Mar 11

I recently read a question from a fellow blogger Briana, who posts at How’s Married Life asking how much she should save to her retirement account each year. As I saw comments come in, for me the larger question wasn’t how much, but simply ‘how.’ Should she save pretax, or post? In the big picture, this question might take second place to the first, after all, the question of how much is such a large factor toward retirement success.

Let’s look at my concern, how she should handle the tax status issue. In her question, she shared her gross salary is $33K.  In 2013, the 15% bracket runs from a taxable $8,925 to $36,250. With no mortgage (yet), I’ll trust she’s taking the standard deduction  of $6100 along with an exemption of $3900. Pretty neat, this adds to exactly $10000 that comes off the top. At this stage of her life, I’m expecting good things in her future, and that includes a higher income.

I suggest that she start now with the Roth 401(k) and Roth IRA for the money she’d like to save. The Roth 401(k) to get the full match her company offers, and the Roth IRA for any more deposits above that. It will take some time before she’s starting to hit the 25% bracket. After all, she would need an income above $46,250 for that to occur when the standard deduction and exemption are included.

As time passes, and she sees her income rise, I suggest monitoring that line on her 1040, “taxable income,” this is the line that tells you what bracket you’re in, and as she slips into the 25% bracket, it’s time to take advantage of the pre-tax retirement accounts as well. Say, she’s finishing her return one March and sees the taxable income is $1000 into the 25% bracket. That’s the time to deposit exactly $1000 into the pre-tax IRA, and start using the pre-tax traditional 401(k) as well just for a portion of her deposits. Say she’s decided to target 10% of her income towards the retirement accounts. It will take $51,389 gross income and a pretax deposit of $5,139 to net that $46,250 I mention was the gross cutoff for the 25% bracket. Keep in mind, that’s in today’s dollars, with today’s tax brackets and current standard deduction/exemptions. These numbers are all inflation adjusted each year and this combination will help shift that target 15% limit as Briana’s income rises. It may take as long as a decade or more for this to occur, which is fine. Ten years of saving post tax money in these accounts before making the shift to pretax savings means her tax burden after retirement will be that much lighter.

The story doesn’t end here. If, and when, she has a new addition to the family, there are more tax deductions that come with the new bundle of joy. Briana may have spent a bit of time fighting off a 25% tax rate only to take a bit of time for maternity leave and drop back to 15% again that year. The good news is that with a bit of planning each year for the year to come you may find the 15% solution works to keep your taxes low while your working and then at retirement when you find your funds have a decent share as post tax Roth flavored money.

On a final note, recent changes in the tax code permit a conversion of 401(k) funds from the pre-tax account to the Roth 401(k). Since matched deposits always are deposited to the pretax traditional side, you’ll still accumulate pretax money over time. If you have extra money you’d invest for the long term and the 401(k) fees are reasonable, it may make sense to do the conversion if you will still be in the 15% bracket. There’s no recharacterization option, so plan wisely.

Briana, I wish you health, happiness,  and wealth. Best of these to you!

written by Joe \\ tags: , ,

Oct 18

fidelity chart

Many articles have been written about the savings you need to have at different ages. In 2009, I wrote my own article Retirement Savings Ratio, which included a spreadsheet to track your own situation. Fidelity recently offered a chart which the New York Times picked up and ran as a story. What’s amazing to me is the numbers are not correct. To be clear, I’m accepting the assumptions Fidelity offers. 5.5% is a pretty conservative growth number, as is a 1.5% annual raise.

Now, when you take the spreadsheet and do a bit of editing, the numbers speak for themselves.

  • Zero out savings from 20 through 24.
  • Change Annual Raise to 1.015 (this is 1.5%)
  • Change percent saved to .15, then manually change the percent to 9 for age 25 and increase 1% each year till age 30
  • The above builds in the 3% employer deposit, so all set there.
  • Annual return is 1.055 (this is 5.5%)

Sorry if this is a bit tedious, but it’s how you can see the numbers for yourself. The result is that the chart underestimates savings by nearly 50% by retirement at 67. From the spreadsheet I wrote:

Age X Salary
25 0x
30 .09x
35 .75x
40  2.91x
45  4.34x
50  6.07x
55  8.18x
60  10.73x
67  15.25x

I was tipped off that something was wrong when I saw linear growth, 1x through 6x every five years. That alone told me these numbers weren’t calculated correctly. Growth over time is exponential, not linear. Don’t believe me, pull a copy of the spreadsheet and run the numbers yourself. Most important, don’t believe everything you read. Unfortunately, I can’t get a copy of the underlying spreadsheet Fidelity used to produce their chart, but you can grab a copy of mine.

Keep in mind, rules of thumb are just that, guidelines that apply to people in the center of a range. Some people retire and find that with 40-50 hours more time each week, are spending far more than they did prior to retiring. Others were saving 20% for retirement, 20% went to the mortgage, and 20% or more to college tuition payments. These folk were living on less than half their income. This article was not about calculating your number but about my observation how one pro got it wrong. A future article will discuss your number in greater depth.

written by Joe \\ tags: , ,

May 31

On a Personal Finance and Money board within the Stack Exchange Network, I’m a frequent poster, answering questions as they come up. On occasion, I’m struck by a question that’s so well thought out, it’s worthy reading in its own right. The question asked was “One should save about 15% of their income for retirement.” What assumptions are tacit in that statement? and the clarification follows:

What assumptions are tacit in the statement that “saving and properly investing 15% of one’s income over a lifetime is a pathway to a successful retirement?”

By this, I mean items along the lines of:

  • Single, married, or single and dating at time of retirement?
  • Retire at 55, 60, 65, 80?
  • 25K/yr income, 50K/yr income, 150K/yr income?
  • That 15% goes to a tax advantaged account? (i.e. 401k, IRA, Roth, your nephew’s 529?)
  • Kids or no kids?
  • Paying for said kids’ college or not paying?
  • 2003 to 2007 returns, 2008 to 2009 returns, or “I averaged the whole S&P500 over 2 world wars and order of magnitude technology advances” returns?
  • Dual incomes the whole time?
  • Making a lot more money at time of retirement, or making about the same money as early to mid career at or about the time of retirement?
  • Renting a house the whole time, or owning a house as early as possible?
  • Obscene ROR’s on that house, or assuming it loses money?
  • Your expenses go down at retirement, stay the same, or go up?
  • Medicare exists? Social security exists? Tax rates go up, down, stay the same?
  • You’ll never get laid off, you might get laid off, you get laid off often?
  • Family helps you out with major purchases, or does not?
  • No, big, or modest inheritance?
  • Live in a cheap area, or live in a “statistically average for costs, land, CPI, wages” area of the US?
  • Taxes go up, taxes go down, taxes stay about the same?
  • Leaving a nest egg when you die? Or, dying broke?
  • Living to the statistical average age of men and women in the US, or, living to be 101.2?
  • Inflation under control? Inflation to the moon? Has it considered deleveraging and deflation?
  • State with an income tax? Or only a state with sales tax?

The truth is that no answer could really address this list. 22 items to consider, each of which might greatly impact the money you’ll need to retire in the manner you’d like. In general, I think many people will prefer a downsize, if they hadn’t done it soon after the kids took off for college. In which case, money for housing expenses might drop and can be used for travel or other things that the retiree might want to do.

What do you think of this list? What’s missing? Is it possible to plan for every variable decades away or does the picture only get clear as retirement gets closer?

written by Joe \\ tags: ,

Apr 17

Some comments are worth highlighting as they make a great Q&A. A question I received on my article Inheriting or Bequeathing an IRA follows:

Dear Joe,
My Mom passed away in December 2011. Her wishes in her Will were for her assets to be divided equally between myself and my 2 sisters. At some point my Mom listed me as beneficiary of her traditional IRA. The custodian has refused to abide by the instructions in the Will as the beneficiary form supersedes the Will. This is in the state of Tennessee. Is there a way to get the balance of the IRA divided 3 ways without cashing it in for a lump sum payout. We all would like to stretch out the payout. If I choose to disclaim a portion of the balance would it go to my Mom’s estate and enable my other 2 sisters to receive their portion? The tax attorney says to talk to the CPA, and the CPA says to talk to the tax attorney….The amount is around $170,000, so the taxes would be substantial on a payout. Any guidance would be appreciated.

Dear Anne,
If you are the listed beneficiary, and there is no other, by disclaiming the money, it would revert to her estate. The five year rule then applies, all funds must be depleted within 5 years after the owner’s passing. I can’t say whether the custodian will permit a partial disclaiming.
If it were me – I’d take the RMDs each year, pay the tax, and gift the siblings their “share.” You can view Pub 590 to see your RMD, but for example, at 50, the divisor to use is 34.2, so 170,000/34.2 is $4971. You can withdraw more if you wish, but be mindful of where you are in your marginal rate.

Right after I posted the response, The Wall Street Journal published Inherited IRAs: a Sweet Deal / A Generous Benefit for Families Survives a Senate Challenge. This is a great article that discusses the benefit of inheriting an IRA along with some of the pitfalls. But the key thing was that the article introduced me to M.D. Anderson, a tax preparer in Chandler, Ariz who has his own site was kind enough to support my advice. M.D.’s response to my request for help follows:

On your reader’s question –

I will generally assume the parent or relative we lost here was older, 70.5 + older is what I will assume in this answer. If THAT is true, there is no 5 year rule but instead, the account can continue to pay out based on the life expectancy of the decedent. Disclaiming with no Contingent beneficiary other than the estate (controlled with or without a Will or Trust) has to be timely done no later than 9 months after the year of death. And, the disclaiming benificiary may not control what happens to the money as well or it would be possibly disqualified under IRS rules.
Of course if the decedent is older than 89 under the newest mortality tables, less than 5 years could apply for year left to pay out while tax deferring and if really old — well the mortality table collapses down to 1 year or less to pay tax on death benefits received.
However, if the person wasn’t yet 70.5 at death, then yes, 5 years is the longest the estate can take to pay out the funds to estate beneficiaries which I assume, are all 3 siblings. Agree, this would equalize minus fees and estate expenses, and help fund the desired result.
But adding in those Executor/trix and statutory percentage of the legal fees, you increase the loss of good money here trying to go that route along with the higher risk a disclaimer action can be questioned by later tax authorities.
So, you got it 100% right in your advice. The gifting idea may be “as good as it gets”, hoping the one designated beneficiary asking these questions isn’t in too high of a tax bracket. The net $ received defeats the stretch potential we have with properly set up inherited/beneficial IRA accounts.
M.D Anderson,

Thanks, M.D. ! There are a few things to learn from all of this. If the mom truly meant to have her three children as beneficiaries of all of her assets, her retirement accounts should have reflected this before her passing. The sibling trying “to make it right” has her work cut out for her given the rules surrounding IRAs and their inheritance. The concept of the IRA and Roth IRA is pretty simple. It’s when the owner passes that things get really messy, and as Anne states above, CPAs and Tax Attorneys even have issues understanding the rules. If you have any questions or concerns regarding your IRA or Roth IRA, why not post a question at my RothMania site and I’ll answer it for you.

written by Joe \\ tags: , ,

Mar 27

Today is a special day in the world of Personal Financial Blogging. As my regular readers know, I’ve expressed mixed feelings about the Roth IRA. When I read articles telling me that a couple converted a million dollars to Roth, slamming themselves into the top bracket (35%, and possibly higher, through the effect of AMT) and then financing the tax due, I realized that some sanity was in order. Level headed discussion about how to best benefit from this type of retirement and not go too far in the other direction. I realized that far more discussion was in the future than I’d want to write in one place as I’m trying to maintain a variety of topics here. So, I planned to launch RothMania, a new blog dedicated solely to the Roth IRA and Roth 401(k) and how they can help you reduce your lifetime tax bill.

Today is the launch of the new RothMania site. Coincident to this, Jeff Rose of Good Financial Cents has coordinated The Roth IRA Movement a day in which Personal Financial Bloggers are all writing articles on the Roth.

At RothMania, to celebrate the occasion I’ll be giving away copies of Ed Slott’s The Retirement Savings Time Bomb. All you need to do to be eligible is ask your question regarding the Roth IRA.

If you are new the Roth, Let me start getting you up to speed. The Traditional IRA typically is funded with pre-tax money. If you are in the 25% marginal bracket, this means you are out of pocket $3750 in order to put away $5000 into your IRA. It grows tax-deferred, but is then taxed on withdrawal. The assumption is that you will be in a lower bracket at retirement and therefore save money. That said, the Roth IRA is the mirror image of this. A Roth lets you deposit money you’ve already paid tax on, but then the growth and eventual withdrawals are not taxed again.

That simple, Joe? Uh, hardly. You see, both flavors of IRA have Phaseouts, where for the traditional, you may not be permitted to deduct the IRA deposit from your income, and for the Roth, where you can’t deposit at all. Then there are the choices that come with being able to convert the traditional IRA to Roth, and the tax implications of these conversions. In the end, there’s no “one size fits all,” but there is a best strategy for each individual situation, and that’s what needs to be determined on a case by case basis. Let’s look at a short few examples of the IRA no-brainer, the times it’s not tough to decide what’s right.

  • You are just above the AGI limit ($112K MFJ, $68K Single) for a Traditional IRA deduction. Time to make that Roth deposit.
  • A dependent child has low income, and would otherwise have no tax due. She can deposit up to the lesser of $5000 or her total income to a Roth, and jump start her retirement savings.
  • A retiree, single, with a 2012 taxable income of $25,000. She can convert from Traditional IRA to Roth enough to get her taxable income up to $35,350. This would tax the difference of $10,350 at 15%, and avoid the potential of having ever increasing RMDs put her into the 25% bracket.

written by Joe \\ tags: , ,