Another year-end tax tip - top off your accounts. Even if you're an employee, you can often defer most of your last paycheck of the year into your employer sponsored retirement plan. Why would you do this and how would you pay the bills in the meantime? I've broken the why into different categories.
High Taxable Income Years (over $200,000)
High earners would look for ways to defer more in years where you expect higher than usual income and you want additional deductions. Let's say you inherited an IRA or annuity this year - that usually means you have extra taxable income. Or maybe you downsized and no longer carry a large mortgage - that means less itemized deductions. Or maybe you exercised stock options or received a year-end bonus.
What you want to do is look at your expected 2013 tax bracket based on your estimated taxable income for the year. If you have income that falls into a higher tier bracket, then additional deductions are going to reduce your tax bill at that higher tax rate. Meaning if you had $2,000 of income that was going to fall into the 33% federal tax bracket, then an additional $2,000 contributed to a deductible plan would reduce your federal tax liability by $660.
What do you use for living expenses if you defer most of your paycheck? Use some of your savings account, then throughout the following year you can replace the savings you used. There is nothing wrong with using some savings on a temporary basis particularly if it is helping you save more.
If you're self-employed, you have a different set of choices. Many plans for self-employed people don't require that you contribute to the plan until your tax filing deadline next year, but in many cases you must have the plan established by 12/31. You can learn more in 4 Best Retirement Plans for Self-Employeds.
Lower Taxable Income Years (i.e. less than $200,000)
And what if your taxable income is low this year? As long as you have some earned income you can fund a Roth IRA. We routinely have clients who are eligible to fund a Roth move money from their taxable savings and investment accounts into Roths. By doing so they have not actually saved additional money but they have still shifted money into a tax-free account - as you're only allowed to contribute so much each year you have to take advantage of this every year that you can.
Learn more ~ or join the conversation!
Every few days I'll be expanding upon one of the ten year-end money moves I discussed in my recent article 10 Year-End Money Moves for Near Retirees.
Last week I discussed Harvesting Losses and Gains. Today I want to talk about Roth conversions.
First of all what is a Roth conversion? It is when you take a regular IRA account that has tax deductible dollars in it (or a 401k) and you decide you want to move a portion of it into a tax-free Roth IRA. You pay tax on the amount moved in the tax year that you do it. But from that point on, the dollars in the Roth grow tax-free.
There are numerous reasons you might do this and I've written quite a few articles about Roth conversions including the following:
- 5 Questions to Determine if a Roth Conversion is Right for You
- Don't Let Them Talk You Out of a Roth Conversion
- 6 Things a Roth Conversion Calculator Won't Tell You
Despite all that I've written, I just came across one of the best Roth articles I've ever read, written by Robert Klein. He brings up the excellent point that the ideal time to do a Roth conversion is when the market has dropped significantly. He also outlines six income tax scenarios that make it more conducive to pursuing a Roth conversion. Read his article at Considering a Roth IRA conversion before year-end?
If you really want to dig in, I'd also suggest checking out The Roth Revolution, where James Lange, who is both a CPA and an attorney, makes several free PDFs on Roths available for reading.
At the end of each year it's the same process. We scour everything in our client's taxable accounts to see if there is anything with a loss.
This year we're not finding much. Some real estate funds, closed-end funds that transferred in from a client's account with a former adviser, and a few bond funds.
So what do we do with these losses? We try to use them for tax planning, of course.
Harvesting losses by exchanging one fund or investment for an almost identical fund or investment allows you to realize the loss for tax purposes while maintaining your investment allocation and exposure to future gains.
You can learn how it works and why you might do it in How to Realize a Capital Loss for Tax Reasons.
The last few years, since the initiation of the 0% capital gains tax rate for those that fall in the 15% tax brackets, we also look for opportunities to harvest capital gains. Sometimes we can realize just enough gain to fill up a client's 15% bracket and by doing so the client pays no tax on the capital gain. Pretty cool.
This type of tax planning takes work. It takes pretty much all our time for most of the month of December. By diligently doing it each year, we save people money. And that's what they pay us for.
You can do your own tax planning. I explain how in 3 Ways to Do Your Year-End Tax Planning.
This question came in about a month ago, and brings up some excellent points about 401k loans and how they work.
My questions regarding a 401K loan have to do with the ongoing valuation of your account after a loan has been made. Let's say I have a $100K balance in my 401k. Let's say I borrow $50K, repayable over 5 years.
1. What will the initial and follow on quarterly statements look like? Will the balance be shown at $100K or $50K with a loan of $50K?
2. What will happen to the account balance, as far as earnings go? Will the fund's rate of return be applied to the $100K or the $50K?
3. What would happen to the account balance, as far as losses go? If there is a total loss because the fund failed, would the loss be $50K with a $50K outstanding loan, or would the loss be $100K with a $50K outstanding loan?"
"Hello 401k loan inquirer,
Here's the thing about a 401k loan - you have borrowed the money from yourself. The custodian or 401k provider is not lending you anything. Below are the answers to your questions.
- Each 401k provider reports in their own way. Technically the 401k loan you took is a receivable to your 401k account. For example if you made a loan to someone, the amount owed to you is an asset on your net worth statement, just as an account receivable is an asset to a business. With a 401k loan you owe money to your 401k account, so as far as your account is concerned the loan is an asset to the account while being a liability to you personally. Unfortunately this makes it confusing and there doesn't seem to be agreement in how the loans are reported. I have seen plan providers report the balance minus the outstanding loan and then list the loan separately with a footnote that tells you the loan amount is not included in the total. I have also seen statements where they started with a net balance, then added in the outstanding loan to give you a total vested value that did include the loan balance. I'm not sure how your 401k plan provider would report it.
- No, the fund's rate of return is not applied to the loan balance, so in this case investment returns only apply to the $50k that is still invested. The amount you borrowed is NOT invested in anything. You owe it back at an interest rate that is determined by your 401k plan rules. Think of the loan as note receivable with a pre-determined interest rate. The loan to you is the investment.
- The gains and losses apply only to the $50k that is invested. With a margin loan, you can lose more money than you have, but with a 401k loan you are not actually borrowing against invested funds. Instead you are making a withdrawal by selling investments, but it is called a loan so you can repay it and thus avoid the income taxes and penalties that would otherwise be associated with a withdrawal.
Learn more in 7 Things to Know About 401k Loans.
"I have been a subscriber to your newsletter and find it very helpful. My wife and I currently have a Simple IRA, a Traditional IRA, 3 Sep IRA's and a 401 (k) Sep. I would like to put these all into one brokerage account so they would be easier to manage. My question is, can I do this, especially with the Simple IRA? I'm 64 and thinking ahead before I retire at 66. Thank you for your time."
"Hi too many baskets,
I like the way you are thinking. Consolidating accounts as you near retirement has numerous advantages.
You cannot consolidate accounts with your spouse, but you should be able to get to the point of having one IRA for you and one for your wife.
You would work with your financial institution to rollover or transfer account balances into one Traditional IRA for you (you could likely use the one you already have) and one for your wife.
With your SIMPLE IRAs you have two considerations. First, is it still an active plan that you contribute to? If so, you'll need to keep it open until you are ready to terminate the plan. Second, you must have had the plan for over 2 years. If you have not had the plan for over two years do NOT attempt to consolidate or transfer this until you have met the two year requirement. There is an extra penalty tax for SIMPLE withdrawals if made in the first two years after starting participation in the plan. You do not want to risk incurring this penalty.
With your SEP 401k plan, is it still an active plan? If so, you will need to keep it open until you are ready to terminate the plan.
If you will not be making additional contributions to any plans other than an IRA, then you can work toward consolidating everything to one IRA for each of you. If you will still be making contributions, you will need to keep the active plan open.
Hope that helps!"
Reader question received this week...
I am a public employee and will receive a public employee pension upon retirement. I also have a QDRO that will require me to pay $2,000 / month. I know my SS benefits will be either none or greatly reduced.
Q: Will the Ex-Wife be considered as a public employee when she applies for social security benefits? If so, does the method of payment from me to her make a difference? For instance a direct payment from me to her, verses a payment from the pension fund administer. And would I have a choice in that?
Q: When I eventually make QDRO payments, are those payments tax deductible by me?
Any information that you can supply will be appreciated."
Here's my answer...
"First, I must qualify my answer by saying that no part of my answer should be considered legal or tax advice. Your question has numerous parts which would need to be verified by an attorney, a tax professional, and the Social Security office.
However, let me tell you what I think the answers are.
When funds are paid by a QDRO (Qualified Domestic Relations Order) they are paid directly from the plan administrator or custodian to the ex-spouse. This would mean the $2,000 a month would be taxable income to your ex-wife and it would have no impact on your tax return. This would be the preferred structure. I do not know if you have a choice. If you do, I would think you would want the plan administrator to handle it. A QDRO is a court order, so the plan administrator must follow its terms and the nature of a QDRO allows tax deferred accounts or payments to be given to an ex with them taking on the tax consequences. A QDRO payment is different than alimony. Alimony paid is tax deductible to the person paying it, and is considered taxable income to the person receiving it.
As your ex-wife would be receiving a pension from benefits not covered by Social Security tax withholding, she may be subject to two provisions of Social Security that have the potential to reduce her Social Security benefits: the Windfall Elimination Provision (WEP) and/or Government Pension Offset (GPO). However, with WEP there is a substantial earnings test, so even if WEP applied to her, if she has been in the private sector most of her life I would think she would have enough earnings that she would receive her full Social Security benefits. GPO affects spousal or survivor benefits so it could affect any potential widow/widower benefit or spousal benefit that she may be eligible for based on your earnings record. These would be questions for a senior person at the Social Security office to address as to the final answers.
More About Divorce and Retirement
You saved it. Now, guess what? You are required to withdraw it. What am I talking about?
I am talking about the required minimum distribution provision of the tax code. When you reach age 70 ½ you are required to take money out of IRA/401(k) and other similar retirement account types. This is a checklist item in our planning firm and near the end of each year we check to make sure everyone who is required to do so has taken their distributions.
There is a formula that determines how much you have to take. It is based on your age and the prior year-end account balance. Each year you are older you are required to withdraw a higher portion of your remaining balance.
When I say withdraw, that doesn't mean you have to spend it. You could simply transfer shares of a mutual fund or stock from your IRA to a non-IRA account to meet your required distribution.
Although you are not required to spend it, you are required to report this withdrawal as taxable income on your tax return - even if you simply move investments from the IRA to a non-IRA.
For many, when they reach their 80's these required distributions cause them to be in a much higher tax bracket then they ever anticipated.
If you inherit a retirement account you also have required minimum distributions, but they work a bit differently than if it was your own account.
Don't let the rules catch you off guard. Here are things to check out to learn more:
Many high income earners transition into retirement without a clue. It's befuddling to me. I've had such people sit in my office telling me they've never had to do a budget in their life and they aren't about to start now.
This is immature and bordering on childish.
Yet this is how many people approach retirement.
They get a big deferred comp payout or an early separation package and their bank account is flush with cash. They stop thinking in terms of what is coming in each month. First, they remodel the house. Then a vacation or two. Then a car. Then as they start to see the cash balance get lower they think "Hmmm. Maybe we need a plan?"
That's about when I hear from them.
There is something you can do to avoid this - and it doesn't have to be a budget in the traditional sense.
You can set up a holding account. Any deferred comp payouts, early retirement bonuses, Social Security, pensions, IRA distributions, etc., all go into the holding account which can be a simple no-fee checking account.
From this account you set up a paycheck to transfer into your spending account. For example every 1st and 15th of the month you would transfer a set amount from the holding account to your spending account. By doing this you have created your own paycheck.
This simple money management process is an incredibly effective way to monitor spending in retirement. It doesn't require you to account for every penny or do a detailed budget. But you do know exactly the amount of your paycheck from your holding account to your spending account.
And for those who are willing to take a deeper look at things, which I highly advise you do, here's How to Make a Retirement Budget.
If you're not retired yet, I have a question for you. If you were to save 1% more starting in 2014, what is the worst thing that could happen?
1% more means for every $1,000 you earn, you save an additional $10.
We had one client who told us that when they first married he and his wife committed to putting $10 each per week into a jar. Now, years later they have upped it to $20 per week. This seemingly small gesture has had a huge impact on their financial security. It taught them that you really don't miss it. It taught them how easy it was to do it.
1% may not seem like much, but it reflects a commitment to your own financial well-being.
You could do it by increasing your contribution to a 401(k) plan. You could use a piggy bank. You could add to your savings account through an automatic contribution.
So, will you do it? 1%?
Here are few options:
Executives have fascinating compensation packages. Their comp plans can include such things as:
- Supplemental Executive Retirement Plans (SERPs)
- Restricted Stock Units (RSUs)
- Incentive Stock Options (ISOs)
- Non-Qualified Stock Options (NSOs)
- Deferred Comp Plans
Then there are the other more traditional benefit plans that the executives can also use such as:
- Employee Stock Purchase Plans (ESPPs)
- Employee Stock Ownership Plans (ESOPs)
- 401(k) Plans
Each of these plans have their own rules and tax consequences.
Last week we were meeting with an executive who participates in many of the types plans listed above. As we looked at all the options and his potential retirement date, which was over ten years away, I asked a simple question, "In your line of work, at your level, what's the likelihood you'll still work for this company from now until retirement?"
His answer was that it wasn't very likely.
I asked this question because I have watched many executives I have worked with end up in an entirely different situation then what we had originally projected. We plan for the long term, but the plans get disrupted because of the nature of their career; I call it career risk. (The RMA designation I hold teaches this concept as evaluating someone's human capital potential.)
If you are exposed to a substantial amount of career risk, what can you do? I might argue that your planning focus might be a bit different than someone with less career risk. Your focus should be determining what decisions you can make to secure a minimum lifestyle later on, regardless of the job changes you may experience.
In this person's case, they are saving a lot - which means they already get it. They understand the precariousness of corporate America, and so they aren't upgrading their lifestyle to match their title.
Your career can be your greatest asset. Don't take it for granted. Use it while you have it, and assess the risk of its continued income stream just as you would assess risk in other areas of your financial life.