Tax Planning Archives - Page 2 of 2 - DESMO Wealth Advisors, LLC

It’s Time To Smart Rebalance Your Portfolio. Here is Why, When, and How.

When should you rebalance your investments? As with many questions, the best place to start is with why. Why should we rebalance in the first place? Your asset allocation, how you allocate your savings to different investments, is a key element of an investment strategy. It represents the risk-return tradeoff you are willing to make to achieve your investment goals. You typically arrive at your asset allocation through a process that includes goal setting and understanding your risk tolerance and risk capacity. Your asset allocation, not timing market cycles or picking stocks, determines 90% of how your investment is going to perform in good and bad times.

What To Know About The Coronavirus Aid, Relief, and Economic Security Act (CARES)

The CARES Act is an economic relief plan for individuals and businesses of unprecedented size, totaling about $2 trillion. As a comparison, the 2019 US GDP was about 21 Trillion. The Act is very broad and includes many different programs aimed at reaching broad sections of the economy. Our goal is simply to inform readers and clients of parts of the Act that may affect their financial plans, not to dig deep. This commentary should not be viewed as tax advice. Consult with your advisor or tax professional, or schedule a call with us if you think any of the items we discuss may impact you, or want to learn more.

Taxpayers’ Recovery Rebates

This is the item that has garnered the most attention. Taxpayers may receive tax rebates up to $1,200 for single filers and up to $2,400 for married filing jointly. The credit amount is further increased by up to $500 for each child under the age of 17. The rebates are phased out according to the following schedule.

The Tax Foundation estimates that over 90% of filers will get a rebate, and nearly all filers below the 80th percentile of income.

If you have not filed for 2019, consider filing now if your 2019 income is lower than 2018. Otherwise you can decide to wait until July 15. The tax rebate will be based on the latest income tax return that you filed (2018 or 2019). A lower income may give you a higher rebate. The final rebate amount will depend on 2020 income (with tax returns filed in 2021). Taxpayers who receive a smaller rebate than they are eligible for based on 2020 income will receive the difference after filing a 2020 tax return, but overpayments of rebates due to a higher income in 2020 will not be clawed back.

Distributions and loans from retirement plans

The act relaxes requirements for qualified distributions under employer sponsored plans and IRA accounts. Up to $100,000 can be withdrawn in total across such plans by someone affected by the Coronavirus. The withdrawals will be:

Exempt from the 10% penalty for early withdrawals;
Exempt from normal withholding requirements;
Eligible to be repaid over 3 years;
And the resulting income distribution can be spread over three years.

The act also relaxes some of the constraints on loans from retirement plans. Loan amounts are increased to $100K and 100% of the vested amount can be withdrawn.

Relief for Student Loan Borrowers

Student loan payments on federal student loans are deferred until Sept 30, 2020. Over the six months, no interest is accrued on the loans. You have to proactively suspend the payments. So, if you have a federal student loan, call your provider to suspend them. If you think you may qualify for student loan forgiveness, you may want to suspend the payments in case the loan is forgiven in the future.

The act also contains a special provision that allows payments of student loans by employers to be excluded by taxable income, up to the $5,250 amount typically allocated to employer educational assistance programs. If your employer has an educational assistance program, ask them if they are willing to include student loan repayments for you this year.

Small Business Help

The act contains a number of programs to help small businesses affected by the coronavirus. Here is a rundown. Check the SBA website for details and to apply. The criteria are intentionally broad, so if you are a small business affected by COVID-19, chances are there is a program for you. One catch is to apply early, as some of these may be on a first-come first-served basis. Check out our instructional video to apply for a disaster relief loan on the SBA website.

Paycheck Protection Program

Small businesses may take out loans to help pay for payroll costs, health insurance premiums, rent, mortgage interest, and other costs. A portion or all of the loan may be forgiven if used in the first eight weeks on eligible expenses. In addition, the maximum interest rate that can be charged for a loan made under this program is 4% and the term of the loans can be up to 10 years. That can be a good rate for many small businesses. Finally, payments on these loans can be deferred for six months.

The SBA has additional programs to help small businesses, so we encourage you to check them out.

Employee Retention Credit and deferral of payroll tax payments

Employers whose activity was partially or completely suspended may be eligible for a payroll tax credit. The credit is equal to 50% of wages paid to each employee, up to a maximum of $10,000 of wages per employee, subject to caveats.

In addition, according to the Act, employers are able to defer payroll taxes through the end of 2020, until the end of 2021 and 2022. Specifically, 50% of the payroll taxes that would otherwise be due throughout 2020 can be deferred until December 31, 2021. The remaining 50% is due on December 31, 2022.

Net Operating Losses (NOL) rules

The CARES Act allows NOL from 2018, 2019, or 2020 to be carried back up to five years. This should allow companies to reduce prior years’ tax bills, allowing them to claim refunds of amounts previously paid to provide further liquidity to get them through the COVID-19 crisis. The law allows for up to 100% of taxable income to be offset for 2018, 2019, and 2020.

Waived Required Minimum Distributions (RMDs) from retirement accounts

The Act eliminates any RMD that needs to be taken in 2020. If you have taken your RMD within 60 days, you can roll it over to your retirement account by the end of the 60 days window.

Increased tax deductions for charitable contributions

Charitable contributions may drop during this crisis period. To reduce this drop, the Act introduces a new above-the-line deduction (directly reduces your adjusted gross income or AGI) of $300 for charitable contributions. In addition, the AGI limit for cash contributions (currently limited at 60% of a taxfiler’s AGI) is raised to 100%.

Increased unemployment benefits

The Act gives a substantial boost to unemployment benefits. The first week of unemployment is now covered. In addition, there is a boost to the benefits of $600 a week, and a 13 week extension beyond the normal duration determined at the state level (26 weeks in Texas).

Overall, the CARES Act addresses a number of key issues that individuals and businesses are facing right now as a result of COVID-19, so it is a welcome development. Take a look at the list and the links provided, and consult your tax professional or financial advisor to learn more. Act quickly, as some of these programs have time limits or are on a first-come-first-serve basis.

Until Next Time!

Massi De Santis is an Austin, TX fee-only financial planner. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.

You Have Inherited a Retirement Account: Now What?

A retirement account can be a great gift and a good estate planning tool. But trying to figure out what to do with it can easily turn into a daunting task. The details of how you can receive the inherited money depend on a number of variables, including your relationship to the original account owner, the type of plan inherited (IRA, Roth, 401(k), etc), the age of the deceased, and, with the SECURE Act, whether the original account owner passed away in 2019 vs. 2020 or later (take a look at the IRS page here to get an idea).

Luckily, your options are relatively simple and only depend on a few key principles, which we analyze here. The rest is only details of implementation; the details may be important but aren’t likely to drive your decisions.

Your Options for Retiring (Austin Texas)

You really have four basic options when it comes to receiving inherited retirement money:

Treat the account as your own;
Treat yourself as the beneficiary of the inherited IRA;
Take the money now as a lump-sum;
Disclaim the account.

A good guiding principle is to choose the option that lets us get the most out of the inherited gift, after considering taxes, our financial goals, and our needs.

Economics

Choosing the right option depends on your needs, goals, and financial situation. Generally, you want to choose the option that increases the amount of resources for your goals. In the case of an inherited IRA, we achieve this by reducing the taxability of the proceeds while taking advantage of the tax-deferred or tax-free growth that the retirement account can provide.

Suppose you have inherited a Roth IRA and you are not disclaiming the account. If you are the spouse of the deceased you can decide to use the Roth IRA as your own (option 1). This means that the account will be considered as if it had always been your account, subject to normal Roth IRA rules that depend on your age. Most notably, contributions can be withdrawn tax-free, at any time! Earnings can be distributed tax-free too, provided they qualify (based on your age and a 5-year holding period rule). The Roth is definitely the best type of account to inherit; consider this when you make your estate plans.

Inheriting a Roth and why you should discuss with a Wealth Management Fee Only Fiduciary

With the Roth, option 3 (take the money now) can be justified if you have an immediate liquidity need. If you need the cash, the distribution can be 100% tax-free, if the earnings on the account satisfy the 5-year holding period rule. If you treat yourself as the beneficiary (option 2), you can take distributions (potentially 100% tax-free) any time you need, but you will also be required to take certain distributions, using the same rules that apply for traditional IRAs and 401(k)s. Yes, required distributions apply for a Roth account too, if it’s inherited.

For a spouse beneficiary, you have to start taking distributions based on when the deceased owner would have reached 70 ½ (or 72 if passed away after 2019). The amount of the minimum distribution is based on your life expectancy. If the beneficiary is not a spouse, the same rule applies only if the deceased passed away before the end of 2019. Otherwise, the entire amount will have to be withdrawn within 10 years from having inherited the account, with no additional requirement over the 10 years. In all of these cases, the money left in the inherited Roth IRA will grow tax-free, for up to 10 years (non-spouse) or longer (spouse).

As the spouse, when would you choose the inherited IRA instead of treating the Roth as your own? The inherited route may be for you if you think you need to make withdrawals that would not be qualified distributions if the Roth was your own (see here for a discussion of Roth IRAs).

Traditional IRA and 401(k) accounts

The options are the same as in the Roth example. The difference is in the taxability of the distributions from the accounts. Any distribution, required or not, is considered as ordinary income. Taking a lump-sum is rarely optimal, except for small amounts at low-income brackets, and if liquidity is needed. Large lump-sum amounts can result in an increase in your tax bracket, and there is a mandatory 20% withholding on the amount. If you treat the account as your own (option 1), which is only available to spouses, it means that your own retirement account will increase by the amount you inherited. This could be a good choice for someone who does not need to withdraw until retirement. The inheritance just increased their retirement savings, and they can devote future saving resources to other goals.

Option 2, being the beneficiary as the inherited IRA, can be used by spouses (or non-spouses, if the original owner died before the end of 2019) to withdraw some regular income from the account while leaving the remaining assets to grow tax-deferred, to be used later as a source of retirement income, for example. For non-spouses, the tax deferral is limited to 10 years, but the benefit is still there.

Withdrawing from an inherited IRA, talk to a Financial Advisor in Austin TX

If option 2 is chosen, how should someone withdraw over time? Because any withdrawal is taxed as ordinary income, we need to consider the effect of the withdrawal on the marginal tax rate. Consider the non-spouse, 10-year horizon. Except for the lowest tax brackets, the growth benefit from deferring the withdrawal for 10 years is unlikely to offset a bump in the marginal tax rate. So, waiting 10 years to withdraw everything from the account is not optimal. A better choice is to smooth out the withdrawals, moving back from year 10, to minimize the impact on the marginal rate while retaining some of the tax-deferral benefit. In the case of a spouse, the choice may be between the need to make periodic withdrawals and building future retirement wealth, which is best considered within a comprehensive plan.

A 401(k) plan works similarly to a traditional IRA. You can treat the 401(k) as your own by rolling it over the account to your own IRA if you are the spouse (option 1), or use the other options as for the IRA. Finally, when would someone disclaim the inherited account (option 4)? Common reasons are to reduce taxation, make the assets available to other beneficiaries, or to even things out among multiple beneficiaries. If you think disclaiming the account may be for you, make sure to follow the rules specified here.

While the details of calculating taxable amounts and required distributions can be quite complex, the choices you have are relatively straightforward, as summarized below.

Choice	What it means	Who can use
1. Treat as your own	Same rules as your own IRA apply	Spouse only
2. Inherited IRA	Can take distributions any time, with taxability depending on the type of account.	Spouse; non-spouse
	Required distributions can be based on your life expectancy, with start date based on the age of the deceased.	Spouse; non-spouse (if deceased in 2019 or earlier)
	10 Year Rule	Non-spouse (if deceased after 2019)
3. Lump-sum	Taxable depending on the account type	Spouse; non-spouse
4. Disclaim the account	You are no longer the beneficiary	Spouse; non-spouse

As always, the best choice depends on your goals, needs, and current financial situation, so talk to us or a trusted financial planner if you have any questions.

Until Next Time!

Your Plan and the SECURE Act of 2019

While most of us were enjoying the Holidays, our government was hard at work and on December 20, 2019, the Setting Every Community Up for Retirement Enhancement (SECURE) Act, was signed into law by President Trump. What does the SECURE Act mean for American savers, and for our DESMO clients? Mostly good news I am happy to report. We will communicate directly with our clients if any of these changes impact their financial plans. In the meantime, you can be confident that our financial planning technology already incorporates the changes included in the bill.

The bill is about 1700 pages long and it is quite broad, so we focus on most items we believe are of common interest across our audience. If you think that any of these changes and others you may have read about affect you, or you simply would like to learn more, don’t hesitate to contact us or your trusted advisor.

Elimination of the lifetime “stretch” provision for inherited IRA accounts

Under previous law, beneficiaries of an inherited IRA account had the option to withdraw from their accounts over their own life expectancy. With the SECURE Act, this provision still holds for spousal beneficiaries, but it is eliminated for non-spousal beneficiaries that inherit an IRA account starting in 2020. Instead, the SECURE Act introduces a new 10-Year rule. Under the 10-Year rule, the entire inherited retirement account must be emptied by the end of the 10th year following the year of inheritance. Within the 10-year period, there are no distribution requirements, so designated beneficiaries will have some flexibility in terms of the timing of the distributions.

Increased retirement savings incentives

Required Minimum Distribution Increased to Age 72

Previous law required that most individuals begin to take annual required minimum distributions (RMD) from their retirement accounts when they reached the age of 70½. Besides eliminating the confusing ½ year requirement, the SECURE Act delays this requirement to age 72. This gives savers additional tax-deferral benefits. The new law only applies to people who turn 70½ after December 31, 2019. If a person turned 70½ in 2019, the law does not apply—that person must take an RMD in 2019, 2020 and beyond.

Repealed maximum age for IRA contributions

The SECURE Act also repeals the maximum age for traditional IRA contributions. Previously, you could contribute to an IRA only if you were younger than 70½ years old. With the new law, you can continue to contribute to your IRA as long as you (or your spouse) have earned income. Repealing the limit allows workers to save longer for retirement, and even after withdrawals begin.

Qualified Charitable Distributions (QCD) still allowed at 70 and ½

Even though the RMD age has been increased to age 72, QCDs are allowed starting the year you turn 70 ½, as per the previous law.

A new exception to the early withdrawal penalty for childbirth and adoption

Section 113 of the Act introduces a new exception to the early withdrawal penalty for funds withdrawn to pay for expenses incurred through the first year after birth or adoption. The total amount with respect to any birth or adoption cannot exceed $5,000. Income taxes will apply to this amount, and the amount withdrawn can be contributed back to the plan.

Expansion of 529 plan qualified expenses

The SECURE Act expands the list of 529 qualified expenses. The Tax Cut and Jobs Act of 2017 already expanded 529 qualified expenses to include tuition at an elementary or secondary public, private, or religious school, up to $10,000 per tax year. The SECURE Act legislation further expands the list. First, the Act allows 529 funds to be used to pay for apprenticeship program expenses that include fees, books, supplies, and required equipment. In addition, as much as $10,000 over a person’s lifetime can be used for qualified student loan payments.

Incentives for small employers to offer retirement plans

Tax Incentives

Employers with fewer than 100 employees are eligible for a 50% tax credit for retirement plan startup costs as high as $5,000. This is much bigger than the previous incentive, capped at $500. In addition, since auto-enrollment is a proven way to increase employee participation, small employers can receive a credit of up to $500 a year for up to three years for including automatic enrollment in their plans.

Multi-employer plans

The Act also includes a provision that makes it easier for employers to join together in multiple-employer plans (MEPs), effective 2021. These arrangements allow small firms to reach a scale that could increase their negotiating power with providers and at the same time reduce administrative and compliance costs. Section 101 of the Act stipulates that in the event a single employer fails to fulfill obligations, the IRS can essentially disqualify that employer’s portion of the plan, while allowing the MEP to maintain its qualified status. For employers to benefit from the new MEP rules provided for by the SECURE Act, the MEP will have to be administered by a “Pooled Plan Provider”, such as a Registered Investment Advisor.

Feel free to contact or schedule a call if you have any questions about these changes and how they may affect your plan. We are here to serve you!

Until Next Time!

Photo by Maitree Rimthong from Pexels

Massi De Santis is an Austin, TX fee-only financial planner. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.

The Value Of Investment Management

Investment management used to be for people with a lot of money that needed help to manage it. Not any more. With greater responsibility for our future needs, evolving markets that increase available investment opportunities, and technology that has lowered the cost of investment management, the service now makes sense for most people. We review some good reasons why you should let a professional manage your investments, even if you already know what your asset allocation should look like. The value of professional investment management can be well above its cost, and its cost can be well below the cost of not using the service.

Sometimes I get this question from our financial planning clients: “once we make our investment plan, can I manage the investments myself and just review it with you in our annual comprehensive plan review?” The answer is yes you can, but you have to be prepared to do quite a bit of work. Managing your investments is a bit like car maintenance. You have to keep your engine running smoothly and efficiently, so you can make sure you get to the important places you want to go to. Do you do your own car maintenance?

The engine of your growth

Your investments make up the engine of your plan, helping you move forward and towards your goals. So it is important that they are selected strategically to maximize the likelihood of achieving your goals while managing key risks. And equally important, investment selection is a dynamic concept. Your investments need regular review and evaluation. You can’t just set them and forget them. Your life, goals, risk tolerance, risk capacity, tax situation, and asset allocation change over time, and these changes need to be reflected on your plan. Even if you expect nothing to change in your life this year and hold passive funds, your asset allocation at the end of the year will be different from the beginning of the year, due to differences in performance across your investments. And keeping your investments in sync with your goals isn’t just about making sure your asset allocation is kept in check.

In this post we review some good reasons why you should let a professional manage your investments, even if you already know what your asset allocation should look like. And while quantifying the benefit is not always easy, the value of investment management services can go well beyond its cost, just in terms of time, effort, and peace of mind.

Select investments tailored to your goals

As a fee-only financial advisor and fiduciary, we aim to select the best investments for your plan. We make sure that our custodial partner has a complete selection of funds to implement our clients’ plans in a cost effective way, balancing costs and benefits of each investment option. We research the funds we select, and build model portfolios suitable for each individual client and goal. If you decide to manage your asset allocation on your own, you are restricted by the options available to you, the amount of research time you elect to devote to building and maintaining your allocation, and your investment expertise. Your old 401(k) plan may have limited investment options. And if you decide to roll it over to an IRA, which provider should you choose? How do you navigate across thousands of funds? Do you understand the risk and return properties of each fund? Think about time, energy spent, and peace of mind.

Optimizing your growth engine

Say your asset allocation is a mix of 60% stocks and 40% bonds. How do you build this allocation? Which investments go in the 60% stock bucket, which ones in the 40% bond bucket?

For your 60% bucket, you can use a simple index fund, tracking a world equity market index. But is this the best way to get that exposure? Index funds have low expense ratios but may have other costs in terms of performance and missed opportunities. Can we use more information than a simple index in building our portfolios? For example, research shows that like with everything else, the price and quality of a company matter for future returns. Research also shows that small companies are generally riskier and, historically, have yielded higher returns than large companies. So there are measurable quantities that can help us understand how to combine stocks in a portfolio. Using this information when combining your investments can help you achieve higher returns for a given level of risk.

And your risk management too

And it’s not just about stocks. Returns on bonds too are related to measurable characteristics, like the maturity of each bond and the creditworthiness of each issuer. You can use these characteristics to design a bond allocation that best manages the risks for your goals. For example, longer maturity bonds and bond funds can be used to manage income risk, while shorter term bonds can be used to reduce the volatility of your portfolio, or for goals that require capital preservation, like a safety net or a cash reserve. Corporate bonds and bond funds can be used as additional diversification and to increase the yield of the bond bucket in a mix of stocks and bonds.

(Tax) Location, location, location

For our 60/40 allocation example, should we just replicate the same asset allocation in each type of account, including taxable, tax-deferred, and tax free? How do you decide which investments should go in taxable ones vs non-taxable one? Old wisdom is to put stocks in a taxable account and inefficient bonds in tax advantaged accounts. Unfortunately, this old wisdom is just that, old. What matters to investors is how much wealth can be generated, after all taxes, over the investment horizon (including liquidation taxes at the end). Net wealth depends on tax efficiency and on expected returns. Not all stocks and bond investments are the same in terms of tax efficiency and expected returns. For example, emerging market stock funds are generally less efficient than US stock funds. Letting some of your high growth assets grow tax free may generate more wealth than relegating them to taxable accounts. We use technology to continually evaluate tax tradeoffs and implement a tax-coordinated portfolio.

Tax loss harvesting

Tax loss harvesting (TLH) is the name for a strategy that uses investment losses to reduce taxable investment gains and other income, potentially yielding greater after tax returns. With this strategy, when an investment loses value, it is sold and replaced with another investment. With the sale, the loss is realized and can be used to offset taxable gains and other income. The replacement investment makes sure the portfolio stays well diversified and maintains the desired asset allocation (in terms of cost, liquidity, and behavior). An illustrative example can be replacing the Vanguard Value ETF with the iShares S&P 500 ETF, or vice-versa.

Many investors relegate tax loss harvesting to once a year, typically towards the end of the year. But, since relatively large losses and gains can occur throughout the year, tax loss harvesting should be a regular consideration. Each of your contributions, for example, create loss harvesting opportunities, because the price of an investment at any given time can be compared to the price you paid when you contributed to it. For some of the portfolios we create, we can use intelligent technology provided by our custodial partner Betterment to regularly scout for TLH opportunities.

Smart Rebalancing

Because of performance differences across investments, your asset allocation will drift from its target over time. Depending on market movements, the drift can be large even in relatively short periods of time. So it is important to monitor your performance and make appropriate changes to ensure your asset allocation is always consistent with your objectives. Because changes in asset allocation may involve costs due to trading and taxes, it is important to consider these costs before making any changes. The best way to reduce potential tax liabilities is to allow for small deviations from the target asset allocation, and use planned contributions to rebalance towards the target. Monitoring the allocation and rebalancing regularly this way can reduce the likelihood of bigger changes down the road, which can result in larger taxes and other costs.

Advisor Guidance

We focused above on tangible benefits that can directly affect returns. But the value of having an expert manage your investments does not end here. Besides the time and effort saved by delegating this task, working with an expert brings the benefit of peace of mind. Think about the questions we have just considered.

How do I invest my savings?
Am I managing my risks correctly?
Am I appropriately considering the effect of taxes on my portfolio?
Should I worry about what’s happening in the market this week?
How do I know when it’s time to make a change to any of these things?

These are real questions investors routinely ask. Do you have peace of mind, knowing you are making good decisions in the above areas? Having these questions linger without expert help can increase your anxiety, and that can lead to suboptimal investment decisions.

Will you stick with it?

So you have a plan, you are ready to tackle the questions above. You think you will do your research, spend time selecting portfolios, think about taxes, review your investments periodically to rebalance and harvest losses. It may not be as good as working with an advisor, but close enough, and you can avoid advisor fees. But, will you do it? Before you answer, consider this related question. Have you been doing it?

Avoiding big mistakes

Advisor guidance can help you avoid investment mistakes, like that costly variable annuity, the active funds your neighbor suggested, the investment in pets.com you just had to have, or getting out of the market because you read it on Money.com. Without a real advisor, we may seek guidance in the wrong places, including self-proclaimed experts in the financial news, and may be subject to fads and herd behavior. How well can you behave?

The Power of Goals Based Investing

Remember why you are doing this. Your investments are the engine to help you achieve your goals. Your goals, when properly defined, are the why of your plan. Moving closer to your goals can make you feel good about the efforts you make to realize them, increasing your life satisfaction. And by appealing to our aspirational nature, focusing on our goals can help us find the strength to overcome setbacks. We use a goals-based approach both when we design your investment plan, and when we manage your investments. Our technology allows us to assign investments to different goals, so performance can be evaluated in a meaningful way, by measuring progress towards your goals, and not just in terms of total returns.

There are many ways in which having an advisor manage your investments is beneficial to you, from the tangible benefits in terms of potential performance to the less tangible, but even more important benefits of saved time, energy, and peace of mind, which you can use for other things that matter to you. Estimates of the measurable benefits vary, but a simple analysis by Vanguard shows that advisor guidance alone can improve returns by 1.5% annually, a value greater than the average cost of a fee-only advisor (Vanguard estimates the total of the services we discussed to be between 2% and 3%). The benefits of extra time, energy, and peace of mind? Priceless.

So don’t wait, talk to us about our investment management services.

Until next time!

Retirement Savings: Options, Options, Options

Having a strategy to optimize our current resources is crucial to successful retirement outcomes. When it comes to choosing savings accounts, there are many options available, including 401(k), IRA, Roth accounts, and HSA. But how do you choose among them? Read more to find how. Review their key features and how to combine them to improve your retirement plan.

All information in this post is provided for illustrative and educational purposes only and should not be considered tax or investment advice, or a recommendation to buy or sell any type of securities.

There are a number of accounts designed to help you grow your retirement savings. Some are offered through your employer, and others you can open on your own. There are at least two versions for each type, giving you at least four options. Then you have Health Savings Accounts. Yes, a health account can be used for retirement purposes. If you are lucky, you may have a pension plan or a cash benefit plan. Making the best allocation decisions can have a big impact on the growth of your nest egg. Consider that your retirement horizon is long and it includes all your retirement years. So, how do we navigate through this maze and which type of account should we consider?

Your Employer’s 401(k) Plan

Let’s start with your employer retirement plan. This is the so called 401(k) plan, or 403(b) for non-profit employers. Why start from this plan? Contributing to the 401(k) is always a good idea because it is tax advantaged. You put money in the account before it gets taxed. This lowers your tax bill this year. After that, your money grows tax free. When you take the money out, the entire amount is taxed as ordinary income. The ability to defer taxes until after you retire helps you grow a larger nest egg.

Tax-Free Contributions ⟶ Taxable Withdrawals (tax deferral)

Max the match

In addition, many companies offer a “match” for part of the money you contribute to these accounts. A typical scheme is for the employer to match 50% of your contribution until you contribute 6% of your salary. That means the employer will contribute up to 3% of your salary. If you make $50,000 a year and contribute $3,000 (6%), your employer contributes $1,500, under this scheme. So your total contribution (employee + employer) will be 9%, or $4,500 in this example. Some companies may have a greater match, and others may contribute even if you don’t put anything in it.

Unless you have a particular situation and cannot afford it, contributing up the match amount is a no brainer. If you leave your company, you can take the money with you. You can keep the same account, roll the money over to your new employer’s 401(k) plan, or to an IRA, which we discuss below. The money your employer contributes may be yours or not. It depends on the so called vesting schedule. In some companies, employer contributions vest right away, so they are yours to keep. At other companies, vesting can occur over a number of years. Check your employer vesting schedule to find out. There is a 10% penalty (in addition to income taxes) for withdrawing your money before you reach the age of 59 and ½. So it’s never a good idea to simply cash out your 401(k) money.

Know your limits

For some people, saving in their 401(k) account is all they need. Estimate your monthly expenses in retirement (subject of a forthcoming blog), then use a calculator like this to figure out how much you need to save. There is a limit on how much of your salary you can contribute every year. For 2019, the limit is $19,000, plus an additional $6,000 if you are 50 years of age or older, called the catch-up contribution.

Health Savings Accounts

If your are enrolled in a high deductible health plan, you may be eligible to contribute to an HSA account. Why do I include the HSA as part of retirement savings? Because the tax advantage of the HSA can be better than any of the other retirement accounts. Contributions to HSA are tax exempt. Like 401(k) contributions, they help you reduce taxable income. But there is more. While you pay Social Security and Medicare taxes on your 401(k) contributions, HSA contributions are exempt from those, so the tax advantage is greater for HSA contributions.

Tax free contributions and distributions?

What happens when you retire? You can withdraw from your HSA savings tax-free to pay for approved health care expenses, including Medicare part B, supplemental health, and long term insurance premiums. Health care expenses can be relatively large in retirement, so having a tax-free source to draw from is great. If not used for health care, your withdrawals are taxed as ordinary income.

For households with enough income and saving capacity, contributing the maximum amount to an HSA plan is generally good practice. Increasing your HSA contribution is also a good year-end tax planning tip to lower your taxable income. Access to an HSA plan is a good reason to choose a high deductible plan over other options with lower deductibles. Plus, many companies contribute to employee HSA accounts. The key in these accounts is to have your HSA savings invested, so check the investment options of your provider.

Traditional Individual Retirement Account (IRA)

If you don’t have a 401(k) account or an HSA, you still have options to help you save for retirement. The IRA is one such option. Everyone with earned income can contribute to a traditional IRA. So you can start contributing to an IRA when you are a student and working half time. It’s never too early to start thinking about retirement. If you don’t have earned income but your spouse does and you are filing jointly, you can contribute to a spousal IRA.

Your contributions are fully tax deductible if you and your spouse are not active participants in a qualified plan, like the 401(k). If you are an active participant and income is below certain thresholds, you may be able to deduct part of your contribution. When you retire, any withdrawals above your after-tax contributions are taxed as ordinary income. If you only made tax deductible contributions, your entire withdrawal amount is taxed. There is a penalty of 10% for early withdrawals (before 59 and ½ of age) from IRA accounts. The penalty can be waived in some cases (to pay for certain education expenses, first time home purchase, some medical expenses, and other cases).

You can contribute up to the smaller of either the earned income, or the annual contribution limit, which is $6,000 for 2019 and 2020, with an additional $1,000 for people who are 50 years or older.

Roth Versions

There are Roth counterparts to the traditional 401(k) and the traditional IRA. In a Roth account (from the last name of the guy who came up with these accounts) the taxation works differently. Your contributions to a Roth are part of your taxable income. Once you are taxed on the contributions, you are done. You don’t have to pay taxes again on anything you withdraw from the account in retirement.

Taxable Contributions ⟶ Tax-Free Withdrawals in Retirement

Roth 401(k) are newer and not all companies offer them. So you need to check with your company if your plan offers these accounts. Whether you can contribute to a Roth IRA depends on your income. For married filing jointly, the threshold is $193,000 for the maximum allowed contribution. The allowed contribution is then phased out between $193,000 and $203,000.

Any money you contribute directly to a Roth IRA can be taken out without any taxes or penalties. So if you need that money for a wedding or a new bike, you can withdraw it, in principle. Not suggesting you do that, but you could. The point is that the Roth IRA can act as an emergency fund. Penalties and taxes apply to the gains (with some exceptions as we saw for the IRA).

Annual Limits

The same annual limits that apply to traditional 401(k) and IRA apply to the Roth counterparts. In addition, the limits apply to the sum of the contributions across the traditional and Roth account. For example, the $19,000 401(k) limit applies to the sum of the amounts contributed to a traditional 401(k) and Roth 401(k). Similarly for the $6,000 IRA limit.

What’s Better Roth or Traditional?

The main difference is in when you are taxed: Now vs. later. So as a starting point, if your income tax bracket is low, you should contribute to a Roth type of account. Younger workers with steep income trajectories are likely candidates for Roth contributions to their 401(k) and/or IRA. Chances are that by the time they retire, their income brackets are higher than today’s. As your income rises, you may need tax deferred contributions to lower your current tax rate. Contributing to a tax deferred account is a good idea. You have both the HSA and the 401(k) for this purpose.

If you are a high earner, you may need additional savings for retirement. Exhaust your HSA capacity, then look to both the traditional and Roth IRAs. Having your nest egg spread across Roth and traditional accounts has benefits in retirement. For example, while traditional IRA withdrawals are considered taxable income and can affect the taxability of your Social Security benefit, Roth withdrawals do not. If you can’t contribute to a Roth IRA because your income is too high, you can contribute to a traditional IRA and then ‘convert’ that contribution to Roth by rolling it over to a Roth account (a so called Roth conversion). You may have to pay income tax on your conversion (if the contribution was deductible), but will benefit from having the Roth in retirement. If you have a variable income, make Roth contributions or conversions in years when your income is lower.

The Bottom Line

The bottom line is that while it is great to have options, planning your savings across multiple accounts is not simple. Here are the general principles we reviewed:

Start contributing to a (Roth) IRA early if you can.
Don’t leave money on the table. Contribute up to the maximum employer match.
Consider the HSA as a retirement savings vehicle. HSA accounts can be better than Roth (tax-free in and tax free out).
Consider your tax bracket and the benefit of diversification across accounts when determining Roth vs. traditional contributions.

If you are a DIYer, do your homework on each of these options, and consider how they fit within your comprehensive financial plan. For most people that need to look outside of their company’s 401(k) for their retirement needs, the difference between making optimal choices and suboptimal ones can be big. Remember our $10 a day calculation? If you find this complicated, I suggest you talk to a trusted fee-only financial planner. Your nest egg and your retired self with thank you.

Until next time!

Massi De Santis is an Austin, TX fee-only financial planner. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.

Back to School Time!

It’s back to school time! School supplies, meet the teacher, curriculum night, school dismissal, PTO,… Every year we work so hard to make sure our kids have an excellent return-to-school experience. So, let’s use some of that momentum towards our long term goals. Don’t sweat. Just two things.

One

Back to school is a great time to evaluate your children or grandchildren’s education plan. For most people, the most effective way to save for higher education is a 529 plan, even if you live in a state with no income taxes, like Texas. Many states have income tax deductions for contributions, making the in-state plan relatively more attractive, but don’t stop there if your state has high fees and poor investment options. See the Morningstar Morningstar 529 Landscape report for a review of different plans, or ask your advisor for help in selecting one that works for you. Total costs, the availability of low cost mutual funds, and investment options that automatically lower the risk exposure over time are common elements of good 529 plans, according to the Morningstar report.

For gift tax purposes, you can contribute today as if your contribution was made ratably over five years, allowing you to use five years’ worth of annual exclusions at once. Withdrawals are tax free for qualified expenses, which include tuition, fees, books, supplies, and certain room and board expenses at post secondary educational institutions. Since 2018, qualified expenses also include tuition at an elementary or secondary public, private, or religious school, up to $10,000 per tax year, making 529 plans even more desirable.

Start with Goals

Next, review your goals. What range of schools and costs are you looking at? How much should you or can you save towards it? Use a calculator (like this one) to evaluate potential tradeoffs and get ballpark estimates of what you may need to save. The calculator can tell you how much you expect to accumulate by the time you child starts college under a number of scenarios that you can modify. There is a lot of discussion about the increasing cost of college. Unfortunately, no one knows what the future cost will be, although you can expect it to go up. The greater the cost, the more you will need to save. Set a goal that you think is reasonable, and review it every year as actual costs are published (see here for help). If you are not sure, save as much as you reasonably can. The uncertainty of college costs will gradually resolve over time.

Finally, think about asset allocation. Many plans offer “glidepath” allocations. In a glidepath, more risk is taken early on, when you have more time to adjust your savings and goals in case returns aren’t as expected. The allocation then gradually shifts to more conservative investments as you get closer to needing the funds. You can typically choose between more or less aggressive glide paths.

If college planning is important to you, let’s talk, or consult a CFP® professional.

Two

The other thing I recommend you do right now is to check the tax withholding from your paycheck. What? You always wondered how that’s calculated? Glad you asked. Withholdings are calculated by the IRS considering the amount you earn and the info in your W4 form (married or single, dependents, etc. You file this through your employer). The goal is to make you pay, at regular intervals, an annual amount that is a close estimate of what you will owe for the year. Following the changes to the tax law for 2018 and beyond, the IRS recommends you do a quick paycheck check-up. You may have read that for 2018 some people, including people who actually got a lower tax bill than in 2017, owed money to the IRS because too little was withdrawn during 2018. It stings when that happens, believe me.

There is still time to avoid big surprises. The IRS hosts a withholding estimator here. Use the YTD section of your last paystub to help you go through the questions. The more questions you can answer the more precise the estimate. At the end of the process, the estimator will suggest the number of allowances to claim on your W4 form to get on track. If you find you may be getting a refund, you may decide to do nothing. When you get it, try to save at least half of it.

OK, you are done! Feel good? Now it’s soccer practice time! Just kidding, find something fun to celebrate the progress you made!

Until next time!