothetical scenario in which an individual’s contribution rate increased from 3% of income to 4%, 6%, and 8%. After 29 years, the final balance jumped from $138,000, to $181,000, $272,000, and $334,000, respectively.

Even with a just a 1% increase — to a 4% deferral rate — the participant’s final accumulation would have been 30% greater than it would have been using a fund selection strategy defined as the “Crystal Ball” strategy, in which the plan sponsor uses a predefined formula to predict which funds may potentially perform well for the next three-year period. Further, the 1% boost in income deferral would have had a wealth accumulation effect nearly 100% larger than a growth asset allocation strategy, and 2,000% greater than rebalancing. Of course these results are hypothetical and past performance does not guarantee future results.

One key takeaway of the study was for plan sponsors to find ways to communicate the benefits of higher deferral rates to employees, and to help them find ways to do so.

Retirement Savings Tips

The Employee Benefit Research Institute reported in 2014 that 44% of American workers have tried to figure out how much money they will need to accumulate for retirement, and one-third admit they are not doing a good job in their financial planning for retirement.² Are you? If so, these strategies may help you to better identify and pursue your retirement savings goals:

Double-check your assumptions. When do you plan to retire? How much money will you need each year? Where and when do you plan to get your retirement income? Are your investment expectations in line with the performance potential of the investments you own?

Use a proper “calculator.” The best way to calculate your goal is by using one of the many interactive worksheets now available free of charge online and in print. Each type features questions about your financial situation as well as blank spaces for you to provide answers. But remember, your ultimate goal is to save as much money as possible for retirement regardless of what any calculator might suggest.

Contribute more. At the very least, try to contribute enough to receive the full amount of any employer’s matching contribution. It’s also a good idea to increase contributions annually, such as after a pay raise.

Retirement will likely be one of the biggest expenses in your life, so it’s important to maintain an accurate cost estimate and financial plan. Make it a priority to calculate your savings goal at least once a year.

Today’s blog content is provided courtesy of the Financial Planning Association.

Source/Disclaimer:

¹Putnam Institute, Defined Contribution Plans: Missing the forest for the trees?, May 2014.

²Ruth Helman, Nevin Adams, Craig Copeland, and Jack VanDerhei. “The 2014 Retirement Confidence Survey: Confidence Rebounds–for Those With Retirement Plans,” EBRI Issue Brief, no. 397, March 2014.

Because of the possibility of human or mechanical error by Wealth Management Systems Inc. or its sources, neither Wealth Management Systems Inc. nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall Wealth Management Systems Inc. be liable for any indirect, special or consequential damages in connection with subscriber’s or others’ use of the content.

Retiring Soon? How to Handle Market Corrections.

Posted On March 2, 2015 By Admin In Retirement Planning /

I was recently asked “How would you protect a soon to be retired investor against the inevitable market correction that will occur in the next couple of years?” It’s a great question and I think it’s very important that investors understand the risks they take when investing. Having not had a significant correction in six years, we may be well overdue. Of course, some forecasters have been calling for a correction for a couple of years, and yet the S&P 500 was up 13% last year and 32% the year before. That’s the problem with trying to time the market – it’s not possible to predict the future and it’s too easy to miss good returns by sitting on the sidelines. So, how should investors position their money if they’re a couple years from retirement?

The first thing is to frame the investment portfolio in a broader context. Someone who is four years from retirement does not have a four-year time horizon, but more likely, a 30-year time horizon, so we want to focus on finding the best solution for the whole 30-year period. That means we have to balance the desire for short-term safety with the long-term need to keep up with inflation and not run out of money. While retirement may be a one-time event, retirement planning is an on-going process.

In addition to withdrawals from accounts, retirees will have other, guaranteed, sources of income, such as Social Security, Pensions, or Annuity payments. These may cover a significant amount of fixed expenses, which allows the investment portfolio to be used in a somewhat discretionary manner during retirement. With corrections occurring every 5 to 6 years on average, a retiree could experience five or more corrections over the course of a 30-year retirement.

The reality is that we have to be willing to accept some level of volatility in a portfolio in exchange for the potential for a higher long-term rate of return. We start with a risk tolerance questionnaire to get to know each client and help select a target asset allocation that will be the most likely to accomplish their financial objectives with the least amount of risk. There’s no magic bullet to give investors a great return and no risk, so it truly is a decision of selecting an acceptable level of risk that will fulfill their planning needs. Almost everyone needs to have a mix of safer assets and assets which offer an opportunity for higher long-term growth. Some of my clients have 50 percent or more in bonds, and that may work for their situation.

With the portfolio construction, I am very focused on creating a strong risk/return profile for each of my models. We diversify broadly to reduce correlation of assets and systematically rebalance each portfolio on an annual basis. Rebalancing provides a discipline of selling assets which have run up and buying assets which are cheaper. We can eliminate some types of risk altogether, including company-specific risks (by owning the whole market rather than a handful of individual stocks), and manager risks. We know that typically 65-80% of equity managers under perform their benchmark over five years, but since we don’t know which managers outperform in advance, choosing managers is simply not a good bet to be making. That’s why we use index funds rather than selecting “five star” fund managers for our core holdings – it puts the odds in your favor.

We buy Low Volatility ETFs for some client portfolios, and I think many investors would be interested in learning about ways to reduce market fluctuations. Low Volatility funds select a basket of the least risky stocks from a larger index. They’re designed to offer a return similar to traditional indexes over time, but with a noticeably lower standard deviation of returns. They’re fairly new strategy (available the last three years or so), but I think are one of the more compelling ideas in portfolio management today. Read more here: http://www.ishares.com/us/strategies/manage-volatility

Lastly, when working with a new client, we can dollar cost average over six months, so if we do have a pullback in the fall (as we did last October), we would have cash to put to work. The key is that even someone who is planning on retiring in the next couple of years needs to have a clear plan that addresses both their accumulation needs and a retirement income strategy. That’s our focus at Good Life Wealth Management and we’d be happy to meet with you and discuss how to accomplish your retirement goals.

Proposed Federal Budget Takes Aim at Investors

Posted On February 17, 2015 By Admin In Retirement Planning /

It was Presidents’ Day yesterday, a day to reflect on the great thinkers and leaders who founded our remarkable nation and have molded its course across the centuries. I try to avoid political commentary here on this blog as my job is to help clients find financial independence so they can be able to retire one day, send their children to college, and not spend the rest of their lives worrying about money.

However, I think my clients and readers should hear about the President’s proposed 2016 budget, which contains a number of never heard before provisions that take aim directly at middle-class investors. The administration says that they are looking to close “loopholes for the rich”, but these proposals aren’t going to increase taxes for Warren Buffet, Bill Gates, or the latest hedge fund billionaire; they’re going to be funded by working professionals who are trying to make a better life for their families.

When I think about closing loopholes to raise taxes, the first thing I think about are eliminating corporate incentives and subsidies, so I was shocked that these proposals are squarely aimed at the wallets of individual investors and primarily their retirement plans. Here are some of the proposals which would impact investors like you.

The first proposal was to eliminate 529 College Savings Plans. I’m sure there are some wealthy elderly grandparents who use 529’s to reduce their estate taxes, but most of the 529 accounts I have seen are barely enough to pay for a year or two of state school, let alone pay for 4 years of SMU, Medical School, or an MBA. But instead of suggesting that we reduce the maximum caps on 529 contributions, the proposal was to eliminate the tax benefits altogether for everyone! Luckily, after widespread outrage, the administration nixed the proposal days later.
Another proposal is to eliminate the “Back Door Roth IRA”. This has been one of my favorite strategies since 2010 and I look for any client who might be eligible. I’ve mentioned the Back Door approach a couple of times in this blog and described it in some detail here. I believe the government should encourage people to save more for retirement, but when you start taking away benefits, it makes it even more of a challenge.
The 2016 budget would also require investors in a Roth IRA to take Required Minimum Distributions after age 70 and 1/2. Currently, you can let a Roth account grow tax free for as long as you’d like, and even leave those assets to your spouse or heirs income tax-free. The only relief the budget provides is that if all of your retirement accounts (all types) are under $100,000, you would not have to take RMDs.
The 2016 budget would eliminate the “Stretch IRA”. Today, if you inherit an IRA from a non-spouse (such as a parent), you can take only RMDs and continue to let the money grow. Under the proposal, the Stretch IRA (also called Beneficiary IRA or Inherited IRA) goes away, and all the money must be withdrawn within 5 years. If it’s a sizable IRA, that could be quite a tax hit, pushing an heir into a high tax bracket. It means that more of your IRA will end up with the IRS and less with your heirs. Instead of encouraging heirs to manage the inheritance as a long-term program, it will force them to take the money out quickly.
The proposed budget would cap the tax benefit of retirement contributions to 28%. So, if your family is in the 39.6% tax bracket (actually 40.5% when you include the 0.9% Medicare surtax), you will only get a partial deduction for the money you contribute to your 401(k) or IRA.

In all, there were a dozen proposals that would impact investors in retirement accounts. And since my business is focused on retirement planning, you bet I’m concerned. You should be too. Luckily the proposed budget is little more than a wish-list or starting point. Hopefully, few of these will make it into law for 2016. If they do, investors in the future are likely to have a different mix of retirement accounts and “taxable” accounts. Luckily, we’re already skilled at creating tax-efficient investment portfolios with low-turnover ETFs and municipal bonds.

In the mean while, you can still fund a Back Door Roth for 2014 (through April 15) and 2015, or take advantage of any of the current programs. I know what I would prefer to happen with these proposals, but no matter what does occur, we will learn, adapt, and still be successful. I still believe that there is no better place on Earth to become wealthy than America.

A Business Owner’s Guide to Social Security

Posted On January 13, 2015 By Admin In Retirement Planning /

For many small business owners I meet, their business is their retirement plan. They expect that either they will be able to receive an income while handing off day-to-day management to an employee or they hope to sell the business and use the proceeds to fund their retirement. Both approaches carry a high degree of risk as the success of one business will make or break their retirement. As a financial planner, I want to help business owners achieve financial independence autonomous from their business.

Social Security plays a part in their retirement planning, but for most people covers only a portion of their expenses. While the Social Security Administration observes that 65% of participants receive more than half of their income from Social Security, the average Social Security benefit today is only $1294 a month and $648 for a spouse.

Five Social Security Considerations for Business Owners

For the sake of simplifying the points below, I am assuming that the business owner is the husband, but anyplace I use “he”, this could of course be “she”. Age 66 is the Full Retirement Age (FRA) for individuals born between 1943-1954, however, the FRA increases from 66 to 67 for individual born between 1955 and 1960.

1) Salary versus Distributions

While sole proprietorships generally pay self-employment tax on all earnings, business owners who have established as an entity such as a corporation or LLC may receive income from salary as well as distributions or dividends. Only salary is countable towards your Social Security benefit; other forms of entity income, such as distributions or dividends are not subject to Social Security taxes and therefore not used in determining your Social Security benefit amount. (Benefits are calculated based on your highest 35 years of income, inflation adjusted; the Social Security maximum wage base for 2014 was $117,000.)

Avoiding Social Security taxes (15.3%) is often a consideration in selecting an entity structure. For example, we may see an owner pay himself $50,000 in salary and take another $100,000 in distributions from the company profits, rather than taking all $150,000 as salary. At retirement, a business owner’s Social Security benefit amount is only based on their salary, so in the example above, his benefit amount will be less than a worker who received the full $150,000 as salary. I’m not suggesting that business owners should forgo these tax savings and take more income as salary, however, they should consult with their financial planner to estimate their Social Security benefits and create other vehicles to save and invest their tax savings to make up for the lower SS benefits they will receive as a result of taking a lower salary.

2) SS between 62 and FRA

Approximately half of SS participants start taking benefits immediately at age 62; 74% of current recipients are receiving a reduced benefit from starting before FRA. Starting at age 62 will cause a 25% reduction in benefits versus starting at age 66. While SSA will automatically recalculate your benefits if you continue to work while receiving benefits, the actuarial reduction (up to 25%) remains in place for life.

3) Survivor Benefits

Many people consider their own life expectancy in deciding when to start Social Security. The payback for deferring SS benefits from age 66 to 70 may take until age 79 or 80, depending on your estimate of COLAs. If the owner is concerned that they will not live past 79 or 80, they often take benefits at 66. However, there is an additional vital consideration which is survivorship benefits for your spouse.

A surviving spouse will receive the higher of their own benefit or the deceased spouse’s benefit. The higher earner’s benefit will end up being the benefit for both lives. Therefore, it often makes sense to maximize the higher earner’s benefit amount by delaying to age 70, especially if the spouse is younger and has a longer life expectancy. For each year you wait past age 66, you receive an 8% increase in benefits (delayed retirement credits or DRCs), which is a good return. When people take early benefits based solely on their own life expectancy, they fail to consider that their benefit also impacts their survivor’s benefit amount.

4) File and Suspend

One of the problems with delaying to age 70 is that the owner’s spouse will be unable to receive a spousal benefit until the owner files for his benefit. This is generally not an issue if the spouse has a substantial benefit based on her own earnings. If she does not, however, there is a solution to enable the spouse to receive her spousal benefit while the husband delays until age 70. In a “File and Suspend” strategy, the business owner files for benefits at age 66, to allow his spouse to receive her spousal benefit, (the full amount, provided she is also age 66 or higher). The owner then immediately suspends his benefit, which entitles him to earn the deferred retirement credits until age 70.

DRCs do not apply to the spousal benefit, so if the spousal benefit applies (spousal is higher than her own benefit, or she does not have a benefit based upon her own work record), she should not delay past age 66. That’s why it is essential to know if a spouse will receive their own benefit or a spousal benefit. The spouse should never delay past age 66 if receiving a spousal benefit – you’re losing years of benefits with no increase in amount.

To recap: File and Suspend works best when the spouse is the same age or older and has little or no earnings history on her own.

5) Claim Now, Claim More Later

For a business owner who is still working, but whose spouse has already filed for her own SS benefit, at his FRA, he can restrict his application to his spousal benefit and receive just a spousal benefit. This will allow him to still receive DRCs and delay his own benefits until age 70, while receiving a spousal benefit without penalty. That’s free money. (Note: this only works when spouse is already receiving benefits and he is at FRA. You cannot restrict an application to the spousal benefit prior to FRA.)

I can help you to compare different Social Security timing strategies to make the best decision for your situation. Before we get started, you will need to first download the current Social Security statements online at www.ssa.gov/myaccount/ for both yourself and your spouse. A Social Security statement never shows any spousal benefit amounts, and the calculators on the SSA website do not consider file and suspend strategies, so you cannot consider these scenarios without using other tools.

What Not to Do With Your 401(k) in 2015

Posted On December 23, 2014 By Admin In Retirement Planning /

In a recent article, “Are You Smarter Than a Fifth Grader? You Better Be If You Want to Participate in a 401(k)”, I mentioned that a basic financial education might help prevent investors from making common mistakes with their 401(k) accounts. What are those mistakes? Here are the top five blunders to avoid with your 401(k) in 2015 and a preferred outcome for each situation.

1) Using your 401(k) as an emergency fund. It’s all too common for participants to cash out their accounts if they have an emergency or when they leave a job. Withdrawals before age 59 1/2 are subject to a 10% penalty and ordinary income tax, in which case you end up losing 30 to 50 cents of every dollar in your account to the IRS. Preferred Outcome: make sure you have sufficient emergency funds before starting a 401(k). When changing jobs, roll your 401(k) to the new 401(k) or an IRA, or leave it at the old plan, if possible.

2) Contributing only up to the company match. Getting every matching dollar available is a smart idea, but a significant number of participants contribute only up to this level. Just because the company matches 4%, doesn’t mean 4% will be enough to generate the amount of money you need to retire! Preferred Outcome: aim to save 10-15% of your salary for retirement. If you can, contribute the maximum to your 401(k), which is $18,000 for 2015, or $24,000 if over age 50.

3) Giving up when the market is down. No one likes to open their 401(k) statement and see that the account is worth thousands of dollars less than the previous month. Unfortunately, if you move into a money market fund, or worse, stop contributing, you may actually be making things worse. Preferred Outcome: focus on your long-term goals and not short-term fluctuations. When the market is down, consider it an opportunity to buy shares on sale.

4) Not Being Diversified. Although it’s tempting to pick the fund with the best 1-year return, there’s no guarantee that particular fund will continue to outperform. (In fact, it’s quite unlikely.) Other participants put their 401(k) into a money market fund, which is almost certainly going to be a poor choice over 10 or more years. Your best bet is to be thoroughly diversified in an allocation appropriate for your age and risk tolerance. Preferred Outcome: develop a target asset allocation; if in doubt, use a target date fund to make these decisions for you.

5) Taking a 401(k) Loan. While taking a 401(k) loan is an option, I rarely meet participants with significant balances who take loans. You have to pay back loans with cash, not salary deferrals, which means that many participants stop their contributions in order to pay back the loan. Any amount not paid back on time is considered a distribution, subject to taxes and the 10% penalty, if under age 59 1/2. Additionally, if you change jobs or are laid off, you will have to pay back the loan within 60 days. Preferred Outcome: don’t sabotage your retirement by taking a loan. Consider other options first.

At Good Life Wealth Management, we know how important 401(k) plans are to your retirement planning. And that’s why all our financial plans include detailed recommendations for each of your accounts.

Are Your Retirement Expectations Realistic?

Posted On December 8, 2014 By Scott Stratton, CFP(R), CFA In Retirement Planning /

While many individuals have very realistic ideas about retirement, I find that some people may be significantly overestimating their preparedness for funding their financial needs. Here are three specific mistakes which can hurt your chance of success in retirement, and a realistic solution for each issue.

Mistake #1: Thinking you can live on a small fraction of your pre-retirement income.
Occasionally, I’ll meet someone who is currently making $100,000, but who thinks that they will need to spend only $40,000 a year in retirement to maintain their current lifestyle. On a closer look, they’re saving about $15,000 today so they are really living on about $85,000 a year. This is a key problem with creating a retirement budget: when we add up projected expenditures, it is very easy to underestimate how much we need because we often forget about unplanned bills like home and auto repairs, or medical expenses. And don’t forget about taxes! Taxes do not go away in retirement, either.

Realistic Solution: Even though some expenses will be lower in retirement, most retirees find that they need 75-90% of their pre-retirement income to maintain the same lifestyle.

Mistake #2: Taking too high of a withdrawal rate.
20 years ago, William Bengen published a paper that concluded that 4%, adjusted for inflation, was a safe withdrawal rate for a retiree. While this topic has been one of the most discussed and researched areas in retirement planning, most financial planners today remain in agreement that 4%, or very close to 4%, is the safe withdrawal rate. However, many individuals who have a million dollar portfolio think that they might be able to take out $60,000, $70,000, or more a year, especially when the market is performing well.

There are two important reasons why it’s prudent to use a more conservative 4% rate. The first is market volatility. The market is unpredictable, so we have to create a withdrawal strategy which will not excessively deplete the portfolio in the event that we have large drop, or worse, a several year bear market at the beginning of a 30-year retirement. The second reason is inflation. We need to have growth in the portfolio to allow for the increased cost of living, including the likelihood of increased medical costs. At just 3% inflation, $40,000 in expenses will double to $80,000 in 24 years. And with today’s increased longevity, many couples who retire in their early 60’s will need to plan for 30 years or more of inflation in retirement.

Realistic Solution: At a 4% withdrawal rate, your retirement finish line requires having a portfolio of 25 times the amount you will need to withdraw in the first year.

Mistake #3: Assuming that you will keep working.
Some people plan to keep working into their 70’s or don’t want to retire at all. They love their work and can’t imagine that there would ever be a day when they are not going to be working. They plan to “die with their boots on”, which in their eyes, makes retirement planning irrelevant.

Unfortunately, there are a number of problems with this line of thinking. The Employee Benefits Research Institute 2014 Retirement Confidence Survey found a significant gap between when people planned to retire and when they actually did retire. Only 9% of workers surveyed plan to retire before age 60, but 35% actually retired before this age. 18% planned to retire between 60 and 64, versus 32% who actually retired in that age range. The study cites three primary reasons why so many people retire earlier than planned: health or disability, layoff or company closure, and having to care for a spouse or other family member. The study also notes that one in 10 workers plan to never retire. Even if you’re willing to keep working, the statistics are clear: most people end up retiring earlier than planned.

For a healthy 65-year old couple, there is a good chance that at least one of you will live into your 90’s. If you still think you don’t need a retirement plan because you will keep working, do it for your spouse, who might have 25-plus years in retirement if something were to happen to you. Don’t make your plan’s success dependent on your being able to keep working in your 70’s and 80’s.

Realistic Solution: Make it a goal to be financially independent by your early 60’s; then you can work because you want to and not because you have to.

A comprehensive financial plan addresses these concerns and establishes a realistic framework for funding your retirement. And whether you’re 30 or 60, it is never too early, or too late, to make sure you are on track for financial independence.

5 Retirement Strategies for 2015

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

For 2015, the IRS has announced that contribution limits will increase for a number of retirement plan types. For 401(k) and 403(b) plans, the annual contribution limit has been increased from $17,500 to $18,000. The catch-up amount for investors over age 50 has increased from $5,500 to $6,000, so the new effective limit for participants over 50 is now $24,000. Be sure to contact your HR department to increase your withholding in January, if you are able to afford the higher amount.

Traditional and Roth IRA contribution limits will remain at $5,500, or $6,500 if over age 50. SIMPLE IRA participants will see a bump from $12,000 to $12,500, and SEP IRA contribution limits are increased from $52,000 to $53,000 for 2015.

If you’re not sure where to start, here are my five recommendations, in order, for funding retirement accounts.

1) Choose the Traditional Plan

More and more employers offer Roth options in their 401(k) plans, but I believe the most investors are better off in the traditional, pre-tax plan. The only way the Roth is preferable is if your marginal tax rate is higher in retirement than it is today. The reality is that your income will probably be lower in retirement than when you are working. Even if your income remains the same 20 years from now, it is likely that tax-brackets will have shifted up for inflation and you may be in a lower tax rate. Lastly, there has been continued talk of tax simplification, which would reduce tax breaks and potentially lower marginal tax rates, which would also be negative for Roth holders. So, my advice is to take the tax break today and stick with the pre-tax, regular 401(k).

2) Maximize Employer Plan Contributions

Your first course of action will always be to maximize your contributions to your employer plan. Many individuals do this, but I’m surprised that with many couples, the lower paid spouse often does not. If you’re being taxed jointly, every dollar contributed reduces your taxes at your marginal rate. And don’t forget that since 2013, on income over $250,000, couples are subject to an additional 0.9% tax on Earned Income and an additional 3.8% on Investment Income to provide additional revenue to Medicare. Add the 3.8% Medicare Tax to the top rate of 39.6%, and you could be paying as much as 43.4% tax on your investment income. That’s a big incentive to maximize your pre-tax contributions as much as you can.

3) Traditional IRA, if deductible

If you maximize your employer contributions for 2015, and are able to do more, here is your next step: If your modified adjusted gross income is under $61,000 single ($98,000 married), then you can also contribute to a Traditional IRA and deduct your contribution. If your spouse is covered by an employer plan but you are not, the income limit is $183,000. This opportunity is frequently missed by couples, especially when one spouse does not work outside the home.

And of course, if neither spouse is covered by an employer retirement plan, both can contribute to a deductible Traditional IRA, without any income restrictions.

4) Roth IRA

If you make above the amounts in step 2, but under $116,000 single, or $183,000 joint, you are eligible to contribute to a Roth IRA. If your income is above these amounts, you would not be eligible to directly contribute to a Roth IRA. However, if either spouse does not have a Traditional IRA (including SEP or SIMPLE), he or she would be able to fund a “Back-Door Roth IRA”. This is done by contributing to a non-deductible IRA and then immediately converting to a Roth. Since there are no gains on the conversion, the event creates no tax.

5) Self Employment

If you have any 1099 income, are self-employed, or work as an independent contractor, you would also be able to contribute to a SEP IRA in addition to funding a 401(k). You can contribute to both accounts, subject to a combined limit of $53,000, if you have both W-2 and 1099 Income.

One option I’ve not seen discussed often is that someone who is self-employed could also fund a SEP and convert it to a Roth. If you don’t have any other Traditional IRAs, this could, in theory, be used to fund a Roth with up to $53,000 a year. The conversion would be a taxable event, but it would be cancelled out by the deduction for the SEP contribution.

There are quite a few variations and details in terms of eligibility for each family. Want to make sure you’re taking advantage of every opportunity you can? Give me a call to schedule your free planning meeting.

5 Tax Savings Strategies for RMDs

Posted On November 3, 2014 By Admin In Retirement Planning /

In November each year, we remind investors over age 70 1/2 to make sure they have taken their Required Minimum Distribution (RMD) from their retirement accounts before the end of the year. If an investor does not need money from their IRAs, the distribution is often an unwanted taxable event. Although we can’t do much about the RMD itself, we can find ways to reduce their taxes overall.

Clients who have after-tax contributions to retirement accounts often ask about which account they should take their RMDs, but it doesn’t matter. The IRS considers IRA distributions to be pro-rata from all sources, regardless of the actual account you use to make the distribution. Whichever account you use to take the RMD, the tax due is going to be the same.

If all your contributions were pre-tax, your basis in all accounts is zero and you can ignore the comments above. Note that you do not have to take a distribution from each individual account, even though each custodian is likely to send you calculations and reminders about your RMD for that account. All that matters is that your total distribution meets or exceeds the RMD for all accounts each year.

For investors taking RMDs, here are 5 steps you can take to reduce your income taxes:

1) Asset Location. Avoid generating taxable income in your taxable accounts by moving taxable bonds, REITs, and other income generating investments to your retirement account. This will keep the income from the investments out of a taxable account, leaving your RMD as your primary or only taxable event. Placing stable, income investments in your IRA will also be a benefit because it will keep your IRA from having high growth. Otherwise, if your IRA grows by 20%, your RMDs will grow by 20%. (Actually more than 20%, since the percentage requirement increases each year with age).

Keeping stocks and ETFs in a taxable account allows you to choose when you want to harvest those gains and also allows you to receive favorable long-term capital gains treatment (15% or 20%), a tax benefit which is lost if those positions are held in an IRA. Lastly, if you hold the stocks for life, your heirs may receive a step-up in basis, which is yet another reason to hold stocks in a taxable account and not your retirement account.

2) Charitable Donations. If you itemize your tax return and are looking for more deductions, consider increasing your charitable donations. And instead of giving a cash donation, donate shares of a highly appreciated stock or mutual fund and you will get both the charitable donation and you’ll avoid paying capital gains on the position later.

3) Stuff your deductions into one year. Many investors in their 70’s have paid off their mortgage and it is often a “wash” between taking the standard deduction versus itemizing. If this is the case, consider alternating years between taking the standard deduction and itemized deductions. In the year you itemize, make two years of charitable donations and property taxes. How do you do this? Pay your property tax in January and the next one in December and you have put both payments into one tax year. Do the same for your charitable contributions. The following year, you will have few deductions to itemize and will take the standard deduction instead.

4) Harvest losses. Investors are often reluctant to sell their losers, but selectively harvesting losses can save money at tax time. Besides offsetting any capital gains, losses can be applied against ordinary income of up to $3,000 a year, and any leftover losses carry forward indefinitely.

5) Roth IRA. If you don’t need your RMD because you are still working, consider funding a Roth IRA. There is no age limit on a Roth IRA, so as long as you have earned income, you are eligible to contribute $6,500 per year. If you qualify for a Roth, then your spouse would also be eligible to fund a Roth, even if he or she is not working. Although the Roth is not tax deductible, the contribution does enable you to put money into a tax-free account, which will benefit you, your spouse, or your heirs in the future.

There is a “five year rule” which requires you to have a Roth open for five years before you can take tax-free withdrawals. This rule applies even after age 59 1/2, so bear that in mind if you are establishing a Roth for the first time.

One additional suggestion: although you have until April 1 of the year after you turn 70 1/2 to take your first RMD, waiting until then will require you to have to take two RMDs in that year. It may be preferable to take your first RMD in the year you turn 70 1/2, by December 31.

Retirement Cash Flow: 3 Mistakes to Avoid

Posted On October 28, 2014 By Scott Stratton, CFP(R), CFA In Retirement Planning /

Living off your portfolio is unfamiliar territory for new retirees, and although it’s sounds simple, there are a number of common pitfalls which many people encounter in their first few years of retirement. Here are three mistakes you should avoid to help keep your retirement cash flow safe.

1) Not including everything in your budget

A retirement income plan establishes a safe withdrawal rate designed to last for 30 or more years of retirement. For example, we may determine that a couple can safely withdraw $4,500 a month from their accounts, in addition to their Social Security and pension. They set up a $4,500/month transfer and this works well until they encounter a large, unanticipated bill. Then, they require additional withdrawals to cover their expenses and suddenly their plan to withdraw only 4% that year balloons to 6% or 7%.

When we create a budget, it should include everything, and not just your ordinary monthly bills. The following are some “unexpected” expenses that have caused retirees to request additional withdrawals in recent years:

Home repairs, such as a new roof or AC
Needing $35,000 for a new car
Medical expenses not covered by insurance
Property taxes
Vacations
Buying a Vacation Home
Boats, or RVs

It’s easy to consider a 401(k) account or Pension Lump Sum payout as being all available, but it’s better to view the account as a 30-year stream of income. Rather than looking at the account as a $1 million slush fund, consider it a $40,000 salary with a 3% raise each year. A retiree needs to have an emergency fund just like everyone else and to budget and save for large expenses. The principal of your retirement account cannot be both your permanent source of income and your emergency fund.

2) Reinvesting Dividends in a taxable account.

If you are taking withdrawals, or will need to take withdrawals, from your taxable account, I’d suggest turning off dividend reinvestment on all your positions. Have your funds pay dividends and capital gains in cash and hold the resulting cash for your withdrawals. This will save you from having to sell positions and creating taxes on capital gains in order to access your money.

You probably have substantial gains in mutual funds if you’ve owned them for a long time. Mutual funds typically use the average cost basis method, so if you have a 75% gain in the position, any withdrawal will be considered to have a 75% gain. ETFs and individual stocks use the specific lot method, and sales are generally considered to be First In, First Out (FIFO), unless you specify lots at the time of the trade or change your default cost basis disposal method to another option. While that does give an investor more flexibility in managing the tax implications of ETF sales than with mutual funds, I find that most don’t bother and simply go with the default of FIFO.

The easiest way for retirees to avoid this headache is have distributions paid in cash. If you end up with more cash than you need at the end of the year, you can always use the money to rebalance your portfolio. (Which is preferable to having to make sales in order to rebalance the portfolio, anyways.)

3) Ignoring the Low Interest Rate environment.

Today’s low interest rates present a challenge for retirees and many of the conservative ideals of the past are simply not providing the same level of financial security today. This applies to both assets and liabilities. On the asset side, keeping the majority of your money in a bank account or CD may be safe in the short-term, but with today’s historically low interest rates running below inflation, you’ll lose purchasing power each year. We call this a negative real return. A balanced and properly diversified portfolio has short-term risk, but is likely to increase your wealth over time. If you’re investing for the long-term, make sure all your investments aren’t designed as short-term holdings, or they may be setting you up for eventual disappointment.

Many near-retirees have a goal of being debt-free, which is a laudable ambition, but with today’s low rates, you could lock in a mortgage in the 3% range. Selling investments or cashing out a 401(k) and paying taxes on the withdrawal to pay off a 3% mortgage could hurt your long-term financial strength, provided you are willing to hold investments that can potentially return more than 3%. By paying off their mortgages, some home owners inadvertently wind up house rich and cash poor, which does not give you much flexibility in paying your living expenses. From a cash flow perspective, you may be better off keeping a mortgage versus tying up a majority of your net worth in home equity.

One additional note on mortgages: eligibility for a mortgage is based largely on your income. If you are going to refinance a mortgage, do so while you are still working and before you retire. Once you are retired, it will be more difficult to underwrite a mortgage with no income, even if you have sufficient assets to buy the property outright.

These types of issues come up frequently with new retirees, and we give a lot of thought to the pros and cons of each choice. Individual situations can vary and there are sometimes reasons why no rule of thumb can apply 100% of the time. If you have questions about retirement cash flow and your personal portfolio, please send me a message and we can discuss your options.

The Geography of Retirement

Posted On September 29, 2014 By Scott Stratton, CFP(R), CFA In Retirement Planning /

Retirees move for various reasons: to find a better climate, to spend more time pursuing activities they love, or to be closer to family. Sometimes, the decision is based on a desire to downsize and reduce their cost of living. There are many financial considerations regarding your choice of retirement location, but there are three key factors that I would use as a starting point when weighing your options.

1) Look at total costs and not just income taxes if moving out of state. Every year, I see articles about retiring to “tax-free” states like Florida or Texas. There are seven states which have no personal income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Additionally, New Hampshire and Tennessee do not tax personal wages, but do tax dividends and interest. While moving to a tax-free state sounds like a great idea, there may be other costs of living that could offset those state tax-savings. Be sure to calculate the cost of property taxes, property insurance, and sales taxes. For a retiree who has $50,000 in annual income, the savings in income tax may be relatively small and your total living expenses could actually increase if you move to another state. It’s better to look at your whole cost of living, especially if your income in retirement will be modest.

When you look at property taxes, make sure to research whether your state offers any property tax programs for seniors. Texas, for example, will freeze school taxes for residents over 65, placing a ceiling on the tax on your primary residence. Some states offer seniors an income-based reduction on property taxes; it’s worth going through that paperwork to confirm you are eligible, rather than assuming you’re eligible and finding out later that you will not receive the tax rebate.

2) Consider travel costs. It’s one thing to enjoy a vacation for a few weeks, but some retirees find themselves feeling disconnected and missing out on family activities if they move away permanently. They find themselves coming back “home” more frequently and for longer periods. Before long, they’re spending $5,000 a year or more on travel costs between two locations. That’s fine if that’s the lifestyle you want, but it is an expense that you must consider if you’re thinking that moving is going to be a cost-saving plan. How will you feel about not spending holidays with your family, or missing your grandchildren’s birthdays and soccer games? Is the cost and hassle of travel going to make it worth while to move?

3) Know your health care coverage. If you are part of a health care network, such as a Medicare Advantage Plan (part C), what is covered out of state? This is a common issue for snowbirds who divide their time between a northern home and their southern winter get-away. I’ve spoken with quite a few whose “plan” is to have all of their appointments and check-ups take place when they’re home. But what happens if you get sick while you’re away? Out-of-network care may be very expensive or not covered by your insurance. It’s a risk both to your health and your finances.

This concern also applies for US citizens who are looking to move abroad to a low-cost location. It’s relatively easy to receive your Social Security and Pension out of the country, but for Medicare, you will have very limited or no coverage. Be sure to read this Medicare brochure before deciding to move overseas: Medicare Coverage Outside the United States.

If you decide to live abroad, you may think you don’t need to enroll in Medicare Part B. But if you later move back to the US, there will be a penalty (permanently higher premiums) to enroll in Part B if you didn’t sign up at age 65. And you must have Part B in order to participate in Medicare Advantage or to enroll in Prescription Drug coverage (part D). So be very careful you understand the potential future costs if you are planning on turning down Part B at age 65.