Posts Tagged ‘retirement plans’

Investing in a Retirement Account is Like Taking Out a Loan

Traditional retirement plan contributions come with a loan attached to it with a variable rate of interest, to be determined at a later date by the tax code and your income level. #interestrate #interest #loan #IRS #taxesEver since the FIRE (financial independence/early retirement) movement hit the scene I started to question conventional financial wisdom. 

Most of the advice preached was re-purposed from generations past. A penny saved is a penny earned turned into a variety of frugal anecdotes. You can’t read Proverbs (from the Bible) and not recognize the many similarities in advice. Sound money principles have ancient roots.

For a time the FIRE community welcomed me as one of their own before I stepped back a bit to cut my own path. (No sense in another voice calling out the same message.) I’m still part of the community, but gave myself permission to question the dictums of said community. The hope was to build a bridge from where we are to a higher level.

It also became clear my net worth was near the top of the demographic. This bothered me and caused me to conclude something was wrong.  How could a backwoods farm boy with nothing more than a high school education, a few college courses and a full personal library do better than virtually all within a community so dedicated to wealth?

I don’t trust luck to carry me that far. It had to be something else.

Then I started reading what was published in the tax field and felt a great disturbance in the force. While the advice was fundamentally sound, it also lacked in effectiveness if brought to task. All too often blogs were using IRS publications as their authority. (The IRS is NOT a tax authority; they are a bill collector.) If people followed this advice and the IRS ever challenged (likely with so many people tempting fate) there was a real risk of loss. (If you go to Tax Court and say you used an IRS publication as your substantial authority you lose automatically even of you a right! IRS publications have zero authority in Tax Court.)

Sometimes the math was fuzzy. A blogger might claim a certain level of frugality when it didn’t add up. Some claimed a level of wealth that also didn’t add up. Either the rules of mathematics were suspended or someone was trying to pull the wool over their reader’s eyes.

The biggest area of concern involved retirement accounts. The mantra of filling retirement accounts to the hilt for long periods of time has some obvious issues

Some retirement account problems are less apparent. Everyone keeps saying this is the best thing since sliced bread. But is it? 

So I started running some numbers and it wasn’t as clear as most are led to believe. There was something fundamentally wrong with the advice.

 

Numbers Game

The issue is with traditional retirement accounts (IRA, 401(k), 457, 403(b), Keogh, profit-sharing and cash balance plans); Roth type retirement plans don’t have this issue.

Don't lose your retirement account to hidden taxes. Current tax savings are dwarfed by future taxes on all the gains at the highest rate allowed by law. It's your money! Don't give it to the IRS. #retirement #account #hidden #taxesRoth style retirement plans don’t get an up-front deduction, but grow tax-free. Most financial blogs consider this the best animal in the yard. I agree.

A close cousin — if you qualify for it — is the health savings account where you get a deduction and tax-free growth, to be used for qualified medical expenses. The biggest drawback of the HSA is the amount you can invest annually is relatively small. 

Roth retirement plans are limited in many cases based on income on if the employer has the option in their 401(k) . The maximum Roth IRA contribution is also relatively small. (Exact limits are excluded from this post so changes in the limit don’t distract from the evergreen content.)

The mega-backdoor Roth (a favorite of the FIRE community) allows for sizable Roth contributions with one caveat: it’s probably illegal (according to the IRS). The IRS hasn’t attacked the mega-backdoor Roth because there is no current revenue to be raised by taking such action; Roth investments are not deductible.

However, once these accounts grow in size the IRS could come back and disallow the tax-free advantage, plus interest and penalties. If the IRS has a kind heart (ahem) they could forgo the excess contribution issues which would certainly mean penalties several hundred percent of the entire investment. You decide what course you wish to take. 

The safest retirement plan route means traditional retirement plan investments after you maximized your Roth contributions. Or is it?

 

Loan Document

Traditional retirement plan contributions come with a loan attached to it with a variable rate of interest, to be determined at a later date by the tax code and your income level.

All you debt-free warriors should feel a bit nervous at this point. Just as a mortgage-free home still has loan-like obligations (property taxes, insurance, maintenance), a traditional retirement account has an unannounced interest-like expense and it is a big one.

And this is what disturbed me so much that I had to publish a post on it. 

We all know that traditional retirement accounts get a tax deduction at your ordinary tax rate up to the retirement plan contribution limits. We should also know that these accounts grow tax-deferred and that all distributions are taxed at ordinary rates.

This is a real problem if your goal is to maximize your net worth. In the early years the tax benefit makes it seem like it is the best deal on the planet. But as time passes the math tells a darker tale.

Let’s start with a simple example to get a fundamental understanding of this matter:

Joe contributes $10,000 to his t401(k). This is subtracted from his income on the W-2 and never reaches his tax return. His tax bracket is 30%.

We will disregard actual tax brackets as they change over time and we are more interested in a workable formula for determining the best course currently and for future readers as well.

The good news is Joe saved $3,000 on his taxes this year. However, in 40 years, when Joe retires, he discovers his investment in a broad-based index fund performed as index funds have over long periods in the past: around 7% per year on average. Joe is a very happy man! He now has $149,744.58. 

If Joe were to take the entire amount in one year it would be a fairly large tax. However, Joe decides to take the money out over a number of years. As a result his ordinary tax rate is only 15%. (We will disregard taxes on Social Security benefits and other similar issues to make calculations easier.)

Joe now has a tax bill of $22,462. (Numbers are rounded.) That is $19,462 more in additional tax! Call the 19 grand a tax or anything else you want, but it looks like interest on the $3,000 to this accountant.

Even though Joe saw his tax rate decline by half in retirement he still saw his tax bill increase over 700%. His interest rate would be slightly less than 5.2% annualized in this situation assuming Joe never saw his account value increase after he started taking distributions, an unlikely event.

 

Early Payments

If I approached you and said I would borrow you $20,000 at 5.2% would you take it? Unless you have bad credit that is a high interest rate, especially since it in not deductible. Worse, you can’t make early payments to get out of the deal! You can’t jump ship until you are at least 59 1/2 years old. And if you are stubborn I’ll kick you overboard at 70 1/2. 

The good news is I’m a nice guy and will not do that to you. On the other hand, Congress has passed laws the IRS carries out doing just that.

And we haven’t seen the worst part yet! Retirement plan distribution included in income can cause more of your Social Security benefits to be taxed and can also increase the premium you pay for Medicare once you reach age 65.

A small tax deduction today can do real damage in the future. This is why I say I want multiple tax benefits before I get excited about a tax deduction

All this assumes your tax bracket drops when you retire. Considering the massive government fiscal deficits during a strong economy, it seems to this accountant taxes will go up in the future. And if your income remains high in retirement your tax bracket will also be higher.

Consider this: If Joe had a 30% ordinary tax rate on his retirement plan distributions his taxes would have climbed to $44,923, a full 7% annualized rate. For people with good credit this is a massive interest rate and almost nobody is thinking about this.

 

The Cold Equations

Joe’s example is unfair. First, Joe will put a lot more into his retirement plan over his lifetime, therefore, the damage will be much larger.

Second, retirement plan distributions happen over a number of years. While this might sound like a solution to the problem, it actually makes it worse as the investments continue to grow over time.

Third, smaller account balances experience the same issue only with smaller numbers and that tax rates might be lower due to the lower income level.

Fourth, early retirement does not solve the problem. Yes, you can take a limited amount of money from a traditional retirement account before age 59 1/2 without penalty under Section 72(t). This only reduces the amount of time the money has to grow; it doesn’t resolve the issue.

No matter how you cut it, traditional retirement accounts are best viewed as loans from the government, due in retirement. If you don’t pay the piper, your beneficiaries will.

 

 

Alternatives

Your experience will differ from that of others. You can use the simple example above to determine your implied interest rate assessed as tax in the future. You may discover this isn’t an issue for you. Or, you might need a moment for reflective prayer.

We saw that greed for a current tax deduction produces a 5%+ interest rate loan from the government, payable in retirement. So, what alternatives are there?

The best comparison is doing nothing at all (investing in a non-qualified account). You still invest in the same index fund. Dividends and capital gains are taxed at the lower long-term capital gains (LTCG) tax rate (15% or less for most taxpayers) instead of ordinary rates later (up to 37% federal, plus state income taxes). 

Since the money is outside a traditional retirement account you don’t have to worry about early distributions or required minimum distributions. And if you die your beneficiaries get a step-up in basis the retirement accounts don’t get. Gains on these investments are also taxed at the lower LTCG rate. 

 

Matching

I can hear the complaint already: What if my employer matches?

A valid argument. We’ll go back to Joe again and assume his employer matched his contribution 100%.

Joe invested $10,000 of his own money and his employer matched his retirement plan contribution with another $10,000. 

Joe still gets a deduction worth $3,000 for his contribution. The employer’s match is free money and not taxed until Joe takes the money out.

In total, Joe has $20,000 invested in his retirement account. His account grows to $299,489 in 40 years. The tax on this at a 15% tax rate is: $44,923. 

The initial tax benefit to Joe is $3,000, plus $10,000 from his employer, for a total of $13,000. The implied interest rate in this situation is around 3.15%.

The lesson of this part of the story is that using your employer’s retirement plan up to the match maximum is still a good idea for most. After hitting the matching maximum you might be better served putting the rest into a non-qualified account, however.

 

Smart readers will also be quick to point out the extra tax savings means you have more to invest which mitigates any of the extra taxes owed in the future. This would be true if people actually did that.

When was the last time you invested your tax savings from a traditional retirement account investment? Where did you invest it? Uh-huh. Thought so. You spend the tax savings as most do.

(If you are one of the few who actually pull the tax savings from the family budget and invest it in a non-qualified account my hat comes off to you. You still need to run the numbers to verify the best course of action.)

 

Facts and Circumstances

You can’t read tax law for more than a few minutes before running across the words “facts and circumstances”. And this situation is no different.

The IRS has hidden interest-like charges on retirement accounts. Here is how to avoid them. #avoidtaxes #taxes #retirement #IRS #interestI gave you the tools to build a working plan based on your facts and circumstances. Use a future value calculator to determine the interest rate the tax code is forcing you to pay if you use traditional retirement accounts. 

Employer matching is a real benefit that is diminished by the tax code after very long periods of time. (I would focus on the employer match closely as real value can be found there.)

After the employer match and available Roth retirement plan contributions allowed are exhausted you might find non-qualified accounts the best course of action, for you

The important thing is that you are reading this. That means you are more likely to run your numbers for the best options, for you

There are a lot of factors at play. Index funds still kick out dividends and some capital gains which are currently taxed. This slightly reduced the implied interest rate of the traditional retirement plan if you are prone to investing tax savings. It also assumes you keep your fingers off the pile until retirement. 

The one thing to remember is that deferred taxes frequently come with an implied interest rate paid as a higher future tax.

This is the kind of stuff I think about in the dark of the night. It might also be the prime reason I top the net worth list at Rockstar Finance.

 

 

More Wealth Building Resources

Credit Cards can be a powerful money management tool when used correctly. Use this link to find a listing of the best credit card offers. You can expand your search to maximize cash and travel rewards.

Personal Capital is an incredible tool to manage all your investments in one place. You can watch your net worth grow as you reach toward financial independence and beyond. Did I mention Personal Capital is free?

Side Hustle Selling tradelines yields a high return compared to time invested, as much as $1,000 per hour. The tradeline company I use is Tradeline Supply Company. Let Darren know you are from The Wealthy Accountant. Call 888-844-8910, email Darren@TradelineSupply.com or read my review.

Medi-Share is a low cost way to manage health care costs. As health insurance premiums continue to sky rocket, there is an alternative preserving the wealth of families all over America. Here is my review of Medi-Share and additional resources to bring health care under control in your household.

QuickBooks is a daily part of life in my office. Managing a business requires accurate books without wasting time. QuickBooks is an excellent tool for managing your business, rental properties, side hustle and personal finances.

cost segregation study can reduce taxes $100,000 for income property owners. Here is my review of how cost segregation studies work and how to get one yourself.

Worthy Financial offers a flat 5% on their investment. You can read my review here. 

When Adding to Your Retirement Plan is a Bad Idea

You're retired now; you're not supposed to pay taxes anymore. Simple strategies to avoid taxes on capital gains, retirement distributions and Social Security.Building a large nest egg fast requires fancy footwork involving a high savings rate and avoidance of taxes. At least that is the conventional wisdom. 

But conventional wisdom has been wrong before and even in demographics such as the FIRE* community where the idea of maxing out retirement accounts is practically a religious belief, cracks are beginning to appear.

Less understood are the benefits of NOT investing in a retirement account. Yes, traditional retirements accounts (tIRA and t401(k)) reduce your taxable income while providing tax deferred growth. But when the money comes out it is all taxed at ordinary rates while a similar investment in a non-qualified account will largely have been taxed at the lower long-term capital gains (LTCG) rate, though without any tax deferral.

Other serious issues arise from fully funded retirement accounts. Once you hit age 70 1/2 you must take a distribution from traditional accounts—the dreaded required minimum distribution (RMD). RMDs reduce your ability to control your tax matters which means fewer potential tax credits, higher Medicare premiums and taxation on up to 85% of your Social Security benefits.

 

A Growing Problem

Recently I was a guest on The FI Show podcast. Cody and Justin did a great job prying solid tax information out of me. Things I think are normal problems to deal with are unheard of by the general public. Except the general public will suffer the consequences. And Cody and Justin knew a good story when they heard it. 

The one issue I brought up that shocked most was the size of the RMD some people will face and the catastrophic tax issues involved as a result. I mentioned I have a few clients looking down the barrel of a half million dollar RMD when they hit 70 1/2. This was shocking news, but it shouldn’t be.

The broad stock market averages in the U.S. (S&P 500, for example) tend to increase about 10% per year on average, or about 7% after inflation. (Stocks for the Long Run by Jeremy J. Siegel)  Depending on the time frame covered skews the averages a bit above or below the stated returns so we will use these numbers loosely for illustrative purposes only. 

5 ways to avoid taxes on required minimum distributions. Tax-free retirement income. Why a non-retirement account can be better than a retirement plan.This means if you invest $1,000 today in a broad-based index fund you can expect the investment to double in nominal terms in around 7 years and in real terms every 10 years. 

Here is where the problems begin. A common question from clients is how to add even more to their retirement plans to defer taxes. If the client is in the early stages of building wealth this makes sense. But if a client is 50 with $2 million in traditional retirement plans we need to discuss the issues further before adding to the stack.

Remember, a 50 year old will need to start taking required distributions in 20 years. Since, on average, the investment will double every 7 years in nominal terms the $2 million doubles to $4 million, then to $8 million and then to nearly $16 million when RMDs kick in!

While $2 million sounds like a lot—and it is; trying to save a few more tax dollars today can hurt you a lot later. In the example above the RMD the first year exceeds $500,000! There is not a lot of tax planning I can do for you at that point to help you. It’s required! That means control of your tax situation is reduced to the point of Band-Aide solutions, if that. 

Now I understand you might be younger and have less than $2 million socked away. But the earlier you start (I’m talking to members of my FIRE community here) the bigger the numbers get. If, for example, you manage a mere $100,000 in your traditional IRAs and 401(k) by age 30 and never drop another dime into those accounts and the market just performs average you get 40 years of compounding growth, or almost 6 doublings! 

Visualize the growth. From $100,000 to $200,000 to $400,000 to $800,000 to $1.6 million to $3.2 million to almost $6 million! (Remember we get just shy of 6 doublings.) 

Six million is a smaller problem than our first example, but still an issue. And it assumes you never defer another dime into your traditional retirement accounts.

 

5 Ways to Avoid RMD Problems

Whenever I consult with a client I have to make clear my advice will consider “all years” rather than just “this year”. If my advice saves you money this year but increases your taxes the next or some future year, the benefit is less than it appears up close. 

Traditional retirement plans are just such an example where “all years” planning is so important. A few million in a traditional retirement account with generate adequate RMDs to cover a very ample lifestyle. The drawback is the increased taxes on Social Security benefits and taxes on the RMD at ordinary rates.

When adding to your retirement account can cost you taxes later. Alternatives to retirements plans. Retirement planning for tax-free living.Solution 1

After a certain point (your facts and circumstances will determine that point) it is better to fill your Roth IRA or use the Roth feature of your 401(k). Yes, the Roth gives you no up-front tax deduction. But, the earnings growth is NOT deferred; it is TAX-FREE! 

RMD issues don’t plague the Roth investment the way it does traditional plans. Roth distributions are also tax-free which add flexibility to tax planning in later years. This makes the job for a future Wealthy Accountant working with you to save you money easier. (I assume I’ll retire at some point, if only because I forget to breath one day.) 

Also where traditional retirement plans are a tax nightmare for beneficiaries when you die, the Roth is a much more pleasant experience. 

I’m perplexed when people show reluctance in filling a Roth investment. The tax deduction today in minor compared to the future taxes avoided due to the tax-free nature of Roth growth! Remember, this thing tends to double every 7 or so years. A 25 year old dropping a mere $5,000 into a Roth can expect somewhere around $500,000 at age 70! That means $495,000 tax-free dollars. I’m sorry, I can’t find you a better deal than that. (Not legally, at least.)

Solution 2

There also seems to be a fear amongst some when it comes to investing in non-qualified (non-retirement) accounts. To these people there is something sacrilegious about not getting a deduction and paying taxes as you go. And I can’t understand why.

Think of it this way. When you take money from your traditional retirement plan, the one you got a deduction for up front and enjoyed tax deferral on the gains, you pay tax at ordinary rates which currently top out at 37%. And state taxes can add more.

But your non-qualified plan also enjoys a lot of tax deferral! Index funds are by design tax efficient. This means they are not trading a lot to get incremental gains at the expense of extra taxes. This also means most index funds throw off few capital gains, hence a de facto deferral. Only dividends are currently taxed and most of these are qualified and taxed at LTCG rates. 

The highest LTCG tax rate is 20%. And many will pay 0% tax on LTCGs. (In 2019 a joint return can have income up to $78,750 before LTCG are taxed. And the 20% rate doesn’t kick in until your reach $488,851.) 

Because a lot (most) of your gains are deferred anyway with an index fund and the tax rate is lower when you do sell (compared to traditional retirement accounts) and there are no RMDs or early withdrawal penalties, non-qualified accounts should play a central role in the portfolio of most investors.

The deductible retirement account investment is not the default.

Keith’s Rule 76: If investing in a deductible retirement account doesn’t provide additional tax benefits outside a simple deduction it is probably not worth it.

This means that dropping money into a 401(k) at work needs matching to offset the future losses from higher taxes and RMD issues. It also means you need to consider if a contribution to a traditional retirement account will provide larger credits elsewhere (Education Credits, Saver’s Credit, Earned Income Credit, Premium Tax Credit, et cetera). 

It’s not always a simple calculation. An IRA deduction might not work while profit-sharing in your business might. Facts and circumstances play a vital role. 

Solution 3

Once you reach age 59 1/2 you can start taking money out of your retirement accounts without tax penalty. This makes a lot of sense if you retire early, even if you don’t need the money.

Your income level will determine if this works for you.

By the time you reach 60 you may either have retired or slowed down to part-time or accepted a less stressful, lower income profession. As a result your tax bracket might be zero or something close to it.

With the standard deduction for joint returns now $24,000, many will have ample room to move money from retirement accounts early. If your income is comprised of LTCGs only there is an opportunity to move some money from retirement accounts tax-free.

Remember, joint returns enjoy tax-free LTCGs up to $78,750 of income. If you take a $24,000 distribution from your traditional retirement account and have another $40,000 of LTCGs you would pay zero tax. The standard deduction would cover the retirement distribution and your income would not exceed $78,750 so your LTCGs would also be tax-free.

Take taxes out of retirement. You paid taxes your entire working life. It's about time you got to live without government fingers in your pocketbook.Solution 4

Some of you are hyper-savers and started maxing out retirement accounts at a young age. Now you have $1.5 million and you still haven’t reached the ripe old age of 40. Your RMD issues are going to be huge even if you stop adding to the pile now.

Your reasoning for building such a large nest egg at a young age was so you could take time to be with family and travel.  Enter Section 72(t) of the Tax Code.

Section 72(t) says you can withdraw money at any age from your traditional IRA without penalty if you follow a few rules.

  1. Distributions are based on IRS tables. The larger your account balance and the older you are the more you can access under 72(t).
  2. Once started, you must take the same distribution each year for at least five years or until you reach age 59 1/2, whichever is later. (There are some rules that allow for increasing your distribution each year based on inflation.)

Distributions under 72(t) are taxed as ordinary income without penalty. 

Warning! If you fail to continue taking the required 72(t) distribution for 5 years or until age 59 1/2, whichever come later, all prior distributions under 72(t) are subject to penalty.

Section 72(t) is a powerful tool in tax planning for early retirees. Since your income is lower you effectively get tax-free, or nearly so, distributions while also enjoying potential tax-free LTCGs.

Solution 5

Sometimes I have to pull out all the stops to protect my client. That is why I consider it vital to keep RMDs below a certain threshold if at all possible.

The reason I mentioned on The FI Show podcast a few clients I have facing $500,000+ RMDs is because I lose all control in tax planning with these clients. Which begs the questions: At what level of RMD do I retain at least some control?

Glad you asked.

The answer is: $100,000.

Here’s why.

Under current tax law I can have my client elect to have up to $100,000 of her RMD sent to a charity of her choice and not include it in income.  

This is more important than you think! The ability to not include up to $100,000 in income allows me to potentially access a large sum of LTCGs are low or no tax. It might also allow fewer Social Security benefits to be included in income. 

This strategy allows me to micromanage with the client for an optimum tax outcome. The more room I have to move, the better the magic I can perform.

 

Final Comments

Conventional wisdom is NOT always right! Filling retirement accounts to the brim make for great titles on CNBC and personal finance blogs, but around here we are more interested in workable knowledge. One size does not fit all.

Consider this one last point. A non-qualified account not only enjoys significant tax deferral and lower tax rates on LTCGs, but also opens the possibility to tax-loss and -gain harvesting. Two additional powerful tools in the wealth-builders toolbox.

Always consider your facts and circumstances. I’ve consulted with several thousand clients this past decade and it is rare that any two got exactly the same advice. It is never that easy. Never. The individual is important. You are the most important part of the equation. 

These ideas I shared with you today are only a start. They are the framework to build your financial plan. But the details require the master’s touch.

 

* Financial independence, retire early

 

 

More Wealth Building Resources

Credit Cards can be a powerful money management tool when used correctly. Use this link to find a listing of the best credit card offers. You can expand your search to maximize cash and travel rewards.

Personal Capital is an incredible tool to manage all your investments in one place. You can watch your net worth grow as you reach toward financial independence and beyond. Did I mention Personal Capital is free?

Side Hustle Selling tradelines yields a high return compared to time invested, as much as $1,000 per hour. The tradeline company I use is Tradeline Supply Company. Let Darren know you are from The Wealthy Accountant. Call 888-844-8910, email Darren@TradelineSupply.com or read my review.

Medi-Share is a low cost way to manage health care costs. As health insurance premiums continue to sky rocket, there is an alternative preserving the wealth of families all over America. Here is my review of Medi-Share and additional resources to bring health care under control in your household.

QuickBooks is a daily part of life in my office. Managing a business requires accurate books without wasting time. QuickBooks is an excellent tool for managing your business, rental properties, side hustle and personal finances.

cost segregation study can reduce taxes $100,000 for income property owners. Here is my review of how cost segregation studies work and how to get one yourself.

Worthy Financial offers a flat 5% on their investment. You can read my review here. 

 

Investing Alternatives When Index Funds are Unavailable

Note: This post is not intended as personal or personalized advice. It is provided for informational reference only and is the opinion of the author.

Anyone who has been around the FIRE, leanfire, FI blogosphere, podcasts and book tours know the demographic is heavily invested in index funds and for good reason. Active management’s record tends to be unflattering compared to index peers and with a heavier expense ratio for opportunity to enjoy underperformance.

People serious about building wealth as quickly as possible learn the index fund trick early on. But there are times when index funds are not an option.

Back in the 1990s I was a securities broker with H.D. Vest Financial Services down in Dallas as my broker/dealer. Broker/dealers have an obligation to monitor their brokers so they require all investments of brokers placed though the broker/dealer. Back then it meant actively managed funds only and the expense ratios were a heck of a lot higher back then. There was only one redeeming grace in the deal: all mutual fund trades were commission free with the exception of 12(b)1 fees which generally were 25 basis points of the account’s value. In a way all mutual funds looked like no-load funds for me.

My net worth grew significantly slower during my tenure with Vest. Actively managed funds with heavy fees caused underperformance. My choices were also limited. The worst part is the rule extended to my other businesses and immediate family. Mrs. Accountant and the girls couldn’t invest elsewhere either. Vest even wanted to know where I had money in the bank and a list of all income properties and loans. It was a pain in the tail. Now you know another reason why the dream of schlepping securities wore off fast.

 

Normal People with Abnormal Choices

Stock brokers aren’t the only people with restricted investment choices. Work retirement plans hold a large percentage of all investable funds in most households. 401(k)s and other work retirement plans are notorious for limited choices. The choices are frequently laden with fees driving down performance.

Matching and the ease of regular investing make work retirement plans the best options even when the choices are bad. I’m asked to help clients make the best choice in their 401(k) more than any other request. Most people are clueless to the jargon used to help employees invest their contributions and employer matching wisely.

In my stock broker days my investments were exclusively growth & income funds. Before I knew about index funds front-brain I already knew a basket of successful growing companies throwing off an increasing dividend was a solid decision. The advantage I had was the large basket to choose from. I had my pick of thousands of funds so I had options, even if they were limited to actively managed funds.

Now we need to learn how to pick the best investment from a limited pool. The right choice in your 401(k) could shave years needed to retire and add tens of thousands of dollars to your account value.

 

Needle in a Haystack

Employers offer more retirement plan options than ever before to limit their liability. However, most employers aren’t licensed to give financial advice so they steer clear. Large employers may bring in an investment advisor, but these advisors may not have your best interest at heart and they may not have the time to know you well enough to give quality advice.

Your best defense is knowledge. Certain choices tend to better than others. Specialized funds are almost always the worst choice as they usually have higher fees and are not broadly diversified. Sector funds are a good example. I know of no reason anyone would want a gold fund in their 401(k) portfolio.

International and aggressive growth funds also tend to have higher fees. They can outperform, but they still have a higher mountain to climb to offset the higher fees. All else equal, the lower a fund’s fees the better the long-term results.

Realistically there are only a few acceptable choices for most 401(k) investments. Money markets are out because you have no chance of growing your nest egg. Bond funds are a poor choice in a low interest rate environment and only a small percentage of the portfolio should be in bonds if you are approaching retirement and rates justify a modest investment. Company stock is not diversified and if your employer does poorly your job and retirement are both at risk. Insurance products are almost always the worst of all choices. That leaves broad based funds.

Acceptable choices (in this accountant’s mind) include: growth & income, growth and international or world funds. It is my opinion the largest investment in most 401(k) portfolios should be a growth & income fund when an S&P 500 index or total market index fund isn’t available. Growth & income funds will be the closest choice to an S&P 500 index fund and G&I funds tend to have lower expense ratios than other actively managed funds.

I’m content with one investment in a 401(k). A G&I fund is a diversified choice, grabbing a large slice of large growing companies. But it looks too barren to be correct so people want more. More isn’t always better.

Growth funds are similar to G&I funds with the exception that they can hold non-dividend paying stocks. Amazon is a large growing company that doesn’t pay a dividend. A growth fund can own Amazon; a G&I fund generally cannot.

You may also wish to have international exposure. BP (British Petroleum) is more likely to be in a world or international fund. (Some G&I funds may hold BP.) Toyota is another example. International funds have higher fees due to higher trading costs and travel expenses for the active managers.

G&I funds have the lowest expense ratio of my group followed by growth funds. Fees play such a large role in long-term performance that I have an allergic reaction to more than 10% or so of a 401(k) in an international fund.

If you can’t stand a simple G&I fund in your 401(k) there are a few mixes I approve of:

70% G&I; 20% growth: 10% international, or

80% G&I; 10% growth; 10% international, or

60% G&I; 25% growth; 15% international

Of course you need to modify to your personal situation. (I have to say that for liability reasons. Personally, I can’t think of a better mix than the first choice I offered unless index funds are an option.)

 

A Plethora of Choices

Studies have shown more choices aren’t always better. If you have a dozen choices in your 401(k) you are more likely to take advantage of the 401(k) than if it had 20 choices. The more choices added might reduce employer liability, but it also discourages employees from taking advantage of the 401(k) due to the apparent overwhelming nature of setting up the account.

I’ve seen this first hand in my office. Some employer retirement plans offer a small number of choices, but some come to a rabbit hunt with a bazooka! A hundred choices aren’t needed to offer employees quality choices!

When the stack of papers to sign up for a 401(k) plan exceeds an inch employees are lost. Even I need to spend time digging through the papers before providing reasonable options. Here is what I look for when reviewing employer retirement plan options.

First, most choices are junk. I dump all the specialty funds and insurance products. I’ve yet to see an insurance company fund outperform. The gold and bitcoin funds are removed from the list, too.

Next I separate my choices by investment house. I like Vanguard and Fidelity. If I’m unfamiliar with the investment house, but like the fund option I need to dig deeper. I want to feel comfortable with the investment house as well as the mutual fund.

Then I separate further into categories. I pray for at least one reasonable growth & income fund in the lot. If not, I have to settle for a growth fund.

Last, I review expense ratios. Once again, the lower the fees the higher the chance the fund will perform better. The change in the total stock market value is reflected in all investor accounts, minus fees. Unless you can prove you can outsmart the market, fees are a good determinant of return comparable to the overall market (peers). (Don’t even start with me. Even the pros can’t beat the market consistently.)

From my list I usually pick the fund with the lowest expense ratio with attention paid toward which investment house runs the fund.

 

The Final Choice

Employer retirement plans are often the best tool a person has to accumulate significant wealth. Many employers match contributions at some level. The money is tied up so it is difficult to withdraw; this prevents impulse decisions from ruining your plans. Employers are providing more choices than ever. This is a double edged sword. Move past the psychological deer-in-the-headlights response to a large number of options and hone the list to a workable few choices and then make the choice! Employer retirement plans also make it super easy to invest on a consistent and regular basis, the true foundation of any retirement plan.

Lack of an index fund as an option is no excuse to not invest in an employer retirement plan. Many people face the same problem. I did back in the 1990s and made the best of it. My current net worth would be well into the seven figures lower if I took a pass when I sold securities because of restrictions. The bank would have been a much worse choice.

Of course, you need to modify my suggestions to your personal situation. I think you will find the best choice for you will be very similar to what I propose. No choice is the absolute worst choice! Without investing you will never reach your retirement goals or financial independence!

It’s your life. You can get serious with whatever choices you have or work forever.

 

Wealth Building Resources

Personal Capital is an incredible tool to manage all your investments in one place. You can watch your net worth grow as you reach toward financial independence and beyond. Did I mention Personal Capital is free?

Medi-Share is a low cost way to manage health care costs. As health insurance premiums continue to sky rocket, there is an alternative preserving the wealth of families all over America. Here is my review of Medi-Share and additional resources to bring health care under control in your household.

QuickBooks is a daily part of life in my office. Managing a business requires accurate books without wasting time. Quickbooks is an excellent tool for managing your business, rental properties, side hustle and personal finances.

A cost segregation study can save $100,000 for income property owners. Here is my review of how cost segregation studies work and how to get one yourself.

Worthy Financial offers a flat 5% on their investment. You can read my review here. 

Maximizing Retirement Investments with Multiple Plans

Every so often I say something that starts a firestorm or causes my inbox to overflow. Since the laws of nature state I am one human being and have a limited amount of time to read and answer emails, most emails go unanswered unless from a current client.

It may have been something I said in a podcast or new readers enjoying a deep drink of my lovely prose triggering the question in question. (Yes, I wrote that intentionally.) The latest question storm revolves around retirement plans. The questions are all the same with slight nuances. As a human being with limited time to dedicate to cold call questions, I left most unanswered and the few I did respond to were given quick and to the point answers. And as I fired off these quick answers it occurred to me I misinterpreted the question asked in some cases. A fresh blog post on the subject should clear that up. If not, some ointment might also do the job.

The question stuffing my email is this: Can I have more than one retirement account? My accountant told me I can’t contribute to an IRA if I have a retirement plan at work. Is she right? We will address this line of questioning in a bit. There is a small twist to the question from some readers. Can I have two retirement plans in my business or side gig? I sent many a quick answer as follows: In most cases there is nothing in the Code disallowing such action, but it would be impractical to do so. My answer is wrong! I should have left questions unanswered if I didn’t have time for an adequate response.

The Skinny on Retirement Plans in Your Business

My answer wasn’t completely wrong, just wrong in many cases when you include the facts and circumstances of the questioner’s situation.

A small business can have two retirement plans, just not at the same time! Your side gig may have a solo 401(k), what Fidelity calls a Self Employed 401(k). The side gig may take on a life of its own and employees enter the scene. The solo 401(k) is no longer allowed. You have many options. For example, you might replace the solo 401(k) with a traditional 401(k) or a Simple 401(k) or a SIMPLE IRA. We will leave the characteristics of each retirement plan for another day. Today we will focus on when you can have more than one retirement plan at a time.

What is NOT allowed is a SIMPLE IRA plan and a 401(k) at the same time. Other restrictions exist. For example, a SIMPLE IRA cannot be shut down during the year. You must inform employees the SIMPLE plan will terminate at the end of the year before November 2nd of the current year.

Each retirement plan has its own limitations. The real question I am getting in emails is: Can I stack retirement plans to increase my retirement plan contributions? The answer is yes in most cases, but not within your business.

If you have two employers you can participate in both employers’ retirement plan as long as you don’t exceed the contribution limits. The 401(k) annual contribution limit is $18,000 per year with an additional $6,000 per year allowed for taxpayers age 50 or older.

Another limit facing all taxpayers in the ultimate retirement plan contribution limits of $54,000 annually, $60,000 for taxpayers age 50 and older. This $54,000/$60,000 limit includes the employer’s match! If you plan on maximizing your retirement plan contributions you need to track the employer match as well to avoid exceeding the limit.

If you have a 401(k) at your job you are allowed a solo 401(k) in your side gig or a SIMPLE IRA or other retirement plan that fits your needs as long as contribution limits are not exceeded. There are some limitations if you have ownership in your employer.

Some government employees have a 457 plan. The 457 contributions are not considered salary deferrals so you can load up the 457 plan while simultaneously filling a 403(b) or 401(k) in a side business or separate employer. The $18,000 ($24,000 age 50 and older) applies to the 457 plan and a 401(k)/403(b) plan at a separate employer. In effect, you can drop $18,000 into each retirement account.

The 457(b) plan also has a unique feature for taxpayers age 50 and over and within three years of retirement. Readers in this situation can reader more about the catch-up features of their retirement plan here.

Personal Retirement Plans

The questions that perplexed me the most claimed their accountant said they can’t contribute to an IRA if they have a retirement plan at work. It did not make sense to me at first. Unless limited by the $54,000/$60,000 limit, you can contribute to an IRA even if you have a retirement plan at work. What I think happened was readers misinterpreted what their tax professional said. IRA contributions are allowed, but may not be deductible.

Traditional and Roth IRA contributions allowed begin to phase out as your income increases until no contribution is allowed. However, a spousal IRA may be allowed if only one spouse has employment.

Too Many Choices

I included multiple links in this post rather than muddy this discussion with too many sidebars on separate types of retirement plan rules. The real problem is the number of choices. The reason so many ask about their retirement plan options is because the choices are endless. There are a limited number of plans, but the way the plans can be used produces a mind-boggling amount of choices and restrictions. My office is filled with books on this stuff. The answer is not always as simple as we would like it to be. (If you want to get serious about how retirement plans work, here is one book to start with.)

I think it is a mistake to answer these kinds of questions in a quick fashion as a favor to the reader. A quick, short answer means I didn’t crack open the books and verify what was being asked. This means I probably gave a half answer or worse, an incorrect one.

If I don’t answer an email question, do not be offended. I am not a free tax service so when I answer a quick question it is out of weakness. As this blog grows that weakness is getting crushed and that is a good thing.

There is a better chance I will respond to a comment. Answering the same email 68 times is a poor use of time when I can answer it once for all to benefit from.

It is with heavy heart I must inform you I will no longer answer personal tax questions unless you engage my services. I accept a small number of new clients per year. If you are looking for consulting I have more time available for that. Tax season is already stuffed to the rafters. There is a fee for my time. Rather than try to answer a bunch of questions halfway, I will serve paying clients with a complete answer. Many times I need to do research. I know a lot, but not everything. I open the book often.

Some things to consider: If you want to hire me I require a detailed outline of your questions in advance, plus a copy of your two most current tax returns. I disclose my fee when I offer engagement. It changes from time to time so I stopped publishing my regular fees. Be aware I am not cheap. It’s just a matter of economics. Too many people want me so fees are part of the filtering process.

Consulting conversations are on Wednesday only. I research and run my practice the rest of the week. I dedicate Wednesday to the phone or in person consultations. Be aware I am always scheduled out two months or more for consultations. If you need something this afternoon there is no way I can fit it in.

I love my work and want to serve as many people as possible. To do that I must firm-up my processes. I send all emails to my office manager, Karen, after I give them a quick review. I love compliments, suggestions and concerns I may have said something wrong in a post. I read them all. Karen decides which clients we can take on before contacting them. I accept 3-5 new consulting jobs per week max while I receive over 80 requests per week and growing. Please understand my time constraints.

Finally, I want to let you in on a little secret about tax professionals. When a tax pro prepares a tax return they get paid for the service. Many of these pros feel obligated to answer questions and consult for free because they prepared the return. This is unfair to the tax pro and leads to poor consulting. Tax pros frequently require research. This takes time and time is money. I am not the only good tax guy out there. You become a priority when the work involved includes some income with it. Demand your tax pro invoice you for consulting and demand adequate research connected to the fee-based consulting. This will divert questions from me to highly qualified tax pros in your local community.

Hopefully I whet your appetite on maximizing your retirement contributions today. Use the links to further your education. Use the comments for tax questions and if time permits I will answer your question. You can also contact me if you wish to hire my services. The best news of all: I have no problem working with your accountant to carry out a tax strategy. Once your tax pro knows how to use a tax saving strategy they can spread the good news to all their clients. We need to grow this thing so all middle class Americans get the same high quality tax advice the wealthy do at a price they can afford.