Archives for August 2016

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A Look at the New 60-Day Rollover Rules

A reader writes in, asking:

“I heard from my financial advisor that the IRS is eliminating the 60-day requirement for rollovers. Is that correct?”

No, that’s not correct. The 60-day requirement is not going anywhere. It’s in the actual Internal Revenue Code itself, and the IRS doesn’t have the power to rewrite our laws.

Let’s start with a bit of background for readers who aren’t familiar with the 60-day rule. When you do a rollover from one retirement account to another (e.g. from a 401(k) to an IRA), you have two options:

  1. You can do a direct transfer in which the money is sent directly from the first custodian to the second custodian, or
  2. You can do an indirect transfer in which the money is sent to you and you then have 60 days (from the date on which you receive the distribution) to get it deposited into the appropriate account with the second custodian.

If you do an indirect transfer, but you fail to get the money deposited within the 60-day window, you have a problem. Specifically, you won’t be able to roll the money into a retirement account, so it will simply count as a distribution (which will usually be taxable, sometimes subject to the 10% penalty, and so on).

The Code does provide the IRS with the ability to waive the 60-day requirement in cases in which “the failure to waive such requirement would be against equity or good conscience, including casualty, disaster, or other events beyond the reasonable control of the individual subject to such requirement.” For example, waivers have been granted in cases in which the taxpayer becomes seriously ill during that 60-day window.

Historically, however, in order to get such a waiver, you would (in most cases) have had to follow the formal process for applying to the IRS for a private letter ruling. And you would then have to wait for the results of such ruling. (And in the meantime, no financial institution would have been able to accept the money as a rollover contribution, since it was outside of the 60-day window.)

The New Rules

Now, however, the IRS has announced (in Revenue Procedure 2016-47) that you will essentially be given the benefit of the doubt (that a waiver will be granted) if you self-certify that you missed the 60-day window for one of several specific reasons listed (e.g., death in the family, serious illness, error on the part of one of the financial institutions). The Revenue Procedure even provides an example letter than you can use to make such a self-certification.

The result would be that:

  • You can file your taxes in keeping with the assumption that the 60-day requirement will be waived (rather than having to report a taxable distribution), and
  • Financial institutions will be able to accept the money as a rollover.

Of note, making such a self-certification does not guarantee the IRS will ultimately grant a waiver. The IRS can still examine your self-certification, and if they determine that the requirements for a waiver were not in fact met, you will not be granted one.

One final point: Despite the above changes, the easiest and safest method for getting money from one retirement account to another is still to opt for a direct transfer.

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

Investing Blog Roundup: Advanced Tax Planning with Muni Bond Funds

We’ve talked before about both tax-loss harvesting and tax-gain harvesting with bonds. This week, author/advisor Allan Roth shares an advanced tax planning strategy using muni bond funds, in which investors can expect to be able to claim a tax loss without actually having incurred an economic loss.

Investing Articles

Other Money-Related Articles

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What Does Present Value Mean?

A reader writes in, asking:

“I’ve recently been using different Social Security calculators to compare claiming strategies. I’ve read that they calculate the ‘net present value’ of benefits received. What exactly does that mean?”

The concept of present value falls under the broader topic of “time value of money.” The idea of time value of money is one that people know intuitively: you would rather receive a dollar today than a dollar at some point in the future. The primary reason why you would (usually) prefer to receive a given amount of money now rather than the same amount of money at some point in the future is that, if you had the dollar today, you could invest it and start earning a return immediately.

The concept of present value asks: what is the value today of a certain amount of money at some point in the future? For example, how much would you be willing to pay today for $100 one year from now?

We answer that question by first figuring out a “discount rate,” which is the rate of return we give up by not having the money available today. For example, if we could safely earn a 3% return over the next year, then our “discount rate” would be 3%. This means that the present value of $100 one year from now would be $100 ÷ 1.03, or $97.09.

For many people, the concept of present value is easier to understand in reverse. In our example, $97.09 is the present value of $100 one year from now, because if we grow $97.09 by 3% for one year (i.e., we multiply it by 1.03) we get $100. So we would be indifferent between having $97.09 today or $100 one year from now.

And, using the same 3% discount rate, what would be the present value of $100 two years from now? It would be calculated as $100 ÷ 1.03^2, or $94.26. (And we can confirm that this figure is correct, because if we grow $94.26 by 3% for the first year and by another 3% for the second year, we do indeed get $100.)

Present Value of a Series of Cash Flows

We can also use the present value concept to calculate the present value of a series of cash flows. For example, what is the present value of an annuity that pays you $10,000 per year for the next 20 years? We would answer that question by calculating the present value of $10,000 one year from now, the present value of $10,000 two years from now, and so on all the way up to 20 years in the future. Then we would add all of those present values together.

And that’s what Social Security calculators are doing. They’re using data about mortality to calculate the present value of the stream of cash flows that you would likely receive with strategy A, and comparing that to the present value of the stream of cash flows that you would likely receive with strategy B.

So What Does Net Present Value Mean?

The net present value of an investment/strategy is the sum of the present values of all of the cash flows received, minus the sum of the present values of all of the cash outflows. In the case of Social Security claiming strategies, however, there are no relevant cash outflows. That is, the cash outflows are the Social Security payroll taxes you pay over the course of your career in order to qualify for a benefit, but those taxes are the same regardless of which claiming strategy you use, so we do not need to include them in an analysis that compares claiming strategies.

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Topics Covered in the Book:
  • How retirement benefits, spousal benefits, and widow(er) benefits are calculated,
  • How to decide the best age to claim your benefit,
  • How Social Security benefits are taxed and how that affects tax planning,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

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Investing Blog Roundup: More 401(k) Lawsuits

Over the last couple of weeks, lawsuits have been filed against a whole list of retirement plan sponsors. As Morningstar’s John Rekenthaler explains, the plans being targeted are not the worst plans around. In fact, they’re better than average. So why are these plans being targeted? And should we expect the lawsuits to result in any improvement for the employees in question — or the industry in general?

Other Money-Related Articles

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Single Premium Immediate Annuity: Why They’re Useful and When to Buy Them

The following is an excerpt from my book Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less.

Many annuities (maybe even most) are a raw deal for investors. They carry needlessly high expenses and surrender charges, and their contracts are so complex that very few investors can properly assess whether the annuity is a good investment.

That said, one specific type of annuity can be an extremely useful tool for retirement planning: the single premium immediate annuity (SPIA).

What’s a SPIA?

A single premium immediate lifetime annuity is a contract with an insurance company whereby:

  1. You pay them a sum of money up front (known as a premium), and
  2. They promise to pay you a certain amount of money periodically (monthly, for instance) for the rest of your life.

For some annuities, the payout is a fixed amount each period — making for a single premium immediate fixed annuity.

For other annuities, the payout is linked to the performance of a mutual fund — making for a single premium immediate variable annuity. For the most part, I’d suggest steering clear of variable annuities. They tend to be complex and expensive. And because they each offer different bells and whistles, it’s difficult to make comparisons between annuity providers to see which one offers the best deal.

In contrast, fixed SPIAs are helpful tools for two reasons:

  1. They make retirement planning easier, and
  2. They allow for a higher withdrawal rate than you can safely take from a portfolio of stocks, bonds, and mutual funds over the course of a potentially-lengthy retirement.

Note: It’s possible to buy a fixed SPIA with a payout that adjusts upward each year in keeping with inflation. Naturally, inflation-adjusted fixed annuities require higher initial premiums than fixed annuities without an inflation adjustment.

Retirement Planning with SPIAs

Fixed SPIAs make retirement planning easier in exactly the same way that traditional pensions do: They’re predictable. If you know that you need $X of income each year in retirement, you can go to an online annuity quote provider, put in $X as the payout, check “yes” for inflation adjustments, and you’ll get an answer: “For $Y, you can purchase an annuity that will pay you $X per year, adjusted for inflation, for the rest of your life — no matter how long you might live.”

Pretty easy, right? You now have a specific figure for the minimum amount of savings necessary to retire safely. With a traditional stock and bond portfolio, retirement planning is more of a guessing game.

SPIAs and Withdrawal Rates

Fixed SPIAs are also helpful because they allow you to retire on less money than you would need with a typical stock/bond portfolio. For example, as of this writing (with interest rates near historical lows), according to Vanguard’s online SPIA quote provider , a 65-year-old male could purchase an inflation-indexed annuity paying 5.35% annually.

If that investor were to take a withdrawal rate of 5.35% from a typical stock/bond portfolio, then adjust the withdrawal upward each year for inflation, there’s a meaningful chance that he’d run out of money during his lifetime. That risk disappears with an annuity.

How is that possible? In short, it’s possible because the annuitant gives up the right to keep the money once he dies. If you buy a SPIA and die the next day, the money is gone. Your heirs don’t get to keep it — the insurance company does. And the insurance company uses (most of) that money to fund the payouts on SPIAs purchased by people who are still living.

In essence, SPIA purchasers who die before their life expectancy end up funding the retirement of SPIA purchasers who live past their life expectancy.

But I Want to Leave Something to My Heirs!

For many people, knowing that the money used to purchase an annuity will not go to their heirs is a deal breaker. It’s perfectly natural to want to leave something to your kids or other loved ones.

The important takeaway here is that, depending on how your desired level of spending compares to the size of your portfolio, choosing not to devote any portion of your portfolio to an annuity could backfire. That is, there’s a possibility that, rather than resulting in a larger inheritance for your kids, the decision results in you running out of money while you’re still alive, thereby causing you to become a financial burden on your kids.

Annuity Income: Is It Safe?

Because the income from an annuity is backed by an insurance company, financial advisors and financial literature usually refer to it as “guaranteed.” But that doesn’t mean it’s a 100% sure-thing. Just like any company, insurance companies can go belly-up. It’s not common, but it’s certainly not impossible, especially given that:

  1. The longer the period in question, the greater the likelihood of any given company going out of business, and
  2. The entire point of an annuity is to protect you against longevity risk (that is, the risk that you last longer than your money). So presumably, we’re talking about a fairly long period of time.

However, if you’re careful, the possibility of your annuity provider going out of business doesn’t have to keep you up at night.

Check Your Insurance Company’s Financial Strength

Before placing a meaningful portion of your retirement savings in the hands of an insurance company, it’s important to check that company’s financial strength. I’d suggest checking with multiple ratings agencies, such as Standard and Poor’s, Moody’s, or A.M. Best. (Note that each of these companies uses a different ratings scale, so it’s important to look at what each of the ratings actually means.)

State Guarantee Associations

Even if the issuer of your annuity does go bankrupt, you aren’t necessarily in trouble. Each state has a guarantee association (funded by the insurance companies themselves) that will step in if your insurance company goes insolvent.

It’s important to note, however, that the state guarantee associations only provide coverage up to a certain limit. And that limit varies from state to state. Equally important: The rules regarding the coverage vary from state to state.

For example, Connecticut provides coverage of up to $500,000 per contract owner. But they only provide coverage to investors who are residents of Connecticut at the time the insurance company becomes insolvent. So if you have an annuity currently worth $400,000, and you move to Missouri (where the coverage is capped at $250,000), you’re putting your money at risk.

In contrast, New York offers $500,000 of coverage, and they cover you if you are a NY state resident either when the insurance company goes insolvent or when the annuity was issued. So moving to another state with a lower coverage limit isn’t a problem if you bought your annuity in New York.

Minimizing Your Risk

In short, annuities can be a very useful tool for minimizing the risk that you’ll run out of money in retirement. But to maximize the likelihood that you’ll receive the promised payout, it’s important to take the following steps:

  1. Check the financial strength of the insurance company before purchasing an annuity.
  2. Know the limit for guarantee association coverage in your state as well as the rules accompanying such coverage.
  3. Consider diversifying between insurance companies. For instance, if your state’s guarantee association only provides coverage up to $100,000 and you want to annuitize $300,000 of your portfolio, consider buying a $100,00 annuity from each of three different insurance companies.
  4. Before moving from one state to another, be sure to check the guarantee association coverage in your new state to make sure you’re not putting your standard of living at risk.

One last point about annuitizing: Even if your only goal is to maximize your spending power, you may not want to annuitize everything. The reason is that annuities cannot easily be sold. And, since it’s always possible that you’ll be faced with a sudden, large expense, it’s usually best to keep a portion of your portfolio in liquid assets: stocks, bonds, cash, and so on.

Simple Summary

  • Single premium immediate fixed annuities can be helpful because they allow for a higher level of spending than would be safely sustainable from a typical portfolio of other investments.
  • In exchange for this increased safety, you give up control of the money as well as the possibility of leaving the money to your heirs.
  • Before buying an annuity, check the financial strength of the insurance company and make sure you’re familiar with the rules and coverage limits for your state’s guarantee association.

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

401k Rollover: Where, Why, and How

The following is an excerpt from my book Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less.

After leaving your job, you’ll have to decide whether or not you want to roll your 401(k) over to an IRA. For the most part, the answer is easy: Yes, roll over your 401(k).

Better Investment Options in an IRA

There’s no question that reducing your investment costs is one of the most reliable ways to improve your investment returns. Unfortunately, many 401(k) plans have only one low-cost investment option: an S&P 500 index fund. (And some plans don’t even have that much!) This forces you to either:

  • Use high-cost mutual funds for the remaining portions of your portfolio (bonds, international stocks, small cap stocks, etc.), or
  • Keep an inappropriately large holding of the S&P index fund in order to keep costs down (thereby throwing your asset allocation out of whack).

In contrast, with an IRA, you’ll have access to a wide array of low-cost investment options in every asset class.

Lower Fees in an IRA

In addition to limiting you to high-cost funds, most 401(k) plans include administrative fees. In contrast, many brokerage firms charge no annual IRA fees at all.

Between less expensive investment options and lower administrative costs, it’s likely that you can reduce your total investment costs by 0.5%-0.75% per year simply by moving your money from a 401(k) to an IRA. That might not sound like much, but when compounded over your whole retirement, improving your investment return by 0.5% can have a significant impact on how long your money lasts.

Try thinking of it this way: If you plan to use a 4% withdrawal rate from your portfolio, paying unnecessary investment costs of 0.5% per year would mean that you can only actually spend 3.5% of your portfolio value — that’s a 12.5% reduction in your ability to spend!

Roth 401(k) Rollover to Avoid RMDs

If you have a Roth 401(k) account, there is an additional point in favor of rolling it over (into a Roth IRA). Specifically, after you reach age 70½, you will have to start taking required minimum distributions each year from your Roth 401(k). In contrast, Roth IRAs do not have required distributions while the owner is still alive. So by rolling your Roth 401(k) to a Roth IRA, you can avoid having to deal with RMDs during your lifetime.

Reasons Not To Roll Over a 401(k)

There are, however, a few specific situations in which it doesn’t make sense to roll over a 401(k) — or other employer-sponsored retirement plan — after leaving your job.

Retiring Early?
If you are “separated from service” (i.e., you leave your job, were laid off, etc.) in a calendar year in which you turn age 55 or older, distributions from your 401(k) with that employer will not be subject to the 10% additional tax that normally comes with retirement account distributions before age 59½.

As a result, if you are 55 or older when you leave your job (or you will turn 55 later that year) and you plan to retire prior to age 59½, it may make sense to put off rolling your 401(k) into an IRA until you are 59½. This way, if you need to spend some of the money prior to age 59½, you can do so without having to worry about the 10% additional tax.

Planning a Roth Conversion?
If you currently have a traditional IRA to which you made nondeductible contributions and you are planning a Roth conversion, you may want to hold off on rolling over your 401(k) until the year after you’ve executed the Roth conversion, so as to minimize the portion of the conversion that’s taxable.

Does Your 401(k) Include Employer Stock?
If your 401(k) includes employer stock that has significantly appreciated in value from the time you purchased it, you’d do well to speak with an accountant before rolling over your 401(k) or taking distributions from the account. Why? Because under the “net unrealized appreciation” rules, you may be able to take a lump-sum distribution of your 401(k) account, moving the employer stock into a taxable account and rolling the rest of the account into an IRA.

Why would such a maneuver be beneficial? Because, if you roll the stock into a taxable account, only your basis in the stock (i.e., the amount you paid for it) will be taxed as a distribution. The amount by which the shares have appreciated in value (the “net unrealized appreciation”) isn’t taxed until you sell the stock. And even then, it will be taxed at long-term capital gain tax rates (currently, a max of 20%) instead of being taxed as ordinary income.

In contrast, if you roll the stock into an IRA, when you withdraw the money from the IRA, the entire amount will count as ordinary income and will be taxed according to your ordinary income tax bracket at the time of withdrawal.

Example: Martha recently retired from her job with a utility company. She owns employer stock in her 401(k). The stock is currently worth $100,000. The total amount she paid for the shares was $42,000.

  • If she rolls her entire 401(k) into an IRA, when she withdraws that $100,000, the entire amount will be taxable as ordinary income.
  • If, however, she rolls the employer stock into a taxable account, she’ll only be taxed upon her basis in the shares ($42,000). And when she eventually sells the shares, the gain will be taxed as a long-term capital gain (at a maximum rate of 20%) rather than as ordinary income.

Remember, though, that holding a significant amount of your net worth in one company’s stock is risky — especially when that company is your employer. Be careful not to take on too much risk in your 401(k) solely in the hope of getting a tax benefit in the future.

And to reiterate, if you think you might benefit from the net unrealized appreciation rules, it’s definitely a good idea to speak with a tax professional to ensure that you execute the procedure properly.

How to Roll Your 401(k) Into an IRA

In most cases, rolling over a 401(k) is just four easy steps:

  1. Open a traditional IRA if you don’t already have one,
  2. Request rollover paperwork from your plan administrator,
  3. Fill out the paperwork and send it back in, and
  4. Once the money has arrived in your IRA, go ahead and invest it as you see fit.

When you’re filling out the paperwork, you’ll want to initiate a “direct rollover.” That is, do not have the check made out to you. Have it made out to — and sent to — the new brokerage firm.

If for some reason the check arrives in your own mailbox, don’t panic. But be sure to forward the check to the new brokerage firm ASAP. If you don’t get it rolled over into your new IRA within 60 days, the entire amount will count as a taxable distribution this year, which would likely result in a hefty tax bill.

Where to Roll Over Your 401(k)

In terms of where to roll over your 401(k), you have three major options. You can roll your 401(k) account into an IRA account at:

  1. A mutual fund company,
  2. A discount brokerage firm, or
  3. A full service brokerage firm.

Rolling a 401(k) into an IRA account with a mutual fund company can be a good choice. As long as you make sure to choose a fund company that has low-cost funds, low (or no) administrative fees for IRAs, and a broad enough selection of funds to build a diversified portfolio, you should do just fine. For example, Vanguard and Fidelity have excellent index funds and would be great places to roll over a 401(k).

Your second option is to roll your 401(k) account into an IRA account at a discount brokerage firm, such as Charles Schwab. Due to the proliferation of exchange-traded funds (ETFs), you can now quickly and easily create a low-cost, diversified portfolio at any discount brokerage firm.

Option #3 — using a “full service” brokerage firm — is one I’d generally recommend against. At these companies, financial advisors will usually try to sell you a portfolio of funds with front-end commissions (a needless cost) or an advisory account with unnecessarily high ongoing fees.

Simple Summary

  • In most cases, it’s beneficial to roll your 401(k) into an IRA after leaving your job. Doing so will give you access to better investment options and will likely reduce your administrative costs as well.
  • If you left your job at age 55 or older (or in the year in which you turn age 55), and you plan to retire prior to age 59½, you may want to postpone rolling over your 401(k) until you reach age 59½.
  • If you’re planning a Roth conversion of nondeductible IRA contributions, you may want to hold off on a 401(k) rollover until the year after your Roth conversion is complete.
  • If you have employer stock in your 401(k), before rolling your 401(k) into an IRA, it’s probably a good idea to speak with an accountant to see if you can take advantage of the net unrealized appreciation rules.
  • In most cases, the best place to roll over a 401(k) is a mutual fund company with low-cost funds or a discount brokerage firm that offers low-cost (or no-cost) trades on ETFs

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."
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