The Secret Way to Contribute $35,000 to a Roth IRA

Posted On August 10, 2015 By Admin In Retirement Planning /  

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Roth IRAs are incredibly popular and for good reason: the ability to invest into an account for tax-free growth is a remarkable benefit. Unlike a Traditional IRA or Rollover IRA, there are no Required Minimum Distributions, and you can even leave a Roth IRA to your heirs without their owing any income tax. For retirement income planning, $100,000 in a Roth IRA is worth $100,000, whereas $100,000 in a Traditional IRA may only net $60,000 to $75,000 after you pay federal and state income taxes.

The only problem with the Roth IRA is that many investors make too much to be able to contribute and even those who can contribute are limited to only $5,500 this year. If you’re a regular reader of my blog, you may recall a number of posts about the “Back-Door Roth IRA”, which is funded by making a non-deductible Traditional IRA contribution and immediately making a Roth Conversion.

But there is another way to make much bigger Roth contributions that is brand new for 2015. Here it is: many 401(k) plans offer participants the ability to make after-tax contributions. Typically, you wouldn’t want to do this. You’d be better off making a tax-deductible contribution.

When you separate from service (retire, quit, or leave) and request a rollover, many 401(k) plans have the ability to send you two checks. One check will consist of your pre-tax contributions and all earnings, and the second check will consist of your after-tax contributions.

What can you do with these two checks? This was a gray area following a 2009 IRS rule. If the distributions were from an IRA, you would have to treat all distributions as pro-rata from all sources; i.e. each check would have the same percentage of pre-tax and after-tax money in it.

Remarkably, the IRS ruled in 2014 that when a 401(k) plan makes a full distribution, it can send two checks and each check will retain its unique character as a pre-tax or after-tax contribution. No pro-rata treatment is required. This will allow you to rollover the pre-tax money into a Traditional IRA and the after-tax money into a Roth IRA. This rule applies only when you make a full distribution with a trustee to trustee transfer.

Since this is a new rule for 2015, it is likely that your HR department, 401(k) provider, and CPA will have no idea what you are talking about, if you ask. Refer them to IRS Notice 2014-54. Or better yet, refer them to me and I can explain it in plain English!

Even though the salary deferral limit on a 401(k) is only $18,000, the total limit for 2015 is actually $53,000 or 100% of income. So you should first contribute $18,000 to your regular, pre-tax 401(k). Assuming there is no company match or catch-up, you could then contribute another $35,000 to the after-tax 401(k) to reach the $53,000 limit.

Let’s say you do this for five years and then retire or change jobs. At that point, you would have made $175,000 in after-tax contributions which could be converted into a Roth IRA, and since your cost basis was $175,000, there would be no tax due.

The earnings on the after-tax 401(k) contributions would be included with your other taxable sources of funds and rolled into a Traditional IRA. Only your original after-tax contributions will be rolled into the Roth account. Please note that this two-part rollover only works when you separate from service and request a FULL rollover. You may not elect this special treatment under a partial withdrawal or an in-service distribution.

Lastly, before attempting this strategy, make sure your 401(k) plan allows for after-tax contributions and will send separate checks for pre-tax and after-tax money. While this strategy is perfectly legal and now explicitly authorized by the IRS Notice, 401(k) plans are not required to allow after-tax contributions or to split distribution checks by sources. It’s up to each company and its plan administrator to determine what is allowed. The IRS Notice stipulates that this process is also acceptable for 403(b) and 457 plans, in addition to 401(k) plans.

Not sure if this works with your 401(k)? Call me and I will review your plan documents, enrollment and distribution forms, and call your plan administrators to verify. I think this would be a great approach for someone who is a handful of years away from retirement who wanted to stuff as much as possible into retirement accounts. Additionally, anyone who has the means to contribute more than $18,000 to their 401(k) each year might also want to consider if making these after-tax contributions would be a smart way to fund a significant Roth IRA.

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Choosing a Small Business Retirement Plan

Posted On August 3, 2015 By Admin In Retirement Planning /  

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If you own your own business, or are self-employed, there are a myriad of options for establishing a retirement plan for yourself and your employees. If you want to attract and retain high quality employees, you need to be able to offer wages and benefits that are competitive within your industry. There are many employees who will prefer a job that includes the stability of a robust benefits program over a job that just offers a higher salary.

I am surprised how often owners of small businesses balk at establishing a retirement plan. Yes, it may entail some additional costs and extra administrative work. Some business owners aren’t planning to retire, so they aren’t focused on creating a retirement nest egg. Of course, if you think your employees feel the same way – that they want to work for you until they die, you may be overestimating the attractiveness of your workplace!

Establishing a company retirement plan doesn’t need to be complicated or have unknown, limitless expenses. There are quite a few benefits to starting a plan, including:

  • Being able to move company profits into a creditor-protected account for the owner and his or her family as a tax deductible business expense.
  • Creating assets that are separate from your company. Diversifying your net worth so your wealth is not 100% linked to the value of your company. What would your spouse be able to do with your company, if you were hit by a bus tomorrow?
  • Providing valuable benefits so you can hire and keep top quality employees. Offering your employees a program to encourage their own retirement saving.

Luckily, there are a number of retirement plan options for employers, each with its own unique benefits. Here is a quick overview of six retirement plans to consider and a profile of the ideal candidate for each.

1) 401(k). The 401(k) is the gold standard of retirement plans, and while it would seem to be the obvious choice, 401(k) plans can be expensive, complicated, and often a poor fit for a smaller company. Many 401(k) providers are happy to work with your company if you have $500,000 or $1 million in plan assets, but fewer are willing to work with start-up plans or companies with fewer than 50 full-time employees.

Sometimes employers decide to offer a 401(k) but are not willing to provide a matching contribution. You may think you’re adding a benefit, but this often backfires. You will have very low participation without a match, so the administrative cost per employee and the fixed costs for the amount of assets in the plan ends up being higher. And since 401(k)’s have “top heavy” testing, the higher paid employees who do want to participate are often told that they have contributed too much to the plan and that they have to remove some or all of their contributions. No one wins in this situation.

The solution to avoiding the top heavy testing is to establish a “safe harbor” plan, but this will require that the company provides a matching contribution.

Best candidate for a 401(k): a company who is willing to provide a matching contribution for employees and will have at least 10 or 20 participants in the plan (actual participants, not just eligible employees). Without the company willingness to offer a match, I’m not sure the plan will satisfy the needs of the owner or the employees. 401(k)’s tend to have a better participation rate in companies with higher paid, white collar employees.

2) SIMPLE IRA. The Savings Incentive Match PLan for Employees (SIMPLE) was created to enable employers with fewer than 100 employees to be able to offer a “401(k)-like” plan, without complicated rules or high administrative costs. Employees choose to participate and have money withheld from their paycheck. They may contribute up to $12,500 for 2015; if over age 50, they may contribute an additional $3,000. The company will match employee contributions up to 3% of their salary.

If you have payroll of $200,000 a year, and ALL employees participate, you’d match $6,000 of their contributions. The company match is a tax deductible business expense. Both employee and employer contributions vest immediately and are held in each employee’s name where the employee chooses how to invest their account. If a participant makes a withdrawal in the first two years, the penalty is 25%. If the withdrawal is after two years, but before age 59 1/2, the penalty is 10%. For the business owner, there is no top heavy testing, so you may contribute the maximum (plus the match) to your own account, regardless of whether your employees choose to participate or not.

Best candidate for a SIMPLE IRA: any company with 2-100 employees that is willing to match 3% of employee contributions and wants a plan that is easy to administer and low cost. More owners should be looking at the SIMPLE rather than trying to make a 401(k) fit. It’s a great option. There are two reasons why you might choose a 401(k) instead. The first would be if you plan to have more than 100 employees. Second, if you think many of your employees will want to contribute more than $12,500 in a SIMPLE, they could contribute $18,000 to a 401(k). If neither of those reasons apply, a SIMPLE is a great alternative to a 401(k).

3) SEP-IRA. The Simplified Employee Pension (SEP) is an employer-funded plan. The employee does not contribute any money to a SEP; employer contributions are elective and can vary from year to year. However, the company must provide the same percent contribution to all eligible employees, from zero to 25% of salary. The maximum contribution for 2015 is $53,000 (at $265,000 of net income). Contributions are a tax deductible business expense.

If you are looking for a profit-sharing type of plan that allows the employer flexibility of how much to contribute each year, the SEP may be a good fit. In practice, the vast majority of SEP plans are established by sole proprietors or other self-employed individuals who do not have any employees, other than possibly a spouse. Since your contribution amount to a SEP depends on your profits, it is impossible to know the exact amount you can contribute until you do your taxes. Most SEP contributions occur in April, but the unique thing about a SEP is that it is the only IRA which you can fund after the April 15 deadline. If you file an extension, you can contribute to a SEP all the way up to October 15 on your individual return, or September 15 on a corporate return.

Best candidate for a SEP: a business owner with no additional employees. Note that any 1099 independent contractors you hire are not eligible for your company SEP, only W-2 employees.

4) Individual 401(k). Also called a “Solo 401(k)” or “Self-Employed 401(k)” sometimes, this is just a regular 401(k)/Profit Sharing plan where a custodian has created a set of boilerplate plan documents to facilitate easy administration. Even though the Individual 401(k) is for a single individual (and spouse) who is self-employed, there are technically two contributions being made: as the employee, you can make a salary deferral contribution (up to $18,000), and then as the employer, you can make a profit sharing contribution, up to 25% of net income. The plan has the same total contribution limit as a SEP, but because of the 2-part structure of the contributions, people with under $265,000 in net income can often contribute more the the Individual 401(k) than they can to a SEP.

The Individual 401(k) is what I have used for myself for my work as a financial advisor. I am also then able to make a SEP contribution based on my (small) earnings as a free-lance musician. Note that once your Individual 401(k) assets exceed $250,000, you will be required to submit a form 5500 to the IRS each year. If you are interested in an Individual 401(k), we can establish one for you with our custodian, TD Ameritrade.

Best candidate for an Individual 401(k): Self-employed person, with no employees (and no plans for employees), who wants their own 401(k) and plans to contribute more than they can to an IRA.

5) Traditional IRA. The Traditional IRA is not an employer-sponsored retirement plan. However, if you are single and do not have an employer-sponsored plan, you can contribute up to $5,500 to a Traditional IRA as a tax-deductible contribution, regardless of how much you make. Or, if you are married and your spouse is also not eligible for an employer-sponsored plan, then you can each contribute $5,500 into a Traditional IRA, with no income restrictions. I point this out, because if you don’t have any employees and only plan to contribute $5,500 (or $11,000 jointly) each year, then you don’t need to start a 401(k) or any of these other plans. Just do the Traditional IRA.

Best candidate for the Traditional IRA: a business owner not looking to offer an employee benefit, who will contribute under $5,500 per year.

6) Defined Benefit Plan (Pension Plan). 401(k) plans are “Defined Contribution” plans, where the employee makes the majority of the contributions and determines how to invest their account. At the other end of the spectrum is the Defined Benefit Plan, or Pension Plan, where the employer makes all the contributions, manages the investment portfolio, and guarantees the participants a retirement pension. Undoubtedly, there are fewer and fewer large employers offering DB plans today because of their cost and complexity. However, for a specific set of situations, a DB Plan can be a brilliant way to make very large contributions on behalf of owners and highly-paid employees of small companies. The Plan will aim to provide a set benefit, for example, 50% of the final salary, with 30 years of service, at age 65. Each year, the plan’s actuary will calculate how much the company needs to contribute to the plan’s account to be on track to offer this benefit for all eligible employees. Obviously, the amount contributed for employees who are older will be higher, as will be the amount contributed for higher income employees.

The plan does not need to pay pension benefits for an indefinite period. Assuming the owner is the oldest employee, he or she can simply shut down the plan when he or she retires and then distribute the plan assets into IRAs for vested participants. In a situation where the owner is much older (say 61, versus employees in their 30’s and 40’s), and the owner makes $300,000 versus employees who make $50,000, the vast majority of the assets will be distributed to the owner upon dissolution of the plan. The DB Plan can be in addition to a DC Plan, like a 401(k), and is a great way to maximize contributions for an owner with very high earnings who is planning to retire in a couple of years.

Best candidate for a DB Plan: high earners who are older, who will retire and shut down their business, and who have a couple of much younger employees. Many small law firms and medical practices fit this profile exactly. If you have been lamenting that the $53,000 limit in a Profit Sharing Plan is too low for you, consider adding a DB Plan.

At Good Life Wealth Management, retirement planning is our forte. We can help you determine the best plan for your needs and make it easy for you and your employees to get started. Drop me a line and let’s schedule a time to talk about how we can work together.

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Guaranteed Income Increases Retirement Satisfaction

Posted On July 20, 2015 By Admin In Retirement Planning /  

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Several years ago, for a client meeting, I prepared a couple of Monte Carlo simulations to show a soon to be retired executive possible outcomes of taking his pension as a guaranteed monthly payment, versus taking a lump sum, investing the proceeds, and taking withdrawals. When I showed that the taking the pension increased the probability of success by a couple of percent, my boss promptly cut me off, and warned the client that if they didn’t take the lump sum they would have no control of those assets and would not be able to leave any of those funds to their heirs. That’s true, but my responsibility was to present the facts as clearly as possible for the client to make an informed choice, without injecting my own biases.

The fact is that retirees who are able to fund a larger portion of their expenses from guaranteed sources of income are less dependent on portfolio returns for a successful outcome. New research is finding that retirees with higher levels of guaranteed income are also reporting greater retirement satisfaction and less anxiety about their finances. Sources of guaranteed income include employer pensions, Social Security, and annuities. This is contrasted with withdrawals from 401(k) accounts, IRAs, and investment portfolios.

For the last two decades, the financial planning profession has been advocating 4% withdrawals from investment portfolios as the best solution for retirement income. Unfortunately, with lower interest rates on bonds and higher equity valuations, even a conservative 4% withdrawal today, increased annually for inflation, might not last for a 30+ year retirement. (See my white paper, 5 Reasons Why Your Retirement Withdrawals are Too High, for details.)

Professor Michael Finke from Texas Tech, writing about a Successful Retirement, found that, “The amount of satisfaction retirees get from each dollar of Social Security and pension income is exactly the same — and is higher than the amount of satisfaction gained from a dollar earned from other sources of income. Retirees who rely solely on a defined contribution plan to fund retirement are significantly less satisfied with retirement.”

Emotionally, there are a couple of reasons why guaranteed income is preferred. It mimics having a paycheck, so retirees are comfortable spending the money knowing that the same amount will be deposited next month. On the other hand, investors who have saved for 30 or 40 years find it very difficult to turn off that saving habit and start taking withdrawals from the accounts they have never touched.  Although taxes on a $40,000 withdrawal from an IRA are the same as from $40,000 income received from a pension, as soon as you give an individual control over making the withdrawals, they want to do everything possible to avoid the tax bill.

The biggest fear that accompanies portfolio withdrawals is that a retiree will outlive their money. No one knows how the market will perform or how long they will live. So it’s not surprising that retirees who depend on withdrawals from investments feel more anxiety than those who have more guaranteed sources of income. The 2014 Towers Watson Retiree Survey looked at retirees’ sources of monthly income and found that 37% of retirees who had no pension or annuity income “often worry” about their finances, compared to only 24% of retirees who received 50% or more of their monthly income from a pension or annuity.

While I’ve pointed out the negative outcomes that can occur with portfolio withdrawals, in fairness, I should point out that in a Monte Carlo analysis, investing a pension lump sum for future withdrawals increases the dispersion of outcomes, both negative and positive. If the market performs poorly, a 4% withdrawal plan might deplete the portfolio, especially when you increase withdrawals for inflation each year. However, if the market performs on average, it will likely work, and if the initial years perform better than average, the portfolio may even grow significantly during retirement. So it’s not that taking the lump sum guarantees failure, only that it makes for a greater range of possible outcomes compared to choosing the pension’s monthly payout.

What do you need to think about before retirement? Here are several steps we take in preparing your retirement income plan:

1) Carefully examine the pension versus lump sum decision, using actual analysis, not your gut feeling, heuristic short-cuts, or back of the envelope calculations. If you aren’t going to invest at least 50% of the proceeds into equities, don’t take the lump sum. Give today’s low interest rates, the possibility of retirement success is very low if you plan to invest 100% in cash, CDs, or other “safe” investments.

2) Consider your own longevity. If you are healthy and have family members who lived for a long time, having guaranteed sources of income can help reduce some of the longevity risk that you face.

3) Social Security increases payments for inflation, whereas most pension and annuities do not, so we want to start with the highest possible amount. We will look at your Social Security options and consider whether delaying benefits may improve retirement outcomes.

4) If your guaranteed income consists only of Social Security, and is less than 25% of your monthly needs, you are highly dependent on portfolio returns. Consider using some portion of your portfolio to purchase an annuity. If you are several years out from retirement, we may consider a deferred annuity to provide a future benefit and remove that income stream from future market risks. If you are in retirement, we can consider an immediate annuity. For example, a 65-year old male could receive $543 a month for life, by purchasing an immediate annuity today with a $100,000 premium.

Annuities have gotten a bad rap in recent years, due in large part to unscrupulous sales agents who have sold unsuitable products to ill-informed consumers. However, like other tools, an annuity can be an appropriate solution in certain circumstances. While many financial planning professionals still refuse to look at annuities, there has been a significant amount of academic research from Wade Pfau, Michael Finke, and Moshe Milevsky finding that having guaranteed income may improve outcomes and satisfaction for retirees. This growing body of work has become too substantial to ignore. I believe my clients will be best served when we consider all their options and solutions with an open mind.

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Our First Year, in Review

Posted On June 1, 2015 By Admin In Financial Planning /  

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It’s our one-year anniversary at Good Life Wealth Management and we want to thank all of our clients, readers, and friends for your support this year. We’re only getting started with the great things we want to do, so please keep following for future news!

We’re donating 10% of our profits for 2015 to Operation Kindness and there’s nothing we would love more than being able to write them a large check at the end of the year. If you’re looking for a financial advisor, want to make a change in your current approach (or lack thereof), or just want a second opinion, please don’t hesitate to give us a call.

Over the past year, I’ve posted 53 articles to share important financial planning concepts which can help you achieve your goals. Chances are good that if you have a common financial question, I may have written about it already. Here are the articles we’ve posted over the past year; if you see one of interest, please click on the link. Thank you for reading!

 

Introducing Good Life Wealth Management

Three Studies for Smart Investors

6 Steps to Save on Investment Taxes

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

Why Alan Didn’t Rollover His 401(k)

8 Questions Grandparents Ask About 529 Plans

How to Maximize Your Social Security

A Young Family’s Guide to Life Insurance

Catching Up For Retirement

Student Loan Strategies: Maximizing Net Worth

Health Savings Accounts

Socially Responsible Investing

Retirement Withdrawal Rates

Machiavelli and Happiness in an Age of Materialism

5 Tax Mistakes New Retirees Must Avoid

The AFM Pension Plan: What Every Musician Needs to Know

5 Techniques for Goal Achievement

The Geography of Retirement

Bringing Financial Planning to All

Community Property and Marriage

Adversity or Opportunity?

Retirement Cash Flow: 3 Mistakes to Avoid

5 Tax Savings Strategies for RMDs

5 Ways to Save Money When Adopting a Pet

How Some Investors Saved 50% More

An Attitude of Gratitude

5 Retirement Strategies for 2015

Are Your Retirement Expectations Realistic?

Year-End Tax Loss Harvesting

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

The Dangers Facing Fixed Income in 2015

Are Equities Overvalued?

A Business Owner’s Guide to Social Security

Should You Invest in Real Estate?

How to Become a Millionaire in 10 Years

Indexing Wins Again in 2014

Get Off the Sidelines: 3 Ways to Put Cash to Work

Proposed Federal Budget Takes Aim at Investors

4 Strategies to Reduce the Medicare Surtax

Retiring Soon? How to Handle Market Corrections

Three Things Millennials Can Teach Us About Money

Deferral Rates Trump Fund Performance

How Much Can You Withdraw in Retirement?

Growth Versus Value: An Inflection Point?

Our Investment Process

Which IRA is Right for You?

Rethink Your Car Expenses

Will the IRS Inherit Your IRA?

Fixed Income: Four Ways to Invest

Setting Your Financial Goals

Giving: What’s Your Plan?

Are We Heading For a Bear Market?

Should You Hedge Your Foreign Currency Exposure?

 

Have a question or a topic you’d like to learn more about? Send your questions to [email protected].

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Rethink Your Car Expenses

Posted On April 13, 2015 By Admin In Financial Planning /   1 Comment

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“Don’t be penny wise and pound foolish.”

This old nugget of wisdom remains relevant today with many people feeling frustrated that even with a decent income, it seems so difficult to save as much as we’d like for retirement and our other financial goals. Rather than worrying about the pennies, I think investors who want to increase their saving are best served by focusing on their two biggest expenses: their home and cars.

Although not a great investment, a home is generally an appreciating asset and offers some valuable tax deductions. It is possible to have too much home and be house rich and cash poor, but our focus is better first directed on car expenses. I love cars, as do most Americans. A car represents freedom, and as a kid, I couldn’t wait to learn to drive. I took my drivers permit test right on the day of my 16th birthday. We view our cars as a representation of our self, our status, and our importance. Yes, even Financial Advisors are guilty of this irrational vanity! (Or is it insecurity?)

Unfortunately, a car is a depreciating asset and often our biggest expense outside of our home. New car prices seem to have outpaced wage growth, and everyone always wants the latest and greatest. We have to set priorities for how we use our income, and any money we spend on a car is gone. You won’t get it back, it’s just flushed away. That’s money we can’t invest and can’t use to create our future independence and income. If you want to have more of your money working for you, it pays to be smart about your cars. Here are five ways to keep your automotive expenses down.

1) Keep what you have. Cars greatest depreciation is in their first 3-5 years, so if you can keep your car longer, your annual costs will be lower. The more frequently you replace your cars, the more expensive it will be. That’s the number one thing you can do: keep your vehicles 7-12 years. The more often you sell one car and buy another, the higher your costs over time.

2) Don’t fear the occasional repair. Today’s cars are more dependable and long-lasting than ever. Psychologically, people hate repairs, since they seem to always occur at the most inopportune moments. Many people would rather spend $500 a month on a new car payment rather than risk having $1,000 to $2,000 a year in maintenance and unplanned repairs. Does it make sense to spend $6,000 a year to avoid spending $2,000? Probably not, but this is what you are doing if you think that you must sell a car as soon as it is past its warranty.

It’s true, it feels much worse to spend $2,000 on an unplanned repair than to spend the same amount in scheduled car payments. In behavioral finance, this is called “prospect theory”, where people feel the impact of a loss much more severely than the benefit of an equivalent gain. Unfortunately, this can lead to less than ideal decisions, such as buying a $40,000 car because we’re upset over a $400 repair.

If a car is in relatively good shape, it will most likely be cheaper to keep a car with 100,000 miles on the road, rather than replacing it with a new car.

3) Pay cash for your cars. Most people don’t want to spend $60,000 on a new car, even though we all want that $60,000 car. I’d like to first point out the opportunity cost here. At a hypothetical 8% rate of return, spending $60,000 today on a car means not having $120,000 in 9 years, $240,00 in 18 years, or $480,000 in 27 years. That’s a steep price for a car. Which would you rather have, a new car today or potentially an additional $480,000 at retirement?

The strategy of paying cash for cars isn’t just about saving on interest payments; it’s about changing your behavior. Paying cash will force you to spend less, to look at used cars, and to keep your current car longer. Too often, I hear people brag that they got a new car and kept their payment the same. So what! Your current payment was going to end – all you’ve done is keep yourself in debt for another 5 or more years.

If you currently have a car payment, once your payments end, set aside that monthly amount in a savings account for your next car. Paying cash forces you to delay buying a new car. Otherwise, it’s very easy to take a loan for a new vehicle and then rationalize why you “needed” a new car.

4)  Save money on maintenance. If you’re handy with tools, you can save a lot of money by doing some routine maintenance yourself. My dealership wanted $499 for a 30,000 mile service consisting of an oil change, tire rotation, brake fluid change, and replacement of two air filters. I did the work myself and spent less than $70 on materials. Oil changes are cheap, so you can’t save much there, but you can save a lot if you learn to replace your brakes.

Don’t try to save money by skipping preventative maintenance. Make sure you change all fluids on the factory recommended schedule. Even if you do some work yourself, I’d also suggest developing a good relationship with an independent mechanic who you trust to give you honest advice.

5) Know when to buy new, buy used, or lease. The price of used cars has skyrocketed in recent years. It used to be that a 1-year old car had lost 20% or more of its value. Today, that can be under 10% for some popular makes and models. This increased residual value has changed some of the old rules about car buying. A gently used 2-3 year old car is, in many cases, not the bargain that it was 10 years ago. In those situations where resale value is very high, you might actually consider buying new. This will improve your future resale value, keep you under warranty longer, and possibly offer better terms on any financing. If you’re planning to keep the car for a long time (7-12 years), starting with a new car can be a good decision.

Buying used cars used to be an easy way to save 30% or more. There are still some good deals on used cars, but consider dependability, any remaining factory warranty, and the cost of maintenance on used vehicles. If you get bored with vehicles after a couple of years, used cars will have less depreciation than buying new.

Leasing is more expensive than keeping your cars for as long as I’d suggest. However, it is still a good alternative to buying a new car every three years, provided you drive fewer miles than stipulated in your lease agreement (often 10,000 or 12,000 miles per year). For models with high residual values, lease rates have stayed low.

Manage your car depreciation like you would any other liability. At the end of the day, a car is just a way to get from point A to point B. It doesn’t define us, who we are, or what our value is to our family or society. If you have other priorities like retiring early, buying a vacation home, or making your first million (or your second or third million), recognize when your car buying is not helping you get closer to achieving your more important goals.

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How Much Can You Withdraw in Retirement?

Posted On March 24, 2015 By Admin In Retirement Planning /  

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With corporate pensions declining in use, retirees are increasingly dependent on withdrawals from their 401(k)s, IRAs, and investment accounts. The challenge facing investors is how to plan these withdrawals and not run out of money even though we don’t know how long we will live or what returns we will receive in the market on our portfolio.

Pensions and Social Security provide a consistent source of income that you cannot outlive. When I run Monte Carlo simulations – computer generated outcomes testing thousands of possible scenarios – we find that the larger the percentage of monthly needs that are met from guaranteed sources, the lower chance the investor will run out of money due to poor market performance from their portfolio.

If you do have a pension, it is very important to consider all angles when deciding between a lump sum payout and participating in the pension for the rest of your life. It is not a given that you will be able to outperform the pension payments, especially if you are healthy and have a long life expectancy.

The most obvious way to avoid running out of money (called longevity risk by financial planners) would be to annuitize some portion of your portfolio through the purchase of an immediate annuity from an insurance company. While that would work, and is essentially the same as having a pension, very few people do this. You’d be giving up all control of your assets and reducing any inheritance for your beneficiaries. With today’s low interest rates, you’d probably be less than thrilled with the return. For example, a 65-year old male who places $100,000 in a single life immediate annuity today would receive $542 a month.

The problem with annuitization, besides giving up your principal and not leaving anything for your heirs, is that it doesn’t allow for any increase in expenditures to account for inflation. There are three approaches we might use to structure a withdrawal program for a retiree.

1) Assume a fixed inflation rate. In most retirement planning calculators, projected withdrawals are increased by inflation to maintain the same standard of living. After all, who doesn’t want to keep their standard of living? The result of this approach is that the initial withdrawal rate then must be pretty low. 20 years ago, the work of William Bengen established the “4% rule” which found that a withdrawal rate of 4% would fund a 30-year retirement under most market conditions.

On a $1 million portfolio, 4% is $40,000 a year. But that is just the first year. With 3% inflation, we’d plan on $41,200 in year two, and $42,436 in year three. After 24 years, withdrawals would double to $80,000. The 4% rule is not the same as putting your money in a 4% bond; it’s the inflation which requires starting with a low initial rate.

While we should plan for inflation in retirement, this method is perhaps too rigid in its assumptions. If a portfolio is struggling, we’re not going to continue to increase withdrawals by 3% and spend the portfolio to zero. We have the ability to respond and make adjustments as needed.

2) Take a flexible withdrawal strategy. We may be able to start with a slightly higher initial withdrawal rate if we have some flexibility under what circumstances we could increase future withdrawals. In my book, Your Last 5 Years: Making the Transition From Work to Retirement, I suggest using a 4% withdrawal rate if you retire in your 50’s, a 5% rate if you start in your 60’s, and 6% if retiring in your 70’s. I would not increase annual withdrawals for inflation unless your remaining principal has grown and your withdrawal rate does not exceed the original 4, 5, or 6%.

This doesn’t guarantee lifetime income under all circumstances, but it does give a higher starting rate, since we eliminate increases for inflation if the portfolio is shrinking. Under some circumstances, it may even be prudent to reduce withdrawals to below the initial withdrawal amount temporarily. That’s where having other sources of guaranteed income can help provide additional flexibility with your planning.

3) Use an actuarial method. This means basing your withdrawals on life expectancy. Required Minimum Distributions (RMDs) are a classic example of an actuarial strategy: you take your account value and divide by the number of years of life expectancy remaining. If your life expectancy is 25 years, we take 1/25, or 4%. The next year, the percentage will increase. By the time someone is in their 90’s, their life expectancy will be say three years, suggesting a 33% withdrawal rate, which may work, but obviously will not be sustainable. However, the more practical problem with using the RMD approach is that many people aren’t able to cut their spending by 20% if their portfolio is down by 20% that year. So even though it has a sound principle for increasing withdrawals, the withdrawal amounts still require flexibility based on market results.

But there are other ways to use the actuarial concept, and even my approach of different rates at different retirement ages is based on life expectancy. There’s no single method that will work in all circumstances, but my preference is to take a flexible strategy. But this does mean being willing to reduce spending, and forgo or even cut back inflation increases, if market conditions are weak.

We have a number of different tools available to evaluate these choices throughout retirement, but the other key factor in the equation is asset allocation. Bengen found that his 4% rule worked with equity allocations between 50% and 75%. Below 50% equities, the portfolio struggles to keep up with inflation and withdrawals become more likely to deplete the assets in the 30-year period. Above 75% equities, the portfolio volatility increases and rebalancing benefits decrease, increasing the number of periods when the 4% strategy would have failed.

When sorting through your options, you need candid and informed advice about what will work and under what circumstances it would not work. We hope for the best, but still have a plan for contingencies if the market doesn’t cooperate as we’d like. We will be able to consider all our options as the years go by and be proactive about making adjustments and corrections to stay on course. For any investor planning for a 30-year retirement, it’s not a matter of if the market will have a correction, but when. It’s better to have discussed how we will handle that situation in advance, rather than waiting until the heat of the moment.

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Retiring Soon? How to Handle Market Corrections.

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

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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.

 

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

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

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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.

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Are Your Retirement Expectations Realistic?

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

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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.

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5 Retirement Strategies for 2015

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

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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.

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