The AFM Pension Plan: What Every Musician Needs to Know

Posted On September 16, 2014 By Scott Stratton, CFP(R), CFA In Retirement Planning /

If you’re a professional musician in the US, you likely received your annual statement from the American Federation of Musicians Employers’ Pension Plan in the past several weeks. The main purpose of the mailing is to verify your Covered Earnings from the past year. Professional musicians often have basic questions about the AFM Pension, in part, because the annual statement doesn’t tell you very much about your personal situation other than your reported earnings and the amount your employer(s) contributed to the pension fund.

Give the importance of the Pension Fund to the retirement planning of musicians, here are five key questions about the plan that every musician should know.

What is the Fund?

The AFM Employers’ Pension Fund (EPF) is a Trust Fund established by the AFM and funded through contributions from employers throughout the country, as required under a Collective Bargaining Agreement. Whether you’re a member of the Chicago Symphony, a Broadway theater musician, or a free-lance performer, you may be covered by the EPF. Currently, there are over 50,000 musician participants (active and retired) in the plan, and the fund has assets of over $1.7 Billion.

How do I find out how much I am going to get?

The pension benefit you will receive depends on your contributions and the age you retire. While it is possible to calculate your benefit manually (it’s just algebra), it is much easier and simpler to use their website at www.afm-epf.org. Create your own Participant Login and use the Pension Estimator tool. Please note that while your contributions and earnings are always in annual amounts, the pension amounts shown are monthly benefits.

To be vested in the pension, you must have received covered earnings for 5 years, or 20 quarters. You receive a “quarter” of credit for $750 of covered earnings, and you will receive a full year of credits if you earned at least $3,000 in that year.

The normal age of retirement is 65 for the pension, but you can start as early as 55, provided you are retired at that age. If you are still working after 65, you can elect to start your pension at 65 and keep working, or you can delay benefits until you do retire and your benefit amount will be actuarially increased based on the age you decide to start benefits.

Once you’re logged on to the website and are on the Pension Estimator, you can create various scenarios to see what your pension benefit might be. If you’re vested, you’re guaranteed a benefit. If you want to find out how much benefit you’re eligible for based on your past earnings, enter 0 under Estimated Additional Contributions, and then hit “Calculate Benefit”. This defaults to age 65 for retirement, but you can make it for any age between 55 and 65. When you enter 0, your estimate doesn’t include any future earnings, so you will probably also want to create other estimates based on the future number of years you plan to work. As a simple estimate, you might take the past year’s employer contribution to the plan and multiply it by the number of years you plan to work. Just remember that the estimate is based on today’s payout and crediting rules, which could be changed in the future.

What are the payout options?

First, if your expected lifetime payments total less than $5,000, the EPF will give you a “cash-out” and send you a lump-sum payout. This is mandatory. However, if the expected payments exceed $5,000, there is no option to take a lump-sum or a rollover. You must take the monthly payments.

You can elect a Single Life Benefit (SLB), a 50% Joint and Survivor, or a 75% Joint and Survivor. The survivor options will pay you for life and then pay a reduced benefit (50% or 75%) to your “joint annuitant” for the rest of their life. If you are married, the plan defaults to the 50% J&S, but anyone can elect one of the joint and survivor options, regardless of your marital status. The joint amount is calculated as a percentage of the SLB, with a reduction based on the age difference between you and your joint annuitant. The younger your joint annuitant, the greater the reduction and the lower your monthly benefit amount. Your joint annuitant must be within 19 years of your age to elect the 75% plan.

The joint benefit is a valuable resource to take care of your spouse or partner, if they should outlive you, and it’s a relative bargain. Choose carefully, because your election at retirement is permanent. If you do outlive your joint annuitant, there is no option to change your plan or to select another joint annuitant.

The amount of your AFM pension is highly sensitive to the age of the participant at retirement. If you started benefits at 55, you’d receive only 37% of the benefit amount you’d receive at age 65. And that is assuming you didn’t work after 55 and had no additional contributions! Also, if you work past 65, your benefit also can grow significantly. For example, if you work to age 68, your benefit base would be increased by 35%, on top of the additional benefits you accrued from working between 65 and 68. This is one reason (of many) that some musicians are reluctant to retire – for every year they keep working, their pension is increasing by at least 10-11%.

How does the AFM-EPF compare with Social Security benefits?

With Social Security, Full Retirement Age is 66 (increasing to 67 for individuals born after 1954), but you may start benefits as early as 62, or delay to 70. With the AFM EPP, Full Retirement Age is 65, but you can start as early as 55; you can delay the EPP past 65 only if you are still working and contributing to the plan.

One big difference is that Social Security has Cost of Living Adjustments (COLAs) based on inflation, whereas the AFM EPP does not. The amount you receive will remain the same for the rest of your life. Because there are no COLAs in the AFM plan, you have to be careful and not start benefits too early. If you can afford to wait until 65, it is a huge advantage to wait to full retirement age to receive benefits, even if you stopped working earlier. The reason is that you are guaranteed a 10-11% increase in benefits for each year waiting, which is better than Social Security (which increases by a maximum of 8% a year). You may or may not get 10-11% in your investment portfolio, but waiting on the pension is a guaranteed increase for life. Most musicians will receive both the AFM EPP and Social Security, but you do not have to start them at the same time.

With Social Security, your spouse may receive a survivor benefit. If your Social Security benefit is greater than your spouse’s benefit, then he or she will receive your benefit amount for the rest of their life, and their own benefit goes away. (If their SS benefit is already greater than your amount, they will not receive any increase or survivor’s benefit.) With the AFM plan, you don’t have to be married to have a joint annuitant and they can receive 50% or 75% of your amount after your death.

I heard the plan is in trouble. Is my pension safe?

The AFM EPP is overseen by the Federal government and is covered by the Pension Benefit Guarantee Corporation (PBGC), which is similar to the FDIC in regulating pension plans and providing protection for individual participants. The plan has been considered to be in “critical and declining” status, which occurs when the projected assets are insufficient to cover the projected liabilities. That description is a bit of a simplification, but the current “red zone” status means that the plan was expected to become insolvent by 2036.

Thankfully, the plan received a $1.4 Billion bailout from the Federal Government, under the American Rescue Plan Act. This is projected to be enough to keep the plan solvent through 2051.

In the event that the plan should fail, individual participants would have their benefits insured by the PBGC. While this should give some comfort, I should point out that there are limits to PBGC coverage based on the number of years of service, so it is possible that some participants would not be fully covered if their benefit amount exceeded the levels of protection under the PBGC. Since we do need to be concerned about the viability of the pension plan, I would council any musician to not rely solely on the pension. You need to have other sources of assets and cash flow to provide a strong and secure retirement.

I don’t think anyone becomes a musician for the money, but musicians have the same financial needs and concerns as any other professional. Unfortunately, a lot of musicians don’t pay much attention to their own financial planning, and don’t know where to turn for honest advice. This topic is often part of a broader retirement or tax planning conversation. If you’d like help applying these ideas to your own situation, you can request an introductory conversation here.

Related Retirement Income Topics
– Retirement Income Planning
– Guardrails Withdrawal Strategy
– Social Security: It Pays to Wait
– Required Minimum Distributions
– What Is a MYGA?

5 Tax Mistakes New Retirees Must Avoid

Posted On September 8, 2014 By Admin In Retirement Planning /

New retirees often overlook the bite that taxes will take out of their income. Even though they are no longer receiving a paycheck, taxes can still add up in retirement. There are quite a few ways to reduce these taxes, which unfortunately, most people will miss on their own. Here are 5 mistakes you can avoid through careful planning.

1) Taking a large withdrawal from a retirement account in one year. If your income is modest and you will require $60,000 from an IRA, you will pay much less in taxes by taking withdrawals of $20,000 over three years versus taking $60,000 out in one year. Plan ahead and aim to smooth your withdrawals from qualified accounts, or better yet, take only RMDs. Don’t wait until an emergency or for a large expense to plan your IRA distributions.

2) Taking a withdrawal from a retirement account to avoid a capital gain on selling a stock. The IRA withdrawal will be fully taxable as ordinary income, but a long-term capital gain would be taxed at the lower rate of 15% (or 20% if you’re in the top tax bracket). Only the gains portion of the sale is taxable, whereas 100% of the IRA distribution is taxable. For ETFs and individual stocks, you can even specify which lots to sell, giving you the opportunity to sell the lots with the highest cost basis, rather than the default first in, first out, or average cost method used by mutual funds.

3) Inefficient Asset Location. I often see that portfolios are set up with bonds in a taxable account and stocks in the IRA, so that retirees can take the income from the bonds and avoid touching the stocks in the IRA. Actually, it would be much more tax efficient to reverse the locations and place the bonds in the IRA.

Bond interest is taxed as ordinary income, as are IRA distributions. Put your bonds in the IRA and take your bond income from the IRA, as the distributions will be taxed exactly the same. Place your stocks in the taxable account, and you can receive favorable tax rates (15%) on capital gains and dividends, and you won’t have any capital gains until you sell. (If you’ve been burned by taxable distributions from equity mutual funds, it’s time for you to learn about ETFs.)

Keeping high growth stocks out of your IRA will also reduce your future RMDs and reduce the taxes that will have to be paid by your heirs. Heirs receive a step-up in basis on stocks in a taxable account, but not in an IRA. By placing bonds in your IRA, you can reduce future taxes in many ways. This concept can often be difficult for people to grasp, so if you’d like an example, feel free to email me or give me a call.

4) Selling the oldest savings bonds. Many retirees hold EE savings bonds but are not managing these bonds. Some older bonds had fixed rates or guaranteed minimums, whereas bonds issued starting May 2005 currently pay only 0.50%. (This resets every 6 months, and this rate is current through 10/31/2014.) As a result, you’re better off selling your newer bonds and keeping the older ones (pre-2005) which have higher interest rates. Don’t forget that the bonds are guaranteed to reach their face value in 20 years, so you may be rewarded by holding on to a 17 year old bond for a couple more years. EE bonds will receive interest for up to 30 years, which is the maximum time you should hold bonds. By selling the newer bonds, you will pay less in taxes compared to selling older bonds which have appreciated more. Use the tools at TreasuryDirect.gov to keep track of the current values and interest rates on your EE bonds.

5) Failing to harvest losses on investments. While your heirs will receive a step-up in cost basis for an appreciated security, they will lose any tax benefits associated with a position at a loss. Sell the position and redeploy the capital as needed to maintain your target asset allocation. A loss can be used to offset any capital gains in that year, plus $3,000 can be used against ordinary income and any remaining loss will carry forward to future years.

New retirees can undermine their retirement planning if they ignore the impact of taxes. It can be costly to make changes after the fact, so it’s best to make sure you have a plan in place before retirement. It’s not a once and done event either, because managing taxes is an ongoing process. Many people turn to a financial planner for selecting investments, and discover that they receive even greater benefits from other areas such as tax management.

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.

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.

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.

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.

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.