Watch These Two Market Indicators
While a roaring economy typically rewards equity investors, the GDP growth rate in the U.S. has continued to grow at that same 2.2% pace that we have seen since the recovery began in March 2009. When you compare that to the GDP growth rates of past economic expansions, some may classify the current growth rate as “sub par”. As in the tale of the
While a roaring economy typically rewards equity investors, the GDP growth rate in the U.S. has continued to grow at that same 2.2% pace that we have seen since the recovery began in March 2009. When you compare that to the GDP growth rates of past economic expansions, some may classify the current growth rate as “sub par”. As in the tale of the tortoise and the hare, sometimes slow and steady wins the race.
The number one questions on investor’s minds: “It’s been a great rally but are we close to the end?” Referencing the chart below, if you look at the length of the current economic expansion, going back to 1900 we are now witnessing the 3rd longest economic expansion on record which is making investors nervous because as we all know that markets work in cycles.
However, if you ignore the “length” of the rally for a moment and look at the “magnitude” of the rally it would seem that total GDP growth of the current economic expansion has been relatively tame compared to some of the economic recoveries in the past. See the chart below. The chart shows evidence that there have been economic rallies in the past that were shorter in duration but greater in magnitude. This may indicate that we still have further to go in the current economic expansion.
What causes big rallies to end?
Looking back at strong economic rallies in the past, the rallies did not die of old age but rather there was an event that triggered the next recession. So we have to be able identify trends within the economic data that would suggest that the economic expansion has ended and it will lead to the next recession.
Watch these two indicators
Two of the main indicators that we monitor to determine where we are in the current economic cycle are the Leading Indicators Index and the Yield Curve. History rarely repeats itself but it does rhyme. Look at the chart of the leading indicators index below. The leading indicators index is comprised of multiple economic indicators that are considered “forward looking”, like housing permits. If there are a lot of housing permits being issues, then demand for housing must be strong, and a strong housing market could lead to further economic growth. Look specifically at 2006. The leading indicators went negative in 2006, over a year before the stock market peaked in 2007. This indicator was telling us there was a problem before a majority of investors realized that we were on the doorstep of the recession.
Let’s look at the second key indicator, the yield curve. You will hear a lot about the “slope of the yield curve” in the media. In a healthy economy, long term interest rates are typically higher than short term rates which results in a “positively slopped” yield curve. In other words, when you go to the bank and you have the choice of buying a 2 year CD or a 10 year CD, you would expect to receive a higher interest rate on the 10 year CD because they are locking up your money for 10 years instead of 2.
There are periods of time where the interest rate on a 10 year government bond will drop below the interest rate on a 2 year government bond which is considered an “inverted yield curve”. Why does this happen and why would investors by that 10 year bond that is yielding less than the 2 year bond? This happens because bond investors are predicting an economic slowdown in the foreseeable future. They want to lock in the current 10 year interest rate knowing that if the economy goes into a recession that the Fed may begin to lower the Fed Funds Rate which has a more rapid impact on short term rates. It’s a bet that the 2 year bond rate will drop below the 10 year bond rate within the next few years.
If you look at the historical chart of the yield curve above, the yield curve inverted prior to the recession in the early 2000’s and prior to the 2008 recession.
Looking at where we sit today, within the last 6 months the leading indicators index has not only been positive but it’s accelerating and the yield curve is still positively sloped. While we realize that there is not a single indicator that accurately predicts the end of a market cycle, these particular economic indicators have historically been helpful in predicting danger ahead.
There will always be uncertainty in the world. Currently it has taken the form of U.S, politics, tax reforms, geopolitical events, and global monetary policy but it would seem that based on the hard economic data here in the U.S. that our economic expansion that began in March 2009 may still have further to go.
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
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.
How Much Money Do I Need To Save To Retire?
This is by far the most popular question that we come across as financial planners. You may have heard some of the "rules of thumb" like “80% of your current take-home pay” or “1 million dollars”. In reality, the answer varies greatly on an individual by individual basis. This article will outline the procedures that we follow as financial planners to help
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This is by far the most popular question that we come across as financial planners. You may have heard some of the "rules of thumb" like “80% of your current take-home pay” or “1 million dollars”. In reality, the answer varies greatly on an individual by individual basis. This article will outline the procedures that we follow as financial planners to help individuals answer this very important question.
Step 1: Estimate Your Annual Expenses In Retirement
The first step is to get a ballpark idea of what your annual expenses might look like in retirement. The best place to start is to list your current monthly and annual expenses. Then create a separate column labeled “expenses in retirement”. Whether you are 2 years, 10 years, or 20 years away from retirement the idea is to pretend as if you were retiring tomorrow and determining what your annual expenses might look like. Some of your expenses in retirement will be lower, others may be higher, but most people find that a lot of their current expenses will carry over at the same level into the retirement years. This is because most people have become accustom to a certain standards of living and they intend to maintain that standard of living in retirement. Here are a few important questions that you should ask yourself when forecasting your retirement expenses:
How much should I budget for health insurance?
Will I have a mortgage or debt when I retire?
Do I plan to move when I retire?
Since I will not be working, should I budget additional expenses for vacations and hobbies?
Will I need to keep my life insurance policies after I retire?
Step 2: Adjust Your Retirement Expenses For Inflation
Now that you have a ballpark number of your annual expenses in retirement, you will need to adjust those expenses for inflation. Inflation is just a fancy word for “the price of everything that we buy today will gradually go up in price over time”. If the price of a gallon of milk today is $2 then most likely 20 years from now that same gallon of milk will cost $3.51. A 75% increase!! Historically inflation has grown at a rate of about 3% per year. There are periods of time when the rate of inflation grows faster or slower but on average it grows at 3% per year.
Another way to look at inflation is $20,000 in today’s dollars will not buy the same amount of goods and services 10 years from now because inflation erodes the purchasing power of your $20,000. If I did my annual expense planner and it tells me that I need $50,000 per year in retirement to meet all of my estimated expenses, let’s look at what adjusting that $50,000 for inflation does over different periods of time assuming a 3% rate of inflation:
Today’s Dollars 5 Years From Now 10 Years From Now 20 Years From Now
$50,000 $56,275 $65,238 $87,675
In the above example, if I am retiring in 10 years, and my estimated annual expenses in retirement will be $50,000 in today’s dollars, by the time I retire 10 years from now my annual expenses will increase to $65,238 per year just to stay in the same place that I am in today. Also, inflation does not stop when you retire, it continues into the retirement years. If I am 50 today and plan to live until 90, I have to apply this inflation adjustment for 40 years. It’s clear to see how inflation can have a significant impact on the amount that you may need to withdrawal for your account to meet you estimated expenses at a future date.
Step 3: Gather The Information On Your Current Assets
Once you know your expenses, you now need to gather all of the information on your retirement accounts and pension plans. You should collect the most recent statement for all of your investment accounts (401K, 403B, IRA’s, brokerage accounts, stocks, etc.), pension statements (if applicable), obtain your most recent social security statement, and gather information on the other sources of income and/or assets that may be available when you retire. Such as:
Sale of a business
Downsizing the primary residence
Rental income
Part-time employment
Step 4: Project The Growth Of Your Retirement Assets
There are three main categories to consider when calculating the growth rate of your retirement assets:
Annual contributions
Withdrawals
Investment rate of return
For annual contributions, it’s determining which accounts you plan on making deposits too each year and how much? For most individuals, their employer sponsored retirement plan is the main source of new contributions to their retirement nest egg. If your employer makes regular employer contributions to your retirement plan, you should factor those in as well. For example, if I am contributing 8% of my pay into the plan and my employer is providing me with a 4% matching contributions, I would reasonably assume that I’m adding 12% of my pay to my 401(k) plan each year.
The most popular question that we get in this category is “how much should I be contributing each year to my retirement account with my employer?” We advise employees that they should have a goal of contributing 10% of their pay each year to their retirement accounts. This is an aggregate total between your personal contributions and the employer contributions. Even if you cannot reach that level right now, 10%+ is the target.
Let’s move onto the next category…….withdrawals. Pre-retirement withdrawals from retirement accounts have become much more common in recent years due largely to the rising cost of college education. Parents will take loans from their 401K/403B plans or take early withdrawals from IRA accounts to fulfill the need for additional income during the years that their children are in college. If part of your overall financial plan is to use your retirement accounts to pay for one-time expenses such as college, you will need to factor that into your projections.
The third variable to consider when determining the growth of your assets is the assumed annual rate of return on your investments. There are many items to consider when determining a reasonable annual rate of return for your accounts. Some of those considerations include:
Time horizon to retirement
Allocation of your portfolio (stocks vs bonds)
Concentrated holdings (10%+ of your portfolio allocated to a single investment)
Accumulation phase versus distribution phase
The answer to the question: “what rate of return should I expect from my retirement accounts?”, can really only be determine on a case by case basis. Using an unreasonable rate of return assumption can create a significant disconnect between your retirement projections versus what is likely to actually occur within your investment accounts. Be careful with this step.
Step 5: Factor In Taxes
Don’t forget about the lovely IRS. All assets are not treated equally from a tax standpoint. For most individuals, the majority of their retirement savings will be in pre-tax retirement vehicles such as 401(k), 403(b), and Traditional IRA’s. That means when you take distributions from those accounts, you will realize earned income, and have to pay tax. For example, if you have $400,000 in your 401K account and you are in the 25% tax bracket, $100,000 of that $400,000 will be lost to taxes as withdrawals are made from the account.
If you have after tax investment accounts, it’s possible that you may owe little to no taxes on withdrawals. However, if there are unrealized investment gains built up in your after tax investment accounts then you may owe capital gains tax when liquidating positons.
Also note, you may have to pay taxes on a portion of your social security benefit. The amount of your social security benefit that is taxable varies based on your level of income.
Step 6: Spend Down Your Assets
In the final step, you should run long term projections to illustrate the spend down of your assets in retirement. Here are the steps:Example
Start with your annual after tax expense number $60,000
Subtract social security less taxes: ($20,000)
Subtract pension payments less taxes (if applicable): ($10,000)
Annual Expenses Net SS and Pensions: $30,000
In the example above, this individual would need an additional $30,000 after-tax to meet their anticipated annual expenses in Year 1 of retirement. I stress “after-tax” because if all of the retirement assets are in a pre-tax retirement account then they would need to gross up their distributions for taxes to get to the $30,000 after tax. If it is assumed that $40,000 has to be withdrawn from an IRA each year, the 3% inflation rate is applied to the annual expenses, and the life expectancy of this individual is 20 years from the date that they retire, this individual would need to withdrawal $1,074,814 out of their retirement accounts over the next 20 years to meet their income needs.
Step 7: Identify Multiple Solutions
There are often times multiple roads to reach a destination and the same is true when planning for retirement. If you find that you assets are falling short of the amount that is needed to sustain your expenses in retirement, you should work with a knowledgeable financial planner to identify alternative solutions. It may help you to answer questions like:
If I decided to work part-time in retirement how much would I have to earn?
If I downsize my primary residence in retirement how does this impact the overall picture?
If I can’t retire at age 63, what age can I comfortably retire at?
What are the pros and cons of taking social security benefits prior to normal retirement age
I also encourage clients to spend time looking at their annual expenses. If you find that your are cutting it close on income versus expenses in retirement, it's usually easier to cut expenses than it is to create more income in the retirement year.
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.
Stock Options 101: ISO, NQSO, and Restricted Stock
If you are reading this article, your company has probably granted you stock options. Stock options give you the potential share in the growth of your company’s value without any financial risk to you until you exercise the options and buy shares of your company’s stock.
types of stock options
If you are reading this article, your company has probably granted you stock options. Stock options give you the potential share in the growth of your company’s value without any financial risk to you until you exercise the options and buy shares of your company’s stock.
Stock options give you the right to purchase a specific number of shares of the company’s stock at a fixed price. There is typically a vesting schedule attached to option grants that specify when you have the right to exercise your stock options. Companies can offer employees:
Incentive Stock Options (“ISO”)
Nonqualified Stock Options (“NQSO”)
Restricted Stock
It is very important to understand how these different types of options and grants are taxed otherwise it could lead to unfortunate tax surprises down the road.
Non-Qualified Stock Options (NQSO)
A non-qualified stock option (NQSO) is a type of stock option that does not qualify for special favorable tax treatment under the US Internal Revenue Code. Thus the word nonqualified applies to the tax treatment (not to eligibility or any other consideration). NQSOs are the most common form of stock option and may be granted to employees, officers, directors, contractors, and consultants.
You pay taxes on these options at the time of exercise. For tax purposes, the exercise spread is compensation income and is therefore reported on your IRS Form W-2 for the calendar year of exercise.
Example: Your stock options have an exercise price of $30 per share. You exercise them when the price of your company stock is $100 per share. You have a $70 spread ($100 – 30) and thus $70 per share is included in your W2 as ordinary income.
Your company will withhold taxes—income tax, Social Security, and Medicare—when you exercise the options.
When you sell the shares, whether immediately or after a holding period, your proceeds are taxed under the rules for capital gains and losses. You report the stock sale on Form 8949 and Schedule D of your IRS Form 1040 tax return.
Incentive Stock Options (ISO)………..
Incentive stock options (ISOs) qualify for special tax treatment under the Internal Revenue Code and are not subject to Social Security, Medicare, or withholding taxes. However, to qualify they must meet rigid criteria under the tax code. ISOs can be granted only to employees, not to consultants or contractors. There is a $100,000 limit on the aggregate grant value of ISOs that may first become exercisable (i.e. vest) in any calendar year. Also, for an employee to retain the special ISO tax benefits after leaving the company, the ISOs must be exercised within three months after the date of termination.
After you exercise these options, if you hold the acquired shares for at least two years from the date of grant and one year from the date of exercise, you incur favorable long-term capital gains tax (rather than ordinary income tax) on all appreciation over the exercise price. However, the paper gains on shares acquired from ISOs and held beyond the calendar year of exercise can subject you to the alternative minimum tax (AMT). This can be problematic if you are hit with the AMT on theoretical gains but the company's stock price then plummets, leaving you with a big tax bill on income that has evaporated.
Very Important: If you have been granted ISOs, it’s important to understand how the alternative minimum tax can affect you prior to exercising your stock options.
Restricted Stock……………….
Your company may no longer be granting you stock options, or may be granting fewer than before. Instead, you may be receiving restricted stock. While these grants don't give you the same potentially life-altering, wealth-building upside as stock options, they do have additional benefits compared to ISO’s and NQSO’s.
The value of stock options, such as ISO’s and NQSO’s, depend on how much (or whether) your company's stock price rises above the price on the grant date. By contrast, restricted stock has value at vesting even if the stock price has not moved or even dropped since grant.
Depending on your attitude toward risk and your experience with swings in your company's stock price, the certainty of your restricted stock's value can be appealing. By contrast, stock options (ISO & NQSO) have great upside potential but can be "underwater" (i.e. having a market price lower than the exercise price). This is why restricted stock is often granted to a newly hired executive. It may be awarded as a hiring bonus or to make up for compensation and benefits, including in-the-money options and nonqualified retirement benefits, forfeited by leaving a prior employer.
Of course, the very essence of restricted stock is that you must remain employed until the shares vest to receive its value. While you may have between 30 and 90 days to exercise stock options after voluntary termination, unvested grants of restricted stock are often forfeited immediately. Thus, it is an extremely effective “golden handcuff” to keep you at your company.
Fewer Decisions
Unlike a stock option, which requires you to decide when to exercise and what exercise method to use, restricted stock involves fewer decisions. When you receive the shares at vesting—which can be based simply on the passage of time or the achievement of performance goals—you may have a choice of tax-withholding methods (e.g. cash, sell shares for taxes), or your company may automatically withhold enough vested shares to cover the tax withholding. Restricted stock is considered "supplemental" wages, following the same tax rules and W-2 reporting that apply to grants of nonqualified stock options.
Tax Decisions
The most meaningful decision with restricted stock grants is whether to make a Section 83(b) election to be taxed on the value of the shares at grant instead of at vesting. Whether to make this election, named after the section of the Internal Revenue Code that authorizes it, is up to you. (It is not available for Restricted Stock Units (RSUs), which are not "property" within the meaning of Internal Revenue Code Section 83)
If a valid 83(b) election is made within 30 days from the date of grant, you will recognize as of that date ordinary income based on the value of the stock at grant instead of recognizing income at vesting. As a result, any appreciation in the stock price above the grant date value is taxed at capital gains rates when you sell the stock after vesting.
While this can appear to provide an advantage, you face significant disadvantages should the stock never vest and you forfeit it because of job loss or other reasons. You cannot recover the taxes you paid on the forfeited stock. For this reason, and the earlier payment date of required taxes on the grant date value, you usually do better by not making the election. However, this election does provide one of the few opportunities for compensation to be taxed at capital gains rates. In addition, if you work for a startup pre-IPO company, it can be very attractive for stock received as compensation when the stock has a very small current value and is subject to a substantial risk of forfeiture. Here, the downside risk is relatively small.
Dividends
Unlike stock options, which rarely carry dividend equivalent rights, restricted stock typically entitles you to receive dividends when they are paid to shareholders.
However, unlike actual dividends, the dividends on restricted stock are reported on your W-2 as wages (unless you made a Section 83(b) election at grant) and are not eligible for the lower tax rate on qualified dividends until after vesting.
Comparison Chart
stock option comparison chart
Disclosure: The information listed above is for educational purposes only. Greenbush Financial Group, LLC does not provide tax advice. For tax advice, please consult your accountant.
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.
Types of Retirement Plans
The comparing retirement plans chart gives business owners the ability to compare different types of plans available to their company.
Types of Retirement Plans
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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.
Rollover Chart
Provides individuals with clarification on the rollover rules for retirement accounts and IRA’s.
Rollover Chart
RC
Provides individuals with clarification on the rollover rules for retirement accounts and IRA’s.
Click on the PDF link in the green box below.
Expense Planner
The expense planner is used to determine your annual after tax expenses both now and in retirement.
Inherited IRA's: How Do They Work?
An Inherited IRA is a retirement account that is left to a beneficiary after the owner’s death. It is important to have a general knowledge of how Inherited IRA’s work because a minor error in how the account is set up could lead to major tax consequences.
how do inherited ira's work
An Inherited IRA is a retirement account that is left to a beneficiary after the owner’s death. It is important to have a general knowledge of how Inherited IRA’s work because a minor error in how the account is set up could lead to major tax consequences.
Before going into the different kinds of Inherited IRA’s, if you are the sole beneficiary of your spouse’s IRA, you are able to transfer the assets to your own existing IRA or to a new IRA through what is called a “Spousal Transfer”. This account is not treated as an Inherited IRA and therefore is subject to all the rules a Traditional IRA would be subject to as if it was always held in your name. If the spouse needs to have access to the money before age 59 ½, it would probably make sense to set up an Inherited IRA because this would give the spouse options to access the money without incurring a 10% early withdrawal penalty.
Withdrawal Rules for Spouse & Non-Spouse Beneficiaries
The SECURE Act that passed in December 2019 dramatically changed the distribution options that are available to non-spouse beneficiaries. If you are spousal beneficiary please reference the following article:
10 Year Method
All the assets must be distributed by the 10th year after the year in which the account holder died. This option may make sense compared to the Lump Sum option explained next to spread out the tax liability over a longer period.
Lump Sum Distribution
You may take a lump sum distribution when the account is inherited. It is recommended that you consult your tax preparer to discuss the tax consequences of this method since you may move up into a different tax bracket.
Additional Takeaways
If the decedent was required to take a distribution in the year of death, it is important to determine whether or not the decedent took the distribution. If the decedent was required to take a RMD but did not do so in the year they passed, the inheritor must take the distribution based on the life expectancy of the decedent or the distribution will be subject to a 50% penalty. Distributions going forward will be based on the life expectancy of the inheritor.
It is important to be sure a beneficiary form is completed for the Inherited IRA. If there is no beneficiary and the account goes to an estate then the inheritor will have limited choices on which distribution method to choose among other tax consequences.
You are only able to combine Inherited IRA’s if they were inherited from the same individual. If you have multiple Inherited IRA’s from different individuals, you cannot commingle the assets because of the distributions that must be taken.
There is no 60 day rule with Inherited IRA’s like there is with other Traditional IRA’s. The 60 day rule allows someone to withdraw money from an IRA and as long as it’s replenished within 60 days there is no tax consequence. This is not available with Inherited IRA’s, all non-Roth distributions are taxable.
The charts below are from insurancenewsnet.com publication titled “Extended IRA Quick Reference Guide” give another look at the details of Inherited IRA’s.
inherited ira options
inherited ira distribution options
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.
Backdoor Roth IRA Contribution Strategy
This strategy is for high income earners that make too much to contribute directly to a Roth IRA. In recent years, some of these high income earners have been implementing a “backdoor Roth IRA conversion strategy” to get around the Roth IRA contribution limitations and make contributions to Roth IRA’s via “conversions”. For the 2020 tax year, your
backdoor roth ira strategy
This strategy is for high income earners that make too much to contribute directly to a Roth IRA. In recent years, some of these high income earners have been implementing a “backdoor Roth IRA conversion strategy” to get around the Roth IRA contribution limitations and make contributions to Roth IRA’s via “conversions”. For the 2021 tax year, your ability to make contributions to a Roth IRA begins to phase out at the following AGI thresholds based on your filing status:
Single: $125,000
Married Filing Jointly: $198,000
Married Filing Separately: $0
However, in 2010 the IRS removed the income limits on “IRA Conversions” which open up an opportunity……if executed correctly…….for high income earners to make “backdoor” contributions to a Roth IRA.
Why would a high income earning want to contribute to a Roth IRA? Once high income earners have maxed out their contributions to their employer sponsored retirement plans, they usually begin to fund plain vanilla investment management accounts or whole life insurance policies. When assets accumulate in an investment management account, once liquidated, the account owner typically has to pay either short-term or long term capital gains on the appreciation. For whole life insurance, even though the accumulation is tax deferred, if the policy is surrendered, the policy owner pays ordinary income tax on the gain in the policy.
With a Roth IRA, after tax contributions are made to the account and the gains in the account are withdrawn TAX FREE if the account owner at the time of withdrawal is over the age of 59½ and the Roth IRA has been in existence for 5 years. A huge tax benefit for high income earners who are typically in a medium to higher tax bracket even in retirement.
Here is how the strategy works
Rollover all existing pre-tax IRA’s into your employer sponsored retirement plan
Make a non-deductible contribution to a Traditional IRA
Convert the Traditional IRA to a Roth IRA
Here are the pitfalls in the execution process
Over the years, more and more individuals have become aware of this wealth accumulation strategy. However, there are risks associated with executing this strategy and if not executed correctly could result in adverse tax consequences.
Here are the top pitfalls:
Forget to aggregate Pre-Tax IRA’s
Do not understand that SEP IRA’s and Simple IRA’s are included in the Aggregation Rule
They create a “step transaction”
Pitfall #1: IRS Aggregation Rule
The IRA aggregate rule stipulates that when an individual has multiple IRAs, they will allbe treated as one account when determining the tax consequences of any distributions (including a distribution out of the account for a Roth conversion).
This creates a significant challenge for those who wish to do the backdoor Roth strategy, but have otherexisting IRA accounts already in place (e.g., from prior years’ deductible IRA contributions, or rollovers from prior 401(k) and other employer retirement plans). Because the standard rule for IRA distributions (and Roth conversions) is that any after-tax contributions come out along with any pre-tax assets (whether from contributions or growth) on a pro-rata basis, when all the accounts are aggregated together, it becomes impossible to justconvert the non-deductible IRA.
picture
If an individual has pre-tax IRA’s we typically recommend that they rollover those IRA’s into their employer sponsored retirement plans which eliminates all of their pre-tax IRA balance and then open the opportunity to execute this backdoor Roth IRA contribution strategy.
Pitfall #2: SEP IRA & Simple IRA's count
Many smaller companies and self-employed individuals sponsor SEP IRA’s or Simple IRA Plans. Many individuals just assume that these are “employer sponsored retirement plans” not subject to the aggregation rules. Wrong. In the eyes of the IRS these are “pre-tax IRA’s” and are subject to the aggregation rules. If you have a Simple IRA or SEP IRA, make sure you take this common pitfall into account.
Pitfall #3: Beware IRS Step Transaction Rule
This is probably the most common pitfall that we see when executing this strategy. Individuals and investment advisors alike will make deposits to the non-deductible traditional IRA and then the next day process the conversion to the Roth IRA. In doing this, you run the risk of creating a “step transaction”.
There is a very long explanation tied to “step transactions” and how to avoid a “step transactions” but I will provide you with a brief summary of the concept.
Here it is, if you use legal loop holes in the tax system in an obvious effort to side step other IRS limitations (like the Roth IRA income limit) it could be considered a “step transaction” by the IRS and the IRS may disallow the conversion and assess tax penalties.
Disclosure: Backdoor Roth IRA Conversion Strategy
It is highly recommend that you work closely with your financial advisor and tax advisor to determine whether or not this is a viable wealth accumulation strategy based on your personal financial situation.
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.
Simple IRA vs. 401(k) - Which one is right for your company?
There are a lot of options available to small companies when establishing an employer sponsored retirement plan. For companies that have employees in addition to the owners of the company, the question is do they establish a 401(k) plan or a Simple IRA?The right fit for your company depends on:
compare simple ira and 401k
There are a lot of options available to small companies when establishing an employer sponsored retirement plan. For companies that have employees in addition to the owners of the company, the question is do they establish a 401(k) plan or a Simple IRA?The right fit for your company depends on:
What are the company's primary goals for establishing the plan?
How much the owner(s) plan to contribute to the plan?
How many employees does the company have?
Do you want to restrict the plan to only full time employees?
The cost of maintaining each plan?
Does the company intend to make an employer contribution to the plan?
Diversity of the investment menu
Below is a chart that contains a quick comparison of some of the main features of each type of plan:
simple ira vs 401K comparison chart
For many small companies it often makes sense to start with a Simple IRA plan and then transition to a 401K plan as the company grows or when the owner intends to start accessing the upper deferral limits offered by the 401(k) plan.
Simple IRA's are relatively easy to setup and the administrative fees to maintain these plans are typically lower in comparison to 401(k) plans. Most Simple IRA providers will only charge $10 - $30 to custody the accounts.
By comparison, 401(k) plans are ERISA covered plans which require a TPA Firm (third party administrator) to maintain the plan documents, conduct year end plan testing, and file the 5500 each year. The TPA fees vary based on the provider and the number of employees eligible to participate in the plan. A ballpark range is $1,500 - $2,500 for companies with under 50 employees.
However, the additional TPA fees associated with establishing a 401(k) plan may be justified if:
The owners intend to max out their employee deferrals
The owners are approaching retirement and need to make big contributions
The company wants to maintain flexibility with the employer contribution
The company would like to make Roth contributions, loans, or rollovers available
WARNING: Most investment providers are "one trick ponies". They will talk about 401(k) plans and not present other options because they either do not have a thorough understand of how Simple IRA plans work or they are only able to offer 401(k) plans. Before establishing a retirement plan it is important to work with a firm that presents both options, helps you to understand the difference between the two types of plans, and assist you in evaluating which plan would best meet your company's goals and objectives.
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.
