Ask Linda: Pre-tax versus Post-tax savings

Dear Linda,Should I save to my pre-tax 401k at work or my Roth IRA? I cannot fully fund both.

Sincerely,

Super Saver

Dear Super Saver,

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To determine which account you should save to, calculate your tax rate today versus your projected rate in retirement. In general, Roth contributions are made with after-tax dollars and distributed tax-free. The 401k is the opposite - contributions are made with pre-tax dollars and distributions are taxed at ordinary income rates.

If you are in a higher tax bracket now than you will be in retirement, save to the pre-tax 401k. If you will be in a higher tax bracket in retirement, save to the Roth IRA.

There are other considerations:

  • Tax laws can change - We don't know for sure what tax rates will be in the future, therefore, some people prefer to save to both types of accounts to hedge this uncertainty and manage their tax bill in retirement.

  • Employer matching - If your employer offers a match on contributions, save at least enough to the 401k to receive that "free money".

  • Investment options - If your 401k options are limited and expensive, you may choose to invest in the Roth IRA for the ability to create a custom strategy.

  • Income phaseouts - You may make too much money to contribute to a Roth IRA. You can typically get around this with a backdoor Roth IRA, but saving to a 401k may still be the best option for high earners.

  • Flexibility - Roth IRA's and 401k's have different hardship provisions for accessing money earlier than generally allowed (age 59 1/2 with exceptions). Examples relate to education expenses, medical bills and a first time home purchase. Additionally, some 401k's allow you to take out a loan. While this isn't necessarily a good idea, it is an option that is not available to you with the Roth IRA.

Even though one savings vehicle may end up being a better choice for you mathematically, realistically, either is fine as long as you are saving enough. Have a fee-only, fiduciary Advisor develop a custom retirement planto make sure you are on track.

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“Ask Linda” is a monthly personal finance column where the founder of Planning Within Reach, LLC, Linda Rogers, picks one question from her readers and publishes a detailed answer with the hope that it benefits others. If you would like to ask Linda a question, email her or contact her on Twitter.

Can't get yourself FIREd? You can still have a LIFE.

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FIRE stands for financially independent, retire early. The movement continues to grow, with retirees in their 20's through 40's. It has caught on because it is unexpected - we don't picture retirees being so young. Yet it is entirely possible and there is an ever-growing number of blogs and books that prove it. The typical profile of someone who has achieved FIRE:

  • Graduated from college with very little or no student loan debt

  • Earned $100,000+ per year with benefits

  • Saved 50%+ of their gross income by knowing where every dollar is going

  • Is typically single, married without children, or married with 2 or fewer children (I haven't seen any with more than 2 kids, but with the increasing number of FIREs, I am sure there will be some!)

  • Is typically burnt out on their current job and would prefer to be done with working instead of finding more rewarding employment

Obviously, this is very hard to achieve if you are earning minimum wage in a job without health insurance, have a mountain of student loan debt, or a large family. Still, there are a lot of positive things to take from the movement. For example, it is good to be reminded that you have choices. You don't have to do what your parents did or your neighbors are doing. Some FIREs live full-time in an RV, stopped eating meat, started cooking at home, etc. Many say they don't feel deprived after these changes - they simply changed a habit and are just as happy with the newer, cheaper way of doing things.

There are also risks. For those without children, what if they end up having kids and doubling their annual expenses?  Are they prepared to forego soccer and birthday parties to stay within their annual budget? Did they factor in healthcare costs correctly or purchase long-term care insurance? Are they prepared for the next bear market? Most of the profiles I have read are of people who have retired recently, so we don't know the success of their plans given uncertainties. We can choose to take the best of what we have seen and make it more universally attainable. So even if you can't get FIREd, you can still have a LIFE.

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Live a more balanced life today

FIRE assumes a balanced life occurs after the retirement date. Don't wait a decade or more for that goal - life is too short. We created a plan for a client showing he could work part-time until age 40 so he could spend more time with his young children now, while they were home. This is the opposite of FIRE, but that solution made more sense to him. Evaluate what you can do today to achieve a more balanced life, whether it is carving out more family time or finding a different employer.

Imagine you are financially free

The goal of FIRE is to be financially free - so imagine you are retired. What would you do every day considering your family, friends and social network are busy during the week and have limited funds? After traveling the world and tinkering with your hobby, is there something you could do every day without getting bored? Can you make money doing it? We created a plan for a former stay-at-home Mom to go back to nursing school. She didn't need to work, she wanted to. She loves her new career and can see herself doing it for a long time.

Focus on what you can control

A good chunk of our monthly expenses are fixed: housing, insurance, and utilities are a few examples. FIRE user forums are filled with people who downsized or started biking to work. That is great, but for most people obsessing over every dollar leads to fatigue and they lose motivation for tracking expenses completely. Instead, focus on what you can control - the discretionary expenses. You can use our free FLEXCash system or whatever works for you, but the simpler it is, the more likely you are to stick with it.

Educate yourself

When people say they want to make a career change, we recommend they speak with someone who is currently doing that job. Learn about their daily activities, their work-life balance, and see if they are earning a livable wage. Similarly, if you want to retire early, talk to someone who actually did it. Were the sacrifices worth it? What would they do differently? If you retire early and end up needing or wanting to return, it may be difficult to re-enter your industry after a prolonged absence.

Keep reading FIRE stories if you enjoy them, but don't define success as being retired. Retirement isn't a race worth winning if you aren't happy in the end. Whether you choose to get FIREd or to get a LIFE, have a money roadmap in place so you know where you're going.

How to Recognize a Ponzi Scheme

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A Ponzi scheme is a fraudulent investment. The organizers of the scheme do not invest your money in something with intrinsic value. Instead, they pay you a "return" with the contributions of new investors. Ponzi schemes received their name in the 1920's after Charles Ponzi was convicted of running this type of business. Despite all the knowledge we have of previous Ponzi schemes, they continue to defraud people from all walks of life. We are even seeing a new wave of Ponzi schemes involving virtual currencies, such as Bitcoin. Here is a summary of what to look for to protect yourself against Ponzi schemes:

High returns with little or no risk.

All investments, especially those expecting higher returns, involve risk. Be suspicious if someone is selling you an investment that allegedly defies the odds.

Unusually consistent returns.

Investment values go up and down on a daily basis. If your investment generates regular, positive returns, regardless of the overall market, that is a red flag.

Unlicensed sellers.

Most, but not all, Ponzi schemes involve unlicensed individuals or unregistered firms. Research your Broker or Investment Advisor to confirm they are registered with the SEC or required state regulators.

Unregistered investments.

Ponzi schemes typically involve investments that have not been registered with regulating authorities. By not registering, they can avoid disclosing details about the company's management, products, services, and finances.

"Black box" strategies.

Don't invest in something you don't understand. It is not a good sign if your Advisor grows irritated with your questions or treats you as if you don't understand something that is obvious.

Lack of detailed or complete paperwork.

You should be able to read about an investment in writing. Confirm the paperwork is detailed and complete without spelling and grammatical errors.

Difficulty receiving your money.

As the pool of investors grows, it becomes increasingly difficult to recruit enough new investors and contributions to keep the scheme running. Therefore, the organizers may encourage you to re-invest your return versus withdrawing it. They may also become more aggressive with their sales tactics and encourage you to tell your friends and family about the investment. If you were told the investment was liquid, but you are unable to retrieve your money in a timely matter, or without significant penalties, that is cause for concern.

Unfortunately, if you are caught up in a Ponzi scheme, there is no guarantee that you will get your money back or that the perpetrators will be prosecuted. There are many reasons for this, one being that the statute of limitations on financial crimes is five years. PWR is fighting to get this extended, but the reality is that many people don't realize they have been defrauded until year two or three, leaving insufficient time to complete the necessary legal proceedings. Therefore, the best way to protect yourself is to avoid a Ponzi scheme altogether.

Source: https://www.sec.gov/fast-answers/answersponzihtm.html

Impact Investing: The Myths

Impact investing opportunities continue to grow with one of every five dollars being invested sustainably as of 2016. Regardless, there are myths about impact investing that continue to persist, despite evidence to the contrary. For our second post in a series on impact investing, we debunk these common myths. Myth: My investment return will suffer if I implement an impact investing strategy.

Deutsche Asset Management and the University of Hamburg aggregated the findings of over 2,000 studies in 2016. Around 90% of the studies concluded there is either a neutral or positive correlation between a company's ESG ratings and financial performance. Morningstar Research completed a separate evaluation and came to the same conclusion - there is no performance penalty associated with impact investing.

Myth: Impact investing is for rich people.

There are impact investments that only accept accredited investors, individuals who consistently make over $200,000 per year or have a net worth of over $1M (excluding their residence). However, if you don't qualify as an accredited investor, you still have plenty of options. Examples include:

  • Mutual funds and ETF's that are ESG-focused
  • Green bonds which finance projects that have positive environmental benefits
  • CD's that help fund projects in your local community, such as affordable housing

Myth: An impact investing strategy simply excludes "sin" stocks or industries such as tobacco, guns, alcohol, and gambling.

Divesting from controversial stocks or industries, also known as negative or exclusionary screening, may be part of an impact investing strategy. But it is not the only tool, nor is it the most effective. When constructing a portfolio, investors should take a holistic approach that starts with documenting their values and financial goals. Next, they can identify appropriate strategies, which may include evaluating ESG ratings, divestment and engagement. Finally, investors should analyze how implementing the chosen strategy affects the risk and return characteristics of the investment portfolio. Research shows that divesting from controversial stocks or industries in an ad hoc manner can lead to portfolio underperformance and is therefore not recommended.

Myth: Social or environmental change should be the responsibility of governments and philanthropists, not of investors.

The Sustainable Development Goals (SDG's) developed by the United Nations focus on "ending poverty, protecting the planet and ensuring that all people enjoy peace and prosperity". These goals cannot be met by governments and philanthropists alone. Impact investors are filling the gap by providing capital and resources. They are also developing innovative ways to work with governments and philanthropists to advance change, such as pay for success programs. These programs accept private investors' money to expand social programs that have already proven to be effective. After an evaluation period, if the program reaches the pre-determined goals of benefiting society and generating value for the government, the government remits payment (principal and return) to the investors. If the program doesn't meet its goals, the government pays nothing.

Myth: Creating an impact investment strategy is too difficult.

While creating any investment strategy requires time and effort, creating an impact investing strategy is only getting easier as the number of available resources and vehicles continues to grow. If you want help, engage a fee-only, fiduciary advisor who is knowledgeable about impact investing and willing to take into account your values versus an advisor who insists on doing "business as usual".

Do you want to learn more about impact investing? Contact a PWR planner to learn how you can get started. For related posts, check out Impact Investing: The Lingo.

Ask Linda: What should I do with this unexpected bonus?

Dear Linda,I will be receiving an unexpected bonus shortly. I want to make sure I am smart with the money and have a plan in place for what I am going to do with it. Any ideas?

Sincerely, Lucky Lady

Dear Lucky Lady,

Your question is a common one we receive around this time of year as companies complete their prior-year reporting and issue bonuses. You are wise to create a strategy before spending the bonus. Without knowing the details of your situation, here are some general thoughts to help you get started.

1) Obtain a detailed tax projection from your tax preparer so you know how much of the bonus will be yours to keep after taxes. If your employer withholds less taxes than projected, reserve the balance so you have it available when it is due at tax time. You can also increase your W-4 withholding for the rest of the year. Withhold at least enough to avoid the underpayment tax penalty.

2) Pay off high-interest rate debt including credit cards, personal loans, or student loans. For example, some student loans charge close to a 7% interest rate. If you pay that loan off, it is as if you earned a risk-free rate of return of 7% on the money. However, if you plan to qualify for a student loan forgiveness program, you may not want to rush and pay it off. It will depend on your situation.

3) Build a cash emergency reserve. If you don't have this in place, reserve at least three months' worth of expenses in a high-interest rate savings account. You can reserve a larger amount if you are worried about losing your job, are expecting to move soon, or simply feel more comfortable holding a larger amount of cash. Realize that the interest rate on a savings account will not keep up with inflation over the long-term, so keep this account at the minimum balance required for your personal situation.

4) Increase your retirement savings at work. If your employer offers a retirement plan, you can save up to the IRS limit for 2018. For example, if you have a 401k or TSP, the limit is $18,500 if you are under 50 years old and $24,500 if you are over 50 years old.

Increase savings elsewhere. After you have implemented the first four suggestions, you may consider one or more of the following options:

- Save to a Roth IRA or Traditional IRA, if you qualify.

- Maximize your Health Savings Account (HSA), if you qualify.

- Consider after-tax 401k contributions, if available. After-tax 401k contributions are different than Roth contributions. There is no tax deduction on the savings, but the money will grow tax-deferred and can be rolled into a Roth IRA (without limitation) after you leave the company. Not every company offers this option.

- Save to a Brokerage account. There is no tax deduction on contributions to a brokerage account, but it is still a good option. Qualified retirement accounts (such as a 401k or TSP) are taxed differently than a brokerage account. When you have a mix of account types, you have more flexibility to utilize asset location strategies and manage your tax bill in retirement.

- Save to a donor-advised fund (DAF). A DAF is an investment account for charitable purposes. You invest as you would with any investment account and when you are ready to donate to a qualified charity, use the money from the DAF. Assuming you are eligible for charitable deductions, you will receive the deduction when you place money into the DAF, not when money is withdrawn. If you are charitably inclined and expect to be in a higher tax bracket now than in the future, take advantage of the tax deduction now while it provides a greater benefit to you.

- Save $10K to an I-Bond. I-Bonds are government bonds adjusted for inflation. You are allowed to buy $10K each calendar year per person.

- Fund other goals you may have. Confirm you have enough life and disability insurance, and if not, use the bonus to become adequately insured. If you are saving for a house, earmark some of the bonus for the down payment. If you are saving for a child's college education, consider a 529 plan.

Work with a fee-only, fiduciary advisor and tax preparer if you want a customized strategy that prioritizes your available options in detail.

Tax Planning for 2018

The TCJA (Tax Cuts and Jobs Act) passed in late 2017 affects your tax planning for 2018. We highlighted the changes that are most likely to pertain to our clients. The information is general in nature, and not a substitute for individual and customized tax advice from your tax preparer. 1) Some retirement plan contributions have increased.

If you contribute to a TSP, 401k, or 403b, you may be eligible to increase your savings. The limit is now $18,500 versus $18,000 in 2017. The catch-up contribution (for those age 50 and older) remains unchanged at $6,000. If you contribute to a SEP IRA, the maximum annual contribution is now the lesser of $55,000 (vs $54,000 in 2017) or 25% of compensation.

Roth IRA and IRA contribution limits remain unchanged at $5,500 per year with a $1,000 catch-up contribution.

2) The annual, per-recipient, gift tax exclusion rises to $15,000 (from $14,000 in 2017).

Examples of gifts that are affected by this exclusion limit include how much you can contribute to a child's 529 plan or how much you can gift a child for a wedding or down payment.

3) Alimony is treated differently.

Alimony is no longer allowed to be deducted on the payer's tax return. Likewise, it will no longer be included as taxable income for the recipient. In the past, alimony was treated as "earned income" for purposes of the recipient being able to save to an IRA. This is no longer the case for 2018 going forward.

4) "Backdoor" Roth IRA conversions have been legitimized.

You can only contribute to a Roth IRA if you make less than the income limit defined by the IRS. Many of our clients make too much money to contribute to a Roth IRA. The backdoor Roth conversion is a term used when a taxpayer moves non-deductible contributions in a Traditional IRA account to a Roth IRA account, without owing taxes or being subject to income limitations. The TCJA explicitly states this is now a legitimate planning tool and is allowed.

That being said, you need to be careful. For example, if you have any pre-tax or deductible IRA money (say from an old employer's 401k that you rolled into an IRA), you will owe taxes on the conversion of the non-deductible IRA money to a Roth even though it is a separate account. Here is another resource that goes into more detail (see gotcha #4).

5) Charitable Deductions will not be as big of a benefit, if at all, for many people.

The charitable deduction is an itemized deduction on your schedule A. The TCJA eliminates or cuts many itemized deductions and increases the standard deduction, so many people who have used the schedule A in the past, may not use it in 2018, therefore getting no benefit for their charitable donations.

For clients that have IRA's and are over 70 1/2 (and therefore subject to required minimum distributions or RMD's), a better way to give to charity may be through qualified charitable distributions (or QCD's). This is when you transfer your RMD directly from a traditional IRA to the qualified charity. The RMD is typically taxable income, but when you execute a QCD, it is excluded from taxable income. It gives you the same benefit as if you took a taxable distribution from your IRA, gave the money to charity, then deducted the donation. The limit on QCD's is $100,000 for 2018.

6) You may want to bunch your deductions every other year.

Since many people may be on the border as to whether they will get the standard or itemized deduction, it is worth having your tax preparer do a tax analysis to see if you can reduce your taxes with good planning. For example, one year you may want to reach for the itemized deduction by paying January's mortgage payment in December, pre-pay property taxes and/or contribute double to charity. The following year would be a standard deduction year (no pre-payments or charity), followed by the same strategy the following year to itemize.

The tax law and changes are complicated, so check with your tax and financial advisor before implementing any of the above strategies. PWR prepares taxes. If you are looking for help implementing these strategies, or need a tax preparer, review our services page or schedule a free call to learn more.

Are you Self-Employed?

Consider a SEP-IRA. A Simplified Employee Pension (SEP) plan is a retirement savings vehicle available to those who are self-employed. This past year, I came across a handful of new clients who were self-employed and not aware of a SEP-IRA and its benefits. The following is a summary focused towards business owners who do not have employees. You can use the SEP-IRA with employees, but I do not go into the details of that below. A SEP-IRA follows the same investment, distribution and rollover rules as traditional IRA’s. The amount you can contribute is based on a formula. The IRS demonstrates this with an example here.

The due date for contributions is the due date of your business income tax return including extensions. There is flexibility with the contributions in that you can contribute in some years and not others. The SEP can also be paired with other retirement savings vehicles. For example, you can contribute to a Roth IRA in addition to a SEP-IRA.

As you prepare to gather information for your taxes in the next few months, remember the SEP-IRA. It may be a good retirement plan for you. To learn more, review IRS Publication 560 and check with your tax preparer.

 

Image courtesy of hin255/Freedigitalphotos.net

 

The Possibilities are Endless with Systematic Savings

 

Systematic savings is an easy yet powerful concept.  It involves setting up an automatic deduction from one account to another at some frequency (weekly, monthly, yearly, etc).   

Many of us already experience systematic savings with our paycheck.  We have automatic deductions for retirement such as 401(k) or TSP plans. Federal taxes are also automatically deducted from our paycheck.  The IRS knows that they are much more likely to get their money if they force you to pay as you go.

The benefits of systematic savings have been so well documented that the government passed a law in 2006 allowing businesses to auto-enroll employees into retirement savings plans.  Once people are enrolled, they are much less likely to make a change.  Instead, they learn how to adjust to a smaller amount in their paychecks, if they even notice.

We can apply the concept of automatic savings to other things.  It doesn’t cost anything to open up a new savings account at my bank.  Therefore, I set up separate accounts for various goals and save automatically for these goals each month. 

The idea started when we got our dog, Fulton, a few years ago.  We looked into pet insurance and, at the time, it didn’t seem to make sense for us.  Insurance didn’t cover as much as we thought it would, so it seemed hard to justify the cost.  That being said, we didn’t want to dip into our savings account in the event of a health emergency for him.

As an alternative, we decided to self-insure.  Instead of paying pet insurance premiums every month, we automatically contribute the cost of a monthly insurance premium to a separate savings account.  If we need money for a surgery or medication for our dog, we just take it out of that separate account without touching our other investments.  And when our dog passes away, we will still have the savings account to do with it what we want.  If we were paying premiums, we wouldn’t get that money back.

The negative side is that if your pet needs a $10,000 surgery, and you do not have even close to $10,000 in his savings account, you are going to have to come up with the money. If you had opted to pay insurance premiums, it may have been covered. 

Systematic savings accounts will work for some people and maybe not for others.  You have to consider your risk tolerance, self-discipline, and current emergency fund.

I have found the concept to be liberating. We have an account for future cars and car repairs.  We also have a travel fund.  You don’t stress over purchasing a gift or going out to dinner with friends when you know you are saving each month for things that are important to you, and you can enjoy the rest.  Give it a try next time you find an expense that is throwing your monthly budget into a tailspin!