Social Security Loophole: Age 62+ With Kids In High School
There is a little known loophole in the social security system for parents that are age 62 or older with children still in high school or younger. Since couples are having children later in life this situation is becoming more common and it could equal big dollars for families that are aware of this social security filing strategy.
There is a little known loophole in the social security system for parents that are age 62 or older with children still in high school or younger. Since couples are having children later in life this situation is becoming more common and it could equal big dollars for families that are aware of this social security filing strategy.
Here is how it works. If you are age 62 or older and you have children under that age of 18, they can collect a social security benefit based on your earnings history equal to half of the parents social security benefit at normal retirement age. This amount could equal as much as $16,122 per year for one child for higher income earners. If you have multiple children the total annual amount paid to your family members could equal between 150% to $180% of your normal retirement benefit which could be in excess of $40,000 per year depending on your earnings history.
There are some key considerations. First, your children cannot collect on this “family benefit” until you have begun to collect your social security benefit. You can turn on your social security benefit as early as age 62 but they reduce the monthly amount that you receive if you turn on the benefit prior to your normal retirement age. However, it may make sense to do so depending on the amount of the family benefit paid and the duration of the benefit. If you wait until normal retirement age, you will receive a slightly higher social security benefit for yourself, but all of the social security dollars that could have been paid to your children is lost.
Second, if you are still working and your earned income exceeds certain thresholds this filing strategy may not be advantageous due to the earned income penalty. They reduce your social security benefit by $1 for every $2 earned over a given threshold ($16,920 in 2017). Not only is your social security benefit reduce but also the benefit to your dependents.
Due to these restrictions, this filing strategy yields that greatest benefit to parents that are either fully or partially retired, age 62 or older, with a child or children below the age of 18.
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.
Planning for Long Term Care
The number of conversations that we are having with our clients about planning for long term care is increasing exponentially. Whether it’s planning for their parents, planning for themselves, or planning for a relative, our clients are largely initiating these conversations as a result of their own personal experiences.
The number of conversations that we are having with our clients about planning for long term care is increasing exponentially. Whether it’s planning for their parents, planning for themselves, or planning for a relative, our clients are largely initiating these conversations as a result of their own personal experiences.
The baby-boomer generation is the first generation that on a large scale is seeing the ugly aftermath of not having a plan in place to address a long term care event because they are now caring for their aging parents that are in their 80’s and 90’s. Advances in healthcare have allowed us to live longer but the longer we live the more frail we become later in life.
Our clients typically present the following scenario to us: “I have been taking care of my parents for the past three years and we just had to move my dad into the nursing home. What an awful process. How can I make sure that my kids don’t have to go through that same awful experience when I’m my parents age?”
“Planning for long term care is not just about money…….it’s about having a plan”
If there are no plans, your kids or family members are now responsible for trying to figure out “what mom or dad would have wanted”. Now tough decisions need to be made that can poison a relationship between siblings or family members.
Some individuals never create a plan because it involves tough personal decisions. We have to face the reality that at some point in our lives we are going to get older and later in life we may reach a threshold that we may need help from someone else to care for ourselves or our spouse. It’s a tough reality to face but not facing this reality will most likely result in the worst possible outcome if it happens.
Ask yourself this question: “You worked hard all of your life to buy a house, accumulate assets in retirement accounts, etc. If there are assets left over upon your death, would you prefer that those assets go to your kids or to the nursing home?” With some advance planning, you can make sure that your assets are preserved for your heirs.
The most common reason that causes individuals to avoid putting a plan in place is: “I have heard that long term care insurance is too expensive.” I have good news. First, there are other ways to plan for the cost of a long term care event besides using long term care insurance. Second, there are ways to significantly reduce the cost of these policies if designed correctly.
The most common solution is to buy a long term care insurance policy. The way these policies work is if you can no longer perform certain daily functions, the policy pays a set daily benefit. Now a big mistake many people make is when they hear “long term care” they think “nursing home”. In reality, about 80% of long term care is provided right in the home via home health aids and nurses. Most LTC policies cover both types of care. Buying a LTC policy is one of the most effective ways to address this risk but it’s not the only one.
Why does long term care insurance cost more than term life insurance or disability insurance? The answer, most insurance policies insure you against risks that have a low probability of happening but has a high financial impact. Similar to a life insurance policy. There is a very low probability that a 25 year old will die before the age of 60. However, the risk of long term care has a high probability of happening and a high financial impact. According to a study conducted by the U.S Department of Human Health and Services, “more than 70% of Americans over the age of 65 will need long-term care services at some point in their lives”. Meaning, there is a high probability that at some point that insurance policy is going to pay out and the dollars are large. The average daily rate of a nursing home in upstate New York is around $325 per day ($118,625 per year). The cost of home health care ranges greatly but is probably around half that amount.
So what are some of the alternatives besides using long term care insurance? The strategy here is to protect your assets from Medicaid. If you have a long term care event you will be required to spend down all of your assets until you reach the Medicaid asset allowance threshold (approx. $13,000 in assets) before Medicaid will start picking up the tab for your care. Often times we will advise clients to use trusts or gifting strategies to assist them in protecting their assets but this has to be done well in advance of the long term care event. Medicaid has a 5 year look back period which looks at your full 5 year financial history which includes tax returns, bank statements, retirement accounts, etc, to determine if any assets were “given away” within the last 5 years that would need to come back on the table before Medicaid will begin picking up the cost of an individuals long term care costs. A big myth is that Medicare covers the cost of long term care. False, Medicare only covers 100 days following a hospitalization. There are a lot of ins and outs associated with buildings a plan to address the risk of long term care outside of using insurance so it is strongly advised that individuals work with professionals that are well versed in this subject matter when drafting a plan.
An option that is rising in popularity is “semi self-insuring”. Instead of buying a long term care policy that has a $325 per day benefit, an individual can obtain a policy that covers $200 per day. This can dramatically reduce the cost of the LTC policy because it represents less financial risk to the insurance company. You have essentially self insured for a portion of that future risk. The policy will still payout $73,000 per year and the individual will be on the line for $45,625 out of pocket. Versus not having a policy at all and the individual is out of pocket $118,000 in a single year to cover that $325 per day cost.
As you can see there are a number of different options when it come to planning for long term care. It’s about understanding your options and determining which solution is right for your personal financial situation.
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.
Small Business Owners: How To Lower The Cost of Health Insurance
As an owner of a small business myself, I’ve had a front row seat to the painful rise of health insurance premiums for our employees over the past decade. Like most of our clients, we evaluate our plan once a year and determine whether or not we should make a change. Everyone knows the game. After running on this hamster wheel for the
As an owner of a small business myself, I’ve had a front row seat to the painful rise of health insurance premiums for our employees over the past decade. Like most of our clients, we evaluate our plan once a year and determine whether or not we should make a change. Everyone knows the game. After running on this hamster wheel for the past decade it led me on a campaign to consult with experts in the health insurance industry to find a better solution for both our firm and for our clients.
The Goal: Find a way to keep the employee health benefits at their current level while at the same time cutting the overall cost to the company. For small business owners reducing the company’s outlay for health insurance costs is a challenge. In many situations, small businesses are the typical small fish in a big pond. As a small fish, they frequently receive less attention from the brokerage community which is more focused on obtaining and maintaining larger plans.
Through our research, we found that there are two key items that can lead to significant cost savings for small businesses. First, understanding how the insurance market operates. Second, understanding the plan design options that exist when restructuring the health insurance benefits for your employees.
Small Fish In A Big Pond
I guess it came as no surprise that there was a positive correlation between the size of the insurance brokerage firm and their focus on the large plan market. Large plans are generally defined as 100+ employees. Smaller employers we found were more likely to obtain insurance through their local chambers of commerce, via a “small business solution teams” within a larger insurance brokerage firm, or they sent their employees directly to the state insurance exchange.
Myth #1: Since I’m a small business, if I get my health insurance plan through the Chamber of Commerce it will be cheaper. I unfortunately discovered that this was not the case in most scenarios. If you are an employer with between 1 – 100 employees you are a “community rated plan”. This means that the premium amount that you pay for a specific plan with a specific provider is the same regardless of whether you have 2 employees or 99 employee because they do not look at your “experience rating” (claims activity) to determine your premium. This also means that it’s the same premium regardless of whether it’s through the Chamber, XYZ Health Insurance Brokers, or John Smith Broker. Most of the brokers have access to the same plans sponsored by the same larger providers in a given geographic region. This was not always the case but the Affordable Care Act really standardized the underwriting process.
The role of your insurance broker is to help you to not only shop the plan once a year but to evaluate the design of your overall health insurance solution. Since small companies usually equal smaller premium dollars for brokers it was not uncommon for us to find that many small business owners just received an email each year from their broker with the new rates, a form to sign to renew, and a “call me with any questions”. Small business owners are usually extremely busy and often times lack the HR staff to really look under the hood of their plan and drive the changes needed to improve the plan from a cost standpoint. The way the insurance brokerage community gets paid is they typically receive a percentage of the annual premiums paid by your company. From talking with individuals in the industry, it’s around 4%. So if a company pays $100,000 per year in premiums for all of their employees, the insurance broker is getting paid $4,000 per year. In return for this compensation the broker is supposed to be advocating for your company. One would hope that for $4,000 per year the broker is at least scheduling a physical meeting with the owner or HR staff to review the plan each year and evaluate the plan design options.
Remember, you are paying your insurance broker to advocate for you and the company. If you do not feel like they are meeting your needs, establishing a new relationship may be the start of your cost savings. There also seemed to be a general theme that bigger is not always better in the insurance brokerage community. If you are a smaller company with under 50 employees, working with smaller brokerage firms may deliver a better overall result.
Plan Design Options
Since the legislation that governs the health insurance industry is in a constant state of flux we found through our research that it is very important to revisit the actual structure of the plan each year. Too many companies have had the same type of plan for 5 years, they have made some small tweaks here and there, but have never taken the time to really evaluate different design options. In other words, you may need to demo the house and start from scratch to uncover true cost savings because the problem may be the actual foundation of the house.
High quality insurance brokers will consult with companies on the actual design of the plan to answer the key question like “what could the company be doing differently other than just comparing the current plan to a similar plan with other insurance providers?” This is a key question that should be asked each year as part of the annual evaluation process.
HRA Accounts
The reason why plan design is so important is that health insurance is not a one size fits all. As the owner of a small business you probably have a general idea as to how frequently and to what extent your employees are accessing their health insurance benefits.
For example, you may have a large concentration of younger employees that rarely utilize their health insurance benefits. In cases like this, a company may choose to change the plan to a high deductible, fund a HRA account for each of the employees, and lower the annual premiums.
HRA stands for “Health Reimbursement Arrangement”. These are IRS approved, 100% employer funded, tax advantage, accounts that reimburses employees for out of pocket medical expenses. For example, let’s say I own a company that has a health insurance plan with no deductible and the company pays $1,000 per month toward the family premium ($12,000 per year). I now replace the plan with a new plan that keeps the coverage the same for the employee, has a $3,000 deductible, and lowers the monthly premium that now only cost the company $800 per month ($9,600 per year). As the employer, I can fund a HRA account for that employee with $3,000 at the beginning of the year which covers the full deductible. If that employee only visits the doctors twice that year and incurs $500 in claims, at the end of the year there will be $2,500 in that HRA account for that employee that the employer can then take back and use for other purposes. The flip side to this example is the employee has a medical event that uses the full $3,000 deductible and the company is now out of pocket $12,600 ($9,600 premiums + $3,000 HRA) instead of $12,000 under the old plan. Think of it as a strategy to “self-insure” up to a given threshold with a stop loss that is covered by the insurance itself. The cost savings with this “semi self-insured” approach could be significant but the company has to conduct a risk / return analysis based on their estimated employee claim rate to determine whether or not it’s a viable option.
This is just one example of the plan design options that are available to companies in an attempt to lower the overall cost of maintaining the plan.
Making The Switch
You are allowed to switch your health insurance provider prior to the plan’s renewal date. However, note that if your current plan has a deductible and your replacement plan also carries a deductible, the employees will not get credit for the deductibles paid under the old plan and will start the new plan at zero. Based on the number of months left in the year and the premium savings it may warrant a “band-aide solution” using HRA, HSA, or Flex Spending Accounts to execute the change prior to the renewal date.
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 Secret: R&D Tax Credits…You May Qualify
When you think of Research and Development (R&D) many people envision a chemistry lab or a high tech robotics company. It’s because of this thinking that millions of dollars of available tax credits for R&D go unused every year. R&D exists in virtually every industry and business owners need to start thinking about R&D in a different light because
When you think of Research and Development (R&D) many people envision a chemistry lab or a high tech robotics company. It’s because of this thinking that millions of dollars of available tax credits for R&D go unused every year. R&D exists in virtually every industry and business owners need to start thinking about R&D in a different light because there could be huge tax savings waiting for them.
Most companies don't realize that they qualify
Road paving companies, manufactures, a meatball company, software firms, and architecture firms are just a few examples of companies that have met the criteria to qualify for these lucrative tax credits.
Think of R&D as a unique process within your company that you may be using throughout the course of your everyday business that is specific to your competitive advantage. The purpose of these credits is to encourage companies to be innovative with the end goal of keeping more jobs here in the U.S. If you have an engineers on your staff, whether software engineers, design engineers, mechanical engineers there is a very good chance that these tax credits may be available to you. The R&D tax credits also allow you to look back to all open tax years so for companies that discover this for the first time, the upside can be huge. Tax years typically stay open for three years.
Accountants may not be aware of these credits
One of the main questions we get from business owners is “Shouldn’t my accountant have told me about this?” Many accounting firms are unaware of these tax credits and the process for qualifying which is why there are specialty consulting firms that work with companies to determine whether or not they are eligible for the credit. Some of our clients have worked with these firms and the company only pays the consulting firm if you qualify for the tax credits. Kind of a win-win situation.
We recently attended a seminar that was sponsored by Alliantgroup out of New York City and on their website it listed the following description of companies that qualify for these credits:“
Any company that designs, develops, or improves products, processes, techniques, formulas, inventions, or software may be eligible. In fact, if a company has simply invested time, money, and resources toward the advancement and improvement of its products and processes, it may qualify”.
We love helping our clients save taxes and in this case, like many others, we were looking at R&D in a different light.
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.
NY Free Tuition - Facts and Myths
On April 9th New York State became the first state to adopt a free tuition program for public schools. The program was named the “Excelsior Scholarship” and it will take effect the 2017 – 2018 school year. It has left people with a lot of unanswered questions
On April 9th New York State became the first state to adopt a free tuition program for public schools. The program was named the “Excelsior Scholarship” and it will take effect the 2017 – 2018 school year. It has left people with a lot of unanswered questions
Do I qualify?
How much does it cover?
What’s the catch?
Can I move my finances around to qualify for the program?
This article was written to help people better understand some of the facts and myths surrounding the NY Free Tuition Program.
Who qualifies for free tuition?
It’s based on the student’s household income and it phases in over a three year period:
2017: $100,000
2018: $110,000
2019: $125,000
MYTH #1: “If I reduce my household income in 2017 to get under the $100,000 threshold, it will help my child qualify for the free tuition program for the 2017 – 2018 school year.” WRONG. The income “determination year” is the same determination year that is used for FASFA filing. FASFA changed the rules in 2016 to look back two years instead of one for purposes of qualifying for financial aid. Those same rules will apply to the NY Free Tuition Program. So for the 2017 – 2018 school year, the $100,000 free tuition threshold will apply to your income in 2015.
MYTH #2: “If I make contributions to my retirement plan it will help reduce my household income to qualify for the free tuition program.” WRONG. Again, the free tuition program will use the same income calculation that is used in the FASFA process so it is not as simple as just looking at the bottom line of your tax return. For FASFA, any contributions that are made to retirement plans are ADDED back into your income for purposes of determining your income for that “determination year”. So making big contributions to a retirement plan will not help you qualify for free tuition.
What does it cover?
MYTH #3: “As long as my income is below the income threshold my kids (or I) will go to college for free.” DEFINE “FREE”. The Excelsior Scholarship covers JUST tuition. It does not cover books, room and board, transportation, or other costs associated with going to college. Annual tuition at a four-year SUNY college is currently $6,470. Here are the total fees obtained directly from the SUNY.edu website:
Tuition: $6,470 Covered
Student Fee: $1,640 Not Covered
Room & Board: $12,590 Not Covered
Books & Supplies: $1,340 Not Covered
Personal Expenses: $1,560 Not Covered
Transportation: $1,080 Not Covered
Total Costs $24,680
When you do the math for a student living on campus, the “Free” tuition program only covers 26% of the total cost of attending college.
What’s the catch?
There are actually a few:
CATCH #1: After the student graduates from college they have to LIVE and WORK in NYS for at least the number of years that the free tuition was awarded to the student OTHERWISE the “free tuition” turns into a LOAN that will be required to be paid back. Example: A student receives the free tuition for four years, works in New York for two years, and then moves to Massachusetts for a new job. That student will have to pay back two years of the free tuition.
CATCH #2: The student must maintain a specified GPA or higher otherwise the “free tuition” turns into a LOAN. However, the GPA threshold has yet to be released.
CATCH #3: It’s only for FULL TIME students earning at least 30 credit hours every academic year. This could be a challenge for students that have to work in order to put themselves through college.
CATCH #4: This is a “Last Dollar Program” meaning that students have to go through the FASFA process and apply for all other types of financial aid and grants that are available before the Free Tuition Program kicks in.
CATCH #5: The free tuition program is only available for two and four year degrees obtained within that two or four year period of time. If it take the student five years to obtain their four year bachelor’s degree, only four of the five years is covered under the free tuition program.
Summary
There are many common misunderstandings associated with the NYS Free Tuition Program. In general, it’s our view that this new program is only going to make college “more affordable” for a small sliver of students were not previously covered under the traditional FASFA based financial aid. Given the rising cost of college and the complexity of the financial aid process it has never been more important than it is now for individuals to work with a professional that have an in depth knowledge of the financial aid process and college savings strategies to help better prepare your household for the expenses associated with paying for college.
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.
Strategies to Save for Retirement with No Company Retirement Plan
The question, “How much do I need to retire?” has become a concern across generations rather than something that only those approaching retirement focus on. We wrote the article, How Much Money Do I Need To Save To Retire?, to help individuals answer this question. This article is meant to help create a strategy to reach that number. More
The question, “How much do I need to retire?” has become a concern across generations rather than something that only those approaching retirement focus on. We wrote the article, How Much Money Do I Need To Save To Retire?, to help individuals answer this question. This article is meant to help create a strategy to reach that number. More specifically, for those who work at a company that does not offer a company sponsored plan.
Over the past 20 years, 401(k) plans have become the most well-known investment vehicle for individuals saving for retirement. This type of plan, along with other company sponsored plans, are excellent ways to save for people who are offered them. Company sponsored plans are set up by the company and money comes directly from the employees paycheck to fund their retirement. This means less effort on the side of the individual. It is up to the employee to be educated on how the plan operates and use the resources available to them to help in their savings strategy and goals but the vehicle is there for them to take advantage of.
We also wrote the article, Comparing Different Types of Employer Sponsored Retirement Plans, to help business owners choose a retirement plan that is most beneficial to them in their retirement savings.
Now back to our main focus on savings strategies for people that do not have access to an employer sponsored plan. We will discuss options based on a few different scenarios because matters such as marital status and how much you’d like to save may impact which strategy makes the most sense for you.
Married Filing Jointly - One Spouse Covered by Employer Sponsored Plan and is Not Maxing Out
A common strategy we use for clients when a covered spouse is not maxing out their deferrals is to increase the deferrals in the retirement plan and supplement income with the non-covered spouse’s salary. The limits for 401(k) deferrals in 2021 is $19,500 for individuals under 50 and $26,000 for individuals 50+. For example, if I am covered and only contribute $8,000 per year to my account and my spouse is not covered but has additional money to save for retirement, I could increase my deferrals up to the plan limits using the amount of additional money we have to save. This strategy is helpful as it allows for easier tracking of retirement accounts and the money is automatically deducted from payroll. Also, if you are contributing pre-tax dollars, this will decrease your tax liability.
Note: Payroll deferrals must be withheld from payroll by 12/31. If you owe money when you file your taxes in April, you would not be able to go back and increase your deferrals in your company plan for that tax year.
Married Filing Jointly - One Spouse Covered by Employer Sponsored Plan and is Maxing Out
If the covered spouse is maxing out at the high limits already, you may be able to save additional pre-tax dollars depending on your Adjusted Gross Income (AGI).
Below is the Traditional IRA Deductibility Table for 2021. This table shows how much individuals or married couples can earn and still deduct IRA contributions from their taxable income.
As shown in the chart, if you are married filing jointly and one spouse is covered, the couple can fully deduct IRA contributions to an account in the covered spouses name if AGI is less than $99,000 and can fully deduct IRA contributions to an account in the non-covered spouses name if AGI is less than $184,000. The Traditional IRA limits for 2017 are $5,500 if under 50 and $6,500 if 50+. These lower limits and income thresholds make contributing to company sponsor plans more attractive in most cases.
Single or Married Filing Jointly and Neither Spouse is Covered
If you (and your spouse if married filing joint) are not covered by an employer sponsored plan, you do not have an income threshold for contributing pre-tax dollars to a Traditional IRA. The only limitations you have relate to the amount you can contribute. These contribution limits for both Traditional and Roth IRA’s are $5,500 if under 50 and $6,500 if 50+. If married filing joint, each spouse can contribute up to these limits.
Unlike employer sponsored plans, your contributions to IRA’s can be made after 12/31 of that tax year as long as the contributions are in before you file your tax return.
Please feel free to e-mail or call with any questions on this article or any other financial planning questions you may have.
Below are related articles that may help answer additional questions you have after reading this.
Traditional vs. Roth IRA’s: Differences, Pros, and Cons
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.
Traditional vs. Roth IRA’s: Differences, Pros, and Cons
Individual Retirement Accounts (IRA’s) are one of the most popular retirement vehicles available for savers and the purpose of this article is to give a general idea of how IRA’s work, explain the differences between Traditional and Roth IRA’s, and provide some pros and cons of each. In January 2015, The Investment Company Institute put out a research
Individual Retirement Accounts (IRA’s) are one of the most popular retirement vehicles available for savers and the purpose of this article is to give a general idea of how IRA’s work, explain the differences between Traditional and Roth IRA’s, and provide some pros and cons of each. In January 2015, The Investment Company Institute put out a research report with some interesting statistics regarding IRA’s which can be found at the following link, ICI Research Perspective. The article states, “In mid-2014, 41.5 million, or 33.7 percent of U.S. households owned at least one type of IRA”. At first I was slightly shocked and asked myself the following question: “If IRA’s are the most important investment vehicle and source of income for most retirees, how do only one third of U.S. households own one?” Then when I took a step back and considered how money gets deposited into these retirement vehicles this figure begins making more sense.
Yes, a lot of American’s will contribute to IRA’s throughout their lifetime whether it is to save for retirement throughout one’s lifetime or each year when the CPA gives you the tax bill and you ask “What can I do to pay less?” When thinking about IRA’s in this way, one third of American’s owning IRA’s is a scary figure and leads one to believe more than half the country is not saving for retirement. This is not necessarily the case. 401(k) plans and other employer sponsored defined contribution plans have become very popular over the last 20 years and rather than individuals opening their own personal IRA’s, they are saving for retirement through their employer sponsored plan.
Employees with access to these employer plans save throughout their working years and then, when they retire, the money in the company retirement account will be rolled into IRA’s. If the money is rolled directly from the company sponsored plan into an IRA, there is likely no tax or penalty as it is going from one retirement account to another. People roll the balance into IRA’s for a number of reasons. These reasons include the point that there is likely more flexibility with IRA’s regarding distributions compared to the company plan, more investment options available, and the retiree would like the money to be managed by an advisor. The IRA’s allow people to draw on their savings to pay for expenses throughout retirement in a way to supplement income that they are no longer receiving through a paycheck.
The process may seem simple but there are important strategies and decisions involved with IRA’s. One of those items is deciding whether a Traditional, Roth or both types of IRA’s are best for you. In this article we will breakdown Traditional and Roth IRA’s which should illustrate why deciding the appropriate vehicle to use can be a very important piece of retirement planning.
Why are they used?
Both Traditional and Roth IRA’s have multiple uses but the most common for each is retirement savings. People will save throughout their lifetime with the goal of having enough money to last in retirement. These savings are what people are referring to when they ask questions like “What is my number?” Savers will contribute to retirement accounts with the intent to earn money through investing. Tax benefits and potential growth is why people will use retirement accounts over regular savings accounts. Retirees have to cover expenses in retirement which are likely greater than the social security checks they receive. Money is pulled from retirement accounts to cover the expenses above what is covered by social security. People are living longer than they have in the past which means the answer to “What is my number?” is becoming larger since the money must last over a greater period.
How much can I contribute?
For both Traditional and Roth IRA’s, the limit in 2021 for individuals under 50 is the lesser of $6,000 or 100% of MAGI and those 50 or older is the lesser of $7,000 or 100% of MAGI. More limit information can be found on the IRS website Retirement Topics - IRA Contribution Limits
What are the important differences between Traditional and Roth?
Taxation
Traditional (Pre-Tax) IRA: Typically people are more familiar with Traditional IRA’s as they’ve been around longer and allow individuals to take income off the table and lower their tax bill while saving. Each year a person contributes to a Pre-Tax IRA, they deduct the contribution amount from the income they received in that tax year. The IRS allows this because they want to encourage people to save for retirement. Not only are people decreasing their tax bill in the year they make the contribution, the earnings of Pre-Tax IRA’s are not taxed until the money is withdrawn from the account. This allows the account to earn more as money is not being taken out for taxes during the accumulation phase. For example, if I have $100 in my account and the account earns 10% this year, I will have $10 of earnings. Since that money is not taxed, my account value will be $110. That $110 will increase more in the following year if the account grows another 10% compared to if taxes were taken out of the gain. When the money is used during retirement, the individual will be taxed on the amount distributed at ordinary income tax rates because the money was never taxed before. A person’s tax rate during retirement is likely to be lower than while they are working because total income for the year will most likely be less. If the account owner takes a distribution prior to 59 ½ (normal retirement age), there will be penalties assessed.
Roth (After-Tax) IRA: The Roth IRA was established by the Taxpayer Relief Act of 1997. Unlike the Traditional IRA, contributions to a Roth IRA are made with money that has already been subject to income tax. The money gets placed in these accounts with the intent of earning interest and then when the money is taken during retirement, there is no taxes due as long as the account has met certain requirements (i.e. has been established for at least 5 years). These accounts are very beneficial to people who are younger or will not need the money for a significant number of years because no tax is paid on all the earnings that the account generates. For example, if I contribute $100 to a Roth IRA and the account becomes $200 in 15 years, I will never pay taxes on the $100 gain the account generated. If the account owner takes a distribution prior to 59 ½ (normal retirement age), there will be penalties assessed on the earnings taken.
Eligibility
Traditional IRA: Due to the benefits the IRS allows with Traditional IRA’s, there are restrictions on who can contribute and receive the tax benefit for these accounts. Below is a chart that shows who is eligible to deduct contributions to a Traditional IRA:
There are also Required Minimum Distributions (RMD’s) associated with Pre-Tax dollars in IRA’s and therefore people cannot contribute to these accounts after the age of 70 ½. Once the account owner turns 70 ½, the IRS forces the individual to start taking distributions each year because the money has never been taxed and the government needs to start receiving revenue from the account. If RMD’s are not taken timely, there will be penalties assessed.
Roth IRA: As long as an individual has earned income, there are only income limitations on who can contribute to Roth IRA’s. The limitations for 2021 are as follows:
There are a number of strategies to get money into Roth IRA’s as a financial planning strategy. This method is explained in our article Backdoor Roth IRA Contribution Strategy.
Investment Strategies
Investment strategies are different for everyone as individuals have different risk tolerances, time horizons, and purposes for these accounts.
That being said, Roth IRA’s are often times invested more aggressively because they are likely the last investment someone touches during retirement or passes on to heirs. A longer time horizon allows one to be more aggressive if the circumstances permit. Accounts that are more aggressive will likely generate higher returns over longer periods. Remember, Roth accounts are meant to generate income that will never be taxed, so in most cases that account should be working for the saver as long as possible. If money is passed onto heirs, the Roth accounts are incredibly valuable as the individual who inherits the account can continue earning interest tax free.
Choosing the correct IRA is an important decision and is often times more complex than people think. Even if you are 30 years from retiring, it is important to consider the benefits of each and consult with a professional for advice.
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.
What is a Bond?
A bond is a form of debt in which an investor serves as the lender. Think of a bond as a type of loan that a company or government would obtain from a bank but in this case the investor is serving as the bank. The issuer of the bond is typically looking to generate cash for a specific use such as general operations, a specific project, and staying current or
What is a Bond?
A bond is a form of debt in which an investor serves as the lender. Think of a bond as a type of loan that a company or government would obtain from a bank but in this case the investor is serving as the bank. The issuer of the bond is typically looking to generate cash for a specific use such as general operations, a specific project, and staying current or paying off other debt.
How do Investors Make Money on a Bond?
Your typical bonds will generate income for investors in one of two ways: periodic interest payments or purchasing the bond at a discount. There are also bonds where a combination of the two are applicable but we will explain each separately.
Interest Payments
There are interest rates associated with the bonds and interest payments are made periodically to the investor (i.e. semi-annual). When the bonds are issued, a promise to pay the interest over the life of the bond as well as the principal when the bond becomes due is made to the investor. For example, a $10,000 bond with a 5% interest rate would pay the investor $500 annually ($250 semi-annually). Typically tax would be due on the interest each year and when the bond comes due, the principal would be paid tax free as a return of cash basis.
Purchasing at a Discount
Another way to earn money on a bond would be to purchase the bond at a discount and at some time in the future get paid the face value of the bond. A simple example would be the purchase of a 10 year, $10,000 bond for a discounted price of $9,000. 10 years from the date of the purchase the investor would receive $10,000 (a $1,000 gain). Typically, the investor would be required to recognize $100 of income per year as “Original Issue Discount” (OID). At the end of the 10 year period, the gain will be recognized and the $10,000 would be paid but only $100, not $1,000, will have to be recognized as income in the final year.
Is There Risk in Bonds?
Investment grade bonds are often used to make a portfolio more conservative and less volatile. If an investor is less risk oriented or approaching retirement/in retirement they would be more likely to have a portfolio with a higher allocation to bonds than a young investor willing to take risk. This is due to the volatility in the stock market and impact a down market has on an account close to or in the distribution phase.
That being said, there are risks associated with bonds.
Interest Rate Risk – in an environment of rising interest rates, the value of a bond held by an investor will decline. If I purchased a 10 year bond two years ago with a 5% interest rate, that bond will lose value if an investor can purchase a bond with the same level of risk at a higher interest rate today. This will make the bond you hold less valuable and therefore will earn less if the bond is sold prior to maturity. If the bond is held to maturity it will earn the stated interest rate and will pay the investor face value but there is an opportunity cost with holding that bond if there are similar bonds available at higher interest rates.
Default Risk – most relevant with high risk bonds, default risk is the risk that the issuer will not be able to pay the face value of the bond. This is the same as someone defaulting on a loan. A bond held by an investor is only as good as the ability of the issuer to pay back the amount promised.
Call Risk – often times there are call features with a bond that will allow the issuer to pay off the bond earlier than the maturity date. In a declining interest rate environment, an issuer may issue new bonds at a lower interest rate and use the profits to pay off other outstanding bonds at higher interest rates. This would negatively impact the investor because if they were receiving 5% from a bond that gets called, they would likely use the proceeds to reinvest in a bond paying a lower rate or accept more risk to earn the same interest rate as the called bond.
Inflation Risk – a high inflation rate environment will negatively impact a bond because it is likely a time of rising interest rates and the purchasing power of the revenue earned on the bond will decline. For example, if an investor purchases a bond with a 3% interest rate but inflation is increasing at 5% the purchasing power of the return on that bond is eroded.
Below is a chart showing the risk spectrum of investing between asset classes and gives a visual on the different classes of bonds and their most susceptible risks.
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Types of Bonds
Federal Government
Bonds issued by the federal government are backed by the full faith and credit of the U.S. Government and therefore are often referred to as “risk-free”. There are always risks associated with investing but in this case “risk-free” is referring to the idea that the U.S. Government is not likely to default on a bond and therefore the investor has a high likelihood of being paid the face value of the bond if held to maturity but like any investment there is risk.
There are a number of different federal bonds known as Treasuries and below we will touch on the more common:
Treasuries – Sold via auction in $1,000 increments. An investor will purchase the bond at a price below the face value and be paid the face value when the bond matures. You can bid on these bonds directly through www.treasurydirect.gov, or you can purchase the bonds through a broker or bank.
Treasury Bills – Short term investments sold in $1,000 increments. T-Bills are purchased at a discount with the promise to be paid the face value at maturity. These bonds have a period of less than a year and therefore, in a normal market environment, rates will be less than those of longer term bonds.
Treasury Notes – Sold in $1,000 increments and have terms of 2, 5, and 10 years. Treasury notes are often purchased at a discount and pay interest semi-annually. The 10 year Treasury note is most often used to discuss the U.S. government bond market and analyze the markets take on longer term macroeconomic trends.
Treasury Bonds – Similar to Treasury Notes but have periods of 30 years.
Treasury Inflation-Protected Securities (TIPS) – Sold in 5, 10, and 20 year terms. Not only will TIPS pay periodic interest, the face value of the bond will also increase with inflation each year. The increase in face value will be taxable income each year even though the principal is not paid until maturity. Interest rates on TIPS are usually lower than bonds with like terms because of the inflation protection.
Savings Bonds – There are two types of savings bonds still being issued, Series EE and Series I. The biggest difference between the two is that Series EE bonds have a fixed interest rate while Series I bonds have a fixed interest rate as well as a variable interest rate component. Savings bonds are purchased at a discount and accrue interest monthly. Typically these bonds mature in 20 years but can be cashed early and the cash basis plus accrued interest at the time of sale will be paid to the investor.
Municipal Bonds (Munis) – Bonds issued by states, cities, and local governments to fund specific projects. These bonds are exempt from federal tax and depending on where you live and where the bond was issued they may be tax free at the state level as well. There are two categories of Munis: Government Obligation Bonds and Revenue Bonds. Government Obligation Bonds are secured by the full faith and credit of the issuer’s taxing power (property/income/other). These bonds must be approved by voters. Revenue Bonds are secured by the revenues derived from specific activities the bonds were used to finance. These can be revenues from activities such as tolls, parking garages, or sports arenas.
Agency Bonds – These bonds are issued by government sponsored enterprises such as the Federal Home Loan Mortgage Association (Freddie Mac), the Federal Home Loan Mortgage Association (Fannie Mae), and the Federal Agricultural Mortgage Corporation (Farmer Mac). Agency bonds are used to stimulate activity such as increasing home ownership or agriculture production. Although they are not backed by the full faith and credit of the U.S. Government, they are viewed as less risky than corporate bonds.
Corporate Bonds – These bonds are issued by companies and although viewed as more risky than government bonds, the level of risk depends on the company issuing the bond. Bonds issued by a company like GE or Cisco may be viewed by investors as less of a default risk than a start-up company or company that operates in a volatile industry. The level of risk with the bond is directly related to the interest rate of the bond. Generally, the riskier the bond the higher the interest rate.
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.
