5 Times a Roth 401k Conversion is a Good Idea

Roth IRAs have become one of the most popular ways to build retirement savings over the years. In fact, they’re so popular that thousands of people clamor every tax season to convert their traditional IRAs to Roth IRAs.

This conversion is one of the most popular financial planning moves, since it can reduce your tax burden and eliminates required minimum distributions (RMDs).

More recently, a new form of Roth account has emerged: Roth 401k plans. Roth 401k plans are essentially the same alternative to traditional 401k plans that Roth IRAs are to traditional IRAs. Contributions are made after tax, and gains and withdrawals are tax free.

And with Roth 401k plans on the scene, many sponsors are starting to allow their participants to convert their traditional, pretax 401k balances into Roth, after tax balances. This transition is known as a Roth 401k conversion.

Roth 401k conversions are not unlike Roth IRA conversions. The transition will create taxable income, but your assets will never leave your employer’s 401k plan.

Here’s how one might work:

Johnny has a $100,000 saved up in his employer’s 401k plan. He didn’t pay any income tax on his contributions, and they will continue to grow tax free until he starts taking withdrawals.
When he starts taking withdrawals after age 59 1/2, he’ll owe income tax on every dollar he takes out of his account.
If Johnny were to convert his 401k contribution to Roth contributions, he would owe income tax on the entire $100,000 this year. His account would continue to grow tax free as it would have otherwise.
But, when he begins taking withdrawals down the road, they won’t be taxable income to Johnny. Essentially, he would be paying his tax burden now instead of later.

Conversions can be appealing. You pay taxes on the account now, rather than in the future when you might be in a higher bracket. But the decision is not always so cut and dry. And since this is a question I get in my practice from time to time, I thought it’d help to share 5 circumstances where a Roth 401k conversion is a good idea.

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5 Baseball Lessons that Apply Perfectly to Investing

I’ve mentioned this before: I’m a big baseball fan.

I played baseball every single spring and summer for 25 consecutive years – ages 5 through 30. From little league all the way through college and 10 years on the adult league circuit, I played first base, outfield, and pitched. To this day I consider myself a devoted baseball “guy.”

As I’ve progressed throughout my career in finance, I’ve noticed a lot of similarities between success in baseball and success in investing. Admittedly, it might be because I think about baseball so much that it’s permeated everything else in my life, and now I can’t keep it out.

But honestly, the way that successful baseball players approach the game is strikingly similar to the way that successful investors manage a portfolio. When it comes to preparation, mental approach, strategy, and execution, many of the factors that drive success in baseball directly apply to investing.

Here’s five of them:

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Does the 4% Rule Still Work?

Recently I had a client come into my office who was concerned about his and wife’s and his retirement.

This client works at a company that sponsors a 401(k), but his wife works for the state and will receive a pension after retiring. My client was concerned that his 401(k) savings wouldn’t be enough to cover their annual living expenses, after accounting for their pension and social security benefits.

“Do we need to save more? I’m not sure we could. We’ve got Danny in college now and our daughter right behind him. I’m just worried we’ll zero out our savings and have to cut back on spending.”

We talked about how much he was saving in his 401(k), and how much that might amount to in 15 years when they planned to retire. But really, the crux of my client’s concern was that he’d spend through his savings too fast after they stopped working.

In his financial plan, we’d originally planned for withdrawals of 3.5% of his nest egg per year. Whatever was left over after he and his wife passed would go to the kids.

“I just think that 3.5% might be too much. I’ve been reading some pretty negative things about the 4% rule recently. 3.5% just seems too close for comfort. What’s your take on it?”

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The Ultimate 7 Step Checklist For Hiring a Financial Advisor

A few years back, I had a friend approach me at a BBQ. He had some questions about how his financial advisor was managing his accounts.

Friend: “Yeah, I just don’t know if this guy is doing the right thing for me. We talk every now and then, he seems like a nice guy, but my portfolio hasn’t really gone anywhere.

Plus, every time we chat he has some brand new investment idea he tries to sell me on. And every single time, he talks up his new idea like it’s the Michael Jordan of portfolio management. (My friend is a big NBA fan). His ideas sound good….I’m just not sure I’m in the right situation. I feel like there’s more going on behind the scenes that I don’t see, but I don’t know what questions to ask.”

Me: “Well how did you find him?”

Friend: “A coworker recommended him. Said the guy made him a ton of money a few years ago.”

Me: “How are you paying him?”

Friend: “Well, I’m not really sure. Everything gets wrapped through the account somehow.”

Me: “OK. Let’s take a step back. Maybe it’d help to identify what you’re looking for in an advisor. If you were starting fresh, what would you like an advisor to help you with?”

Friend: “Hmmm. I guess manage my money and help it grow, make sure I’m on track for retirement, and make sure I don’t run out of money after I stop working.”

Me: “So if you were starting from scratch, what qualities would you look for in an advisor? What criteria would you use?”

Friend: “I really have no idea. I’ve never thought of it that way. Plus there’s about a million financial advisors around here, I get information overload. I guess I’d go with someone I know and like, and seems to have a good reputation. What should I be looking for?”

I had to think about my friend’s question for 10 seconds or so. At the time, I was working at Charles Schwab, but strongly considering starting my own firm.

Me: “I think if I were looking for an advisor, I’d try to find someone who’s competent, trustworthy, unbiased, enjoyable, and looks after for my finances for a fair and transparent price.”

Friend: “Whoa whoa whoa. Slow down with the laundry list. That’s a whole lot of stuff I don’t understand. It sounds GOOD though. I need to tend the grill, but let’s reconvene in a few minutes.”

Coincidentally, this was one of the very reasons I was considering starting my own firm. There are about 300,000 professionals in the U.S. today who call themselves “financial advisors” or “financial planners.” But in my opinion, only a small portion of them have the qualities and service model I’d look for in an advisor.

I’ve had this question come up many times in the years since, and my friend isn’t the only one who’s not sure how to evaluate a potential advisor. And without knowing what questions to ask, how can you be sure you’re finding someone trustworthy and competent?

Because of this, I thought it’d be helpful to build a checklist you can use to evaluate financial advisors & planners. If I were looking to hire someone for help with my finances, these are the exact qualities I’d look for and the exact criteria I’d use. And at the very least, hopefully you’ll be armed with a few good questions to ask.

Click here to download the Ultimate 7 Step Checklist for Hiring a Financial Advisor

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How to Analyze a Variable Annuity

Ever had a variable annuity pitched to you? Maybe you own one. They’re a popular way for many people to mix guaranteed retirement income with the growth potential of equities.

But I’m guessing even if you hold a variable annuity, you’re not 100% sure how it works.

“What are the annual fees again?”

“How does that bonus period work?”

These were a few of the questions a client asked me recently when he was considering a variable annuity.

**Full disclosure – I do not sell variable annuities**

This client just wanted a second opinion. He’d recently met with an advisor who pitched him a variable annuity, and wanted input from an objective source.

My client was in a tough position. He’d just lost his father, and was about to receive a sizable inheritance. He wanted to use this inheritance to produce income throughout retirement, since he was about to turn 60.

He was skeptical about investing in the markets, fearing that another financial crisis would destroy his nest egg. At the same time, he struggled with the idea of buying an annuity. He was attached emotionally to the money since it was coming from his father’s estate, and he didn’t want to fork it over to an insurance company. On top of that, the annuity he was considering was complicated and confusing, and he was feeling a little lost.

After walking through everything together, my client decided to use some of his inheritance to purchase an annuity – but not the one he was being pitched. He opted for a fixed rather than a variable annuity, which he bought with a small portion of the money from his father. He decided to invest the majority of the money in a diversified portfolio geared to produce income.

My client isn’t alone, and I get a lot of questions about variable annuities. Since they have so many moving parts, I wanted to share exactly how I analyze variable annuities using my client’s contract as an example.

There’s a lot of nonsense floating around the internet when it comes to annuities. Hopefully this framework is useful to you if you’re considering buying one.

American Legacy Annuity Analysis

In this video, I’ll analyze the American Legacy variable annuity offered by Lincoln Financial Group, which my client was considering. This specific contract is the American Legacy Shareholder’s Advantage annuity, with the i4LIFE Advantage Guaranteed Income Benefit. I’ll also assume that the Enhanced Guaranteed Minimum Death Benefit (EGMDB) is chosen.

Framework: How a Variable Annuity Works

Before we discuss how to analyze a variable annuity, let’s take a step back and review how they work & where they came from.

Variable annuities have become very popular in the retirement planning industry over the last 25 years. Essentially, they’re a contract between you and an insurance company that guarantee you a series of payments at some point in the future.

There are two phases in a variable annuity: the accumulation phase and the payout phase. What’s unique about a variable annuity is that you invest your contributions during accumulation phase – hence the term “variable.” These investments are known as sub accounts and behave a lot like mutual funds. They are professionally managed and will follow a specific investment strategy described in a prospectus.

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Employee Stock Options: The Top 5 Mistakes That Leave Money on the Table

Employee stock options can be a wonderful form of compensation. Unfortunately, far too many employees leave money on the table when managing them. Here are the top five mistakes you should strive to avoid:

1) Underappreciating Tax Liabilities

There are two types of company stock options: incentive stock options (ISOs) and non-qualified stock options (NQSOs). They differ in structure, who they’re offered to, and how they’re taxed. Here’s a good review of both.

In order to maximize the value of a stock option grant, employees should always try to minimize the resulting tax liabilities. Stock options can be tricky creatures from this perspective since the option grant, exercise, and resulting stock sale can all be taxed differently. Exercising ISOs can even subject employees to the alternative minimum tax (cue shudder). Thus, tax minimization should be a focal point of any long term stock option strategy.

2) Exercising Options and Selling Shares Immediately

Rather than exercising and selling immediately for a profit, it’s almost always better to exercise employee stock options and hold the shares for at least a year. By doing so, the difference between the sale price and strike price is taxed as a long term capital gain instead of ordinary income.

Since long term capital gains are taxed at lower rates than ordinary income, this can be a big tax saving technique. Also, keep in mind that incentive stock options must also be held for two years after the grant date to qualify as long term capital gains.

3) Forgetting About Them Until It’s Too Late

The very worst case scenario is when employees forget about stock option grants and allow them to expire unused. While not nearly as costly, another common mistake is neglecting options until they approach expiration. Allowing the exercise window to close limits your options, thwarting the benefits of a thoughtful long term plan.

Employees should start thinking about their stock option strategy immediately after they’re granted. Starting early leaves you the most flexibility, and the best opportunity to minimize taxes and maximize their value.

4) Neglecting Stock Plan Rules Before Resigning

Most companies force employees to exercise stock options upon termination of employment. Normally they have 90 days to take action, but the window varies from place to place.

This window for stock options will also be different than the windows for severance packages and other benefits, making things a bit confusing. Before tendering resignation, be sure to understand your company’s stock plan and set a strategy accordingly.

5) Failing to Account for a Merger or Acquisition

Mergers and acquisitions affect employee stock options in several different ways. Sometimes vesting schedules accelerate, while in others the existing company’s shares will be phased out and replaced with the new company’s.

When going through a merger, employees should keep abreast of how management is handling their stock plan, and adjust accordingly. If necessary, pester HR for up to date information. The only way to maximize stock option value is to concoct a strategy with up to date data.

72t Distributions: The Ultimate Guide to Early Retirement

What’s the most common piece of retirement advice you’ve ever heard?

I bet it has something to do with tax advantaged retirement savings. Most people are inundated with voices telling them to start saving early and take advantage of tax deferrals. It’s solid advice. Saving tax deferred money through IRAs, 401(k) plans, and other retirement vehicles is a wonderful way to grow your wealth over time. The downside? Those pesky withdrawal penalties. The IRS will typically ding you 10% if you withdraw from these accounts before turning 59 1/2. And if you’re considering an early retirement, this can pose a problem. Fortunately there are loopholes, including taking 72t distributions in substantially equal periodic payments.

Tax Advantaged Savings

The IRS wants us to save for retirement. By allowing us to defer taxes in retirement accounts like IRAs, Roth IRAs, and 401(k)s, the government is essentially begging us to improve our own financial futures.

The catch is that we have to keep our money in these accounts until we reach 59 1/2. Otherwise we’re hit with a 10% penalty, in addition to income tax.

The IRS does provide 9 ways for us to take withdrawals without incurring the penalty:

Take withdrawals after 59 1/2
Roll withdrawals into another IRA or qualified account within 60 days
Use withdrawals to pay qualified higher education expenses
Take withdrawals due to disability
Take withdrawals due to death
Use withdrawals for a qualified first-time home purchase up to a lifetime max of $10,000
Use withdrawals to pay medical expenses in excess of 7.5% of adjusted gross income
As an unemployed person, take withdrawals for the payment of health insurance premiums
Take substantially equal periodic payments pursuant to rule 72t

But it you’re seeking to retire early, you probably don’t want to wait until 59 1/2. And if this is you, most of the loopholes the IRS provides will not apply.

Except for the final loophole, that is. Rule 72t allows you to take withdrawals from your qualified retirement accounts and IRAs free of penalty, IF you take them in “substantially equal period payments” over your lifetime. Here’s how:

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SEC Money Market Reform

Since the crisis in 2008, regulators have paid extra attention U.S. financial markets. Sweeping changes like Dodd-Frank and the Department of Labor fiduciary ruling will change the way Americans save for retirement. While these two examples have received tremendous media coverage, others haven’t. SEC money market reform efforts have important implications, but seem to have flown under the radar. Here’s what you need to know:

Background

Money market funds are a type of mutual fund developed in the 70s, which invest in short term fixed income securities. Their objective is two-fold:

Never lose money
Provide a higher yield than interest bearing bank accounts

The money fund market is comprised of three types: government funds, tax exempt funds, and prime funds. As you can guess, each type describes what securities the fund may invest in.

Government money funds invest in government securities only, and as a result are thought to be the safest of the three types. Tax-exempt funds invest in municipal securities that are exempt from U.S. federal income tax, while prime funds may invest in both corporate and U.S. government debt. So, while government funds may be safer, prime funds normally offer a higher yield in exchange for slightly more risk.

Reserve Primary Fund

Many investors have historically viewed all three types of money market funds as safe alternatives to cash. This view changed during the financial crisis in 2008. At the time, the Reserve Primary Fund was the largest money market fund in America, with assets of over $55 billion.

Being a prime fund, the Reserve Primary invested in an array of corporate debt issues. And in 2008, its portfolio included sizable chunk of securities issued by Lehman Brothers – which wasn’t seen as an overly risky proposition at the time.

As you probably know, the Lehman Brothers investment did not turn out well. Lehman Brothers was in far more trouble than its management let on, and the company eventually went bankrupt and could not repay its debts. This meant the Reserve Primary Fund lost its entire investment in the debt securities, striking a blow to its portfolio value.

Breaking the Buck

The hit was large enough to cause the fund to lose money, as its net asset value fell from a stable $1.00 to $0.97 per share. Also known as “breaking the buck,” only three other money funds had lost money in the 37 year history of money market mutual funds.

The reaction from the fund’s investors was fierce, as the consensus opinion at the time viewed the Reserve Primary Fund as a safe alternative to cash. Investors ran for the exits and demanded millions in redemptions. The fund lost over 60% of its assets in a mere two days, compromising its ability to meet other redemption requests and further spreading market contagion.

To diffuse the situation, the U.S. Treasury Department stepped in and offered to insure money market funds much like the FDIC insures bank deposits. Investors in funds participating in the Treasury’s program would be guaranteed at least a $1.00 net asset value if their fund broke the buck. This support helped limit liquidation pressure, and helped stabilize money markets until the crisis subsided.

SEC Money Market Reform

Unsurprisingly, the government does not want to be in the business of insuring money market funds today. So, the SEC has responded with reforms to help avoid this situation in the future. In July of 2013 the SEC amended Rule 2a-7, which will be enacted in October of 2016 and change the market structure of money funds.

The amendment essentially bifurcates money funds into two broad categories: retail and institutional. The previous classifications of government, tax-exempt, and prime will still exist, meaning that each will be further partitioned into retail and institutional classes.

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The 9 Most Common Small Business 401k Mistakes

It’s no secret that small businesses are often short on resources. And my guess is that keeping close tabs on your 401k plan is not at the top of your to-do list.

As you likely know, sponsoring a 401k plan comes with certain responsibilities, and neglecting them can get you in hot water with the IRS and Department of Labor.

If you’re wondering whether your bases are covered, here are the 9 most common small business 401k issues I see in my practice:

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Buying Bonds vs Buying Bond Funds

Stock markets tend to be pretty good at keeping investors up at night. Peaks, troughs, business cycles, corrections, and crashes are par for the course when investing in stocks. And for many investors this is just a little too much excitement.

For anyone uncomfortable with the risk of investing in stocks, bonds are often the first alternative. They won’t nock knock your socks off with huge returns, but bonds can provide steady income with less risk that your portfolio sours.

But when it comes to buying bonds, investors have a big choice to make: do you buy individual bonds or bond funds.

Unlike stocks, the choice between buying individual securities or a fund that includes individual securities has major implications.

Here’s a quick guide that explains what you need to know.

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