Lifestyle Drift

Lifestyle Drift

Have you received a pay raise, bonus or an inheritance and as a result changed your spending habits? Have you bought things such as expensive items, cars or even a new home because of one of these events? Soon, your lifestyle starts to inflate or creep to where your standard of living resets at this new higher income level. Spending can quickly become unsustainable if your income doesn’t stay at the same pace and continue to rise. Importantly, you’ll need to save substantially more now to continue that lifestyle in retirement than originally planned. From experience, most families continue at near the same spending level if not more in retirement, especially when grandchildren enter the picture! 

There isn’t any harm with spending more money if you make more, however you need to also increase your savings for important goals at the same level. For example, if your income is now $250,000 or above, you’ll need to save quite a bit more than the $19,000 401(k) contribution to maintain your lifestyle when you decide to retire. These savings targets increase much more if you want to “make work optional” at an earlier age.

 It’s inevitable that your income will rise as you progress through your career, however there are good habits to follow to prepare for the future while still enjoying the “now”:

 Prepare and follow a budget

No matter your income level, having a household budget is key to achieving your goals. It allows you to put all your income and expenses on one sheet of paper to determine how much savings you can automate each month. Many households are cash flow “rich” thereby they are best served by figuring out monthly savings targets. This article discusses a budget technique that can be used as a template for your budgeting. It’s especially important to have a cash flow plan for families where cash bonuses and restricted stock make up a large portion of their annual income. 

Develop and adhere to a pre-determined plan for extra income

If you receive a bonus, you should have a pre-determined savings allocation for those extra resources. This meaning that of the bonus that you receive after-tax, possibly 25% is allocated to spending (i.e. the fun stuff), 25% to travel and short-term savings, and 50% to long-term savings. That way, you get to spend and enjoy a large portion of your bonus while also saving a large sum towards the future. Too often do people receive a bonus and quickly spend it. Having a pre-determined plan or formula for how to allocate these excess dollars is important as your budget won’t account for this income.

Routinely update your retirement projections

Your financial plan needs to be updated each time your spending level increases as the plan is not going to be successful if it is based on $100,000 of annual spending in retirement when your lifestyle now requires $200,000 a year. Many households attempt to exclude child costs from this figure as they won’t have dependents in retirement, however experience has taught that the spending has been replaced by spending on trips and supporting children and grandchildren.

We suggest reading the book Making Work Optional: Steps to Financial Freedom to learn about how best to prioritize your savings to achieve your long-term goals. Importantly, make sure to read the section about “mistakes to avoid” on your path to financial freedom.

Please contact Merriman if you have any questions about developing a cash flow plan or for any of your other financial planning needs.

Fall Items to Check Off Your List

Fall Items to Check Off Your List

With fall fast approaching, it’s time to take care of a few things before year end that can also set you up for the start of next year.

    • Retirement contributions and withdrawals – Just as it’s important to make the necessary contributions to your retirement plan based on your financial plan, you must also take your required minimum distribution (RMD) by December 31 to avoid any penalties if above age 70 ½ or own an inherited IRA. The Merriman Client Services team is hard at work making sure these are all completed for clients. Contributions: The deadline for 2018 Roth IRA and Traditional IRA contributions is April 15, 2020.

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The Ins and Outs of Deferred Compensation Plans

The Ins and Outs of Deferred Compensation Plans

Executives and other highly compensated employees might notice a different option in their benefits plan, beyond the usual 401(k). Some employers also offer Section 409A nonqualified deferred compensation plans to high earners, which have their own mix of rules, regulations and potential drawbacks to navigate. However, when you’re earning income in the hundreds of thousands, it’s important to consider every option for saving on taxes and setting aside a larger nest egg for retirement. Contributing to the usual bevy of IRAs and 401(k) might not be enough to see you through your golden years, and tools like deferred compensation plans could also help you bridge the gap of early retirement.

Deferred compensation plans look a bit different than the 401(k) you already know. Like a 401(k), you can defer compensation into the plan and defer taxes on any earnings until you make withdrawals in the future. You can also establish beneficiaries for your deferred compensation. However, unlike 401(k) plans, the IRS doesn’t limit how much income you can defer each year, so you’ll have to check if your employer limits contributions to start building your deferred compensation strategy. Elections to defer compensation into your nonqualified plan are irrevocable until you update your choices the following year, and you have to make your deferral election before you earn the income. If you’re in the top tax bracket (37.0% in 2019), this can allow you to defer income now and receive it at a later date (such as when you retire) in a lump sum or a series of payments, when you expect to be in a lower tax bracket.

Unlimited contribution amounts and optional payout structures may sound too good to be true, but nonqualified deferred compensation plans also have significant caveats to consider. The big risk is that unlike 401(k), 403(b) and 457(b) accounts where your plan’s assets are qualified, segregated from company assets and all employee contributions are 100% yours—a Section 409A deferred compensation plan lacks those protections. 409A deferred compensation plans are nonqualified, and your assets are tied to the company’s general assets. If the company fails, your assets could be subject to forfeiture since other creditors may have priority. The IRS permits unlimited contributions to the plan in exchange for this risk, and the potential loss of deferred compensation can motivate company officers to maintain the health of the company.

Let’s review potential distribution options from nonqualified deferred compensation plans. A Section 409A deferred compensation plan can provide payment no earlier than the following events:

  • A fixed date or schedule specified by the company’s plan or the employee’s irrevocable election (usually 5 to 10 years later, or in retirement)
  • A change of company control, such as a buyout or merger
  • An unforeseen emergency, such as severe financial hardship or illness
  • Disability
  • Death

Once your income is deferred, your employer can either invest the funds or keep track of the compensation in a bookkeeping account. Investment options often include securities, insurance arrangements or annuities, so it’s important to evaluate the potential returns and tax benefits of your deferred compensation plan versus other savings options. Plan funds can also be set aside in a Rabbi Trust; however, those funds still remain part of the employer’s general assets.

Nonqualified deferred compensation plans have a variety of structures, rules and withdrawal options depending on how your employer builds the plan. Consider the following pros and cons of deferred compensation plans when reviewing your employer’s options.

Pros

  • You can defer a significant amount of income to better help you replace your income in retirement. The IRS does not limit contributions.
  • You have the ability to postpone income in years when you’re in high tax brackets until later when you expect to be in a lower tax bracket.
  • If your employer offers investment options, you may be able to invest the money for greater earnings.
  • There are no nondiscrimination rules for participants, so the plan can benefit owners, executives and highly compensated employees specifically. Other retirement plans may limit contributions or participation due to discrimination rules.

Cons

  • Your deferred compensation plus any investment earnings are subject to forfeiture based upon the general financial health of the company.
  • The election to defer compensation and how/when it will be paid out is irrevocable and must be made prior to the year compensation is earned.
  • Depending on the terms of your plan, you may end up forfeiting all or part of your deferred compensation if you leave the company early. That’s why these plans are also used as “golden handcuffs” to keep important employees at the company.
  • The plan may or may not have investment options available. If investment options are available, they may not be very good (limited options and/or high expenses).
  • If you leave your company or retire early, funds in a Section 409A deferred compensation plan aren’t portable. They can’t be transferred or rolled over into an IRA or new employer plan.
  • Unlike many other employer retirement plans, you can’t take a loan against a Section 409A deferred compensation plan.

The questions below are helpful for assessing whether a deferred compensation plan makes sense for you.

  • Is your company financially secure? Will it remain financially secure?
  • Will your tax rate be lower in the future when this deferred compensation is paid?
  • Can you afford to defer the income this year?
  • Does the plan have investment options? Are the fees and selection of funds reasonable?
  • Does the plan allow a flexible distribution schedule?

Section 409A deferred compensation plans have inherent drawbacks and prominent risks, but they could help you save toward your retirement planning goals. We recommend working with a Merriman advisor to review your specific plan terms and financial situation when preparing for the future. We can help you decide whether a nonqualified deferred compensation plan makes sense for your situation, weigh issues like future taxes and create a long-term plan. We want you to feel ready for everything life has to offer.

 

Mega Backdoor Roth Explained!

Mega Backdoor Roth Explained!

By: Geoff Curran & Jeff Barnett

Everyone thinks about saving for retirement, and not many people want to work forever. However, have you thought about the best way to save for the future? If you are setting aside the yearly max in your 401(k) and channeling extra savings to your brokerage, you might be missing out on powerful tax-advantaged saving opportunities. In this article, we will show you how we help clients maximize savings, minimize taxes and secure their future using the Mega Backdoor Roth IRA.

 

Most people know they can contribute to their employer’s retirement plan from their paychecks through pre-tax and Roth contributions up to $19,000 a year ($25,000 if age 50 or older; IRS, 2018). What people miss is whether their retirement plan allows for additional after-tax contributions beyond this limit. Enter the supercharged savings!

It turns out that some company plans permit you to contribute up to the IRS maximum for total contributions to a retirement plan, which is $56,000 in 2019 ($62,000 with catch-up contributions; IRS, 2018). The IRS maximum counts contributions from all sources, including pre-tax employee deferrals, employer matching contributions, and even after-tax contributions for the Mega Backdoor Roth. That means you might be able to contribute an additional $20,000 or more after-tax each year after maxing your elective deferral and receiving your match. You can then convert the extra after-tax savings to Roth dollars tax-free. This more than doubles what most individuals can contribute to their retirement plan, and you won’t have to pay taxes on your Roth account distributions in retirement. This benefit is even greater when both spouses have this option available through their employers, so be sure to check both plans.

Retirement plans like those at Boeing, Facebook, and Microsoft permit easy conversions of after-tax to Roth dollars within the retirement plan. Other companies offer a variation where you can make in-service distributions and move after-tax dollars into a Roth IRA. Make sure to check with your benefits team to find out if your company’s retirement plan supports after-tax contributions and Roth conversions, the steps involved and the maximum amount you can contribute to the after-tax portion of your retirement plan. It’s important not to run afoul of plan rules or IRS requirements, so also be sure to consult experts like your accountant or financial advisor if you have any questions.  

Why contribute extra after-tax?
Now that we have covered the high-level view, let’s hammer down the why. The benefit of contributing to your employer’s after-tax retirement plan is that those contributions can subsequently be converted to Roth tax-free. This is sometimes called a ‘Mega Backdoor Roth,’ whereby you can contribute and convert thousands of dollars per year depending on your retirement plan. Once converted, these Roth assets can grow tax-free and be distributed in retirement tax-free. After several years of Mega Backdoor Roth contributions, you can amass a meaningful amount of wealth in a tax-free retirement account

How do I contribute?
1. Log in to your employer’s retirement plan through their provider website, such as Fidelity.

2. Find the area where you change your paycheck and bonus contributions (i.e., deferrals).

3. Find “after-tax” on the list showing how much you elected to contribute pre-tax, Roth, or after-tax to your 401(k).

4. Enter a percentage to have withheld after-tax from your upcoming paychecks and bonuses that works for your budget.

5. Select an automated conversion schedule, such as quarterly (Microsoft’s retirement plan even offers daily conversions!). If your plan doesn’t offer automated periodic conversions, contact your retirement plan provider regularly throughout the year to convert the assets.

6. Remember to select an appropriate investment allocation for your retirement account that aligns with your overall investment plan.

Is any part of the conversion taxed?
For retirement plans that don’t convert after-tax contributions to Roth daily, there may be growth in the account prior to conversion. This growth is subject to taxation at ordinary income tax rates. For example, if you converted $22,000 ($20,000 contributions + $2,000 investment growth over the period), you’ll owe income tax on the $2,000.

We suggest speaking with a Merriman advisor to determine if your retirement plan allows additional after-tax contributions, how to fit it within your budget and its impact on your retirement savings goals.


References: Internal Revenue Service. (2018, November 2). Retirement Topics – 401(k) and Profit-Sharing Plan Contribution Limits. Retrieved from https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits

How to report a backdoor Roth IRA contribution on your taxes

How to report a backdoor Roth IRA contribution on your taxes

Updated June 25, 2019

By: Geoff Curran & Jeff Barnett

When you are thinking about how to put your hard-earned dollars to work, it’s important to consider every avenue for tax-advantaged savings. Backdoor Roth IRA contributions are great tools for high earners to take advantage of Roth IRAs even after passing the income limits for standard contributions, and the steps for making backdoor Roth IRA contributions are pretty simple. However, the documentation and tax forms for the process can be confusing, and you may run into trouble when it comes time to report everything to Uncle Sam. Whether you work with a professional tax preparer, use tax software such as TurboTax or complete your taxes by hand, understanding the mechanics of the money movements can help ensure you file your taxes correctly. 

Let’s walk through each step in the backdoor Roth IRA process to illustrate the moving parts. You got here by making too much money to deduct Traditional IRA contributions or to contribute to a Roth IRA normally. However, there is no income limit on converting a Traditional IRA to a Roth IRA, which is the crux of the backdoor Roth IRA.

Step one of the Backdoor Roth IRA is making a non-deductible contribution to your Traditional IRA. It’s your responsibility to report the non-deductible contribution to your Traditional IRA at tax time on IRS form 8606, Nondeductible IRAs. Form 8606 helps track your basis and avoid paying additional tax on your non-deductible contribution as you convert the balance to a Roth IRA.

The second step after making your non-deductible Traditional IRA contribution is converting your Traditional IRA balance to a Roth IRA. You will owe tax on any earnings in the Traditional IRA before converting, but from that point on, those dollars are now Roth IRA assets and aren’t subject to future tax. Use Form 8606 for calculating the taxable amount from the conversion if you had any earnings in the Traditional IRA.

Around tax-time, you’ll receive a 1099-R from your custodian showing the distribution from your Traditional IRA that was converted to your Roth IRA the previous year. Later in the year you’ll also receive an information reporting Form 5498 that shows the contribution you made to the Traditional IRA and the amount that was converted to Roth. We recommend keeping Form 5498 for your records, but you don’t need to report Form 5498 in your tax filing.

Now that we have walked through the steps, let’s look at an example of how to report a backdoor Roth IRA contribution. Tom, a 35-year-old physician in the Pacific Northwest and diehard Seahawks fan, is working on his Married Filing Jointly tax return after making a $6,000 non-deductible Traditional IRA contribution last year that he converted to his Roth IRA. Tom didn’t have any other Traditional IRA assets aside from his non-deductible contribution in 2018, and he didn’t have any earnings in his Roth IRA conversion. Part 1 of Tom’s Form 8606 is filled out below.

Next let’s look at Part 2 of Tom’s Form 8606, where the conversion portion is reported. If line 18 is 0, as it is in this example, none of the conversion ends up being taxable.

 

 

 Note: Our example uses the increased 2019 IRA contribution limit ($6,000 for individuals under age 50) on the 2018 tax year forms. The 2019 tax year forms won’t become available until January 2020.

Tom won’t end up owing any taxes on his Backdoor Roth IRA, and his correct reporting of the contribution and conversion will avoid running afoul of the IRS. However, tax forms and reporting can be a daunting challenge. If stressors like tax law changes, new forms and confusion around the whole process keep you from sleeping soundly, reach out to a Merriman advisor to discuss whether a backdoor Roth IRA makes sense for you. You might even have other options available for tax-advantaged savings that you haven’t considered. Check out Mega Backdoor Roth Explained to see how you might be able to do a backdoor Roth in your employer 401(k) plan. We love navigating complex issues like these and giving guidance to elevate your finances.    

 

 

References:

Internal Revenue Service. (2018, November 1). About Form 5498, IRA Contribution Information (Info Copy Only). Retrieved from https://www.irs.gov/forms-pubs/about-form-5498

Internal Revenue Service. (2019, February 27). About Form 8606, Nondeductible IRAs. Retrieved from https://www.irs.gov/forms-pubs/about-form-8606

Internal Revenue Service. (2019, April 18). About Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.. Retrieved from https://www.irs.gov/forms-pubs/about-form-1099-r