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

Gift Card Scams & Stolen Emails

Gift Card Scams & Stolen Emails

Holidays and long weekends are a popular time for email scammers to strike. Recipients of scam messages are more likely to believe urgent pleas for money or assistance from an acquaintance on vacation who says they are unreachable by phone. Meanwhile, victims are less likely to check their email on their day off to discover strange replies that might tip them off that their account has been hacked and used to send scams to their contacts.

That might help explain why this morning after Independence Day weekend, I have already heard from several people who received an email from a known contact who claims to be travelling and in urgent need of a birthday gift for a relative (warning bells!)

In this scam, the contact asks the recipient as a favor to purchase a several hundred dollars in gift cards and email them to the relative with the promise of repayment as soon as they return from their trip. Of course, many people can identify this as a scam and know that they should not purchase the gift cards (which are commonly requested by scammers in lieu of wire transfers), but a more serious concern is that the sender’s email account has very likely been compromised and used to send this scam to dozens of their personal and business contacts without their knowledge.

Is there anything you can do?

If you ever receive one of these messages from a friend or colleague, you may wish to notify them via telephone (not by email – you’ll see why in a bit) that their email password may have been stolen and their email account compromised. They should immediately change their password, and if they have reused the same password on other online systems, they should change it there as well, preferably using a unique password on every system.

Why not just reply to the email?

In many cases the attackers perpetuating these scams will also create email filter rules to automatically delete or redirect inbound emails to an external mailbox that they control. This prevents the real account owner from being alerted to the compromise and allows the attacker to monitor the email remotely for signs that they’ve been discovered. So after changing the email password, users should also check their email filtering rules for any suspicious rules that were created without their knowledge. Filter rules are a feature that most users don’t access frequently, so these links may help finding the setting for several common email providers:

How can users protect their accounts?

Everyone can follow a few basic precautions that will help avoid a compromised online account:

1. Use a password manager to generate and securely store random, unique passwords for each and every site so that one stolen password does not jeopardize multiple accounts.

2. Enable two-step verification (also known as two-factor authentication) on all accounts that offer it, but especially for email and banking accounts. This makes it much more difficult for an attacker to log in with a stolen password. Instructions depend on your provider, but most email and banking services offer this option now:

 

3. Never type a password into a website that was accessed via an email link. Attackers steal passwords by forging email from a well-known website with a link to a fake login form. The login page may look exactly like the real site, but the password is sent to the attacker instead. The forgery might even log into the legitimate site afterword to avoid raising suspicion.

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

Restricted Stock Units (RSUs)

Restricted Stock Units (RSUs)

Restricted stock units (RSUs) play a big role in compensation packages, especially for high-tech companies. Thanks to the tech industry, RSUs have become increasingly popular as many employers offer them as part of their compensation package. It’s important to understand what RSUs are and how they work, to ensure you’re not leaving any money on the table when negotiating your salary, and to help you determine when/how to sell them for cash needs or diversifying your investments.

RSUs are issued by an employer to an employee in the form of company stock. They’re restricted because you can’t sell them until they vest, meaning you don’t really own them yet. Vesting typically occurs after you’ve been with your company for a pre-determined length of time or have hit pre-determined performance goals. The shares either vest in stages (grading) or all at once (cliff). When your RSUs vest, they’re considered income and are taxed as such. Your employer will hold back a certain amount of your shares to pay your income taxes, and you’ll receive the rest. Your taxable income is the market value of the shares at vesting. Once your shares vest, you can sell them.

 

We always recommend that folks sell their RSUs once they vest to better diversify their risk. You already rely on your company for your paycheck and many other benefits that it’s best to limit how much of your wealth is dependent on your company. It’s also best to diversify your investments and avoid concentrated positions in any one stock regardless. If you do choose to hold your RSUs when they vest rather than selling them, any future gains will be taxed at current capital gains rates.

If RSUs are a part of your compensation package and you’d like help to better understand how to make them work for your needs, please reach out to us.

Written by: Hannah Ahmed, CFP®, CDFA®

 

Debt Repayment: Alleviate your money from its obligation to the past

Debt Repayment: Alleviate your money from its obligation to the past

There is a good chance you, or a close family member, carry debt. It’s common for the typical American household to carry amounts exceeding six figures (Tsoie & Issa, 2018). Debt can be mysterious in the sense that individuals might owe a similar amount, but perspectives on how to repay debt vary dramatically. Debt is also not always negative and can provide strategic benefits in your financial plan. Consider a home mortgage for example, the underlying asset is likely to increase in value. Mortgages often offer a valuable source of leverage, but loans on depreciating assets like cars can quickly end up with negative equity. Other loans, like high interest credit card debt, can be especially menacing.  This article will focus on consumer debt repayment and we will highlight a few common approaches to help the borrowers make real progress on eliminating debt.

Many households across the country have debt related to auto loans, credit cards and even personal loans. The decision to take on debt is personal and the need or desire for debt means different things to just about everyone. Below are some common questions to consider when developing a debt repayment plan.

  • How do you organize debt?
  • Which debt should be paid first?
  • Should debt be paid off ahead of investing for retirement?

One strategy that many people find effective for debt elimination is using rolling payments. Rolling payments involves focusing on aggressively paying off one loan at a time, while making the minimum payments on other debt. With rolling payments, you throw as many excess dollars in your budget as possible toward repaying one loan. Once the target loan is paid off, roll that loan payment into paying off the next debt beyond the monthly minimums. Keep rolling your payments to the next loan on your list until the ball and chain of your bad debt is paid in full. To illustrate a couple different ways to prioritize your debt list, we are going to look at three approaches for prioritizing debt, including, an interest rate approach, a behavioral approach and a combination strategy that factors in retirement savings.

When evaluating debt repayment from an interest rate approach, order all debts from highest interest to lowest, and attack the highest rate first. Focusing on interest rates makes sense because you are reducing the debt with the highest interest rate drag. Although progressive, the downside to this approach is that it might take months or even years until you finally check a loan off your list. Many people become worn out and lose motivation to follow the plan. There will also be cases where a loan with a lower interest rate, but larger balance will be more impactful on the overall repayment plan than a small loan with a higher rate. However, prioritizing debt strictly by interest rates ignores that.

Interest Rate Approach Example

Let’s meet Steve, who has three outstanding debts. Steve has student loans totaling $22,000 at 6%, a car note of $15,000 at 3.5% and $8,000 of credit card debt at 17% annual interest. Utilizing the interest rate approach, Steve will prioritize his debts according to the table below and use the rolling payment method, we discussed for repayment.

Illustrating the Behavioral Approach

Now let’s consider Steve’s situation from the behavioral approach. This behavioral method prioritizes starting with the smallest loan regardless of interest rates. Compared to the interest rate approach, you will likely end up paying more interest overall with the behavioral strategy, but the small wins along the way provide motivation and reason to celebrate. This method has been popularized by the personal finance personality, Dave Ramsey, who consistently recommends focusing on behavior. He refers to this approach as the “debt snowball”. You can still take advantage of rolling payments with the behavioral strategy, so once each loan is paid off, roll the payment to the next debt on the list.

Combining Perspectives: Debt Repayment and Retirement Savings

The power of compounding interest reveals its best to contribute early and often towards retirement savings for maximum growth. If your debt is not too overwhelming, it can be valuable to continue retirement savings while paying down loans. With this in mind, we can utilize a combination approach that addresses both debt reduction and retirement savings. One method is to target either a specific debt reduction or savings goal. Use your primary goal as a minimum benchmark then throw as many extra dollars in the other direction (debt or savings) as possible. Combining goals of retirement savings and debt elimination is best utilized when loan interest is less than the expected return of investments for retirement. Focusing on both savings and paying off debt can be helpful for identifying opportunities to “beat the spread” by investing versus paying off debt.

No matter how you decide to repay debt, take comfort in knowing the best strategy is one you can commit to and stick with during tough times. Here at Merriman, we believe in the power of committing to a sound plan for guidance throughout your financial life. If you’re lost on where to start, please take a few minutes to read First Things First by Geoff Curran, which provides a guide toward prioritizing your savings. If you have questions or would like to learn a bit more, please contact a Merriman advisor who can help navigate your specific situation.

 

 

References:

Tsosie, C., & Issa E.E. (2018, December 10). 2018 American Household Credit Card Debt Study. Retrieved from https://www.nerdwallet.com/blog/average-credit-card-debt-household/