4 Things To Review on Your Retirement Plan During Open Enrollment

Every year after Halloween, time begins to accelerate as the year hurtles through the holidays and to its eventual end. But before you brace yourself for the feasts and family, you have some business of your own to take care of. For most employers, November 1st marks the beginning of open enrollment for company benefits.

While the centerpiece of open enrollment is healthcare benefits, its also a good time to pay some attention to your retirement account. You should revisit your contributions and your investments, consider switching your contributions to a Roth option and update your beneficiaries.

Contributions

Your minimum contribution should be enough to get your company’s match. Most employers require you to contribute 6.0 percent to get the full company match. If you are contributing the minimum, you aren’t saving enough for retirement. Make an effort to increase your contributions this year, and each year from here on out, until you hit the maximum.

The 2018 contribution limits for employer sponsored retirement accounts, such as 401(k)s, has gone up. It is now $18,500 and if you are over 50, you can contribute up to $24,500. If your goal is to contribute the maximum to your account, you may need to adjust your contributions.

Rebalancing

With the stock market up, you may find that you have more money in mutual funds investing in stocks than you intend. Now is a good time to sell some of your stock market investments and buy more conservative investments to rebalance your account to its target allocation. If your company’s plan offers an auto rebalancing feature, where your account could be automatically rebalanced to its target allocation, now would be a good time to turn it on.

Not sure what your allocation should be? Most plans offer help with figuring this out, whether its through planning tools available on the web site or some form of professionally managed investment option.

In the professionally managed category, target date retirement funds are now widely available. You can tell which ones these are, because they have a year in the name of the fund, such as target retirement 2045.

Target date funds are fully diversified investment options. The fund’s manager gradually reduces the fund’s allocation to risky stock market investments as the target date approaches. All you have to do is select this investment option, and your retirement account will be managed in a reasonable way for your age and the time remaining before you stop working.

If your company’s plan doesn’t offer target date retirement funds, they may offer a managed account option. With a managed account option, your investments will be managed for you by an investment adviser based on information you provide, usually through an on-line questionnaire.

If none of these are available to you, one easy rule of thumb is to subtract your age from 120 and invest that percentage in stock mutual funds. Then invest the rest in bond funds.Asset Allocation

Roth Accounts

Now is also a good time to check whether your company offers a Roth retirement account option. Both accounts allow your investments to grow tax free while you are saving for retirement, but they differ in the tax treatment on both the front and back ends.

With a Roth option, your contributions are after tax, whereas with a traditional account, your contributions are before tax. While the before tax contributions make the traditional accounts appealing on the front end, Roth accounts have more advantages on the back end, when you are withdrawing your money.

When you want to spend your money in retirement, withdrawals from a traditional account will be fully taxable, while withdrawals from a Roth account will be fully tax-exempt. The following table shows the advantage of the Roth account over a traditional account with a single year’s contribution.

roth example

Because the growth in your investments will be far greater than your contributions, your tax bill on withdrawal from a traditional account will be higher than the tax advantage you gained on deposit. That makes the Roth option, with no tax obligations on withdrawal, more attractive.

Roth accounts have other advantages. You can withdraw your contributions, though not your earnings, at any time without paying taxes. This comes in handy if you plan to retire before you are 59 ½. You also won’t be required to take a minimum distribution when you turn 70. Finally, withdrawals from a Roth account are not included in your income calculation for determining whether your social security benefits are taxable.

Anyone can contribute to a Roth retirement account through work. There are no income limitations as there are with Roth IRAs. If your employer matches your contribution, they will match your Roth contribution by making a contribution to a traditional account. So you will wind up with two retirement accounts through work.

If you move your balance in your traditional account to the Roth account you will be taxed on the amount transferred, so don’t do that unless you’ve checked with a tax professional and know what you’re in for. However, your future contributions can go toward a Roth account.

Beneficiaries

Review your beneficiaries. Regardless of any other documents you may have, such as a will, financial institutions rely solely on your beneficiary designations to distribute your account in the event of your untimely demise.

If your spouse has changed, make sure your prior partner is not still your beneficiary. Do not make minor children beneficiaries, because financial institutions cannot distribute money directly to them until they turn 18. Consider establishing a family trust, and making it your beneficiary, to allow your children’s guardians easier access to the money needed to raise your kids.

There is no time like open enrollment to focus your attention on financial matters. Before things get hectic with the holidays, take advantage of this annual checkpoint to make sure you are on the right track with your retirement benefits. Your work related retirement plan may well make up the bulk of your retirement savings, so take advantage of what is available to you.

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The Stock Market is at Record Highs. Should You Get Out?

Both the Dow Jones Industrial Average and the S&P 500, the venerable U.S. stock market indices, closed near record highs on Friday, October 13th. Both indices have been steadily climbing all year. The Dow, including dividends, is up 17.92 percent and the S&P, also including dividends, is up 15.86 percent just this year.

The run up has investors waiting for the other shoe to drop. Surely the next move can only be down. Every week there are articles discussing whether we are on the verge of another stock market bubble bursting. You’ve worked hard for your savings, and nothing is worse than seeing a big hole in the value of your nest egg. So should you sell your stock market investments to avoid that?

To see how it might turn out, look at what happened following the last stock market peak, in September of 2007, just before the financial crisis. If you had perfect foresight you would have sold then, and avoided the following drop in value of 51 percent. Then you would have bought back your investment at the low in February of 2009. By now your investment would have more than tripled.

But let’s be realistic. We only have perfect hindsight. We know nothing about the future. We can’t tell whether we are at a peak or just a nice view point along the way. And we certainly won’t be able to tell when the market has hit bottom.

To get a sense of what most investors did following the stock market peak in 2007, we can look at investor net buys or sales of mutual funds and exchange traded funds investing in the stock market during the time period. In the following chart, fund net buys (actually sales because they are negative) are in blue and the S&P 500 Total Return Index is in orange.

Funds flows and performance

Yes, investors began taking money out of the stock market as it began to decline from it’s highs. But they continued to take money out even as it rebounded. As the market surpassed it’s previous peak investors were still withdrawing money. It wasn’t until the end of 2012 that stock funds began to see steady net buys.

The biggest monthly net sale was in October of 2008 and the biggest monthly net buy following that was January of 2013. If you had sold and bought back in those months your return from September of 2007 through October 13, 2017 would have been just 11.89 percent, or about 1.3 percent per year.

Even being off by a few months would have cost your returns. If you didn’t sell until December 2007 and didn’t buy until May 2009, your money would have only doubled instead of tripled. If you had waited another six months on both ends, your money would be only 1.5 times more than at the 2007 peak.

What if you had done nothing? If you had not touched your stock market investments, by now your money would have more than doubled. Doing nothing is certainly easier than picking both the top and bottom of the stock market. Steadily adding to your investments, as you would in your retirement account, would have been even better.

Where stock market declines become devastating is when you have to withdraw your money during the decline to meet expenses.  To avoid that, don’t invest any money you will need to spend in the next ten years there. Anything that you won’t need for more than ten years can stay invested in the stock market. Historically, the S&P 500 has finished higher than it started in 26 out of every 27 ten-year periods.

Of course there will be another market down-turn. But no one knows when or how severe it will be. In the mean time you need your savings to grow for your long term goals, like retirement. So no, don’t get out of your stock market investments now and in fact keep adding to them. If you have more than ten years before you need to spend your money, you have plenty of time for your savings to recover from the next down-turn, whenever that is.

Sources: Yahoo Finance S&P 500 Total Return Index and Data Hub US Investor Flow of Funds

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Ten Ideas to Change Your Thinking About Saving Money

This is my 100th post. I sincerely thank everyone who has read them either directly on my blog, or on Linked In, Facebook or Twitter. These posts have had over 3,000 visits, and there are now around 500 fabulous followers.

To mark the occasion, I considered giving 100 tips for saving, or 100 ways to reduce debt or something of that nature. But I realized even if I could come up with that many, no one would make it past the first ten anyway. So you get ten.

Of all of the things I’ve written about personal finance, the topic of changing your mindset toward saving may be the most powerful. So, here are ten different ways of thinking that will help you achieve your financial goals.

  1. Saving money isn’t natural. People have all sorts of natural tendencies, but saving money isn’t one of them. If you are not a natural saver, there isn’t anything wrong with you, nor should you allow that to be your excuse. Saving is a learned behavior, and anyone can learn it.
  2. Financial security has more to do with what you have than what you make. While having a good income certainly makes life easier, building savings is the only way to make life financially secure. Having savings gives you the flexibility you need to meet life’s opportunities and challenges.
  3. Saving is more important than how you invest. The best investment strategy will not allow you to achieve your financial goals unless you are saving enough to begin with.
  4. Life is about trade offs. You can do anything you want, but you can’t do everything you want. If you spend money on one thing, you can’t spend it on another. If you spend more than you make today, you can’t spend as much tomorrow, and if you don’t save money now, you will have to save much more in the future. Conversely, saving money today is worth multiples of what you save down the road.
  5. Spend with intention. Money is only as good as what you do with it. By all means, spend money on what is important to you. That includes both today, and making sure you have enough to do the same in the future. Maximize what you have to spend on the important things by minimizing what you spend on the unimportant ones.
  6. Goals are the first step toward success. The only way to get what you want is to decide what that is. While big goals are important, don’t discount the value of the small goals that lead up to the big ones. Achieving your retirement savings goals starts by achieving your monthly savings goals.
  7. Be prepared to reach your goals. You can’t get where you’re going without a road map. Know what is required to achieve your goals. Lay out the specific things that you will do as well as the things that you won’t. Track your progress frequently and adjust your plan as needed.
  8. Commitment is half the battle. Commit to your goals and your process. Simply calendaring an action or telling someone else about your intentions will greatly increase your chance of getting it done. Write down and/or discuss with someone close to you both your plans and how you expect to achieve them.
  9. A budget is a plan for how you spend, not a diet for your money. A budget is more about planning to achieve your goals than giving things up. It is a way to document the steps that you will take. Every month you stay on budget is a month you are closer to your ultimate goal, and that is an achievement in and of itself.
  10. Be grateful. As the interfaith scholar David Steindl-Rast once said, “it is not joy that makes us grateful; it is gratitude that makes us joyful”. Gratitude helps you appreciate your life as it is, and it helps you avoid the temptation to compare what you have to what others have.

It can be hard to move forward without changing how we think about our lives. I hope these 100 posts have informed and inspired you to think differently about how you can reach your financial goals. Please keep coming back, because I’ll keep writing.

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Who Robbed Social Security?

The Social Security Trust Funds are estimated to be depleted by 2034. Were they robbed? I’ve heard a variety of versions of this story. Essentially many believe the Trust Funds were diverted/robbed to pay for other government programs leaving future retirees high and dry.

The fact is the Social Security Trust Funds have received every dollar they were entitled to receive under the laws that govern the program, and no money from the Funds was ever used for anything but the payment of benefits. So why will they run out of money in just seventeen years?

Over the decades since Social Security was created, we, the American people fought tooth and nail against tax increases that would have kept the Trust Funds afloat and were happy to see benefits extended beyond those in the original design. As a result Social Security has been severely underfunded. If anyone robbed Social Security it was us.

The two funds, the Social Security Disability Income Fund and the Social Security Old Age and Survivor Insurance Fund together help support 60 million people; 43 million retired people and their dependents, 6 million survivors of deceased people and 11 million disabled people.

In 2023 when the Disability Income Fund is depleted, the tax revenue supporting the program will only be able to pay 89 percent of the benefits, and in 2035 when the Old Age and Survivor Insurance Fund is depleted, the tax revenue will only support 77 percent of projected benefits. Most analysts implicitly assume the Old Age and Survivor Trust will be tapped to fund disability payments, bringing the projected life of the two together to 2034, 100 years after Social Security’s conception.

When Franklin D. Roosevelt first considered creating a social insurance program in 1934, he envisioned a self supporting system, similar to an insurance contract, where contributions for a worker would be collected over his or her lifetime and invested. The contributions and investment interest combined would provide the funding to pay out the worker’s benefit at the end of their work life.

Of course this wasn’t possible in the early years of the program, because it would be decades before a worker would have contributed enough for a fully funded benefit. Therefore the early payments had to be funded from the contributions of those still working.

The new law included a schedule of tax increases to be implemented over time to make the program self-funding. Without the tax increases, the system was projected to require government subsidization by 1980.

When Social Security was implemented the benefit payments were cheap relative to the tax revenues that were being collected.  In 1940, there were more than 159 workers for every beneficiary. As a result, congress didn’t see any harm in pushing the tax increases back as well as expanding the program.

By 1955, we were down to nine workers for every beneficiary, and the ratio of workers to beneficiaries steadily declined from there. Sure enough, just as predicted, the system was in dire straights by 1977.

After two rounds of tax increases and increases in the full retirement age in the 1980s, congress secured some breathing room. But with the baby boomers retiring in droves and after a decade of low interest rates, that breathing room turned out to be shorter than anticipated.

In order to solve the problem, an immediate tax increase of 2.6 percent or an immediate reduction in benefits for all current and future beneficiaries of 16 percent (or some combination of the two) is necessary. Yet fixing Social Security is blatantly off the current administration’s agenda.

Social Security is once again in dire need of a fix, and few who are still working have confidence that the program will be there for them. Yet we continue to demand that our politicians avoid tax increases and changes in benefits for the worse. As the time when we have no choice but to severely curtail benefits draws nearer, keep in mind that we are only getting what we asked of our politicians. The only thieves in the Social Security heist are us.

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Save Early, Save Often

The fact that it is better to start saving for your eventual retirement when you are young is common knowledge. It doesn’t take a financial wizard to understand that if you start saving early you have more years to save, and therefore you will wind up with more money. Yet, this doesn’t capture the true power of saving early. The real power comes in having your money work for you longer, though this is hard to imagine without a demonstration.

Suppose you graduate from college and are offered a job paying $45,000 per year. Your mom is like me, and advises you to save ten percent of your earnings in your company’s 401(k) plan. You set up your account to have ten percent automatically contributed. Your plan offers a target date retirement fund, so you pick the one with a date 45 years in the future and never think about it again.

Target date retirement funds are fully diversified investment funds designed to be appropriate for the time you have until you retire. They generally have fund names that include the approximate date you will stop working. In this case the name might be Target Retirement 2060. They start out nearly fully invested in the stock market but gradually become more conservative as the time remaining until you retire gets shorter. Target retirement funds are one stop funds, so you don’t need other types of investments.

With a modest inflation rate of two percent per year, your salary and contributions increase over time, but never exceed $11,000 per year. Because you have chosen a target retirement fund, you are largely invested in the stock markets for most of your working career, giving you the best opportunity for growth. Assume your investments have an average annual return of 7.0 percent until you are 57. As the fund gets more conservative, your returns drop down to 5.0 percent for the rest of your career. Given all this, you will wind up with about $1,475,000 which is just about what you will need added to your social security benefits to maintain your lifestyle.

Your contribution to your nearly one and a half million dollars? $335,000. You only had to contribute less than a quarter of your balance. The remaining three quarters plus came from your money working for you. The amount of time it works for you is key to how much you have to save.

Let’s say instead, because of student loans or whatever, you don’t start contributing to your 401(k) until you are 32. After all, you still have 35 years to save. That should be good enough.

You can accumulate the same amount of money, but your contributions have to be much bigger. In every year you contribute, you need to contribute nearly three quarters more than you would have if you started saving at 22. That’s money you could use to save for your kids college education, or to take family vacations. Your total contributions to your balance is $494,000, $159,000 more than had you started saving ten years earlier. Still it’s not bad. You only have to contribute a third of your total balance.

OK, after you paid off your student loans your kids were in day care. Then they had sports and clubs you had to pay for. The dust finally doesn’t settle until you are 42. At last you have a little extra money to save in your 401(k). Unfortunately you need to contribute a lot of extra money to your account to save up the same amount. Your annual savings need to be more than three times your contributions had you started saving at 22. You have to contribute almost half of the $1,475,000. The following graphs compare the three situations.

retirement savings

Nobody’s life goes like these examples, but they demonstrate the point. Saving early on is very powerful. The more time your money has to work for you, the less you have to save. That is why other financial goals need to take a back seat to saving for retirement. If you wait, you may get around to doing what you need to eventually, but you will have to give up much more of your income to do it.

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Home or Retirement?

The housing market in many areas of the country has seen dramatic increases in prices over the last five years. Home prices in coastal metro areas, like Portland, seem to be on fire. If you don’t already own a home, your hopes of buying one may be dimming as each month brings higher prices. It takes time to save up for a down payment, especially with today’s housing prices. Should you take the money you’ve stashed in your retirement savings and use it to buy a home?

Using the S&P/Case Shiller 20 City Composite Home Price Index, home prices have risen, on average, nearly 8.0 percent per year since the bottom of the housing market in 2012. The fast pace of price increases was at least partially due to the depths of the decline in the market. Since the last peak in housing prices in 2006, nationwide home values are still down. Longer term, home price appreciation has been much more modest. Nationwide, since 1980, home values have only increased 3.6 percent per year. Even in trendy Portland, prices are up just 4.7 percent per year. So values are unlikely to continue to run at the pace of the recent past.

Still it’s hard to not want to jump in for fear of being priced out of the market altogether, especially if you have enough money for a down payment sitting in your retirement account. But raiding that account is not the answer.

Depending on the account type there are limitations to what you can do. If you withdraw your money from a traditional 401(k) or IRA, you will have to pay taxes on the balance you take out, and you may also pay a tax penalty.  You could borrow money from your 401(k), but you can only borrow the lower of $50,000 or half of your balance.

If you have a Roth IRA, you can withdraw your contributions at any time, however if you withdraw earnings on your contributions before age 59½ you will pay both taxes and a penalty. Roth 401(k)s have similar rules, plus many employer plans limit withdrawals while you still work for your company, though loans are still an option.

If you take a loan from your 401(k), you will make monthly payments, and those payments are not considered contributions to your plan. So, unless you make a contribution and a loan payment, you will miss out on the employer match if your company offers one. Loan interest is paid to you, but the interest rate is generally lower than the return you can expect from growth oriented investments available in your plan. And if you leave your job before the loan is paid, you will have to repay the loan in full or pay taxes and penalties as if the loan were a distribution.

Let’s say you have the best situation possible. You have a Roth IRA account with a balance of $100,000, and you can withdraw enough to cover your down payment without triggering taxes. You have three choices. You can continue to save in your Roth IRA and at the same time save for a down payment for your home. You can stop making your Roth IRA contributions and use the money to add to your savings for a down payment on a home, or you could withdraw the down payment from your Roth IRA.

With option one, your retirement account will continue to grow as before. But the cost of the home you want to buy will continue to rise, and given how low interest rates are today, you will likely pay higher interest on your mortgage loan. With option two, your balance won’t grow quite as fast, because you aren’t adding money to your account. With option three, you buy today with a down payment withdrawn from your IRA. You put a big dent in your retirement savings, but your home price will appreciate and you can lock in today’s low interest rates.

To figure out which option is best, I’ve calculated the combined retirement plan balance and home equity twenty years from now using some assumptions. I’ve assumed home values will increase on average 3.6 percent per year for the next 20 years, but over the next five years they grow at a somewhat faster pace of 4.0 percent per year. Using a modest home in my neighborhood (1,100 sq ft) as an example, today’s purchase price is $390,000, but in five years, the same house would be valued at $474,000. Today’s 30 year mortgage rate is 4.25 percent, and I’ve assumed rates rise to 6.25 percent over the next five years.

I’ve also assumed that you would ordinarily save $5,500 (the maximum for 2017) per year in your IRA. The average annual return on your IRA investments over the next 20 years is 8.0 percent, because you are still young and investing primarily in stocks. The following chart shows the results.

home v retirement

In option one and two, you put off buying the home for five years while you save up the down payment. In option one you are able to save for both. In option two you opt to not add to your IRA, but you don’t take anything out either. In both cases you pay a higher price for the house and higher interest rates, because you have to wait five years. In option three, you take out enough from your IRA to cover the 20 percent down payment on the home today, leaving you with about $22,000 in retirement savings.

You do have more home equity in option three, but your retirement account has taken a nasty hit. The value is only half what it would have been if you hadn’t touched the balance and continued to make the contributions. Even if you stopped contributing to your IRA while you save for a down payment, you would be better off than if you raided it today.

To raise a down payment for the house in question, you would need to save about $19,000 per year to be able to buy it in 5 years with the assumptions I’ve made. To recover from raiding your IRA, you would need to save the same amount above your normal $5,500 contribution over nine years, or $171,000 instead of $95,000.

As tempting as it might be to use the savings you’ve already built for retirement for a down payment on a home, in the end you won’t come out ahead. You need that balance to grow for you as long as possible. Dipping into those savings takes valuable time away from growing your account. As hard as it may be, you will still be better off saving for your home, even in the face of rising prices.

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Never Too Late

Maybe you’ve been spending the last several years paying down your student loans. Maybe you took some time off to stay home with the kids while they were young, keeping you from saving. Perhaps tough times kept you out of a job and decimated your nest egg, or you simply let time pass without thinking about the future. Is it too late to rescue your financial security?

It is never too late to do something to ensure that you can pay your bills and be happy when you do stop working for pay. True the sooner you begin saving for the future, the more choices you will have, but there are always choices.

Take Ben and Jeanette. Ben is in his early sixties. He would love to be able to stop working and spend more time riding his motorcycle and seeing the National Parks with Jeannette. Work is a hassle. The commute is long. But with too little saved for retirement, giving up work just now is out of the question.

It’s not that Ben and Jeanette didn’t save along the way. They did, but just not enough. And they took a hit to their retirement account when they used a big portion of their savings to pay for college expenses for their two children. The timing couldn’t have been worse. They took the withdrawal in the depths of the financial crisis. The combination of the low valuation on their investments and the taxes they had to pay meant it would take a long time to rebuild their savings. They had less time for their savings to work for them.

Ben realized his dilemma when he started trying to figure out when exactly they would be able to retire. Between his and Jeanette’s social security benefits and their current savings, they wouldn’t have nearly enough for a comfortable lifestyle. Ben sharpened his pencil and came up with a new plan.

First, Ben plans to work until he is 70. This will not only allow them to save more over the next several years, but it will increase their social security benefit. Delaying taking social security benefits until Ben is 70 will increase the benefit by about 25 percent.

Second, he and Jeanette are saving like crazy. Now the kids are off on their own, they have more money to sock away for their eventual retirement. That is their priority, and he and Jeanette will make their savings goal before they do anything else with their money.

Third, they are planning to be mortgage free by the time Ben and Jeanette stop working. They won’t be able to accomplish that in their current home, but they can move to a lower cost area. They have already decided on a cheaper location where they can buy a house outright with the equity in their current home. With less than ten years remaining to work, Ben and Jeanette will be able to fill the gap in their savings and have the retirement they want.

There are more ways than one to make up for a shortfall in your savings. Valarie, who had to take on a mortgage after retirement, is considering renting out a room in her house so she can have more wiggle room in her budget. Katherine and her husband, James, bought a home with their adult daughter’s family and converted the garage to an apartment for themselves. Cassel, like Ben and Jeanette, moved to Ohio from Portland at the age of 69 so that he and his wife, Sandra, could afford to buy a home and pay less for housing than their high Portland rent.

You don’t have to spend as much as you do today to be happy. T. Rowe Price did a survey of recent retirees who had at least some money in a 401k account or IRA, and found that most are able to manage. On average, the more than 1,000 retirees surveyed live on two thirds of their pre-retirement income. While three in ten are surprised by how hard it is to live without their working income, 85 percent said they didn’t need to spend as much as they did while they were working to be happy.

Of course, the earlier you begin saving for the future the easier it will be. You can get away with saving less of your income the earlier you start, and you will have far more flexibility to create the type of retirement that you want. But even if you didn’t start saving early, you can still find financial security after you stop working. If you are open minded about a lifestyle that is different from your’s today, you might be surprised by how many options you have. It’s never too late to start planning for your future.

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To Roth or Not to Roth

You may have a benefit at work that you are unaware of. Or if you were aware of it, perhaps you aren’t sure what to do about it. An employer sponsored Roth retirement savings account is a valuable benefit that many employees don’t take advantage of.

About half of employers offering a retirement savings plan offer both a traditional plan and a Roth plan according to a study by Aon Hewitt.

In a traditional plan, your contributions are taken from your pay before taxes and excluded from your taxable income. For example, if you are single with a $45,000 income, your federal taxes for the year would be $7,028. If you made a 6.0 percent contribution to your retirement savings plan, your federal taxes would only be $6,353, saving you $675 in taxes for the year, and allowing you to save $2,700 while your pay is only reduced by $2,025. If your employer matches your contribution, and most do, their contribution and the investment earnings are also tax free until you reach retirement.

When you start withdrawing the money from your savings plan in retirement, your entire withdrawal will be taxed as income. If you have other sources of income at that time, and you don’t need to draw on your retirement savings account, you will still need to make a required minimum withdrawal from the account every year after you are 70½, so the government can start getting some tax revenue on that money.

A Roth account is different. If you contribute to a Roth retirement savings account, your contributions are made after taxes are taken from your pay. You won’t get the current tax benefit of $675 in our example. However, your withdrawals in retirement are completely tax free.

This is a big benefit when you begin living on your savings. If you don’t have to pay taxes on your withdrawals, your savings will go farther. In addition, if you don’t need the money, you are not required to take a minimum distribution, so your savings can continue to grow tax free.

Finally, withdrawals from your Roth account won’t count as income in determining whether your social security benefits are taxable as long as the withdrawal is “qualified“. In other words it takes place after you turn 59½ and the withdrawal is made at least five years after the contribution.

In an employer sponsored Roth retirement savings plan there is no income limit. Anyone can contribute. This is a big difference from a Roth IRA outside of work. With a Roth IRA, only those with annual incomes lower than $118,000 for singles and $186,000 for married couples can contribute up to the full IRA contribution limit ($5,500).

The contribution limits in a Roth savings plan are the same as those for a traditional plan ($18,000 for 2017). If you take advantage of the Roth option in your plan, your employer’s contribution will still be made in the traditional plan, so you will wind up with some savings in a Roth account and some savings in a traditional account.

If you have been saving through a traditional retirement savings plan at work, you can still make future contributions to a Roth account. Whether it’s worthwhile to convert your traditional savings to a Roth is a trickier question and one worth getting some specific tax advice on. When you convert your traditional retirement savings to a Roth account, the amount you convert will become taxable income in the year you make the change. That can put a big dent in your savings. Not all employer plans allow a conversion, so you will also want to check with your benefits administrator.

We can’t predict what our taxes will be when we retire, but if we have done our job right and saved enough to support ourselves, it’s a good bet we’ll be paying them. Having some savings that can be withdrawn without paying taxes will be an advantage. Check whether your employer offers a Roth version or your retirement savings plan, and if they do, consider making the change.

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Robo-Advisers Can be Better than Human Advisers for Small Accounts

Do you work with an investment adviser?

How often do you meet with your adviser?

What do you talk about beyond the investments?

What are you paying for your advice?

Unfortunately, for too many people who answer yes to the first question, particularly those with small balances (less than $1 million), the remaining answers are never, nothing and I don’t know.

Over the last several months I’ve reviewed a number of investment portfolios for people who work with advisers. Sometimes it’s good to get an unbiased second opinion, especially if it is free and not given with the intention of winning business. In general, the investment strategies have been just fine, but what has caused me concern is the high fees combined with a lack of service.

In one account, the adviser was charging what seemed to be a relatively low annual fee of 0.60 percent of assets under management (about $6 per $1,000), but he was investing the money in class A shares, which not only had high internal expense ratios, but also had a front end load of 3.50 percent. The internal expense ratio is what the mutual fund manager gets paid to manage the mutual fund. The front end load is paid to the adviser for selling the mutual fund to you. The investor was depositing $1,000 per month, and every month’s deposits were being hit with the 3.50 percent load. That was in addition to the management fee. Average expenses were nearly 2.0 percent per year on the account.

What was the adviser doing for this compensation? Nothing. The owner had never met the guy. He had taken over the account from the previous adviser who no longer worked for the firm.

In another case, a friend left one adviser because he didn’t think his investments were doing as well as they should have been. He moved his investments to an adviser at his credit union. The new adviser charged a 1.0 percent per year management fee and invested the money in a variety of mutual funds. All of the mutual funds had above average internal expenses, making total expenses close to 2.0 percent again. At least in this case, my friend had met with the adviser. But only once. There was no financial planning. There was no assessment of estate planning needs. There was not even any subsequent review of the investments.

Below is a table showing the average investment advisory fee charged by a sample of advisers nationwide from a survey conducted by Advisory HQ.  If your portfolio is less than $1 million it is pretty typical to pay an adviser at least 1.0 percent. These fees don’t include any investment expenses, which could increase total expenses a little or a lot depending on whether the adviser uses cheap index funds or expensive actively managed funds.

asset-management-fees

Advisers need to make a living and smaller accounts just don’t pay for themselves. Some advisers work on an hourly fee, but most don’t like to do that. There is no leverage in that fee model. The adviser can only make as much as she has hours in the day. Most advisers work on a percent of assets under management structure, where their income can grow with the amount of assets they manage. But that means advisers have an incentive to work with larger accounts. An adviser can make almost as much money with one $1 million account as she can with ten $100,000 accounts.

In order to make small accounts work for advisers, they often streamline the service model. If your account is small, you may see your adviser less often than larger accounts do. Your service may be limited to investment management, which will include creating a portfolio of mutual funds. The adviser will review your investments regularly and maintain the portfolio structure over time, though they may not speak with you very often. If that is all you are getting, you can do just as well for a lot less money.

Enter robo-advisers. The very name seems derogatory. However they are a great solution for people who aren’t getting much service from their current human adviser. Robo-advisers use automated systems to create an investment portfolio for you based on your investment objectives, time to meet those objectives and other information designed to gauge how much investment risk you can take without running for the exits.

These advisers generally use low cost exchange traded index funds or index mutual funds, so the investment expenses are low. Because the investments are maintained automatically, there is no human to pay, and therefore the fees charged by the advisers are low too (some are even free). That leaves more of your investment return for you.

Two of the top rated robo-advisers are Betterment and Wealthfront. Betterment offers investment management using exchange traded funds from 12 different investment categories. Fees for service are tiered and range between 0.15 percent for accounts with more than $100,000 invested and 0.35 percent for accounts with less than $10,000 invested. There is no account minimum. Average investment expenses are just 0.13 percent. For a $100,000 account, you would pay just $380 per year all in. That is $210 less than the average human investment adviser’s fees alone, without taking the investment expenses into account.

Wealthfront offers a similar service. They use exchanged traded funds from 11 different investment categories. They charge no fee for the first $10,000 and then charge 0.25 percent for higher balances. Their investment expenses are about 0.12 percent per year. Annual expenses on a $100,000 account would be about $345. Nerd Wallet has done a good review of several different robo-advisers that is worth checking out.

Robo-advisers are registered investment advisers that take fiduciary responsibility for their clients’ accounts. Fiduciary responsibility means they are required to invest in their clients’ best interest. However they have been criticised. The main concerns are that they can’t offer advice on money they aren’t managing, because the systems simply can’t see it, and the information gathered by questionaires may be too shallow.

If you aren’t getting a lot of service from your adviser, he isn’t in any better shape than a robo-adviser. If you have an account he doesn’t manage, like your 401(k), your investments with your adviser and your 401(k) investments may not come together in a cohesive investment strategy. Human advisers tend to tout the advantages of their customized approaches, but unless your advisor is meeting with you regularly, his investment strategy will be based on limited information too.

The primary driver of investment strategies in general is your time horizon. Your time horizon dictates how much risk you can reasonably take, and therefore how much of your investments should be in risky stock market investments versus lower risk income oriented investments. Time horizon is something that can reasonably be collected through an electronic questionaire. I’ll bet your adviser had you fill in that information on a form when you opened your acount.

A good adviser is worth the money that you pay. A good adviser will help you with saving as well as investing. She will meet with you regularly and take into account all of your investments, even the ones she doesn’t manage. She will advise you on how to put an estate plan in place, how much insurance you should own and how to manage your tax burden effectively. She’ll help you understand what you need to retire, and how long it will take you to get there. If you are getting this kind of service, 1.0 percent of assets under management is a reasonable fee. It is low if your account is less than $1 million.

If you are not getting this kind of service, 1.0 percent is way too expensive. If your adviser isn’t going to do more than put together a few expensive mutual funds for you and send you a statement once a quarter, you shouldn’t be paying him so much. All you are getting is a faceless automated solution. A robo-adviser will do the same thing for a lot less money.

Image courtesy of iosphere at FreeDigitalPhotos.net

 

 

The Social Security Trust Funds Are Melting

This summer, my husband, Jeff, and I traveled to Glacier National Park. One of our reasons for going was we wanted to see the glaciers before they melted. The photo above is us at Grinnell Glacier on the east side of the park. As you can see, it’s a little soupy around the edges. By most predictions, it and all of the other glaciers will be gone within ten to fifteen years. The Social Security Trust Fund is in a similar state. If nothing is changed, the trust fund will be gone inside of twenty years.

According to the 2016 Trustee’s report, the fund backing Social Security Disability Income payments will be exhausted by 2023, and the fund backing Old Age and Survivor Insurance (what we usually think of as “Social Security”) will be exhausted in 2035. The two are separate, and by current law one cannot be used to pay for the other. Yet most analysts implicitly assume the Social Security trust will be tapped to fund disability payments, bringing the projected life of the two together to 2034.

The Trust Fund balance is declining because benefit payments are growing by more than what tax revenue and interest earnings can cover. That requires the use of the Fund principal to make the payments. The principal is the accumulation of all previous tax collections and interest earned after benefit payments. The following chart, showing income from taxes and interest minus benefit payments, illustrates the problem. The declining slope of the line means that benefits are higher than income.

social-security-trust-fund

The two funds help support 60 million people; 43 million retired people and their dependents, 6 million survivors of deceased people and 11 million disabled people. In 2023 when the Disability Income Fund is depleted, the tax revenue supporting the program will only be able to pay 89 percent of the benefits, and in 2035 when the Old Age and Survivor Insurance Fund is depleted, the tax revenue will only support 77 percent of projected benefits. In order to solve the problem, an immediate tax increase of 2.6 percent or an immediate reduction in benefits for all current and future beneficiaries of 16 percent (or some combination of the two) is necessary.

This isn’t what was intended when Franklin D. Roosevelt first considered creating a social insurance program in 1934. FDR envisioned a self supporting system, similar to an insurance contract, where contributions for a worker would be collected over his or her lifetime and invested. The contributions and investment interest combined would provide the funding to pay out the worker’s benefit at the end of their work life.

Of course this wasn’t possible in the early years of the program, because it would be decades before a worker would have contributed enough for a fully funded benefit. Therefore the early payments had to be funded from the contributions of those still working. The new law included a schedule of tax increases to be implemented over time to make the program self-funding. Without the tax increases, the system was projected to require government subsidization by 1980.

When Social Security was implemented the benefit payments were cheap relative to the tax revenues that were being collected.  In 1940, there were more than 159 workers for every beneficiary. As a result, congress didn’t see any harm in pushing the tax increases back as well as expanding the program. But by the mid-70’s the system was running out fo money. Since then, there have been changes to the retirement age and increases in taxes to shore up the funds, but they haven’t been enough to over come the rising tide of retirees.

By 1955, the ratio of workers to beneficiaries had fallen to just under 9 and ranged between 3 and 4 from 1970 to 2009. Now the ratio is less than 3, and by 2035 it will be just over 2. The reluctance to increase taxes combined with the eagerness to expand benefits have created a pay as you go system with too few left to pay.

Social Security is already a poor substitute for a retirement income. Benefits represent a fraction of the income earned by the typical working individual. Based on current benefit calculation methods, for those with median lifetime earnings, social security will replace about 41 percent of those earnings. For the highest earners the ratio is just over a quarter. If benefits are cut due to inadequate tax revenue, Social Security will replace less than a third of average earnings for those with median income levels and only a fifth for those with the highest income levels.

income-replaced-by-social-security

There are no current proposals on the table to reform the system. The Trust Funds will continue to melt away, just like the glaciers. While the demise of the Trust Funds won’t mean that Social Security will go away, it could provide even less support than it does today. With little hope that Social Security will be shored up, saving to fund your own retirement has to be a priority. Without savings, Social Security alone will not even provide for basic living expenses. It is never too late to start saving. Take stock of where you are, set a savings goal and make what you can of the time you have in the work force.

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