Taxable and Tax-Deferred Accounts Page (k) s, 403(b) s, 457 Plans Page 3

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1 Index Taxable and Tax-Deferred Accounts Page 2 401(k) s, 403(b) s, 457 Plans Page 3 Account Structure July 2016 Investor Education Investor Education is Critical to reach your Financial Goals Wealth gives you Freedom and Control of your Life Setup an Auto-Investment Plan to Invest on a Regular Basis in Bull and Bear Markets Create a Diversified Portfolio with the Proper Asset Allocation Purchase Quality Investments Manage your Portfolio Properly PDM Investment Services, LLC A Registered Investment Advisor 5131 Standish Drive, Troy, Michigan * * info@fginvestor.com For complete disclosure see our website Traditional IRAs, Roth IRAs Page 4 Annual IRA Contribution Traditional Non-Deductible IRA Taxable Accounts Personal Company Individual 401 (k), Page 9 SEP IRA and Simple IRA Plans Account Titles Page 10 Beneficiary Designations Page 11 Required Minimum Distribution (RMD) Page 14 Traditional IRA to Roth Conversion Page (k) to IRA Rollover Page 16 Flexible Spending Account (FSA) Page 18 Health Savings Account (HSA) Education Savings Accounts Page 19 Coverdell Education Savings Account 529 College Savings Plan College Decisions Page 22 Annuities Page 23 1

2 Taxable and Tax-Deferred Accounts Accounts are either taxable or tax deferred. For tax-deferred accounts, select between a Traditional IRA or a Roth IRA. Use the variables below to help decide. Number of years until retirement Salary now and salary at retirement Tax rates now and at retirement (2012 historically low tax rates) Risk tolerance Select the account structure that fits your situation. It is often best to have a 401 (k), IRA from a rollover and a Roth IRA for each spouse since we may not know our tax situation at retirement. IRA contributions for the previous year must be made by April 15th of the current year. Max out investment accounts in the following order: Traditional 401 (k) Roth IRA Traditional IRA (IRA Rollovers) Taxable accounts Tax Management Taxable Accounts Passive managed equity ETF s and index funds Low turnover stocks Low interest bearing investments Traditional IRA/Roth Active managed equity funds High turnover stocks High interest bearing investments (Bond funds, high yield bond funds, REITS) Highest expected return investments (Roth best) 2

3 401k, 403 (b), 457 Employer Sponsored Plans Should always be first choice to max out. An employer-sponsored retirement-savings plan funded by employee contributions, company matching and profit sharing. First investment choice if company matching. Pre-tax money is invested into the account. Tax-deferred earnings growth. Average employer match is 60% of first 5%. Always contribute enough to take full advantage of the match. The match cannot go into a Roth 401 (k). Taxable distributions. RMD at 70.5 years old unless you are still working at the company issuing the 401 (k) and own less than 5% of the company. Ok if you transferred other 401 (k) s before 70.5 years old. See Uniform Lifetime Table for distribution based on age and year-end value of account. Penalty free distributions after 59.5 years old. 10% penalty for distributions taken before 59.5 years old. At 55 years old and employment terminated you can take an early partial distribution without a 10% penalty. Funds in company plans are protected by federal law from creditors in bankruptcy and lawsuit judgments, depending on state laws. Annual elective deferred contributions for 2016 are $18,000 and $24,000 if 50 or older at the end of the calendar year. Pace your contributions over the year so you don t hit your own cap too early in the year and miss out on company matches later in the year. Company matches and profit sharing add to the limits above for a combined max of $51, (k) - Defined contribution plan offered by most private and public companies. An employer-sponsored retirement-savings plan funded by employee contributions, 403 (b) - Defined contribution plan offered by non-profit hospitals, colleges and public schools. Many 403(b) s are annuity based with higher fees and surrender fees Defined contribution plan offered by state and local governments. Pension - Defined benefit plan offered by about 20% of any type of company. A pension is funded by the company and employees may be required to contribute a percentage of their salary on a pre-tax basis. The payout is based on years of service and age. 401(k) Loans Most advisors do not recommend taking out a loan against your 401 (k) unless it is your only option to get emergency cash for food, shelter or medical bills. If your job is not secure, never take out a 401(k) loan. A loan will set you back for retirement savings. Some business owners take a loan against their 401(k) to get a lower interest rate to expand the business. You can generally borrow up to 50% of your 401 k) balance. Loans are generally less than 10 years. The borrowed money is taken out of your 401(k) growth portfolio and no longer grows with the stock market. The interest rate of the loan is generally at or below bank rates. A lower interest rate does not make up for the lost stock market appreciation. You loan payments are taken out of your paycheck after tax reducing your take home pay. If you are no longer working at the company who started your 401 (k) most plans will not let you take out a loan. If you are terminated from the company your loan is usually due within 60 days. If you do not have the cash the balance comes out of you investments triggering a 10% penalty and a tax bill. 3

4 Traditional 401 (k) or Roth 401 (k)? Assumption: You start out in a lower tax bracket, move to a higher tax bracket over your working years and move to a lower tax bracket in retirement. The Traditional 401 (k) has pre-tax money going in. Pre-tax money going in gives you more budget flexibility to save more now. Save more now, grow more tax deferred and pay taxes on a larger accumulated amount. Good for higher income workers in a higher tax bracket for a needed tax break. The Roth 401 (k) has post-tax money going in. Post-tax money going in gives you less budget flexibility to save more now. Save less now, grow less tax deferred and pay no tax on a smaller accumulated amount. For a Roth 401 (k) the employee contribution is post-tax and can be rolled into a Roth IRA and the employer match contribution may be pretax and could be rolled into Traditional IRA depending on the plan. Good for lower income workers in a lower tax bracket now to save on taxes when you are in a higher tax bracket in retirement. A combination of Traditional 401 (k) and Roth 401 (k) may be best for efficient tax management in retirement. No income restrictions with a Roth 401 (k) like a Roth IRA giving you the opportunity to collect some tax-free income in retirement. You could use a Roth 401 (k) for your first job and a Traditional 401 (k) for your second job so you have both to roll into each type of IRA. This decision can often be a wash since many people are in a higher tax bracket during the accumulation phase and a lower tax bracket in the retirement phase. It is often difficult to predict your tax bracket in retirement in advance. The tax code can change by retirement. In retirement, it is best to have taxed accounts (only capital gains taxes), traditional IRA s (ordinary income tax rate) and Roth IRA s (tax free) to withdraw from to manage your taxes paid each year. 4

5 Traditional IRA (Contributory IRA) / Rollover IRA Pre-tax money is invested into the account before 70 years old. There are restrictions for workers who participate in a company plan, have no earned income and have high income. Pretax money is invested into the account. Tax-deferred earnings growth. Penalty free distributions after 59.5 years old. Taxable distributions ordinary income rate. 10% penalty for distributions taken before 59.5 years old. If unemployed, can reduce penalty by health insurance premium, medical bills and higher education costs. You may be able to avoid an early withdrawal penalty if you take Substantially Equal Periodic Payments (SEPP 72t tax code) Setup a distribution plan using RMD, fixed amortization of fixed annuitization using the IRS life expectancy table. Once the payments began, they must continue for five years or until 59.5 years old. You can only take a 60-day loan from a specific IRA account and return the funds to that IRA or a different account once during a one-year period. If you make a withdrawal from the same IRA more than once during a one-year period, the second withdrawal is treated by the IRS as a taxable IRA distribution, subject to income taxes and a 10-percent early withdrawal penalty tax. RMD at 70.5 years old. See Uniform Lifetime Table for distribution based on age and year-end value of account. Form 1099-R shows previous year distribution. Submit with that year taxes. Form 5498 shows account value at end of last year and new-year RMD calculation. IRA Distribution Request Form used to make new-year RMD distribution. Best for accumulation in higher tax brackets assuming you will be in a lower tax bracket in retirement. A maxed out contribution to a Roth is more valuable that a maxed out contribution to a Traditional IRA if you goal is to max out. Annual contribution limits in 2015 are $5,500, $6,500 if 50 years old at the end of the calendar year. Annual contribution limits in 2016 are $5,500, $6,500 if 50 years old at the end of the calendar year. Phase-out funding for joint filing is $184,000 adjusted gross income for 2016 not covered by pension and spouse is in a pension or 401 (k) and $98,000 if both are in a pension or 401 (k). Check with your accountant at tax time for allowed contribution. If your AGI is high, it may still be beneficial to contribute to a traditional IRA for tax-deferred growth without a tax deduction. Check with your accountant at tax time. Watch the 5-year after last contribution withdrawal rule. Make sure you keep your beneficiaries current on all types of IRAs. The beneficiary form trumps the will. If none are named it goes to the estate losing the stretch IRA feature. A 401 (k) can rollover into a Rollover IRA or be transferred to a Traditional IRA. Use a Rollover IRA title if you want to be able to roll into your new 401 (k). Once in Traditional IRA, not eligible to roll back. Funds in company plans 401 (k) s are protected by federal law from creditors in bankruptcy and lawsuit judgments, depending on state laws. Ok to mix rollover and traditional in a rollover IRA (track separately) or a traditional IRA (lose ability to roll into another 401 (k). A Traditional IRA can be transferred into another Traditional IRA but not a Rollover IRA if you want to keep its status. Use a Traditional IRA title if you want to be able to combine other Traditional IRA s and 401 (k) s into one Traditional IRA. A Rollover IRA can be transferred into a new 401 (k), Rollover IRA or a Traditional IRA and lose its rollover status. 5

6 Inherited IRA Inherited IRA s can be from your spouse or other family member. The tax benefit is better if inherited from a spouse. The rules are complicated. You must seek out a professional for advice. Once you touch an inherited IRA, you cannot go back. If the surviving spouse is under 59.5, they should maintain it as an inherited IRA to avoid a 10% penalty in case they need money from it. You can add your name to the inherited IRA. Title should read John Smith, deceased, date of death, FBO. If the surviving spouse is over 59.5, they should do a spouse rollover into their like IRA. No 10% penalty for withdrawals and no RMD until A Stretch IRA, is an inherited IRA where you extend distributions for you over your life. Contributions are not allowed in inherited IRA s. Penalty free distributions at any age. Tax-deferred earnings growth. Taxable distributions ordinary income rate. Can take full distribution without penalty. Inherited from spouse: RMD at 70.5 years old. Inherited from non-spouse: RMD at 59.5 years old, within 12 months of death. RMD is based on deceased accounts. Inherited IRA s are not protected in a bankruptcy. Inherited IRA s from spouse can be rolled into your Traditional IRA for bankruptcy protection and postpone RMD until Roth IRA After-tax money is invested into the account at any age. There are restrictions for high- income earners. You are not required to have earned income. After tax money is invested into the account. Tax-deferred earnings growth. No RMD if original owner. Penalty free distributions after 59.5 years old on earnings portion. Penalty free distributions at any age on contribution portion of the Roth. Tax-free distributions. Best for accumulation in lower tax brackets assuming you will be in a higher tax bracket in retirement. A maxed out contribution to a Roth is more valuable that a maxed out contribution to a Traditional IRA if you goal is to max out. Annual contribution limits for 2015 are $5,500, $6,500 if 50 years old. Annual contribution limits for 2016 are $5,500, $6,500 if 50 years old. Phase-out funding for joint filing is $184,000 adjusted gross income for Check with your accountant at tax time for allowed contribution. 6

7 Annual IRA Contribution You have until April 15 th to make your prior year contribution. Ask your accountant if you and your spouse can contribute to a Roth IRA or take a deduction for a Traditional IRA contribution. If you know your joint AGI is going to be less than $183,000 in 2015, you may also be able to make your 2014 contribution now or any time before April 15 th There are three ways to make a deposit into your IRA brokerage account. Take a Deposit Slip and a check to your local branch and make the deposit. Specify your account number and contribution year. Fill out an Account Transfer Form and send it to your brokerage firm. This will transfer money from your taxable brokerage account to IRA brokerage account. Fill out an Authorization to Wire Form. This will transfer money from your bank account to your IRA brokerage account. See your bank for a Wire Transfer Form. Traditional Non-Deductible IRA A traditional nondeductible IRA is only worthy of consideration by high-income investors who are already contributing fully to other taxsheltered retirement-savings vehicles such as 401 (k) s and Health Savings accounts. Best when used with dividend and mutual fund investments for tax-deferral of ordinary income tax distributions. The only advantage over a taxable account is tax-deferred growth. A taxable account is better in a tax efficient portfolio with low trading, low dividend and capital gains distributions. Taxable accounts do not have to wait till 59.5 to withdraw and no RMD is required. Money coming out of taxable accounts is taxed at a lower rate (capital gains only, 0% or 15% rate for some) than an IRA (ordinary income tax rate for gains) An IRA has slightly more legal protection than taxable account. Same as traditional IRA except: No income limit No pre-tax money going in All IRA withholdings are taxed at ordinary income. When you withdraw you miss out on the 15% capital gains rate of a taxable portfolio. A traditional non-deductible IRA is for high income earners that have maxed their 401 (k) and invest in bonds and mutual funds, not stocks. A Form 8606 must be filed with income taxes to track the cost basis. For most people it is not worth the bother. Penalty Free Withdrawals IRA withdrawals before 59.5 are subject to a 10% penalty to help force retirement savings. Below is a list of circumstances under which individuals may withdraw from an IRA prior to 59.5 years old without a tax penalty. Death If you die prior to 59.5, beneficiary may withdraw the assets without penalty. (So long as they did not rollover into their IRA) Disability Physical or mentally not capable to gain employment. Substantially Equal Periodic Payments Must continue until 59.5 or five years. Home Purchase Up to $10,000 toward the purchase of your first house or a home after no home ownership for two years. Unreimbursed Medical Expenses Medical expenses in excess of 7.5% of your adjusted gross income. Medical Insurance Unemployed to pay medical insurance if they meet specific criteria. Higher Education Expenses For you, spouse or children of certain institutions and only certain expenses. IRS Levy To pay back taxes. Active Duty Call-Up 7

8 IRA Matrix Table 8

9 Personal Company Individual 401 (k), SEP IRA and Simple IRA Plans All take per-tax money, grow tax deferred and are taxed as income on the way out. Individual 401 (k) Owner of the business Contribution Limit: 20% of net self-employment income or 25% of compensation plus $18,000/$24,000 (50) up to $53,000. $24,000 employee + % of income for employer contribution. Employee contribution is allowed. Up to $24,000 if over 50 years old and $18,000 if under 50 years old. Employer contribution is allowed. (For me I am the employer and employee) Amount is based on % of income Schwab has a good plan with a simple template and application. Schwab documents: Schwab Individual 401 (k) Plan Adoption Agreement Schwab Individual 401 (k) Basic Plan Description Individual 401 (k) Account Application Schwab Individual 401(k) Plan Summary Plan Description Individual 401 (k) Elective Deferral Agreement SEP IRA Owner and employees in plan Contribution Limit: 20% of net self-employment income or 25% of compensation up to $53,000. Contribution amount is % of profits. Employer contribution is required. Employee contribution not allowed. SIMPLE IRA More for low wage earners and business employees. Owner and less than 100 employees in plan Contribution Limit: $12,500 under 50 years old and $15,500 at 50 years old. Contribution amount is % of profits. Employer contribution is required. Employee contribution is allowed. Taxable Accounts Last choice for saving after you have maxed out your 401 (k) and IRA. A taxable account invests with after-tax money, has no tax-deferred growth and capital gains are taxable upon withdrawal. There are no limitations on the amount you can invest. Reasons to have a taxable investment account are listed below. Liquidity for large purchases and early retirement income Use of tax losses to lower taxes Low or non-tax withdrawals in retirement More control over your tax bill in retirement Your heirs will receive a step-up tax basis 9

10 Account Titles Individual Accounts (Taxable, IRA, Roth and 401k accounts) Assets are titled in one name. They will be passed according to your estate plan or beneficiaries. Assets from an individual account will be added to the total estate and will be subject to probate and taxed at the prevailing estate tax rate in the year of the owner s demise. Joint Tenants with Right of Survivorship (JTWROS or JTRS) (Avoids Probate) (Taxable Accounts) This type of account will pass directly to the surviving account holder when the first account holder dies. This is most common for married couples. Tenants in Common (Taxable Accounts) A way for two or more people to have equal ownership interests in a property. Each owner has the right to leave his or her share of the property to any beneficiary upon the owner's death. Each party (owner) in a tenancy-in-common agreement has the right to use the property even if the physical size of the stake is different. Tenants by Entirety (Taxable Accounts) A method allowed in half the states by which married couples can hold the title to a property. In order for one spouse to modify his or her interest in the property in any way, the consent of both spouses is required by tenants by entirety. It also provides that when one spouse passes away, the surviving spouse gains full ownership of the property. A husband could not sell his ownership interest in a vacation home owned with his wife without the wife's consent. Convenience Account (Taxable Accounts) The account works like a power of attorney with survivorship going in accordance with the will. This is a Uniform Multiple-Person account allowed in some states mostly used for children to pay older parents bills. A joint title account with a child for safety and ease could create a gift tax on half of the account. Transfer on Death (TOD) or Payable on Death (POD) (Avoids Probate) (Taxable Accounts) Commonly used on taxable accounts (non-ira) for people without a will or trust and are not married. A TOD or Life Insurance policy can help pay for a funeral and debt payments during the probate process. Assets will be transferred to the designated beneficiaries without going through probate. This tilting will supersede a will. TOD Brokerage accounts. POD Bank and CD accounts. Revocable Living Trust (Avoids Probate) (Mostly used with taxable accounts and in some cases tax deferred accounts) Benefits of a revocable living trust: Avoid estate taxes, avoids probate and has lower settlement costs. Define who receives your assets. Distribute assets faster than a will in probate. Distribute your assets to your children in predefined amounts and predefined ages. Assign a guardian to your minor children. (Under 18 in most states including Michigan) Appoint a trustee to handle your estate and distribute your assets. Define financial and durable power of attorney and a patient advocate. 10

11 Beneficiary Designations Have You Checked Your Beneficiary Designations Lately? What would happen to your 401 (k), IRA and Taxable accounts if you or your spouse passed away? Are your accounts setup to transfer quickly and efficiently to the love ones you desire? Are your accounts setup to avoid probate? Do you have a trust to specify a guardian for your minor children? There are many types of accounts and beneficiaries to consider. Individual, joint, trust and transfer on death are a few of them. Who should you leave your accounts to? Spouse, children, parents, siblings or a charity? You should review the beneficiaries on your accounts every five years or when life changes occur. Life changes include marriage, divorce, birth, health change, death and the creation of a trust. To find you account beneficiaries look at your statement, log into your account or call your custodian. An incorrect spelling or change to a married name should be updated. The social security on record is always the same. You should keep a copy of your beneficiary documents for your records and check your account documents for accuracy. Upon death, the account is transferred without probate to beneficiaries. If no beneficiaries are named, your estate will be named beneficiary and go through probate. If the beneficiary is a minor (under 18 in most states) the court assigns an executor until the children are no longer minors. Beneficiaries (True Beneficiaries) are used for Qualified Employee Benefit Plans (401 k), IRA s and annuities, not taxable, bank and CD accounts. Beneficiary designations must match the rest of the estate plan. Putting a beneficiary on a taxable, bank or CD account will supersede a will. 11

12 Things to consider when naming or updating a beneficiary (About your family and beneficiaries) Single, married or divorced A birth or death Marriage of a beneficiary You and your spouse s age and health Children, age of children, special needs child, responsibility level of children Net worth and account size Tax implications If you have a trust Beneficiary Names Individual (spouse, children, etc.) Trust Estate (probate) Charity Beneficiary Default Options If you fail to document your beneficiary designation, your beneficiary may be determined by federal or state law or by the plan that governs the retirement account. Qualified Plans (401k, pensions) Federal law designated the living spouse as the beneficiary. IRA s State law designates. The default is usually the living spouse then the estate (probate). Scottrade Beneficiary Form If neither primary nor contingent is indicated, the individual or entity will be deemed to be a primary beneficiary. If more than one primary beneficiary is designated and no distribution percentages are indicated, the beneficiaries will be deemed to own equal share percentages in the IRA. Multiple contingent beneficiaries with no share percentage indicated will also be deemed to share equally. If no primary beneficiary survives you, the contingent beneficiaries will acquire the designated share of my IRA. If no beneficiaries are named, your estate will be named beneficiary and go through probate. If any primary or contingent beneficiary dies before you, his or her interest and the interest of his or her heirs will terminate completely, and the percentage share of any remaining beneficiaries will be increased on a pro rata basis. Per-Capita Designation If one of the primary beneficiaries deceases their share will be divided by the other primary beneficiaries. Per Strip Designation If one of the primary beneficiaries deceases their share of the distribution will go to their heirs, typically children. 12

13 Below are commonly used beneficiaries. Consult your estate-planning attorney for your particular situation. Taxable Accounts Primary Beneficiary Contingent Beneficiary Single TOD Trust Married without Children JTWROS (Spouse) TOD Trust Married with Children JTWROS (Spouse) TOD Trust Divorced with Children TOD Trust Divorced without Children TOD Trust Tax Deferred Accounts Primary Beneficiary Contingent Beneficiary Single Parents (50%/50%) Siblings (Parents in poor health and not getting married soon) Married without Children Spouse Parents or Trust Married with Children Spouse Children or Trust Divorced with Children Children or Trust Divorced without Children Parents or Trust Before you submit your beneficiary designation, consult your estate-planning attorney to determine whether it will produce the results you desire. You can also check with your financial advisor, accountant or custodian. You should not assume that your IRA custodian will notify you if the designation is ambiguous or does not meet requirements. In most cases, the problem is noticed only after the account owner is deceased and the beneficiary is ready to claim the assets. By ensuring that your beneficiary designation is in good order, you help to ensure that your beneficiary will be able to access the assets at any time. Estate Beneficiary Not recommended for tax deferred accounts. May lose IRA tax benefits. Funds are distributed over 5 years unless original owner was taking RMD at owner distribution rate. Individuals can stretch the distribution and taxes over longer periods than estates. Trust Beneficiary Use only if you need more control, beneficiaries are minors or you want to stay out of the hands of creditors. If the trust does not qualify as a designated beneficiary, it may be required to be withdrawn in as little as 5 years and may not be turned into an Inherited IRA for a stretch distribution. Higher tax rates may also be higher. Retirement Trust Account A trust that meets the IRS criteria for retirement account rules qualifying it as a designated beneficiary. You can take withdrawals based on life expectancy of the oldest beneficiary. If the beneficiary is a minor (under 18 in most states) the court assigns an executor until the children are no longer minors. IRA inheritors must withdraw a minimum amount each year, starting December 31 st of the year after they inherit the account. The inherited IRA should be titled Inherited IRA (stretch IRA). See Inherited IRA rules above for distribution options. 13

14 Required Minimum Distribution (RMD) The year you turn 70.5 years old, you must start taking annual distributions from your IRA s and 401(k) s, or you will pay a 50% penalty on the RMD amount you should have taken out each year. The year you turn 70.5, you must take your first RMD distribution by April 1 st of the next year. Each year after, you have until December 31 st of that year to take the distribution. Make sure you have a list of all your IRAs. The following require an RMD annual distribution. Traditional IRA s and Rollover IRA s 401 (k) s, 403 (b) s, 457 s Qualified IRA Annuity SEP IRA Simple IRA Inherited IRA s Inherited from spouse: RMD at 70.5 years old. Inherited from non-spouse: RMD at 59.5 years old, within 12 months of death. RMD is based on deceased accounts. Roth IRA - No RMD if original owner. Still Working Exemption If you are still working past 70.5 (and do not own more than 5% of the company) can delay RMDs on the company plan until you retire. RMD Calculation The RMD for the present year calculation is based on the account balance on December 31 st of the previous year. Calculate the RMD for each IRA type account individually (IRA, SEP IRA, SIMPLE IRA). Take the RMD out of each account or you can take the sum out of one account. 403 (b) s can also be aggregated together. Inherited IRA s and 401 (k) s must come out of their account. Divide the balance by the divisor in the IRA Uniform Lifetime Table based on your age that year for the distribution amount. For the first year, if your birthday is between Jan 1 and June 30, use the age 70, if it is between July 1 and Dec 31 use 71 for the age in the calculation. Joint Life Expectancy Table for client whose spouse is 10 years younger and was the sole beneficiary for the entire year. Single Life Expectancy Table is used for IRA beneficiaries. Tax Documents Form 1099-R shows previous year distribution. Submit with that year taxes. Form 5498 shows account value at end of last year and new-year RMD calculation for the new year. IRA Distribution Request Form (Scottrade) Inherited IRA Distribution Request Form (Scottrade) Form 5329 to request a waiver of the 50% penalty the first year. Distribution Process Find you RMD amount from Form 5498 or calculate from the table. Fill out the IRA Distribution Request Form from your custodian. (RMD amount, Federal tax withdrawal and state tax withdrawal amount) Submit IRA Distribution Request Form to your custodian before December of each year. 14

15 Traditional IRA to Roth Conversion Converting to a Roth IRA can help reduce taxes on retirement assets. You pay taxes now on the date of the conversion so you do not have to pay taxes when you withdraw in retirement. A conversion makes sense when you expect you will be at a higher tax rate when you retire than you are now. The higher tax rate could come from higher taxable income and or a higher tax rate. Most people will be at a lower tax rate when they retire, so a Roth conversion may not make sense. If you will never need the money and want to pass it on without taxes, the conversion may benefit your heirs. The main variables to consider are listed below. Value of the Traditional IRA ($100,000) Current joint taxable income level ($120,000) Current federal and state tax rate (25%+4%=29%) Taxable income level in retirement ($70,000) Taxable income can come from SS, a pension, taxable account capital gains and IRA and 401 (k) distributions. Most people withdraw from taxable accounts first, where taxes were already paid, reducing their taxable income and tax bracket. Tax rate in retirement (15%+4%=19%) Your risk level and expected return (6.4%) The year you expect to start withdrawing from the IRA (In 20 years) Based on the numbers above, in 20 years at your first withdrawal date your converted Roth would be worth $245,522. If you kept it a Traditional IRA, it would be worth $280,103 after taxes were paid. The Roth is worth $34,581 less because your starting portfolio was reduced by $29,000 to pay taxes at the time of the conversion. This would likely push you into a higher tax bracket increasing your tax rate even higher. If the tax bracket at the time of the conversion was the same at the time of withdrawal, both portfolios would have the same worth of $245,522. If you are at a 29% tax rate now and will be at a higher rate of 34% at the time of withdrawal, your converted portfolio would be worth $245,522 and your IRA portfolio would be worth $228,232 after taxes. The converted portfolio would be worth $17,290 more than the IRA portfolio. Use an on-line conversion analysis programs or seek out expert advice to review your situation. 15

16 401 (k) to IRA Rollovers (You can only rollover a 401 (k) into an IRA if you have left your company) Advantages of Rolling Your 401 (k) into a Professionally Managed Traditional IRA Access to all asset classes and sectors. Access to more active and passive mutual funds. Access to better rated mutual funds. Professional portfolio design and management. Professional active asset class management. It is much easier and there is more flexibility drawing an income stream from an IRA than a 401 (k). Account consolidation. Behavior coach for disciplined emotional support through, bull markets, bear markets and bubbles. Easy to read quarterly performance reports. Opportunity for stronger performance if a professionally managed portfolio can outperform a client-managed 401 (k) by at least the 1% management fee, the client is ahead Simplify and consolidate tax-deferred accounts to make it easier to manage and track performance. Professional management saves you the time of researching funds and implementing allocation changes annually and every time your company changes plans. Gives you more control over your investments. Estate planning advantages. Beneficiaries can keep money in an IRA. Beneficiary does not have to be a spouse. Easier to make penalty-free early withdrawals for a first house, medical hardship and college. Outside annual contributions allowed for employees that left the company. Lower custodian administrative costs with discount broker like Scottrade and Schwab. Typical 401 (k) custodian administrative fees range from 0.5% to 2.0% depending on the size and custodian. Rolling your 401 (k) into a non-professionally managed IRA may underperform due the increased difficulty and discipline of managing your own non-401 (k) account. Disadvantages of Rolling Your 401 (k) into a Professionally Managed Traditional IRA The purchase of some of the new funds in the IRA may carry a transaction fee of $17 with Scottrade. If employment is terminated at 55 years old you can take an early partial distribution without a 10% penalty from a 401(k). A 401 (k) may have better protection from creditors in bankruptcy. If the 401 (k) contains a sizable stake in company stock, you may be better off keeping the 401 (k) and taking distributions from the 401 (k) to enable you to pay ordinary income tax on the cost basis of the shares and long-term capital gains tax on the appreciation in the shares over and above the cost basis. In an IRA the investor would owe income tax on the whole amount of the distribution. 16

17 If you do not currently have a financial advisor for your 401 (k) and you now use an advisor for your new IRA, you will be paying a portfolio management fee of around 1% annually. The extra cost could be lower than some hidden 401 (k) administrative fees. The performance of the professionally managed IRA should be at least 1% better than the client-managed 401 (k). Statistics According to a Vanguard study from 2004 to 2014 between 50% and 60% of participants rolled their workplace savings over to an IRA. The rollover percent rises sharply each year after they leave their company. IRA Rollover Rules A person can only do one IRA-to-IRA rollover (60-day rollover) in a 365-day period from all of a person s IRA accounts (check was made out to the person). A rollover means a distribution from an IRA that is payable to the IRA owner who can then roll those funds over to the same or another IRA within 60 days. This is different than a direct trustee-to-trustee transfer, which is not a rollover. A direct trustee-to-trustee transfer goes from custodian to custodian or the check is made out to the new custodian name (Scottrade/FBO your name). There are no limitations to the number of direct transfers. The rule does not apply to Roth IRA conversions. 17

18 Flexible Spending Account (FSA) An employer sponsored health insurance saving plan that allows you to accumulate pre-tax money to be used to pay medical bills like copayments, deductibles and day-care costs. Typically offered in lower deductible health insurance plans. FSA Contribution Limit for 2014 is $2,500. Money going in is pre-tax and the money is not taxable on the way out if used for qualified health-care expenditures. Return on the assets in the account is $0. $500 limit on the amount of unused FSA funds that can roll over one year to the next. Started in Before you would lose it all. There are no wage restrictions. Health Savings Account (HSA) Employer sponsored health insurance saving plans allow you to accumulate pre-tax money to be used to pay medical bills like co-payments and deductibles offered in high-deductible health care plans. The growing number of high deductible healthcare plans is driving the popularity of HSA s. Deductibles greater than $2,000/year/family are considered high deductible. Most people place their HSA contribution into a money market fund, than use a debit card to pay for uncovered medical expenses over the course of the year. They are a great way to accumulate tax-deferred and tax free money over the year to pay for medical expenses in high deductible plans. Extra money can be saved in an investment portfolio to be used in retirement for health care premiums and for long-term care. Since an HSA has the benefits of an IRA in tax credit and Roth out tax free, it may be worth using as another tax deferred saving account. You could contribute the max, invest in a growth portfolio and let it grow for retirement medical expenses. Refrain from using the money on current healthcare expenses. Over 30 years, investing in an HSA and paying healthcare costs from your bank account grows the largest after taxes. Next is investing and spending in an HSA and investing extra cash in your 401 (k) and last is investing and spending from your HSA and investing extra cash in a taxable investment account. HSA Contribution Limit in 2016 is $3,350 for singles and $6,750 for families. Plus $1,000 for over 55 years old. Money goes in pre-tax, grows tax free and is taken out tax free if used for qualified health-care expenditures at any age. It has a tax deduction like an IRA going in and a tax free distribution like a Roth for medical expenses coming out. Return on the account is like a diversified mutual fund portfolio in your 401 (k). You select a portfolio offered by the plan. No limit on the amount of unused HSA funds that can roll over one year to the next. There are no wage restrictions. Contributions stop after you leave your job or turn 65 years old. There is a 20% penalty for withdrawals for non-medical expenses before age 65. At 65 years old, you can take money out for non-medical use, but you are taxed at your ordinary income rate like a 401 (k) and IRA. Great substitute for Long Term Care plans. Plans have fees up to $100 annually. Higher fee plans over 0.5% should be used with caution. Some plans offer employer matches. HSA s can transfer to the surviving spouse at death. For high-income earners this is another great way to reduce your taxes after you maxed out your 401 (k). For retirement savings, max out your 401 (k) and IRA s first because early HSA withdrawals have more restrictions. The biggest issue is most people struggle managing their 401 (k). Another account to manage may be too much to handle. 18

19 Education Savings Accounts The amount of money you want to invest for your child s education and your adjusted gross income are typically the deciding factors in deciding if you open an ESA or 529 Plan. Opening both is also an option. Coverdell Education Savings Account (ESA) An Education Savings Account (ESA) is a college savings plan with tax advantages that is managed by individuals or a financial advisor. An Education Savings Account is flexible, has unlimited investment options, minimum financial aid impact, not locked into a plan and participants have more control. Set up by parent. The parent has control until the child is 30 years old. Can contribute up to 18 years old. Funded with after-tax money like a Roth IRA. (Non-deductible contribution) Contribution limitations of $2000 each year. A contribution of $2000 per year for 18 years growing at 8% per year will be worth $58,000 adjusted for 3% inflation in 18 years, enough to pay for a large amount of 4 years of most colleges. Funding phase-out period for AGI is $190,000 to $220,000 for married filing joint. Tax-deferred earnings growth. No federal tax on distributions. (Principal & Capital Gains) For qualified education purposes like tuition, books and housing. State tax is paid on distributions. (Capital Gains) Can be used for any level of school in U.S. schools. Must be liquidated after the beneficiary turns age 30 to get the tax exemption and avoid the 10% penalty. 10% penalty on use for nonqualified expenses. Reduces financial aid eligibility. Portfolio managed by parent or advisor. Annual fees are 0% to 0.5%. Discount brokers offer low transaction costs. You may also pay advisor fees. Unlimited investment choices like stocks, bonds and mutual funds. Can transfer between children. Where to go to start an ESA? Most brokerage firms offer ESAs. Select the broker with low or no annual fees for an ESA. Use the same selection method used for an IRA or taxable account. Some good brokerage firms to use for an ESA are Scottrade, Schwab, Fidelity and TD Ameritrade. Parent s 401 (k), Roth IRA or Traditional IRA Money can be withdrawn for children s qualified education expenses without the usual 10% penalty for early withdrawals, and as long as withdrawals are contributions only. It is not recommended you tap into your retirement accounts unless you have saved a substantial amount of money in the account and you will likely not need it all at retirement. 19

20 529 College Savings Plan A 529 plan is a college savings plan that is managed by individual states with tax advantages. Purchasing a plan in the state in which you live has the most tax advantage. A 529 has limited flexibility, limited investment options, locks you into a plan and has an average annual fee of 1.1%. Set up by anyone for the child. The person who set up the account is in control and can pull out. Can contribute at any age, varies by plan. Funded with after-tax money like a Roth IRA. (Non-deductible contribution) Money invested in out of state plans can be used in any state. If the plan is in the state where you live, some plans let you take state tax deductions for contributions. No state tax on some plans if you use the plan in your state. Tax-deferred earnings growth. State tax is paid on distributions. (Capital Gains) No federal tax on distributions. (Principal & Capital Gains) Contribution of up to $250,000 over the life of the plan depending on the individual state plan and age. No funding income restrictions. Can contribute at any age. For qualified education purposes like tuition, books and housing. Better tax advantage for higher income families ($150,000) that have a strong stock position in their portfolio. The tax advantage overcomes the higher fees (+0.4%) associated in 529 plans. Lower income families ($50,000) may not see enough tax advantage to overcome the fees unless their state has a good tax break and they are invested more in bonds with non-qualified dividends. Can be used for post high-school education in U.S. colleges. 10% penalty for use for nonqualified expenses. Reduces financial aid eligibility. Portfolio managed by the plan. Higher costs than a ESA but they manage the portfolio. Annual fees are typically between 0.3% and 1.0%. (0.9% average) No transaction costs for investment purchases. Limited investment choices. Most plans offer age-based investments. Can transfer between children or other blood relative. 20

21 Where to go for a 529 plan? The options and benefits of 529 plans vary by state. Some plans are direct-sold and some are broker-sold plans. Each plan has various investment options like age-based, indexed and active management. Start with the plan in your state unless it has high costs and poor investment choices. Some plans offer a state income tax break. We recommend you do your own research for your state plan. See the plan website, Consumer Reports, Smart Money or Kiplinger s for their ratings. Morningstar s 2015 Best 529 College Savings Plans Alaska T. Rowe Price College Saving Plan Direct sold, T. Rowe Price managed, highly rated, average cost and good investment choices. Age-based portfolios = 21, static portfolios = 50. Direct sold. Morningstar Gold rating. Maryland College Investment Plan T. Rowe Price managed, highly rated. Age-based portfolios = 7, static portfolios = 6. Direct sold. Morningstar Gold rating. Nevada Vanguard 529 College Saving Plan Direct sold, Upromise managed, Vanguard index funds, highly rated, low cost and quality investment choices. Age-based portfolios = 15, static portfolios = 9. Direct sold. Morningstar Gold rating. Utah Educational Saving Plan Direct Sold, Utah Education Savings Plan managed, Vanguard funds, highly rated, low cost and quality investment choices. Age-based portfolios = 35, static portfolios = 8. Direct sold. Morningstar Gold rating. Ohio College Advantage 529 Savings Plan Direct sold, Ohio Tuition Trust Authority managed, highly rated, low cost and quality investment choices. Age-based portfolios = 20, static portfolios = 17. Direct sold. Morningstar Silver rating. Virginia American Funds College America and Virginia529 invest Broker Sold, American Funds managed, highly rated, average costs and good quality investment choices. Age-based portfolios = 35 static portfolios = 155. Advisor sold. Morningstar Silver rating. Michigan Education Savings Program TIAA-CREF managed, above average rated, low annual fee of 0.35% and quality investment choices. Age-based portfolios = 18, static portfolios = 5. Direct sold. Morningstar Silver rating. Illinois Bright Directions College Savings Program Advisor sold, Union Bank & Trust managed. Morningstar Silver rating. Other Silver Rated are New York s 529 and California s Scholar Share College Savings Plan. Other 529 College Savings Plans Massachusetts U Fund College Investing Plan Fidelity managed, average rated. Minnesota College Savings Plan TIAA-CREF managed, Vanguard, PIMCO and Oppenheimer funds, average rated, high fees. Illinois Bright Start College Savings Direct Direct sold, Oppenheimer (OFI Private Investments) managed. MS Bronze rating. Prepaid Plans Most people should stay away from prepaid plans offered by states. These plans have pay-out guarantees that cover tuition and some fees. Many of these plans face a large deficit due to the poor stock market performance and are being closed. Some of these plans are backed by the state and some are not, and could go bankrupt. Prepaid plans pay their full benefits if you attend an in-state college. 21

22 College Decisions In the past, when college costs were reasonable and scholarships and grants were easier to obtain, parents and students focused on their favorite school and dream career even if it means jeopardizing their own lifestyles in retirement or saddling the new graduate with high student loan payments. Many students picked degrees in fields of interest or that were easy with no consideration of demand for jobs or return-on-investment. They graduated and could not find jobs in their field and had to settle for unrelated low paying jobs. There are plenty of job openings in the U.S. in fields like engineering, information technology, skilled trades and the medical field with no graduates to fill them. Now parents and students are starting to look deeper into career and college decisions. Listed below are things to consider. Job demand in the career Expected salaries College costs Student loan debt limits Calculation of return-on-investment Parents and students need to spend more time identifying their child s skills, talents, personality and interests when selecting a career and college. Never rely on solely a consoler s advice. Some students like to work with their hands, where a trade school may make more sense. The demand for electricians, technicians, plumbers and mechanics has been strong due to the lack of qualified candidates. Attending a twoyear community college before transferring to the desired four-year college can save money. Commuting to a local college if their degree is offered can save up to 50% of college costs. Consider if your child would do better commuting or living on-campus. Colleges and banks are being pressured to start putting students interest ahead of them when consoling on careers and loans. Up to now, most schools and banks only cared how much money they could make off of you and did not care how you would pay or if you would find a job. Student loan debt has sky rocked to extreme levels of over $1 trillion, more than credit card debt. There are fears of a collapse from defaults, causing the next financial crisis. In 2013, the average graduate carried about $30,000 in student loan debt. Their loan payments are hindering the kids ability to be financially independent after graduation. Many are moving back home with parents and putting off purchases of cars and houses. Student loan debt is high-risk debt that has a high interest rate over 6%, regardless of your credit rating. Once you graduate and get a good full-time job, pay off the student loan debt as fast as possible. Consider trading the debt for lower interest rate loans like car or home loans with interest rates below 4%. If a parent or relative is hording cash, consider paying off the 6% loan with the cash from a loan from them at 3%. The new graduate cuts their interest rate by 50% and the parent gets 3% return, better than 0% at the bank. Also consider the loss of claiming the interest on your taxes. Many parents want students to help pay a portion of college costs so they have some skin in the game, regardless of the parent s income. Parents are involving kids more in the financial side because they want them to take ownership of their education and know more about what is involved. Sit down with your child and go over the college funding plan as they are selecting a career and college. Funding could be split up the following ways: FAFSA Federal Student Loan, College fund (529 or ESA), Parent contribution, Student contribution for part-time work. For parent contributions, always write checks directly to the school or abide by the gift tax law to avoid filing a gift tax form 22