Friday, April 21, 2017

Traditional vs. Roth IRA - 5 Points To Consider

I was recently asked by a client how to determine whether they should contribute to a Roth IRA or a Traditional IRA. It's a great question and one that many people must consider when deciding which option is most suitable for them and their situation.

Before we begin, allow me to set one thing straight, a traditional IRA invests PRE-TAX dollars and a Roth IRA invests POST-TAX dollars. Meaning in a traditional IRA you are choosing to pay the taxes in retirement but in a Roth you have already paid the taxes prior to investing the money.

It all comes down to taxes! Everyone has their opinions; pay the tax now, defer the taxes until retirement, split the money up into a little bit of each. Arguments can be made for these views but you came here in search of my opinion so that's what I'm going to give you.

Where Are Taxes Headed?

Contrary to popular belief current taxes are actually quite low when you look at the historical landscape. Couple that fact with the fact that our national debt is climbing at a substantial rate and you have a recipe for one thing: higher future taxes! This isn't to say that in the short-term taxes can't go slightly lower than where they are now but when deciding for retirement the short term should have little relevance. In my opinion, it's safe to assume that future income taxes will be higher than what we currently have in place. If that's the case, then it makes even more sense to pay the tax on your earnings now instead of pushing that tax bill (which will grow to be quite large over 30/40 years) off until you begin taking money out in retirement. The one advantage you do receive by contributing to a Traditional IRA is that you can deduct your contribution from your earned income for that year (assuming your income doesn't fall into the phase out limits). This is advantageous to you because that means you'll be able to pay slightly less tax for that year because you can report less earned income.

Income Limits

There is one unfortunate drawback to a Roth IRA; making a lot of money may prevent you from contributing to one. The IRS sets phase out limits that will dictate how much you may contribute to a Roth if your income falls within the established thresholds. If you're a single tax filer the phase outs begin at $118K of income per year and end at $133K per year. Meaning, if you make between $118K and $133K you will not be able to make a full Roth IRA contribution ($5500/year under age 50 and $6500/year ages 50 and above). If you are married, your combined income thresholds are $186K to $196K. If your income falls between the upper and lower limits, you'll be permitted to make a partial contribution. The closer you come to the higher threshold the smaller of a contribution you'll be permitted to make.



Avoid An Inflated Retirement Nest Egg!


Many baby boomer clients I work with now have a substantial amount of money saved in Traditional IRA accounts. Say you're in your early 60's and have roughly a million dollars in a traditional IRA. This number looks pretty on paper but most don't take into account the effect taxes will have on that number. Assume you have an effective tax rate of 25% when you retire, a very likely possibility. All those years of hard work to build up your retirement nest egg and little did you know that you're going to end up having to give 1/4 of it back to Uncle Sam in taxes. Yep, a quarter of a million dollars will be taken from you because you decided it was better to pay your tax bill in retirement. That's a harsh reality for someone who's been banking on this million-dollar account to last them through retirement.

Maintain Control Of Your Money

One thing people fail to consider when making this decision is that there are required minimum distributions or RMD's in a traditional IRA. What this means is, at age 70.5 the government will begin forcing you to take distributions from your Traditional IRA account because they want their tax money! This is not a requirement if you own a Roth IRA. If you have a Roth and do not need to take money out of your account at age 70.5 you can continue to let that money grow tax free until YOU decide to take withdrawals.

Strategy


As you can see, there are a lot of factors that come into play when facing this decision. It's for this reason I always recommend sitting down or speaking with an advisor to make sure all your unique circumstances are accounted for when deciding. Also, there are strategies involved in working around the government mandated income limits. In some cases, there are ways you can contribute to a Roth even if your income exceeds the thresholds. You can also consider utilizing other investment vehicles that mimic the tax-free growth features offered in a Roth IRA. Lastly, if your income is coming in close to the limits set by the IRS your advisor should be discussing some of the ways you can reduce your income so that you fall under the lower threshold. This is a planning tool I've been using quite a bit lately with my young, high earning clients. We find deductions that can offset their income enough so that they fall under the income limits and can take advantage of a Roth.

I'm giving my blog readers exclusive access to my 5 Point Financial Plan completely FREE. The concepts in this plan are one's that I utilize in every new client meeting and set the foundation for proper financial planning. It's loaded with value and not something you'll want to pass up on. Click below to get  your own PDF version!




Neither Woodbury Financial Services, Inc. nor its representatives or employees provide legal or tax
advice. IRA strategies implementing various tax strategies or tax codes may not be appropriate for
all investors. Please consult your investment and tax professional prior to implementing a strategy.

Wednesday, April 5, 2017

401K Plans - The Ugly Truth

Employer sponsored plans such as; 401k's, 403b's and 457's can be a great idea for people looking to stash away as much money as possible for their retirement. The question of whether your plan is right for you and your goals can be highly subjective both to you and the plan in question. For this blog, I will predominately use 401K's as the umbrella term for all company/government sponsored plans since they tend to be the most commonly known. However, these characteristics, good or bad, can be applied to any company plan.


The most important question you need to determine is whether your employer will offer any sort of matching contributions. As I've said on numerous occasions an employer match is a must because they're giving you free money. If they do offer a match, then it would be a good idea to find out how much and whether there is a vesting schedule for the plan. A vesting schedule is the employer’s way of "handcuffing" you for lack of a better term, meaning for you to receive the employer match you must stay for a specified time. So, this is one variable to consider if you're in the fortunate position of choosing between two different job offers with virtually identical pay and benefits. Going a step further, unless you're maxing out an IRA there's no reason you should be contributing anything more than what is required to receive your employers match. If you're already maxing out your Roth or Traditional IRA, then you can add additional money to your 401K more than the match.

Fees seem to be a priority for everyone lately and a recent survey found 92% of people believed their 401K plan had no fees. That means, 9 out of every 10 employees contributing money from their hard-earned paychecks thought they weren't paying any fees to be a part of their company plan. Unfortunately, this couldn't be any further from the truth because most 401k's are loaded with fees and have extremely poor investments choices. In fact, many people don't know how the funds in a 401K plan are chosen. The plan selects the mutual fund company who is willing to pay the most to have their funds represented in the investment lineup. A little-known secret is that these fund companies typically try and offer their most unattractive funds because they know there's a greater probability that they will be selected with limited investment options available. I ran into one client who found that if they wanted to select the lowest cost investments offered in their plan they were subject to a 3.5% initial sales charge for each purchase. 3.5% just so they can take advantage of the lowest cost option in their plan!


BUT WAIT, THERE'S MORE! Not only can the fund expenses be outrageous but the plan will also apply a handful of useless fees and give them an important sounding name so that you'll never question their legitimacy. Plan administration fees, asset management fees and individual service fees are just a few of the ones I typically see but I know there are many others. I've heard the fee hurdle can be as high as 3-4% in some plans meaning you need to earn that much of a return before you even start making money. Now, if you're contributing to a plan that offers a match these returns (or lack thereof) can be hidden behind the match you receive from your employer. You may not notice your subpar returns because your employer is making contributions and it's bumping up your balance each year. It's for this reason that I recommend investors only contribute enough to get the match and then allocate the rest of their money into an IRA. If you have plan that has no match, then you should be utilizing an IRA first and only use your 401K if you've maxed out your IRA and still have additional money to invest.


Would you like to know who has the most to lose when it comes to company sponsored plans? Teachers, nurses and anyone else involved in a 403b plan. 403b plans are not subject to the ERISA requirements and therefore their plans tend to be even more excessive with their fees and expenses. Wouldn't you know it, the people educating the next generation and taking care of us when we need it most are left out in the cold when it comes to their retirement plans.

My intention for this blog was not to scare people away from utilizing their 401K's. As I've said before, these can be extremely useful tools in building up assets for retirement but please stay informed and ask your plan sponsor questions. Company plans always seem to slip under the radar when it comes to discussions regarding fees and I think it's because the investor is gravely uninformed. This can be seen quite clearly when you hear of studies that show more than 90% of people believe they pay no fees in their company plan. An advisor can give you comprehensive advice tailored specifically to your unique goals but you don't get that from a company plan so I think it's time these plans start justifying their fees and expenses.

I'm giving my blog readers exclusive access to my 5 Point Financial Plan completely FREE. The concepts in this plan are one's that I utilize in every new client meeting and set the foundation for proper financial planning. It's loaded with value and not something you'll want to pass up on. Click below to get  your own PDF version!