How Could The Midterm Elections Impact The Stock Market?

The most common question that I have been asked over the past few weeks is: “If the Republicans lose control of either the House or the Senate in November, what impact do you think that will have on the markets?”   How much the stock market may go up or down in the days leading up to or directly after the midterm elections, regardless of the result, is anyone’s guess.  But if we use history as a guide, investors will probably realize that this situation is not uncommon, and there is probably less to worry about than investors think. 

A Shift In Power Is Not Uncommon

If we look back at every midterm election going back to 1934, on average, the president’s party has lost 30 seats in the House and 4 seats in the Senate during a midterm election year.  There are only three years in history that the president’s party actually gained seats due to a midterm election:  1934, 1998, and 2002.  So if the Republican’s lose seats in Congress in November that would really be the norm instead of the exception to the rule.  If it is in fact the norm, investors have to ask themselves, “how much of that shift in power is already priced into the market?” 

How Does The Stock Market React During Midterm Election Years?

In attempting to answer this question there are two components: volatility and return.  As many would guess, during midterm election years volatility typically rises leading up to the elections. Looking at the S&P 500 Index going all the way back to 1970, the volatility levels in the stock market are typically 10%+ more volatile when compared to the levels of volatility in the S&P 500 when there are no midterm elections.

From a return standpoint, the results speak for themselves.    Below is a bar chart that shows the return of the S&P 500 Index 12 months following the midterm elections 1950 – 2015:

stock market returns

12 months after a midterm elections the S&P 500 Index averages a 15.1% annual return.  In all other years the stock market averages a 6.8% annual return.

But What About A Flip In Control

It’s one things to lose seats in Congress but do we have to worry more because it’s not just about losing seats this year, it’s about a shift in power within Congress?  Again, using history as a guide, let’s look at what has happened in the past.  The House majority switched parties as a result of midterm elections in 1994, 2006, and 2010.  In all three of those years where a shift in power was in the cards, the stock market was either down or flat leading up the midterm elections in November.   However, in all three of those years the stock market was significantly higher 12 months after the midterm elections. See the chart below: 

past returns of S&P 500 Index

The Stock Market Cares More About The Economy

If you asked me which environment I would choose to invest in:

A)  Stable political environment and bad economy

B)  Unstable political environment and good economy

I would probably choose “B” because at the end of the day the stock market is historically driven by the economy.    While politics have the power to influence the economy, if we end up in a gridlock situation after the November elections, that is also the norm.  Going back to 1948, we have had a “divided government” 61% of the time.  As we get closer to the elections, there is a very good chance that the level of volatility in the markets will increase because the stock market doesn’t like uncertainty.  But if we use history as our guide, the 12 months following the midterm elections may reward investors that stay the course.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Don't Let Taxes Dictate Your Investment Decisions

Everyone hates to pay more in taxes. But this is something that has to be done. Sometimes taxes can often lead investors to make foolish investment decisions. The stock market bottomed in March 2009 and since then we have experienced the second-longest bull market rally of all time. This type of market environment typically creates a stockpile of unrealized gains in the equity portion of your portfolio. When you go to sell one of your investment holdings that has appreciated in value over the past few years there may be a big tax bill waiting for you. But when is it the right time to ignore the tax hit and execute the trade?

Do The Math

What sounds worse? Writing a check to the government for $10,000 in taxes or experiencing a 3% loss in your investment accounts? Most people would answer paying taxes. After all, who wants to write a check to the government for $10,000 after you have already paid your fair share of taxes throughout the year. It’s this exact situation that gets investors in a lot of trouble when the stock market turns or when that concentrated stock position takes a nosedive.

Before making this decision make sure you do the math. If you have $500,000 in your taxable investment account and the account value drops by 3%, your account just lost $15,000. It would have been better to sell the holding, pay the $10,000 in taxes, and you would still be ahead by $5,000. Before making the decision not to sell for tax reasons, make sure you run this calculation.

Gains Are Good

While most of us run from paying taxes like the plague, remember gains are good. It means that you made money on the investment.  At some point you are going to have to pay tax on that gain unless your purposefully waiting for the investment to lose value or if you plan to die with that holding in your estate.

If you put $100,000 in an aggressive investment a year ago and it’s now worth $200,000, if you sell it all today, you will have to pay long term cap gains tax and possibly state tax on the $100,000 realized gain. But remember, what goes up by 100% can also go down by 100%. To avoid the tax bill, you make the decision to just sit on the investment and 3 months from now the economy goes into a recession. The value of that investment drops to $125,000 and you sell it before things get worse. While you successfully decreased your tax liability, the tax hit would have been a lot better than saying goodbye to $75,000.

As financial planners we are always looking for ways to reduce the tax bill for our clients but sometimes paying taxes is unavoidable. The more you make, the more you pay in taxes. In most tax years, investors try to use investment losses to help offset some of the realized taxable gains. However, since most assets classes have appreciated in value over the last few years, investors may be challenges to find investment losses in their accounts.

Capital Gains Tax

A quick recap of capital gains tax rates. There are long-term and short-term capital gains. They apply to investments that are held in non-retirement account. IRA’s, 401(k), and 403(b) plans are all tax deferred vehicles so you do not have worry about realizing capital gains tax when you sell a holding within those types of accounts.

In a taxable brokerage account, if you buy an investment and sell it in less than 12 months, if it made money, you realize a short-term capital gain. Short-term gains do not receive preferential tax treatment. You pay tax at the ordinary income tax rates.

However, if you buy an investment and hold it for more than a year before selling it, the gain is taxed at the preferential long-term capital gain rates. At the federal level, there are three flat rates: 0%, 15%, and 20%. At the state level, it varies based on what state you live in. If you live in New York, where we are headquartered, long-term capital gains do not have preferential tax treatment for state income tax purposes. They are taxed as ordinary income. While other states like Alaska, Florida, and Texas assess no taxes at the state level on capital gains.

The tax rate that you pay on your long-term capital gains at the federal level depends on your AGI for that particular tax year. Here are the thresholds for 2021:

long term cap gains rates

A special note for investors that fall in the 20% category, in addition to being taxed at the higher rate, there is also a 3.8% Medicare surtax that is tacked onto the 20% rate. So the top long-term capital gains rate for high income earners is really 23.8%, not 20%.

Don't Forget About The Flat Rate

Investors forget that long-term capital gains are taxed for the most part at a flat rate. If your AGI is $200,000 and you are considering selling an investment that would cause you to incur a $100,000 long-term capital gain, it may not matter from a tax standpoint whether you sell it all this year or if you split the gain between two different tax years. You are still taxed at that flat 15% federal tax rate on the full amount of the gain regardless of when you sell it.There are of course exceptions to this rule. Here is a list of some of the exceptions that you need to aware of:

• Your AGI limit for the year

• The impact of the long-term capital gain on your AGI

• College financial aid

• Social security taxation

• Health insurance through the exchange

First exception is the one-time income event that pushes your income dramatically higher for the year. This could be a big bonus, a good year for the company that you own, or you sell an investment property. In these cases you have to mindful of the federal capital gains tax thresholds. If it’s toward the end of the year and you are thinking about selling an investment that has a good size unrealized gain built up into it, it may be prudent to sell enough to keep yourself out of the top long-term capital gains bracket and then sell the rest in January when you enter the new tax year. That move could save you 8.8% in taxes on the realized gains. The 23.8% to tax rate minus the 15% median rate. If you are at the beginning or in the middle of a tax year trying to make this decision, the decision is more difficult. You will have to weigh the risk of the investment losing value before you flip into a new tax year versus paying a slightly higher tax rate on the gain.

To piggyback on the first exception, you have to remember that long term capital gains increase your AGI. If you make $300,000 and you realize a $200,000 long term capital gain on an investment, it’s going to bump you up into the highest federal long term capital gains tax rate.

College financial aid can be a big exception. If you have a child in college or a child that will be going to college within the next two years, and you expect to receive some type of financial aid based on income, be very careful about when you realize capital gains in your investment portfolio. The parent’s investment income can count against a student’s financial aid package. Also, FASFA looks back two years for purposes of determining your financial aid package so conducing this tax versus risk analysis requires some advanced planning.

For those receiving social security benefit, capital gains can impact how much of your social security benefit is subject to taxation.

For individuals that receive their health insurance through a state exchange platform (Obamacare) and qualify for income subsidies, the capital gains income could decrease the amount of the subsidy that you are receive for that year. Be careful.

Don't Make The This Mistake

Bottom line, nothing is ever simple. I wish I could say that in all instances you should completely ignore the tax ramifications and make the right investment decision. In the real world, it’s about determining the balance between the two. It’s about doing the math to better under the tax hit versus the downside risk of continuing to hold a security to avoid paying taxes.

While the current economic expansion may still have further to go, we are probably closer to the end than we are the beginning of the current economic expansion. When the expansion ends, investors are going to be tempted to hold onto certain investments within their portfolio longer than they should because they don’t want to take the tax hit. Don’t make this mistake. If you have a stock holding within your portfolio and it drops significantly in value, you may not have the time horizon needed to wait for that investment to bounce back. Or you may have the opportunity to preserve principal during the next market downturn and buy back that same investment at lower level.

In general, it’s good time for investors to revisit their investment portfolios from a risk standpoint. You may be faced with some difficult investment decisions within the next few years. Remember, selling an investment that has lost money is ten times easier than selling one of your “big winners”. Do the math, don’t get emotionally attached to any particular investment, and be prepared to make investment changes to your investment portfolios as we enter the later stages of this economic cycle.

About Michael.........

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Should I Rollover My Pension To An IRA?

Whether you are about to retire or if you were just notified that your company is terminating their pension plan, making the right decision with regard to your pension plan payout is extremely important. It's important to get this decision right because you only get one shot at it. There are a lot of variables that factor into choosing the right option. While selecting the monthly payment option may be the right choice for your fellow co-worker, it could be the wrong choice for you. Here is a quick list of the items that you should consider before making the decision.

• Financial health of the plan sponsor

• Your age

• Your health

• Flexibility

• Monthly benefit vs lump sum amount

• Inflation

• Your overall retirement picture

Financial Health Of The Plan Sponsor

The plan sponsor is the company, organization, union, municipality, state agency, or government entity that is in charge of the pension plan. The financial health of the plan sponsor should weigh heavily on your decision in many cases. After all what good is a monthly pension payment if five years from now the company or entity that sponsors the plan goes bankrupt?

Pension Benefit Guarantee Corporation

But wait……..isn’t there some type of organization that guarantees the pension payments? The answer, there may or may not be. The Pension Benefit Guarantee Corporation (PBGC) is an organization that was established to protect your pension benefit. But PBGC protection only applies if your company participates in the PBGC. Not all pension plans have this protection.

Large companies will typically have PBGC protection. The pension plan is required to pay premiums to the PBGC each year. Those premiums are used to subsidize the cost of bankrupt pension plans if the PBGC has to step in to pay benefits. But it’s very important to understand that even through a pension plan may have PBGC protection that does not mean that 100% of the employee’s pension benefits are protected if the company goes bankrupt.

There is a dollar limited placed on the monthly pension benefit that the PBGC will pay if it has to step in. It’s a sliding scale based on your age and the type of pension benefit that you elected. If your pension payment is greater that the cap, the excess amount is not insured. Here is the PBGC 2021 Maximum Monthly Guarantee Table:

Another important note, if you have not reached age 65, your full pension benefit may not be insured even if it is less than the cap listed in the table.

Again, not all pension plans are afforded this protection by the PBGC. Pension plans offered by states and local government agencies typically do not have PBGC protection.

If you are worried about the financial health of the plan sponsor, that scenario may favor electing the lump sum payment option and then rolling over the funds into your rollover IRA. Once the money is in your IRA, the plan sponsor insolvency risk is eliminated.

Your Age

Your age definitely factors into the decision. If you have 10+ years to retirement and your company decides to terminate their pension plan, it may make sense to rollover your balance in the pension plan into an IRA or your current employer’s 401(k) plan. Primarily because you have the benefit of time on your side and you have full control over the asset allocation of the account.

Pension plans typically maintain a conservative to moderate growth investment object. You will rarely ever find a pension plan that has 80%+ in equity exposure. Why? It’s a pooled account for all of the employees of all ages. Since the assets are required to meet current pension payments, pension plans cannot be subject to high levels of volatility.

If your personal balance in the pension plan is moved into our own IRA, you have the option of selecting an investment objective that matches your personal time horizon to retirement. If you have a long time horizon to retirement, it allows you the freedom to be more aggressive with the investment allocation of the account.

If you are within 5 years to retirement, it does not necessarily mean that selecting the monthly pension payment is the right choice but the decision is less cut and dry. You really have to compare the monthly pension payment versus the return that you would have to achieve in your IRA to replicate that income stream in retirement.

Your Health

Your health is a big factor as well. If you are in poor health, it may favor electing the lump sum option and rolling over the balance into an IRA. Whatever amount is left in your IRA account will be distributed to your beneficiaries. With a straight life pension option, the benefit just stops when you pass away. However, if you are worried about your spouse's spending habits and your spouse is either in good health or is much younger than you, you may want to consider the pension option with a 100% survivor benefit.

Flexibility

While some retirees like the security of a monthly pension payment that will not change for the rest of their life, other retirees prefer to have more flexibility. If you rollover you balance to an IRA, you can decide how much you want to take or not take out of the account in a given year.

Some retirees prefer to spend more in their early years in retirement because that is when their health is the best. Walking around Europe when you are 65 is usually not the same experience as walking around Europe when you are 80. If you want to take $10,000 out of your IRA to take that big trip to Europe or to spend a few months in Florida, it provides you with the flexibility to do so. By making sure that you have sufficient funds in your savings at the time of retirement can help to make things like this possible.

Working Because I Want To

The other category of retirees that tend to favor the IRA rollover option is the "I'm working because I want to" category. It has becoming more common for individuals to retire from their primary career and want to still work doing something else for two or three days a week just to keep their mind fresh. If the income from your part-time employment and your social security are enough to meet your expenses, having a fixed pension payment may just create more taxable income for you when you don't necessarily need it. Rolling over your pension plan to an IRA allows you to defer the receipt of that income until at least age 70½. That is the age that distributions are required from IRA accounts.

Monthly Pension vs Lump Sum

It’s important to determine the rate of return that you would need to achieve in your IRA account to replicate the pension benefit based on your life expectancy. With the monthly pension payment option, you do not have to worry about market fluctuations because the onus is on the plan sponsor to produce the returns necessary to make the pension payments. With the IRA, you or your investment advisor are responsible for producing the investment return in the account.

Example 1: You are 65 and you have the option of either taking a monthly pension payment of $3,000 per month or taking a lump sum in the amount of $500,000. If your life expectancy is age 85, what is the rate of return that you would need to achieve in your IRA to replicate the pension payment?

The answer: 4%

If your IRA account performs better than 4% per year, you are ahead of the game. If your IRA produces a return below 4%, you run the risk of running out of money prior to reaching age 85.

Part of this analysis is to determining whether or not the rate of return threshold is a reasonable rate of return to replicate. If the required rate of return calculation results in a return of 6% or higher, outside of any special circumstances, you may be inclined to select the pension payments and put the responsibility of producing that 6% rate of return each year on the plan sponsor.

Low Interest Rate Environment

A low interest rate environment tends to favor the lump sum option because it lowers the “discount rate” that actuaries can use when they are running the present value calculation. Wait……what?

The actuaries are the mathletes that produce the numbers that you see on your pension statement. They have to determine how much they would have to hand you today in a lump sum payment to equal the amount that you would have received if you elected the monthly pension option.

This is called a “present value” calculation. This amount is not the exact amount that you would have received if you elected the monthly pension payments because they get to assume that they money in the pension plan will earn interest over your life expectancy. For example, if the pension plan is supposed to pay you $10,000 per year for the next 30 years, that would equal $300,000 paid out over that 30 year period. But the present value may only be $140,000 because they get to assume that you will earn interest off of that money over the next 30 years for the amount that is not distributed until a later date.

In lower interest rate environments, the actuaries have to use a lower assume rate of return or a lower “discount rate”. Since they have to assume that you will make less interest on the money in your IRA, they have to provide you with a larger lump sum payment to replicate the monthly pension payments over your life expectancy.

Inflation

Inflation can be one of the largest enemies to a monthly pension payment. Inflation, in its simplest form is “the price of everything that you buy today goes up in price over time”. It’s why your grandparents have told you that they remember when a gallon of milk cost a nickel. If you are 65 today and your lock into receiving $2,000 per month for the rest of your life, inflation will erode the spending power of that $2,000 over time.

Historically, inflation increases by about 3% per year. As an example, if your monthly car payment is $400 today, the payment for that same exact car 20 years from now will be $722 per month. Now use this multiplier against everything that you buy each month and it begins to add up quickly.

If you have the money in an IRA, higher inflation typically leads to higher interest rate, which can lead to higher interest rates on bonds. Again, having control over the investment allocation of your IRA account may help you to mitigate the negative impact of inflation compared to a fixed pension payment.

A special note, some pension plans have a cost of living adjustment (“COLA”) built into the pension payment. Having this feature available in your pension plan will help to manage the inflation risk associated with selecting the monthly pension payment option. The plan basically has an inflation measuring stick built into your pension payment. If inflation increases, the plan is allowed to increase the amount of your monthly pension payment to help protect the benefit.

Your Overall Financial Picture

While I have highlighted a number of key variables that you will need to consider before selecting the payout option for your pension benefit, at the end of the day, you have to determine how each option factors into your own personal financial situation. It’s usually wise to run financial projections that identify both the opportunities and risks associated with each payment option.

Don’t be afraid to seek professional help with this decision. They will help you consider what you might need to pay for in the future.  Are you going to need money spare for holidays, transportation, even funeral costs should be considered. Where people get into trouble is when they guess or they choose an option based on what most of their co-workers selected. Remember, those co-workers are not going to be there to help you financially if you make the wrong decision.

As an investment advisor, I will also say this, if you meet with a financial planner or investment advisor to assist you with this decision, make sure they are providing you with a non-bias analysis of your options. Depending on how they are compensation, they may have a vested interest in getting you to rollover you pension benefit to an IRA. Even though electing the lump sum payment and rolling the balance over to an IRA may very well be the right decision, they should walk you through a thorough analysis of the month pension payments versus the lump sum rollover option to assist you with your decision.

About Michael.........

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

403(b) Lawsuits Continue To Spread To More Colleges

In the last 3 years, the number of lawsuits filed against colleges for excessive fees and compliance issues related to their 403(b) plans has increased exponentially.  Here is a list of just some of the colleges that have had lawsuit brought against them by their 403(b) plan participants: 

• Yale

• NYU

• Duke

• John Hopkins

• MIT

• Columbia

• Emory

• Cornell

• Vanderbilt

• Northeastern

• USC

The fiduciary landscape has completely changed for organizations, like colleges, that sponsor ERISA 403(b) plans.  In 2009, new regulations were passed that brought 403(b) plans up to the compliance standards historically found in the 401(k) market.   Instead of slowly phasing in the new regulations, the 403(b) market basically went from zero to 60 mph in a blink of an eye.  While some of the basic elements of the new rules were taken care of by the current service providers such as the required written plan documents, contract exchange provisions, and new participant disclosures, we have found that colleges, due to a lack of understanding of what is required to fulfill their fiduciary role to the plan, have fallen very short of putting the policies and procedures in place to protect the college from liabilities that can arise from the 403(b) plan. 

Top Violations

Based on the lawsuits that have been filled against the various colleges, here is a list of the most common claims that have been included in these lawsuits: 

• Excessive fees

• Fees associated with multiple recordkeepers

• Too many investment options

• Improper mutual fund share class

• Variable annuity products

Excessive Fees

This is by far number one on the list.  As you look at these lawsuits, most of them include a claim that the university breached their fiduciary duty under ERISA by allowing excessive fees to be charged to plan participants.

Here is the most common situation that we see when consulting with colleges that leads to this issue.  A college had been with the same 403(b) provider for 60 years.   Without naming names, they assume that their 403(b) plan has reasonable fees because all of the other colleges that they know of also use this same provider.   So their fees must be reasonable right?  Wrong!!

If you are member of the committee that oversees that 403(b) plan at your college, how do you answer this question?  How do you know that the fees for your plan are reasonable?  Can you show documented proof that you made a reasonable effort to determine whether or not the plan fees are reasonable versus other 403(b) providers?

The only way to answer this question is by going through an RFP process.  For colleges that we consult with we typically recommend that they put an RFP out every 3 to 5 years. That is really the only way to be able to adequately answer the question: “Are the plan fees reasonable?”   Now if you go through the RFP process and you find that another reputable provider is less expensive than your current provider, you are not required to change to that less expensive provider.  However, from a fiduciary standpoint, you should acknowledge at the end of the RFP process that there were lower fee alternatives but the current provider was selected because of reasons X, Y, and Z.  Document, document, document!!

Investment Fees / Underperformance / Investment Options

Liability is arising in these 403(b) plans due to 

• Revenue sharing fees buried in the mutual fund expense rations

• Underperformance of the plan investments versus the benchmark / peer group

• Too many investment options

• Investment options concentrated all in one fund family

• Restrictions associate with the plan investment

• Investment Policy Statement violations or No IPS

• Failure to document quarterly and annual investment reviews

Here is the issue.  Typically members of these committees that oversee the 403(b) plan are not investment experts and you need to basically be an investment expert to understand mutual fund share classes, investment revenue sharing, peer group comparisons, asset classes represented within the fund menu, etc.   To fill the void, colleges are beginning to hire investment firms to serve as third party consultants to the 403(b) committee.  In most cases these firms charge a flat dollar fee to: 

• Prepare quarterly investment reports

• Investment benchmarking

• Draft a custom Investment Policy Statement

• Coordinate the RFP process

• Negotiation plan fees with the current provider

• Conduct quarterly and annual reviews with the 403(b) committee

• Compliance guidance

Multiple Recordkeepers

While multiple recordkeepers is becoming more common for college 403(b) plans, it requires additional due diligence on the part of the college to verify that it’s in the best interest of the plan participants.   Multiple recordkeepers means that your 403(b) plan assets are split between two or more custodians.  For example, a college may use both TIAA CREF and Principal for their 403(b) platform.  Why two recordkeepers?  Most of the older 403(b) accounts are setup as individual annuity contracts.  As such, if the college decides to charge their 403(b) provider, unlike the 401(k) industry where all of the plan assets automatically move over to the new platform, each plan participant is required to voluntarily sign forms to move their account balance from the old 403(b) provider to the new 403(b) provider.  It’s almost impossible to get all of the employee to make the switch so you end up with two separate recordkeepers.

Why does this create additional liability for the college?  Even through the limitation set forth by these individual annuity contracts is out of the control of the college, by splitting the plan assets into two pieces you may be limiting the economies of scale of the total plan assets.  In most cases the asset based fees for a 403(b) plan decreases as the plan assets become larger with that 403(b) provider.  By splitting the assets between two 403(b) platforms, you are now creating two smaller plans which could result in larger all-in fees for the plan participants.

Now, it may very well be in the best interest of the plan participants to have two separate platforms but the college has to make sure that they have the appropriate documentation to verify that this due diligence is being conducts.  This usually happens as a result of an RFP process.  Here is an example.  A college has been using the same 403(b) provider for the last 50 years but to satisfy their fiduciary obligation to the plan they going through the RFP process to verify that their plan fees are reasonable.  Going into the RFP process they had no intention of change provides but as a result of the RFP process they realize that there are other 403(b) providers that offer better technology, more support for the plan sponsor, and lower fees than their current platform.  While they are handcuffed by the individual contracts in the current 403(b) plan, they still have control over where the future contributions of the plan will be allocated so they decide that it’s in both the plan participants and the college’s best interest to direct the future contributions to the new 403(b) platform.

Too Many Investment Options

More is not always better in the retirement plan world.  The 403(b) oversite committee, as a fiduciary, is responsible for selecting the investments that will be offered in accordance with the plan’s investment menu.  Some colleges unfortunately take that approach that if we offer 80+ different mutual funds for the investment that should “cover all of their bases” since plan participants have access to every asset class, mutual fund family, and ten different small cap funds.    The plaintiffs in these 403(b) lawsuits alleged that many of the plan’s investment options were duplicates, performed poorly, and featured high fees that are inappropriate for large 403(b) plans.

To make matters worse, if you have 80+ mutual funds on your 403(b) investment menu, you have to conduct regular and on-going due diligence on all 80+ mutual funds in your plan to make sure that they still meet the investment criteria set out in the plan’s IPS.  If you have mutual funds in your plan that fall outside of the IPS criteria and those issues have not been addressed and/or documented, if a lawsuit is brought against the college it will be very difficult to defend that the college was fulfilling its fiduciary obligation to the investment menu. 

Improper Mutual Fund Share Classes

To piggyback on this issue, what many plan sponsors don’t realize is that by selecting a more limited menu of mutual funds it can lower the overall plan fees.  Mutual funds have different share classes and some share classes require a minimum initial investment to gain asset to that share class.  For example you may have Mutual Fund A retail share class with a 0.80% internal expense ratio but there is also a Mutual Fund A institutional share class with a 0.30% internal expense ratio.  However,  the institutional share class requires an initial investment of $100,000 to gain access.  If Mutual Fund A is a U.S. Large Cap Stock Fund and your plan offers 10 other U.S. Large Cap Stock Funds, your plan may not meet the institutional share requirement because the assets are spread between 10 different mutual funds within the same asset class.  If instead, the committee decided that it was prudent to offer just Mutual Fund A to represent the U.S. Large Cap Stock holding on the investment menu, the plan may be able to meet that $100,000 minimum initial investment and gain access to the lower cost institutional share class. 

Variable Annuity Products

While variable annuity products have historically been a common investment option for 403(b) plans, they typically charge fees that are higher than the fees that are charged by most standard mutual funds.  In addition, variable annuities can place distribution restrictions on select investment investments which may not be in the plan participants best interest.

The most common issue we come across is with the TIAA Traditional investment.  While TIAA touts the investment for its 3% guarantee, we have found that very few plan participants are aware that there is a 10 year distribution restriction associated with that investment.  When you go to remove money from the TIAA Traditional fund, TIAA will inform you that you can only move 1/10th of your balance out of that investment each year over the course of the next ten years.  You can see how this could be a problem for a plan participant that may have 100% of their balance in the TIAA Traditional investment as they approach retirement.   Their intention may have been to retire at age 65 and rollover the balance to their own personal IRA.  If they have money in the TIAA Traditional investment that is no longer an option.  They would be limited to process a rollover equal  to 1/10th of their balance in the TIAA Tradition investment between the age of 65 and 74.  Only after age 74 would they completely free from this TIAA withdrawal restriction.

Consider Hiring A Consultant

While this may sound self-serving, colleges are really going to need help with the initial and on-going due diligence associate with keeping their 403(b) plan in compliance.  For a reasonable cost, colleges should be able to engage an investment firm that specialized in this type of work to serve as a third party consultant for the 403(b) investment committee.  Just make sure the fee is reasonable.  The consulting fee should be expressed as a flat dollar amount fee, not an asset based fee, because they are fulfilling that role as a “consultant”, not the “investment advisor” to the 403(b) plan assets. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

What Does Tax Reform Mean For The Markets In 2018?

2017 ended up being a huge year for the U.S. stock market.  The rally in the stock market was unmistakably driven by the anticipated passing of tax reform and Congress delivered. However, the sheer magnitude of the stock market rally has presented investors with a moment of pause and a lot of unanswered questions as we enter into the first quarter of 2018. The two main questions being:

• What does tax reform mean for the markets in 2018?

• We are now in the second longest economic expansion of ALL TIME!!! I know what goes up, eventually comes down. Are we overdue for a major correction in the stock market?

Without a crystal ball, no one knows for sure. However, the purpose of this article is to identify indicators in the economy and the financial markets that may help us gauge the direction of the U.S. economy and equity markets as we progress through 2018.

Tax Reform: Uncharted Waters

While tax reform is a welcome friend for corporate America, we have to acknowledge that this also puts us in uncharted waters. Looking back, there has never been a time in history where the U.S. has injected fiscal stimulus (tax reform) into an economy that is already healthy. The last major tax reform was in the early 1980’s when the U.S. economy was trying to dig itself out of the long 1970’s recession.

When the economy is in a recession, the U.S. can either inject fiscal stimulus or monetary stimulus to get the economy growing again. The U.S. used monetary stimulus to dig us out of the Great Recession of 2008 – 2009. They lowered interest rates to basically 0%, pumped cash into the economy in the form of bond buying, and provided a financial back stop for the U.S. banking system.

These economic stimulus tools are similar to the concept of giving a patient in a hospital a shot of adrenaline. If a patient is flat lining, it provides that patient with a huge surge of energy. The patient’s body goes from 0% to 60%+ in under a minute. So what happens when you give someone who is completely healthy a shot of adrenaline? Do they go from 100% to 110%? My point is a healthy patient does not go from 100% to 160%. Both patients get a boost but the boost to the healthy patient is much lower as a percentage of where they started.

While we have never given the U.S. economy an adrenaline shot after a long economic expansion, I think it’s reasonable to apply the same general concept as our two hospital patients. Tax reform may very well lead to another year of positive returns for the stock market in 2018 but I think it’s very important for investors to set a reasonable expectation of return for the U.S. equity markets given the fact that we are injecting growth into an economy that is already at “full employment”.

Not Enough Workers

One of the greatest challenges that the U.S. economy may face in 2018 is a shortage of qualified workers. Prior to tax reform being passed, companies both large and small, have had plenty of job openings but have not been able to find the employees with the skills necessary to fill those positions.

For example, if Apple had 1000 job openings in November 2017 just to meet the current demand for their goods and services but in 2018, due to tax reform, consumers have more money to spend, and the demand for Apple products increases further, Apple may need to find another 2000 employee to meet the increase in demand. They are having trouble now finding the 1000 employees to meet their current demand, how are they going to find another 2000 quick enough in 2018 to meet the increase in demand? If they can’t make the phones, they can’t sell the phones. Fewer sales equals less revenue, which equals less net profit, which may lead to a lower appreciation rate of the stock price. For disclosure purposes, I’m not picking on Apple. I’m just highlighting an issue that may be common among the companies that make up the S&P 500 Index if tax reform leads to a spike in demand in 2018. If Wall Street is expecting accelerated earnings, how are the companies expected to deliver those enhanced earnings without the employees that they need to increase supply?

The unemployment rate in the U.S. is currently 4.1%. You have to go all the way back to the late 1960’s to find an employment rate below 4%. So we are essentially at “full employment”.

Rising Wages

The blue line in the chart above is also very important. The blue line represents wage growth. This answers the question: "Are people making more for doing the same amount of work?" If you look back historically on the chart, when the unemployment rate was falling, typically wage growth was increasing. It makes sense. When the economy is good and the job market is healthy, companies have to pay their employees more to keep them. Otherwise they will go work for a competitor, who has 10 job openings, and they get paid more. Wage growth is good for employees but it's bad for companies. For companies, employee wages are usually their largest expense. If you increase wages, you are increasing expenses, which decreases profits. Lower profits typically results in lower stock prices. Companies in 2017 had the luxury of strong demand but limited wage growth. My guess is you will begin to see meaningful wage growth in 2018 as companies see an increase in demand as a result of tax reform and end up having to raise wages to retain and attract employees. This is just another reason why 2018 may be a good year for the stock market but not a great one.

What Fuels GDP Growth?

Gross Domestic Product ("GDP") is the economic indicator that is used to measure how much the U.S. economy produces in a year. It's how we gauge whether our economy is growing or contracting. Since March 2009, the GDP growth rate has averaged about 2.2% per year. This is subpar by historic standards. In most economic expansions, GDP is growing at an annual rate of 4%+.

Before we get into what pieces of tax reform may help to increase the GDP growth rate, let us first look at what GDP is made of. Our GDP is comprised of 5 categories (for my fellow econ nerds that assign 4 categories to GDP, we split capital spending into two separate categories):

• Consumption or "Consumer Spending" 69.1%

• Government Spending (includes defense) 17.3%

• Investment (ex-housing) – "Business Spending 12.7%

• Housing 3.8%

• Net Exports -2.9%

Consumer Spending (+)

Consumer spending which makes up 69.1% of our GDP should increase as a result of tax reform in 2018. In general, if people have more discretionary income, they will spend all or a portion of it. Tax reform will lower the tax bill, for not all, but many U.S. households, increasing their disposable income.  Also, if we see an increase in wage growth in 2018, people will be taking home more in their paychecks, allowing them to spend more.

Dr James Kelly, the chief economist of JP Morgan, made a very interesting observation about the evolution of the tax bill. When the tax bills were in their proposed state, one for the Senate and a separate bill for the House, each bill to stay under the $1.5 Trillion 10 year debt cap reduced taxes by about $150 Billion dollars per year. 50% of the annual tax reduction was going to businesses with the other 50% going to individual tax payers.

In order to get the bill passed before the end of the year, Congress was forced to shift a larger proportion of the $150 billion in tax brakes per year to individual taxpayers. In the tax bill’s final form, Dr Kelly estimated that approximately 75% of the tax reductions were now being retained by individual taxpayers with only 25% going to businesses. With a larger proportion of the tax breaks going to individual taxpayers that could increase the amount of discretionary income available to the U.S. consumer.

Government Spending (Push)

The anticipated increase in government spending really stems from the Trump agenda that has been communicated. One of the items that he campaigned on was increasing government spending on infrastructure. At this point we do not have many details as to when the infrastructure spending will begin or how much will be spent. Whatever ends up happening, we are not forecasting a dramatic increase or decrease in government spending in 2018.

Investment - Business Spending (+)

Even though business spending only represents 12.7% of our GDP, we could see a sizable increase in spending by businesses in 2018 for the following reasons:

• Corporate tax rate is reduced from 35% to 21%

• The repatriation tax will allow companies to bring cash back from overseas at a low tax rate

• Prior to tax reform, companies already had historically high levels of cash on their balance sheet. What are they going to do with more cash? (See the chart below)

If having more cash was not a large enough incentive by itself for companies to spend money, the new tax rules allowing immediate expensing of the full cost of most assets purchased for the next five years should be. Under the current tax rules, when a business purchases a new piece of equipment, a fleet of trucks, office furniture, whatever it is, the IRS does not allow them to deduct 100% of purchase price in the year that they buy it. They have to follow a "depreciation schedule" and they can only realize a piece of that expense each year. The current tax rules put companies at a tax disadvantage because companies are always trying to shelter as much income as possible from taxation. If Company XYZ buys a piece of equipment that cost $1,000,000, the IRS may require Company XYZ to depreciate that expense over a 10 year period. Meaning they can only realize $100,000 in expenses each year over that 10 year period, even though they already paid the full $1,000,000 for that new piece of equipment.Under the new tax reform, if Company XYZ buys that same new piece of equipment for $1,000,000, they can deduct the full $1,000,000 expense against their income in 2018. Whoa!!! That's huge!! Yes it is and it's a big incentive for companies to spend money over the next five years.

Housing & Net Exports (Push)

We do not expect any significant change from either of these two categories and they represent the smallest portion of our total GDP.

Watch GDP In 2018

The GDP growth rate in 2018 may give us the first indication as to how many "extra innings" we have left in this already long bull market rally. If we do not see a meaningful acceleration in the annual growth rate of GDP above its 2.2% average rate, the rally could be very short lived. On the flip side, if due to tax reform consumer spending and business spending leaps forward in 2018 and 2019, we may be witnessing the longest economic expansion of all time. Time will tell.

Share Buybacks

You will undoubtedly hear a lot about “Share Buybacks” in 2018. Remember, U.S. corporations will most likely have piles of cash on their balance sheets. Instead of spending that money on hiring new employees, buying new equipment, or building a new plant, what else might they do with the cash? The answer, share buybacks.

If a public company like Nike has extra cash, they can go into the market, purchase their own stock, and then get rid of those outstanding shares. Basically it increases the earnings per share for the remaining shareholders.

Example: Let’s assume there are only 4 shares of Nike owned by 4 different people and Nike is worth $100,000. That means that each shareholder is entitled to 25% of that $100,000 or $25,000 each. Now because of tax reform, Nike has $50,000 of extra cash just sitting in its coffers that it otherwise would have paid to the government in taxes. Nike can go into the market with $50,000, purchase 2 shares back from 2 of the shareholders (assuming they would be willing to sell), and then “retire” those two outstanding shares. After that is done, there are 2 outstanding shares remaining but the value of Nike did not change. So the two remaining shareholders, without paying anything extra, now own 50% of Nike, and their shares are worth $50,000 each.

Share buyback may push stock prices higher from a simple math standpoint. If the formula is the value of the company divided by the number of shares outstanding, the fewer shares there are, assuming the value of the company stays the same, the price per share will go up.   The incentive for these share buybacks will most likely be there in 2018. Not only will companies have the cash but share buybacks are a way that public companies can reward their current shareholders..

Is The Stock Market Too Expensive?

The P/E ratio of the S&P 500 Index is another barometer that investors will need to keep a close eye on in 2018. P/E ratios help us to answer the questions: “Is the stock market cheap, fairly valued, or expensive at this point?” The “Forward P/E Ratio” divides the price of a stock by the estimated future 12 months of earnings. The average Forward P/E ratio for the S&P 500 Index between December 1989 – September 30, 2017 was 16.0. As of December 22, 2017, the Forward P/E ratio of the S&P 500 Index is 19.99. In other words, it’s running at 25% above its 25 year historic average. See the chart below:

Conclusion, the U.S. stock market is not “cheap” and it’s a stretch to even classify it as “fairly valued”. I think we are well into what I would consider “expensive territory”. What does that mean for investors? You have to stay on your toes!!

Now, we have an anomaly in the mix with tax reform and history does not speak to how this could play out. If tax reform leads to an acceleration in corporate earnings, that in turn could slow the steady climb in the P/E ratio of the S&P 500 because earnings are the denominator in the formula. If stock prices and earnings are accelerating at the same pace, the stock market can go up without a further acceleration of the P/E ratio. Thus, keeping the stock market from becoming more overpriced and further increasing the risk of owning stocks in the S&P 500.

Summary

In 2018, investors should keep a close eye on the U.S. GDP growth rate, the level of spending by corporations and consumers, the volume of share buybacks by U.S. companies, and the P/E ratio of the S&P 500 Index.

About Michael.........

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Tax Reform: Your Company May Voluntarily Terminate Your Retirement Plan

Make no mistake, your company retirement plan is at risk if the proposed tax reform is passed.  But wait…..didn’t Trump tweet on October 23, 2017 that “there will be NO change to your 401(k)”?  He did tweet that, however, while the tax reform might not directly alter the contribution limits to employer sponsored retirement plans, the new tax rates will produce a “disincentive” for companies to sponsor and make employer contributions to their plans.

What Are Pre-Tax Contributions Worth?

Remember, the main incentive of making contributions to employer sponsored retirement plans is moving income that would have been taxed now at a higher tax rate into the retirement years, when for most individuals, their income will be lower and that income will be taxed at a lower rate.   If you have a business owner or executive that is paying 45% in taxes on the upper end of the income, there is a large incentive for that business owner to sponsor a retirement plan.  They can take that income off of the table now and then realize that income in retirement at a lower rate.

This situation also benefits the employees of these companies.  Due to non-discrimination rules, if the owner or executives are receiving contributions from the company to their retirement accounts, the company is required to make employer contributions to the rest of the employees to pass testing. This is why safe harbor plans have become so popular in the 401(k) market.

But what happens if the tax reform is passed and the business owners tax rate drops from 45% to 25%?  You would have to make the case that when the business owner retires 5+ years from now that their tax rate will be below 25%.  That is a very difficult case to make.

An Incentive NOT To Contribute To Retirement Plans

This creates an incentive for business owners NOT to contribution to employer sponsored retirement plans.  Just doing the simple math, it would make sense for the business owner to stop contributing to their company sponsored retirement plan, pay tax on the income at a lower rate, and then accumulate those assets in a taxable account.  When they withdraw the money from that taxable account in retirement, they will realize most of that income as long term capital gains which are more favorable than ordinary income tax rates. 

If the owner is not contributing to the plan, here are the questions they are going to ask themselves: 

• Why am I paying to sponsor this plan for the company if I’m not using it?

• Why make an employer contribution to the plan if I don’t have to?

This does not just impact 401(k) plans. This impacts all employer sponsored retirement plans: Simple IRA’s, SEP IRA’s, Solo(k) Plans, Pension Plans, 457 Plans, etc.

Where Does That Leave Employees?

For these reasons, as soon as tax reform is passed, in a very short time period, you will most likely see companies terminate their retirement plans or at a minimum, lower or stop the employer contributions to the plan.  That leaves the employees in a boat, in the middle of the ocean, without a paddle.  Without a 401(k) plan, how are employees expected to save enough to retire?  They would be forced to use IRA’s which have much lower contribution limits and IRA’s don’t have employer contributions.

Employees all over the United States will become the unintended victim of tax reform.  While the tax reform may not specifically place limitations on 401(k) plans, I’m sure they are aware that just by lowering the corporate tax rate from 35% to 20% and allowing all pass through business income to be taxes at a flat 25% tax rate, the pre-tax contributions to retirement plans will automatically go down dramatically by creating an environment that deters high income earners from deferring income into retirement plans.   This is a complete bomb in the making for the middle class.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

A New Year: Should I Make Changes To My Retirement Account?

A simple and easy answer to this question would be…..Maybe?  Not only would that answer make this article extremely short, it wouldn’t explain some important items that participants should take into consideration when making decisions about their retirement plan.Every time the calendar adds a year we get a sense of reset.  A lot of the same tasks on the to do list get added each January and hopefully this article helps you focus on matters to consider regarding your retirement plan.

Should I Consult With The Advisor On My Plan?

At our firm we make an effort to meet with participants at least annually.  Saving in company retirement plans is about longevity so many times the individual meetings are brief and no allocation changes are made.  Even if this is the result, an overview of your account, at least annually, is a good way to keep retirement savings fresh in your mind and add a sense of comfort that you’re investing appropriately based on your time horizon and risk tolerance.

These individual meetings are also a good time to discuss other financial questions you may have.  Your retirement plan is only a piece of your financial plan and we encourage participants to use the resources available to them.  Often times these meetings start off as a simple account overview but turn into lengthy conversations about various financial decisions the participant has been weighing.

How Much Should I Be Contributing This Year?

This answer is not the same for everyone because, among other things, people have different retirement goals, financial situations, and time horizon.  That being said, if the  company has a match component in their plan, the first milestone would be to contribute enough to receive the most the company is willing to give you.  For example, if the company will match 100% of your contributions up to 3% of pay, any amount you contribute less than 3% will leave you missing out on retirement savings the company is willing to provide you.

Again, the amount that should be saved is dependent on the individual but saving anywhere from 10% to 15% of your compensation is a good benchmark.  In the previous example, if the company will match 3%, that means you would have to contribute 7% to achieve the lower end of that benchmark.  This may seem like a difficult task so starting at an amount you are comfortable with and working your way to your ultimate goal is important.

Should You Be Making Allocation Changes?

The initial allocation you choose for your retirement account is important.  Selecting the   appropriate portfolio from the start based on your risk tolerance and time until retirement can satisfy your investment needs for a number of years.  The chart below shows that over longer periods of time historical annual returns tend to be less volatile.

When you have over 10 years until retirement, reviewing the account at least annually is   important as there are a number of reasons you would want to change your allocation.  Lifestyle changes, different retirement goals, or specific investment performance to name a few. Participants tend to lose out on investment return when they try to time the market and are forced to sell low and buy high.  This chart shows that even though there may be volatility in the short term, as long as you have time and an appropriate allocation from the start, you should see returns that will help you achieve your retirement goals. 

About Rob……...

Hi, I’m Rob Mangold. I’m the Chief Operating Officer at Greenbush Financial Group and a contributor to the Money Smart Board blog. We created the blog to provide strategies that will help our readers personally , professionally, and financially. Our blog is meant to be a resource. If there are questions that you need answered, pleas feel free to join in on the discussion or contact me directly.

Types of Retirement Plans

Types of Retirement Plans

RC2

The comparing retirement plans chart gives business owners the ability to compare different types of plans available to their company. 

Click on the PDF link in the green box below.

Understanding Investment Tax Forms

investment tax forms

Types of Investment Income

Making a wide variety of investments is a wise move as it means if one market drops, not all of your investments will be affected. If you've only invested in stocks or real estate then it would be a good idea to diversify. Take a look at this review and see if Bitcoin is something you want to invest in. The whole point of investing is to make a profit from your investments so you want to give yourself as much of a chance of success as possible. Income from investments can be divided into four main categories;

Interest – Interest income is paid on bonds and other types of fixed-income securities such as fixed annuities. Interest is always taxable as ordinary income unless it is paid inside an IRA or qualified plan or annuity contract. Municipal bond interest is also tax free and interest from treasury securities is exempt from taxation at the state and local levels.

Dividends – These represent a portion of a company's current profits that it passes on to shareholders. Dividends can be taxed as ordinary income, or they may qualify for lower capital gains treatment in some cases if they are coded as "qualified" dividends.

Capital Gains – This represents the amount of profit realized when an investment is sold at a higher price than that for which it was bought. Long-term gains are realized for investments held for at least a year and a day before they were sold, and are taxed at a lower rate than ordinary income. Short-term gains are taxed as ordinary income.

Retirement and Annuity Distributions – Although distributions from retirement plans are not technically a form of investment income, they are listed here because IRA and retirement plan owners can only access the gains from their investments in these accounts by taking distributions. Normal distributions are always taxed as ordinary income.

Tax Forms

Each income type listed above is broken out on a corresponding 1099 form issued by the broker or issuer of the income generated. Every form includes the name, address and tax ID number of the issuing entity. These forms are listed as follows:1099-INT – Breaks out the interest paid to the investor. This form is issued for anyone who owns bonds, CDs or mutual funds that invested in fixed income securities or cash or has an interest-bearing bank or brokerage account.

• Box 1 shows total taxable interest paid

• Box 2 shows the amount of early withdrawal penalty, if any

• Box 3 shows the amount of U.S. Treasury security interest paid

• Box 4 shows the amount of tax withheld

• Box 5 shows investment expenses

• Box 6 shows foreign tax paid

• Box 7 shows the foreign payor

• Box 8 shows tax-exempt interest

• Box 9 shows interest from special private activity bonds

• Box 10 shows the CUSIP number for tax-free bond interest

• Boxes 11-13 show state ID information and withholding

1099-DIV – This breaks down the total amount of dividends paid to an investor. It is issued to holders of any common stock, preferred stock, or mutual fund that invests in them. However, it is not issued to owners of cash value life insurance policies, as those dividends are merely a return of premium.

• Box 1a shows total ordinary dividends

• Box 1b shows total qualified dividends

• Boxes 2a-d break down capital gains from mutual funds, REITs and collectibles

• Box 3 shows nondividend distributions

• Box 4 shows federal tax withheld

• Box 5 shows investment expenses

• Boxes 6 and 7 show foreign tax paid and the foreign payor

• Boxes 8 and 9 show cash and noncash liquidation distributions

• Box 10 shows private interest dividends

• Box 11 shows specified private activity bond interest dividends

• Boxes 12-14 show state ID information and withholding

1099-B – This form breaks down the amount of capital gain or loss that the investor realized for that tax year. It is issued to everyone who bought or sold publicly traded securities at a gain or loss. Many brokerage firms issue additional statements that break down the loss or gain for each trade and then quantify them into net long- and/or short-term gains and losses for the year.

• Box 1a shows the date of sale or exchange

• Box 1b shows the date of acquisition

• Box 1c shows whether it is a long- or short-term gain or loss

• Box 1d shows the ticker symbol of the security

• Box 1e shows the quantity sold

• Box 2a shows the gross proceeds reported to the IRS both before and after commission and expenses

• Box 2b shows a checkbox if loss not allowed due to amount shown in box 2a

• Box 3 shows cost or other basis

• Box 4 shows federal tax withheld

• Box 5 shows any amount of wash sale loss that was disallowed

• Box 6 has checkboxes for noncovered securities and for sales where the basis in box 3 was reported to the IRS

• Box 7 shows income from bartering

• Box 8 is for a description of the security if needed

• Boxes 9-12 break down realized and unrealized gains and losses from derivatives contracts

• Boxes 13-15 show state ID information and withholding

1099-R – This form is issued to everyone who receives distributions from IRAs, qualified retirement plans or annuity contracts that are not housed inside a tax-deferred account or plan.

• Box 1 shows the gross distribution amount

• Box 2a shows the amount of taxable distribution

• Box 2b has checkboxes for taxable amount not determined and total distribution

• Box 3 shows amount of capital gain included in box 2a

• Box 4 shows federal tax withheld

• Box 5 shows employee/Roth contributions

• Box 6 shows net unrealized appreciation in employer securities

• Box 7 shows the distribution code that determines how the distribution is taxed

• Box 8 shows the value of any annuity contract included in the distribution

• Box 9a shows the value of distribution percentage that belongs to the recipient

• Box 9b shows the amount of the employee's investment for annuity distributions where the exclusion ratio must be computed

• If Box 10 is filled, refer to instructions on Form 5329

• Box 11 shows the year the recipient first made a Roth contribution of any kind

• Boxes 12-17 show state and local ID information and withholding

1099 MISC – Although most of this form pertains to earned income, it is also used to report royalty income (box 1) and working interest income (box 7) in oil and gas leases.Form 5498 – The receiving custodian of a qualified plan rollover or IRA transfer issues this to the account holder as proof that the transfer was not a taxable event and should not be counted as a distribution. 

Michael Ruger

About Michael.........

Hi, I'm Michael Ruger. I'm the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Should I Establish an Employer Sponsored Retirement Plan?

establishing an employer sponsored retirement plan

Employer sponsored retirement plans are typically the single most valuable tool for business owners when attempting to:

• Reduce their current tax liability

• Attract and retain employees

• Accumulate wealth for retirement

But with all of the different types of plans to choose from which one is the right one for your business? Most business owners are familiar with how 401(k) plans works  but that might not be the right fit given variables such as:

• # of Employees

• Cash flows of the business

• Goals of the business owner

There are four main stream employer sponsored retirement plans that business owners have to choose from:

• SEP IRA

• Single(k) Plan

• Simple IRA

• 401(k) Plan

Since there are a lot of differences between these four types of plans we have included a comparison chart at the conclusion of this newsletter but we will touch on the highlights of each type of plan.

SEP IRA PLAN

This is the only employer sponsored retirement plan that can be setup after 12/31 for the previous tax year. So when you are sitting with your accountant in the spring and they deliver the bad news that you are going to have a big tax liability for the previous tax year, you can establish a SEP IRA up until your tax filing deadline plus extension, fund it, and take a deduction for that year.

However, if the company has employees that meet the plan's eligibility requirement, these plans become very expensive very quickly if the owner(s) want to make contributions to their own accounts. The reason being, these plans are 100% employer funded which means there are no employee contributions allowed and the employer contribution is uniform for all plan participants. For example, if the owner contributes 15% of their income to the SEP IRA, they have to make an employer contribution equal to 15% of compensation for each employee that has met the plans eligibility requirement. If the 5305-SEP Form, which serves as the plan document, is setup correctly a company can keep new employees out of the plan for up to 3 years but often times it is either not setup correctly or the employer cannot find the document.

Single(k) Plan or "Solo(k)"

These plans are for owner only entities. As soon as you have an employee that works more than 1000 hours in a 12 month period, you cannot sponsor a Single(k) plan.

The plans are often times the most advantageous for self-employed individuals that have no employees and want to have access to higher pre-tax contribution levels. For all intents and purposes it is a 401(k) plan, same contributions limits, ERISA protected, they allow loans and Roth contributions, etc. However, they can be sponsored at a much lower cost than traditional 401(k) plans because there are no non-owner employees. So there is no year-end testing, it's typically a boiler plate plan document, and the administration costs to establish and maintain these plans are typically under $400 per year compared to traditional 401(k) plans which may cost $1,500+ per year to administer.

The beauty of these plans is the "employee contribution" of the plan which gives it an advantage over SEP IRA plans. With SEP IRA plans you are limited to contributions up to 25% of your income. So if you make $24,000 in self-employment income you are limited to a $6,000 pre-tax contribution.

With a Single(k) plan, for 2021, I can contribute $19,500 per year (another $6,500 if I'm over 50) up to 100% of my self-employment income and in addition to that amount I can make an employer contribution up to 25% of my income. In the previous example, if you make $24,000 in self-employment income, you would be able to make a salary deferral contribution of $18,000 and an employer contribution of $6,000, effectively wiping out all of your taxable income for that tax year.

Simple IRA

Simple IRA's are the JV version of 401(k) plans. Smaller companies that have 1 – 30 employees that are looking to start are retirement plan will often times start with implementing a Simple IRA plan and eventually graduate to a 401(k) plan as the company grows. The primary advantage of Simple IRA Plans over 401(k) Plans is the cost. Simple IRA's do not require a TPA firm since they are self-administered by the employer and they do not require annual 5500 filings so the cost to setup and maintain the plan is usually much less than a 401(k) plan.

What causes companies to choose a 401(k) plan over a Simple IRA plan?

• Owners want access to higher pre-tax contribution limits

• They want to limit to the plan to just full time employees

• The company wants flexibility with regard to the employer contribution

• The company wants a vesting schedule tied to the employer contributions

• The company wants to expand investment menu beyond just a single fund family

401(k) Plans

These are probably the most well recognized employer sponsored plans since at one time or another each of us has worked for a company that has sponsored this type of plan. So we will not spend a lot of time going over the ins and outs of these types of plan. These plans offer a lot of flexibility with regard to the plan features and the plan design.

We will issue a special note about the 401(k) market. For small business with 1 -50 employees, you have a lot of options regarding which type of plan you should sponsor but it's our personal experience that most investment advisors only have a strong understanding of 401(k) plans so they push 401(k) plans as the answer for everyone because it's what they know and it's what they are comfortable talking about. When establishing a retirement plan for your company, make sure you consult with an advisor that has a working knowledge of all these different types of retirement plans and can clearly articulate the pros and cons of each type of plan. This will assist you in establishing the right type of plan for your company. 

Michael Ruger

About Michael.........

Hi, I'm Michael Ruger. I'm the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.