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Monday, September 8, 2014

Creative Ways to Cut Your 401(k) Fees

This story appears in the September 8, 2014 issue of Forbes.                                                                    
What’s your 401(k)’s composite expense ratio? Higher than 0.1% a year? Then you should be looking for an escape hatch. It could save you a pile of money.
If the mere question about ratios leaves you flummoxed, you have company. Plenty of employees don’t pay attention to what they are losing to fund fees. They should.  The difference between high-cost funds and low-cost funds could easily add up over the course of a career to several hundred thousand dollars.
The operators of retirement plans and even employers do not necessarily mind the state of confusion that prevails. One way or another the considerable paperwork cost of a 401(k) must be paid, and the most common way to do that is to extract it via fund expense ratios. The plan may offer a few bargain funds, yet still depend for its economics on having most of the workers wander blindly into higher-fee options.
To get your costs down, you may have to be a bit creative. Consider these real-life cases.
X, 23, has just joined a fast-growing West Coast technology firm. The pay is high, but the 401(k) plan is bad. There’s no employer match, and most of the funds on offer are expensive. Employees who sign up but neglect to make an investment choice are deposited into a balanced fund (a mix of stocks and bonds) that costs a rapacious 1.28% of assets annually.
Not wanting to pass up the valuable tax deferral, X is contributing the maximum $17,500 a year. She wants a mix of stocks and bonds. There’s one cheap stock fund available, an S&P 500 index fund at 0.09% a year. But the cheapest bond fund, American Century Ginnie Mae, costs 0.55%.
Solution: She will put her entire 401(k) contribution into the stock index fund. Then she will restore her balance by adjusting other assets. She has an inherited IRA at low-cost Vanguard. She’ll shift some of that money from stocks to bonds. With an investment of $10,000 or more, she is eligible for the bargain share class of the Vanguard Total Bond Market Index mutual fund. Annual cost: 0.08%.
Y, 37, is a new partner in a medical practice. There are all manner of compliance costs for retirement plans, and those costs must be recouped. The best the three docs could do was a menu drawn from the American Funds collection, priced at 0.58% to 1.13% a year.
The doctor’s plan has an escape hatch. For a $100 transaction fee, a participant can use a “brokerage window” to buy just about any security. When his balance gets big enough, it will make sense for him to pay the fee and buy a dirt-cheap exchange-traded fund on the New York Stock Exchange. Schwab and Vanguard have ETFs costing as little as 0.05% a year.
Suppose Dr. Y moves $100,000 over to the Schwab U.S. Aggregate Bond ETF, with an expense ratio of 0.06%. His annual portfolio cost will go from $580 (or worse) to $60. He’ll gladly pay the $100 transaction fee, a brokerage commission and a bid/ask spread of a few cents per ETF share.
Z is a 61-year-old manager at a nonprofit with a Fidelity-managed 403(b) plan, something very similar to a 401(k). The menu includes some low-expense stock index funds. But the cheapest fixed-income choice is the Fidelity Intermediate Bond Fund at 0.45% a year.
The $500 million plan has a brokerage window with a $75 fee. This window is opened just a crack: Z may not buy ETFs, and when he gets a Vanguard fund he is herded into the expensive share class.
Last year Z crawled through the window with $172,000, putting the money into the Vanguard bond market index fund at an expense ratio of 0.2%. His savings will run to $430 a year.
A survey by benefits consultants Aon Hewitt found that 76% of large employers have workers pick up all the costs of 401(k) administration. Among employers that push all or some of the costs onto employees, a rising minority (now 26%) assess account administration fees, such as $25 per account per year. The rest continue the tradition of burying costs in overpriced funds, a practice that helps youngsters with tiny balances but hurts workers who have been around long enough to accumulate respectable sums.
The game seems to be tilting to the older workers. Two in five large-company plans have the brokerage escape hatch .

Tuesday, July 22, 2014

Pre-tax and Post-tax IRA contributions: Eat your vegetables first

Marginal income tax rates are at an historical all-time low. Our Government debt is at an all-time high and currently 17.5 trillion dollars. Ten thousand baby boomers are retiring every single day. Social Security is expected to only be able to pay .77 cents for each dollar of scheduled benefits by the year 2033, and we have recently overhauled the health care system, which is likely to cost us all a lot of money as we shift health care responsibility from individuals to the government. These are just a few of the reasons that so many people are considering tax planning as part of their overall financial well being, and these are some of the reasons why I’ve recently converted more of my traditional IRAs to Roth IRAs. But what about those who have both pre-tax and post-tax contributions inside of a traditional IRA. Should an investor convert the post-tax contributions to a Roth?
One of the questions I am getting asked more and more these days has to do with the mechanics for conversions from a traditional IRA to a Roth IRA. As you probably know a traditional IRA is typically funded with pre-tax dollars and defers taxation into the future while a Roth IRA is funded with post-tax dollars and future distributions are, in most instances, free from federal income tax. So should you be deferring taxes into the future given the reality of our current economic conditions or not?
I recently consulted with a person who had made both pre-tax and post-tax contributions to his IRA.  He was interested in converting only the post-tax portion of his IRA to a Roth.
Before I get too deep into the weeds, let me explain that most individuals can make contributions to an IRA, but depending on the amount of income they have will determine if  the contribution is tax deductible in the year they make the contribution or not. A pre-tax contribution is money that was contributed to the IRA and was not taxed at the time of the contribution. Pre-tax contributions are what the majority of  people contribute to an IRA.
A post-tax contribution is where the individual already paid taxes on the income received and made a contribution to their IRA, but did not receive a tax benefit in the year of the contribution. This usually occurs for high income earners and they may also be precluded completely from being able to contribute to a Roth IRA. For example a married couple filing a joint tax return in 2014 covered under a workplace retirement plan will have tax deductions phased out for contributions to an IRA when their income is between $96,000 – $116,000.  That same married couple not covered by a workplace retirement plan will have tax deductions phased out when contributing to an IRA when their income is between $181,000 – $191,000, and a married couple filing jointly with a modified adjusted gross income of more than $191,000 is ineligible to contribute to a Roth.
If all of the money being considered for conversion to a Roth IRA was in traditional IRAs and was pre-tax dollars, then the rules are very clear and easy to understand. You simply pay tax on the amount you convert in the year you convert.
Things get a little more complicated when you have both pre-tax and post-tax contributions to a traditional IRA since it is not possible to convert only the post-tax contributions of a traditional IRA to a Roth IRA. The IRS has a pro-rata rule that requires you to add the value of all your IRAs and determines what percentage is post-tax vs pre-tax. Then when you convert dollars from your traditional IRA to a Roth IRA, a portion of the conversion is considered taxable and a percentage is not taxable based on the pro-rata formula.
For example, you had a rollover IRA with $90,000 of pre-tax contributions and a traditional IRA with $10,000 of post-tax contributions. The IRS would require you to add $90,000 + $10,000 = $100,000 of total IRA assets. Then you divide $10,000 / $100,000 and find that 10% of the IRA assets would be considered tax free upon conversion. So if you were to then convert just the post-tax traditional IRA of $10,000, then the IRS would consider 10% of that IRA conversion to be post-tax money and 90% to be pre-tax. On the $10,000 dollar conversion, $9,000 would be taxable as ordinary income  and $1,000 would not be taxable.
When consulting with people on these rules they sometimes express frustration and feel this is unfair and double taxation because they have already paid tax on the $10,000 in the post-tax traditional IRA. I understand why people feel this way however these are how the IRS rules work, and the IRS uses the sum of all your IRA accounts and does not view them independently of one another for the purpose of converting traditional IRAs to a Roth IRA.
When people have both both pre- and post-tax IRA contributions, they should track the basis of the post-tax contributions in their traditional IRA using form 8606 when filing their taxes every year. This way they will know how much of their future distributions will be taxable vs tax free when they begin taking money out of their retirement accounts.
When I was growing up my dad used to teach us to delay gratification. To eat our vegetables first and dessert last. One of my favorite quotes is from Jim Rohn who said, “All men will experience pain. The pain of discipline or the pain of regret. The pain of discipline weighs an ounce compared to the pain of regret that weighs a ton.”  Paying taxes now may not be fun, but I have a feeling paying taxes in the future might really be painful.
Everyone of us are lucky to live in the greatest country in the world and most people I know don’t mind paying their fair share of taxes. For a lot of people it makes sense to diversify future tax liabilities. In my mind converting a traditional IRA to a Roth IRA is the equivalent of eating your vegetables first and saving the dessert for later. I personally really like the idea of a tax-free retirement.

Thursday, June 12, 2014

A Map for Your Family

Your financial life is probably more complicated than you realize. You may have multiple bank, retirement, and investment accounts; insurance policies; a safe-deposit box; and more. You have bills to pay and perhaps a mortgage and other outstanding loans. And then there are the people you might depend on for financial matters: your attorney, financial advisor, insurance agent, and accountant, just to name a few.
Now think for a moment about how your family would navigate this financial sea if you were gone.

A letter of instructions can help guide your loved ones. Because a letter of instructions is not a legal document, you can simply sit down and write it yourself. Here are some topics you may want to include.
  • A list of documents and their locations, including (but not limited to) your will, financial account documents, insurance policies, tax returns, real estate deeds and mortgage documents, vehicle titles, Social Security and Medicare cards, marriage and/or divorce papers, and birth certificate.
  • Contact information for the professionals mentioned above as well as others who may be helpful, such as a business partner or trusted friend.
  • A list of bills and creditors, including when bills and payments are typically due.
  • Passwords and logins for any important online information.
  • Your final wishes for burial or cremation, a funeral or memorial service, organ donation, and charitable contributions in your memory.
Keep your letter of instructions in a safe, yet accessible place and tell your loved ones where it can be found. It would also be wise to give the letter to the executor of your estate and other trusted friends or advisors.
A letter of instructions is an important step to help your family during a difficult transition period. Because your wishes may change, be sure to update the letter regularly.

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. Copyright © 2014 Emerald Connect, LLC.

How to make your money last until your 100

Let's suppose that you -- or your spouse or partner -- live to age 100. Will your money last that long? You don't want to experience "money death" before leaving this planet for good. Even if you don't live to be 100, it's smart to make sure your retirement income will last a long time, because there's a good chance you'll make it to your 90s.
If you're currently in your 60s, it'll take a lot of money to be fully retired for 30 years or more. Let's just do one simple reality check to illustrate. Suppose you spend $50,000 per year on all your living expenses -- housing, food, utilities, medical premiums, medical expenses, entertainment and so on. This isn't a bad assumption, given that the average American household spent $51,442 per year on these expenses in 2012, according to the Consumer Expenditure Survey. If you live 30 years, that's $1.5 million, and we haven't even factored in inflation, which is sure to increase your living expenses.
Do your IRAs and 401(k) accounts total $1.5 million?
The good news is, they don't have to. You have other sources you can also count on, such as Social Security, employment income or an employer-sponsored pension, if one is coming to you. But you'll still want to plan your finances carefully to make sure you'll have enough to cover your living expenses until age 100 and beyond.
You'll want to maximize the sources of retirement income that are paid for the rest of your life, no matter how long you live. That means delaying Social Security benefits until age 70, the age at which you will have maxed out the delayed retirement credits.
If you're eligible for a traditional pension that pays you a monthly income for the rest of your life, you'll also want to wait until the normal retirement age, typically age 65, to start benefits. At that age, there's no longer a reduction taken for early retirement. If your employer attempts to seduce you with the offer of a lump sum payment in lieu of the monthly pension, turn it down -- you'll get more money over your lifetime by taking the monthly pension.
One good retirement strategy is to cover your basic living expenses with sources of income that are guaranteed for life and indexed for inflation. This way, you don't need to worry about the roof over your head and food on the table if you live a long time or inflation kicks in.
Social Security is a good source of such income, which is one valid reason to wait until age 70 to start benefits. Another good source is an immediate annuity that's indexed for inflation or that increases at a fixed rate, such as three percent per year. You can use your retirement savings to buy such an annuity.
Note: Employer-sponsored pension plans aren't indexed for inflation, so they don't fit the parameters of this retirement strategy, but they're still a valuable benefit because they're paid as long as you live.
For your discretionary living expenses, such as travel and entertainment, it's not quite as critical that your retirement income lasts for life or is indexed for inflation. For these expenses, you might consider investing your remaining savings in stocks with the potential for growth. Then you can make periodic withdrawals, either with a systematic withdrawal method or as needed, to cover these type of expenses.
The possibility of living to age 100 is another reason it's a good idea to work until your 70s. This lets you wait to start Social Security benefits, and by working longer, you'll need less retirement savings.
For example, suppose you need an annual retirement income of $20,000 to supplement your Social Security income. If you purchase an immediate lifetime annuity that increases at three percent per year, according to Income Solutions, a 65-year-old couple would need about $461,000 in savings, but a 75-year-old couple would need only $349,000. Plus, if you waited from age 65 to 75, you'd have 10 more years for your savings to grow.
If you don't want to buy an immediate annuity to generate $20,000 per year, then you'll need more savings. The so-called "four percent rule" is intended to use invested savings to generate retirement income for 30 years, which gets a 65 year-old only to age 95. The four percent rule would require savings equal to about $500,000 to generate an annual retirement income of $20,000. And lately, the four percent rule has been called into question as delivering a retirement income that may be too high, given the low level of interest rates and the drag of fees for investment and advisor expenses.
The bottom line is that if you expect to live to your mid-90s or even age 100, buying a lifetime annuity with some portion of your savings is a good idea.
Finally, you'll want to have a strategy for paying for medical and long-term care expenses. You can remove most of the uncertainty and exposure for high medical expenses through participating in Medicare and buying the appropriate Medicare supplement plan.
Medicare and medical insurance, however, don't typically cover long-term care expenses. In this case, you'll either want to buy long-term care insurance, keep your home equity in reserve to tap in case you need long-term care, keep an investment account that's dedicated to long-term care expenses, or -- more likely -- some combination of these strategies.
The bottom line is, it will take some careful planning to support yourself and your spouse or partner until age 100. You'll want to consider working as long as you can, saving as much as you can, carefully managing your living expenses and creating a fulfilling and engaging life that makes it all worthwhile.