On April 4th, it was announced that McKenzie Bezos would be receiving 36 billion dollars worth of assets from her divorce from Jeff.
First of all, congratulations to Jeff and McKenzie for keeping this divorce process short, out of the media as much as possible, and out of the courts. We are not going to know the details of the Bezos’ agreement. However, some information has been disclosed in the press.
As reported by CNN, McKenzie is keeping 4% of their Amazon stock, worth approximately 36 billion dollars. Jeff retains voting power for her shares as well as ownership of the Washington Post and Blue Origin, their space exploration venture. According to The Economist, this makes the Bezos divorce the most expensive in history by a long shot.
Unsurprisingly, McKenzie’s wealth is concentrated in AMZN stock. That has worked out well for the Bezos’ for the past several years. It is likely to continue to be a great source of wealth for both of them in the future. As it stands, McKenzie is now the third richest woman in the world. Who knows, if she holds onto AMZN stock, she could become the richest woman in the world one day! McKenzie’s concerns with budgeting, taxes, and wealth strategy will soon be in a class of their own.
There are, however, some lingering considerations for McKenzie, particularly when it comes to capital gains taxes, portfolio management, philanthropy and wealth transfer.
A benefit of keeping the stock until her death is that her estate will benefit from a step up in cost basis. This would mean that the IRS would consider the cost of the stock to be equal to the value at her death. This favorable tax treatment would wipe out her capital gains tax liability.
Nevertheless, the standard advice that wealth strategists give clients with ordinary wealth applies to Ms. Bezos as well: it would be in McKenzie’s best financial interest to diversify her holdings. Diversifying would help her reduce the risk of having her wealth concentrated into a single stock. It is a problem that McKenzie (and Jeff) share with many employees of technology and biotech startups.
An advantage of having more money than you need is that you have the option to use the excess to have a measurable impact on the world through philanthropy. In 2018, Jeff and McKenzie created a $2B fund, the Bezos Day One Fund, to help fight homelessness. Given that the home page of the fund now only features Jeff’s signature, this may mean that Jeff is keeping this also. McKenzie will likely organize her own charity. What will her cause be?
McKenzie’s net worth is far in excess of the current limits of federal and state estate taxes. Unless she previously planned for it during her marriage, she will have to revise her estate plan. Even though she would benefit from a step up in basis on her AMZN stock if she chooses not to diversify, she would still be subject to estate taxes, potentially in the billions of dollars.
Of course, no matter how much estate tax McKenzie ends up paying, it is likely that she will have plenty to leave to her heirs.
1) Harvest your Tax Losses in Your Taxable Accounts
As of[ October 26, the Dow Jones is up 1.65%, and the S&P500 is up just 0.98% ]for the year. Unfortunately, many stocks and mutual funds are down for the year. Therefore you are likely to have a number of items in your portfolio that show up in red when you check the “unrealized gains and losses” column on your brokerage statement.
However, you can also offset your losses against gains. For example, if you were to sell some losers and hypothetically accumulate $10,000 in losses, you could then also sell some winners. If the gains in your winners add to $10,000, you have offset your gains with losses, and you will not owe capital gain taxes on that joint trade!
This could be a great tool to help you rebalance your portfolio with a low tax impact. Beware though that you have to wait 30 days before buying back the positions that you have sold to stay clear of the wash sale rule.
2) Reassess your Investment Planning
Tax loss harvesting is a great tactic to use for short-term advantage. As an important side benefit, it allows you to focus on more fundamental issues. Why did you buy these securities that you just sold? Presumably, they played an important role in your investing strategy. And now that you have accumulated cash, it’s important to re-invest mindfully.
You may be tempted to stay on the sideline for a while and see how the market shakes out. Although we may have been spoiled into complacency after the Great Recession, the last month has reminded us that volatility happens.
Take the opportunity to review your goals, ensure that your portfolio risk matches your goals and that your asset allocation matches your risk target..
3) Check on your Retirement Planning
It is not too late to top out your retirement account! In 2018, you may contribute a maximum of $18,500 from your salary, including employer match to a 401(k), TSP, 403(b), or 457 retirement plan, subject to the terms of your plan. Those who are age 50 or over may contribute an additional $6,000 for the year.
If you have contributed less than the limit to your plan, there may still be time! You have until December 31 to maximize contributions for 2018, reduce your 2018 taxable income (if you contribute to a Traditional plan), and give a boost to your retirement planning.
Alternatively to deferring a portion of your salary to your employer’s Traditional plan on a pre-tax basis, you may be able to contribute to a Roth account if that is a plan option for your employer. As with a Roth IRA, contributions to the Roth 401(k) are made after tax, while distributions in retirement are tax-free.
Many employers have added the Roth feature to their employee retirement plans. If yours has not, have a chat with your HR department!
Although the media has popularized the Roth account as tax-free, bear in mind that it is not. Roth accounts are merely taxed differently . Check in with your Certified Financial Planner practitioner to determine whether electing to defer a portion of your salary to on a pre-tax basis or to a Roth account on a post-tax basis would suit your situation better.
It is health insurance re-enrollment season! The annual ritual of picking a health insurance plan is on to us. This could be one of your more significant financial decisions for the short term. Not only is health insurance expensive, it is only getting more so.
First, you need to decide whether to subscribe to a traditional plan that has a “low” deductible or to a high deductible option. The tradeoff is that the high deductible option has a less expensive premium. However, should you have a lot of health issues you might end up spending more. High deductible plans are paired with Health Savings Accounts (HSA).
The HSA is a unique instrument. It allows you to save money pre-tax and to pay for qualified healthcare expenses tax-free. Unlike Flexible Spending Accounts (FSAs), balances in HSAs may be carried over to future years and invested to allow for potential earnings growth. This last feature is really exciting to wealth managers: in the right situation clients could end up saving a lot of money.
If you pick a high deductible plan, make sure to fund your HSA to the maximum. Employers will often contribute also to encourage you to choose that option. If you select a low deductible plan, make sure to put the appropriate amount in your Flexible Spending Account. FSAs are used to pay for medical expenses on a pretax basis. Unlike with an HSA, you cannot rollover unspent amounts to future years.
6) If you are past 70, plan your RMDs
If you are past 70, make sure that you take your Required Minimum Distributions (RMDs) each year. The 50% penalty for not taking the RMD is steep. You must withdraw your first minimum distribution by April 1 of the year following the year in which you turn 70 ½, and then by December 31 for each year after.
Perhaps you don’t need the RMD? You may want to redirect the money to another cause. For instance, you may want to fund a grandchild’s 529 educational account. 529 accounts are tax-advantaged accounts for education. Although contributions are post-tax, growth and distributions are tax-free if they are used for educational purposes.
Or, you may want to plan for a Qualified Charitable Distribution from the IRA and take a tax deduction. The distribution must be directly from the IRA to the charity. It is excluded from taxable income and can count towards your RMD under certain conditions.
7) Plan your charitable donations
Speaking of charitable donations, they can also be used to reduce taxable income and provide financial planning benefits. However, as a result of the Tax Cut and Jobs Act of 2017 (TCJA), it may be more complicated than in previous years. One significant difference of the TCJA is that standard deductions went up to $12,000 for individuals and $24,000 for married filing jointly. Practically what that means is that you need to accumulate $12,000 or $24,000 of deductible items before you can feel the tax savings benefit.
In other words, if a married couple filing jointly has $8,000 in real estate taxes and $5,000 of state income taxes for a total of $13,000 of deductions, they are better off taking the standard $24,000 deduction. They would have to donate $7,000 before they could start to feel the tax benefit of their donation. One way to deal with that is to bundle your gifts in a given year instead of spreading them over many years.
For instance, if you plan to give in 2018 and also in 2019, consider bundling your donations and giving just in 2019. In this way, you are more likely to be able to exceed the standard deduction limit.
If your thinking wheels are running after reading this article, you may want to check in with your wealth manager or financial planner: there may be other things that you could or should do before the end of the year!
Note: The information herein is general and educational in nature and should not be construed as legal, tax, or investment advice. We make no representation as to the accuracy or completeness of the information presented. To determine investments that may be appropriate for you, consult with your financial planner before investing. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions.We make no representation as to the completeness or accuracy of information provided at the websites linked in this newsletter. When you access one of these websites, you assume total responsibility and risk for your use of the websites to which you are linking. We are not liable for any direct or indirect technical or system issues or any consequences arising out of your access to or your use of third-party technologies, websites, information, and programs made available through this website.
Financial Planner or Estate Planner: Which Do You Need?
Financial Planners and Estate Planners are two different professions that are often confused. There is some overlap between professionals in these fields, but their roles are rather distinct. When you are striving to make a long-term plan for a strong financial future, both financial planners and estate planners play a crucial role.
In fact, when you consider some of the most recent personal finance statistics, it becomes very clear that many Americans could really benefit from retaining the services of both a financial planner AND an estate planner. For instance, 33% of Americans have no money saved for retirement, 60% lack any form of an estate plan, and only 46% have money saved for emergencies. Better planning starts with understanding what both types of planners do.
What is a Financial Planner?
A financial planner is a professional who offers a wide range of services that can assist both individuals and businesses to accomplish their long-term financial goals and accumulate wealth. They fall into two categories:
Registered Investment Advisor
Certified Financial Planner
Certified Financial Planners (CFP) are required to comply with the Certified Financial Planner Board of Standards, which means they have a basic level of expertise backed by a larger organization. Ethically they have to work in your best interest.
Services provided by both financial advisors and CFPs include:
While you might believe only wealthy individuals need to work with an estate planner, you should consider the fact that everything you have accumulated in your life comprises your estate. Accumulated assets such as vehicles, furniture, bank accounts, life insurance, your home, and other personal possessions are all included in your estate.
When you work with both a financial planner and an estate planner, they will keep you accountable by periodically reviewing your documentation and beneficiaries and making sure everything is updated and reviewed as necessary. By taking the time to work with both these professionals, no important decisions will be overlooked, and you will take control of your financial future.
Note: This article was authored by Kristin Dzialo, a partner at Eckert Byrne LLC, a Cambridge, MA law firm that provides tailored estate planning. Eckert Byrne LLC and Insight Financial Strategists LLC are separate and unaffiliated companies. This article is provided for educational and informational purposes only. While Insight Financial Strategists LLC believes the sources to be reliable, it makes no representations or warranties as to this or other third party content it makes available on its website and/or newsletter, nor does it explicitly or implicitly endorse or approve the information provided.
We all think that we are fully rational all the time but in reality the way our brains operate that is not always the case.
One of the key functions of the brain is self-defense. When the brain perceives danger it makes automatic adjustments to protect itself. When it perceives discomfort it seeks to engage in an action that removes the stress.
In his book “Thinking Fast and Slow” Nobel Prize Winner Daniel Kahneman explains how we all have a two way system of thinking that we use to make decisions. He labels the two components as System 1 (Thinking Fast) and System 2 (Thinking Slow).
System 1 is automatic, fast responding and emotional. System 2 is slower, reflective and analytical.
Think of your System 1 as your gut reaction and your System 2 as your conscious, logical thought.
While we all like to think that our key life decisions are governed by our logical thought (System 2) research has shown that even major decisions are often driven by our gut feel.
Which System do we use to make a decision? That depends on the problem. If we have seen the problem many times before such as what to do when see a red light we default to our automatic System 1 thinking.
When we face a challenge or issue that we have not seen before or maybe infrequently we tend to use System 2, our more reflective and analytical capabilities.
Kahneman’s research shows that we spend most of our time in System 1. While most people think of themselves as being rational and deliberate in their decision making, the reality is that we often employ “short-cuts” or heuristics to make decisions.
Most of the time, these “short-cuts” work just fine but occasionally for more difficult or complex problems the impressions arrived from System 1 thinking can lead us astray.
Why? Above all else, System 1 thinking seeks to create quick and coherent stories based on first impressions. These impressions are a function of what our brain is sensing at that moment in time.
According to Kahneman, conclusions are easily reached despite often contradictory information as System 1 has little knowledge of logic and statistics. He calls this phenomenon – WYSIATI – for “what you see is all there is”.
The main implication from WYSIATI is that people often over-emphasize evidence that they are familiar with and ignore evidence that may be much more relevant to the problem at hand but that they are not fully aware of.
System 1 conclusions therefore may be biased and lead to decision “short-cuts” or heuristics that seriously impair the quality of a decision.
Loss aversion creates inertia. Inertia often works against investors that overvalue the attractiveness of their current holdings.
There are different degrees of loss aversion. According to Prospect Theory, all investors value gains less than losses but some exhibit an extreme dislike for potential losses that significantly hinders their long-term wealth creation potential.
Nobody likes to lose money, but taking on risk in order to compound your hard earned savings is an integral feature of how capital markets work. You don’t get a higher reward unless you take additional risk.
Most investors know that stocks do better than bonds over the long-term but that the price of these higher returns is more risk. Investors also understand that bonds do better most of the time than simply purchasing a CD at the local bank or investing in a money market mutual fund.
But knowledge stored in your logical and analytical System 2 thinking does not always make it through in the face of stress or uncertainty.
People can become too risk averse for a couple of reasons:
Case A: They let their fears and emotions guide their investment decision making and give disproportionate importance to avoiding any losses
Case B: They fail to calibrate their expectations to the likely frequency of outcomes.
In Case A, investors seek the perceived safety of bonds often not realizing that as interest rates go up bonds can lose money. Or they simply pile into CD’s not realizing that their returns most often fail to keep up with inflation. Stocks are frowned upon because you can lose money.
Investors in Case A let their decisions be driven by emotion and fear and will over-value the importance of safety and under-value the importance of future portfolio growth. Their account balances will not go down much when capital markets experience distress, but neither will they go up much during equity bull markets.
In Case B investors mis-calibrate their expectations for various investment outcomes and the consequences can be as dire as in the first situation. Behavioral finance research has shown that investors frequently over-estimate the likelihood and magnitude of extreme events such as stock market corrections.
What are the implications for investors playing it too safe?
Let’s consider the case of investors currently working and saving a portion of their income to fund a long-term goal such as retirement. These individuals are in the accumulation phase of their financial lives.
Somebody in the accumulation phase will naturally worry more about how fast they can grow their portfolio over time and whether they will reach their “number”. People in the accumulation phase care primarily about their balances going up year after year. They are in “growth” mode.
The Hypothetical Setting:
To better illustrate this situation let’s look through the eyes of a recent college grad called Pablo earning $40,000 a year. Pablo is aware of the need to save part of his salary and invest for the long-term. He just turned 22 and expects to work for 40 years.
Pablo will also be receiving annual 2.5% merit salary increases which will allow him to save a greater amount each year in the future.
Pablo faces two key decisions – what percentage of his salary to save each year and the aggressiveness of his portfolio which in turn will determine its most likely return.
He is conflicted. He has never made this much money before and worries about losing money. He also understands that he alone is responsible for his long-term financial success.
Pablo knows that there is a trade off between risk and return but he wants to make a smart decision. His System 1 thinking is saying play it safe and don’t expose yourself to potential loses.
At the same time his rational and informed System 2 thinking is influenced by a couple of finance and economics classes he recently took while in college.
Pablo can succumb to automatic System 1 thinking and invest in a very conservative portfolio. Or he can rely on his System 2 thinking and invest in a higher risk and commensurately higher return portfolio.
One Alternative – Save 10% of his Income and play it safe investing
For simplicity sake assume that Pablo decides to put 10% of his salary into an investment fund. The fund consists primarily of high grade bonds such as those contained in the AGG exchange traded fund.
From the knowledge gained in his econ and finance classes Pablo estimates that this portfolio should return about 4% per year – a bit below the historical norm for bonds but consistent with market interest rates as of August 2018.
Pablo also understands that such a portfolio will have a bit of variability from year to year. He estimates that the volatility of this portfolio is likely to be about 6% per year. Again, this estimate is in line with current bond market behavior as of August of 2018.
He knows that this is a low risk, low return portfolio but the chances of this portfolio suffering a catastrophic loss are negligible. He is petrified of losing money so this portfolio might fit the bill.
How large could his portfolio be expected grow to over 40 years of saving and investing in this conservative manner? We built a spreadsheet to figure this out. We assumed a 4% portfolio return on principal, 2.5% annual salary increases and a half year of investment returns on annual contributions also at 4%. Remember that this is a hypothetical example with no guarantee of returns.
At the end of 40 years Pablo’s salary is assumed to have grown to $107,403 and his portfolio, invested in this conservative manner, would have a balance of $575,540. The growth of this portfolio (identified as 10_4) is shown in Figure 1. The naming convention for the portfolios corresponds to the savings rate followed by the assumed hypothetical rate of return on the strategy.
Source: Insight Financial Strategists, Hypothetical Example
Pablo knows that his portfolio will not exactly return 4% every year. Some years will be better, other years much worse but over the next 40 years the returns are likely to average close to 4%.
But Pablo does not feel comfortable just dealing in averages. If things go bad, how bad could it be?
Given the volatility of this conservative portfolio there is a 10% chance of losing 3.6% in any given year. These numbers are calculated by Insight Financial Strategists based on an approximation of a log-normal simulation and are available upon request. Not catastrophic but nobody likes losing money.
Figure 2 shows the 90th and 10th probability bands for this conservative portfolio. These bands are estimated based on the expected average return of the portfolio and its volatility.
The actual portfolio return would be expected to lie about 2/3 of the time within these bands. In the short-term, say 1 to 2 years out, the portfolio returns are more unpredictable. Over longer horizons, the average return to this conservative portfolio should fall within much tighter bands given the assumed risk and return numbers in the log-normal simulation.
Based on the calculations, the average returns over ten years should range between 6.3% and 1.4% per annum. Clearly, even this conservative portfolio has some risk especially in the short-term, but over longer holding periods returns should smooth out.
Source: Insight Financial Strategists
Another Alternative – Save 20% of his Income and continue investing in a conservative portfolio
Assuming the same 2.5% annual salary increases, the final salary would have been the same but his nest egg would have grown to $1,151,080. Pablo keeps looking at Figure 1 (the 20_4 line representing a 20% savings rate invested at an assumed 4%) and starts thinking that maybe a bit of extra saving would be a very good thing.
He still has a 10% probability of being down 3.6% in any given year, but if his budget allows, he feels that he can forego some frills until later.
Now, Pablo is starting to get excited and wonders what would happen if he invested more aggressively, say in a variety of equity funds?
Yet Another Alternative – Keep saving the same amount but invest more aggressively
The likely returns would go up but so would his risk. He estimates that based on current market conditions and the history of stock market returns (obtained from Professor Damodaran of NYU) that this more aggressive portfolio should have about an 8% annual rate of return with a volatility of around 14% per year. These estimates are both a bit lower than the 1926-2017 average reflecting higher current (as of August 2018) valuations and lower levels of overall market volatility.
He is thinking that maybe by taking more risk in his portfolio during his working years he will be able to build a nest egg that may even allow him for some luxuries down the road.
He also knows that things do not always work out every year as expected. Pablo is pretty confident that 8% is a reasonable expectation averaged over many years, but how bad could it be in any given year?
A log-normal simulation was conducted using the assumed risk and return numbers – same approach as before.
Figure 3 shows the 90th and 10th percentile bands for this portfolio.
Source: Insight Financial Strategists
Given the volatility of this equity-oriented portfolio, there is a 10% chance of losing 9.2% in any given year (based on the simulations). Ouch, the reality of equity investing is starting to sink in for Pablo.
But Pablo is also encouraged to see that his returns in any given year are equally likely to be about 26% or higher. That would be nice!
Especially when it comes to equities there is a wide range of potential returns but over time these year by year fluctuations should average out to a much narrower range of outcomes. While our best estimate is that this portfolio will return on average 8% per year over a ten-year window the range of expected outcomes should be between a high of 12.9% and a low of 1.6%.
Pablo decides to research the history of stock, bond, and cash returns by reading our April Blog on Understanding Asset Class Risk and Return and looking at a chart of long-term returns from Morningstar (Figure 4).
He is surprised to find that over the long-term equities do not seem as risky as he previously thought. He is also quite surprised by the wide gap in wealth created by stocks versus bonds and cash.
The research makes Pablo re-calibrate his expectations and he starts wondering whether the short-term discomfort of owning equities is worth it in the long run.
Pablo’s System 1 thinking is on high alert and his first thought after seeing how much he could lose investing in equities is to run back to the safety of the bond portfolio.
But something tells him to slow down a bit and think harder. This is a big decision for him and his System 2 thinking is kicking in. Before he throws the towel in on the equity-oriented portfolio he glances again at Figure 1 to see what might happen if he invests more aggressively.
What he sees astounds him. It is one thing to see compounding in capital market charts and yet another to see it in action on your behalf. Small differences over the short term amount to very large numbers over long periods of time.
If Pablo were to invest in the more aggressive portfolio there would be more hiccups over the years but his ending account balance should be $1,440,075 if he consistently put aside 10% of his salary every year.
If he saved 20% the ending portfolio balance would double in size.
Decision Time – Picking among the alternatives
Pablo is now faced with a tough decision. Does he play it safe and go with the conservative portfolio? Or, does he go for more risk hoping to end up with a much larger nest egg but knowing that the ride may be rough at times?
Beyond the numbers, he realizes that he needs to look within to make the best possible decision. His System 1 thinking is telling him to flee, but his System 2 thinking is asking him to think more logically about his choices. He also needs to deal with how much he is planning to save from his salary.
Fear versus Greed:
He needs to come to terms with how much risk he is willing to take and whether he can stomach the dips in account balance when investing in riskier assets. As Mike Tyson used to say, “Everybody has a plan until they get hit in the face”.
In structuring his investment portfolio Pablo needs to balance fear with greed. Paying attention to risk is absolutely necessary but always in moderation and in the context of historical precedents. If Pablo lets his fears run amuck he may have to accept much lower returns.
With the benefit of hindsight, he may come to regret his caution. On the other hand, the blind pursuit of greed and a disregard for risk may also in hindsight come back to bite him. Pablo needs to find that happy medium but only he can decide what is right for him. Risk questionnaires can help in this regard. Try ours if you like!
Consumption Today versus Tomorrow:
Pablo also needs to come to grips with how much current consumption he is willing to forego in order to save and invest. We live in an impulse oriented society. Spending is easy, saving is hard.
Saving is hard especially when you are starting out. On the other hand, over time the saving habit becomes an ingrained behavior. The saving habit goes a long way toward ensuring financial health and the sooner people start the better.
Will Pablo be able to save 10% of his salary? Or, even better will he be able to squeeze out some additional expenditures and raise his saving to 20%?
If possible Pablo should consider putting as much money in tax-deferred investment vehicles such as a 401(k). He should also have these contributions and any other savings automatically deducted from his paycheck. That way he won’t get used to spending that money. Pablo may come to see these deductions from his paycheck as a “bonus” funding future consumption.
“The greatest mistake you can make in life is to continually be afraid you will make one”
— ELBERT HUBBARD
This has been an eye-opening experience for our hypothetical friend Pablo. He was not expecting such a difference in potential performance. He now realizes the importance of maximizing saving for tomorrow as well as not succumbing to fear when investing for the long-term.
He has learned several invaluable lessons that also apply to individuals in the accumulation phase of their financial lives
Lesson 1: The Importance of Saving
Delaying consumption today allows you fund your lifestyle in the future
Saving even small amounts makes a big difference over the long-term
Lesson 2: The value of patience and a long-term perspective
In the early years you may not notice much of a difference in portfolio values
Keep saving and investing – disregard short-term market noise and stick to a plan
Lesson 3: Small differences in returns can amount to huge differences in portfolio values
Seemingly tiny differences in returns can result in large differences in portfolio values
Compounding is magic – take advantage of it when you can
Lesson 4: The importance of dealing with your fear of losing money
Letting your first instinct to avoid risky investments dictate what you own will work against you
Investing involves risk – best to manage rather than avoid risk
The pain and agony of losing money in any given year is alleviated over the long term by the higher returns typically accruing to higher risk investments
Lesson 5: Investing in your financial education pays off
Gaining a proper understanding of capital market relationships is an invaluable skill to possess
Leaning on financial experts to expedite your learning is no different than when athletes hire a coach
Much of the data used in these illustrations comes courtesy of Professor Aswath Domodaran from NYU and covers US annual asset returns from 1928 to 2017. Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. References to specific investment themes are for illustrative purposes only and should not be construed as recommendations or investment advice. Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk.
This piece may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.
Stock and bond markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Investing involves risk, including risk of loss.
Approximately 1.5 million foreign nationals move to the US every year to study, work and live. Many come on green card visas, and others on working and other temporary visas. They come from all walks of life. They are engineers, scientists, physicians, academics.
Anyone who has moved to another country can testify that it is a daunting task. Everything is new. A lot of what was known must be relearned. What number to call for emergencies? How much to tip at restaurants if at all? And how to deal with investment and other financial matters?
Engineers, scientists, physicians, academics, and business people moving to the US often continue to hold assets in checking, investment accounts and in real estate in other countries. Some may even inherit assets in other countries while living in the US. Eventually many move back to their home country or a third country.
All newly arrived people in the US face the common dilemma of how to efficiently reinvent their financial lives. In many ways the US financial system may seem odd. Many of the differences relative to their former home base can be found relatively easily.
However, there are financial pitfalls specific to foreign nationals living in the US to be aware of. Here are five of them.
Failure to understand US reporting requirements
Unless they have been in a monastic retreat, US citizens will know that their government cares about their foreign income and assets. Ugly acronyms such as FATCA and FBAR have been designed to ensure tax compliance from all Americans. What is often overlooked is that the reporting requirements of foreign income and assets also apply to all residents of the US, including foreigners living in the US.
Foreign nationals in the US routinely underestimate the impact of necessary reporting requirements. They do so at their own peril. Whether they are citizens or not, residents of the US are subject to taxation on their worldwide income. In many cases, taxes paid overseas can be offset by credits to US taxes, thus limiting the monetary impact. The real challenge is the obligation to report. Laws, including the aforementioned FATCA and FBAR, obligates all US residents to report foreign income and assets.
In a routine instance, a foreign national may own a checking account, a brokerage account, or even real estate in their home country. When moving to the US and focusing on the excitement and challenge of a new life, it is easy to forget about these assets or believe that they do not fall under the jurisdiction of the IRS.Such an assumption would be wrong.
All these assets are subject to reporting to US government authorities. Under the Foreign Account Tax Compliance Act of 2010 (FATCA) the US government set up a global reporting infrastructure to mandate foreign banks and governments to report foreign-held assets owned by US residents to the US government. To ensure compliance, foreign institutions are subject to stiff penalties when they fail to report assets owned by US residents. In other words, if you own a foreign asset, it is unlikely to be a secret to the US government.
Reporting requirements don’t stop with banks and governments. Taxpayers are also responsible for reporting their own information through FBAR and IRS form 8938 filings. Information in those forms is then compared with the bank and government reports. Discrepancies and failures to report can be considered tax evasion and fraud. They are subject to penalties that can be punitive. Ignoring this issue is not a sustainable strategy, because eventually, the government will catch up. If in doubt check with a professional.
Get overwhelmed by US tax complexity
Foreign nationals who come to America are often overwhelmed by the complexity of the U.S. tax system. As a result, they often become paralyzed by the complexity and end up missing out on taking care of their financial needs. On average, foreign nationals in the US have the advantage of being stronger savers than Americans. However, to gain a sustainable advantage you need to invest your savings to allow the laws of compound growth work for you and fructify your savings. For every problem, there is a solution.
Although it looks daunting, US tax complexity can also be overcome. Because software solutions are not typically designed to handle the complexities of foreign assets and income, it is advisable to hire professionals who have experience with international matters.
Not being aware of tax treaties
The US maintains tax treaties with some 68 foreign countries that determine rules and exceptions for the treatment of various taxable events. The treaties provide a framework to avoid or minimize double taxation on a variety of active and passive income. Failure to be aware of the tax treaties, their provisions, and their implementation can result in unnecessary withholdings and taxes.
Tax treaties can also provide benefits. If you have worked in the US for a while, you will have accumulated social security credits, potentially qualifying you for social security retirement benefits. Through “totalization” agreements with 26 countries, those credits can be transferred to a number of social security peer systems in those countries, thus improving retirement benefits in those countries. The reverse is also true. If you have social security equivalent credits in those 26 countries and retire in the US, they could be counted towards your US social security benefits. In the case where there is no totalization agreement and the foreign national has contributed to US social security for 10 years or longer (technically 40 quarters), the foreign national is usually eligible for a US social security retirement benefit.
Cashing out retirement accounts upon leaving the U.S.
Foreign nationals often accumulate substantial U.S. retirement account balances during their American career. Most companies offer a 401(k) retirement plan; foreign national employees are also eligible to participate. It is often an easy decision: 401(k) plans provide an easy saving mechanism and an immediate tax reduction. It allows a maximum annual saving for people under 50 of $18,500 a year including the company match, if applicable.
When they look to return to their home country, people are often conflicted about how to handle those accounts. Broadly speaking the choices are to leave the accounts unperturbed or to cash out and go home. Often the decision is to cash out.
Cashing out of a deferred tax retirement account such as a 401k or an IRA before age 59 ½ results in punitive taxation. The distribution is taxed as income. Usually, it propels the account owner to a higher tax rate resulting in additional costs. For instance, a taxpayer that was in the 24% tax bracket could find himself or herself in the 32% bracket as a result of a retirement account distribution.
To add insult to injury, the distribution is also subject to a 10% penalty for those who take when they are younger than 59 1/2. It is easy to see that cashing out is an expensive proposition that robs you of the benefits of saving and tax-deferred growth.
The other possibility is to leave the account in the US or roll it over to an IRA if it is in a 401k or other company sponsored plan. The immediate advantage is that there is no immediate income tax or penalty. In addition, the investment options are usually much stronger and less expensive than in other countries. The downside is that the assets may be subject to estate taxes if the foreign national dies owning the asset. And, as with Americans, distributions in retirement are subject to income taxes. For those who choose to leave the retirement accounts in the US, a plan can be built to optimize income and estate taxes to ensure that you can benefit from the fruits of your savings.
Not recognizing the advantages of keeping U.S. investment accounts when leaving.
The US investment environment is more favorable to individual investors than most others. Mutual fund and ETF expense ratios are lower, transaction costs are lower, and management fees are lower. Market liquidity is usually higher even for many investments that are focused on specific foreign markets. And the range of investment options available to individuals is wider. For instance, there are 80 ETFs listed in Singapore and 134 listed in Hong Kong, compared with 1,707 in the US (August 2018).
It should be noted that although financial assets held by foreigners are not `subject to US capital gains taxes, dividends and interest are subject to withholding taxes of 10% to 30%, depending on whether there is a tax treaty. Often tax treaties can help mitigate the impact of income and estate taxes, including the withholding tax. Again this is an area where financial professional familiar with the intricacies of cross-border families can really help.
On balance, when they leave the US, foreign nationals can continue to enjoy the generally stronger US investment climate.
Moving to the US to continue a thriving career is often a dream of many foreign nationals. A new lifestyle, upward progress and a taste of American culture. What is there not to like about such an adventure? But that dream may not turn out to be that great in real life if you don’t properly address the complexities and uniqueness of the US tax system. However, the five mistakes outlined in this note can be easily addressed with the help of the right professional. Do so, and you will reap the rewards
Although the number of pension plans has significantly declined over the years there are still many of them out there, and many divorcing couples have to figure out how to deal with them. The prime benefit that a pension plan provides is a fixed lifetime income. A stream of income in retirement could well be a pension synonym. It used to be that fixed income was considered a negative. However, nowadays it is the lucky retiree who benefits from a pension plan!
In case of divorce, issues surrounding who is entitled to the pension present a challenge especially in the case of grey divorces (usually defined as people over 50). Divorce and pension plans can sometimes generate conflict as the owner of the asset will often feel more proprietary about it than with other assets. Employees are often emotionally vested in their pension. They feel, more than with other assets, that they have really earned it. And that their spouse has not. They often will have stayed in a job that they may not have liked for the privilege of qualifying for a higher paying pension. Couples look forward to getting that income when they retire. And so spouses will want to make sure that they get their share of it as part of the divorce.
Pension rights after divorce are determined as part of the overall divorce process. In a negotiated divorce, the parties can decide, within limits, how to divide their assets. In the worst case, the courts will make the decision.
What is a pension plan and how does it work?
The value of a pension benefit can be difficult to determine. Unlike other accounts, pensions don’t come with a statement that makes them easily comparable to other assets; they come with the promise of a benefit (the monthly payment that someone might get at retirement). So the number one priority when a pension is involved in a divorce is to get a valuation. The financial consequences of divorce are serious, and not getting a valuation may lead to struggling financially after divorce
Risk of Valuation
Even when valued, the number provided on a report may lead to a false sense of security. Unlike other retirement statements, the value of a pension is estimated using the parameters of the beneficiary and of the pension. In most cases the divorce pension payout is calculated with a predetermined formula based on the employee’s length of employment and income. In some cases, the benefit may vary depending on a few other factors.
The next step is to estimate how long the benefit might be paid. That is done using actuarial tables. Based on periodic demographic studies, actuarial tables predict our life expectancy. Some actuarial tables include those produced by the Society of Actuaries, the Internal Revenue Service, and the Pension Benefit Guaranty Corporation (PBGC). A pension valuation will normally use the estimates from the actuarial tables representing an average life expectancy of a cohort of people born in the same year. The estimates are usually accurate within their parameters, as individual variability is smoothed out for large populations. However, individual longevity is harder to predict as it may fall within a wider range.
With the amount of the payment and the length of time that the payments will be made, how much is all of that worth? Pension valuators use a “discount rate” to approximate the value of a future payment. The principle is that the value of a dollar paid next year will be less than the value of a dollar paid today. Hence you should be willing to accept less than a dollar for the promise of a payment next year, and even less for the promise of payment the year after.
Financial analysts will use the concept of the prudent rate of return, the rate that a prudent person would invest at in order to receive that dollar next year or beyond. That of course could be subject to interpretation. Often the standard that is used is the government bond rate for the duration of the payment. US government bonds are often considered to be risk free by economists and the public, although that too is subject to debate (Currently US government debt is rated at AA+ (below AAA) by Standard & Poor’s, the leading debt rating agency). Nonetheless that rate is often used for individual pension valuations.
The PBGC, on the other hand, has developed its own rates. The PBGC uses different rates before retirement, and rates during retirement. The former are significantly higher than the latter and assumes a rate of return that is in excess of the risk free rate. That may be a better model for actual human behavior, as people will normally be tempted to take more risk for a better return, rationalizing, of course, that the incremental risk is not significant. On the other hand, for rates during retirement the PBGC uses rates that are well below the norm, reflecting the reality that retirees are even more risk averse than the average population.
Financial analysts will determine the value of the pension by taking a present value of the pension payments over the expected longevity of the individual at the determined discount rate(s). The number that comes out is usually a single number assuming a date of retirement.
Understanding that we are working with an estimate, people usually ignore the fact that the magic number does not take into account the likely variability of the inputs, in particular longevity.
If you will be the alternate payee (ie, if you are the spouse aiming to get a share of the other’s pension), it is important to pay attention to the fact that the real value of your share of the pension will fall within a range. It will not be a single number Hence when you trade that pension for another asset that has a fixed value, you want to make sure that you are not short changing yourself.
On the other hand if you are the beneficiary of the pension, it is painful enough to give up a share of it. You don’t want to give up part of that asset if it will not be fully used. If it is the alternate payee that passes away early, his or her stream of payments stops, and, in most cases, does not revert back to you, the initial beneficiary. If that were to happen you will have wasted a potentially substantial asset.
In summary it is important for divorcing couples to fully understand the value of their pensions for themselves and for their spouse. Divorce already destroys enough wealth. There is no need to destroy more.
Risk of Default
Pensions have a risk of default or reduced benefits in the future. According to the Society for Human Resources Management 114 pension funds are expected to fail in the next 20 years. That is true even for pensions that do not look like they are in trouble currently. Some people may think that this is farfetched. Yet you only have to look at the Pensions Right website to convince yourself that benefit reductions do happen. When you consider that retirement can last 20, 30 or 40 years, you will want to evaluate if your pension plan is robust enough to last that long, and continue making payments for that long.
The risk of benefit reductions or outright default may apply mostly to the private sector. Yet public sector plans may be at risk also. For instance, Social Security has a trust fund that, together with payroll deductions, funds its retirement benefits (social security retirement benefits are effectively a pension). According to the 2009 Social Security Trustees Report, the Social Security trust fund will run out in 2037. When that happens, the Trustees project that retirement benefits will be cut by 24%.
It should be noted that Social Security benefits are not divisible in divorce The beneficiary keeps his or her benefits. The ex-spouse can get 50% of the beneficiary’s benefits (if married 10 years or longer) or 100% of his or her own, whichever is higher, but not both. That happens without prejudice to the prime beneficiary.
However, in 2037, both parties can expect a Social Security retirement benefit cut of 24%, unless Congress remedies the situation beforehand.
People also underestimate personal risk. If you receive a pension as an alternate payee (ie the spouse who is getting a share of the pension from the former employee), you will want to consider the risks that your payments may be interrupted due to issues with your ex-spouse. Many pensions stop spousal payments when the beneficiary passes. When that happens, the alternate payee will have to find an alternate source of income to compensate.
It is worth remembering that our life expectancies are random within a range. The expected longevity of women reaching 65 years of age is to 85 years of age. We often anchor on this or other numbers forgetting that few women pass away at 85. Most will pass away either before 85 or after 85. According to a paper by Dr. Ryan Edwards for the National Bureau of Economic Research, the standard deviation for longevity is 15 years. That means that most women will live to 85, +/- 15 years. From 70 to 100 with an average of 85. That is a wide range! What if the beneficiary of the pension passes away 10 years before his her life expectancy, and the alternate payee lives 10 years longer than life expectancy? That means that the alternate payee may have to do without his or her share of the pension for 20 years or longer (if the two ex spouses have the same expected longevity).
And what about inflation risk?
Most pensions do not have a Cost of Living Adjustment (COLA). That does not apply to all of them. For instance, the Federal Employee Retirement Systems (FERS) has a limited COLA. Effectively, when there is no inflation adjustment, the value of a pension payment is reduced every year by the amount of inflation. How bad can that be, you ask? Assuming a 3% inflation rate the value of a fixed payment will decrease by almost 50% over 20 years. . What is the likelihood that expenses will have reduced by 50%?
A Last word
Pensions are a very emotional subjects in divorce. Perhaps because we are naturally risk averse, and perhaps because our risk aversion is exasperated by divorce related anxiety, we like to cling to what we perceive as solid. People will often want to keep the marital home, even if they cannot afford it, or take a chunk of a pension even when it may make better sense to trade it for another asset. Worse yet they will want to know whether to keep the house or pension in divorce.
What other asset you may ask? You could trade the pension for a tax- deferred retirement asset, such as an IRA or a 401k. Or any other asset that you and your spouse own. The right decision will end up being different for everyone.
As a Divorce Financial Planner, it is my task to make sure that each side understands exactly what is at stake, and to help prepare them for rebuilding financially after divorce. In many cases it makes sense for both parties to get a share of the pension. In others it does not. How to keep your pension in a divorce is a vital question. Even more important is to understand the true value of the pension, and its ambiguities. It is a difficult task in a process that is already filled with anxieties and uncertainties to focus effectively on yet one more ambiguity. Yet for successfully managing finances after divorce it must be done.
If you are self-employed, one of your many tasks is to plan for your own retirement. While most Americans can rely on their employer’s 401(k) for retirement savings, this is not the case for self-employed people.
In some respects, that is an advantage: most employees barely pay any attention to their 401(k). It is an opportunity for the self-employed to make the best choices possible for their business and personal situation.
The most obvious benefit of saving for retirement is that you will have to retire anyway, one day, and you will need a source of income then. With a retirement account, most people appreciate that it is specifically meant to save for retirement. People also appreciate the tax benefits of the SEP IRA and Solo 401(k).
The more immediate benefit is that retirement savings in tax-deferred accounts help reduce current taxes, possibly one of the greatest source of costs for small businesses. Of course, the tax saved with your contribution will have to be paid eventually when you take retirement distributions from the SEP-IRA.
When it comes to tax-deferred retirement savings vehicles for the self-employed and owner and spouse businesses, two of them stand out due to their high contribution limits and flexible annual contributions: the SEP IRA and the Solo 401(k). These two vehicles provide a combination of convenience, flexibility, and efficiency for the task.
The SEP IRA is better known by its initials than its full name (Simplified Employee Plan IRA). For 2018 the SEP IRA contribution limits are the lesser of 25% of compensation up to $275,000, or $55,000 whichever is less. You may note that this is significantly higher than the limit for most 401(k)s plans, except those that have a profit sharing option. SEP IRA rules generally allow contributions to be deductible from the business’ income, subject to certain SEP IRA IRS rules.
One of the wrinkles of SEP IRA eligibility is that it applies to employees: you have to make a contribution of the same percentage of compensation as you are contributing for yourself. So if you have employees, another plan such as a Solo 401(k) might be a better choice.
And for fans of the Roth option, unfortunately, the SEP IRA doesn’t have one. When comparing the SEP IRA vs Roth IRA, the two clearly address different needs.
The Solo 401(k) also known as the individual 401(k) brings large company features to the self-employed. It generally makes sense for businesses with no common law employees. One of the Solo 401k benefits is that just owners and their spouses, if involved in the business, are eligible. Employees are not. So, if you are interested in just your own retirement plan (and your spouse’s), a Solo 401(k) may work better for you than a SEP IRA. If your business expands to include employees and you want to offer an employer-sponsored retirement plan as a benefit to them, then you should consider a traditional company 401(k) option.
The Traditional Solo 401k rules work in the same way as the SEP IRA: it defers income taxes to retirement. It makes sense if you believe that you will be in an equal or lower tax bracket in retirement. Those who think that they may be in a higher tax bracket in retirement should consider a Roth option for their Solo 401(k): it will allow you to contribute now on an after-tax basis, and you will benefit from tax-free distributions from the account after retirement. A Roth 401k calculator may be required to compare the benefits. Again, the Roth option is not available in SEP accounts.
Solo 401k contribution limits permit you to contribute the same amount as you might in its corporate cousins: up to 100% of compensation, up to $18,500 a year when you are younger than 50 years old, with an additional $6,000 annual catch-up contribution for those over 50 years of age.
In addition, profit sharing can be contributed to the Solo 401(k). The Solo 401k limits for contributions are up to 25% of compensation (based on maximum compensation of $275,000) for a maximum from all contributions of $55,000 for those under 50 years of age and $61,000 for those over 50 years of age.
Another difference with the SEP IRA is that the Solo 401(k) can be set up to allow loans. In that way, you are able to access your savings if needed without suffering a tax penalty.
So Which Plan Is Best for You?
The SEP IRA is simpler to set up and administer. However, the Solo 401(k) provides more flexibility, especially for contribution amounts. Given that the amount saved is one of the key factors for retirement success, that should be a consideration.
Comparing the Solo 401k with the traditional employer 401k, you may no longer have to ask how to open a Roth 401k. You will have control of that. On the other hand you will be entirely responsible for figuring out your Roth 401k employer match.
As could be expected, administration of the Solo 401(k) is slightly more onerous than that of the SEP IRA.
Solo 401(k) and SEP IRA
A Last Word
If you don’t have a plan get one. It is easy. It reduces current taxes. And it will help you plan for a successful retirement. The SEP IRA and the Solo 401(k) were designed specifically for small businesses and the self-employed. Although we have reviewed some of the features of the plan here, there are more details that you should be aware of. Beware of the complexities!
4 Counter-Intuitive Steps to Take Now to Make Your 401(k) Rock
With the demise of traditional defined benefit plans, 401(k)’s provide the most popular way for individuals to save for their retirement.
401(k)’s are also the second largest source of US household wealth right behind home equity.
According to the Investment Company Institute there were over 55 million active participants in 401(k) plans plus millions of former employees and retirees as of the end of last year. The amount of money is staggering at $5.3 trillion as of the end of 2017.
Given the importance of 401(k)’s to US household financial health you would think that plan participants would watch their balances like a hawk and actively manage their holdings.
Some people do, but the vast majority of people do not truly understand what they own or why. Most people know that the more they contribute to their 401(k) the higher their ending balances are going to be, but beyond that there is a lot of confusion.
Picking funds before figuring out your goals and objectives is like picking furniture before you know the size and shape of your dining room. It might work out but it would involve a lot of luck. Do you want to count on luck when it comes to your financial future?
A different way of addressing the challenge is to start the other way around. Start with the end goal in mind.
Re-frame the problem to first figure out what you are trying to do. You want your 401(k) to work for you and your family, right? Sound like a better starting point?
Without knowing what you are trying to do and what really matters to you putting money into your 401(k) loses meaning.
What funds to select
First figure out for yourself why you are taking money out of your paycheck to put into your 401(K). What is your “why”?
The answer may be obvious to you, but when money gets tight due to some unforeseen life event you will be glad that you have a tangible picture for its ultimate use.
Visualize what you are going to do with that money. Is it for a retirement full of adventure? Is it for buying that dream sailboat that you’ll take around the world? Or, is it simply to preserve your lifestyle once you retire? Money has no intrinsic value if you don’t spend it on things that matter to you and your family.
“Money cannot buy peace of mind.
It cannot heal ruptured relationships, or build meaning into a life that has none.”
— Richard M. DeVos, Billionaire Co-founder of Amway, Owner of Orlando Magic
So, if starting with the end in mind makes sense to you, let’s take a look at the four counter-intuitive steps that you can take now to make your 401(k) work for you. Figure 1 lays it all out.
Step 1: Define what matters to you and inventory your resources
Visualize your goals and objectives for the type of life you and your family want to lead. Don’t just think about your retirement – think as broadly as possible.
Close your eyes, visualize, pour a nice glass of cabernet for you and your partner before you have the “talk”, write it down in your journal – whatever approach gets you out of your everyday busy persona and makes you focus on what you really want out of life.
How do you want to use your money to accomplish this lifestyle?
Maybe you and your spouse want to engage in missionary work in 10 years. Maybe you also need to fund college expenses for your children? Maybe you see a lakefront house in the near future? There is no cookie cutter approach when it comes to people’s dreams! It’s up to you to make them up.
Your house, your emergency fund, investments in mutual funds, possibly a little inheritance, company stock. Almost forgot, your spouse’s 401(k) and that condo that he/she bought before you met. Take a comprehensive inventory of your assets.
How much debt do you have? That is part of your financial picture as well. Do you anticipate paying your mortgage off in the next few years?
Wealth managers talk about a concept called the household balance sheet. It’s the same idea that financial analysts use when evaluating a company. In the corporate world you have assets, liabilities and the difference is net worth. In your own world you have assets, obligations and unfunded goals, and net worth is the difference.
Sounds a bit harsh when it involves you, right? Don’t take it personally. The key idea is taking an inventory of what you own, what you owe and then matching that up to your goals and aspirations.
Step 2. How aggressive do you need to be while being able to sleep at night
The whole idea of saving and investing is about making your goals and aspirations a reality. If you already have enough assets to fund your desired lifestyle into perpetuity then you don’t really have to worry too much about investing. Just preserve what you got!
If you are like most people, you need to make your investments work for you. You need a return on your assets.
It’s a good idea to be realistic about goals and objectives. Are your goals reachable? Is there only a tiny probability of reaching them?
Are your goals a stretch, reachable with some effort, or a slam dunk?
Your answer will dictate how aggressive you will need to be in your investment strategy.
If your goals are a stretch you need high return/high risk investments – be ready for a volatile ride and many highs and lows
If your goals are within reach using conservative asset class return assumptions you need a moderate return/moderate risk portfolio – you will still experience fluctuations in your portfolio that will leave you feeling anxious at times, but the periods of recovery will more than make up for the periods of stress
If your goals are a slam dunk, you are lucky and you will only need low return/safe investment strategies – your portfolio values will not fluctuate much in the short-term but your portfolio will also not grow much in size
To some extent this is the easy part. There is a link between risk and return in the capital markets. Higher risk usually translates over long periods of time into higher returns. Equities do better on average than bonds and bonds in turn do better than money market investments. So far so good.
Figuring out the required rate of return to fund your goals and objectives given your resources involves math but little emotional contribution.
But what about your emotions?
This is the tricky part. Many people are able to conceptualize risk in their heads, but are entirely unable to deal with their emotions when they start losing money.
They think of themselves as risk takers but can’t stand losing money. They panic every time the stock market takes a dip. It does not matter why the market is tanking – they do not like it and run for the exits.
Let’s examine a simple situation where we classify your need and comfort level with investment risk in three states: low, medium and high.
Figure 2 lays out all the possibilities. Ideally, your two dimensions of risk will match up directly. For example, if your need for risk is low and your comfort level with taking risk is low you are all set. Same if you need a high risk/high return strategy to meet your goals and objectives and you are comfortable experiencing significant fluctuations in your portfolio.
The real problem for you is, however, when the two dimensions of risk are not aligned. You’ll need to resolve these differences as soon as possible to regain any hope of financial health.
Let’s say you are really risk averse. You fear losing money. Your worst case scenarios (bag lady, eating cat food) keep popping up in your nightmares. If your goals and objectives are ambitious in relation to your resources (high need for risk) those nightmares will not go away and you will live in fear.
You can do one of two things – learn to live with fear or, scale back your goals and objectives. There is no right or wrong answer – it’s up to you but you must choose.
What if you are comfortable taking on lots of investment risk? Would you like a low risk/low return portfolio? Probably not. In fact, such a portfolio would probably drive you crazy even if you did not need any higher returns.
People comfortable with investment risk frequently suffer from fear of missing out (FOMO). They think that they should be doing better. They want to push the envelope whether they need to or not.
FOMO is as damaging of an emotion as living in fear. Both states spell trouble. You will need to align both dimensions of risk to truly get that balance in your financial life.
Step 3. Determine the asset allocation consistent with your goals and risk preferences
Sounds like a mouthful, right? Let’s put it in plain English. First of all, the term asset allocation simply refers to how much of your investment portfolio you are putting into the main asset classes of stocks, bonds and cash/bills.
Sure, we can get more complicated than that. In our own research we use ten asset classes, but in reality breaking up the global equity and bond markets into finer breakouts is important but not critical for the average individual investor.
Figuring out the right range of stocks, bonds and cash is much more important than figuring out whether growth will outperform value or whether to include an allocation to real estate trusts. Do the micro fine tuning later once you have figured out your big picture asset allocation.
All right, since we are keeping things simple let’s look at some possible stock/bond/cash allocations. We are going to use information from our IFS article on risk and return. As a reminder the data used in these illustrations comes courtesy of Professor Aswath Domodaran from NYU and covers US annual asset returns from 1928 to 2017.
The top half of the table shows the performance and volatility of stocks, bonds and cash/bills by themselves. From year to year there is tremendous variability in returns but for the sake of simplicity you can use historical risk and returns statistics as a rough guide.
Here is what you should note:
If you need high risk/high portfolio returns and you can take the volatility go with a stock portfolio with average historical returns of 12%. On a cumulative basis nothing comes close to stocks in terms of wealth creation but you should expect a bumpy ride
If you only need low risk/low returns and you are extremely risk averse go with cash/bill type of portfolios returning, on average, 3%. This portfolio is probably just going to keep up with inflation
If you have a medium tolerance for risk and medium need for taking risk then you will likely gravitate toward a combination of stocks, bonds and cash
There is an infinite number of combinations of asset class weights – the three asset allocations in the bottom panel of Table 1 may very well apply to you depending on your risk tolerance, need for return and time horizon
What about the stock/bond/cash mixes?
The 60% stock/40% bond allocation has over this 1928-2017 period yielded a 9% return with a 12% volatility. Historically, you lost money in 21% of years but if you are a long-term investor the growth of this portfolio will vastly outstrip inflation
The 40% stock/60% bond portfolio is a bit less risky and also has lower average yields. When a loss occurs, the average percentage loss is 5%. This portfolio may appeal to a conservative investor that does not like roller coaster rides in his/her investment accounts and does not need the highest returns.
The 25% stock/50% bond/25% cash portfolio is the lowest risk/return asset class mix among our choices. Historically this portfolio yields an average return of 6% with a volatility also of 6%. This portfolio may appeal to you if you are naturally risk averse and have a low tolerance for portfolio losses, but you might want to also check whether these returns are sufficient to fund your desired goals and objectives
Step 4. It’s finally time to pick your funds
Yes, this is typically where people start. Many times people pick a bunch of funds based on a friend’s recommendation or simply based on the brand of the investment manager. Rarely do people dig deep and evaluate the track record of funds.
A lot of people pick their funds and declare victory. They are making a huge mistake. They are not framing the problem correctly.
The problem is all about how to make your 401(k) work for you in the context of your goals and objectives, your resources and your comfort with investment fluctuations.
Picking funds is the least important part. You still have to do it but first figure out what matters to you, your need and comfort with risk and your target stock, bond, cash mix.
Once you have your target asset allocation go to work and research your fund options. Easier said than done, right?
Here are some fund features that you should focus on:
Passive or Active Management – a passive fund holds securities in the same proportions as well-known indices such as the S&P 500 or Russell 2000. An active fund is deliberately structured to be different from an index in the hope of achieving typically higher returns
Fund Style – usual distinctions for equity funds are market capitalization, value, volatility, momentum and geographic focus (US, international, emerging markets). For bond funds the biggest style distinctions are maturity, credit and geographic focus
Risk Profile – loosely defined as how closely the fund tracks its primary asset class. Funds with high relative levels of risk will behave differently from their primary asset class. Accessing a free resource such as Morningstar to study the basic profile of your funds is a great starting point. For a sample of such a report click here
Fund expenses – these are the all in costs of your fund choices. Lower costs can translate into significant savings especially over long periods of time. In general, index funds tend to be lower cost than actively managed funds
Understanding what makes a good fund choice versus a sub-optimal one is beyond the financial literacy and attention span of most plan participants.
For most people a good rule of thumb to use is to allocate to at least two funds in each target asset class.
Let’s make this more concrete. Say your target asset allocation is 60% stocks and 40% bonds. Most 401(k) plans have a number of stock and bond funds available.
What should you do? A minimalist approach might entail choosing an S&P 500 index fund and an actively managed emerging market equity fund placing 30% in each. This maybe appear a bit risky to some so maybe you only put 10% in the emerging market fund and 20% in a US small capitalization fund.
Same on the bond side where you might allocate 20% to an active index fund tracking the Bloomberg US Aggregate index and 20% in a high yield actively managed option.
Let your fund research dictate your choice of funds. You should keep things simple.
Know what funds you own and why. Keep your fund holdings in line with your asset allocation. Spreading your money into a large number of fund options does not buy you much beyond unneeded complexity.
Picking funds that closely match the risk and return characteristics of your asset classes (say stocks and bonds) is good enough.
Trying to micro-manage the selection of funds will not likely lead to a huge difference in overall portfolio returns.
The task facing you in managing your 401(k) may seem daunting at times. You may feel out of your own depth.
You are not alone but if you reverse the usual way in which most participants manage their 401(k)’s you should gain greater control over your long-term financial health.
Start with the end in mind. What is this money for? Think about your life goals and objectives. Depending on your resources, you will need to figure what type of risk/return portfolio combination you will need as well as how comfortable you are dealing with the inevitable investment fluctuations.
Lastly, keep it simple when choosing your funds. You have figured out the important stuff already. Pick at least a couple of funds in each of your target asset classes by performing some high level research from sites such as Morningstar and MarketWatch.
Keep in mind that more funds do not translate into higher levels of diversification if they are all alike. Know what you own and why.
If this is all just too much for you, consider hiring Insight Financial Strategists to review your 401(k) investment allocations. We will perform a comprehensive analysis of your asset allocation and fund choices in relation to your stated goals and objectives while also keeping your expressed risk preferences in mind.
The analysis will set your mind at ease and make your 401(k) work for you in the most effective manner. We are a fee based fiduciary advisor, which means we are obligated to act solely in your best interest when making investment recommendations.
In general, when IRA aggregation is permissible for distribution purposes, all the Traditional IRAs, SEP IRAs, and SIMPLE IRAs of an individual are treated as one traditional IRA. Similarly, all of an individual’s Roth IRAs are treated as a single Roth IRA.
IRA Aggregation does not apply to the return of excess IRA contributions
The IRA contribution limit for individuals is based on earned income. Individuals under 50 years of age can contribute up to $5,500 a year of earned income. Those older than 50 years of age are allowed an additional catch up contribution of $1,000. The contribution limit is a joint limit that applies to the combination of Traditional and Roth IRAs.
When the IRA contribution happens to be in excess of the $5,500 or the $6,500 limit (for people over 50), the excess contributions, including net attributable income (NIA), ie the growth generated by the excess contribution, must be returned before the IRA owner’s tax filing due date, or extended tax filing due date. Those who file their returns before the due date receive an automatic six-month extension to correct the excess contributions.
Mandatory aggregation applies to the application of bases for Traditional IRAs
Contributions to Traditional IRAs are usually pre-tax. Thus, distributions from IRAs are taxable as income. In addition, distributions prior to 59.5 years of age are also subject to a 10% penalty.
After-tax contributions to an IRA, but not the earnings thereof, may be distributed prior to 59 ½ years of age without the customary 10% penalty. Distributions from an IRA that contains after-tax contributions are usually prorated to include a proportionate amount of after-tax basis (amount contributed) and pre-tax balance (pro rata rule).
Suppose that Janice has contributed $700 to a non-deductible Traditional IRA, and it has grown to $1,400. If Janice takes a distribution of $500, one half of the distribution is returnable on a non-taxable basis, and the other half is taxable and subject to the 10% penalty if Janice happens to be under 59½ years of age. You can see why Janice would want to keep accurate records of her transaction in order to document the taxable and non-taxable portions of her IRA.
Limited aggregation applies for inherited Traditional IRAs
In practice, it means that if Johnny inherited two IRAs from his Mom and another from his Dad, Johnny must take the Required Minimum Distributions for his Mom’s two IRAs separately from his Dad’s, and also separately from his own IRAs.
Furthermore, IRAs inherited from different people must also be kept separate from one another. They can only be aggregated if they are inherited from the same person. In addition, inheriting an IRA with basis must be reported to the IRS for each person.
Mandatory aggregation applies to qualified Roth IRA distributions
Qualified distributions from Roth IRAs are tax-free. In addition, the 10% early distribution penalty does not apply to qualified distributions from Roth IRAs.
Roth IRA distributions are qualified if:
– they are taken at least five years after the individual’s first Roth IRA is funded;
– no more than $10,000 is taken for a qualified first time home purchase;
– the IRA owner is disabled at the time of distribution;
– the distribution is made from an inherited Roth IRA; or
– the IRA owner is 59½ or older at the time of the distribution.
If Dawn has two Roth IRAs, she must consider both of them when she takes a distribution. For instance, if Dawn takes a distribution for a first time home purchase, she can only take a total $10,000 from her two Roth IRAs
Optional aggregation applies to required minimum distributions
The RMD for each IRA must be calculated separately; however, the owner can choose whether to take the aggregate distribution from one or more of his Traditional, SEP or SIMPLE IRAs.
So, if Mike has a Traditional, a SIMPLE and a SEP IRA, he would calculate the RMD for each of the accounts separately. He could then take the RMD from one, two or three accounts in the proportions that make sense for him.
As a reminder, Roth IRA owners are not subject to RMDs.
Limited aggregation applies to Inherited IRAs
Beneficiaries must take RMDs from the Traditional and Roth IRAs that they inherit with the exception of spouse beneficiaries that elect to treat an inherited IRA as their own.
With this latter exception, RMD rules apply as if the spouse was the original owner of the IRA.
When a beneficiary inherits multiple Traditional IRAs from one person, he or she can choose to aggregate the RMD for those inherited IRAs and take it from one or more of the inherited Traditional IRAs. The same aggregation rule applies to Roth IRAs that are inherited from the same person.
Suppose again that Johnny has inherited two IRAs from his Mom and one from his Dad. Johnny can calculate the RMDs for the two IRAs inherited from his Mom, and take it from just one. Johnny must calculate the RMD from the IRA inherited from his Dad separately, and take it from that IRA.
If in addition, Johnny has inherited an IRA from his wife, he may aggregate that IRA with his own.
If an IRA distribution is rolled over to the same type of IRA from which the distribution was made within 60 days, that distribution is excluded from income.
Such a rollover can be done only once during a 12-month period.
In this kind of situation, all IRAs regardless of types (Roth and non-Roth) must be aggregated. For instance, if an individual rolls over a Traditional IRA to another Traditional IRA, no other IRA to IRA (Roth or non-Roth) rollover is permitted for the next 12 months.
Conclusion: What you should keep in mind
These are some of the more common IRA aggregation rules. There are others including rules for substantially equal periodic payments programs (an exception to the 10% early distribution penalty), and those that apply to Roth IRAs when the owner is not eligible for a qualified distribution.
Lastly, many of the potential problems that people may face with IRA aggregation can be avoided with proper documentation. Recordkeeping is essential. Individuals can do it themselves or they can rely on their Wealth Managers. In the case where you have to change financial professionals, make sure that you have documented the history of your IRAs.
When working year taxes are lower than projected tax rates in retirement, it usually makes sense to contribute to a Roth account . In this situation, paying taxes upfront results in lower projected lifetime taxes. For instance, assuming that Vanessa is in the 24% tax bracket, she will need to earn $7,236 to make a $5,500 contribution to a Roth IRA. That is because, she will owe federal taxes of $1,736 on her earnings (not counting state taxes where applicable), leaving her with $5,500 to contribute. However, Vanessa’s distributions in retirement would be tax free. If her marginal tax rate in retirement is greater than 24%, she would have saved on her distributions.
When working year tax rates are higher than projected tax rates in retirement, it usually makes sense to contribute to a Traditional IRA or Traditional 401(k) . Contributing to a Traditional account in that situation generally results in a reduction in taxes in the year of contribution; taxes will be due when the assets are withdrawn from the account, hopefully in retirement. For instance, If Vanessa contributes $5,500 to a Traditional IRA can result in a reduction in taxable income of $5,500. If she is in the 24% federal income tax bracket, Vanessa would save $1,320 in federal income taxes (not counting potential applicable state income taxes). If Vanessa is in the 12% marginal federal tax bracket in retirement, when she takes $5,500 in distribution, she would then owe federal income taxes of $660.
The new Tax law, aka the Tax Cut and Jobs Act or TCJA, passed in December 2017, comes with a number of features, including a permanent reduction in corporate taxes. Most important for individuals and families, it significantly reduces individual tax brackets starting in 2018.
In practice this will result in a large tax hike in 2026 for many individuals and families. For instance if Susanna and Kevin make $150,000 and file “Married Filing Jointly”, they might be in the 22% marginal tax bracket in 2018. With the same income in 2026, Susanna and Kevin would be in the 25% marginal tax bracket. Of course, there are several other factors that will impact their final tax bill, but most people in that situation will stare at a higher tax bill.
Susanna and Kevin could also take advantage of the temporary nature of the TCJA tax cuts to convert some of their traditional tax deferred retirement accounts to Roth accounts. In so doing, they would take distributions from the Traditional account, transfer to the Roth, and pay income taxes on the conversion. This way Susanna and Kevin would create themselves a source of tax free income in retirement, that could help them stay in their tax bracket and partially insulate them from future tax increases.
Now is the time to take steps to manage your taxes
Because Roth conversions increase current taxable income, many people will find them a limited possibility as only so much funds can be converted without jumping into the next tax bracket. However, working people can also think in terms of changing their current contributions from Traditional 401(k)s to Roth 401(k)s. That would have the similar impact of increasing current taxable income and income tax due for the benefit of creating a reserve of future tax free assets.
Consider changing from a Traditional 401(k) to a Roth 401(k)
Of course, it is not always clear where Susanna’s and Kevin’s taxable income would come from in retirement. That is because their sources of income will likely change significantly. While they would no longer earn income, they may then have social security income, pension income, and retirement plan income which are all taxed as ordinary income. They may also take income from other assets with different tax characteristics, such as savings or investments. That might make the projection of their taxable income more difficult.
It is possible that Susanna and Kevin’s income needs will influence the tax characteristics of their income when they retire in 2026 or later; that may place them in a different tax bracket altogether. For instance Wealth Managers routinely advise clients to postpone Social Security income as late as they can, preferably until 70 in order to maximize lifetime social security income. When that happens it is possible that income between retirement and 70 could come from other sources, such as investments. When that happens taxable income could be significantly lower as investments are usually taxed at a lower capital gains rate.
This may sound self serving, but I’ll write it anyway: the best way to know what Susanna and Kevin’s income would look like in retirement, and how it might be taxed, is for them to check in with a skilled Certified Financial Planner. Otherwise they would just be guessing.
Considering a Roth Conversion in Retirement
So what about people who are already retired? The situation is similar. Take David and Emily, a retired couple with social security income, state pension income, and retirement plan income. From 2018 to 2025, their $100,000 taxable income places them in the marginal 22% federal tax bracket. With the same income in 2026, they would end up in the 25% tax bracket. Through no fault of their own David and Emily will see their income tax increase in 2026.
One of the ways that David and Emily can fight that is to convert some of their Traditional retirement accounts to Roth between 2018 and 2025, pay the income taxes on the additional income, and then use distributions from the Roth when their taxes go up in 2026 to stay within their desired tax bracket. In this way, David and Emily could potentially reduce their overall taxes over the long term.
The key challenge for retirement contributors would be to calibrate the right amount of Roth conversion or Roth contributions so as to minimize current and overall taxes owed.
Because each situation will be different, it will pay to check with a Certified Financial Planner to estimate future income and tax rates, and to plan a strategy that will maximize your financial well being.
Check out our other posts on Retirement Accounts issues:
Note 1: this post makes assumptions regarding potential individual tax situations. It simplifies the many factors that enter into tax calculations. It omits many of the rules that are applicable to Roth accounts and Roth conversions. It also assumes that the TCJA will be unchanged. None of these assumptions may be correct. Please check with the relevant professionals for your individual situation.
Note 2: Insight Financial Strategists LLC does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Insight Financial Strategists LLC cannot guarantee that the information herein is accurate, complete, or timely, and makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.