Six Reasons To Take Advantage of Roth Conversions
Pay me now or pay me later applies to your retirement accounts. Let’s talk about when it makes sense to pay up now and minimize your tax liability during retirement.
Pay me now or pay me later applies to your retirement accounts. Let’s talk about when it makes sense to pay up now and minimize your tax liability during retirement.
Investment losses can be painful, but they often come with great opportunity. This includes not only buying equities at discounted prices, but significant tax benefits if you are opportunistic.
Kevin Lao 00:00
[music] hey, everybody and welcome to the Planning for Retirement Podcast where we help people plan for retirement. My name is Kevin Lao and I’m your host. Just a quick disclaimer, I have my own registered investment advisory firm. It’s Imagined Financial Security. We’re registered here in Florida. But this information is for educational purposes only and should not be used as investment, legal or, tax advice.
If you do have questions about how to work with my firm, you can go to my website at imaginefinancialsecurity.com. So, today’s episode nine, the 5 Most Common Estate Planning Mistakes, I’ve seen a lot of them over the years, being in the business and I’ve been thinking about doing this episode for a long time, because Estate Planning is a conversation I have with just about everybody, and it’s not a fun conversation because we’re talking about death, disability in capacity.
So, no one wants to address Estate Planning and it’s no surprise that only 1/3 of American adults have an Estate Plan in place. But one thing I always hear from any client is, that they don’t want to be a burden on their loved ones. I’ve put together this episode, and hopefully you find this helpful. These are easy to address, easy to fix. But I always recommend talking to a licensed attorney that can actually help you create and execute your documents properly.
So, if you’re one of the 2/3 of adult Americans, you’re obviously in the majority, and you may not have an Estate Plan, that’s ok. It’s very easy to set up your basic will, your basic power of attorney, which is someone that can make financial decisions, if you’re incapacitated, a living will which is essentially, if you are in a vegetative state.
Who’s going to make that decision? What are your wishes in that situation or, a power of attorney for health care, which is someone that can also make healthcare decisions on your behalf, if you’re unable to? Those are the primary documents that most Estate Plans will incorporate. You may need a trust, you may not need a trust and that’s again, up for a licensed attorney, someone that can review your situation and give you some advice on that.
Many people think that if their situation is fairly simple, they may not need a trust and that’s may be true. But you might need a trust for variety of reasons, which we’ll cover here in a minute. So, number one, simply getting an Estate Plan done is, really the first battle.
Again, I’m guilty of this too, my wife and I, we did our first Estate Plan before we had children. So, it was all about who’s going to receive our assets, if something happened to both of us? Who’s going to take care of our dogs? At the time, we had three dogs in our household.
So, there were there was some complexity but not a lot. Since then we had three children and we finally updated our state plan about a year ago. It felt pretty good, frankly, to get it done. To make sure everything was directed to our beneficiaries, making sure that we had guardianship for our kids. If something were to happen to both of us.
03:23
We had someone named that would take care of our kids and also to manage the assets for them. But not properly executing your documents is, super common because it takes a little bit of heavy lifting. If you set up a will or, set up a trust, you are going to have to go in and look at all of your accounts whether you have 401K’s, IRAs, life insurance, annuities, bank accounts, investment accounts, and you might need to make some changes on those beneficiary designations.
So, there are two types of assets in this world, assets that can pass outside of the probate process by having a beneficiary, and then assets that will pass through probate if proper beneficiaries are designated or, if there are no investment beneficiary designation, eligibility. So, let’s start with accounts that can be passed outside of probate.
Most commonly those would be retirement accounts like a 401K, 403B, life insurance contracts, annuity contracts, even assets that are not held inside of retirement accounts like, joint bank accounts or, individual bank accounts or, joint or, individually held investment brokerage accounts. All of those have the option to name a primary beneficiary and most of the time a secondary or, contingent beneficiary. And then for bank accounts the alternative, the name for it is a TOD or, a POD, which is transfer on death or, payable on death.
So, once you’ve reviewed all of your accounts and you have an Estate Plan in place, most of the time your attorney will tell you, hey, here’s who you should name as primary based on your wishes. Here’s who you should name as the contingent beneficiary based on your wishes and you have to do that for every single account that you have. Again, this is up to you, your attorney is not going to do this for you. You’ve got to contact those institutions, get those beneficiary designations updated.
I’ve seen scenarios where clients have been divorced for 20 years, and their ex-wife or, ex-husband is still the primary beneficiary on their 401k. Especially, if you’ve moved around from company to company, a bunch of different retirement accounts or, you have several life insurance policies, one with work, one outside of work, one that your grandmother took out for you when you were a baby, look at all those beneficiary designations. Make sure they are up to date and then make sure you have a contingent beneficiary if that option is available.
Now, the second part to this mistake of, not properly executing is, if you have a trust, making sure that the assets that should be held in trust are titled to the trust. So again, some heavy lifting involved, especially, if you’re moving a property inside of a living trust or, an investment brokerage account inside of a living trust. If you’re naming a trust as a primary or, contingent beneficiary of those accounts that we just talked about, all of that needs to be done by the individual client.
06:23
Again, if paperwork might be involved, you might need to get on the phone with customer service and jump through some hoops. But it’s worth it in the end, because your documents aren’t really going to do anything unless you have the proper beneficiary designations and the assets are titled with the right ownership.
So again, those are all scenarios that you can easily review, take a look at, making sure that they’re all up to date, and review them once every year, two years, three years. I mean, if your situation isn’t really changing a lot, you may not need to review them every year. But definitely every couple of years, every three years, you probably want to review those beneficiary designations and make sure that they’re titled properly.
I hear this all the time, hey, Kevin, I don’t need a trust. I don’t have over 11 and a half million dollars, which is the current exemption for estate tax purposes. Maybe they have $5 million or, $6 million and they might have other concerns in terms of inheritance for their children or, grandchildren or, they might be concerned about divorce of the one of their kids and assets being split to that son-in-law or, daughter-in-law that they’re not a huge fan of to begin with.
Maybe there’s a creditor protection concern or, spendthrift concerns are a child with special needs that may need care for the rest of their life. Therefore a trust could make a lot of sense in solving those issues in terms of inheriting assets outright. So, all of those reasons are reasons to own a trust, whether it be a living trust or, an irrevocable trust or, a testamentary trust or, if you have minor children that’s another one.
My wife and I, we have three kids that are under 18. If something were to happen to both of us, we have guardianship named and we also have a trust that would be set up to be managed for our boys, until they are of age and that is designated inside of the trust.
So, think of a trust as essentially another entity that will help you execute your wishes and manage the assets properly for your beneficiaries, if there are concerns about them inheriting assets outright or, if you just want to make sure that those assets stay in the family and aren’t subject to divorce proceedings or, creditor protection concerns those types of things.
Another reason I have a trust is, to simply avoid probate. Probate is expensive. It can cost anywhere from two to 3% of your estate. So, if you have an estate that’s $2 million, I mean, that could easily cost you a 30, 40 $50,000 to go through the probate process, and setting up a trust might cost you three or $4,000.
09:02
So, this is a big reason why a lot of people will go through the process to setting up a living trust, even if there aren’t a lot of the concerns that I just mentioned. They love their son-in-law or, daughter-in-law or, their kids are totally able to manage a large inheritance. They may still want to set up a trust. So it’s passed outside of the probate process to avoid the cost of probate and also the public record of probate. It keeps that privacy involved.
The assets may still stay in trust for a lot of those concerns that we just talked about. But that beneficiary their son or, daughter or, whoever that beneficiary is, can still access the assets for whatever purpose that they want to access those funds for, if they’re able to manage it themselves. You also have the ability to set up a corporate trustee.
This is an area that I see is, definitely becoming more common where, maybe there’s several children involved, and one of them is just completely off the rails. Not able to manage assets. There’s a lot of concern, if there was a big windfall of a million or, $2 million that’s passed on to one of the children, they may want to have a trust set up for that beneficiary, and not have that person as the trustee into, in terms of making the financial decisions, when you’re no longer here.
So, you may want to consider a corporate trustee, which is a trust company or, a bank or, financial institution, can serve as a corporate trustee, to ensure the wishes of the trust are executed on that beneficiary’s behalf if you have concerns of the management of those assets.
Special needs trusts and other things as well, having a corporate trustee. I see a lot of times will fit in those situations, because the siblings of that special needs child may not be available. Maybe they’re, a neurosurgeon or, they’re deployed overseas, and they’re just not available to make those financial decisions for their brother or, sister. So a corporate trustee can also be put in place, in lieu of an individual, if you have a trust setup.
There’re a lot of benefits of trust. I’m talking a lot about trust, because I’m a big fan of them, just for the simplicity of the execution of your wishes, and all of the benefits of trust provides, whether it’s a living trust or, a testamentary trust. Again, consult your attorney, see if that makes sense in your financial plan and if it does, make sure that it’s properly executed on the back end.
So, what does that mean? There are certain assets that when they’re passed on to the next generation, are going to be heavily taxed, and then there are some assets that are not going to be taxed at all that are super tax efficient to leave to beneficiaries.
The big one I’ll highlight here is, for traditional 401k is, traditional IRAs that used to have the benefit of what’s called a stretch IRA, when they’re inherited by a non-spousal beneficiary, like a son or, daughter or, a grandchild. Those are no longer available for most beneficiaries. Ok, there are some exceptions to the rule.
12:11
I did a Podcast on this recently, maybe episode three or two. It’s called the Tax Trap of Traditional 401Ks and IRAs. So, look at that, I talked more about this in detail but generally speaking, there could be a scenario where, you have several accounts and certain accounts you may want to designate for retirement income, and spend those down during your lifetime.
Then there are other assets that you may want to protect and preserve, to leave those, to the next generation, given the tax efficiency of those, how those assets are passed on? A lot of that’s going to be dependent on your tax situation in retirement, if you’re in a high tax bracket or, low tax bracket, where you think taxes might go in the future? And then also, what tax bracket is your beneficiary in?
Are they in a really high tax bracket or, a really low tax bracket? And that will drive a lot of those decisions that you’re going to want to make as you approach retirement, and then go through retirement, in terms of spending on your assets.
I mentioned earlier, not being a burden on loved ones is important to just about, everyone I talked to. What I find is, that sometimes, you’ll get an Estate Plan done, and you may not tell your brother-in-law that they’re the executor or, you may just mentioned in passing, hey, something happened. Would you be able to manage the trust or, manage the financial affairs?
But they really don’t understand or, know what that means, what’s involved? And I’ve seen a lot of scenarios where a big mess is left to a family member, to clean up and take care of it. So, I think, being transparent with the key decision makers, that are going to help execute your estate, whether it’s a trust or, being the executor of your will, I believe is super important, and then making getting things organized in a way that’s easy for those individuals to execute on.
So, if you have tons of accounts all over the place, does that make sense? Do you want to simplify your balance sheet a little bit? I create a two page document for all of my clients just to simply say, hey, here’s a list of our assets. Here’s a list of our liabilities. Here’s a list of insurance. Where are those accounts held? Who’s a point of contact that you can reach out to? Here’s even a phone number that you can call, and giving that out to my clients powers of attorney or, executors or, trustees.
14:42
I find that as super valuable just to make sure that process is easy for those individuals that are going to execute on your plan. Hope you found this helpful. That’s it for today. Be sure to subscribe if you like what you heard, that way you can stay up to date on new episodes. Again, I always love to hear from you if you have any questions about your personal situation that you want to talk about. You can just visit my website at imaginefinancialsecurity.com and schedule a call with me.
Inflation is running hot, the market is volatile, and I-Bonds have become attractive. This article addresses the basics of I-Bonds and how you can assess if they are right for you.
What to do when stocks are volatile
Kevin 00:12
Hello everyone and welcome to the Planning for Retirement Podcast. My name is Kevin Lao and I am your host. Just a quick background on me, I’m a CFP been in the business for almost 14 years and I have my own firm serving clients all over the US. We’re based here in St. Augustine, Florida. My firm is Imagine Financial Security. But this Podcast is to educate you on the strategies we put in place every day to help our clients plan for retirement and achieve financial independence.
If you have any questions about working with me one-on-one or, even had feedback on our Podcast, I always love to hear from you. And you can visit my website at imaginefinancialsecurity.com and contact me that way. Also, be sure to subscribe and leave us a review on iTunes, if you’d like what you hear.
This episode on January 24th 2022 is episode number eight. It is called what to do when markets are volatile? Before we jump in just a quick disclaimer, this should not be construed as investment, legal or, tax advice. And you should consider your own unique circumstances and consult your advisers before making any changes. So, let’s dive in.
All right, as I mentioned it is Monday, January 24th, it’s the evening. My three boys are now sleeping. So, I have some quiet time to record this episode, which I’ve been looking forward too. We’ve been in some ballot of volatility over the last four to five months really starting with the Delta variant in the third quarter.
The markets got a little bit spooked. Of course, with the recent variant Omicron in the fourth quarter of 2021 and we’re officially in correction territory with the NASDAQ intraday today was down 17% from its previous high. The S&P 500 was minus 10% and some change from its previous high.
We’re definitely in correction territory with both of those and the small caps in the US, are actually in bear market territory. So bear market, just to define this, is a drop of 20% or, more from previous market highs. So, many times I’ve clients or, prospects, they come to me and ask what should they do? What should their strategy be?
And I hear many talking heads in our industry, even advisors, co-workers, friends, family, I hear a lot of people talk about number three, which is do nothing. Bury your head in the sand, just let the dust settle and just don’t look at your statements, and then wait a year.
This is great for people who don’t know what to do because making a mistake is, you certainly want to avoid selling something at the wrong time and making that big mistake.
But the real answer, the one the pros practice, and the one my firm employs is, to do a little bit of both. You sell some things and you buy others.
03:21
Now, what to sell and what to buy is, much more of a complex question. I’ll go into what our process looks like, in just a moment. But first of all, I just want to talk about what’s going on in the markets now? We’ve had record high inflation. We’ve had for many months, really since June, we have had interest rates spike at the beginning of the year, so far in 2021. So, the concern, there is large purchases like, homes and cars are becoming less affordable.
It also impacts the ability for businesses to borrow money, which has been a very easy thing to do for businesses, for many years, really since 2010. So, that’s going to become a little bit more difficult. A little bit more expensive, which will impact the growth and then ultimately, number three, which is really related to the first two is, this concern of slowing growth in 2022 and 2023.
Really, with the reopening from the global shutdown in 2020 towards the end of 2020 and 2021, we’ve been experiencing a rapid expansion because we were experiencing the reopening from the lock downs. Naturally, the pace of growth is going to slow and so, investors are certainly concerned with that, and ultimately concerned with stock prices not being aligned with their valuations.
So, those three things are really contributing to the stock markets being volatile and what I will say is, volatile markets are normal. They’re healthy. If stocks had no volatility, they would not provide the upside potential, they have provided for decades. We’ve all heard the notion of risk and reward.
Well, if there’s no risk involved, there’s no reward involved. I tell my clients and friends, and family and people I talk to is, embrace the volatility. This is an opportunistic period of time in the markets, and we’ll talk about here in just a second. So what do I mean by opportunistic?
Let me throw out a quick statistic that really jumped out to me. This was done by Hartford Funds I believe, and I’ve been looking at this study year after year, and I think they update this almost every year. We talked about bear markets being minus 20% drop a bull market, conversely, as a 20%, increase in prices from previous lows.
06:02
Again, we’re not in a bear market for the S&P or, NASDAQ yet, but I’m just talking about volatile markets in general. When things are bad, we tend to have some of the best performing days in the market. Actually, here’s another one. I’ll follow up on that.
So, if you really add those two up which probably, isn’t fair to do, but let’s say 88% or, north of 80%, of the best days in the S&P 500, over the last 20 years have occurred, while we were in a bear market. Ok. Now, you could argue. You know, a large part of that was 2008-2009, with the worst recession since the Great Depression. We were in a really deep recession, a deep bear markets.
Of course, there were a lot of good trading days during that period of time, but you really look at 2020 as another example, that was the other bear market we’ve had over the last 15 or, so years. There was some great opportunity in March, April, May, June, July of 2020, where if you didn’t take advantage of it, it hurt your recovery.
If you sat it out, there’s no way you would have made back what you’d lost at the beginning of 2020. But the important note is, that when things are bad people tend to run. People tend to get scared and that’s when opportunity arises. Ok, valuations become more attractive, stock prices are lower than they were previously and so investors that have been sitting on the sidelines, opportunistic investors, are now buying in, now getting into the market.
I love that quote and I think it really applies to the process I employ for my clients.
Another interesting statistic I want to throw out there is that, bear markets last 10 months on average, but bull markets last three years. So, this really goes hand in hand with a lot of the advice people give around, just wait it out, don’t make any moves. You just buy and hold.
Don’t make any rash decisions because on average, bull markets tend to last longer than bear markets. If you did nothing, you probably did just fine over the course of a long period of time. Ok. But how do we become opportunistic? How do we really take action during periods of volatility?
This is really what the answer that people are looking for when they come to me during these periods. Ok. What my clients are looking for in an advisor during volatile markets?
So, the answer is simple. We manage to each investment policy statement. Ok, let me repeat that, we manage to each individual investment policy statement.
09:09
A simple way, a simple definition is, it’s a written document that designates a certain percentage to be allocated for each asset class. Ok. How do you create an investment policy statement?
So, the equation in my mind is very simple. It’s your financial goals, combined with your risk tolerance or, risk capacity. Minus your financial resources equals your investment policy statement.
Some examples of asset classes would be, let’s say, large cap US growth stocks or, International stocks or, US bonds or, Real Estate, just to name a few. A well-designed investment policy statement will have asset classes that move in different directions during different periods of each economic cycle. Meaning they’re well diversified from one another.
So, as the market shifts, the percentage you own and each designated asset classes, you then have the opportunity to sell at a premium or, buy at a discount relative to your IPS or, your investment policy statement. Ok. If you have no starting point, it’s never going to make sense mathematically of, when to buy and when to sell?
Whereas, if you have an investment policy statement, and you have a certain percentage that’s supposed to be allocated towards international stocks, and a certain percentage that’s supposed to be allocated to US growth stocks, ok, and that percentage has shifted, based on fundamentals of the economy and stock prices. That’s going to give you the answer of what do you buy and what do you sell?
Let me give you a quick example. Let’s look at the recent bear market we had. Ok. Again, I’m not predicting we’re going to enter a bear market right now. I’m just talking about bear markets, because typically people start to pay attention when their accounts dropping by 20%. Even now, people are starting to look its headlines, are being made because the NASDAQ was down intraday today at over 4%.
So, if you’re like, oh, should I be doing something? The last bear market we had was February, March of 2020. Ok, this was the beginning of the Pandemic sell-off. It was short-lived in early, in August. We had recovered all of the losses from the bear market and stocks have been on a rally ever since. But stocks dropped 35% in a six-week period.
Bonds, on the other hand, were up close to 7% during that same time horizon. Ok, so why is this? I mean, interest rates were low, relatively speaking. Ok. So, how could they return 7% in a two month period? Well, it’s because when people are selling out of stocks, because they’re fearful or, they’re concerned about what’s going on in the economy?
12:01
They have to buy something. I mean, yes, you could go to cash. But a lot of these individuals, a lot of these investors are going to flight to safety. So, US Treasuries, Municipal bonds, Corporate bonds, they’re flighting to safety. So, bonds spiked because of prices going up. People wanted safe investments paying a coupon rate of, one and a half or, two and a half percent, just because they were concerned with stock prices dropping 35% over a six-week period.
Ok, let’s say for simplicity purposes, we had an investment policy statement, based on your financial goals, based on your risk tolerance, based on your time horizon, based on your financial resources. We said, hey, you know what? Let’s use half of your portfolio to be in the stock market. Obviously, diversified within stocks, US stocks, International stocks, large stocks, small stocks, mid-sized stocks, and the other 50% would be in fixed income also, diversified US bonds, International bonds, high quality investment grade versus Junk bonds, high yield.
So, in the first few months of 2020, stocks were down 35% and bonds were up 7%. So, as it relates to your investment policy statement, ok, we are now, under exposed and stocks, and over exposed to bonds simply by the drastic difference in performance during that time. Instead of reacting to headlines, which is very tough to do, I promise you, ok, you wouldn’t believe the phone calls, I was receiving from clients during 2020, at the height of COVID when stocks in a single day, were going down 11 to 12 and 13%.
Ok, the calls that we were feeling were concerning, ok, but we had to stay disciplined, ok, and if we’re now, underweight and stocks, ok, and overweight and bonds, mathematically speaking, as a relates to your investment policy statement, and that 50-50 designation, we had the asset class. By simple way of math, we have to then trim off some of the gains from bonds so, sell at a premium, and purchase stocks at hopefully, discounted prices.
Now, hindsight is 2020 we know how that worked out. But in practice, this is literally the discipline that goes into this, ok. So, we’re not reacting to headlines. We’re not trying to time the market, ok. We’re simply looking at a financial goal, a time horizon, and an investment policy statement related to a certain account, and we’re going to buy some things and we’re going to sell others.
Now, within stocks, we’re going to have different percentages allocated to different segments of the market. Ok, within bonds, same thing. Okay, so I’m just using a very high level simple example of half in stocks and half in bonds. Once we made that move, I know Hindsight is 2020, but stocks went on a tear for the next four months because we had repositioned and loaded up in stocks during the bottom March, April of 2020, and we had that recovery over the next four months, we recovered much faster than, if we had did nothing.
15:34
Ok, the same thing held true in 2021. So, fast forward, ok, we’re looking at it and said, hey, we had a massive run in 2020, and even into 2021. So, that same 50-50 portfolio, we’re now overweight in stocks, and we’re underweight in bonds. As painful as this might be, especially, when we’re going through a significant bull market, we need to buy discipline.
Trim off some of the gains from stocks, not bail out of stocks, but trim off some of the gains, to get it back to that targeted 50% that we want to have in the portfolio and purchase fixed income albeit, it’s not going to generate a ton of interest. Given interest rates are super low, but it’s there for that stability. We’re not overweight, when stocks take the next tumble, which we talked about happens every four years on average for a bear market.
Now, that we’re going into this ballot of volatility, third quarter of 2021, fourth quarter of 2021, first quarter of 2022, if we had followed this discipline, follow this process, we’re not going to be experiencing as much of a dip, as we had, if we had done nothing.
So, my clients that are— let’s say, a client needs $5,000 a month from the portfolio. We need to raise cash somewhere by liquidating a certain asset class. Every single month, when we go into the portfolio, we look at the Investment Policy Statement and figure out what we’re under? What we’re over weighted?
And that drives our decisions on what we’re liquidating to generate income from the portfolio.
Again, it works in the accumulation phase. It works in the income distribution phase, and for those of you that are younger listening to this, and let’s say, you don’t even have fixed income in the portfolio, where you might have cash. You might have cash that you’ve been waiting to invest, that you haven’t put to work yet. This is dry powder. It’s an opportunistic time to deploy that cash strategically, to buy equities at potentially discounted prices and especially,
If your time horizon is 10 or, 15-20 years, you don’t need to even time it perfectly, and you shouldn’t even try to time it perfectly because conceivably, if capital markets continue at the trajectory, they’ve been going over the net, over the last 100 years plus, you’re going to be much better off than just leaving that money in cash. I promise you that especially with inflation.
18:08
So, those of you that are long ways away from retirement, there are strategies you can deploy, instead of selling off fixed income. If you’re closer to retirement, it’s a perfect time to look at what are you overweight in? What are you underweight in? What is your investment policy statement look like? What should it look like? Should it be updated, based on your time horizon, based on your financial goals and circumstances changing? For those of you in retirement don’t panic.
Hopefully, you have a process in place where a certain dollar amount for income each year is, going to be generated from asset classes that are immune to stocks. Ok, in summary, if you don’t know what to do don’t make a knee jerk reaction but at the same time, don’t just sit idle and do nothing. Ok, create an Investment Policy Statement for each account. Ok, that you have follow the Investment Policy Statement, implement it with a discipline process. Don’t act on emotion.
Ok, if you want to consult with an advisor, consult with a fiduciary, go to NAPFA.org. Go to Fee Only network. Go to XY Planning. If you want to consult with me one-on-one, I’m happy to talk. You can get on my website at Imaginefinancialsecurity.com but I hope you find this helpful and can apply during periods of volatility moving forward. Be smart, review your situation, make sure you’re taking the appropriate steps for your own strategy and your own unique circumstances.
Ok, again, hope you enjoy today’s episode. Be sure to subscribe. Leave a review on iTunes like, I mentioned if you liked what you heard, and I really appreciate all of you, and appreciate you tuning into today’s episode. Until next time, have a great one.
In my nearly 14 years in this business, I’ve seen financial advice given by many different professionals. Insurance agents, stock brokers, bank representatives, real estate professionals, next door neighbors and the like. I’ve seen some great advice given, but also some terrible advice. This often times leads to the general public to think “are financial advisors worth it?” This is especially the case now given the lines are blurred between different segments of the “financial services” industry. Vanguard did a study called “Advisor’s Alpha” which I have found is the most helpful and accurate summary of value-added services a comprehensive financial advisor provides. I’ve referenced it to clients and other professionals since 2014 when it was originally published. To summarize it briefly, they outline seven areas of advice that add value to the client’s portfolio by way of net returns annually. They have assigned a percentage to each of the categories which amounts to approximately 3%/year in net returns! In this article, I will highlight some of the key components of their research, as well as put my own spin on it based on my thousands of hours working with clients directly.
First things first, not all advisors are comprehensive (and that’s okay). However, this article is specifically for firm’s like mine that are focused on comprehensive advice and planning, and I would argue the 3%/year figure is on the low end. I will get into this more shortly.
Here is a breakdown of Vanguard value-added best practices that I mentioned previously:
The first thing that should jump out to you is that suitable asset allocation represents around 0%/year! This is given the belief that markets are fairly efficient in most areas, and it’s very difficult for an active fund manager to consistently beat their benchmarks. This is contrary to the belief of the general public in that a financial advisors “alpha” is generated through security selection and asset allocation! What’s also interesting is that the largest value add is “behavioral coaching!” I will get into more about what this means, but I would 100% agree with this. Sometimes, we are our own worst enemy, and this is definitely true when it comes to managing our own investments. It’s natural to have the fear of missing out, or to buy into the fear mongering the media portrays. So if you take nothing else away, the simple notion of having a disciplined process to follow as you approach and ultimately achieve financial independence will add 150% more value than trying to pick securities or funds that may or may not outpace their benchmarks!
Before I dive into my interpretation of their study, I want to note that I will be using five major categories instead of seven. Some of the above mentioned can be consolidated, and there are also some value added practices I, and many other comprehensive planners, incorporate that are not listed in their research.
There are four major components of tax planning a comprehensive financial advisor should provide. The first component is what we call “asset location.” The saying that comes to mind is “it’s not what you earn, it’s what you keep.” Well, taxes are a perfect example of not keeping all that you earn. However, some account types have preferential tax treatment, and therefore should be maximized through sound advice. Certain investments are better suited for these types of tax preferred accounts and other investments tend to have minimal tax impact, and therefore could be better suited OUTSIDE of those tax preferred accounts. A prime example is owning tax free municipal bonds inside of a taxable brokerage or trust account, and taxable bonds inside of your IRA or Roth IRA’s. Another example could be leveraging predominantly index ETF’s within a brokerage account to minimize turnover and capital gains, but owning a sleeve of actively managed investments in sectors like emerging markets, or small cap equities inside of your retirement accounts. According to the Vanguard study, this type of strategy can add up to 75 basis points (0.75%/year) in returns if done properly, which I would concur.
The second component is income distribution. This is often thought of much too late, usually within a few years of retirement. However, this should be well thought out years or decades in advance before actually drawing from your assets. One example I see often is when a prospective client who is on the brink of retiring wants a comprehensive financial plan. Often times they have saved a significant sum of money, but the majority of the assets are held inside of tax deferred vehicles like a 401k or IRA, and little to no assets in a tax free bucket (Roth). This type of scenario limits tax diversification in retirement. On the contrary, someone who has been advised on filling multiple buckets with different tax treatments at withdrawal will have many combinations of withdrawal strategies that can be deployed depending on the future tax code at the time. I have incorporated the rest of the income distribution value-added practice in the next section, but this practice as a whole is estimated to add up to 110 basis points (1.1%/year) in additional returns!
Legacy planning is the third component of tax planning that a comprehensive financial advisor should help with. This isn’t discussed in the Vanguard study, but it’s safe to say a comprehensive plan has to involve plans for your inevitable demise! You might have goals to leave assets to your heirs, especially if you are fortunate enough to have accumulated more than you will ever spend in your lifetime. With the SECURE Act, qualified retirement plans are now subject to the “10-year rule,” and therefore accelerating tax liabilities on your beneficiaries. However, if you incorporate other assets for legacy that can mitigate the tax impact on the next generation, this can save your beneficiaries hundreds of thousands, or even millions of dollars simply by leveraging the tax code properly.
Finally, navigating tax brackets appropriately can be another way a comprehensive advisor adds value. If a client is on the brink of a higher tax bracket, or perhaps they are in a period of enjoying a much lower tax bracket than normal, planning opportunities should arise. If you are in an unusually higher tax bracket than normal, you might benefit from certain savings or tax strategies that reduce their adjusted gross income (think HSA’s, pre-tax retirement account contributions, or charitable giving). If you find yourself in a lower tax bracket than normal, you might accelerate income via Roth conversions or spending down tax deferred assets to lessen the tax burden on those withdrawals. Additionally , considerations on the impact on Medicare premiums in retirement should also be taken into account when helping with tax planning.
As you can see, even though I am not a CPA and I’m not in the business of giving tax advice, helping you be strategic with your tax strategies is part of the comprehensive planning approach. All in, you should expect to increase your returns up to 1%/year (or more depending on complexity) by navigating the tax code effectively.
In my personal practice, this ends up being a significant value add given the work I do with post-retirees. A systematic withdrawal strategy in retirement will involve a monthly distribution 12 times throughout the year. This reduces the risk of needing a sizeable distribution at the wrong time (similar to the concept of dollar cost averaging). For a 30 year retirement, this means 360 withdrawals! Most retirees have at least two different retirement accounts, so multiply 360 by 2 for 720 different income decisions to navigate. In my experience, the selling decisions are often what set investors back, especially if they are retired and don’t have the time to make it back. By putting a process in place to strategically withdrawal income from the proper investments at the right time, and maximize the tax efficiency of those withdrawals, this can add up to 1.1%/year in returns alone, according to Vanguard’s study! I’ve also had clients tell me they value their time more and more the older they get. Instead of spending their retirement managing income withdrawals each month, they would much rather travel, play golf, go fishing, spend time with their grandchildren etc. So yes, I would agree with the Vanguard study that 1.1%/year is appropriate for this category, but I would also argue the peace of mind of not needing to place trades while you are on an African Safari with your spouse is priceless! Yes, I did have a client who admitted to this, and no, his wife was not happy! That’s why they hired me!
The major risks you will see during your lifetime from a financial planning perspective are:
Vanguard’s study focuses mainly on the behavioral risk (value add up to 1.5%/year) and re-balancing (.26%/year). As I mentioned earlier, it’s fascinating they rank behavioral risk as the largest value add out of any category! What is behavioral risk? Let me tell you a quick story. A client of mine was getting ready to retire at the beginning of 2020, right as the pandemic reared it’s ugly head. He had 30+ years working in higher ed and climbed the ladder to ultimately become president of his college for the last 15 years. He is a brilliant man, and a savvy business person. When the pandemic hit us, he was terrified. Not only did he see his portfolio drop from $2.5mm to $2.25mm in four weeks, but he was worried this could lead to the next depression which his parents lived through. We had at least a dozen conversations during those weeks about how he was losing sleep every night, which of course was miserable for he and his wife. Finally, in our last discussion he informed me he wanted to sell out of his retirement investments and move to cash. I plead my case in that we had a well thought out diversified strategy, and looking at the math, we had enough resources in fixed income investments to pay his bills for the next ten years! However, I told him it was his money and I was ready to place the trades if that is what he wanted. He told me he would think on it for the next 24 hours. The next day, he called me and said I was right, we had a plan, and he wanted to proceed with sticking to the plan. Well, by the end of 2020 his account not only fully recovered, but it grew to $2.75mm! I am not pumping my chest on performance, but by being the behavioral coach he needed at that time earned him $500k of growth in his portfolio (a whopping 22%).
I can literally share a hundred of these stories not just from the pandemic, but stories from 2008/2009, the dot com bubble etc. The point is, having an advisor you trust that can help you navigate through the ups and downs of the market and tell you what you NEED to hear, not what you WANT to hear is invaluable. Furthermore, it can free up your time to focus on what matters in your life and have the professionals worry about the market for you!
So all in all, I would agree on the 1.5%/year value add for behavioral coaching and .26%/year to help re-balance the portfolio properly. However, Vanguard’s study doesn’t even take into consideration proper insurance planning and estate planning advice a comprehensive advisor gives to their clients which are also value-adds in and of themselves. In that sense, I would argue this category can add up to 2%/year in additional returns to a client.
This is oftentimes overlooked when working with a financial advisor. Much of the public believes working with an advisor will be more expensive! However, many of them are used to being sold high commission investment products or services that are overpriced. However, through due diligence and leveraging the proper research, Vanguard estimates clients should save on average 0.26%-0.34%/year on expenses. From my personal experience, this might even be on the low end. However, for arguments sake and given it’s their research, let’s say we agree with the value-added range set forth.
Vanguard doesn’t reference this in their study, but that objective point of view is sometimes necessary to drive positive change. I don’t have any specific data on how to quantify this, but I hear time and time again from clients that they so much appreciate having me as an accountability partner. Think about trying to get in tip top shape without a coach or personal trainer! You might do okay, but you certainly wouldn’t push yourself as hard as you could have if you had a coach or trainer. On the contrary, I often hear from new prospective clients how information overload and the fear of making a mistake has caused a whole lot of inaction, which can significantly hurt returns and performance. Think about a surgeon attempting to perform surgery on their own body! They simply wouldn’t. Not that I am comparing my occupation to a surgeon, but someone working to achieve financial independence would benefit substantially from a trusted third party to help navigate all of the different financial decisions they will encounter in their lifetime. This also could be true for married couples who might have differing views on finances. After all, financial reasons are the #1 cause for divorce in America. If I can help a married couple get on the same page with their financial vision, that is a win for them, no questions asked! Without specific data, I would have to say my gut feel is that objectivity should add an additional 0.5%/year in returns over the duration of a relationship, as well as more self confidence and peace of mind that you are on the right path.
If we tally up our TIRES acronym:
This gives us a total value add range of 4.86% – 4.94%/year in additional returns. My firm’s average fee is roughly 0.85%/year. This is why I get so excited to help new and existing clients. The value you receive, is far greater than the cost to pay me, creating a win-win situation. Now, not EVERY client will experience in additional 4-5% in additional value. Some might receive 2%/year, some might receive 10%/year! However, all of you who have yet to work with a comprehensive planner, or for those of you working with an advisor who may not be doing a comprehensive job, it might be time to reevaluate and see what holes you need to fill. If you are interested in learning how to work with me directly, you can schedule a mutual fit meeting with the button below. Or, you can visit my “Process” and “Fees” pages on my website.
Retirement Income Withdrawal Strategies
Kevin Lao 00:12
Hello everyone and welcome to the Planning for Retirement Podcast. My name is Kevin Lao. I am your host. My real job is running a Financial Planning firm in Florida. We serve clients all over the US remotely. But this Podcast is to educate you on the strategies we put in place every day to help our clients plan for retirement and achieve financial independence. The name of my firm is Imagined Financial Security.
So, if you have any questions about working with me one-on-one or, even a feedback on our Podcast, I always love to hear from you. So, you can simply visit my website at Imaginefinancialsecurity.com and contact me that way. Also, be sure to subscribe so you can stay up to date on our newest episodes. This is episode number seven, called Retirement Income Withdrawal Strategies.
Before we jump in just a quick disclaimer, this should not be construed as investment advice, legal or, tax advice and you should consider your own unique circumstances, and consult your advisers before making any changes. These strategies come from my 13 plus years in the Financial Planning Profession, but are constantly evolving and changing as the business evolves.
All right, with that being said, why don’t we dive in? So, there are three primary withdrawal strategies. You have the Systematic Withdrawal Strategy. You have the Bucket Strategy, and you have the Flooring Approach. You don’t have to stay in one lane. You can combine different strategies into your own unique strategy. But I’m going to hit the high points on each of these and talk about the pros, and cons and who might be a good fit for one versus the other.
But before we jump into that, what I will say, for all of you folks that are, let’s say five or, 10 years or, longer away from retirement, you need to start planning early. Ok, but the biggest issue I see a lot of the times, I have clients come to me. They’re right on the brink of retirement. They’re like, hey Kevin, I’ve heard good things. I I’m retiring in a month and they want to create a retirement income plan. There’s not a lot of change we can make happen in order to maximize the efficiency of their plan.
However, someone who’s five years away or, 10 years away, can diversify taxes. They can diversify the different buckets they are using. They can diversify the different investments that can use for income and retirement. So, the earlier you begin this process and this journey of retirement income, the better off you’re going to be when you actually pull the trigger and retire. Ok,
All right, so with that being said, let’s jump into the Systematic Withdrawal Strategy. Now, this is probably the most common strategy that most people have heard of. A lot of folks have heard of the 4% rule and for those of you that don’t know, the 4% rule, it’s an academic study that’s been tested years and decades.
Essentially, what it says is, choosing a well thought out diversified investment strategy and then once you retire, simply withdrawing 4% a year from your portfolio. You have a very low probability of ever outliving your assets. In fact, you have a very high probability of leaving assets to the next generation. Ok.
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There are different variances of the 4% rule or, the Systematic Withdrawal Strategy, meaning you can say, I’m going to do 4%, but I’m going to build inflation each year. Meaning you adjust that dollar amount you’re taking out for inflation or, maybe instead of 4%, you choose 5% or, even 6% depending on your risk level. Ok,
Another strategy is choosing a % and adjust based on what the market does. For example, let’s say you chose 5%, and the market’s not performing well, then you may drop that to four or, 3% temporarily and wait for the market to recover. Conversely, if the markets doing well and you started five, maybe you even take six or, 7% out those years and take a nice vacation or, gift to charity or, whatever you want to do with it.
So, the idea is that there are different percentages that you can come up with in terms of the right withdrawal rate, and I actually did a Podcast on this, as episode number five, and so, check that out. But the idea around Systematic Withdrawals is once you’ve created an a well thought out portfolio of investments, ok, that another key is a well thought out portfolio of investments that are not correlated to one another. Meaning, you have investments that are moving in different directions at different times. Ok,
I’ll give you really high level example, let’s say 50% of your portfolio should be in equities and 50% should be in bonds or, fixed income. If we think back to 2008, 2009, equities dropped anywhere from 40 to 70%, depending on what market you’re looking into?
Ok, well bonds in 2008 during the Great Recession returned close to 6% a year. Ok, many of you have probably heard the notion of buying low and selling high because we had this well thought out investment strategy. Now granted, we have different segments of equities. We have different segments of fixed income. But just from a macro perspective, equities were down in no 809, fixed income was up. We don’t want to sell the losers. Ok,
So, let’s say we needed 10,000 a month from your portfolio. Well, a Systematic Withdrawal Strategy would create a process where we’d be selling $10,000 a month from your fixed income, as investments of your portfolio and letting the equities recover. In fact, we might actually sell a little bit more so we can actually buy up equities at a discounted price. But that’s a different story.
Now, fast forward a year later, in 2009, equities actually performed closer to 25 to 35%. Fixed income still defined, still perform close to 6%. But we want to sell the winners not the losers. So, equities were up at a far greater percentage than fixed income. So, in 2009, we actually might have a process to sell 10,000 a month from the equity portions of the portfolio. Ok,
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The idea is, create the percentage of withdrawal rate that works within your financial plan, your risk tolerance and your investment strategy, and then create a well thought out portfolio so you can take the right investments at the right time, and not sell the wrong thing at the wrong time.
Now, this is great for clients that are comfortable with a little bit of risk in the market. They can stick to a process. Stay disciplined during the ups and downs, which I found is very difficult many times. Especially, once clients retire because they’re not working anymore. They can add more to their portfolio. They don’t have time to recover and they may have a desire for liquidity, and leaving assets to their heirs. Ok,
Now, the downside is, its labor intensive. I mean, if you’re taking a distribution every month, there’s going to be a selling decision every single month. You want to frankly, time it right. You don’t want to wait until the wrong time to sell an investment, if we can liquidate something while it’s appreciating really quickly. Ok, so it’s very labor intensive and if you have 12 distributions a year, if you multiply by over 30 years, that’s 360 decisions of selling that you’re going to be making throughout retirement.
Many times I have clients that are very well qualified to manage their own assets. They come to me and say, Kevin, you know what? I want to go sailing. I want to play golf. I want to spend time with my grandkids. I want to volunteer. I don’t want to do this on an ongoing basis. So, you take care of it. That’s a big burden of their shoulders.
Additionally, if you’re the decision maker, and you’re doing it yourself, if something were happen to you, who will be the one to step in and replace you? Are they qualified? Do they understand your goals and your strategy or, your risk tolerance, right? So, this is another reason why clients oftentimes hire someone like myself, a fiduciary an investment advisor to help them with the income distribution process for these Systematic Withdrawals. Ok,
All right, let’s move on to strategy number two. Now, there’s a lot of similarities from one and two those systematic will draw bucket. Ok, so I’m going to start with the Bucket Strategy and how it differs? But then we’re going to tie it together and explain how there’s a lot of similarities as well?
So, the Bucket Strategy, instead of looking at your assets as one portfolio, one investment strategy, one asset allocation, we are going to look at the different assets on the balance sheet, and actually come up with different investment strategies based on the time horizon in which those assets will be used for income. Let me explain that.
Let’s say, there are three accounts that you have on your balance sheet. Let’s say one is a traditional 401K or, IRA. Ok, so that would be a tax-deferred asset. Let’s say, you also have cash and a brokerage account, you know, investments that are not in a retirement account. But let’s say, you also have a Roth account or, Roth IRA or, Roth 401K, the most tax efficient asset you have on your balance sheet is the Roth account. All of these assets, all of the growth on these accounts are going to grow tax-free. Ok,
09:12
So, the idea is that we want to continue, to leverage the tax-free growth in the Roth accounts. So, we don’t want to tap those for a while. We don’t want to take them early. When I want to take them up you know, initially, we want to let those continue to cook and compound tax-free as long as possible.
Therefore, this account might be the most aggressive account on your balance sheet. Ok, so again, we want to have one overarching asset allocation and then we want to break up sub-asset allocations based on the time horizon of each bucket. Again, the Roth would be long-term assets, most aggressive, ok. Then one step down or, one notch down would be your traditional IRA or, 401K.
Now, these accounts would be subject to required minimum distributions at 72 and you’re going to have to start drawing these in retirement anyways. You might still take out a little bit of risk. Maybe retire to 60 or, 65 so you might have seven to 10 years or, 12 years until you’re taking RMDs or, requirement of distributions. We still might take on a little bit of risk, but not as much as the Roth accounts. Ok,
This would be in the middle of your risk tolerance, and then the most conservative bucket you might have would be your Taxable Brokerage Account. This would be an account. You have some cost basis in. You could take advantage of capital gains and capital losses. If you’re strategic there that’s a whole different conversation. So, this account might actually be the most conservative bucket, knowing that you’re going to be tapping into a lot of these assets at the very beginning of your retirement. Ok,
Again, we’d have one overarching asset allocation, and then we’d have sub-asset allocations in each bucket, and bucket based on the time horizons, ok. Now, the similarity to the Systematic Withdrawal is, distributions are still going to have a process of selling winners, not the losers, ok. So, if you’re tapping into that Taxable Brokerage Account, we’re going to want to make sure, we’re tapping the right investments at the right time and not selling at the wrong time. Ok,
Now, a big differentiator is that it’s, you’ve got to have a little bit of a process over time to rebalance those longer term accounts, because what’s going to happen is, if you’re just liquidating the shorter term accounts, the brokerage or, even the IRA, all of a sudden, then later in retirement, you’re going to become probably, more conservative as you get older, because you have less appetite for volatility. And all of a sudden, your Roth accounts super aggressive, and now you’re all in equities, right.
So, having a more of a process ongoing with the Bucket Strategy is, prudent to maintain your asset allocation and your risk tolerance. For very similar reasons as the Systematic Withdrawal, it’s great for folks that are comfortable with a little bit of risk. Liquidity is important. They may have a desire to leave a legacy. But
12:01
The big benefit of the Bucket Strategy is, more of a behavioral finance component because if we go through some volatility in the Systematic Withdrawal, your overarching portfolio is going to be moving with that type of investment strategy that risk tolerance. Whereas, the Bucket Strategy counts that you’re tapping into currently for retirement, are going to be much less volatile, much less subjected to that risk.
So psychologically, you know short term yes. We’re going through some bad times. Maybe it’s a recession or, just a bear market or, a correction. Well, your most of your equities, your growth assets are in those Roth accounts or, those traditional IRA accounts that we’re not going to be tapping for a long time anyways. Now, we already talked about the downside of it being the labor intensive, with a Systematic Withdrawal really, very similar in terms of the downsides of the Bucket Strategy.
You know its labor intensive. You’ve got to have a system and process in place that contingency plan is critical as well. If something were happen to you, you know your plan. You know, what your power of attorney or, your successor trustee. You know, if you have a trust, do they understand your plan. Ok,
So, lots to consider with a Systematic Withdrawal and the Bucket Strategy, and oftentimes, what I see personally, in my practice, is that we’ll use a combination of these two, right. We’ll create different investment strategies based on the time horizon of withdrawals, and then we’ll create a system for withdrawals on each of those accounts, based on which one we’re tapping for income that year. The final approach is the Flooring Approach.
In general, most people should have Social Security as a floor for income essentially, a guaranteed annuity provided by the government. Ok, now, some folks might have a pension, whether they work for the state or, military so they might be lucky enough to get a pension. Many of us do not have a pension. The income gap that we’re going to be solving for is going to be either created from withdrawals from investments or, creating from an annuity income stream or, a private annuity.
For those of you that don’t know what a private annuity is? It’s essentially a pension that you create with your own assets. Let’s say, you had a 500,000 IRA, and you want to turn that into an annuity, you would go to an insurance company and say, hey, here’s 500,000. How much are you going to pay me for the rest of my life just like Social Security?
They would quote you for monthly income that you’re guaranteed to never outlive, and that’s the benefit to it. It’s very simple. There’s no maintenance involved. You’re basically, delegating the investment process to the insurance company which hopefully is stable and financially secure, and they’re going to guarantee you a check for as long as you live.
So, if you have longevity in your family, maybe your parents lived a long life, your grandparents lived a long life, and you keep you’re an Iron Man or, you keep in really good shape. You might live 30 or, 40 years in retirement, an annuity could solve for that longevity risk that you might have. Ok,
15:02
It’s also great for folks that are very anxious with market swings. So, for those first few strategies, you’re going to have to be comfortable with a little bit of risk. But I had definitely run into people that literally, they wouldn’t be able to sleep at night. If they know their portfolio is subject to volatility in retirement, ok. It’s just a behavioral finance issue.
The idea of a guarantee checks that’s not going to be subject to stock market swings or, changes in the economy. It’s very comforting for certain folks. So, this is a great profile for someone who could be a great fit for this Flooring Approach. Now, the downside is the lack of liquidity on these accounts, so you couldn’t get at that $500,000 Ira, if you turn that into an annuity. Ok,
You couldn’t call the insurance company and say, what I changed my mind, I want to tap into my principal. Most of these contracts do not offer this. Additionally, there’s inflation concern because we’re in a relatively high inflation environment, at least currently, and expect it to at least be in the near term. Oftentimes, these annuity payments are not going to keep pace with inflation very well, and may not increase at all each year, maybe a static, a dollar amount that you’re getting for life.
If you live 30 years, you can imagine how that’s going to impact your buying power every month or, every year that goes by with your monthly income. The final downside would be legacy.
If there’s not a big concern of leaving a legacy to the next generation, an annuity could be a great tool. However, if it is important to you, and you do want to leave assets to let’s say, your children or, grandchildren, many of times these contracts are going to stop after you pass away or, if you’re married, your spouse passes away. Ok,
So hopefully, this is helpful. Again, these three approaches can be combined, ok. Oftentimes, what I see is, let’s say, client needs 70,000 of fixed expenses, and let’s say, Social Security takes care of 35,000 of that so, we might want to say, that 70,000 is your essential needs for cash-flow, and maybe your spending a little bit more above that for things like, travel or gifting.
What we might do is say, hey, let’s take a portion of your assets and turn that into a guaranteed life annuity to get you very close. If not at that 70,000 a year number between Social Security and your annuity, and then the remaining assets for your other discretionary expenses like, travel or, gifting or, home renovations, we can use from your investments, and psychologically that sometimes works.
So, this combination of the Flooring Approach with a Systematic Withdrawal with a Bucket Approach is very common. But again, plan early. Don’t wait until you’re about to retire, to create these different buckets. Create these different opportunities and avenues in which to draw income from.
So, the earlier you can start this process, the better, a big part of my planning for younger clients, that are in their 40s and 50s is to create the right savings rate for each of these buckets, to set up optimization from a tax standpoint, so we can be strategic. And once you get to retirement, based on who’s in office or, what the legislation looks like? What the tax code looks like? We can create a plan that works for that environment and then navigate the changing environment throughout retirement.
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So again, hope you all found this helpful. Again, if you have any questions about your situation or, want to talk one-on-one or, are you interested about working with me one-on-one personally, just go to my website, imaginefinancialsecurity.com and again, subscribe, and continue to listen to our Podcasts. We always appreciate you. Until next time, thanks everybody.
4 Tax Strategies As We Approach Year End
Kevin Lao 00:12
Hello, everybody, and welcome to the Planning for Retirement Podcast. My name is Kevin Lao. I am your host. I’m also the Director of Financial Strategies at my firm. Imagine Financial Security. We provide Financial Planning Services for those all over the US remotely, and also in Florida locally. If you’re interested to learn more about my firm, you can go to my website imaginedfinancialsecurity.com and very excited to bring this episode today on 4 Tax Strategies as we approach the year end.
Just a quick disclosure, this is not tax advice or, investment advice. So, please consult your own attorney, financial planner or, CPA to see what strategy is most relevant for you. But I do want to hit on these topics today. As we approach the year end, not all of them have to be done by the year end, some do. But some we have until April of next year before tax time.
So just wanted to bring these up as many of you are thinking about the holidays and spending time with family. We are thinking about how to save our clients and taxes? So, without further ado, I’m going to introduce the four concepts we’re going to discuss today and we will dive in.
So, first one is Maximizing Retirement Contributions. Second is Health Savings Account contributions or, HSA contributions. Third is Tax Loss Harvesting and fourth will be broken into two sections. The first is Charitable Donations using a Donor Advised Fund and then 4B would be Charitable Donations using a Qualified Charitable Distribution, also known as a QCD.
So, why don’t we start with Retirement Contributions? This is an obvious one. So things like 401K’s, 403B’s, 457B plans, even regular IRAs or, Roth IRAs, taking advantage of the maximum contribution or, the maximum you can contribute to these plans. I bring this up because I can’t tell you how many times I talked to folks that say yes, I’m maxing my 401 K plan.
I look at their pay stub and I look at their year-to-date contributions. And they are maxing the amount of their employer will match. Which oftentimes might be 3% or, 6% but they’re not maximizing their contribution, which for 2021 is 19,500 if you’re under 50. If you’re 50 or older, you can put in a catch-up contribution of 6500 for a total of $26,000 per year.
Yes, we’re in December, we’ve got probably two pay periods left to make contributions. You might have a year-end bonus. So, those are opportunities, you can essentially try to backload those contributions into your 401K or, 403B plan or, 457 plan to try to get either at the max contribution or, close to the max contribution, ok.
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Now, if you don’t have a year and bonus, if you’re just getting your buy weekly pay-checks. Let’s say you’ve got some money sitting in savings, not really earning a lot of interest, maybe 0.01% interest. You might want to consider, hey, live on that savings for a month, ok. And instead of getting your pay-check deposit into your bank account, try to contribute either all or, most of your pay-check into those retirement plans.
So try to backload and try to get closer to that maximum contribution, ok. It might be painful from a cash flow standpoint, but you’re going to take advantage of utilizing that savings, that’s not doing anything for you, and getting in into those retirement plans that are growing tax advantage, ok, don’t just think Tax Strategies being Tax Deductions.
If you have Roth options like Roth 401K’s or, Roth 403 B’s or, if you can qualify for a Roth IRA, strongly consider that. I think we’ve been trained to deferred taxes and I see many people run into what I call the Tax Trap in Retirement. They turned 72. They have all this money saved in their qualified retirement plans and they’re having to take all these distributions out, even though they don’t need it for income.
Therefore, pushing them in a higher Tax Bracket maybe paying more for Medicare premiums so, strongly consider. Does it make sense for you to use a Traditional Retirement Plan or, a Roth Retirement Plan or, a combination thereof?
No one says you have to do 100% of one versus the other. You can use combinations of both to essentially create some tax diversification on your balance sheet. But the key is, try to get as much money as you can, before you’re in on those 401K, 403B plans and then prior to April filing taxes for next year. You leverage those traditional IRA contributions or, Roth contributions, ok.
All right, HSAs or, Health Savings Accounts probably, one of my favorite tools to utilize for retirement planning, and actually just wrote a blog, post on this today actually, and so if you want to read that and to learn more details about HSAs and how to utilize them? You can go to my website imaginefinancialsecurity.com and go to my blog.
Let me just explain what an HSA is briefly? And HSA is essentially an account that you’re eligible for. If you use a high Deductible Health plan, ok, so High Deductible Health plan, essentially your Deductible is going to be a little bit higher than a regular Health Care plan, ok, but you can contribute to an HSA. And you can contribute $3,600 If you’re an individual and 2021 or, 7200.
If you’re in a Family plan, and you could recognize a tax deduction for those contributions so, in my opinion, for many people, if you’re using one of these high Deductible Plans, and you’re relatively healthy, that tax deduction that you can take advantage of by contributing to an HSA. Oftentimes either washes or, put you in a more Beneficial Tax Situation than having a lower deductible.
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Obviously, you can’t predict Health Care costs. You might be paying a little bit more out of pocket in that year. But the true benefit is, you’re getting this money into this account. You’re getting the Tax Deduction for these contributions. What you can do is, you could reimburse yourself for Health Care costs. Either that you recognize throughout the year or, in future years, ok,
The growth on these assets, which you can invest in a basket of securities, like ETFs or, Mutual Funds, the growth on those assets are tax-free and the distributions are tax-free as long as you’re using it for Qualified Health Care expenses. Now, the definition of Qualified Health Care expenses is quite broad. Just do a Google search and you’ll see IRS resources, and other HSA resources in terms of what constitutes as a Qualified Health Care expense. It’s very broad. So, even dealt dental vision, routine check-ups, and surgeries.
So, the true power in these vehicles, in my opinion is, yes, you get the tax deduction today. You can use it to reimburse yourself today. But the true benefit is, if you can let that money compound long-term, ok. Particularly, to let that continue, to grow for Retirement Planning, maybe, you’re letting this thing compound for 10 years of contributions here, and you’re investing it in a well-diversified strategy and you’re growing those assets over time tax free.
You can build up a substantial nest egg to utilize in retirement, to help pay for health care expenses which is estimated in todays until 2021, a 65 year old couple is going to spend $300,000 in retirement on health care costs,
Why not spend it from tax-free buckets as opposed to— let’s say, a traditional 401K or, a traditional IRA, and you have to pay taxes on those distributions, ok. The best part about this is there’s no income phase out. Unlike other traditional IRAs or, Roth IRAs, there’s no phase out for income. So, you can get that deduction and contribute to it regardless, of what that adjusted gross income is?
Just a quick side note, a little bit different than an FSA. Many people have FSA or, flexible spending accounts available. FSA is needed to be emptied by the end of the year. So, just a quick side note, if you have an FSA, make sure you’re taking advantage of those distributions and reimbursing yourself for any healthcare expenses or, go to the doctor and do some things that you were putting off, and take advantage of those dollars in the FSA that you haven’t spent yet, ok.
We talked Retirement Contributions. We talked about HSA contributions. Now, let’s talk about Tax Loss Harvesting. It’s a somewhat complex concept, but let me try to simplify it. When you invest in a security whether it’s a Stock Bond, Mutual Fund and ETF, and these are outside of a retirement account, ok.
So, Retirement Accounts, you get the benefits of tax deferral, and if you sell anything in those, you’re not going to trigger any taxes unless you take a distribution, ok. A non-retirement account or, a non-qualified account, you could still buy those securities individually or, jointly hold them in that account, and you will either have a gain or, a loss, but you’re not going to pay any taxes until you sell that investment.
Unless there’s interest or, dividends that kick off. You’ll get a 1099 each and every year but from a capital gain or, loss standpoint, once you sell something, then you recognize that gain or, loss, ok. Let’s say you invested $10,000 and now it’s your investment is $20,000. Let’s say you sold that investment and you held that instrument more than a year. You would pay a long-term capital gain.
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If you held it less than a year you would pay a short-term capital gain. Short-term capital gains you’re taxed at your regular income bracket. Whereas a capital gain you’re either in 0%, 15% or, 20% capital gains bracket depending on what your income is. But generally speaking, you’re probably in a lower tax bracket with your long-term capital gains, than you are with your regular ordinary income.
Ok, there’s definitely a benefit of utilizing these instruments outside of retirement accounts because they’re liquid. You don’t have to wait till you’re 59 and a half and to tap into those dollars. Allows you for more contributions over and above those Max contribution accounts on your 401K or, IRAs, ok.
So, throughout the year, you might have experienced some assets that grew in value, but you also might experience some assets that lost in value if you have a well-diversified portfolio. Not everything is going up at the same rate, and some might be non-correlated to one another. If you have losses in your portfolio, you might consider actually, selling that investment at a loss to take advantage of that for tax purposes.
What you do with that loss? Let’s say, you had a $10,000 loss on a different investment and you sold it, and then you had a $10,000 gain on another investment that you sold, that would essentially wash out that that gain, and you would not have any taxes due. Now, let’s say you didn’t have any gains and you just sold something at a loss that $10,000 where you can recognize up to $3,000 as a tax deduction today, and then carry forward the rest of those that loss in future tax returns.
Ok, and in order to maintain that same exposure, and that and that investment, let’s say that investment made sense for your long-term goals. So, you wanted them to continue that exposure, you might consider selling that one, and replacing it with not the same one, but something that’s very similar has similar exposure into maybe a sector or, an area of the market that you want exposure to base on your financial plan.
It’s a great strategy to take advantage of not even just at the year end, but throughout the year. Markets aren’t just volatile in December. They’re volatile throughout the year. In times, like in the third quarter when the Delta variant first rear to ted or, now it’s the Omicron, there’s sell-offs in the market in different areas, and we’re constantly looking for opportunities, for clients that have taxable accounts, to actually recognize some of those losses for tax purposes, to either offset gains or, reduce taxable income and carry forward any losses in the future as well.
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Again, make sure you’re talking with a professional this one. There’s a little bit complexity to different rules around, what a wash sale might be? So, you really got to consult with your financial planner or, advisors before you make any decisions with your investment portfolio.
Ok, fourth and final strategy, Charitable Donations. This is the time of year to be charitable, and so many people are thinking about the causes that are important to them. But they also might be thinking, hey, I want to donate to these causes but I also want to recognize some tax benefits. So, I’m breaking this down into two parts.
First would be Donor Advised Funds, and then the second is going to be Qualified Charitable Distribution. Donor advised fund, what is a Donor Advised Fund? It’s essentially an account that you can contribute to most financial institutions offer these and you can contribute really, any dollar amount or, even contributed securities into a Donor Advised Fund. It’s essentially a charity. Ok, that can then benefit as many charities as you’d like.
So, if you had, let’s say, a few $1,000 sitting around, you could either donate it directly to charity or, you could donate it to a Donor Advised Fund, and actually, invest those dollars in a basket of securities for future growth, and either donate to charity or, charities that year or, in years, in the future.
Here’s why this is beneficial from a tax standpoint is. Yes, if you had $10,000 you could donate it directly to charity or, you could donate it to a Donor Advised Fund. It doesn’t make a difference. However, if you are taking a standard deduction, which for 2021, if you’re single, it’s 12,550. If you’re married it’s 25,100.
If you donate to charity, and that donation does not put you above the standard deduction, meaning you’re not itemizing your deductions, that doesn’t really do anything for you from a tax standpoint. You’re not actually getting a tax deduction for it, because you already had the standard deduction that everybody else takes advantage of, ok. That takes the standard deduction.
So, the Donor Advised Fund essentially allows you to front load contributions into this Donor Advised Fund to take a tax deduction now, and contribute to that charity or, charities in the future. Ok, so let me explain how that would work?
Let’s say you normally contribute $5,000 each year, but 5000 hours doesn’t put you above the standard deduction limits, so therefore, you’re not taking it. You’re actually not technically taking a deduction for it. What you might do is say, hey, you know what? I’m going to do this for the next decade.
Ok, I’m charitably minded. I’ve got some cash sitting around maybe, you sold a business or, a property or, you had a great year and you had a great income year, and you’re sitting in some savings. Maybe you take $50,000, which is 10 donations over the course of 10 years of 5000 hours per year, 50,000 and put it into the Donor Advised Fund.
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That will for sure put you over this standard deduction limit, right, give you that tax deduction today, ok. Allow you to essentially either turn around or, write a check for $5000 to that one charity, you’re going to donate to this year, and then the remaining 45,000, you can invest and actually have future growth.
Ok, if you obviously invest wisely, there’s no guarantee of future growth. But you could have future growth on that account, to even give more than $45,000 into the future to that charity or, charities. It’s also not limited to one charity. Like I said, the Donor Advised Fund can benefit as many charities as you’d like, as long as it’s a qualified 501 C3. You can’t gift to like a private foundation or, your grandchildren’s college education.
It’s got to go to a Qualified Charity, but essentially creates a lot of flexibility and allowing you to really front load those donations in a tax year. You might want to get that deduction, when normally wouldn’t have received that deduction, but also allows you to maintain control so you can give to that charity over a period of time, and actually, still invest those dollars and maintain control of those dollars for charitable purposes.
Now, I say control, technically, it’s an irrevocable contribution. You can’t say, hey, you know what, just kidding. I want to take it back and use it for buying a boat. You can’t do that. It’s got to be Charitable Fund. It’s got to go to Qualified 501 C3 organizations and if it does, you get Tax-Free Growth and Tax-Free Distributions on that Donor Advised Fund, ok.
A great tool to utilize, if you charitably minded, you’ve got some cash sitting around. Maybe you’re in a tax year or, you want to get a deduction but just writing a check to one charity is not going to move the needle for your itemized deduction purposes. So, consider the Donor Advised Fund.
Second strategy, Qualified Charitable Distribution. This is for those that are 72 or, older and your RMD age are Required Minimum Distribution age. So, for those of you that don’t know, when you turn 72, the IRS says, hey, you have to take a certain percentage, out of all your qualified plans. Your IRA’s, 401K’s, 403B’s, 457s, really anything that’s not a Roth IRA, it pretty much has a required minimum distribution.
Well, let’s say that $10,000 doesn’t similar example as the Donor Advised Fund. Let’s say it didn’t put them over or, doesn’t put them over that standard deduction limit. So, donating $10,000 is not going to itemize their deductions. Therefore, that 10,000 is not going to move the needle to reduce their taxable income.
So, the nice thing about the Qualified Charitable Distribution is you can donate up to 100% or, $100,000, of your Required Minimum Distribution, if you donate it directly to charity. Ok, so let’s use the example, someone is charitably minded, let’s say normally, they have to take $50,000 out for the Required Minimum Distribution, but they normally give $10,000 to charity.
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Well, if it’s coming from a Qualified Charitable Distribution, instead of taking that $50,000, for your RMD, you say, hey, go to your financial institution. Say, hey, you know what? Give me $40,000 and then the other 10,000 that I need to satisfy for this year. Donate that directly to a charity or, charities. You can name as many as you’d like.
So essentially, what that does, it satisfies your Required Minimum Distribution but that amount that you donate to charity is not included in your adjusted gross income. So, it’s essentially better than taking a tax deduction, because it doesn’t push you into a potentially a higher tax bracket and potentially could even save— it might even keep you on a lower Medicare premium schedule, ok.
It doesn’t matter if you itemize your deductions or, take the standard deduction, you would have had to take that $50,000 that Require Minimum Distribution regardless, and if you’re charitably minded, donate it directly from your IRA. And again, it has to come from a traditional IRA. It can’t come from a 401K plan or, a 403b. So, if you have this goal, you might even consider, if you’re eligible to roll those funds into a traditional IRA, and then turn around and do that QCD or, Qualified Charitable Distribution. Again, that has to be done before calendar year end.
So hopefully, this was helpful. Again, we talked about Retirement Contributions. We talked about HSAs. We talked about Tax Loss Harvesting. We talked about Charitable Donations via the Donor Advised Fund, as well as the Qualified Charitable Distribution. I hope everyone found this helpful. If you have any questions or, if you if you’re curious about, how to work with my firm again?
Go to my website imaginefinancialsecurity.com. There’s plenty of information there and how to get in touch with us. But again, hope you found it helpful. And subscribe to us if you like what you heard. Give us a five star review, if you like what you heard, and I always like to hear your feedback. Until next time, and hope everyone has a wonderful holiday season. Take care.
In simple terms, a Health Savings Account, or “HSA,” is an account owned by an individual that can be used to pay for health care expenses, either now, or in the future. The accounts are eligible for those who have a High Deductible Health Plan and are funded with pre-tax dollars. If the funds are used to pay for qualified expenses, the funds can also be withdrawn tax free for those purposes. If leveraged appropriately, it will be the most tax efficient vehicle you will utilize for retirement planning.
Fidelity conducted a study that estimates a 65 year old couple will need $300,000 earmarked to pay for healthcare expenses. This does not include costs for long-term care services. $300,000 of course represents true expenses, meaning the funds used to pay for those expenses will be net of taxes. If the bulk of your retirement savings are held in a traditional 401k or IRA, you will need close to $450,000-$500,000 in your account balance earmarked for healthcare costs alone. Therefore, many of my clients are leveraging the HSA as part of their overall retirement planning strategy, and I’ll summarize some of the benefits in more detail below.
1. You recognize a tax deduction today.
If you are single, the maximum contribution is $3,600 for 2021 ($3,650 for 2022).
If you are married and participating in a family plan for insurance, the maximum contribution is $7,200 for 2021 ($7,300 for 2022). If you are over 55, there is a $1,000 catch up contribution available as well. Unlike other tax efficient saving strategies, your adjusted gross income level does not phase you out of a contribution. Also, you don’t need to worry if you itemize your deductions or take the standard deduction come tax time, all contributions will reduce your taxable income. You will typically have the ability to make your HSA contribution before tax time. This is helpful as you could wait until March or April before making your contribution from the previous year after you estimate what your tax liability might be. Of course, consult with your tax advisor on federal and state tax impacts of making an HSA contribution.
2. Tax efficient growth
Once the contributions are made, the growth from year to year is not taxable. Unlike a taxable brokerage account (investing in stocks/bonds/mutual funds), you will not receive a 1099 for interest or capital gains purposes. Furthermore, the distributions are also tax free as long as they are used for qualified healthcare expenses. Unlike a normal retirement account, you don’t have to wait until 59 1/2 to take those qualified distributions. We will cover what a qualified healthcare expense is later, but think about the tax power of this vehicle. All other retirement vehicles that you take a tax deduction up front grows tax deferred, not tax free. Furthermore, tax free retirement vehicles like Roth IRAs, Roth 401ks, etc., don’t allow for a tax deduction up front! Therefore, the HSA has the best of both worlds from a tax standpoint in that it’s tax deductible, and grows tax free (as long as it’s used for qualified healthcare expenses).
3. Flexibility
A health savings account can be used for current medical expenses, or future medical expenses. This means you are not required to “empty out” your HSA at the end of the year, unlike it’s cousin, the Flexible Spending Account. This means that the HSA can be used in a year where you have abnormally high medical bills (major surgery, having a child, unexpected ER visit etc.), or can be used in future years, or better yet in your retirement years. Furthermore, there is no limit on the timing of reimbursement. Let’s say you had major surgery in 2021, but had some cash on hand to pay for the expenses. Therefore, instead of taking an HSA distribution, you decided to let it compound and invest it for the long term. Let’s say 15 years later, you needed to raise some cash. Well, let’s say that surgery set you back $5,000 out of pocket, you could reimburse yourself for that surgery that occurred more than a decade ago. This feature also allows you to grow the funds over time with compounding interest before reimbursing yourself. Make sure you have a process to archive receipts, which often times can be done with your HSA provider. The final component of flexibility is portability. If you leave an employer, the HSA always remains with you. You can even roll it over to a different HSA provider if your new company offers a plan that you want to participate in.
4. Growth opportunities
Given the ability to make contributions over your working years without the requirement of withdrawing funds, the HSA also offers an opportunity to accumulate a sizeable balance that can be used in your retirement years. Additionally, you can even invest those unused funds in a basket of securities such as mutual funds or ETFs for even more growth opportunities. Typically, the HSA provider will require some reserve amount that cannot be invested, let’s say $1,000. Once you exceed the $1,000 mark, you can choose from a menu of investment options that suit your time horizon and risk tolerance.
The tax deduction up front, the tax free growth, flexibility, and growth opportunity are all reasons why this vehicle is the most powerful vehicle you can utilize for retirement savings. We already know healthcare is going to be a major expense during retirement, so why not get the most bang for your buck when paying for those healthcare expenses and leverage the HSA?!
Anyone who is not enrolled in Medicare and is enrolled in a high deductible health plan is eligible to participate in an HSA. Most of you probably won’t worry about this, but you cannot be listed as a dependent on someone else’s tax return. Some may view the high deductible health plan requirement as a downside, but most high deductible plans still provide your preventative care like annual physicals, child/adult immunizations, screening services and other routine check ups with little to no out of pocket charge. The minimum annual deductible required to qualify as a high deductible is $1,400 for individual coverage and $2,800 for family coverage. Additionally, the maximum out of pocket expense plus deductible needs to be $7,000 for individual plans or $14,000 for family coverage. These are the basic requirements for the health insurance plan in order to be eligible for an HSA. As you can see, the deductible may be slightly higher, but the tax benefits of the HSA contribution alone can help offset that slightly higher out of pocket cost. Furthermore, that tax free compounded growth on your investments makes the high deductible plan worth it in many instances allowing you to build up that retirement health care nest egg.
The list of qualifying medical expenses is very extensive. Chances are, anything that is non cosmetic is likely a qualified medical expense, including costs associated with dental and vision. If the HSA distribution is deemed non-qualified, the funds are taxable and subject to a 20% penalty if you are under the age of 65. Here is a link to a resource that provides a list of all qualified medical expenses: CLICK HERE
Outside of the traditional list, I wanted to point out a few that might not come to mind initially.
This is monumental, given the likelihood of retirees needing long-term care. The most recent statistic is 70% of those 65 and older will need some type of long-term care services during their lifetime. On average, women receive care slightly longer at 3.7 years vs. men at 2.2 years. Given the costs associated with long-term care, it is prudent to incorporate a plan well before you retire, whether it’s buying insurance, “self insuring,” or a combination of the two. For those who decide to buy insurance, you can withdrawal funds from your HSA tax free to pay the premiums, as long as it’s a qualified long-term care policy. Traditional, stand alone, long-term care policies without any cash value features are generally qualified policies, and HSA funds can be tapped to pay these premiums. Hybrid policies, however, are a bit more complex. These hybrid policies combine life insurance with a long-term care benefit, so if you never need long-term care services, typically your beneficiary will receive some sort of death benefit when you pass away. These policies have historically been considered NOT qualified, and HSA funds could not be used to pay these premiums tax free. However, companies are now identifying what is called a “separately identifiable long-term care premium,” which would be allowable as a qualified premium, and therefore HSA funds could be used in this situation. Consult with your insurance agent and tax advisors to ensure you don’t make any mistakes here.
If you decide not to buy insurance, or you plan on buying a small policy and “self insuring” for any additional long-term care costs, an HSA is a home run tool for this pool of dollars. Long-term care services are in fact qualified expenses, and HSA funds can be tapped to pay these costs. It’s estimated that a private room nursing home is upwards of $105k/year in the US (depending on where you live). If you needed to tap $105k/year to pay into a nursing home and only had tax deferred accounts on your balance sheet, such as a 401k, you would need to make distributions in the amount of $125k-$150k/year depending on your tax bracket. On the contrary, a $105k expense is a $105k distribution from an HSA given the tax free nature of these withdrawals.
I wrote an entire article on long-term care planning. If you are interested in reading more, you can use the link HERE.
This would apply to Medicare part B, C and D. However, Medigap policies are not considered qualified expenses. This is important because if you build up a substantial HSA balance, you could guarantee that you will have qualified medical expenses simply by way of being enrolled in Medicare. Additionally, there might be years where your Medicare premiums go up based on your income (think selling a business or real estate property, Required Minimum Distributions etc.), and you can use the HSA to offset that increase in premium.
If your spouse is named as beneficiary when you pass away, your spouse will take over and continue the tax benefits as an HSA. Basically, there are no changes. However, when the HSA is passed to a non spouse (adult child or other beneficiary), the account is no longer an HSA and the full balance is taxable income for that beneficiary. Nobody has a crystal ball, but if you are building significant savings in an HSA, you might want to have a process to make regular reimbursements during retirement so you don’t create a tax windfall for your heirs. Given the flexibility in the timing of reimbursements, you can very easily go back over the years and pay yourself for medical bills incurred in the past. One other final disclaimer on that note. You cannot reimburse yourself from an HSA for expenses that were incurred before that HSA was established! If you set up an HSA in 2015, you can only reimburse yourself for expenses as long as that HSA was established (2015 and beyond).
Medical costs are pretty much a given, so why not take advantage of the IRS tax code and maximize your ability to pay for them now and in the future. If you are young and healthy, I would strongly encourage the use of a high deductible health plan combined with an HSA. If you have concerns about the higher deductible given your medical history or unique situation, simply do the math on the tax savings of making an HSA contribution vs having a slightly higher out of pocket expense for the deductible. Most HSA providers even give you calculators to help you with that math. However, the real power is in the ability to build up a substantial nest egg with tax free compounding and investment opportunity within the HSA. This will allow for you to recognize some tax relief while you are working and contributing, but have another layer of tax free distributions to supplement your retirement income. This is especially true if you no longer qualify for Roth IRA contributions or don’t have a Roth 401k/403b option available at your employer. Even if are are closer to retirement, don’t let that discourage you. You can still max out the HSA contribution every year, invest the funds in a well diversified portfolio, and have a decent account balance to pay healthcare costs in your retirement years.
Be sure to consult with your tax advisors and financial planner before making any changes to your situation. If you would like to schedule a call with me to review your situation and figure out what strategy fits in your overall plan, you can book a “Mutual Fit” meeting by clicking the button below.
The Annual Report on Philanthropy from Giving USA estimates that individuals gave $324.10 billion to US charities in 2020. This was an increase of 2.2% year over year from the 2019 report. Despite all of the negative news the media likes to focus their attention on, America is a very generous country. However, I run into many people that are uncertain about how to maximize the tax impact of their charitable giving. There are a few key points at play.
-It’s estimated that older generations will transfer $70 trillion of wealth between 2018 and 2042 as a result of diligent savings and investing throughout their lifetimes.
-In 2017 the Tax Cuts and Jobs Act passed, which doubled the standard deduction. This is the amount individuals and couples can deduct automatically on their tax return. This led to fewer people itemizing their charitable donations.
-Finally, the SECURE Act of 2019 has increased the tax liability on qualified retirement plans that pass on to the next generation.
As a result of all of these factors, many of my clients are interested in giving to charity during their lifetime, but at the same time finding ways it could improve their tax situation during their life as well as for their heirs. QCD stands for Qualified Charitable Distribution, and DAF stands for Donor Advised Fund. There are other ways to donate to charity by way of private foundations, establishing special trusts or gifting outright. However, this article will focus on QCDs and DAFs as they are the most common solutions I see used for my clientele. I hope you find it helpful!
When you turn 72, of 70 1/2 before 2020, you are required to take a portion of your qualified retirement plans as a distribution by way of the “Required Minimum Distribution,” or RMD. The amount required is based on a life expectancy table published by the IRS. Most individuals use the table below, unless their spouse is sole beneficiary and is more than 10 years younger. The RMD is calculated by dividing your year end account balance as of December 31st, and simply dividing it by the Distribution Period associated with your age. Example: Let’s say your IRA account balance at the close of the previous year (December 31st) was $1,000,000, and you are turning 75 this year. You will take $1,000,000 and divide it by 22.9, which gives you $43,668.12. That is the amount you will be required to withdrawal before the year is over.
You will notice that each year, the Distribution Period becomes smaller, and therefore the amount required to be withdrawn goes up. If you turned 90 with a $1mm IRA, you would be required to withdrawal $87,719.30! This equates to almost 9% of the account balance. One exercise I will run through with my clients well before turning 72 is to calculate their projected RMD each year during retirement, and compare that to how much they will actually spend for their retirement lifestyle. Over time, I often see the RMD increases at a much higher rate than annual spending, therefore creating a surplus in income over time.
A common complaint I hear: “The IRS is making me take out all of this income I don’t need!” If you want to minimize the tax impact on unnecessary withdrawals, thoughtful planning must be introduced years before turning 72. I often tell my clients that retirement income planning begins at least a decade before they retire in order to optimize their financial plan.
All retirement plans including 401ks, 403bs, 457bs, other defined benefit plans and traditional IRAs have RMD requirements. Roth IRAs do not have RMDs while the owner is alive. Roth 401ks, however, do have RMD requirements. Therefore, many people opt to rolling over their Roth 401ks to their own Roth IRA once they have attained eligibility requirements to avoid the RMD.
It’s critical to satisfy RMD requirements, otherwise you will be hit with a 50% penalty on the funds you did not withdrawal on time. Example: If your RMD amount was $50,000 and you failed to take any money out, you could be responsible to pay a penalty in the amount of $25,000!
If you turn 72 and are actively employed, RMDs associated with their employer plan could be eligible for deferral. Any other accounts not affiliated with that active employer will still have an RMD. Once you separate from service from that employer, you will then begin taking RMDs based on your attained age for that year. For your first RMD, you have the option to defer the distribution until April of the following year. This is helpful if you expect your tax rate to go down the following year. Just note that you will have to take two RMDs that following calendar year, one by April 1st, and the other by December 31st.
I have some clients who wait until December to pull their RMD if they don’t have a need for the cash flow. This way they can maximize their tax deferral and keep their funds invested as long as possible before taking the RMD. On the other hand, if you have a need for the income to meet your expenses, you might opt to take an equal monthly installment to reduce the risk of selling out at the wrong time. It also helps create a steady cash flow stream for budgeting purposes in retirement.
A Qualified Charitable Distribution, also known as QCD, allows for you to donate up to $100,000 of your IRA directly to a qualified 501c3 charitable organization. The Protecting Americans from Tax Hikes (PATH) Act of 2015 has made the QCD a permanent part of the IRS code and allows you to count that distribution towards your RMD that year, but exclude it from your adjusted gross income! The QCD must come from an IRA (traditional IRA, inherited IRA, or an inactive SEP or inactive SIMPLE IRA), it cannot come from another qualified plan like a 401k or 403b plan. Of course, the account must also be in the RMD phase.
Example. If your RMD is $100,000, normally you would be required to withdrawal $100,000 from the balance of your IRA and include the distribution in your gross income. However, you could instead elect to donate up to $100,000 to a charity, or multiple charities, directly from your IRA and reduce your taxable income by up to $100,000. Of course, the charity also receives that donation tax free as well. This results in a significant amount of tax savings for the IRA owner and provides a larger donation to the charity of your choosing. Also note that the $100,000 limit is annually per person. If you are married, you would each have that $100,000 limit if you both qualify for a QCD.
This has become increasingly more beneficial with the Tax Cuts and Jobs Act signed into law in 2017 (TCJA). The TCJA doubled the standard deduction which for 2021 is $12,550 for single tax payers and $25,100 for married couples filing jointly. The new law significantly reduced the number of tax payers who itemize their deductions. Charitable donations are an itemized deduction, so if a tax payer is not itemizing their deductions, the charitable donation has zero tax impact to the tax payer. Therefore, the QCD allows for the tax payer to essentially get a tax benefit for donating to charity without needing to itemize their deductions. Excluding the donation from your adjusted gross income could have other tax advantages as it might reduce your Medicare premiums as well as your overall tax bracket.
It’s important to note that the charity has to be a qualified 501c3 organization. You cannot donate to a private foundation or a Donor Advised Fund. However, there is no limit on the number of organizations you donate your QCD to. Most financial institutions allow you to create a list of the organizations that you want to benefit from your donation, and they will send the checks for you directly from the IRA.
Many clients I serve run into what I call the tax trap of traditional IRAs and 401ks. I wrote an article about this and you can read more about it here. The gist is they are the victim of their own success. They saved and invested wisely, and accumulated a bulk of their assets in tax deferred vehicles, among other assets. At RMD age, they are forced to take distributions they may not need, thus creating a negative tax effect (higher tax brackets, higher Medicare premiums, increased social security taxes etc.). QCDs can certainly help alleviate that tax burden for those that are charitably minded. However, you still want to do some planning well before turning 72 to optimize your tax situation. If you plan to donate to charity during retirement, make sure you leave some room in your tax deferred plans to make those QCDs. On the other hand, make sure your RMD’s wont push you into higher than anticipated tax brackets or bump your Medicare premiums up substantially. You may want to consider doing some Roth conversions, or leveraging a Roth 401k option in lieu of a Traditional 401k. The point is, don’t be blindsided by RMD’s, but be intentional well before you begin taking those distributions so you don’t run into the tax trap!
Qualified charities do not pay taxes on distributions. I mentioned the SECURE Act briefly and also wrote about it in more detail in the article I referenced earlier (link here). The important thing to note is that it eliminated the inherited IRA for most non spousal beneficiaries. Therefore, when you leave those 401ks or IRAs to your children, they will be forced to liquidate all of the funds within 10 years, accelerating taxes on those plans relative to the previous law. This is a further validation for not only QCDs for charitable giving during lifetime, but also for naming those charities as a beneficiary for these tax deferred accounts. Instead of leaving those assets to your children for your legacy goals, you may consider leaving other assets such as life insurance, Roth accounts, or taxable brokerage accounts that are more tax advantageous for those beneficiaries. Again, thoughtful planning is critical to provide these opportunities before it’s too late to make any meaningful changes.
A Donor Advised Fund, or DAF, is an opportunity for individuals to donate cash or securities to these specified accounts, potentially recognize a tax deduction, and allow the funds to grow tax free to be used in the future for charitable giving. Unlike donating to a specific charity outright, the DAF can benefit as many charities as the donor chooses. Additionally, I’ve seen clients name their children as successor Donor Advisors in order to teach the next generation how to be a good steward of their dollars. A big advantage of a DAF is the ability to front load donations. As I mentioned earlier, many tax payers are taking the standard deduction given they don’t have itemized deductions that exceed the standard deduction amounts. However, if you plan to donate each year for the next several years to certain charities, you might consider front loading a contribution to a DAF in order to qualify for an itemized deduction, and then spread out the actual donations over several years. Let’s look at an example.
Brenda is married and normally donates $5k/year to a local animal rescue. The $5k donation, along with other deductions, does not exceed $25,100 (standard deduction for married filing jointly). Therefore, that $5k donation is meaningless from a tax standpoint. However, Brenda will continue to donate $5k for at least the next 10 years. She has cash savings in excess of $100,000, so she decides to donate $50k to a DAF ($5k x 10 years), which puts her over the standard deduction limit and gives her the ability to deduct that $50k donation! Going forward, she will make a distribution from the DAF in the amount of $5k/year over the next 10 years to benefit the charity! Additionally, she can choose to invest the dollars in the Donor Advised Fund, so she has the possibility of growing her account balance even more for her charitable goals.
The DAF also allows for contributions from appreciated assets, like stocks, bonds or mutual funds. Let’s say you owned a stock that appreciated $100k over the original value. This is obviously great news, but if you sold the stock, you would include that $100k in your adjusted gross income and would owe taxes. However, if there is no need for that particular security for your retirement or other financial goals, you could donate that security to the DAF without any tax consequences. Additionally, the DAF could sell the security and reinvest it into a more diversified portfolio without incurring any taxes either. This is a powerful tool to utilize for those appreciated securities that don’t have a specific purpose for your own income needs.
It’s very important to note that a DAF contribution is irrevocable. Donors cannot access those funds except when used for donations to a qualified charity. However, there is no time limit on when the funds need to be distributed. Just like any charitable contribution, make sure it aligns with your financial goals and is coordinated with the rest of your financial picture.
If you plan to make financial gifts to charitable organizations, make sure you consult with your tax advisor, estate attorney and of course your financial planner. Make sure your charitable giving is coordinated with your overall plan, and also make sure you take advantage of tax benefits where possible. There are certainly more ways than a QCD and DAF to satisfy charitable goals, so please be sure that you choose the right solution based on your unique circumstances. If you would like to discuss your charitable giving strategy, or other financial goals, you can always start by scheduling a no obligation “Mutual Fit” meeting below to learn how to work with us. We look forward to speaking with you!
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