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
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.
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.
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.
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.
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 Explainedto 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.
With summer upon us and your thoughts wandering to visions of paradise, have you questioned how to save money on expensive trips? Major travel expenses like airline tickets, hotel nights and rental cars can push trip costs into the thousands. Travel credit cards are an excellent way to save money while traveling and improve your entire vacation experience. However, no single card is perfect for every traveler. Let’s review the factors that set some cards apart and how to find the best card for your travel plans this summer. So what kinds of rewards can you earn with top travel credit cards?
Unlike cash back credit cards, travel card bounties typically come in the flavor of rewards points or miles. You will earn points or miles for every dollar spent, and some cards offer additional rewards for spending in specific categories like hotel accommodations or restaurants. To choose the best card for you, it’s important to know your major spending categories. For example, a card may offer 3x points for travel and dining, as well as 1 point per dollar spent on everything else. Unless you spend a considerable amount on travel and dining, a different card that offers 2x points on all purchases might help you earn more rewards.
One example we can look at to illustrate rewards differences is if you spend $4,000 per month on a credit card and are also planning a $5,000 trip this year. You could earn 3x points on $5,000 of travel spending and 1x points on $48,000 of monthly spending for a total of 63,000 points that year. However, earning 2x points on your entire budget with a different card nets you 106,000 points. That’s over two-thirds more rewards for using another card!
Types of Travel Cards
Now that you know how to earn rewards, the next step is examining types of travel credit cards. Travel credit cards feature two main categories of rewards options—co-branded versus generic.
Co-branded cards bear the name of specific airlines, hotels or rewards programs and often have strict rules for redeeming points. For example, you may be limited to redeeming rewards with the card issuer or their program partners. While co-branded cards are less flexible for where you can spend rewards, they often come with other perks. Some cards allow you to get priority boarding, avoid baggage fees, earn double points on brand purchases or have annual discounted hotel stays.
Extra perks can help you feel like a movie star on your next trip, but rewards on other spending like groceries are often less with co-branded cards. If a co-branded card sounds appealing, we recommend checking out how to use multiple cards across all your spending to maximize rewards. Aligning your purchases with credit cards that offer the best reward for each spending category can help you earn more bonuses. Whether you’re using a travel card to earn 3x miles on your next ticket to Maui or buying groceries with a 2% cash back card, researching the best card for each of your major spending categories pays off.
Compared to co-branded travel credit cards, generic cards offer more flexibility and are not tied to a specific travel company. Generic cards may be used for any airline, hotel or cruise without requirements for redeeming your rewards with a specific brand. This is a great option for people who aren’t committed to a single frequent flier program, loyal to any particular airline, or always stay at the same resort. With a generic card, you can choose travel options that fit your itinerary, even when surprises pop up (like missing the last boat for the night and being stuck staying in the hotel across from the dock, don’t ask how we know). If a generic card fits your style, check out whether your card of choice offers valuable perks like trip cancellation or rental car insurance coverage. Co-branded cards are not the only plastic with awesome perks.
Evaluating Card Benefits
Once you narrow down your travel card options, evaluating other benefits like sign-up bonuses, low annual fees and higher value rewards can help you make the best choice.
Sign-up bonuses can be worth hundreds of dollars and may be the deciding factor between two cards.
Annual Fees offset rewards. You will need to assess if your spending level justifies the potential benefits from higher fee credit cards.
Point Valuations determine how much you get from your reward points. A point on one card or a specific reward option might not be as valuable as rewards offered by another card or different redemption choice.
When you’re thinking of backpacking through Yosemite or hiking up to Machu Picchu, travel credit cards are a great way to save money on your next trip. Credit cards are valuable tools, but it’s also important to use credit wisely and be wary of carrying a high-interest balance. We recommend reaching out to a Merriman advisor if you have questions about credit, spending, or other ways to enhance your finances. We are here to help and offer guidance throughout your financial journey.
Young professionals juggle ramping up their careers, paying off debt, starting retirement nest eggs, buying homes and potentially building families. There is no shortage of goals for funneling your hard-earned dollars, and we can’t forget to have some fun along the way. It’s time to figure out how to take finances to the next level by supercharging savings and intelligently managing debt, so what do we tackle first?
College tuition ranks among housing and medical expenses as having the highest lifetime costs for many Americans. Making matters worse, planning for college involves a daunting landscape of savings plans, loans, scholarships, and trying to build the foundation for your children’s future. If you would like to help your child pay for college, we recommend saving for costs ahead of time. We’ve already reviewed flexible options for college savings like 529 Plans, Coverdell ESAs and UTMAs. This article covers the financing options you have to supplement those savings when it comes time to actually pay for college. (more…)