Just two weeks ago the consensus was that we were going to experience a continuation of the bull market at least into the early part of this year. This is still our view. Although the stock market is a leading indicator, at this time this correction does not appear to be a recession driven correction.
Is 2018 the Year of the Roth 401(k) or the Roth IRA?
Much of the emphasis of the Tax Cuts and Jobs Act(TCJA) passed in December 2017 affected individual income taxes. However, there are also impacts on investment strategies.
From an individual standpoint, the primary feature of the TCJA is a reduction in income tax rates. Except for the lowest rate of 10% all other tax brackets go down starting with the top rate which drops from 39.6% to 37%.
Table 1: 2018 Tax Rates for Married Filing Jointly and Surviving Spouses
However, in general, it is safe to say that most people will see a reduction in their federal income taxes in 2018. Of course, this may prompt a review of many of the decisions investors make with taxes in mind.
Most people are pretty excited to see their taxes go down this year! However, the long-term consequences of the tax decrease should be considered. While the TCJA was passed with the theory that it would stimulate growth such that tax revenues would grow enough to make up for the increased deficit created in the short term by tax cuts, few serious people believe that. The most likely result is that we will experience a small boost in growth in the short term and that federal deficits and the National Debt will seriously increase thereafter.
In the opinion of the non-partisan Committee for a Responsible Federal Budget, not even the expectation of additional short-term growth is enough to temper the seemingly irresistible growth in the federal debt.
Increased deficits will make it more difficult to fund our national priorities, whether it is defense, social security, healthcare, or investment in our national infrastructure. Therefore, I expect that we will initiate another tax discussion in a few years, most likely resulting in tax increases, in addition to the automatic tax increases that are embedded in the TCJA.
With federal income tax rates down in 2018 and our expectation that individual taxes will start increasing after 2018, now may be the time to consider a Roth instead of a Traditional account. The consideration of current and future tax rates remains the same. It just so happens that with lower tax rates in the current year, it becomes marginally more attractive to consider the Roth instead.
Consider the case of Lisa, a married pharma executive, making $225,000. This places her in the 24% federal tax bracket. In 2018, her $10,000 Traditional 401(k) contribution reduces her income taxes by $2,400. In 2017, Lisa would have been in the 28% tax bracket. Her $10,000 Traditional 401(k) contribution would have resulted in a $2,800 reduction in income taxes. Hence, Lisa’s tax savings in 2018 from contributing to his 401(k) goes down by $400 compared to 2017.
Table 2: Tax savings on a 401(k) contribution with $180,000 taxable income
From a tax standpoint, contributing to a Traditional 401(k) is still attractive, just a little less so. To optimize her lifetime tax liabilities, Lisa may consider adding to a Roth 401(k) instead, trading her current tax savings for future tax savings. If Lisa were to direct the entire $10,000 to the Roth 401(k), her 2018 income taxes would increase by $2,400 compared with 2017. Why would Lisa do that? If she expects future income tax rates to go back up, she could save overall lifetime taxes. It may be an attractive diversification of her lifetime tax exposure.
For instance, suppose now that the national debt does grow out of hand and that a future Congress decides to increase tax rates to attempt to deal with the problem. Suppose that Lisa’s retirement income places her in a hypothetical future marginal federal tax rate of 30%. In that case, she will be glad to have invested in a Roth IRA in 2018 when she would have been taxed at a marginal rate of 24%: she would have saved on her lifetime income taxes.
Of course, if Lisa’s retirement marginal tax rate ends up being 20%, she would have been better off saving in her Traditional 401(k), saving with a 28% tax benefit in her working years and paying retirement income tax at 20%.
Note also that Lisa would not have to put the entire $10,000 in the 401(k). She could divide her annual retirement contribution between her Roth and her Traditional accounts, thus capturing some of the tax advantages of the Traditional account, reducing the tax bite in the current year, and preserving a bet on a future increase in income tax rates.
Another possible course of action to optimize one’s lifetime tax bill is to consider a Roth conversion. With a Roth conversion, you take money from a Traditional account, transfer it to a Roth account, and pay income taxes on the distribution in the current year. As we know, future distributions from the Roth account can be tax-free, provided certain conditions are met . A distribution from a Roth IRA is tax-free and penalty free provided that the five-year aging requirement has been satisfied and at least one of the following conditions is met: you have reached age 59½, become disabled, you make a qualified first-time home purchase, or you die. (Note: The 5-year aging requirement also applies to assets in a Roth 401(k), although the 401(k) plan’s distribution rules differ slightly; check your plan document for details.) Because tax rates are lower in 2018 for most individuals and households, it makes it marginally more attractive to do the conversion on at least part of your retirement funds.
Consider David, a single pharma marketing communications analyst. With $70,000 in taxable income, he is now in the 12% marginal federal income tax bracket, down from the 25% federal income tax bracket in 2017. He is working on his part-time MBA in 2019 and expects his income to jump substantially as a result. Additionally, David, a keen student of political economy expects his taxable retirement income to be higher than his current income and overall tax rates to go back up before he reaches retirement. David now has a sizeable Traditional IRA.
For David, the opportunity is to convert some of his Traditional IRA into a Roth IRA. To do that, David would transfer some of his Traditional IRA into a Roth IRA. He would pay income taxes on the conversion amount at his federal marginal rate of 22%. David would only convert as much as he could before creeping into the next federal tax bracket of 24%. If he feels bold, David could contribute up to the 32% federal tax bracket. Effectively this means that David would stop converting when his taxable income reaches $82,500 if he wanted to stay in the 22% tax bracket, and $157,500 if he wanted to stay in the 24% tax bracket.
In this example, if David were to convert $10,000 from his Traditional IRA to his Roth IRA, he would incur $2,200 in additional federal income taxes. If David expects to be in a higher tax bracket in retirement, he would end up saving on his lifetime income taxes.
David could combine this strategy with continuing to contribute to his Traditional 401(k), thus reducing his overall taxable income, and increasing the amount that he can convert from his IRA before he hits the next tax bracket. If he were to contribute $10,000 to his Traditional 401(k) and convert $10,000 from his Traditional IRA to a Roth IRA, you could view this as a tax neutral transaction.
Table 3: Balancing a Traditional 401(k) and a Roth Conversion
This strategy may work best for people who expect to have a reduced income in 2018. Maybe it is people who are back in graduate school, or people taking a sabbatical, or individuals who are no longer working full time while they wait to reach the age of 70 and start collecting social security at the maximum rate.
It is worth remembering that Roth accounts are not tax-free; they are merely taxed differently . That is because contributions to a Roth account are post-tax, not pre-tax as in the case of Traditional accounts. You should note that the examples in this article are simplified. They do not take into account the myriad of other financial, fiscal and other circumstances that you should consider in a tax analysis, including your State tax situation. The examples suppose future changes in taxes that may or may not happen.
Eliminating the deductibility of alimony payments from taxable income is one of the features of the Republican House Tax Reform bill. It is very significant to both payors and recipients of alimony.
The Goddess Nemesis
Written into the fabric of the GOP tax proposal is a change in how alimony is taxed. People paying alimony could lose “the greatest tax deduction ever.” And that could ultimately affect those receiving alimony, too.
Since details of the new tax overhaul bill were released on Nov. 2, people of all income levels and ages have been trying to figure out how they could be affected going forward. One group of folks not likely to be happy: those paying alimony.
Section 1309 of the House bill would eliminate the deductibility of alimony. Killing the alimony deduction is one of the smaller revenue targets for the House Republican tax bill, yet it is exceedingly significant to the people affected.
Under current rules, alimony payors may deduct their payments from their taxable incomes, thus lowering their income taxes. In return, recipients pay income taxes on their alimony income. Because payors are usually in higher tax brackets and recipients in lower tax brackets, families can save money on taxes by shifting the tax burden to the lower earner. The saving can help increase cash flow for divorcing couples. They can then decide how to allocate the savings: to the payor or the recipient … or the court can do it for them.
Killing the alimony tax deduction raises only about $8 billion over 10 years
According to the House, abolishing the alimony deduction would not be a large revenue generator. By killing the alimony tax deduction, the alimony tax bill raises only about $8 billion over 10 years. That is because the tax increase on payors is offset by a tax decrease for recipients. For them, alimony income would no longer be taxable.
This wrinkle could have a significant impact on divorce settlements. For many payors, saving taxes on alimony payments is the one pain relief that comes with making the payments. According to John Fiske, a prominent mediator and family law attorney, “Alimony is the greatest tax deduction ever.” Without the deduction, payors will find it much more expensive and more difficult to agree to pay.
For example, in Massachusetts alimony payors usually pay 30% to 35% of the difference in the parties’ incomes. For a payor in the 33% federal tax bracket, the House tax bill increases the cost of alimony by nearly 50%.
The entire set of laws, guidelines and practices around alimony are based on its deductibility. Passage of the House Republican tax bill is likely to lead to a mad scramble in the states to change the laws and guidelines to adjust alimony payments downward to make up for the tax status change.
The likely net result: although recipients would no longer pay tax on alimony income, abolishing the tax deductibility of alimony is likely to reduce their incomes even further as divorce negotiations take the new, higher tax burden on payors into account.
According to a 2017researchpaper at Harvard Business School, employees who have the option to contribute to a Roth 401(k) instead of a traditional 401(k) tend to contribute the same amount to either account. Given that a Roth 401k tends to result in more money taken out of your paycheck every week or month than a traditional 401k, that’s unexpected!
Take the case of Priya, a 49-year-old single mom. She makes $135,000 a year and lives alone with her son. Not counting her employer’s match, Priya saves $350 per pay period in her traditional 401k, totaling $9,100 a year. Absent other considerations, her $9,100 contribution reduces her annual taxable income from $135,000 to $125,900. As a result, since her taxable income is less, she will pay less income taxes.
Roth 401ks and Roth IRAs are not tax-free: they are merely taxed differently
What if she would reduce her Roth contribution to keep her current cash flow constant? In that case, it is not clear that Priya’s after-tax income in retirement would be higher or lower with a Roth 401k than with a traditional 401k. Answers would require further analysis of her situation.
According to John Beshears, the lead author of theHarvard study, one possible explanation for his finding is that people are confused about the tax properties of the Roth . Another possibility could be that people have greater budget flexibility than they give themselves credit for. Either way, employees should seek additional support before making this very important decision.
A prior version of this article appeared in Kiplinger and Nasdaq.com
You probably get a regular health checkup, you get your teeth cleaned twice a year, you get a second opinion for major health issues. You may even get a second opinion when you buy a boat or a vacation home!
The second reason is the potential to obtain better guidance in adjusting the asset allocation to a more appropriate level that takes into account your own individual goals and risk tolerance. Although 401(k) plans may offer appropriate investments and some educational information about those options, 401k plan sponsors do not usually make available truly personalized advice to plan participants.
Regardless, there are mistakes that you need to avoid in the process of rolling over your 401(k). To avoid those mistakes, it is important to be able to recognize them. (Click here to receive the Top Mistakes in 401(k) Rollovers fact sheet.)
It should be noted that one reason to keep your retirement assets in your 401(k) plan is that costs are often, but not always, lower in 401(k)s. However, without an appropriate investment plan, lower costs may not bear fruit.
In general it is a good idea to get advice from a Financial Planner who is a fiduciary. You may think that your financial advisor is obligated to do what is best for you, the client. However, not all are not obligated to act in your best interest (whereas a fiduciary would be), and may advise higher fee products, or proprietary products sold by the firm he or she represents or products that do the job.
In April 2016 the Department of Labor rolled out a new regulation that is to take effect in 2017 mandating that all investment professionals working with retirement plan participants and IRA owners shall adhere to a fiduciary standard for all retirement accounts for which they provide investment advice. For purposes of the DOL rule, retirement accounts include 401(k)s, IRAs, and Roth IRAs among others. The Department of Labor estimates that the investing public would save $4 billion a year with the new fiduciary rule. As you might expect, the fiduciary rule is opposed by affected Wall Street interests that are seeking to water it down or eliminate it entirely.
The Trump administration issued an executive order on February 3, 2017 to review the rule. While the Trump administration would like to roll it back, the industry is moving ahead with implementation, potentially regardless of possible regulatory about faces. Hence the future of the rule is unclear at this time.
you always have the option to roll over to an IRA that you can manage
Of course, whether or not this regulation takes effect in 2017, you can still benefit from working with a fiduciary advisor. If the advisor you are working with is not working to a fiduciary standard – i.e., with your best interests in mind, seek out someone who is. It’s important: after all you are dealing with your money and your future standard of living in retirement.
In the current regulatory environment, fee-only Financial Planners at Registered Investment Advisor firms usually serve as fiduciaries, and are required to always act in your best interests – they must avoid conflicts of interest, and cannot steer plans and IRA owners to investments based on their own, rather than their clients’ financial interests. In contrast, brokers, insurance agents and certain other investment professionals only have a responsibility to recommend securities that are “suitable.”
Making sure that the investment professional you are working with is acting in your best interest may help you invest your retirement funds more appropriately. Note that the Securities and Exchange Commission (SEC) has not promulgated similar regulations for non-retirement investment accounts so if you are not dealing with a fiduciary advisor, you run the same risk of potentially higher costs or merely suitable investments. In fact if you have an IRA and a brokerage account with your financial advisor, he or she may end up being a fiduciary on one account and not a fiduciary on the other account. How is that for confusing?
We started the year in the middle of a correction, as the S&P500 lost 13.3% between November 4, 2015 and February 11, 2016.
However, supported by a slow but continuing economic recovery, rising corporate profits and low interest rates, 2016 ended up being a pretty good year for the financial markets with the S&P500 rising 11.96%.
Concerns over China, falling oil prices, surging junk bond yields, recession fears, the rising dollar, Brexit, a four-quarter profit recession, a contentious U.S. election, weakness in U.S. manufacturing, and eurozone banking worries all conspired against bullish sentiment during various times of the year.
While the pundits credited a solid market prior to the election to the expectation that Clinton would win, we were surprised by the reaction to Trump’s win and the consequent exuberant market rally. Most of the year’s gains happened in the fourth quarter after the election.
So what about 2017?
Trump and the Republican Congress have made many promises, some of which appear to help sustain the financial markets. In particular the move to tax reform and limit regulations will probably be implemented and is viewed very positively by the business community.
Some proposals such as rebuilding infrastructure have the Congress and Trump at odds. Historically, infrastructure has not been a strong Republican concern. It remains to be seen whether a significant bill can pass Congress.
Some other initiatives are more problematic and could have consequences that have not yet been factored in the financial markets. The move to limit legal immigration and the intent to expel millions of undocumented immigrants could have a ripple effect throughout the economy, including Silicon Valley and the agriculture industry.
Talking about altering trade patterns, starting with the elimination of the TPP and various noises about import tariffs goes counter to decades of bipartisan free trade efforts. It is not clear what the net impact of these policies, which have not yet been fully defined, will have on the economy. However, restricting free trade is not a positive.
Last but not least, Republicans have a political imperative to deal with health care. Will they show the intestinal fortitude to go through with a full repeal of Obamacare, as has been talked about? A full “repeal now and replace later” could create chaos for States, employers, insurance companies, the healthcare industry, and the public. We’ll have to wait and see to evaluate the net effect.
The financial markets are demonstrating optimism in the midst of all this political turmoil, although we don’t know if the clouds on the horizon carry rain or not. Regardless the US economy is strong and resilient; it will survive our dysfunctional politics.
This post is extracted from our January 2017 newsletter. Please write to let us know that you would like a copy
People will often feel very proprietary about their retirement accounts. They will reason that because the account is in their name only, as opposed to the house which is usually in both their names, they should be able to keep those accounts. Most of the time, this is flawed reasoning. The general rule is that assets that are accumulated during marriage are considered marital assets regardless of the titling.
However, there are cases when part of a retirement plan can be considered separate. This often depends on state law, so it is best to check with a specialist before getting your hopes up.
2. Can I Divide a Retirement Account Without Triggering Taxes?
Since there are so many different retirement accounts, the rules to divide them vary widely. Plan administrators will often recommend their own “model” QDRO. It usually makes sense to have a QDRO specialist verify that the document conforms to your interests.
In addition, that money that was set aside for retirement will no longer be there for that purpose. Although you might tell yourself that you will replace that money when you can, that rarely ever happens.
However, if you have no other choice, it so happens that divorce is one of the few exceptions to the penalty rule. A beneficiary of a QDRO (but not the original owner) can, pursuant to a divorce, take money out of a 401(k) without having to pay penalties. However, you will still have to pay income tax on your withdrawal. Note that this only applies to 401(k)s. It does not apply to IRAs.
4. How Do I Compare Retirement Accounts with Non-Retirement Accounts?
Most retirement accounts contain tax-deferred money. This means that when you get a distribution, it will be taxable as ordinary income. At the other end of the spectrum, if you have a cash account, it is usually all after-tax money. In between you may have annuity accounts where the gains are taxed as income, and the basis is not taxed; you may have a brokerage account where your gains may be taxed at long-term capital gains rate; or you may have employee Restricted Stock which is taxed as ordinary income. All of these accounts can be confusing.
In order to get an accurate comparable value of your various assets, you will want to adjust their value to make sure that it takes the built-in tax liability into account. Many divorce lawyers will use rules of thumb to equalize pre-tax and after-tax accounts. Rules of thumbs can be useful for back-of-the-envelopes calculations , but should not be used for divorce settlement calculations, as they are rarely correct.
Because these calculations are not usually within a lawyer’s skill set, many lawyers and clients will use the services of a Divorce Financial Planner to get accurate calculations that can form a solid basis for negotiation and decision making. It is usually better to know than to guess .
5. Should I Request a QDRO of My Spouse’s Defined Benefit Pension?
Another key consideration is that defined benefit plans are complex. Although they have common features, they are each different from one another, and each come with specific rules. You will be well advised to read the “plan document” or have a Divorce Financial Planner read it and let you know the key provisions.
A common provision is that the benefit for the alternate payee can only start when the plan participant starts receiving benefits and must stop when the plan participant passes away. It is all good for the plan participant. But what if as a result of that, the alternate payee ends up losing his or her pension benefits too early?
Hence a key issue of valuing defined benefit plans is that a true valuation is more than just numbers. It also involves a qualitative discussion of the value of the plan, especially for the alternate payee. Some Divorce Financial Planners can handle the valuation of interests in a defined benefit plan easily and the discussion of the plan. Others will refer you to a specialist.
Diversification is simple to understand. In the context of managing your portfolio, diversification is (simply) about investing in diverse securities so as to lower the risk of the portfolio. Ever since Nobel Prize winner Harry Markowitz wrote his seminal paper “Portfolio Selection” in 1952, finance professionals (and increasingly lay people) have understood that the true risk of an asset is its contribution to the risk of a portfolio.
Others will concentrate their portfolio on a few securities, sometimes with very unfortunate results. For instance, between September 1, 2015, until November 17, 2015, the Sequoia fund (symbol SEQUX) lost 26.3% of its value largely due to its high concentration in a single stock, Valeant (VRX). Looking at the price evolution of VRX below (source: Google), and knowing that SEQUX had more than 30% invested in VRX, it is not surprising that the mutual fund tumbled.
Price of VRX from 9/1/2015 12/31/2015
In practice, diversification is hard to implement. There are many levels of diversification. Some of them are:
by individual securities
by asset manager;
by asset class; and
Ideally, an investor will want to diversify so that the various investments are not correlated with one another, have low correlation or even have negative correlation. For instance, according to data from portfolio analytics firm Kwanti, Goldman Sachs (GS) and JP Morgan (JPM) have an 89% correlation based on monthly returns. In other words, buying GS and JPM in the same portfolio only provides a low diversification value.
diversification is about investing in diverse securities so as to lower the risk of the portfolio
Most of us end up investing in mutual funds and exchange-traded funds, not in individual securities. The same principle applies there. Having a single large cap mutual fund that tracks Standard & Poor’s 500-stock index may not be sufficient diversification.
Sure, the S&P 500 ETF provides more than one security and is, therefore, diversified. But in general, most of the securities within a single asset class will be highly correlated with one another (such as with JPM and GS). With that, you would be protecting yourself against the risk inherent in any given company in the portfolio, but not against risks inherent to the asset class or other factors.
Ideally, you would want to be diversified across asset classes, across regions of the world and across asset managers. The following jelly bean chart from Schwab demonstrates the benefits of a wide diversification program: the ranking of the assets by performance changes seemingly randomly from year to year. A fully diversified portfolio (the orange boxes in the chart) is intended to avoid the peaks and valleys of individuals asset classes while providing a more middle-of-the-road return experience.
Is your portfolio diversified? A detailed analysis from a fee-only Certified Financial Planner can give you the full scoop on your portfolio and provide suggestions to mitigate the risks that you are exposed to. Like any other sound advice, apply it now, not later.
Check out some of our other blog posts on investing:
The previous offer had come two days before their last court appearance. There was just not enough time to understand the implications of the various components of the offer and assess whether it was an equitable division of marital assets. Lindy was just too nervous to make the decision “on the steps of the courthouse”, so she said no.
No wonder divorce financial planning has risen as a specialty. Professionals dedicated to meeting the needs of divorcing individuals can help people such as Lindy and Ted understand the financial issues of divorce, negotiate settlements and recover into a financially stable post-divorce life.
In Lindy’s case, she was fortunate to be referred to a Divorce Financial Planner by a divorce coach. Divorce Financial Planners build on financial expertise often acquired by Certified Financial Planners (CFP®) or Certified Public Accountants (CPAs). They also often hold the Certified Divorce Financial Analyst (CDFA®) designation. They excel in their ability to simplify the complex financial issues of divorce so that people like Lindy and Ted can understand the consequences of their decisions and plan accordingly for their separate futures. In addition, Divorce Financial Planners bring to the table an understanding of tax issues in divorce, employee stock options, retirement plans, pension plans, Social Security, real estate and long-term financial planning.
They help assess potential outcomes of strategies such as trading home equity for ownership of retirement accounts—is that a good idea for you for the long term?
In Lindy’s case, the new offer seemed to address her needs better. Ted offered to give Lindy more of the 401(k) in exchange for keeping his pension. In addition, Ted offered more alimony.
However, Ted’s offer was still not clear about his employee stock options, as he did not know how to value them. In addition, the offer did not address the issue of college funding for their 13 year old daughter.
Lindy’s Divorce Financial Planner carefully reviewed the settlement offer in light of her individual circumstances, explained the various issues and made recommendations for her lawyer. After some more negotiations, Lindy and Ted were able to come to an agreement and avoid a costly trial. Even Lindy’s lawyer was happy with the process , as it helped him to focus on his area of expertise: writing the agreement and managing the legal process.
A previous version of this post was published in Kiplinger