Okay then, what is a financial plan?

You may hear some argue that robo-planners will not replace individual, human planners. I call them the “There’s no app for that” group.

We do believe that “There is an app for that.”
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Well, that is not what I had in mind.

But exactly what is “a financial plan”? Finding a good, workable definition is a challenge.

Wikipedia says:

Textbooks used in colleges offering financial planning-related courses also generally do not define the term “financial plan.” For example, Sid Mittra, Anandi P. Sahu, and Robert A Crane, authors of Practicing Financial Planning for Professionals[8] do not define what a financial plan is, but merely defer to the Certified Financial Planner Board of Standards’ definition of ‘financial planning’.

Can’t we define “financial plan”?

Yes. Investopedia offers this broad definition:

While there is no specific template for a financial plan, most licensed professionals will include knowledge and considerations of the client’s future life goals, future wealth transfer plans and future expense levels. Extrapolated asset values will determine whether the client has sufficient funds to meet future needs.

And Wikipedia gives more detail:

In general usage, a financial plan is a comprehensive evaluation of an individual’s current pay and future financial state by using current known variables to predict future income, asset values and withdrawal plans. This often includes a budget which organizes an individual’s finances and sometimes includes a series of steps or specific goals for spending and saving in the future.

So you need to project where your assets can take you to be sure you meet your future in good shape. Makes sense

And what is my definition?

A to do list or “action plan” that tells you what you need to change now so you optimize the use of all your resources to achieve your major, long term goals in the future.         

So what does a financial plan look like?

If you paid to have a financial plan prepared, and have a complicated situation, you may get a glossy, bound book filled with projections, charts and graphs, plus text. While much of it may be boilerplate, it will tell you where you are going from now until you die, how your money will follow if you invest according to the plan, and what you need to change on taxes, insurance, and your estate plan.

At the other extreme, you can glean the essential steps and write them all on a PostIt note, which you then place in a spot you see often enough to remind you what to do:

  • Maximize my 401(k) contributions,
  • Set up and contribute to a Roth IRA,
  • Review my investment allocation, use ETFs,
  • Steer clear of any major credit card debt,
  • Review my beneficiary designations,
  • Sign an medical directive, and
  • Save enough for a fun (not too expensive) vacation next summer!

In the end, it doesn’t matter how many pages or what the plan looks like; what matters is that you learn from reviewing your finances and change how you manage your resources so that improve your finances.

So, yes, a simple to do list could be enough, if you follow it!

Roth or not to Roth? Deciding requires predicting your future tax rate

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More employers now provide the option of a Roth 401(k) as well as a traditional 401(k), so you may ask:

Which should contribute to a Roth 401(k) or a traditional 401(k)?

The answer is not so simple and it depends on your income tax rate now and at retirement. Before offering background and explanation, we start with this Quick Summary

If you have a high tax rate now, and expect a low tax rate later, pick the traditional 401(k)

The traditional plan is better because get the current tax deduction, reducing taxes now at the higher tax rate. This may be true for people in middle or later years of employment.

Note: this is only financially better if you invest the amount of taxes saved.

If you have a low tax rate now, and expect a high tax rate later, pick the Roth 401(k).

The Roth plan is better because you avoid higher taxes later. This may be true for most people starting work now.

If expect to have the tax rate later as you have now, pick the Roth 401(k)

The Roth plan has other benefits described below.

Background – How the Plans Work:

Tax deferred growth

Earnings on both the traditional 401(k) and the Roth 401(k) are not taxed. Not paying taxes on investments in your retirement account means more grows and compounds tax-free – that is why contributing to a retirement plan is so important.

Contributions “pre-tax” vs. after tax

Contributions to a traditional 401(k) are made “pre-tax,” meaning that the amount contributed is excluded from your taxable income for the year.

Contributions to a Roth 401(k) are made after tax – they are not excluded from taxable income.

Taxing withdrawals vs. no tax

Withdrawals from a traditional 401(k) are taxed in the year of withdrawal.

Withdrawals from the Roth plans are not taxed. That is, the after-tax contributions are not taxed a second time and neither is the growth on those contributions.

Other rules – early withdrawal and require minimum distribution

There are penalties for withdrawal before reaching age 59½, unless certain exceptions are met, such as disability or first-time home buyer.

You must begin withdrawing when you reach age 70½ under the IRS Required Minimum Distribution or “RMD” rules. For more on RMD rules, see IRS Retirement Topics – RMDs

Hedging your bets:

If you are not sure of your tax rates, or if you just want more options because you cannot predict, then you can opt to combine plans. For example, you can contribute to your traditional 401(k) up to the employer match and then put the rest in a Roth IRA, if the contribution limits allow.

Conversions:

When you change jobs, you can convert a 401(k) to a Roth IRA, but doing so is a taxable event. If you expect your tax rate to be higher in the future, this is a good move. However, you will want to pay taxes due from other sources. If you have to take funds from the IRA to pay the taxes, you reduce the amount going into the Roth IRA which dramatically reduces the future benefit.

If you convert after-tax contributions made to a traditional 401(k) or non-deductible IRA, you have less on which taxes are due because the after-tax portion is not taxed in converting to a Roth IRA.

Other considerations:

While a Roth 401(k) is subject to RMD, a Roth IRA is not. If you can re-characterize the Roth 401(k) to a Roth IRA, you avoid the RMD. This may mean that you pass more on to your heirs. Also, you may gain investment flexibility compared to a company plan.

If you use a Roth plan, then your taxable income at retirement will be less than if you were withdrawing from a traditional plan where withdrawals are taxed. This could lessen tax due on social security benefits.

On the other hand, if you expect to use funds in your retirement plan to donate to a charity, you are better off getting the tax savings for yourself now. The charity is not subject to much if any income tax.

Also, if you expect your heirs to receive your retirement plan assets and know that those heirs will be in a lower income tax bracket, you should use a traditional plan now to get the tax benefit for yourself. How can you possibly determine that heirs will get more of your retirement than you and also be in a lower tax bracket? I cannot imagine – well, maybe I can, but none of the ideas sound good. Anyway, it seemed like a good idea to mention (they teach you to think this way in law school).

5 Things Every Young Person Should Know About Retirement – You’ve got time, so use that time well!

If you are young, you’ve got time, and if you use that time well, you may even make up for the possibility of no pension and no Social Security benefits.

1. You won’t have what your parents had – no pension and no social security. Millennials are the first post-war generation to face retirement with virtually no pension. Fewer than 7% of Fortune 500 companies offer pension plans to new hires. Also, the way that the Social Security system is currently funded, there will be no reserves by 2033. Social security benefits are paid to retirees from the tax withholdings of the current workforce and also from the Social Security Reserves. Once the reserves are depleted, it is estimated the tax revenues the collected at that time will only be enough to pay out three quarters of the scheduled benefits. There are measures Congress could take to head off this eventual depletion, like changing the benefit formulas, raising payroll taxes or increasing the cap on taxable wage income. Until any changes are actually implemented, don’t count on any benefits!

2. Learn how to save and spend – now! It’s never too late to adopt good spending and saving habits, and the sooner you do it, the better. The more you can set aside that is invested now, the better off you will be. Also, avoid accruing any high interest rate debts. You can make your coffee at home if that is what allows you to max-out contributions to your 401(k) plan, especially if your employer matches what you contribute. If you do not have employer-sponsored plan, open a Roth IRA or even a traditional IRA. It’s a lot easier to put money aside now than it is to play catch-up in your 40s. And you can set up auto-debits so the investments are made as soon as your paycheck hits your bank account – keeping it out of your shopping slush fund!

3. We’re living longer, healthier lives. Longer, healthier lives are good, but they also require more investments at retirement. If you hit the Social Security full retirement of 67 now, the Center for Disease Control estimates you will live to around 86. That’s 19 years of retirement that you need to fund. But, if you are younger, living a longer, healthier life, then you will likely live longer, requiring more funds, unless you choose to work later in your life.

4. The good news is you have time. The Center for Retirement Research at Boston College suggests that, by setting aside money at age 25, you will need to save only about 10% of your annual income to retire at 65. If you wait to save, the percentage you need each year increases. If you wait ten years, starting at age 35, your target savings increases to 15%. Wait until you’re 45 and you’ll need to save 27% of your annual income. Imagine if you were 55 today and wanted to retire at age 67? The message is: don’t wait!

5. You also have great resources. With smartphone apps and do-it-yourself trading services, investing is more accessible and less costly than ever. Also, there are more affordable investment products available like ETFs (see our post), so you avoid high fund manager fees. Saving on fees means more to grow for your retirement. Over the course of 40 years, those fund manager fees add up to real money.

In sum, start saving now. Set up a simple portfolio and adjust it as you go along. The time you’ve got now will reward you later!

Update on Roth conversions – to do or not to do?

In deciding whether to convert your traditional IRA to a Roth, there are many factors to weigh. At present, uncertainty about potential income tax reform makes the decision even more difficult: you are making a decision on what provides greater tax advantages, conversion or not, without confidence in the future tax impact.
Nonetheless, converting makes good tax sense if you expect your future marginal tax rate in retirement to be the same or greater than the rate on the conversion. However, if you expect your tax rate in retirement to be lower, then you will pay more taxes on conversion than you will in retirement.
There are other reasons to consider converting now:
> First, converting an IRA or other plan to a Roth account means that the assets are no longer subject to the Required Minimum Distribution (“RMD”) requirement reached at age 70½, thus allowing you to retain assets as long you wish. At death, your heirs must start withdrawing from the account, but the withdrawals will be income tax-free.
> Second, if you believe your IRA assets will grow significantly over time then it is advantageous to convert. If you convert now, you will have a lower conversion rate (less of the total will have been subject to income taxes). This calculation applies whether your current IRA assets are depressed or have yet to appreciate.
There is a reason not to convert now:
> If you’re single and the conversion puts your AGI over $200,000 (or you’re married and the conversion puts your AGI above $250,000), then the 3.8% Medicare surtax on unearned income may be triggered. However, you can avoid this (and other unintended consequences) by doing partial conversions over multiple years.
What if you err? If you convert and then your account value falls, you have until October 15th of the following year to undo the conversion, thus revering the income taxes paid.
Planning: If you’re considering a conversion, give us a call and we can help you make the right decision for you!

Roth Conversions – decisions on 2010, recharacterize now or pay taxes over two years?

You can still decide as late as October 15th (if you extend filing of your tax returns) to either recharacterize or pay the taxes in 2011 and 2012 instead of on your 2010 taxes for your 2010 conversion to a Roth IRA.

Recharacterize – if you have the misfortune of losing value on the IRA after converting, you can “un-convert” by “recharacterizing” the Roth IRA as a traditional IRA using an IRA-to-IRA transfer (do not distribute funds to yourself, as that distribution voids the recharacterization). You can do this for all or a portion of the account. Once you do so, you cannot convert again until later of 30 days after the recharacterization or the year after the year of the original conversion.
This strategy is useful to address a decreased IRA value or to shift the conversion into future years with less income, so you are in a lower tax bracket.

Tax payments
– 2010 is the only year where you can choose to have the income of the conversion split in half and carried onto your 2011 and 2012 tax returns. This (1) spreads the time to come up with funds to pay the taxes (you never want to use the funds in the IRA as that defeats the purpose) and (2) gives you earnings on funds already available to pay the taxes until the payment due date.

Note: if you are paying taxes on the conversion with your 2010 taxes, the amounts are due April 18, 2011, even if you extend to have the option of recharacterizing. If you do recharacterize, then you will have over paid and have a refund due …. until you convert again.