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Retirement Tax Planning Error: Not Planning for Widow(er)hood

One of the most common retirement tax planning errors I see is specific to married couples: not accounting for the tax changes that will occur once one of the two spouses dies.

For example, using data from the SSA’s 2017 Period Life Table, we can calculate that, for a male/female couple both currently age 60 and in average health, there will be, on average, 11.3 years during which only one spouse is still alive. (That is, the expected period for which both spouses will still be alive is 17.4 years, while the expected period for which either spouse will be alive is 28.7 years. The difference between those two lengths of time, 11.3 years, is essentially the expected duration of “widow(er)hood” for the couple.)

Why This Is Important for Tax Planning

When one of the two spouses dies, there is generally a decrease in income, but it’s typically somewhat modest as a percentage of the household’s overall income — especially for retired couples who have managed to accumulate significant assets. What generally happens is that the smaller of the two Social Security benefits disappears when one spouse dies*, but the portfolio income is largely unchanged (unless the deceased spouse left a significant portion of the assets to parties other than the surviving spouse).

And, beginning in the year after the death, the surviving spouse will only have half the standard deduction that the couple used to have. In addition, there will only be half as much room in each tax bracket (up to and through the 32% bracket), and many various deductions/credits will have phaseout ranges that apply at a lower level of income.

In other words, there’s half the standard deduction and half as much room in each tax bracket, but the surviving spouse is left with more than half as much income. The result: their marginal tax rate generally increases, relative to the period of retirement during which both spouses were alive.

The tax planning takeaway is that it’s often beneficial to shift income from those later (higher marginal tax rate) years forward into earlier (lower marginal tax rate) years. Most often that would be done via Roth conversions or prioritizing spending via tax-deferred accounts.

It’s tricky of course because, as with anything dealing with mortality, we don’t know the most critical inputs. To put it in tax terms, how many years of “married filing jointly” will you have in retirement? And how many years of “single” will you (or your spouse) have in retirement? We don’t know. We can use mortality tables to calculated expected values for those figures, but your actual experience will certainly be different.

So it’s hard (or rather, impossible) to be precise with the math. But it’s very likely that a) there will be some years during which only one of you is still living and b) that one person will have a higher marginal tax rate at that time than you (as a couple) had earlier. So, during years in which both spouses are retired and still alive, it’s likely worth shifting some income forward to account for such.

Often the idea is to pick a particular threshold (e.g., “up to the top of the 12% tax bracket” or “before Social Security starts to become taxable” or “before Medicare IRMAA kicks in”) and do Roth conversions to put you slightly below that threshold each year. But the specifics will vary from one household to another. And the decision necessarily involves a significant amount of guesswork as to what the future holds.

*This is a simplification. There can be various factors (e.g., government pension) that would make the total household Social Security benefit fall by an amount more or less than the smaller of the two individual benefits.

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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.

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6 Fixed-Income Options for a Low-Yield Environment

A reader writes in, asking:

“My wife and I are retired. I have approximately 50% of our savings in Vanguard’s Total Bond Market (TBM) fund. The remaining half is a mix of stock funds as well as a few individual stock holdings.

I am worried how that TBM fund will do going forward, especially over what we hope will be a long retirement.

The Federal Reserve says they’ll keep rates low until at least 2023 unless inflation gets above 2%. But 2% annual inflation still adds up over a few decades. And with US government debt exceeding 20 trillion dollars, inflation over 2% can’t be ruled out. What’s the solution here? Low yields abound, inflation risk still a problem, stocks as risky as ever. Is it time to try something other than TBM for fixed-income? Is it time to increase the equity percentage, even though we are conservative investors?”

There are several reasonable options here. And we’ll discuss them.

But the reality is that (with the exception of option #5, in some cases), none of the options are great. In a low-yield environment, there’s no way to get anything other than low expected returns without taking on significant risk. You basically have to accept that fact and conduct your personal financial planning accordingly. In most cases the best response to low expected returns is to change your expectations rather than change your portfolio.

Trying to find ways around this risk/return relationship is how you end up buying complicated/expensive insurance products you don’t understand or buying esoteric investments with risks you don’t understand. (That is, in a low-yield environment, if an investment appears to be offering you a decent expected return and low risks without any other significant downside, you are misunderstanding some aspect of the product in question. Either the expected return is not what you think it is, or the risks are not what you think they are.)

Option #1: Shop for CD Rates

As long as you stay under the FDIC coverage limit, CDs have no more credit risk than Treasury bonds, and they can provide higher yields, if you’re willing to shop around. For instance, as of this writing, 5-year Treasury bonds are yielding 0.26%, while you can find plenty of 5-year CDs with yields of 1.3%.

The primary downside in my opinion is that it’s somewhat of a hassle — not so much the shopping, but moving money from one financial institution to another. And, when each CD matures, if you’re not willing to shop around again and move the money if necessary (i.e., you simply roll the maturing CD into a new CD at the same bank), you’re going to be missing out on potential yield.

Option #2: Take on More Credit Risk

Another option is to take on more credit risk with the fixed-income part of your portfolio, for instance by switching from a “total bond” fund to an investment-grade corporate bond fund. As an example, as of this writing, Vanguard Intermediate-Term Investment-Grade Fund has a yield of 1.51%, as compared to a 1.18% yield from Vanguard Total Bond Market Index Fund.

But there’s no reason to think that this is a “free lunch.” Yes, it means higher expected returns, but with correspondingly higher risk — not necessarily very different from simply shifting your overall allocation slightly toward stocks.

Option #3: TIPS

Treasury Inflation-Protected Securities (TIPS) offer a given after-inflation yield, as compared to most bonds which provide a given nominal (before-inflation) yield. If, like the reader above, you are concerned that an unexpected high level of inflation will consume most of your purchasing power over time, TIPS alleviate that risk.

Today though, TIPS yields are negative (e.g., -0.55% for 20-year TIPS). In other words, if you buy TIPS right now and hold to maturity, your purchasing power won’t keep up with inflation. But at least it won’t lag it by very much per year. (Point being: if inflation turns out to be very high, lagging inflation by just a little bit per year is actually a relatively decent outcome.)

Option #4: SPIAs

For a household concerned about outliving their money in retirement, a single premium immediate annuity (SPIA) is worth considering. As we’ve discussed elsewhere, it’s basically just a pension you purchase from an insurance company.

And because of the risk-pooling aspect of annuitization (i.e., the fact that the income ends when the annuitant dies, and therefore annuitants who live beyond their life expectancy essentially get to spend the money of annuitants who did not live to their life expectancy), they allow you to spend more per year than you could safely spend from a normal fixed-income portfolio.

An important downside of SPIAs is that they carry inflation risk. Because they pay a fixed nominal amount of income, the purchasing power will decline over time — and would decline dramatically in the event of very high inflation.

Some people make the case that buying a lifetime annuity (i.e., a fixed-income product with a very long duration) is not a good idea when interest rates are low. But as others (e.g., Wade Pfau, David Blanchett) have pointed out, the payout from lifetime annuities is actually most attractive relative to other fixed-income products when yields are low — because the portion of the annuity payment that comes from risk pooling (i.e., the “mortality credits”) is not affected by low interest rates.

Allan Roth recently performed an analysis that found that, when using himself as an example, a lifetime annuity actually provided a higher expected rate of return than AAA-rated corporate bonds. (And therefore a considerably higher expected return than a “total bond” fund that includes a substantial allocation to lower-yielding Treasury bonds.) And that’s while also reducing longevity risk, relative to a bond portfolio.

Option #5: Delaying Social Security

Another option for people in the applicable age range is to effectively sell some bonds to “buy more” Social Security (i.e., spend down fixed-income holdings in order to delay filing for Social Security).

This is the only option on this list that is an exception to the above discussion about risk and expected return. The expected return from delaying Social Security does not change based on current interest rates. So when rates are low, delaying Social Security becomes relatively better.

Option #6: Move Some Money to Equities

Finally, there’s always the option to increase your stock allocation. Stocks do tend to earn more than fixed-income. But as with shifting to riskier bond holdings, shifting from bonds to stocks is not a free lunch. And it tends not to really even increase the amount you can safely spend — at least not at the outset of retirement. (Rather, it provides more of an option for increasing spending later in retirement, if stocks do end up providing good returns over the first part of your retirement.)

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."

Implementing and Refining the “Spend Safely in Retirement Strategy”

A couple of years ago, we discussed a paper by Steve Vernon, Joe Tomlinson, and Wade Pfau, which looked at an assortment of retirement spending strategies and evaluated them based on several different criteria. The authors then put forth a strategy that they referred to as the “Spend Safely in Retirement Strategy,” which generally does a good job of satisfying the various (often competing) criteria.

Broadly speaking, the strategy involves creating two sources of retirement income:

  1. A safe floor of guaranteed lifetime income. The authors refer to these as “retirement paychecks.” This includes Social Security, pensions, and annuity income. These retirement paychecks would be used to cover the necessities like housing, utilities, food, transportation, medical care, etc.
  2. A liquid mutual fund portfolio, from which you pay yourself a “retirement bonus” — used for discretionary expenses. The level of spending from this portfolio varies with investment performance.

And again speaking broadly, the strategy has two steps:

  1. Implement the safe floor of income. Usually this means delaying Social Security if you are single or the higher earner in a married couple. Sometimes it means delaying for the lower earner in a married couple as well. And sometimes it means buying an annuity for additional guaranteed income.
  2. For the remainder of the portfolio (the “retirement bonus” portion), invest in a low-cost stock index fund or all-in-one fund (e.g., target-date fund, balanced fund, or LifeStrategy fund). Then use the IRS’s RMD tables to determine how much to spend from this part of the portfolio each year.

This strategy tends to work well as a rough-draft plan, for a few reasons:

  • Satisfying basic needs via guaranteed income minimizes your exposure to investment risk, longevity risk, investment mistakes, cognitive decline, fraud, or mistakes that might otherwise be made after the death of the more financially knowledgeable spouse.
  • To the extent that the guaranteed income is made up of Social Security, your exposure to inflation risk is minimized as well.
  • Using the RMD tables for discretionary spending accounts for the facts that it is wise to adjust spending based on investment performance, as well as the fact that you can safely spend a greater percentage of the portfolio per year the older you are.
  • The plan is reasonably simple and can in many cases be implemented without needing a financial advisor.

Real-World Implementation

But the basic, two-step plan described above (and in the original report) leaves an assortment of open questions. And when it comes time to actually implement the strategy in a real-world situation, you must come up with answers to those questions.

So I was happy to learn recently that the authors released a follow-up paper that addresses those real-life implementation questions one-by-one. (To be clear, the follow-up paper was published last year. I only recently learned about it though.)

The newer paper addresses questions such as:

  • How would you implement the RMD portion of income before the normal RMD age? (In brief: use the same life-expectancy-based calculation that the IRS uses. The authors provide a table with per-year spending percentages.)
  • How would you select an asset allocation for the RMD portion of the portfolio? (In brief: if your basic needs are completely satisfied by guaranteed sources of income, you can afford a stock-heavy allocation with remaining assets. Whether you want to use such an allocation is up to you and your preferences.)
  • How can you plan for the fact that the portfolio-funded level of spending has to vary as the level of income from other sources (e.g., work income or Social Security) changes over time? (In brief: create a “retirement transition fund” — a portion of the portfolio that has been carved off and invested in something like a bond ladder that will be used to fund the additional spending over the years in question.)
  • How can you plan for an uneven desired amount of total spending, such as a desire to front-load spending in the early years of retirement? (The authors propose a few options here. One such proposed method is to multiply the RMD for each year by a factor such as 1.25 or 1.5, which would increase spending early — and thereby result in less spending later, since you’d be spending a percentage of a portfolio that is smaller than it otherwise would have been. They run through a few examples of how such adjustments would have played out, given various assumptions.)

If you have the time, I’d encourage you to give the newer follow-up paper a read — or at least bookmark it for future reading. As I’ve written previously, I think the strategy that the authors describe is a great rough-draft approach to funding retirement spending (i.e., a sort of “cookie cutter” plan, which you can then adjust based on your own circumstances and preferences).

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."

Inflation-Adjusted Annuities No Longer Available: Now What?

A reader writes in, asking:

“I’ve read on Bogleheads that the last insurance company stopped selling annuities with a CPI adjustment, meaning that there’s no nowhere to buy an annuity that has inflation protection. What are the implications for somebody nearing retirement?”

It’s true: sometime in the second half of 2019 (I’m unsure of the exact date), Principal stopped offering inflation-adjusted lifetime annuities, so they’re now unavailable commercially at all, as the other insurance companies that had been offering them stopped a few years ago.

So what impact does this have on retirement planning?

The first thing that comes to mind is that delaying Social Security is now the only option at all to buy an inflation-adjusted lifetime annuity. But I’m not sure how much this actually changes any decision-making, because it was already the case that delaying Social Security was the most desirable option available for somebody looking for safe lifetime income (with the possible exception of the lower earner in a married couple).

If I personally were in that critical stage of “just about to retire or recently retired” my overall plan for funding retirement spending would have looked something like this, back when inflation-adjusted annuities were available:

  1. Higher earning spouse delays Social Security to age 70,
  2. Lower earning spouse delays Social Security until the point at which our safe income satisfies what we consider to be our “necessary” spending,
  3. Buy an inflation-adjusted lifetime annuity if we needed more safe income than what we would get from Social Security if both of us were already planning to file at age 70,
  4. Use primarily stocks for any remaining assets, since such assets would be intended for discretionary spending (i.e., non-necessities).

But, step #3 is no longer an option.

The primary options to consider as alternatives would be Treasury Inflation Protected Securities (TIPS), a nominal annuity (i.e., one with no cost of living adjustment), or some combination of the two.

This is probably a good time to point out that annuities with a fixed annual cost of living adjustment (e.g., 2% per year) are still available. But as we’ve discussed previously, that doesn’t really protect you from inflation. (And in fact they perform worse in inflationary scenarios than annuities without any COLA at all.)

Creating a TIPS ladder would work well in that it creates a predictable, inflation-protected source of spending. But it has the downside of leaving you exposed to longevity risk (e.g., you build a 30-year TIPS ladder but end up living beyond 30 years).

A nominal annuity eliminates longevity risk, but it leaves you with inflation risk.

As for me personally, I have to admit that if I were recently retired, or just about to retire, I’d have a hard time devoting a particularly large chunk of my retirement savings to a nominal lifetime annuity. But it’s worth pointing out that some researchers have found that nominal annuities tended to be a better deal than inflation-adjusted ones anyway (see Wade Pfau’s An Efficient Frontier for Retirement Income, or David Blanchett’s article in Advisor Perspectives last year, for example).

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."

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.

Most annuities 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 a particularly 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.

Retirement Planning with SPIAs

Fixed SPIAs make retirement planning easier in exactly the same way that traditional pensions do: they’re predictable. With such an annuity, you know that you will receive a given amount of income every year, for the rest of your life — no matter how long you might live. 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 with 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 annuity paying 5.88% annually.

If that investor were to take a withdrawal rate of 5.88% from a typical stock/bond portfolio (and continue spending the same dollar amount each year going forward), 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.

Inflation Risk

Another important downside of single premium immediate annuities is that they are exposed to inflation risk. That is, the amount of income that the annuity pays each year is fixed, thereby leaving you with a purchasing power that will be eroded over time via inflation.

It is possible to purchase an annuity with a cost-of-living adjustment (COLA) each year. But that naturally requires paying a higher initial premium. Also, the COLA is a fixed percentage (e.g., the income increases by 2% annually), so you are still exposed to the risk of high inflation eating away at your purchasing power.

Not too long ago, it was possible to purchase a SPIA that had a COLA that was linked to the consumer price index (i.e., the actual rate of inflation), thereby eliminating inflation risk. But in 2019, the last insurance company offering such products decided to stop selling them. Will they be available again in the future? It’s possible, but I wouldn’t count on it.

It’s worth noting that for some people the lack of inflation protection may not be a problem at all. Some people explicitly desire to spend more per year in early retirement than in late retirement. A fixed nominal dollar amount may actually be a good fit for people with such a preference (because it has the effect of front-loading spending, when we measure spending in terms of actual purchasing power).

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. 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 useful tool for maximizing the amount you can safely spend per year. 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

  • If you desire a larger “floor” of safe income than you will receive from Social Security (and pension, if applicable), a single premium immediate fixed annuity may be a good idea.
  • Such annuities allow for a higher level of spending than would be safely sustainable from a typical portfolio of other investments.
  • In exchange for this safety, you give up control of the money as well as the possibility of leaving the money to your heirs.
  • Another drawback of single premium immediate annuities is that they leave you exposed to the risk that inflation will significantly erode your purchasing power over time.
  • 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."

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.

Comparing Investment Options

Reducing your investment costs is one of the most reliable ways to improve your investment returns. Some employer-sponsored plans offer a satisfactory lineup of low-cost choices. For example, federal employees with access to the Thrift Savings Plan can build an extremely low-cost diversified portfolio without needing to take their money anywhere else.

Many 401(k) plans, however, do not provide their participants with low-cost options. If that’s the case with your employer’s plan, that’s a strong point in favor of rolling the money into an IRA, where 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, you may be able to reduce your total investment costs by 0.5% per year (or even more, in some cases) 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 72 (age 70½ for anybody born before July 1, 1949) 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, you will (in most cases) lose the ability to roll it over, and the entire amount will count as a taxable distribution this year.

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 E*TRADE. 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

  • Rolling your 401(k) into an IRA after leaving your job may give you access to better investment options and/or reduce your administrative costs.
  • 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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