Archives for January 2018

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What *Didn’t* Change as a Result of the New Tax Law?

Quick book-related update: The 2018 edition of Social Security Made Simple is now available (print version here, Kindle version here). The changes are minor, so I’m using the same ISBN as the 2017 edition, which means that the Amazon page will still show the 2017 publication date.

And the writing is finished for the 2018 edition of Taxes Made Simple. My estimate is that the book will be available in roughly 2-3 weeks.

The single topic that readers have asked about most often over the last month or so has been the new deduction for pass-through business income. To my surprise though, there has been another type of email that has been even more common: questions about various things that haven’t changed at all. That is, people want confirmation that certain things weren’t changed by the broad new tax law.

“Is Social Security taxation changing?” (Nope.)

“Has the premium tax credit changed?” (Nope.)

And so on.

So, with that in mind, here’s a non-exhaustive list of things that are essentially unchanged as a result of the new law. (I say “essentially” unchanged, because many of these these deductions/credits/etc. involve dollar amounts that are inflation-adjusted each year. And, going forward, they will be adjusted based on chained CPI-U rather than CPI-U.)

  • The calculation that determines how much of your Social Security benefits are taxable
  • Retirement accounts (aside from the new inability to recharacterize — undo — a Roth conversion)
  • Cost basis tracking/reporting (i.e., the proposed change that would have forced people to use the FIFO method for identifying shares did not occur)
  • The step-up in cost basis that occurs when property is inherited
  • The 3.8% net investment income tax
  • The 0.9% additional Medicare tax for high earners
  • Medicare and Social Security taxes in general (including self-employment tax)
  • Health Savings Accounts (HSAs)
  • Deduction for self-employed health insurance
  • Deduction for student loan interest
  • Itemized deduction for charitable contributions
  • American Opportunity Credit
  • Lifetime Learning Credit
  • Child and dependent care credit (not to be confused with the child tax credit, which has changed, and which in some cases can now be claimed for dependents other than your children)
  • Retirement savings contribution credit
  • Premium tax credit
  • Earned income credit
  • Credit for purchasing a plug-in electric drive vehicle
  • Residential energy credit (for purchasing solar panels or a solar hot water heater for your home)

Hopefully, this should wrap up our discussion of the new tax law — at least for now. I’m looking forward to discussing some non-tax topics in upcoming articles.

For More Information, See My Related Book:

Book3Cover

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

Small Business Entity Selection (2018, New Tax Law)

A reader writes in, asking:

“How does the new tax law affect the decision of how a small business should choose to be taxed?”

As a bit of background, for a business with one owner, the three taxation options are:

  • Sole proprietorship (or LLC taxed as such),
  • C-corporation (or LLC taxed as such), or
  • S-corporation (or LLC taxed as such).

And for a business with multiple owners, the taxation options are:

  • Partnership (or LLC taxed as such),
  • C-corporation (or LLC taxed as such), or
  • S-corporation (or LLC taxed as such).

Sole Proprietorship/Partnership Taxation

As before:

  • Income from a sole proprietorship or partnership is taxed at normal individual income tax rates, and
  • Sole proprietorship income (as well as partnership income if the partner is active in the business) is subject to self-employment tax (i.e., a tax of roughly 15%, to replace the Social Security and Medicare taxes that would be paid by the employee and employer if this were wage income instead).

What’s new is that those individual income tax rates are now, in most cases, lower for a given level of income than they would have been prior to the new law.

In addition, income from such businesses will also qualify for the new deduction for pass-through business income (subject to phaseouts), which makes sole proprietorship/partnership taxation somewhat more advantageous than previously.

C-Corporation Taxation

C-corporations are taxed at their own rate (now a flat rate of 21%, whereas before they had progressive tax brackets like individuals). Then, when they distribute income to shareholders in the form of a dividend, the dividend is taxed at 0%, 15%, or 20% tax rates depending on the taxpayer’s level of taxable income. The dividend may also be subject to the 3.8% tax on net investment income.

Previously, C-corporation tax treatment was not usually advantageous because of this double taxation (i.e., taxation of income at the corporate level, plus taxation of the dividend paid to the shareholders). While the new flat 21% tax rate means that C-corporation income over $50,000 will now be taxed at a lower rate than previously, the overall concept of double taxation still applies. And the net result is that C-corporation tax treatment will still be undesirable for most small business owners.

S-Corporation Taxation

Profit from an S-corporation:

  • Is taxed at individual income tax rates,
  • Qualifies for the new deduction for pass-through business income (subject to phaseouts), and
  • Is not subject to self-employment tax.

In other words, it’s the same as income from a sole proprietorship or partnership, but without self-employment tax.

However, S-corporations are required to pay their owner-employees a “reasonable” level of compensation (i.e., wages/salary) before there can be any profits. And such wages:

  • Are taxed at normal income tax rates,
  • Are subject to regular payroll taxes (i.e., Social Security and Medicare taxes that are essentially the same thing as paying self-employment tax), and
  • Do not qualify as pass-through income for the new deduction.

In other words, the wages themselves are not very tax-efficient. So the savings from S-corporation taxation only kick in once there is enough income from the business to pay a reasonable level of compensation to owner-employees and still have a sizable profit left over.

So, in short, for people whose income level is such that they would be in or below the 24% tax bracket (and therefore unaffected by the phaseouts for the new deduction for pass-through income) sole proprietorship/partnership taxation is now somewhat more appealing relative to S-corporation taxation, because all of the sole proprietorship/partnership income would qualify for the deduction, whereas the wages that the S-corporation would have to pay to the owner-employee(s) would not qualify for the deduction.

Of note, however, is that the opposite conclusion may apply for people in the phaseout range (as well as for non-service business owners who are past the phaseout range). That is, S-corporation taxation may be relatively more advantageous, because it would be advantageous to have the business pay wages to somebody (i.e., the owner-employee), to minimize the impact of the wage-related limit for the deduction.

More than ever, discussing the matter with a qualified tax professional is likely to be advantageous.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less

Topics Covered in the Book:
  • The basics of sole proprietorship, partnership, LLC, S-Corp, and C-Corp taxation,
  • How to protect your personal assets from lawsuits against your business,
  • Which business structures could reduce your Federal income tax or Self-Employment tax,
  • Click here to see the full list.

Investing Blog Roundup: Investing Made Simple, 2018 Edition

Administrative note: There will be no articles next week, to give me more time to work on updating my various books to reflect the recent tax changes. (Publishing every other week may turn out to be the ongoing schedule for a few months.)

Investing Made SimpleOn a related point, the 2018 edition of Investing Made Simple is now available (print version here, Kindle version here). For anybody who hasn’t read the book, it’s exactly what it sounds like: an easy-to-understand, concise introduction to the topic of investing.

As far as the other books, the 2018 edition of Social Security Made Simple is coming along, and I’m in the very early stages of updating Can I Retire and Taxes Made Simple. I have not yet begun work on the two largest projects (i.e., updating the two books about small business taxes).

Recommended Reading

Thanks for reading!

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 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.

A single premium immediate annuity can be a fixed annuity or a variable annuity. With a single premium immediate fixed annuity, the payout is a fixed amount each period. With a single premium immediate variable annuity, the payout is linked to the performance of a mutual fund. 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.

It’s also 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.” (In order to get the most meaningful figure, be sure to get a quote for a SPIA with a payout linked to the consumer price index, rather than one that simply promises a fixed percentage increase from year to year.)

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, even with the low interest rates that prevail as of this writing, according to immediateannuities.com (a website that provides annuity quotes from various insurance companies), a 65-year-old male could purchase an inflation-indexed annuity paying 4.7% annually.

If that investor were to take a withdrawal rate of 4.7% 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—especially given the current environment of low interest rates and high stock valuations. 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 reaching 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, it’s a deal-breaker to learn that none of the money used to purchase an annuity will go to their heirs.

The relevant counterpoint 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 a lifetime 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 Guaranty Associations

Even if the issuer of your annuity does go bankrupt, you aren’t necessarily in trouble. Each state has a guaranty 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 guaranty 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, the guaranty association in Connecticut provides coverage of up to $500,000 per contract owner, per insurance company insolvency. 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 $500,000, and you move to Arkansas (where the coverage is capped at $300,000), you’re putting your money at risk.

In contrast, the guaranty association in 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 guaranty 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 guaranty association only provides coverage up to $250,000 and you want to annuitize $400,000 of your portfolio, consider buying a $200,000 annuity from each of two different insurance companies.
  4. Before moving from one state to another, be sure to check the guaranty association coverage in your new state to make sure you’re not putting your standard of living at risk.

*There are some exceptions. For example, you can buy a SPIA that promises to pay income for the longer of your lifetime or a given number of years. But purchasing such an add-on reduces the payout, thereby reducing the ability of the SPIA to do what it does so well—provide a relatively high payout with very little risk.

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 guaranty 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."

Why Invest in Index Funds?

The following is an adapted, excerpted chapter from the 2018 edition of my book Investing Made Simple: Investing in Index Funds Explained in 100 Pages or Less.

Pay less for a product or service, and you’ll have more money left over afterwards. Pretty straightforward, right? For some reason, many investors seem to think that this rule doesn’t apply to the field of investing. Big mistake.

Index Funds 101

A bit of background: Most mutual funds are run by people picking stocks or other investments that they think will earn above-average returns. Index funds, however, are passively managed. That is, they seek only to match (rather than beat) the performance of a given index.

For example, index funds could be used to track the performance of:

  • The entire U.S. stock market,
  • Certain sectors of the U.S. stock market (the pharmaceutical industry, for instance),
  • Various international stock markets,
  • The bond market of a given country, or
  • Just about anything else you can think of.

Most Actively Managed Funds Lose.

The goal of most actively managed funds is to earn a return greater than that of their respective indexes. For example, many actively managed U.S. stock funds seek to outperform the return of the U.S. stock market. After all, if an active fund doesn’t beat its index, then its investors would have been better off in an index fund that simply tracks the market’s return.

Interestingly, most investors actually would be better off in index funds. Why? Because — due to the high costs of active management — the majority of actively managed funds fail to outperform their respective indexes. In fact, according to a study done by Standard and Poors, for the ten-year period ending 6/30/2017:

  • Less than 15% of U.S. stock funds managed to outperform their respective indexes,
  • Less than 21% of international stock funds managed to outperform their respective indexes, and
  • Less than 23% of taxable bond funds managed to outperform their respective indexes.

Now, lest you think that this particular period was an anomaly, let me assure you: It wasn’t. Standard and Poors has been doing this study since 2002, and each of the studies has shown very similar results. Actively managed funds have failed in both up markets and down markets. They’ve failed in both domestic markets and international markets. And they’ve failed in both stock markets and bond markets.

Why Index Funds Win

The investments included in a given index are generally published openly, thereby making it easy for an index fund to track its respective index. (All the fund has to do is buy all of the stocks — or other investments — that are included in the index.) As you can imagine, implementing such a strategy can be done at a far lower cost than that charged by the average actively managed fund.

Common sense (and elementary school arithmetic) tells us that:

  • If the entire stock market earns, say, a 9% annual return over a given decade, and
  • The average dollar invested in the stock market incurs investment costs (such as brokerage commissions and mutual fund fees) of 1.5%,

…then the average dollar invested in the stock market over that year must have earned a net return of 7.5%.

Now, what if you had invested in an index fund that sought only to match the market’s return, while incurring minimal expenses of, say, 0.2%? You would have earned a return of 8.8%, and you would have come out ahead of most other investors.

It’s counterintuitive to think that by not attempting to outperform the market, an investor can actually come out above average. But it’s completely true. The math is indisputable. John Bogle (the founder of Vanguard and the creator of the first index fund) refers to this phenomenon as “The Relentless Rules of Humble Arithmetic.”

Why Not Pick a Hot Fund?

Naturally, many investors are inclined to ask, “Why not invest in an actively managed fund that does beat its index?” In short: because it’s hard — far harder than most would guess — to predict ahead of time which actively managed funds will be the top performers.

In addition to their “indices versus active” scorecards, Standard and Poors also puts out “persistence scorecards” from time to time. In the most recent one (published June 2017), they found that of the funds that had a top-quartile ranking for the five years ending March 2012, only 22.43% maintained a top-quartile ranking for the following five-year period. Pure randomness would suggest a repeat rate of 25%. In other words, picking funds based on superior past performance proved to be no better than picking randomly!

In another study, Morningstar’s Russel Kinnel looked at the usefulness of expense ratios and star ratings (which are based on past performance) at predicting future performance. Kinnel summarized his findings:

Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance. […] Stars can be helpful, too, particularly in identifying funds that might be merged out of existence.

In other words, past performance can be useful for identifying future poor performers. (That is, the worst performing funds tend to continue to perform poorly, and they are often shut down by the fund company running them.) But if you’re looking to pick a future top performer, picking a low-cost fund is your best bet. And looking for low-cost funds naturally leads to the selection of index funds as likely top-performers.

Taxes Are Costs Too.

If you’re investing in a taxable account (as opposed to a 401(k) or IRA), index funds can help you not only to minimize costs, but to minimize taxes as well. With mutual funds, you pay taxes each year on your share of the capital gains realized within the fund’s portfolio.

Because most active fund managers buy and sell investments so rapidly, a large percentage of the gains end up being short-term capital gains. Because short-term capital gains are taxed at your ordinary income tax rate (as opposed to long-term capital gains, which are currently taxed at a maximum rate of 20%), you’ll end up paying more taxes with actively managed funds than you would with index funds, which typically hold their investments for longer periods of time.

Not All Index Funds Are Low-Cost.

Do not, however, invest in a fund simply because it’s an index fund. Some index funds actually charge expense ratios that are close to — or sometimes even above — those charged by actively managed funds. It’s a good idea to take the time to check a fund’s expense ratio and compare it to the expense ratios of other funds in the same category before investing in it.

When Index Funds Aren’t an Option

Unfortunately, in many investors’ primary retirement account — their 401(k) or 403(b) — they don’t have the option to select any low-cost index funds. If you find yourself in such a situation, my strategy for picking funds would be as follows:

  1. Determine your ideal overall asset allocation (that is, how much of your overall portfolio you want invested in U.S. stocks, how much in international stocks, and how much in bonds).
  2. Determine which of your fund options could be used for each piece of your asset allocation.
  3. Among those funds, choose the ones with the lowest expense ratios and the lowest portfolio turnover. (For funds in your 401(k) or 403(b) this information should be available in the plan documents.)

Simple Summary

  • Because of their low costs, index funds consistently outperform the majority of their actively managed competitors.
  • A fund’s past performance (even over extended periods) is not a reliable way to predict future performance.
  • Not all index funds are low-cost. Before investing in an index fund, take the time to compare its expense ratio to the expense ratios of other index funds in the same fund category.
  • If you don’t have access to low-cost index funds in your retirement plan at work, look for low-cost, low-turnover funds that fit your desired asset allocation.

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) into an IRA. In most cases, the answer will be that, yes, it’s preferable to 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!) This can force 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 500 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 potentially limiting you to high-cost funds, some 401(k) plans include administrative fees, whereas it’s easy to find brokerage firms that will 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.

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?
Alternatively, 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?
Lastly, 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 rate 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. Her total cost basis for the shares is $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 Over a 401(k)

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 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 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 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 (e.g., Edward Jones)—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 usually 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.
  • 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.

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