Tag Archives for " 401(k) "

Nov 17

What’s The Best Retirement Plan for Business Owners?

By Jason Berube | Retirement Planning

What's The Best Retirement Plan for Business Owners?

What's the best retirement plan for business ownersWhat is the absolute LAST thing on the minds of most people when they start their own business?

Retirement planning!

If you own a small business or if you are self-employed, you may realize that your options are somewhat limited. You don’t have the convenience of an employer providing a retirement plan for you. It’s up to you to find a solution that suits your needs.

But don’t worry! Instead, consider these two solid retirement options for self-employed people: the Solo 401(k) plan and the “Mega” IRA, aka SEP-IRA.

But which one is best for you? Let’s look at the key differences between the two.

1. Maximum Allowable Contribution

Both options allow a maximum annual total contribution of $58,000 in 2021. But there are different restrictions on how you may contribute to each.

In 2020, the IRS limits your personal solo 401(k) contributions to $19,500. It also allows your business to make an employer contribution of up to 25% of your earned income for the year. The total of the two contributions cannot exceed $57,000 in 2020 or $58,000 in 2021. If you are 50 years old or older, you may put an additional $6,500 “catch-up” contribution into the plan. 

Let’s say your W-2 wages in 2021 are $154,000. You could max out your employee contribution ($19,500). Your business could contribute up to an additional $38,500 (25% of your W-2 earnings). And if you’re 50 years old or older, you could put in another $6,500 as a catch-up contribution. 

SEP-IRA stands for Simplified Employee Pension. It is an inexpensive vehicle for retirement savings and tax advantages for the right business model. From a tax-break standpoint, the SEP-IRA works very much like other retirement plans, except for the contribution limits. For the tax year 2021, the SEP-IRA contribution limit is $58,000 . It must be entirely in the form of an employer contribution, as opposed to an employee contribution: either up to 25% of wages or up to 20% of net adjusted self-employment income. If you earn at least $290,000 in 2021, you could max out your contribution to your SEP-IRA.

2. Setup Deadline

The deadline to open a Solo 401(k) is December 31 . But you don’t actually have to fund it until you file your taxes. That’s good news for procrastinators! 

A SEP-IRA can be opened and funded up to the tax filing deadlines. If you’re running behind, you may also file for an extension to file for taxes. This would give you more time to open, save, and fund the account.

3. Employees

Do you plan on hiring employees someday? If so, you may want to restrict when and how they may participate in your retirement plan. 

If you have a Solo 401(k), you may need to upgrade it to a regular 401(k) when you hire eligible employees. That’s because the Solo 401(k) only allows contributions for the business owner and spouse

Unlike the Solo 401(k), you can continue your SEP-IRA if you hire employees . However, you will need to contribute on behalf of your employees to their SEP-IRA account. 

It’s exciting to open your own business and be your own boss … and it’s a lot of work. Retirement planning is so important, but it may be the last thing on your mind. 

Let us help! We can work with you to figure out your best option based on your goals and how your business is set up. 

Apr 28

8 Strategies For Financial Success

By Chris Chen CFP | Financial Planning

8 Strategies For Financial Success

8 Strategies for Financial SuccessIf you fail to plan, you plan to fail. That was the subject of a presentation I made at Sun Life Financial in Wellesley. This may sound like an old cliché, but it illustrates an essential aspect of personal finance: a financial plan is critical.

Regardless of age, marital status, or income, it is essential that you have a personal financial plan. Creating a strategy for financial success is easier than it sounds; you just need to know where to start. The eight financial management strategies below can serve as a roadmap for straightening out your finances and building a better financial future.

1. Develop a Budget

There are many reasons to create a budget. First, a budget builds the foundation for all your other financial actions . Second, it allows you to pinpoint problem areas and correct them. Third, you will learn to differentiate between your needs and your wants. Lastly, having a financial plan to cover expenses planned and laid out will give you peace of mind. Once done, be sure to stick with it!

2. Build an Emergency Fund

As part of your budget, you will also need to plan for an emergency fund. As current events remind us, we cannot anticipate the unexpected. We just know that the need for an emergency fund will come sooner or later . To cover yourself in case of an emergency (i.e., unemployment, injury, car repair, etc.), you need an emergency fund to cover three to six months of living expenses.
An emergency fund does not happen overnight. It needs to be part of your budget and financial plan. It also needs to be in a separate account, maybe a savings account. Or some in savings and some more in a CD. The bottom line is that it needs to be out of sight and out of mind so that it will be there when needed.

3. Stretch Your Dollars

Now that you know what you need and what you want, be resourceful and be strategic when you spend on what you want. For instance, re-evaluate your daily Dunkin Donuts or Starbucks habit, if you have one. Can it be weekly instead of daily? If you eat out for lunch every day, could you pack lunch some days? Do you need a full cable subscription?

4. Differentiate between Good Debt and Bad Debt

It is important to remember that not all debt is created equal. There is a significant distinction between good debt and bad debt. Good debt, such as a mortgage, typically comes with a low-interest rate, tax benefits, and supports an investment that grows in value. Bad debt, such as credit card debt, will burden you with high-interest rates, no tax benefits, and no hope for appreciation. Bad debt will actually reduce your standard of living. When looking at your financial plan, you want to make sure that you are keeping bad debts to a minimum. Now that I think of it, don’t keep bad debt to a minimum: make it go away.

5. Repay Your Debts

One of the most important steps to a successful financial plan is paying back your debts, especially the bad ones. Because debt will only increase if you do not actively work to pay it off. You should include a significant amount of money for debt repayment in your budget.
The fact is that paying off debt is a drag, and sometimes it is difficult to see the end of the tunnel. One way to accelerate the process of paying debt down is to pay strategically . When you pay more than your minimum payments, don’t spread it around all your debts. Concentrate your over-payment on a single debt, the one that’s closest to being paid off. It will make that payment go away faster. And when it’s gone, you can direct the liberated cash flow to the next one, and so on.

6. Know Your Credit Score

A high credit score will make it easier to get loans and credit cards with much more attractive interest rates . In turn, this will mean less money spent on interest payments and more money in your pocket. Take advantage of the free credit report that the credit companies must provide you free of charge annually. Make sure that there is no mistake in it.

7. Pay Yourself First

Set aside a portion of your paycheck each month to “pay yourself first” and invest in a savings or retirement account. Take advantage of the tax deferral option that comes with many retirement plans, such as 401(k) or IRAs. If you have just completed your budget, and you don’t know how to do it all, tax-deferred retirement accounts help you reduce taxes now . Also, think of the matching funds that many employers offer to contribute to your 401(k). They are actually part of your compensation. Don’t leave the match. Take it.
In my line of work, people often tell me that they will never retire. The reality is that everyone will retire someday. It is up to you to make sure that you have financial strategies for successful retirement.

8. Check Your Insurance Plans

Lastly, review your insurance coverage. Meet with your Certified Financial Planner professional and make sure that your policies match the goals in your financial plan. Insurance is a form of emergency fund planning . At times, you will have events that a regular emergency fund won’t be able to cover. Then you will be happy to have property or health or disability or long term care or even life insurance. 

If you have any questions or require additional assistance, contact a Certified Financial Planner. He or she can help you identify your goals and create a financial plan to meet them successfully.

Starting your financial plan is the easy step. The hard part is implementing and moving to the next step. Don’t do it alone, and let me know if I can help.

 

 

Jul 16

Do You Have To Pay Taxes in Retirement?

By Chris Chen CFP | Financial Planning , Retirement Planning , Tax Planning

Do You Have To Pay Taxes in Retirement?

Many people mistakenly look forward to not having to pay income taxes in retirement. It is understandable that after a lifetime of paying taxes, retirees would feel that they deserve a break. 

Unfortunately, that is not generally how income taxes work! In this article, I categorize nine sources of income and their corresponding level of taxes. 

It may seem at times that taxes are hitting us from all directions.  However, a variety of tax rules can also give retirees, or ideally pre-retirees, opportunities to plan such that they can optimize their lifetime taxes, and avoid paying more than their fair share .

Social Security

For those filing as single with income below $25,000, or married filing jointly with income below $32,000, social security income is income tax-free. However, single filer retirees with income up to $34,000 or $44,000 for married filing jointly will find that 50% of their social security becomes taxable.  When income increases over $34,000, or $44,000 for married filing jointly then 85% becomes taxable. 

So while it is correct that a portion of their social security income will be income tax-free, many retirees find that they will pay some taxes on their social security income

Retirement Accounts

Retirement accounts such as 401(k), 403(b), and IRAs are an important source of income for retirees.  Income from these accounts is taxed as ordinary income, as if it was being earned in a job, with tax rates ranging from 10% to 37% at the federal level. That is because the initial contribution to those accounts helped to reduce taxable income at the time.  That means that the money in these retirement accounts was never taxed. 

To complicate the matter, distributions from some accounts may be exempt from State taxes. For instance, 403(b) accounts earned in New Jersey are exempt from New Jersey State income taxes at distribution. Similarly, IRA distributions from accounts that were established by Massachusetts taxpayers are exempt from State income taxes. These peculiarities vary from State to State. It’s important to verify how they may apply in your State rather than making an assumption.  

Pensions

Many retirees still receive pension income. Some of the more common ones include state, federal and military pensions. Although private pensions have been in decline for several decades now, there continue to be many people who receive payments from these pensions.

Retirees are often surprised to find that their pension income is taxable as ordinary income at the federal level, just as other retirement account income. As with other retirement income sources, there may be exceptions for state taxes that vary from state to state and pension to pension.

Roth Accounts

Income from Roth accounts is not taxed in retirement.  That is because the initial contribution came from after-tax money. In other words, the income used to make the contribution was taxed on the full amount before the contribution was made. I like to say that “Roth accounts are not tax-free, they are just taxed differently“.

A key benefit of Roth accounts is that their distributions do not count toward high-income surcharges for Medicare Part B and Part D premiums. 

Retirees find that Roth accounts can be tremendously useful to optimize taxes in retirement by strategically combining income from Roth accounts with income from taxable accounts .

As a result, effective retirement planning should include considering saving in Traditional vs Roth accounts and strategically converting Traditional to Roth accounts, when appropriate.

Before jumping into making a Roth conversion, it is important to understand that the point of a Roth account contribution should not be to avoid taxes in retirement per se.  Instead, it should be to reduce lifetime taxes . It is possible that a badly timed Roth contribution would increase lifetime taxes, while also reducing retirement income taxes. A strategic plan is important to think through and implement. 

Municipal Bonds

Income received from municipal bonds is federal tax-free.  Like a Roth contribution, an investment in municipal bonds is made with after-tax money. If you own municipal bonds from the state of your residence, the interest is also state tax-free. However, if you own municipal bonds from states other than your residence, their interest is usually taxable at the state level.

People also wonder what happens when they sell their municipal bonds.  When that happens, the price of the bond can be higher or lower than the face value, known as a premium or a discount. When the price is at a premium, the difference between the premium and the face value can be taxed. That can often be an impediment to a sale as people don’t want to be taxed.  

Investments

When held for one year or longer, investments outside of retirement accounts are subject to long term capital gains taxes. They can range from 0% to 23.8%, including potential Medicare surcharges.  In 2019, for a married couple filing jointly with taxable income up to $78,750, long term capital gains are taxed at 0% federally ($39,375 for people filing as single).

Therefore investments can potentially be taxed less than other sources of income such as retirement accounts. Balancing distributions from investments in conjunction with Traditional retirement and Roth accounts can be a valuable tax optimization tool.

For people preparing to retire, it may make sense to divert investments from retirement accounts to brokerage accounts . Since taxes cannot be entirely avoided, it is about creating a strategy that optimizes investment vehicles to reduce lifetime taxes.

Annuities

Any income from annuities held inside qualified retirement accounts such as an IRA will be taxable as ordinary income in its entirety.

Income from annuities that are not held in qualified retirement accounts is partially taxable as ordinary income. The amount of the distribution that represents your original investment is considered tax-free. 

Therefore, the taxation of annuity income falls somewhat below that the taxation of income from retirement accounts. 

Life Insurance

Loans from the cash value of an insurance policy are considered tax free. That is because, as any loans, they are not considered income. That is a critical point made at the time that an insurance sale occurs.  It should be noted, however, that life insurance is an instance when the tax issues are so prevalent in the discussion that they obscure the other costs of cash value life insurance. The loan from the policy is tax-free, but that in an of itself does not necessarily make life insurance cost-effective or appropriate for your needs.

Earned Income

Income earned in retirement is taxed as any other earned income before retirement. Some retirees continue to earn work income, from part-time jobs or from consulting gigs for example. That income is taxed as earned income as if they were not retired, including Social Security and Medicare. Unfortunately, there is no tax break for working in retirement!

The reality for most of us is that we will owe taxes in retirement. The multiplication of tax situations can make planning difficult for a retiree.

The challenge is to plan our income situation strategically, manipulate it if you will, in order to minimize lifetime taxes. 

Fortunately, wealth planning done properly is a very feasible endeavor that  may help you keep more of what you earned in your pockets!

May 15

5 Symptoms of “Fake” Portfolio Diversification

By Eric Weigel | Investment Planning , Portfolio Construction , Risk Management

5 Symptoms of “Fake” Portfolio Diversification

Photo by Alex Holyoake on Unsplash

What You Need To Do Immediately Diversification is one of the core concepts of investment management yet it is also one of the least understood .

In many ways diversification is like apple pie and motherhood – good for you and always taken at face value without any real introspection.

Investors throw out lots of platitudes about their portfolios being diversified.  Financial literature often contains allusions to diversification but do Main Street people really understand this important concept?

Understanding the portfolio diversification concept is not an academic nicety. Proper diversification is crucial for growing your wealth and managing through the inevitable ups and downs of financial markets .

Think of portfolio diversification benefits in the same way you think about insurance on your house. When nothing bad happens you go on and maybe for a second you think about whether you really need this form of protection.

But when something bad happens like a stock market crash or a tree falls on your garage, you do not even think for a nano second as to what you paid for the protection.  Whatever the price was, it was well worth it!

The portfolio diversification concept is, however, different from typical insurance in some important ways.  When you buy insurance on your house you have a contract regarding the conditions under which the insurer will pay, how much, and importantly a maximum out of pocket deductible.

With portfolio diversification there is no such contract and especially there is no set deductible capping your losses.  When somebody says “my portfolio is diversified” it can mean a million things .  But does it mean what you think it does?

The devil is always in the details, right?  You may think that your portfolio is diversified because nothing bad has happened yet. Or, you may think that your portfolio is diversified because your advisor said so. Who knows?

Or maybe you read a mutual fund advertisement stating that the fund you own has investments in a large number of industries.  Sometimes people think sprinkling their money across a large number of funds with different names means that they are diversified .

Why the confusion? Without getting too technical, diversification can mean a whole lot of different things depending on the context.

Properly understanding the context and what diversification means is difficult for non-financial people to wrap their hands around.  And that is a big problem and why investors often fail to capitalize on what Nobel Prize winner Harry Markowitz once called the only free lunch in financial markets .

When typical investors hear the word diversification they think protection against portfolio losses. If you are diversified, your losses will be less than if you are not diversified, right? During a stock market meltdown such as 2008 your diversified portfolio should do ok, right?

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Should you just assume that you are diversified?

Probably not. Remember the old saying – assume makes an a** out of you and me!  Better be safe than sorry when it comes to your financial health.

Let’s start with some basics. Very simply put, diversification means that you are not exposed to any one investment type determining the bulk of your portfolio returns.  One investment will neither kill nor make your whole portfolio.

A diversified portfolio contains investments that behave differently. While some investments zig, others zag.  When one investment is up big, you might have another one that is down.  Your portfolio ends up in the middle somewhere.  Never as high as your best performing investment and never as low as your worst nightmare investment.

Asset classes such as bonds and stocks have very different behavior patterns. Sometimes these differences get lost in jargon such as risk and return or the efficient frontier concept.

You don’t need a PhD from MIT or Chicago to understand the concept of diversification but pay attention as the details are important.

Why do you own stocks in your portfolio? Why do you own bonds and, say, real estate? Why do you have some money stashed away in an emergency fund at the local bank?

I know these questions may  seem a bit sophomoric but knowing the “why” for each of your investments is important to understanding how well prepared you are to withstand periods of financial market stress.

Most people already know that when economic times are good, stocks will typically go up more than bonds but when there is a crisis the reverse will often occur.

The whole point of owning stocks, bonds and potentially other major asset classes as a mix is to protect your portfolio from bad things happening.

Sure we would all love to get the upside of stocks without any downside but in reality nobody has the foresight to tell us in advance (please avoid subscribing to that doom and gloom publication that just popped up in Facebook) when stocks will collapse and when they will thrive.  Anybody up to buying some snake oil?

Diversification is not necessary if you have a direct line to the capital market gods. If you are a mere mortal proper diversification is absolutely necessary to ensuring you remain financially healthy.

Spreading your bets around, mixing a variety of asset classes, hedging your bets, not putting all your eggs in one basket – whatever your favorite phrase is you also need to live it. Diversification is one of those good habits that you should practice consistently!

With that warning in mind, what are 5 telltale signs that your portfolio may let you down when you need it the most?

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Symptom 1: Your portfolio is nothing more than a collection of funds you have accumulated over time  

Accumulating investments over time is a very common practice.  People sometimes get enamored with a certain investment type such as tech in the late 90’s and when things don’t pan out they are reluctant to sell the investment.

Not dissimilar to hanging on to that old dusty treadmill in the basement or that collection of Bennie Babies in the attic.  Many individual investors are hoarders without admitting it.

Sometimes it is as simple as when people change jobs leaving behind a 401(K).

Solution: Research each one of your funds. For example if you own the Alger Large Cap Growth fund (ACAAX) use a free tool such as Morningstar to do some basic research.

But let me warn you – looking only at past returns will tell you much about the past but virtually nothing about the future.  Ruthlessly eliminate funds that you don’t understand, have high fees or simply do not fit the style that you’re looking for. Don’t eliminate funds based solely on past performance.

Symptom 2: The more funds and strategies the more diversified my portfolio  

Some people think that if you own a lot of different funds or investments you are automatically diversified. A bit of this and a bit of that. Some growth, some value, a sprinkling of emerging markets and a Lifestyle fund thrown in the mix.  There is no rhyme or reason for any of this, but many people use this approach, right?

This is a very common mistake of investors.  A lot of funds of the similar ilk does not make a diversified portfolio. It makes for keeping track of many more things, but not necessarily things that matter to your financial health.

Owning a large number of investments does not mean that you are diversified.  It probably means that you or your advisor are confused about how to construct a portfolio. You can actually be much more diversified with a small number of uncorrelated investments – the number of investments is immaterial.

Solution: Less is often better when it comes to your investments. Too many funds means extra confusion.  Simplify to a small number of funds that will serve as your core portfolio holdings.  Think of these funds as the pillars holding up your financial house.

Choose low cost funds that you will be comfortable holding for decades.  Hint – focus on a small number of broad based index funds covering stocks and bonds.

Photo by Natalie Rhea Riggs on Unsplash

Symptom 3: Your portfolio contains lots of investments with the same “theme”

Sounds like you have a fun portfolio when things go well but a nightmare when they don’t.  People fall in love with investment themes all the time.  They ride the theme hard not properly understanding that market sentiment is often fickle and can change on a dime.

In the late 90’s it was all about the internet.  Many people loaded up on the sector and lost their shirt soon after.

We have had more biotech booms and busts than probably for any other sector over the last 30 years .  Many of the biotech stars of old unfortunately were sold for cents on the dollar despite promising early findings.

Starting in mid-2017 the buzz was all about cryptocurrencies.  Many investors especially those too young to have experienced a stock market meltdown went head first into the craze and now probably are licking their wounds.

Solution: Theme investing is risky. Identifying the next emerging technology or the next Amazon or Google has a very low probability of success. Even the most seasoned venture capital firms thread lightly when it comes to the “new, new” thing.  You should too!

If you really understand a theme think about how long it will take for the mainstream to adopt it in mass.   Invest only a small percentage of your portfolio. For the rest of us, best to keep our greed in check and just say, no!

Symptom 4: All your investments are in the same asset class

This is a variation of the previous issue.  Sometimes you hear people say, “I am just a bond guy”. Or, maybe they say “I am a stock jockey”. People come to identify with their investments as a badge of honor without realizing the consequences to their financial health.  As my mother would say, “do things in moderation”. I still think that this is great advice whether it is about eating or investing.

The problem with just owning investments in one asset class is that you do not get the main course of the free lunch. You get the appetizer, but then you are shooed out of the room.

Diversification within an asset class such as stocks or bonds is not nearly as powerful as diversification across divergent asset classes

What do you mean?

Let’s take the case of stocks. In any given day, most stocks tend to move up or down together.  When the overall equity market (say the S&P 500) is up big for the day, you only find a very small percentage of stocks down for the day.  Similarly, when the broad equity market experiences a meltdown you will unfortunately only find a handful of stocks that went up for the day.

Same applies to bonds but the herding effect is even stronger.  Take the case of US bonds of a similar maturity, say 10 years.  This cohort of bonds moves in a pack all taking their lead from the 10 Year US Treasury.  If the 10 Year Treasury moves up, the vast majority of bonds move up in lockstep.  Same on the downside. Just like sheep.

Sure, some stocks or bonds will do better than others. Overall, securities within an asset class tend to move up or down together.  Call it a sister or brotherhood, while major asset classes relate to each other more as distant cousins.

Solution: For most people it makes sense to hold investments in all the key asset classes.  The three main asset classes that you should own are stocks, bonds and real estate.

Don’t get too cute. If you own a home you probably already have enough real estate exposure.

Why should you own stocks? For growing your nest egg over the long-term.  Sure stocks can be incredibly volatile, but if you plan to hold your stock investments for say longer than 10 years, history tells us that you can potentially maximize the growth of your portfolio. For a good review of the long-term power of stock investing read our recent blog.

Why own bonds? Historically, people held bonds for the yield and stability.  In the current low interest rate environment, focus on stability but keep an eye out for a more normal interest rate environment.  In the US we are already moving in that direction as the Federal Reserve hikes rates and Europe is not that far behind.

But, why is the stability of bonds useful? Mainly as an anchor to your stock investments. Bonds tend to do well during period of stock market stress so they tend to offset some of your losses.

Because bonds tend to be less than 1/3 as volatile as stocks holding a combination of bonds and stocks in your portfolio will dampen valuation changes in your accounts.  The value of your holdings will still be heavily influenced by movements in your stock holdings.  Your account values will, however, not fluctuate as much.  Is this worth it to you?

For many people holding bonds allows them to sleep better at night especially when equity markets go through the inevitable corrections.  A good night’s sleep is a prerequisite for a happy life.

A diversified mix of stocks, bonds and real estate is usually a great starting point for building your long-term financial wealth while allowing you to sleep well at night. Don’t overthink it.

Photo by Jonas Kaiser on Unsplash

Symptom 5: Your portfolio has never gone through a tough market environment

Given the low level of capital market volatility that we have had in the last few years, I would not be at all surprised to see people who dismiss the need for diversification.  After all if you just pick your investments wisely why should you worry?

Somebody that has been riding the FANG (Facebook, Amazon, Netflix and Google) stocks for a number of years probably does not see any need for bonds in their portfolio. Maybe they got a hint that they should diversify a bit during the February 2018 mini-correction but all seems to be forgotten three months later.

Go back to the late 90’s. Investors were riding AOL, Cisco, Dell, and Microsoft.  Very few individual investors saw the implosion that was about to hit and obliterate equity portfolios.

For example, investors in the Technology SPDR ETF (XLK) were riding high on the hog until March 1, 2000 when the XLK hit $60.56.  By July 1, 2002 the price had dropped to $14.32 – a horrific 76% decline from the peak.  It took until late 2017 for the XLK to hit its March 1, 2000 peak. That is a long time to wait to breakeven!

You don’t need diversification when things are going well. You only need it when the bottom is falling out from one of your investments.  Every single investor in the world has gone through a rough performance patch and nobody is immune to the pain and agony of market crashes such as 1987, 2000-2002 and 2008-2009.

Solution: Stress test your portfolio or at a minimum ask yourself what would happen if certain events of the past repeated themselves.

For most people it is far wiser to leave a bit of money on the table by diversifying across asset classes than go head first into a market crash.

Could you withstand a sudden 20% daily loss in the stock market? How about a couple of years of major losses such as over the 2000-2002 period? Would you have the stomach to weather these storms?

Many times the tension is between your rational side and your emotions.  Behavioral research shows that most times the emotional side wins out.  Most investors panic during corrections because they are not properly diversified.

Investing is fun when capital markets are going up and everybody is making money.  Equity market corrections and, heaven forbid, crashes are extremely stressful for the vast majority of investors.

Having a little bit of a cushion can mean the difference between emotionally and financially staying with your investing plan and chucking it all at what may turn out the most painful time.

Recovering from painful events is especially difficult when your state of mind is poor and your pocket book is much lighter than before.

Making decisions under stress is never optimal.  Self-improvement experts always talk about making decisions while in peak states, not when you are emotionally down.

Photo by Austin Neill on Unsplash

 

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Conclusion:

Nobel Prize winner Harry Markowitz called portfolio diversification in finance its only free lunch.  Most people agree with his statement and attempt to build diversification into their investment strategies.

But the devil is in the details.  Many people remain confused by the term and its impact on their financial health.

But understanding portfolio diversification is not an academic nicety – it materially affects your financial health

For most investors the relevant context for diversification involves the key broad asset classes of stocks, bonds and real estate.

If you like smoother rather than bumpier rides, portfolio diversification is for you. You will sleep better at night especially when equity markets go haywire.

Investors can easily fall in the trap of thinking that their portfolios are diversified or that they do not need any diversification.

Making too many assumptions is not a good investment practice. Better to know in advance whether you have the mental fortitude and financial resources to weather the inevitable storms.

For technically oriented investors Portfolio Visualizer is a great free tool that allows you to estimate correlations among your list of funds.

For a more in-depth analysis of your portfolio’s true diversification consult a professional consultant experienced in portfolio construction issues.  You will get a lot more than simple correlations among your funds. You will get a full picture of the risk profile of your investments but keep in mind that ultimately the portfolio you own must work for you.

Your ideal portfolio must be designed in relation to your goals and needs while allowing you to sleep at night.  Only a comprehensive wealth management assessment can give you the level of detail required.

We are expert portfolio construction professionals and would glad help you assess the quality of your portfolio.  Don’t assume that you are diversified.  Contact the team at Insight Financial Strategists  for a free initial consultation.

At Insight Financial Strategists we are your fiduciaries. Our advice is focused solely on our view of your best interests. As fee only practitioners, our interests are aligned with yours.

May 14

4 Counter-Intuitive Steps to Take Now to Make Your 401(k) Rock

By Eric Weigel | Financial Planning , Investment Planning , Retirement Planning

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.

Many people do not make 401(k) choices naturally. Many participants do not even know where to begin when it comes to:

  • What funds to select

  • How much to allocate to each fund

  • Deciding on the proper amount of risk to take

  • Understanding how their 401(k) fits in with the rest of their financial picture

When given a choice, people usually start with the issue or problem that they perceive as the easiest to figure out, not necessarily the one of greatest importance.

Many  people approach the problem of how to invest their 401(k) in a simplistic manner.

Many  401(k) participants start off by selecting funds. For most participants this is not an easy choice, but in comparison to the other issues this one appears manageable.

But sadly, 401(k) participants are getting it backwards by picking funds first. They are not framing the problem correctly.

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.

Figure 1

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 401(k) assets are just one component of your household wealth .  Think about your other assets and financial obligations.  And don’t forget to include your partner’s or spouse’s.

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.

But an honest assessment of both your need to take risk as well as your comfort level with investment fluctuations is necessary in managing your long-term financial health. You will see massive cracks if these two dimensions of risk are not aligned.

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.

Figure 2

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.

Table 1

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.

Most of your 401(k) performance will be driven by your target asset allocation anyway. 

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.

______________________

Conclusion:

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.

 

 

 

Feb 16

Rolling Over Your 401(k) to an IRA

By Jim Wood | Financial Planning , Investment Planning , Retirement Planning

Rolling Over Your 401(k) to an IRA

 

401(k) rolloverChanging jobs or retiring are two life events that provide opportunities to roll over your 401(k) to an IRA . If retiring, many 401(k) plan sponsors allow you to keep your 401(k) savings in their company plan. However, there are good reasons to consider a roll over of 401(k) assets to an IRA .

The first is to gain better control over your investment portfolio, once the assets are within the IRA. Company sponsored 401(k) plans may have limited investment options and restrictive trading and exchange policies. IRAs generally provide a broader range of investment options and more flexibility.

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.)

What are your 401(k) rollover options?

If you are changing jobs, you may have the option to roll over your existing 401(k) into your new employer’s 401(k) plan – be sure to verify that your new employer plan accepts rollovers. Regardless, you always have the option to roll over to an IRA that you can manage. And for the reasons noted above, rolling over to your own IRA may provide you with a better result .

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?

 

A previous version of this post has appeared in the Colonial Times.

Jan 17

Five Common Questions About Divorce

By Chris Chen CFP | Divorce Planning , Financial Planning , Retirement Planning

divorcing-swansdivorcing-swans5 Common Questions About Retirement and Divorce

divorce and retirementRetirement accounts are often one of the major assets of divorcing couples. Analyzing and dividing retirement accounts can be fairly complex . Some of the major questions that I come across include the following:

1. Is My Retirement Account Separate Property?

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?

Most of us know that taking money out of a retirement account will usually trigger taxes and sometimes penalties. However, dividing retirement accounts in divorce provides an exception to that rule. You can divide most retirement accounts in divorce tax-free through a Qualified Domestic Relations Order  (QDRO). As a result of the QDRO, both spouses will now have a separate retirement account.

QDROs are used for 401(k)s, defined benefit pension plans, and other accounts that are “qualified” under ERISA . Many accounts that are not “qualified” such as 403(b)s use a “DRO” instead. The federal government uses its own procedure known as a “COAP”. Some accounts such as IRAs and Roth IRAs can be divided with a divorce agreement without requiring a QDRO.

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.

3. Can I Take Money out Without Penalty?

In general, you cannot take money out of retirement accounts before 59½ years of age without triggering income taxes and a 10% penalty . It makes taking money out of retirement accounts a very expensive proposition as you may only get 60 to 70 cents for every dollar that you withdraw, depending on your tax bracket and the State that you live in.

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.

What is the harm you might ask? Rules of thumb are like the time on a broken clock – occasionally correct, but usually wrong . In the best of cases, they may favor you. In the worst cases they will short change you. If the rule of thumb is suggested by your spouse’s lawyer, it will have a good chance of being the latter.

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?

Defined Benefit pension plans provide a right to a stream of income at retirement . Unlike 401(k)s and IRAs they are not individual accounts. They do not provide an individual statement with a balance that can be divided.

As a result, many lawyers take the path of least resistance and will want to QDRO the pension. It is usually painful to the pension beneficiary who will often feel very emotional about his or her pension. And it is not necessarily in the spouse’s interest to QDRO the pension .

A better approach is to consider the value of the defined benefit pension compared to the other retirement assets. With a pension valuation, you can judge the value of the pension relative to other assets and make better decisions on whether and how to divide it. A pension valuation will allow each party to make an informed decision and eventually provide informed consent when agreeing to a division of retirement assets.

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.

The Bottom Line

Retirement plans are more complex than most divorcing couples expect . Unlike cash accounts they do not lend themselves to a quick asset division decision.  The short and long-term consequences of a sub-optimal decision can be far reaching. It will be worth your while to do a thorough analysis before accepting any retirement asset division.

 

 

A previous version of this post was published in Investopedia

Jul 19

Getting Help When You Need It Most

By Chris Chen CFP | Divorce Planning , Financial Planning

Getting help when you need it most

chess pieces divorcingWhen “Lindy” was trying to figure out the implications of the latest divorce settlement offer that she received from her soon-to-be ex-husband “Ted,” she panicked. She would have asked her lawyer for
guidance, as 79% of divorcing individuals end up doing, but she was not sure that her divorce lawyer could give her the guidance she needed .

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.

Even Lindy’s lawyer was happy with the process

Clearly, there is something wrong with a process in which the financial outcome is so critical to both parties but people like Lindy and Ted get no professional financial support despite spending substantial sums of money litigating a divorce. Yet it is not surprising. The financial issues of divorce have become terribly complex ranging from shorter-term tax issues to longer-term financial planning issues.  Divorce lawyers have enough on their hands with the legal issues of divorce. Increasingly, divorce lawyers are unable to counsel their clients in depth on the financial implications of divorce , which inevitably have a lasting impact on their quality of life and stability long after the divorce itself is finalized.

According to a recent survey conducted by the Institute of Divorce Financial Analysts, 75% of respondents believe that a divorce financial specialist would have been helpful in the preparation, negotiation or recovery phases of their divorces . According to this same survey, 45% of people litigating their divorces felt unprepared to enter financial negotiations and 40% of those mediating their divorces feel the same way.

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

Sep 29

Pension Division in Divorce

By Chris Chen CFP | Divorce Planning , Financial Planning , Retirement Planning

 

Pension Division in Divorce

Pension Division

Themis, Goddess of Justice

Jenni (specifics details have been changed) came to our office for post-divorce financial planning. Jenni is 60, a former stay-at-home Mom and current yoga instructor with two grown children. She never had a professional career and spent much of her adult life with a series of low-paying part-time jobs. She is thinking about retiring now and wanted to know whether she would be able to make it through retirement without running out of assets.

Jenni traded her interests in her husband’s 401(k) in exchange for the marital home, an IRA and half of a brokerage account . The lawyers agreed that the 401(k) should be discounted by 25% to take into account the fact that a 401(k) holds pretax assets.

Adjustments to the Value of a 401k

That sounds reasonable on the surface. But as a professional financial planner, I believe that it was a mistake for Jenni to agree to a 25% discount adjustment to the 401(k). After analyzing her finances, it became clear that Jenni would likely always be in a lower-than-25% federal tax bracket after retirement. Had she met a Divorce Financial Planner sooner, he or she would have likely advised against agreeing to a 25% discount to the value of the 401(k).

Jenni and Ron, her ex-husband, also agreed that she would get half of her marital interest in a defined-benefit pension from his job as a pediatrician with a large hospital.  At the time that pension division was agreed to, Ron thought that there was no value to the pension, and it was probably “not worth much anyway.” Neither lawyer disagreed.

[A Pension does] not come with a dollar balance on a statement

This underscores the importance of seeking the advice of the right divorce professional to analyze financial issues!  Working in a team with mediators and divorce lawyers, divorce financial planners usually pay for themselves .

After a little research I found that Jenni would end up receiving a little over $37,000 a year from the pension division at Ron’s retirement, assuming he is still alive then. This is far from an insignificant sum for a retiree with a projected lifestyle requirement of less than $5,000 a month!

There are also restrictions with dividing Ron’s defined-benefit pension: the ex-spouse or alternate payee (Jenni in this case) can get his or her share only when the employee takes retirement. Furthermore, the payments stop when the employee passes away. (Each defined-benefit pension has its own rules . Each defined benefit pension division should be evaluated individually ).

The Value of  Pension Division Analysis

A defined-benefit pension such as this one does not have a straightforward value in the same way as a 401(k). It does not come with a dollar balance on a statement. A pension is a promise by the employer to pay the employee a certain amount of money in retirement based on a specific formula . In order to get a value and for it to be fairly considered in the overall asset division, it needs to be valued by a professional.

In her case, Jenni’s share of the pension division was 50% of the marital portion of the defined-benefit pension. Was it the best outcome for Jenni? It is hard to re-evaluate a case after the fact. However, had she and Ron known the value of the pension, they might have decided for a different pension division that may have better served their respective interests. Jenni may have decided that she wanted more of the 401(k), and Ron may have decided that he wanted more of the pension. Or possibly Jenni may have considered taking a lump-sum buyout of her claim to Ron’s pension . In any case, they would have been able to make decisions with their eyes open, instead of taking the path of least resistance.

The news that her share in Ron’s defined benefit pension had value was serendipity for Jenni. It turned out that the addition of the pension payments in her retirement profile substantially increased her chances to make it through retirement without running out of assets. But it is possible that an earlier understanding of the pension division and other financial issues could have resulted in an even more favorable outcome for Jenni .

 

A previous version of this article was published at Kiplinger.

Jul 24

Five Considerations For Managing Your Employee Stock Options

By Chris Chen CFP | Financial Planning

Five Considerations For Managing Your Employee Stock Options

Five Considerations for Managing Your Employee Stock OptionsAccording to the 2010 General Social Survey, approximately 8.7% of Americans in the private sector have Employee Stock Options. More have restricted stock, restricted stock units, phantom shares, and so on. The odds that you own them yourself are good especially if you are in senior management. If you are among the lucky few, it is a financial opportunity to build wealth in a way that is difficult with a regular salary. However, because of their special nature Employee Stock Options require special planning.

Employee stock options allow you to purchase your employer’s stock at a pre-determined price. When you exercise the option and purchase the stock you are expected to make a profit. As you ascend in seniority, you are likely to receive more employee stock options and eventually they may form a large portion of your compensation.

A long time ago when I used to receive employee stock options, a mentor instructed me that ESO were a unique opportunity for an employee to build wealth. I agree. However, employee stock options are more complicated than traditional financial instruments such as stocks, bonds, or 401(k) accounts. Their actual value can be volatile, and the impact on your portfolio wealth uncertain if you do not plan for it.

Five key steps to watch are: 

1. Know what you have

Consider what kind of instrument you have. Most people get Non Qualified Stock Options (NQSO); others get Incentive Stock Options (ISO). The major difference is how and when they are taxed. It is important to know what you have so you can plan accordingly

2. Plan for taxes

The good news is that employee stock options receive tax benefits under current Federal law. The down side is that you will eventually owe taxes. NQSO are taxed as ordinary income when they vest. They also incur payroll taxes. ISO are taxed when the underlying stock is sold, i.e. after you have exercised the stock. If you sell the stock more than one year after you exercise it, it will usually be taxed at capital gains rate.  With planning you can make sure that you are ready for the impact.

3. Beware of the risks of ownership

Owning Employee Stock Options may carry additional risks, especially as you get more of them. As Wealth Strategists we recommend that you should not concentrate too much of your wealth in a single stock. As an employee you are already exposed to the risk of your employer: you work there and you depend on your employer for your income. You need to evaluate how much more of that risk you can afford. If in addition to having employee options you also own stock in your employer either directly or in the company 401k, we need to talk!

Of course employee stock options need to vest before you can do anything about them. However, when they vest you can mitigate the concentration risk by diversifying or selling a portion in the most tax efficient manner, then reallocating the proceeds to other investments.

4. Harvest your gains

The optimal time to exercise employee stock options and sell them, is soon after they vest, with allowance added for the tax differences. According to Options Pricing Theory, beloved of MBAs, gains can be maximized by postponing exercise until shortly before expiration. In practice, a bird in the hand is worth two in the bush: you never know when the next market downturn is coming.

5. Plan for Re-investment

Two pressing problems at exercise time are: 1) where to get the money to pay the taxes, and 2) what to do with the proceeds.

One example of a way to handle can be to balance the additional income from stock options with a temporary increase in 401k or IRA contributions. The additional 401k contribution reduces your taxable income, as well as your cash flow. That is balanced by the increase in taxable income and cash flow that comes from the exercised options or sold stock.

In that way your tax level may remain at equivalent levels. And you will have stored away the gain.

Option wealth comes with many complex issues to consider. However, it is an exciting opportunity for you and your family to build or fortify a nest egg and further secure your financial future. As Wealth Managers our primary goal is to help you plan strategically to maximize the value of this unique opportunity.

(a version of this post appeared on boston.com).