7 IRA Rules That Could Save You Time and Money

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

People often end up with several different retirement accounts that are spread between one or more 401(k)s, 403(b)s, IRAs and other retirement accounts.

Treating these various retirement accounts as one, known as “aggregating”, will often make sense.  IRA aggregation can allow more efficient planning for distributions and more efficient investment strategy management . Note that aggregation means treating several accounts as one, not necessarily actually combining them. Nonetheless, there are situations where aggregating IRAs is not permitted and can cause negative tax consequences and could result in penalties .

In general, when IRA aggregation is permissible for distribution purposes, all the Traditional IRAs, SEP IRAs, and SIMPLE IRAs of an individual are treated as one traditional IRA. Similarly, all of an individual’s Roth IRAs are treated as a single Roth IRA.

The following are seven key aggregation rules for IRAs that could save you time and money . The key learning is that it takes strong recordkeeping and awareness of the rules to avoid the pitfalls of aggregation. You should be aware of the requirements, observe them or get help from your Wealth Manager.

1. IRA Aggregation does not apply to the return of excess IRA contributions

The IRA contribution limit for individuals is based on earned income. Individuals under 50 years of age can contribute up to $5,500 a year of earned income. Those older than 50 years of age are allowed an additional catch up contribution of $1,000. The contribution limit is a joint limit that applies to the combination of Traditional and Roth IRAs.

When the IRA contribution happens to be in excess of the $5,500 or the $6,500 limit (for people over 50), the excess contributions, including net attributable income (NIA), ie the growth generated by the excess contribution, must be returned before the IRA owner’s tax filing due date, or extended tax filing due date. Those who file their returns before the due date receive an automatic six-month extension to correct the excess contributions.

2. Mandatory aggregation applies to the application of bases for Traditional IRAs

Contributions to Traditional IRAs are usually pre-tax. Thus, distributions from IRAs are taxable as income.  In addition, distributions prior to 59.5 years of age are also subject to a 10% penalty.

However, individuals may also contribute to a Traditional IRA on a non-deductible basis , ie with after-tax income. Similarly, contributions to an employer-sponsored retirement plan can also be made on an after-tax basis (where allowed by the retirement plan) , and potentially rolled over to an IRA where they would retain their non-deductible character.

After-tax contributions to an IRA, but not the earnings thereof, may be distributed prior to 59 ½ years of age without the customary 10% penalty. Distributions from an IRA that contains after-tax contributions are usually prorated to include a proportionate amount of after-tax basis (amount contributed) and pre-tax balance (pro rata rule).

Some IRA owners will choose to keep non-deductible IRA contributions in a separate IRA which simplifies tracking and administration. However, that has no impact on distributions, because, when applying the pro-rata rule, all of an individual’s Traditional IRAs, SEP IRAs, and SIMPLE IRAs are aggregated and treated as one.

Suppose that Janice has contributed $700 to a non-deductible Traditional IRA, and it has grown to $1,400.  If Janice takes a distribution of $500, one half of the distribution is returnable on a non-taxable basis, and the other half is taxable and subject to the 10% penalty if Janice happens to be under 59½ years of age. You can see why Janice would want to keep accurate records of her transaction in order to document the taxable and non-taxable portions of her IRA.

3. Limited aggregation applies for inherited Traditional IRAs

Inherited IRAs should be kept separate from non-inherited IRAs . The basis in the latter cannot be aggregated with the basis of an inherited IRA.

In practice, it means that if Johnny inherited two IRAs from his Mom and another from his Dad, Johnny must take the Required Minimum Distributions for his Mom’s two IRAs separately from his Dad’s, and also separately from his own IRAs.

Furthermore, IRAs inherited from different people must also be kept separate from one another. They can only be aggregated if they are inherited from the same person.  In addition, inheriting an IRA with basis must be reported to the IRS for each person.

4. Mandatory aggregation applies to qualified Roth IRA distributions

Qualified distributions from Roth IRAs are tax-free. In addition, the 10% early distribution penalty does not apply to qualified distributions from Roth IRAs.  

Roth IRA distributions are qualified if:

– they are taken at least five years after the individual’s first Roth IRA is funded;

– no more than $10,000 is taken for a qualified first time home purchase;

– the IRA owner is disabled at the time of distribution;

– the distribution is made from an inherited Roth IRA; or

– the IRA owner is 59½ or older at the time of the distribution.

If Dawn has two Roth IRAs, she must consider both of them when she takes a distribution.  For instance, if Dawn takes a distribution for a first time home purchase, she can only take a total $10,000 from her two Roth IRAs

5. Optional aggregation applies to required minimum distributions

Owners of Traditional IRAs must start taking required minimum distributions (RMD) every year starting with the year in which they reach age 70½ . The RMD is calculated by dividing the IRA’s preceding year-end value by the IRA owner’s distribution period for the RMD year.

An individual’s Traditional, SEP and SIMPLE IRAs can be aggregated for RMD purposes .

The RMD for each IRA must be calculated separately; however, the owner can choose whether to take the aggregate distribution from one or more of his Traditional, SEP or SIMPLE IRAs.

So, if Mike has a Traditional, a SIMPLE and a SEP IRA, he would calculate the RMD for each of the accounts separately.  He could then take the RMD from one, two or three accounts in the proportions that make sense for him.

As a reminder, Roth IRA owners are not subject to RMDs.

6. Limited aggregation applies to Inherited IRAs

Beneficiaries must take RMDs from the Traditional and Roth IRAs that they inherit with the exception of spouse beneficiaries that elect to treat an inherited IRA as their own.

With this latter exception, RMD rules apply as if the spouse was the original owner of the IRA.

When a beneficiary inherits multiple Traditional IRAs from one person, he or she can choose to aggregate the RMD for those inherited IRAs and take it from one or more of the inherited Traditional IRAs. The same aggregation rule applies to Roth IRAs that are inherited from the same person.

Suppose again that Johnny has inherited two IRAs from his Mom and one from his Dad. Johnny can calculate the RMDs for the two IRAs inherited from his Mom, and take it from just one.  Johnny must calculate the RMD from the IRA inherited from his Dad separately, and take it from that IRA.

If in addition, Johnny has inherited an IRA from his wife, he may aggregate that IRA with his own.

It is important to note that RMDs for inherited IRAs cannot be aggregated with RMDs for non-inherited IRAs , and RMDs inherited from different people cannot be aggregated together.

7. One per year limit on IRA to IRA rollovers

If an IRA distribution is rolled over to the same type of IRA from which the distribution was made within 60 days, that distribution is excluded from income.

Such a rollover can be done only once during a 12-month period.

In this kind of situation, all IRAs regardless of types (Roth and non-Roth) must be aggregated. For instance, if an individual rolls over a Traditional IRA to another Traditional IRA, no other IRA to IRA (Roth or non-Roth) rollover is permitted for the next 12 months.

Conclusion: What you should keep in mind

These are some of the more common IRA aggregation rules.  There are others including rules for substantially equal periodic payments programs (an exception to the 10% early distribution penalty), and those that apply to Roth IRAs when the owner is not eligible for a qualified distribution.

Although IRAs are familiar to most of us, many of the rules surrounding are not . It is still helpful to check with a professional when dealing with them.

Lastly, many of the potential problems that people may face with IRA aggregation can be avoided with proper documentation. Recordkeeping is essential. Individuals can do it themselves or they can rely on their Wealth Managers. In the case where you have to change financial professionals, make sure that you have documented the history of your IRAs.   

Is the new Tax Law an opportunity for Roth conversions?

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

The New Tax Law, known as the Tax Cuts and Jobs Act (TCJA) was passed in December 2017. Its aim was to reduce income taxes on as many constituencies as possible. One of the well known implementations of that desire has been the temporary reduction of individual income tax rates. That provision of the law is scheduled to sunset in 2025. Starting in 2026, individual income tax rates will revert back to 2017 levels, resulting in a significant tax increase on many Americans, following 8 years of reduced tax rates.  

Assuming Congress doesn’t take future action to extend the tax cut, how can the damage of the TCJA’s scheduled tax increase be mitigated? One way to mitigate the damage of the TCJA scheduled tax increase could to switch some retirement contributions from Traditional accounts to Roth accounts from 2018 to 2025 , and switching back to Traditional accounts in 2026 when income tax bracket increase again.  

Another way to blunt the impact of theTCJA is to consider effecting Roth conversions between 2018 to 2025 .

The TCJA has a tax increase built into it

It’s well known that contributions to and withdrawals from Roth IRAs and Roth 401(k)s are taxed differently than their Traditional cousins .  One of the major factors to consider when deciding between a Roth IRA or a Roth 401(k) and a Traditional IRA or Traditional 401(k) are income tax rates during working years and in retirement.  

Generally speaking, Roth accounts are funded post tax, whereas a Traditional accounts are funded pre-tax .  As a result, funding a Traditional 401(k) account reduces current taxable income , usually resulting in lower current taxes. Similarly, you may be able to deduct your contributions to a Traditional IRA from your current tax liability depending on your income, filing status, whether you are covered by a retirement plan at work, and whether you receive social security benefits.   Income taxes must be paid eventually, so retirement distributions from Traditional IRAs and 401(k)s are taxed in the year in which they are withdrawn. In fact, the Internal Revenue Service so wants retirement savers to pay income taxes that it mandates Required Minimum Distributions (RMD) from Traditional accounts after age 70 1/2 . RMDs are taxed as ordinary income in the year they are distributed.

On the other hand Roth accounts are funded with post-tax money and result in retirement distributions that are tax free, provided all requirements are met.  

Roth IRAs and Roth 401(k)s

When working year taxes are lower than projected tax rates in retirement , it usually makes sense to contribute to a Roth account . In this situation, paying taxes upfront results in lower projected lifetime taxes. For instance, assuming that Vanessa is in the 24% tax bracket, she will need to earn $7,236 to make a $5,500 contribution to a Roth IRA. That is because, she will owe federal taxes of $1,736 on her earnings (not counting state taxes where applicable), leaving her with $5,500 to contribute. However, Vanessa’s distributions in retirement would be tax free.  If her marginal tax rate in retirement is greater than 24%, she would have saved on her distributions.

 

It’s important to note that you can only contribute to a Roth 401(k) plan if your employer offers one as a company benefit . Married individuals filing jointly and  making over $196,000, married individuals filing singly and making over $10,000, and single filers making over $133,000 cannot contribute to a Roth IRA, but may contribute to a Roth 401(k).

Traditional Accounts

When working year tax rates are higher than projected tax rates in retirement, it usually makes sense to contribute to a Traditional IRA or Traditional 401(k) .  Contributing to a Traditional account in that situation generally results in a reduction in taxes in the year of contribution; taxes will be due when the assets are withdrawn from the account, hopefully in retirement. For instance, If Vanessa contributes $5,500 to a Traditional IRA can result in a reduction in taxable income of $5,500. If she is in the 24% federal income tax bracket, Vanessa would save $1,320 in federal income taxes (not counting potential applicable state income taxes).  If Vanessa is in the 12% marginal federal tax bracket in retirement, when she takes $5,500 in distribution, she would then owe federal income taxes of $660.

 

Most working people are in higher tax brackets while working than they will be in retirement; hence it usually makes sense for them to contribute to Traditional accounts . That is not true for everyone, of course, as individual circumstances can significantly affect taxes owed.

The New Tax Law

The new Tax law, aka the Tax Cut and Jobs Act or TCJA, passed in December 2017, comes with a number of features, including a permanent reduction in corporate taxes. Most important for individuals and families, it significantly reduces individual tax brackets starting in 2018.  

Table 3: 2018 Federal  Tax Brackets

 

However, while the tax decrease for corporations is permanent, the TCJA tax decrease for individuals and families is temporary. Starting in 2026, individual tax rates will be back to their 2017 levels .

In practice this will result in a large tax hike in 2026 for many individuals and families.  For instance if Susanna and Kevin make $150,000 and file “Married Filing Jointly”, they might be in the 22% marginal tax bracket in 2018.  With the same income in 2026, Susanna and Kevin would be in the 25% marginal tax bracket. Of course, there are several other factors that will impact their final tax bill, but most people in that situation will stare at a higher tax bill.

So what if Susanna and Kevin project that their retirement income would place them in today’s 22% bracket? Most likely that would put them in the 25% federal bracket in 2026, resulting in a possible tax increase. In fact, depending on the exact situation, a large number of Americans will see their taxes increase in 2026 as the result of the sunset of the TCJA individual tax cuts .

Consider a Roth Conversion while working

Susanna and Kevin could also take advantage of the temporary nature of the TCJA tax cuts to convert some of their traditional tax deferred retirement accounts to Roth accounts.  In so doing, they would take distributions from the Traditional account, transfer to the Roth, and pay income taxes on the conversion. This way Susanna and Kevin would create themselves a source of tax free income in retirement, that could help them stay in their tax bracket and partially insulate them from future tax increases.

Now is the time to take steps to manage your taxes

Because Roth conversions increase current taxable income, many people will find them a limited possibility as only so much funds can be converted without jumping into the next tax bracket.  However, working people can also think in terms of changing their current contributions from Traditional 401(k)s to Roth 401(k)s. That would have the similar impact of increasing current taxable income and income tax due for the benefit of creating a reserve of future tax free assets.

Consider changing from a Traditional 401(k) to a Roth 401(k)

In the case of Susanna and Kevin, they could be in the 22% marginal federal tax bracket in 2018.  If they retire in 2026, and their taxable income in retirement does not change, they may be in the 25% marginal tax bracket. For this couple, it may well be worth switching current contributions from a Traditional 401(k) to a Roth 401(k) from 2018 to 2025 , thereby increasing taxes due from 2018 to 2025, and potentially reducing taxes in retirement.

Of course, it is not always clear where Susanna’s and Kevin’s taxable income would come from in retirement.  That is because their sources of income will likely change significantly. While they would no longer earn income, they may then have social security income, pension income, and retirement plan income which are all taxed as ordinary income. They may also take income from other assets with different tax characteristics, such as savings or investments.  That might make the projection of their taxable income more difficult.

It is possible that Susanna and Kevin’s income needs will influence the tax characteristics of their income when they retire in 2026 or later; that may place them in a different tax bracket altogether. For instance Wealth Managers routinely advise clients to postpone Social Security income as late as they can, preferably until 70 in order to maximize lifetime social security income.  When that happens it is possible that income between retirement and 70 could come from other sources, such as investments. When that happens taxable income could be significantly lower as investments are usually taxed at a lower capital gains rate.

This may sound self serving, but I’ll write it anyway: the best way to know what Susanna and Kevin’s income would look like in retirement, and how it might be taxed, is for them to check in with a skilled Certified Financial Planner. Otherwise they would just be guessing.

Considering a Roth Conversion in Retirement

So what about people who are already retired?  The situation is similar. Take David and Emily, a retired couple with social security income, state pension income, and retirement plan income.  From 2018 to 2025, their $100,000 taxable income places them in the marginal 22% federal tax bracket. With the same income in 2026, they would end up in the 25% tax bracket.  Through no fault of their own David and Emily will see their income tax increase in 2026.

One of the ways that David and Emily can fight that is to convert some of their Traditional retirement accounts to Roth between 2018 and 2025, pay the income taxes on the additional income, and then use distributions from the Roth when their taxes go up in 2026 to stay within their desired tax bracket. In this way, David and Emily could potentially reduce their overall taxes over the long term.

Conclusion

The new Tax Law, aka the TCJA, reduces individual and family income federal tax rates substantially starting in 2018. However in 2026 individual federal income tax rates will go back up resulting in a significant tax increase for many American families .  Roth conversions could help many plan to avoid the pain of this planned tax increase by balancing current lower taxes against future higher taxes. To do this successfully requires careful evaluation of current and future taxable income. Planning Roth conversions from 2018 to 2025 could pay significant rewards by lowering taxes after 2026.

The key challenge for retirement contributors would be to calibrate the right amount of Roth conversion or Roth contributions so as to minimize current and overall taxes owed.

Because each situation will be different, it will pay to check with a Certified Financial Planner to estimate future income and tax rates, and to plan a strategy that will maximize your financial well being.

 

Check out our other posts on Retirement Accounts issues:

Rolling over your 401(k) to an IRA

7 IRA rules that could save you time and money

Doing the Solo 401k or SEP IRA Dance

Tax season dilemna: invest in a Traditional or a Roth IRA

Roth 401(k) or not Roth 401(k)

 

 

Note 1: this post makes assumptions regarding potential individual tax situations. It simplifies the many factors that enter into tax calculations. It omits many of the rules that are applicable to Roth accounts and Roth conversions. It also assumes that the TCJA will be unchanged.  None of these assumptions may be correct. Please check with the relevant professionals for your individual situation.

Note 2: Insight Financial Strategists LLC does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Insight Financial Strategists LLC cannot guarantee that the information herein is accurate, complete, or timely, and  makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.

Key Insights Into Understanding Equity Market Corrections

By Eric Weigel | Capital Markets , Investment Planning , Portfolio Construction , Retirement Planning , Risk Management

Corrections, Recoveries and All That Jazz

Stock Market Corrections are tough on equity investors.  Over the last couple of weeks, there has been nowhere to hide – normally defensive strategies provided little relief.

After a long period of minimal equity market hiccups investors were reminded that the opposite side of the return coin involves risk.

Equities do better than bonds, on average, precisely because investors require compensation for the additional risk of their investments.

If risk and return are tied together why do investors get so nervous when suddenly equity markets go haywire?  Memories of 2008 come flooding back and investors get hyper fixated on relatively small market movements.

As of Friday, February 9, the S&P 500 had dropped 8.8% from its high of January 26.  Granted the drop has been swift and intraday market action (the difference between the high and low of the day ) has been off the charts, but you would have thought that we were on the verge of another Financial Crisis.

Figure 1 depicts the rolling 12 month returns on the S&P 500 as of the end of 2017. There are more periods of positive rather than negative returns as expected. We can also see that the downdrafts in recent years have been painful for investors – the implosion of the Technology Bubble (2000-2002) and the 2008 Financial Crisis still very much linger in investor minds today.

Figure 1

The key insight that investors need to come away with from looking at the history of stock market returns is that to get the good (those returns averaging 10% a year) you must be prepared financially and most importantly emotionally to endure the bad (those nasty corrections).

Investors need to remember that risk and return are the opposite side of the same coin.  They also need to understand the context in which market corrections take place.  While history always rhymes every equity market correction possesses unique elements that shape its ultimate effect on investors.

Understanding the market and economic context is incredibly important for everyday investing.  It is, however, absolutely critical for understanding the implications of equity market corrections and most appropriate course of action.

The point is that not all equity market corrections are made of the same cloth.  Some are deep and lasting. Some are deep and over before the eye blinks. Others last for a year or two and progress at a slower rate. And, finally other corrections turn into cataclysmic events that leave investors bruised for a long time.

Given the events of the last couple of weeks we understand the skittishness of equity investors. Last year was fantastic for investors.  We hardly had a hiccup in the last year. Investors started adapting to the environment – high returns and low volatility.

All the fireworks have come from Washington rather than Wall Street.  Yet, the lingering suspicion is that this party like all others before it must end at some time. Maybe it is just time, right?

We are professional wealth managers, not magicians or fortune readers. Nobody knows when the next big stock market crash will happen and least of all nobody knows the severity of the downturn.

At best, we can analyze the current equity market downturn and attempt to better understand the context in which current equity market prices started heading south.

While all equity market downturns are unique, for simplicity sake we categorize periods of extreme equity market distress into three distinct types of corrections – technical, economic and structural.  Each type of correction has its own distinct patterns and associated implications for investors. Not every moving animal in the woods is a Russian Bear!

Technical Correction:

This type of correction typically comes out of nowhere and takes market participants by surprise. One bad day for the stock market turns into 2 or 3 in a row and soon enough there is an avalanche of pundits predicting the next global crisis.

Maybe a bit surprising to some, pundits use perfectly logical arguments to justify their bearishness – inflation is about to spike up, the economy is tanking, earnings are coming down, there are no buyers left, and so forth.

All perfectly valid reasons for an equity market correction but the key characteristic of such prognostications is that they are mostly based on speculation and not rooted in contemporaneous economic trends. The arguments are more based on what we fear as opposed to what the current reality is.

Technical Corrections tend to occur on a regular basis especially for higher risk asset classes such as equities.  Long-term equity investors have seen these before and do not seem fazed by the market action.

Newer generations of investors, however, experience great fear and regret.  The immediate response is to sell down usually their most liquid holdings and wait for the market to calm down.  Maybe they will get in again after the panic is over.

Technical Corrections tend to last only about a week or two.  In the context of long-term capital market history they barely register to the naked eye. Boom they are gone, and people quickly forget what they just went through.  Technical corrections are learning opportunities but are most often quickly forgotten until the next blip.

Economic Corrections:

These types of capital market corrections are caused by the economic business cycle, i.e., periods of economic expansion followed by recession and eventual recovery.  Typically, the clues as to whether the economy is heading into a recession are present ahead of time.

Usually a large number of economic indicators will point in the same direction.  For example, the yield curve may become inverted (long rates lower than short-term rates), business confidence surveys start showing some downward trends, companies start hoarding cash instead of investing in plant and equipment and layoffs start accelerating in cyclically sensitive sectors.

In the last half century, business cycle recessions have been mostly shallow and short-lived. Economic recessions are, no doubt, painful but the implications to investors are fairly straightforward.

In the early stages of a recession, equity investments suffer the most while bond market strategies tend to provide the upside.  As the economy starts recovering, equity investments outperform marginally but with significant volatility.

Being early is never comfortable but it beats being late.  Some of the best equity returns happen during the late early stages of a recovery when the average investor is still too snake bitten to put any money at risk.

And finally, as the economy moves into full expansion mode equity investors typically enjoy a nice margin of outperformance relative to safer assets such as bonds.  As the uncertainty regarding the economic recovery fades in the rear view, capital markets tend to become less volatile as well.

Structural Corrections:

These are the most severe type and involve periods of real economic and financial stress.  Something has gone off the rails and public capital markets are the first to feel the brunt of the economic imbalances.

Structural Corrections are not merely stronger business cycle events. The integrity of the entire economic and financial system is at stake.  Without decisive fiscal and monetary policies there is a risk of total economic collapse.  Under these circumstances, equity investors are often completely wiped out and bond holders don’t fare much better.

Structural Corrections happen during periods of total economic unravelling.  The most usual signs of eminent economic collapse are massive unemployment, huge drops in productive output, and the unavailability of credit at any cost.  The financial system is usually at the root cause of the crisis and liquidity in the system suddenly disappears.  Faith in the system dries up overnight – the first stop are banks, next are capital markets.

The Great Depression of 1929-39 and the Financial Crisis of 2007-09 are prime examples of Structural Corrections that were felt across the globe.  History is, however, littered with other instances of more localized cases such as the 1997 Asian Crisis, the 1998 Russian Default and the Argentinian collapse of 1999-2002.

What should investors do during a correction?

The answer depends on the context surrounding the capital markets at that moment.  For example, the implications of a Technical Correction are very different from those of a Structural Correction.

Misdiagnosing what type of correction you are in can have severe consequences for your financial health.  Becoming too risk averse and selling everything can be as harmful as not being risk-aware enough and always expecting the markets to recover irrespective of business and capital market conditions.

Finding the right balance is key. In reality, after many years of watching markets one is never really 100% sure of anything.  In fact, if anybody says that they have perfect certainty all it means is that they either have not done all their homework or that they fail to understand the statistical concept of probability.

Our preferred approach is based on a solid understanding of capital market behavior coupled with hands-on experience under a variety of capital market situations.  Understanding capital market history is the prerequisite but experience is the key extra ingredient to gain confidence in properly evaluating the context in which markets are experiencing distress.

Table 1 provides a checklist as to the type of issues that we consider when evaluating the type of correction we might be in.

Table 1

Where are we today?

As of February 12 we have already seen signs of recovery, but the S&P 500 is still down 7.5% from its January 26 peak. Investors remain nervous. The CBOE Volatility Index stands at close to 27% which is significantly higher than where it was before the equity market started convulsing.

A 7.5% drawdown on the S&P 500 is not that uncommon. Investors should be wary but also keep their eye on their long game of growing risk-adjusted portfolio returns.

We believe that the current equity market downdraft falls under the category of a Technical Correction. Why? The numbers back up our assertion.  Our view is that equity markets remain healthy and will out-perform lower risk alternatives such as bonds.

Let’s start with a rundown of the negatives about equity markets.  The biggest knock on equity markets is that they are over-valued relative to historical norms such as price-to-earnings ratios. Agreed, the current Shiller P/E stands at 33.6 relative to a historical average of 17.  For access to the latest Shiller data click here.

On an absolute basis the S&P 500 is over-valued.  When considered relative to interest rates the picture changes.  Estimates by Professor Domadoran at NYU, for example, yield fair valuations on the S&P 500.

What else? Interest rates are too low. Agreed again, but low yields are the problem of the bond investor. A low cost of money is actually good for equity investors.

What about rising interest rates? The 10 Year US Treasury Note hit a low of 2.05% in early September and has been rising since. It currently stands at 2.84%.  Higher, for sure.  A real danger to equity markets? Not quite, especially in light of low rates of inflation.

Inflation-adjusted yields (sometimes called real yields) are still significantly below historical norms.

Higher real rates imply lower equity values.  We agree, but we see the current upward progression of interest rates in the US as fairly well telegraphed by the Federal Reserve.

We also still believe that US monetary policy is accommodative.  For example, Federal Reserve Bank of Atlanta estimates generated by the well-known Taylor rule show current Fed Funds rates about 2% too low (read here for a review).

What about the positives regarding equity markets? For one, we have a strong global economy.  Every major economy in the world is in growth mode.  The IMF recently raised their estimate of global GDP growth to 3.9% for both 2018 and 2019.

Inflation seems under control as well. The IMF estimates that global inflation will run 3.2% in 2018, unchanged from last year. Inflation in the US ran at 2.1% in 2017.

Monetary policy remains accommodative.  In the US the Fed reserve is slowly weening investors off artificially low interest rates, while in most other parts of the world (Europe and Japan in particular) central banks have yet to embark on the process of normalization.

The recently enacted lowering of the US corporate tax rate is also a positive for US domiciled companies.  Lower corporate tax rates translate immediately into higher cash flows.  Higher cash flows translate into higher corporate valuations. The main beneficiaries of lower corporate taxes are ultimately shareholders. 

What should investors do today?

Our analysis of the data leads us to the conclusion that the current equity market correction is driven by technical considerations and not fundamental issues.

We do not know how long the equity downdraft may last, but we expect this blip to barely register in the long-run.

Our advice may be rather boring but plain-vanilla seems the best response to the current state of investor panic.

• If you were comfortable with your financial plan at year-end, do nothing. Don’t obsess over every single market gyration. There is not enough evidence to merit an increase in fear or a significant re-positioning of your portfolio towards safer asset classes such as bonds
• If you did not have a plan in place, don’t go out and sell your equity holding before figuring out the status of your financial health in relation to your goals. Consult a certified financial planner if you need help.
• If you have some cash on the sidelines, deploy some of it in the equity markets. Given that all major equity markets have taken a beating spread your money around a bit. We still rate International Developed Markets and Emerging Markets as attractive.  Consider whether it makes sense for you to put some money in the US and some abroad.

Whatever you do don’t panic. Focus on your asset allocation in relation to your needs, goals and appetite for risk. Don’t let that Russian Bear get to you!

Taking risk and suffering the inevitable equity market drawdowns is part of investing. Be cautious but be smart. Talk to your Advisor if you need help. Make your money work for you!

Is 2018 the Year of the Roth 401(k) or the Roth IRA?

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

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

Even then, not everyone’s income taxes will go down in 2018 . That is because some of the features of the bill, such as the limitation on State And Local Taxes (SALT) deductions,  effectively offset some of the tax rate decreases.

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.

Retirement is one area where reduced income taxes may have an impact on the decision to invest in a Traditional or a Roth 401(k) or IRA . The advantages of tax-deferred contributions to retirement accounts, such as Traditional 401(k) and IRAs, are also tied to current tax rates. In Traditional retirement accounts, eligible contributions of pre-tax income result in a reduction in current taxable income and therefore a reduction in income taxes in the year of contribution.

Most people expect to make the same or less income in retirement compared to working life, and thus assume that their retirement tax rate will be equal to or lower than their working year tax rate. For those people, contributing pre-tax income to a Traditional retirement account comes with the possibility of reducing lifetime income taxes (how much you pay the IRS over the course of your life).

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.

If you believe, as I do, that tax rates are exceptionally low this year and will go up in the future, you should have additional incentive to analyze this situation. The decision to contribute to a Roth IRA or 401(k) works best for people who expect to be in a similar or higher tax bracket in retirement , and have at least five years before the assets are needed in order not to pay unexpected penalties. Is that you? The financial implications of whether to invest in a Roth instead of a Traditional account can be complex and significant . They should be made in consultation with your Certified Financial Planner.

 

Check out out other retirement posts:

Seven Year End Wealth Management Strategies

Is the new tax law an opportunity for Roth conversions

Rolling over your 401(k) to an IRA

7 IRA rules that could save you time and money

Doing the Solo 401k or SEP IRA Dance

Tax season dilemna: invest in a Traditional or a Roth IRA

Roth 401(k) or not Roth 401(k)

 

 

Roth 401(k) or not Roth 401(k)?

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

Which is better, more money in your paycheck or more tax-free cash in your retirement? It’s an important question only you can answer. 

According to a 2017 research paper 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!  

Traditional 401k contributions are made on a pre-tax basis while Roth 401k contributions are made post-tax . So, assuming a given level of cash flow available, most of the time contributions to a traditional 401k will be easier than contributions to a Roth 401k because traditional plans drive your annual taxable income lower. You’ll still have to pay taxes on the contributions later when you retire. but the “taxable event” is deferred.

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 Priya were to switch her contributions to her company’s Roth 401k? She is considering contributing the same amount: $9,100. However, because contributions to a Roth are post-tax , they would no longer reduce Priya’s taxable income.  Thus, she would pay taxes on $135,000 instead of $125,900.  Hence Priya would end up owing more taxes for the year.

No brainer for the traditional 401k, right? Wrong. Roth 401ks provide one major advantage. If Priva switched to the Roth and maintained her contribution level, she might end up with more income in retirement as Roth 401k distributions in retirement are tax-free , whereas traditional 401k distributions are taxed as income .  However, switching her contribution to the Roth would be at the expense of her current cash flow.  Can Priya afford it?

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.

It’s important to remember that Roth 401ks and Roth IRAs are not tax-free: they are merely taxed differently . That makes the decision to invest in a Traditional or a Roth 401k is an important financial planning decision :  employees need to understand the benefits and drawbacks of both approaches to make an informed decision that balances current spending desires with future income needs.

According to John Beshears, the lead author of the Harvard 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

Check out out other retirement posts:

Is the new tax law an opportunity for Roth conversions

Rolling over your 401(k) to an IRA

7 IRA rules that could save you time and money

Doing the Solo 401k or SEP IRA Dance

Tax season dilemna: invest in a Traditional or a Roth IRA

 

 

Have you had a Second Opinion?

By Jim Wood | Financial Planning , Retirement Planning

 

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!

But do you get checkups or second opinions for your investment portfolio? How long has it been since you have had a serious look at your investment portfolio? Is it more than 2 years? more than 5 years? If you look under the hood, you may find that your portfolio no longer meets your needs. You may find that changes in your life have evolved your risk tolerance and the asset allocation that’s appropriate for you.

You may find that the stocks, the bonds, the mutual funds, and the annuities that you have grown comfortable with, have reached a phase in their development that does not meet your needs anymore.

The asset allocation that worked when you were younger and carefree may no longer work

As you approach retirement your risk tolerance will change, and should be reflected in your portfolio . The asset allocation that worked when you were 45 or 55 and trying to grow your portfolio, may not work when you are 65 and planning for retirement income and other goals.

For a 65 year old, retirement can easily last 20 or 30 years or longer . Will your investment portfolio carry you through? Will your retirement income from investments keep up with inflation? Will you be able to meet the increasing cost of health care? How will you be taxed? Will there be enough to leave to your grandchildren?

Call today to get peace of mind with a Second Opinion on your investment portfolio from a fee-only advisor. You will be glad you did.

 

Previously published in the Colonial Times

 

Rolling Over Your 401(k) to an IRA

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

 

Changing 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.

Politics and Economics

By Chris Chen CFP | Financial Planning , Retirement Planning

 

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

Five Common Questions About Divorce

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

5 Common Questions About Retirement and Divorce

Retirement 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:

 

 

A previous version of this post was published in Investopedia

PORTFOLIO RISK MANAGEMENT or Can you sleep at night?

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

When choosing an investment or an investment advisor we pay great attention to investment results. We all want the highest possible return on our investments . Most of us understand that the more risk we take the more gain we may make, but also the more we may lose. It is a wonderful thought to consider how much we might make, but it is very prudent and wise to consider how much we might lose if things go bad. What can YOU afford to lose? Does the risk in YOUR portfolio match your needs?

The average gain of the S&P 500 from the start of 2010 to the end of 2014 was 15.45% . Quite a nice average gain and one that most professionals believe cannot be expected to continue in the long term.

In the bear market of the recent Great Recession, the S&P 500 lost over 54.9% of its value from October 9, 2007 to March 9, 2009 . If you had stayed invested in the S&P500 throughout the same period, you would have needed an estimated 122% return for your investment to return to its pre-recession level.

If instead in the same period you had been invested 50% in the S&P 500 and 50% in the Barclays US Aggregate Bond Index, you would have lost approximately 23.84%. You would have then needed a return of only 31.35% for your investment to return to its pre-recession level.

Obviously, this example is hypothetical. There are many other factors that weigh into portfolio design. Although real life portfolios will often contain many more components, this simple example illustrates the benefits of diversification, and the importance of managing risk in a portfolio.

It is up to you and your financial planner to judge the risk that you can afford, and up to your financial planner to help you implement a portfolio that reflects that risk.

The bar chart to the left will allow you to estimate the amount of gain required to offset any loss that you might have experienced.

How did 2015 do for you? At the end of November 2015 the S&P 500 was up 3.01% for the year . Many investors with all stock , and therefore, high risk portfolios, are still down for the year, and perhaps still not sleeping well.

What to do? After a financial planner has assessed your risk capacity, he/she will be able to recommend a fully diversified portfolio that includes all relevant asset classes to match your financial objectives.

Note: The above hypothetical example is based on historical performance of the S&P 500 and Barclays US Aggregate Bond Index using Morningstar data. You cannot invest in indices. Trading and management fees are not computed in the example. This is not investment advice, which can only be given individually based on your risk tolerance and circumstances.

 

A previous version of this post appeared in the Colonial Times