5 reasons to leave your robo-advisor and work with a real person

Leave your robo-advisor

Leave your robo-advisorRobo-advisors have grown in popularity in the last 10 years, offering easy and inexpensive access to professional investment management with human interaction.  Firms like Vanguard, Betterment, Personal Capital, and Wealth Front use online tools and algorithms to build and manage your investment. These digital advisors attract new customers with cutting-edge technology, attractive websites, interactive features, low fees, and cool mobile apps. The rising adoption of robo-advisors and various digital platforms allows the financial industry to become more accessible and consumer-friendly.

Unlike traditional portfolio management firms, most robo-advisors offer their automated investing service with low or no account minimums. You will answer an online questionnaire. Your answers will place you in a specific risk tier group. As a result, the robo-advisor will invest your assets according to your risk profile. The typical digital advisor offers automated portfolio rebalancing and tax loss harvesting. Some may even offer you financial planning advice for an additional fee.

If you have read one of my Investment Ideas articles (here and here), you know that I am a big believer in FinTech, mobile payments, and digitization of the financial industry. The covid outbreak created a massive tailwind for this trend to continue in the next decade. You will experience a complete digital transformation in all aspects of your financial life.

With all that in mind, why someone like yourself will decide to abandon their digital advisor service? So here we go.

Receive personalized advice

Life changes. Often you will be at crossroads in your life trying to make important financial decisions. You will need to talk to someone who understands your situation and can give you personalized advice with your best interest in mind. Unfortunately, digital advisor services rarely, if never offer personalized advice. Algorithms cannot understand your emotions and feelings.

Surely, you can do the research and the hard lifting yourself. There is nothing more rewarding than reaping the benefits from your hard work. However, there is nothing wrong with asking for help. You do not have to do it alone. Working with a fiduciary financial advisor who understands your circumstances will save you time and grievance. Moreover, it will save you and make you money in the long run. And most importantly, it allows you to enjoy what matters most to you.

Build a relationship

Finding a good financial advisor is like finding a personal doctor or a hairstylist who cuts your hair just the way you wanted. Would you ask a robot to cut your hair? Then, why would you leave your wealth and retirement savings to an algorithm? Having a trusted relationship with a fiduciary financial advisor will give you access to objective, unbiased, and reliable financial advice when you need it most. Your financial advisor can point your financial blind spots and recommendations on how to resolve them before they escalate.

I frequently work with clients coming from large robo-advisors. Almost always, their biggest complaint is that they were not able to get answers to their questions. They were calling customer service, waiting in line, and speaking with a complete stranger on the other side.

Building wealth is a marathon, not a race. Why not working with a trusted partner who understands your unique needs and has your best interest in mind.

Invest with purpose

Have you asked yourself, does your investment portfolio represent your philosophy and values?

For many of you, investing is a way to make a meaningful impact on your favorite causes.

Furthermore, most robo-advisors offer a limited number of generic ETFs in various asset classes. However, they do not provide a way to customize your investments according to your core values.  The only you can achieve your purpose is through a customized investment portfolio that represents what you believe.

Impact Investing

Impact investing is about MAKING A DIFFERENCE. It is a philosophy that seeks to achieve sustainable long-term returns by investing in companies that create positive and measurable social, governance, and environmental impact. If you are an impact investor, your goal is to invest your money in areas that match your core beliefs and values.  By choosing the path of impact investing, you will provide the necessary support to address the world’s most urgent challenges in areas such as sustainable agriculture, clean energy, gender equality, social justice, food conservation, microfinance, and affordable access to housing, healthcare, and education.

Thematic investing

Thematic investing is a path to achieve higher long-term returns by investing in specific economic and secular trends caused by structural shifts in our society. It is about CHANGE. The thematic investing strategy relies on megatrends that are changing the way we live. Several of my favorite trends include climate change and renewable energy, 5G and cybersecurity, digital payments and e-commerce, blockchain and digital revolution, the rising power of women, and population growth.

Have a plan

Life is complicated.  As a result, your circumstances will change. You will start a new job, move to a new place. Start a family. Buy a new house. Exercise those stock options that you received when you started your last job. Above all, you must prepare for everything that life has to give.

Once you do the groundwork, it’s easier to update your plan than create a new one from scratch every time your life changes. Your plan will make you feel confident when making complex financial decisions about your future.

According to Vanguard itself, working with a financial advisor can bring you up to 3% average additional return. The advisor alpha comes from value-added services such as behavioral coaching, tax-smart investing, asset allocation, and rebalancing.

Get a customized tax strategy.

Let’s admit it. The US has one of the most complex tax systems in the world. We all get tangled with terms such as AMT, marginal tax bracket, capital gain tax, 401k, step-up basis, tax-deferred and exempt income. With the ever-rising budget deficit, there is no doubt that your taxes will only go higher. Paying taxes is part of life but managing your future tax bill is your responsibility.

One popular way to measure the efficiency of your tax strategy is your tax alpha. Tax Alpha is the ability to achieve an additional return on your investments by taking advantage of all available tax strategies as part of your comprehensive financial planning. Unlike robo-advisors,  our firm can offer a wider range of tax planning tools that can help you realize higher long-term after-tax returns.  For instance, for us, achieving Tax Alpha is a process that starts on day 1.  As a result, we will craft a comprehensive strategy that will maximize your financial outcome and lower your taxes in the long run.

Effective Roth Conversion Strategies for Tax-Free Growth

Roth Conversion

Roth conversion of your tax-deferred retirement savings can be a brilliant move. Learn the must-know rules and tax implications of Roth Conversion before you decide if it is right for you.

Retirement Calculator

What is a Roth Conversion?

Roth Conversion is the process of transferring the full or partial balance of your existing traditional IRA into a Roth IRA. The conversion effectively moves tax-deferred retirement savings into tax-exempt dollars.

A critical downside of Roth conversion is that you need to pay income taxes on the converted amount. For that reason, it is beneficial to have additional taxable savings to cover the tax cost of the conversion.

Unfortunately, not everybody is the right candidate for Roth conversion. Consider your specific financial and tax circumstances before moving forward.

Watch your tax bracket

A crucial element of any Roth conversion decision making is your taxes. The strategy becomes feasible during low tax years or whenever you expect higher tax rates in the future. Higher future tax rates make a Roth IRA more appealing, while lower future tax rates would make a traditional IRA more attractive.

Consider your investment horizon

Generally, you will achieve a higher benefit if you perform your conversions earlier. Your Roth IRA will have time to grow tax-free for longer and will offset the cost of paying taxes upfront. 

Roth IRA 5-year rule

When you do a Roth conversion, you need to be mindful of the 5-year rule. The rule requires that 5 years have passed since your first Roth contributions before taking penalty-free withdrawals of your tax-free earnings.

You can still withdraw your original contributions at any time. However, your earnings are subject to the 5-year minimum restriction. If you do not meet the minimum 5-year holding period, your profits can be subject to ordinary income tax as well as a 10% penalty for early withdrawal.

Furthermore, each separate Roth conversion has a five-year limit. The Five-Year clock begins ticking on January 1st of the year when you make the conversion.

The advantages of Roth conversion

Converting your tax-deferred dollars to Roth RIA can have several financial and estate benefits.

Your money grows tax-free

Savings in your Roth IRA grow tax-free. As long as you meet the 5-year rule, you will not owe any taxes on your distributions. Roth IRA contributions are pre-tax. You are paying taxes beforehand but do not owe taxes on any future earnings.

In comparison, contributions to Traditional IRA are typically tax-deductible. When you take distributions from Traditional IRA, you have to pay ordinary income taxes on your entire withdrawal amount. 

Tax Diversification

If your future tax rate is uncertain for various reasons, you may want to diversify your tax risk through Roth conversion. You will benefit from holding both tax-deferred and tax-exempt retirement accounts. Tax diversification gives you more flexibility when it comes to future retirement withdrawals and tax planning. 

Asset Location

Asset location is a tax-optimization strategy that takes advantage of different types of investments, getting different tax treatments. Investors who own a variety of taxable, tax-deferred, and tax-exempt accounts can benefit from asset location. By doing Roth conversion, you can determine which securities should be held in tax-deferred accounts and which in Roth accounts to maximize your after-tax returns.

No Required Minimum Distributions

Traditional IRA rules mandate you to take taxable required minimum distributions (RMDs) every year after you reach age 72.

Alternatively, your Roth IRA does not require minimum distributions at any age. Your money can stay in the account and grow tax-free for as long as you want them.

Leave behind a tax-free legacy

The Roth IRA can play a crucial role in your estate planning. Your heirs who inherit your Roth IRA will receive a tax-free gift. They will be required to take distributions from the account. However, they will not have to pay any income tax on the withdrawals if the Roth IRA has been open for at least five years. Roth IRA is especially appealing if your heirs are in a higher tax bracket than you.

Keep Social Security income tax and Medicare Premiums low

Another hidden benefit of the Roth conversion is it could potentially lower your future social security income tax and Medicare Premiums.

Up to 85% of your Social Security checks can be taxable for individuals earning more than $34,000 and families receiving more than $44,000 per year.

Your Medicare Plan B premium will be calculated based on your reported income-related monthly adjustment amount (IRMAA) 2 years prior to your application. Even a dollar higher can push in a higher premium bracket,

Roth Conversion Strategies

With some planning, Roth IRA offers substantial tax-free benefits. Due to income limits, many retirement savers end up with significant amounts in tax-deferred accounts such as 401k and Traditional IRA. These plans give you initial tax relief to encourage retirement savings. However, all future distributions are fully taxable.

The Roth conversion may help you reduce your future tax burden and unlock some of the befits of Roth IRA. Here are some of the strategies that can be helpful in your decision process.

  

End-of-year Roth conversion

The stability of your income can be critical to your success. Each conversion must be completed by the end of each tax year. If your income is constant, you can process the conversion at any time. If your income is less predictable, your only choice will be to make your conversions towards the end of the year when you will have more visibility on your earnings.

Conversion during low-income years

The Roth conversion is generally more attractive during your low-income years when you will be in a lower tax bracket. The additional reported income from the conversion will add on to your base earnings. If you do the math right, you will be able to maintain your taxes relatively low. Analyze your tax bracket and convert the amount that will keep in your desired marginal tax rate.

Conversion during a market downturn

Another popular strategy is performing Roth conversion during a market downturn. A Roth conversion could become appealing if your Traditional IRA is down 20% or 30%. At the same time, you have a long-term investment horizon and believe that your portfolio will recover the losses over time.

Your largest benefit will come from the potential tax-free portfolio gains after the stock market goes higher. With this approach, your underlying taxes take a lower priority versus the ability to earn higher tax-free income in the future. However, you still need to determine whether saving taxes on future gains provides a higher benefit than paying higher taxes now.

Monthly or quarterly cost averaging

Timing the stock market is hard. The cost averaging strategy removes the headache of trying to figure out when the stock market will go up or down. This approach calls for making planned periodic, monthly, or quarterly, conversions. The benefit of this method is that at least part of your portfolio may benefit from lower stock values. It is a way to hedge your bets on surprising stock market moves. If your portfolio goes higher consistently throughout the year, your earlier conversions will benefit from lower stock values. If the stock market goes down in the second half of the year, your later-in-the-year conversion will produce a higher benefit.

Roth Conversion barbelling

This strategy makes sense if your annual income is variable and less predictable. For example, your income fluctuates due to adjustments in commissions, bonuses, royalties, or other payments. With barbelling, you perform two conversions per year. You make the first conversion early in the year based on a projected income that is at the high end of the range. The second conversion will occur towards the end of the year, when your income becomes more predictable. If your income is high, you may convert a much smaller amount or even nothing. If your earnings for the year are at the lower end of expectation, then you convert a larger amount.

Roth Conversion Ladder

As I mentioned earlier, each Roth conversion is subject to its own 5-year rule. The 5-year period starts on January 1st of the tax year of your Roth conversion. Every subsequent conversion will have a separate 5-year holding period.

The Roth Conversion ladder strategy requires a bit of initial planning. This approach stipulates that you make consistent annual conversions year after year. After every five years, you can withdraw your savings tax-free from the Roth IRA. In effect, you are creating a ladder similar to the CD ladder.

Keep in mind that this strategy only makes sense under two conditions. One, you can afford to pay taxes for the conversion from another taxable account. Second, your future taxable income is expected to increase, and therefore you would be in a higher tax bracket.

Conclusion

Roth Conversion can be a great way to manage your future taxes. However, not every person or every family is an ideal candidate for a Roth conversion. In reality, most people tend to have lower reportable income when they retire. For them keeping your Traditional IRA and taking distributions at a lower tax rate makes a lot of sense. However, there are a lot of financial, personal, and legacy planning factors that come into play. Make your decision carefully. Take a comprehensive look at your finance before you decide if Roth conversion is right for you.

Successful strategies for (NOT) timing the stock market

Timing the stock market

Timing the stock market is an enticing idea for many investors.  However, even experienced investment professionals find it nearly impossible to predict the daily market swings, instant sector rotations, and ever-changing investors’ sentiments. The notion that you can perfectly sell at the top of the market and buy at the bottom is naïve and oftentimes leads to bad decisions.

The 24-hour news cycle is constantly bombarding us. The speed and scale of information could easily bounce the stock market between desperation, apathy, and fear to euphoria, FOMO, and irrational exuberance.

In that sense, the market volatility can be unnerving and depressing. However, for long-term investors, trying to time the market tops and bottoms is a fool’s errand. Constantly making an effort to figure out when to get in and get out can fire back. There is tremendous evidence that most investors reduce their long-term returns trying to time the market. Market timers are more likely to chase the market up and down and get whipsawed, buying high and selling low.

The hidden cost of timing the stock market

There is a hidden cost in market timing.  According to Fidelity, just missing 5 of the best trading days in the past 40 years could lower your total return by 38%. Missing the best 10 days will cut your return in half.

Source: Fidelity
Source: Fidelity

For further discussion on how to manage your portfolio during times of extreme market volatility, check my article on “Understanding Tail Risk

Rapid trading

Today’s stock market is dominated by algorithm trading platforms and swing traders with extremely short investment horizons.  Most computerized trading strategies hold their shares for a few seconds, not even minutes. Many of these strategies are run by large hedge funds. They trade based on market signals, momentum, and various inputs built within their models. They can process information in nanoseconds and make rapid trades. The average long-term investors cannot and should not attempt to outsmart these computer models daily.

Reuters calculated that the average holding period for U.S. shares was 5-1/2 months as of June 2020, versus 8-1/2 months at the of end-2019. In 1999, for example, the average holding period was 14 months. In the 1960s and 1970, the investors kept their shares for 6 to 8 years.

Timing the stock market
Timing the stock market

 

The market timing strategy gives those investors a sense of control and empowerment, It doesn’t necessarily mean that they are making the right decisions.

So, if market turmoil gives you a hard time, here are some strategies that can help you through volatile times.

Dollar-cost average

DCA is the proven approach always to be able to time the market.  With DCA, you make constant periodic investments in the stock market. And you continue to make these investments whether the market is up or down. The best example of DCA is your 401k plan. Your payroll contributions automatically invest every two weeks.

Diversify

Diversification is the only free lunch in investing. Diversification allows you to invest in a broad range of asset classes with a lower correlation between them.  The biggest benefit is lowering the risk of your investment portfolio, reducing volatility, and achieving better risk-adjusted returns.  A well-diversified portfolio will allow your investments to grow at various stages of the economic cycle as the performance of the assets moves in different directions.

Rebalance

Rebalancing is the process of trimming your winners and reinvesting in other asset classes that haven’t performed as successfully.  Naturally, one may ask, why should I sell my winners? The quick answer is diversification. You don’t want your portfolio to become too heavy in a specific stock, mutual fund, or ETF. By limiting your exposure, you will allow yourself to realize gains and buy other securities with a different risk profile.

Buy and hold

For most folks, Buy and Hold is probably the best long-term strategy. As you saw earlier,  there is a huge hidden cost of missing out on the best trading days in a given period. So being patient and resilient to noise and negative news will ultimately boost your wealth. You have to be in it to win it.

Tax-loss harvesting

If you are holding stocks in your portfolio, the tax-loss harvesting allows you to take advantage of price dips and lower your taxes. This strategy works by selling your losers at a loss and using the proceeds to buy similar security with an identical risk-reward profile. At the time of this article, you can use capital losses to offset any capital gains from the sale of profitable investments. Furthermore,  you can use up to $3,000 of residual capital loss to offset your regular income. The unused amount of capital loss can be carried forward in the next calendar year and beyond until it’s fully used.

Maintain a cash reserve

I advise all my clients to maintain an emergency fund sufficient to cover at least 6 months worth of expenses. An emergency fund is especially critical If you are relying on your investment portfolio for income. The money in your emergency fund will help you withstand any unexpected market turbulence and decline in your portfolio balance. A great example would be the rapid market correction in March 2020 at the onset of the coronavirus outbreak. If you needed to sell stocks from your portfolio, you would be in tough luck. But if you had enough cash to keep afloat through the crisis, you would have been in a perfect position to enjoy the next market rebound.

Focus on your long term goals

My best advice to my clients who get nervous about the stock market is to focus on what they can control.  Define your long-term goals and make a plan on how to achieve them. The stock market volatility can be a setback but also a huge opportunity for you. Follow your plan no matter what happens on the stock market. Step back from the noise and focus on strengthening your financial life.

Your Retirement Checklist

Retirement checklist

A happy and financially secure retirement is a primary goal for many working Americans. I created a retirement checklist that will help you navigate through the complex path of retirement planning. For my readers who are serious about their retirement planning, follow these 12 steps to organize and simplify your planning process. My 12-step retirement checklist can be a practical roadmap regardless of the age you want to retire. Following these steps will ensure that you have reviewed all aspects of your life and how they can impact your decisions before and during your retirement. Here is the crucial retirement checklist of all the things you need to do in preparation for the next chapter of your life.

1. Know what you own

You have worked very hard for this moment. You have earned and saved during your entire career. Now it’s time to benefit from your hard work. The first step of your retirement checklist is understanding what you own. Don’t guess. Don’t assume. You need to thoroughly evaluate all your assets, real estate, businesses, and retirement savings. Everything that you have accumulated during your working years can play a pivotal role in your successful retirement.

2. Gather all your financial documents

On the second step of your retirement checklist, you need to collect all relevant documents that show your asset ownership – financial statements, trust documents, wills, property deeds. This will be an excellent opportunity to gather all your plan statements from old 401k and retirement plans. If you own a real estate, make sure you have all your deeds in place. If you are beneficiary of a trust, collect all trust documents. Check all your bank, saving accounts and social security statements. Make sure that you build a complete picture of your financial life.

3. Pay of off your debt

One of your main pre-retirement goals is to become debt-free. If you are still paying off your mortgage, student loans, personal loans or credit card debt, now it’s a great time to review your finances and come up with a payment plan that will help you pay off your debts and improve your retirement prospects.

4. Build an emergency fund

The emergency fund is your rainy-day money. It’s the money that covers unexpected expenses. So, you don’t have to dip in your regular monthly budget. It’s the money that will help you if you unexpectedly lose your job or otherwise unable to earn money. I recommend keeping at least six months’ worth of living expenses in a separate savings account. Ideally, you should have built your emergency fund long before you decided to retire. If you haven’t started yet, it’s never too late to create one. You can set aside a certain percentage of your monthly income to fill the emergency fund until you reach a comfortable level.

5. Learn your employee benefits

Sometimes employers offer generous retirement benefits to attract and retain top talent. Many companies and public institutions provide 401k contribution matching, profit sharing or a pension. Some employers may even offer certain retirement health care benefits. If you are lucky to work for these companies and public organizations, learn your benefits package. Ensure that you are taking full advantage of your employee benefits. Don’t leave any free money on the table.

6. Secure health insurance

A retired couple will spend, on average, $285,000 for healthcare-related expenses during their retirement. This cost is only going higher at a faster rate than regular inflation. Even if you are in good health, healthcare will be one of your highest expenses after you retire.

Medicare part A and part B cover only part of your healthcare cost including impatient and hospital care. They do not include long-term care, dental care, eye exams, dentures, cosmetic surgery, acupuncture, hearing aids and exams, routine foot care. You will be responsible for paying for Medicare parts D out of pocket through your private Medicare Advantage insurance. Medicare Advantage is a "bundled" plan that includes Medicare Part A (Hospital Insurance) and Medicare Part B (Medical Insurance), and usually Medicare prescription drug (Part D).

7. Maximize your savings

Unless you have a generous pension, you will have to rely on your retirement savings to support yourself during retirement. Your 401k and IRA will likely be your primary retirement income source. So even if you have championed your retirement savings, now it’s a great time to calculate if your accumulated savings can support you during retirement. To boost your confidence, maximize your retirement contributions to 401k plans, IRA and even taxable investment accounts. Once you reach 50, the 401k and IRA plans will allow making additional catch up contributions.

There is another compelling reason to save in tax-deferred retirement accounts. If you are in the prime period of your earnings, you are probably in a very high tax bracket. Maximizing your tax-deferred retirement contributions will lower your tax bill for the year. You can withdraw your money

8. Prepare your estate plan

Estate planning is the process of assigning trustees and beneficiaries, writing a will, giving power of attorney, and health directives. The estate plan will guarantee that your wishes are fulfilled, and your loved ones are taken care of if you die or become incapacitated. Creating a trust will ensure that your beneficiaries will avoid lengthy, expensive and public probate. Update your beneficiaries in all your retirement accounts.

Estate planning is never a pleasant topic or an ice-breaking conversation. The sooner you get it done the sooner will go on with your life.

9. Set your budget

Budgeting is a critical step in your retirement checklist. Once you retire, you may no longer earn a wage, but you will still have monthly expenses. Retirement will give you a chance to do things for which you haven’t had time before that. Some people like to travel. Some may pick up a hobby or follow a charitable cause. Others may decide to help with grandchildren. You may choose to buy a house and live closer to your kids. Whatever lifestyle you choose, you need to ensure that your budget can support it.

10. Create social security and retirement income strategy

The most crucial step in your retirement checklist is creating your income strategy. This is the part where you might need the help of a financial planner so you can get the most out of your retirement savings and social security benefits. Your retirement income strategy should be tailored to your specific needs, lifestyle, type of savings and the variety of your assets.

11. Craft a tax strategy

Even though you are retired, you still have to pay taxes. Up to 85% of your social security benefits can be taxable. All your distributions from your 401k plan and Traditional IRA will be subject to federal and state tax. All your dividends and interest in your investment and savings accounts are taxable as well.

Only, the distributions from Roth IRA are not taxable. As long as you have your Roth IRA open for more than five years and you are 59 ½ or older, your withdrawals from the Roth IRA will be tax-free.

Ask your financial advisor to craft a tax strategy that minimizes your tax payments over the long run. Find out if Roth Conversion makes sense to you.

12. Set your retirement goals

Retirement opens another chapter in your life. The people who enjoy their retirement the most are those who have retirement goals. Find out what makes you happy and follow your passions. Your retirement will give you a chance to do everything that you have missed while you were pursuing your career.

Final words

Navigating through your retirement checklist will be a reflection of your life, career, assets, and family. No one’s retirement plan is the same. Everybody’s situation is unique and different. Follow these simple 12 steps so you can enjoy and better prepare for your retirement. Be proactive. Don’t wait until the last minute for crucial financial decisions. Make well-informed choices so you can be ahead of life events and enjoy your retirement to the fullest.

Understanding Tail Risk and how to protect your investments

Understanding tail risk

What is Tail Risk?

Tail Risk is the possibility of suffering large investment losses due to sudden and unforeseen events. The name tail risk comes from the shape of the bell curve. Under normal circumstances, your most likely investment returns will gravitate in the middle of the curve. For long term investors, this will represent your average expected return. The more extreme returns have a lower probability of occurring and will taper away toward the end of the curve.

Understanding tail risk
Source: Pimco

The tail on the far-left side represents the probability of unexpected losses. The far-right represents the most extreme outcomes of substantial investment gains. For long-term investors, the ideal portfolio strategy will seek to minimize left tail risk without restricting the right tail growth potential.

Why is tail risk important?

Intuitively, we all want to be on the ride side of the bell curve. We want to achieve above-average returns and occasionally “hit the jackpot” with sizeable gains.

In real life, abrupt economic, social, and geopolitical events appear a lot more frequently than a rational human mind would predict. Furthermore, significant market shocks have been occurring about every three to five years resulting in “fatter” tails.

Also known as “Black Swans, they are rare and unique. These “one-off” events impose adverse pressure on your investment portfolio and create risk for outsized losses. Tail risk events bring a massive amount of financial and economic uncertainty and often lead to extreme turbulence on the stock market.

The Covid outbreak, Brexit, the European credit crisis, the collapse of Lehman Brothers, the Enron scandal, the US housing market downfall, and the 9/11 terrorist attacks are examples of idiosyncratic stock market shocks. Very few experts could have predicted them. More notably, they caused dramatic changes to our society and our economy, our consumer habits, and the way we conduct business.

Assessing your tail risk exposure

Retirees and those close to retirement, people who need immediate liquidity, executives, and employees holding a large amount of corporate stock are more susceptible to tail risk events. If you fall into one of these categories, you need to review your level of risk tolerance.

Investing is risky. There are no truly risk-free investments. There are only investments with different levels of risk. It is impossible to avoid risk altogether. The challenge for you is to have a reasonably balanced approach to all the risks you face. Ignoring one risk to help you prevent another risk does not mean you are in the clear.

Winners and losers

It is important to remember that every shock to the system leads to winners and losers. For example, the covid outbreak disproportionately hurt leisure, travel, retail, energy, and entertainment businesses. But it also benefited many tech companies as it accelerated the digital transformation. As bad as it was, the global financial crisis damaged many big and small regional banks. But it also opened the door for many successful fintech companies such as Visa, Mastercard, PayPal, and Square and exchange-traded fund managers like BlackRock and Vanguard. The aftermath of 9/11 drove the stock market down, but it led to a boost in defense and cybersecurity stocks.

Know your investments

The first step in managing your tail risk is knowing your investments. That is especially important if you have concentrated positions in a specific industry, a cluster of companies, or a single stock. Black Swan events could impact different stocks, sectors, and countries differently. For instance, the Brexit decision mostly hurt the performance of the UK and European companies and had no long-term effect on the US economy.

Know your investment horizon

Investors with a long-term investment horizon are more likely to withstand sudden losses. The stock market is forward-looking. It will absorb the new information, take a hit, and move on.

I always give this as an example. If you invested $1,000 in the S&P 500 index on January 1, 2008, just before the financial crisis, you would have doubled your money in 10 years. Unfortunately, if you needed your investment in one or two years, you would have been in big trouble. It took more than three years to recover your losses entirely.

Diversify

Never put all your eggs in one basket. The most effective way to protect yourself from unexpected losses is diversification. Diversification is the only free lunch you will ever get in investing. It allows you to spread your risk between different companies, sectors, asset classes, and even countries will allow your investment portfolio to avoid choppy swings in various market conditions. One prominent downside of diversification is that while you protect yourself from the left tail risk, you also limit the right tail potential for outsized returns.

Hold cash

Keeping cash reserves is another way to protect yourself from tail risk. You need to have enough liquidity to meet your immediate and near-term spending needs. I regularly advise my clients to maintain an emergency fund equal to six to twelve months of your budget. Put it in a safe place, but make sure that you still earn some interest.

Remember what we said earlier. There is no risk-free investment – even cash. Cash is sensitive to inflation. For instance, $100,000 in 2000 is worth only $66,800 in 2020. So, having a boatload of cash will not guarantee your long-term financial security. You must make it earn a higher return than inflation.

Furthermore, cash has a huge opportunity cost tag. In other words, by holding a large amount of money, you face the risk of missing out on potential gain from choosing other alternatives.

US Treasuries

US Government bonds have historically been a safe haven for investors during turbulent times. We have seen the demand for treasuries spiking during periods of extreme uncertainty and volatility. And inversely, investors tend to drop them when they feel confident about the stock market. Depending on their maturity, US treasuries may give you a slightly higher interest than holding cash in a savings account.

While offering some return potential, treasuries are still exposed to high inflation and opportunity cost risk. Also, government bonds are very sensitive to changes in interest rates. If interest rates go up, the value of your bonds will go down. On the other hand, when interest rates go down, the value of your bonds will decrease.

Gold

Gold is another popular option for conservative investors. Similar to treasuries, the demand for gold tends to go up during uncertain times. The faith for gold stems from its historical role as a currency and store of value. It has been a part of our economic and social life in many cultures for thousands of years.

As we moved away from the Gold standard, the Gold’s role in the economy has diminished over time. Nowadays, the price of gold is purely based on price and demand. One notable fact is that gold tends to perform well during periods of high inflation and political uncertainty.

In his 2011 letter to shareholders of Berkshire Hathaway, Warren Buffet described gold as an “asset that will never produce anything, but that is purchased in the buyer’s hope that someone else … will pay more for them in the future…..If you own one ounce of gold for an eternity, you will still own one ounce at its end.”

Buying Put Options to hedge tail risk

Buying put options om major stock indices is an advanced strategy for tail risk hedging. In essence, an investor will enter into an option agreement for the right to sell a financial instrument at a specified price on a specific day in the future. Typically, this fixed price known as a strike price is lower than the current levels where the instrument is trading. For instance, the stock of XYZ is currently trading at $100. I can buy a put option to sell that stock at $80 three months from now. The option agreement will cost me $2. If the stock price of XYZ goes to $70, I can buy it at $70 and exercise my option to sell it at $80. By doing that, I will have an immediate gain of $10. This is just an illustration. In real life, things can get more complicated.

The real value of buying put options comes during times of extreme overvaluation in the stock market. For the average investor, purchasing put options to tail risk hedging can be expensive, time-consuming, and quite complicated. Most long-term investors will just weather the storm and reap benefits from being patient.

Final words

Managing your tail risk is not a one-size-fits-all strategy. Black Swam events are distinctive in nature, lengh, and magnitude. Because every investor has specific personal and financial circumstances, the left tail risk can affect them differently depending on a variety of factors. For most long-term investors, the left tail and right tail events will offset each other in the long run. However, specific groups of investors need to pay close attention to their unique risk exposure and try to mitigate it when possible.

10 practical ways to pay off debt before retirement

Pay off debt before retirement

Pay off debt before retirement is a top priority for many of you who are planning to retire in the near future. In my article Retirement Checklist, I discussed a 12-step roadmap to planning a successful and carefree retirement. One of the most important steps was paying off your debt. According to the Federal Reserve, US households owe $4 trillion in non-housing loans and $10 trillion in mortgage debt. In today’s world, it is easy and effortless to get credit. Loan and credit card offers are lurking on every corner.

Why is it essential to pay off debt before retirement?

Being debt-free is a significant milestone in becoming financially independent. Retirement opens a new chapter in new life. You can no longer rely on your working wage. Your retirement income will come from a combination of steady income sources such as social security, pension, retirement savings, and possibly annuities.  Your income will drop, your healthcare cost will rise, and your debt payments will remain the same. Having a large amount of debt during retirement will reduce your disposable income and strain your financial strength.

For those of you who are committed to paying debt before retirement, I have created a multi-step guide that can help you navigate through the challenges of becoming debt-free

1. Set your goals

Setting your financial and retirement goals is an essential pathway in your life journey. Pay off debt before retirement starts with establishing up your goals. Having goals give you structure and will prepare you for the future. If you do not know where you are going, you can end up anywhere. Following your objectives will provide you with essential life milestones. Achieving your goals will give you a sense of accomplishment and boost your confidence.

2. Take control of your spending habits

If you are approaching retirement with considerable debt, you need to rein in spending habits. You can not be a big spender. Therefore, as long as you spend more than you earn, you will need to cut back. I know it is a painful task. It is not easy to make changes to your lifestyle. Still, think of it as a small and responsible sacrifice today so you can live a better tomorrow.

3. Create a budget

If you find yourself spending more than you make, you will need to set up a budget. Numerous websites and mobile apps can help you track your income and expenses by groups, categories, and periods. Regular budgeting can help you steer away from outsized spending and frivolous purchases.

4. Build an emergency fund

An emergency fund is the amount of cash you need to cover 6 to 12 months of essential expenses. Financially successful people maintain an emergency fund to cover high, unexpected costs. Your rainy-day stash can serve as a buffer if you lose your job or lose your ability to earn income. By maintaining an emergency fund, you could avoid taking debt and cover temporary gaps in your budget. Suppose you don’t have an emergency fund. Start with setting up a certain percentage of your wage that will automatically go to your savings account. Don’t get discouraged if it takes a long time to build your rainy-day fund.  It is okay. Look forward and keep saving.

5. Track your loans

Did you notice that the first four steps of becoming debt-free did not involve debt at all? I hope you will agree that building long-lasting financial habits is the key to financial independence.

So, if you have reviewed my first four recommendations, it is time to look at your debt.

Make a list of all your loans – credit cards, auto, mortgage, student, home equity, personal loans. Sort them by amount and interest rate. Pay attention to due dates and monthly interest charges. Do not miss payments. Late or missed payments can trigger enormous late fees and penalty charges. Stay on top of your loans. Track them daily and monthly.

6. Pay off higher interest loans first

I strongly recommend that you pay off your highest interest loans first. Credit cards tend to have the highest interest rates and the most punishing late fees. If you have credit card debt, there is a high chance that you need to tackle it first.  Remember, there are always exceptions to the rules, and every one case is different.

Another popular theory suggests that you pay off your smaller loans first and repay the bigger loans next. The reasoning behind this recommendation is that paying off even smaller loans awards you with the feeling of accomplishment. You can also focus on the big picture once you eliminate the smaller loans.

Mathematically, paying off your highest interest loans makes more sense. Emotionally, paying off the smaller debt first could be more effective. In the end, you can find a happy medium. Use the approach that works best for you and your specific situation.

7. Pay off or refinance your mortgage

I recommend that you pay off your mortgage by the time you retire. Owning your house without the burden of debt is the ultimate American dream and the secret to a happy retirement. In today’s world, there is nothing more liberating than owning your home. Your home is your fortress. It’s the place where you can be yourself. You can host your family and friends and enjoy your favorite hobby.

Now, if you are still making mortgage payments, you may want to look into refinancing options. With record-low interest rates, today offers an excellent opportunity to lower your monthly mortgage bill. It’s certainly will be easier to refinance your mortgage while still working and having regular income and paystubs. I highly recommend that you shop around for the best offer. Banks and mortgage brokers will offer you a wide range of interest rates, closing costs, and refinancing rules. Generally, stay away from bids with high closing costs. Evaluate your savings for each offer and choose the option that best suits your need.

8. Downsize and relocate

Another popular way to control your cost and pay off debt before retirement is downsizing and relocating. Sometimes you can do them both at the same time. Owning a big house requires high maintenance, bills, and possibly higher property taxes. Moving to a smaller home in a more affordable location can save you a lot of money in the long run. The USA offers a wide range of affordable locations in smaller states and communities. Choose a location that fits your budget, health insurance needs, and lifestyle.

9. Work longer

if you are approaching retirement age and holding debt, you may want to consider working longer. Working after retirement is no longer a stigma. Many retirees choose to work part-time, remain active, and earn an extra income.  The additional money can help your pay off your remaining loans. You can use the extra cash to maintain your emergency fund or support your current lifestyle.

10. Do not touch your retirement savings

Your retirement savings are sacred. They are your ticket to financial freedom. It can be tempting to pay your debt before retirement by tapping into your 401k or IRA. However, this strategy rarely ends very well.  Do not withdraw your 401k or IRA savings unless you are in dire need. Hold on to your retirement savings until you exhaust your other options.  One, when drawing from your retirement plan, you will need to pay taxes. Furthermore, you may have to pay a penalty charge if you are younger than 59 ½. Second, paying off debt without controlling your expense will only have a short-term impact. You will be back where you started in just a couple of months or years. And lastly, tapping your retirement savings now will reduce your future income. How confident are you that you can replace your lost revenue in the future?

Benefits and drawbacks to buying Indexed Universal Life Insurance

Indexed Universal Life Insurance IUL

Today, I am going off the beaten path for me and will discuss the pros and cons of buying Indexed Universal Life Insurance. As a fee-only advisor, I do not sell any insurance or commission-based products. However, on numerous occasions, I have received requests from clients to review their existing insurance coverage. I certainly do not know every IUL product out there. And I might be missing some of the nuances and differences between them. My observation is that IUL is not suitable for the average person due to its complexity and high cost. And yet, the IUL might be the right product for you if you can take advantage of the benefits that it offers. 

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What is an Indexed Universal Life Insurance (IUL)?

Indexed Universal Life is a popular insurance product that promises protection coverage with stock market-like performance and a zero-downside risk. Like other universal life insurance, IUL offers a death benefit and a cash value. Your cash value account can earn interest based on the performance of a specific stock market index such as the S&P 500, Dow Jones Industrial Average, the Nasdaq 100, and Russell 2000.

IUL Illustration rate

IUL policies use an illustration rate for advertising and hypothetically projecting the policy values in their sales materials. The Illustration rate is the fixed rate derived from historical performance. Usually, the illustration rate ranges between 5% and 10%.

Is IUL right for me?

On the surface, Indexed Universal Life Insurance sounds like a great deal. You receive a stock market upside with zero risks for losses. Nevertheless, IUL comes with some severe caveats.

Let’s break down the main benefits and drawbacks of IUL.

 Benefits of Indexed Universal Life Insurance

Tax-Deferred Accumulation

Index Universal Life Insurance allows you to grow your policy cash value and death benefit on a tax-deferred basis. Typically, you will not owe income taxes on the interest credited to your cash value and death benefit.

Tax-Free Distribution

Life Insurance, in general, is a lucrative tool for legacy planning. With IUL, your policy beneficiaries will receive the death benefit tax-free. As long as you maintain your insurance premiums and don’t take outsized loans, you can pass tax-free wealth to the next generation.

Access to a cash value

You can always withdraw your policy basis (original premiums paid) tax-free. In most cases, you can also access your cash value through tax-favorable policy loans or withdrawals. In case of emergency, you may borrow from your indexed universal life insurance policy. You can access your cash value without any penalty regardless of your age.

Supplemental Retirement Income

You can use the cash value from your policy as a source of supplemental retirement income.  You can also use it to cover future medical expenses.

Limited downside risk

IUL offers protection against stock market volatility. An IUL delivers stock market-linked gains without the risks of losing principal due to the stock market declines. With the IUL’s principal-protection guarantee, your annual gains are locked in. Your principal cash value remains the same, even if the stock market goes down.

A guaranteed minimum rate

Many IUL policies come with a guaranteed minimum annual interest rate. This rate is a floor of how much you can earn every year. The guaranteed allows you to receive a certain percentage regardless of how the market performs. This floor rate depends on the specific insurance, and it could vary between 0% and 2%.

Drawbacks of Indexed Universal Life Insurance

IUL is complex

IUL is an extremely complex insurance product. There are many moving parts in your UIL policy, making it confusing and hard to understand. Most sales illustration packages portray an ideal scenario with non-guaranteed average market performance figures. In reality, between your annual premiums, cap rates, floors, fees, market returns, cash value accumulation, riders, and so on, it is tough to predict the outcome of your insurance benefits.

Upfront Commissions

The people who sell IUL are highly trained sales professionals who may not be qualified to provide fiduciary financial advice. The IUL comes with a hefty upfront commission, which is often buried in the fine print and gets subtracted from your first premium payment.

IUL has high fees

The policy fees will shock you and eat your lunch literally. I have personally seen charges in the neighborhood of 11% to 13% annually. These fees will always reduce the benefits of your annual premium and earned interest.

Limited earnings potential

IUL policies will typically limit your stock market returns and will exclude all dividends. Most IULs offer some combination of participation rate and capped rate in comparison to the illustration rate used in their marketing materials.

Participation Rate is the percentage of positive index movement credited to the policy. For example, if the S&P 500 increased 10% and the IUL has an annual participation rate of 50%, your policy would receive 5% interest on the anniversary date.

Cap Rate is the maximum rate that you can earn annually. The cap rate can vary significantly from policy to policy and from insurance provider to the next.

 Why capped upside is an issue?

The problem with cap rates and participation rates is they limit your gains during, especially good years. Historically, the stock market returns are not linear and sequential, as the policy illustration rates suggest. In the 40 years between 1980 and 2019, the stock market earned an average of 11.27% per year. During this period, there were only eight years when the stock market had negative returns or 20% of that period. There were only seven years when the stock market posted returns between 0% and 10%. And there were 25 years when the stock market earned more than 10% per year. In 17 of those 25 periods, the stock market investors gained more than 20% or 42% of the time.

In other words, historically, the odds of outsized gains have been a lot higher than the odds of losses.

However, as humans, the pain of losing money is a lot stronger than the joy of gaining.

In effect, long-term IUL policyholders will give up the potential of earning these outsized profits to reduce their anxiety and stress of losing money.

Surrender charges

IULs have hefty surrender charges. If you change your mind in a couple of years and decide to cancel your policy, you may not be able to receive the full cash value. Before you get into a contract, please find out the surrender charges and when they expire.

Expensive Riders

Indexed Universal Life Insurance typically offers riders. The policy riders are contract add-ons that provide particular benefits in exchange for an additional fee. These provisions can include long-term care services, disability waivers, enhanced performance, children’s’ term insurance, no-lapse guarantee, and many more. The extra fee for each rider will reduce your cash value, similar to the regular policy fees. You need to assess each rider individually as the cumulative cost may outweigh your benefit and vice versa,

Cash value withdrawals reduce your death benefit

In most cases, you might be able to make a tax-free withdrawal from the cash value of your IUL policy. These withdrawals are often treated as loans. However, legacy-minded policyholders need to remember that withdrawing your cash value reduces your beneficiaries’ death benefit when you pass away.

Potential taxable income

There is still a chance to pay taxes on your IUL policy. If you let your policy lapse or decide to surrender it, the money you have withdrawn previously could be taxable. Withdrawals are treated as taxable when they exceed your original cost basis or paid premiums.

401k contribution limits 2021

401k contribution limits 2021

401k contribution limits for 2021 are $19,500 per person. All 401k participants over the age of 50 can add a catch-up contribution of $6,500.

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What is 401k?

401k plan is a workplace retirement plan where both employees and employers can make retirement contributions. These retirement plans can be one of the easiest and most effective ways to save for retirement. As an employee, you can make automatic contributions to your 401k directly through your company payroll. You can choose the percentage of your salary that will go towards your retirement savings, Most 401k will provide you with multiple investment options in stocks and fixed income. Additionally, most companies offer a 401k match up to a certain percentage. In most cases, you need to participate in the plan in order to get the match.

There are two types of contributions – traditional 401k tax-deferred and tax-exempt Roth 401k contributions.

Tax-deferred 401k

Most employees, typically, choose to make tax-deferred 401k contributions. These payments are tax-deductible. They will lower your tax bill for the current tax year. Your investments will grow on a tax-deferred basis. Therefore, you will only owe federal and state taxes when you start withdrawing your savings.

Roth 401k

Roth 401k contributions are pretax. It means that you will pay all federal and state taxes before making your contributions. The advantage of Roth 401k is that your retirement savings will grow tax-free. As long as you keep your money until retirement, you will withdraw your gain tax-free. It’s a great alternative for young professionals and workers in a low tax bracket.

How much can I contribute to my 401k in 2021?

401k contribution limits change every year. IRS typically increases the maximum annual limit with the cost of living adjustment and inflation. These contribution limits apply to all employees who participate in 401(k), 403(b), most 457 plans, and the federal government’s Thrift Savings Plan. Additionally, the limits apply to both tax-deferred and Roth contributions combined. 

  • Employees can contribute up to $19,500 to their 401(k) plan for 2021,  the same amount as  2020.
  • Employees of age 50 or over are eligible for an additional catch-up contribution of $6,500 in 2021, the same amount as  2020
  • The employee compensation limit for calculating 401k contributions is $290,000, $5,000 more than 2020
  • Companies can make a matching contribution up to the combined limit of $58,000 or $64,500 with the catch-up contribution. If an employee makes the maximum allowed contribution, the company match cannot exceed $38,500 in 2021.

Solo 401k contribution limits 2021

A solo 401k plan is a type of 401k plan with one participant. Those are usually solo entrepreneurs, consultants, freelancers, and other small business owners. Self-employed individuals can take advantage of solo 401k plans and save for retirement.

  • The maximum contribution limit in 2021 for a solo 401k plan is $58,000 or $64,500 with catch-up contributions. Solo entrepreneurs can make contributions both as an employee and an employer.
  • The employee contribution cannot exceed $19,500 in the solo 401(k) plan for 2021.
  • Self-employed 401k participants, age 50 or over are eligible for an additional catch-up contribution of $6,500 in 2021.
  • The total self-employed compensation limit for calculating solo 401k contributions is $290,000.
  • Employer contribution cannot exceed 25% of the compensation
  • If you participate in more than one 401k plan at the same time, you are subject to the same annual limits for all plans.

Please note that if you are self-employed and decide to hire other employees, they will have to be included in the 401k plan if they meet the plan eligibility requirements.

 

Roth IRA Contribution Limits 2021

Roth IRA Contribution Limits for 2021

The Roth IRA contribution limits for 2021 are $6,000 per person with an additional $1,000 catch-up contribution for people who are 50 or older.

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Roth IRA income limits for 2021

Roth IRA contribution limits for 2021 are based on your annual earnings. If you are single and earn $125,000 or less, you can contribute up to the full amount of $6,000 per year.  If your aggregated gross income is between $125,000 and $140,000 you can still make contributions but with a lower value.

Married couples filing jointly can contribute up to $6,000 each if your combined income is less than $198,000.  If your aggregated gross income is between $198,000 and $208,000 you can still make reduced contributions.

What is a Roth IRA?

Roth IRA is a tax-free retirement savings account that allows you to make after-tax contributions to save towards retirement. Your Roth investments grow tax-free. You will not owe taxes on dividends and capital gains. Once you reach retirement your withdrawals will be tax-free as well.

Roth vs Traditional IRA

Roth IRA allows you to make after-tax contributions towards retirement. In comparisons. Traditional IRA has the same annual contributions limits. The Traditional IRA contributions can be tax-deductible or after-tax depending on your income. Additionally, your Traditional IRA savings grow tax-deferred. Unlike Roth Roth, you will owe income taxes on your withdrawals.

Roth IRA Rules

The Roth IRA offers a lot of flexibility and few constraints.  There are Roth IRA rules that can help you maximize the benefits of your tax-free savings account.

Easy and convenient

Opening a Roth IRA account is a great way to start planning for your financial future. The plan is an excellent saving opportunity for many young professionals with limited access to workplace retirement plans. Even those who have 401k plans with their employer can open a Roth IRA.

Flexibility

There is no age limit for contributions. Minors and retired investors can invest in Roth IRA as well as long as they earn income.

No investment restrictions

There is no restriction on the type of investments in the account. Investors can invest in any asset class that suits their risk tolerance and financial goals.

No taxes

There are no taxes on the distributions from this account once you reach 59 ½. Your investments will grow tax-free. You will never pay taxes on your capital gains and dividends either.

No penalties if you withdraw your original investment

While not always recommended, Roth IRA allows you to withdraw your original dollar contributions (but not the return from them) before reaching retirement, penalty and tax-free. Say, you invested $5,000 several years ago. And now the account has grown to $15,000. You can withdraw your initial contribution of $5,000 without penalties.

Diversify your future tax exposure

Roth IRA is ideal for investors who are in a lower tax bracket but expect higher taxes in retirement. Since most retirement savings sit in 401k and investment accounts, Roth IRA adds a very flexible tax-advantaged component to your investments. Nobody knows how the tax laws will change by the time you need to take out money from your retirement accounts. That is why I highly recommend diversifying your mix of investment accounts and take full advantage of your Roth IRA.

No minimum distributions

Unlike 401k and IRA, Roth IRA doesn’t have any minimum distributions requirements. Investors have the freedom to withdraw their savings at their wish or keep them intact indefinitely.

Earnings cap

You can’t contribute more than what you earned for the year. If you made $4,000, you could only invest $4,000.

IRA Contribution Limits 2021

IRA Contribution Limits for 2021

The IRA contribution limits for 2021 are $6,000 per person with an additional $1,000 catch-up contribution for people who are 50 or older.

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What is an IRA?

IRA or Traditional IRA is a tax-deferred retirement savings account that allows you to make tax-deductible contributions to save towards retirement. Your savings grow tax-free. You do not owe taxes on dividends and capital gains. Once you reach retirement age, you can start taking money out of the account. All distributions from the IRA are taxable as ordinary income in the year of withdrawal.

IRA income limits for 2021

The tax-deductible IRA contribution limits for 2021 are based on your annual income. If you are single and earn $125,000 or less, you can contribute up to the full amount of $6,000 per year.  If your aggregated gross income is between $125,000 and $140,000 you can still make contributions but with a smaller amount.

Married couples filing jointly can contribute up to $6,000 each if your combined income is less than $198,000.  If your aggregated gross income is between $198,000 and $208,000 you can still make reduced contributions.

Spousal IRA

If you are married and not earning income, you can still make contributions. As long as your spouse earns income and you file a joint return, you may be able to contribute to an IRA even if you did not have taxable compensation. Keep in mind that, your combined contributions can’t be more than the taxable compensation reported on your joint return.

IRA vs 401k

IRA is an individual retirement account.  401k plan is a workplace retirement plan, which is established by your employer. You can contribute to a 401k plan if it’s offered by your company.  In comparison, anyone who is earning income can open and contribute to a traditional IRA regardless of your age.

IRA vs Roth IRA 

Traditional and Roth IRA have the same annual contribution limits.  The Traditional IRA contributions can be tax-deductible or after-tax depending on your income. In comparison. Roth IRA allows you to make after-tax contributions towards retirement. Another difference, your Traditional IRA retirement savings grow tax-deferred, while Roth IRA earnings are tax-free.

 

TSP contribution limits 2021

TSP Contribution Limits for 2021

TSP contribution limits for 2021 is 19,500 per person. Additionally, all federal employees over the age of 50 can contribute a catch-up of $6,500 per year.

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What is TSP?

Thrift Saving Plan is a Federal retirement plan where both federal employees and agencies can make retirement contributions. Moreover, this retirement plan is one of the easiest and most effective ways for you to save for retirement. As a federal employee, you can make automatic contributions to your TSP directly through your employer’s payroll. You can choose the percentage of your salary that will go towards your retirement savings. TSP provides you with multiple investment options in stocks, fixed income, and lifecycle funds. Additionally, most agencies offer a TSP match up to a certain percentage. In most cases, you need to participate in the plan in order to get the match. For more information about investment options in your TSP account, check my article – “Grow your retirement savings with the Thrift Savings Plan.”

Who is Eligible to Participate in the TSP?

Most employees of the United States Government are eligible to participate in the Thrift Savings Plan. You are eligible if you are:

  • Federal Employees’ Retirement System (FERS) employees (started on or after January 1, 1984)
  • Civil Service Retirement System (CSRS) employees (started before January 1, 1984, and did not convert to FERS)
  • Members of the uniformed services (active duty or Ready Reserve)
  • Civilians in certain other categories of Government service

How much can I contribute to my TSP in 2021?

TSP contribution limits for 2021 stayed the same as change every year. IRS typically increases the maximum annual limit with the cost of living adjustment and inflation. These contribution limits apply to all employees who participate in the federal government’s Thrift Savings Plan,  401(k), 403(b), and 457 plans. Additionally, the limits apply to both tax-deferred and Roth contributions combined. 

  • Employees can contribute up to $19,500 to their TSP plan for 2021,  the same amount as  2020.
  • Employees of age 50 or over are eligible for an additional catch-up contribution of $6,500 in 2021, the same amount as  2020.
  • Employee compensation limit for calculating TSP contributions is $290,000, $5,000 more than 2020
  • For participants who contribute to both a civilian and a uniformed services TSP account during the year, the elective deferral and catch-up contribution limits apply to the combined amounts of traditional (tax-deferred) and Roth contributions in both accounts.
  • Members of the uniformed services, receiving tax-exempt pay (i.e., pay that is subject to the combat zone tax exclusion), your contributions from that pay will also be tax-exempt. Your total contributions from all types of pay must not exceed the combined limit of $58,000 per year.

There are two types of contributions – tax-deferred traditional TSP  and tax-exempt Roth TSP contributions.

Tax-deferred TSP

Most federal employees, typically, choose to make tax-deferred TSP contributions. These contributions are tax-deductible. They will lower your tax bill for the current tax year. Your investments will grow on a tax-deferred basis. Therefore, you will only owe federal and state taxes when you start withdrawing your savings.

Roth TSP

Roth TSP contributions are pretax. It means that you will pay all federal and state taxes before making your contributions. The advantage of Roth TSP is that your retirement savings will grow tax-free. As long as you keep your money until retirement, you will withdraw your gain tax-free. It’s a great alternative for young professionals and workers in a low tax bracket.

TSP Matching

Federal agencies can make a matching contribution up to the combined limit of $58,000 or $64,500 with the catch-up contribution. If you contribute the maximum allowed amount, your agency match cannot exceed $38,500 in 2021.

If you are an eligible FERS or BRS employee, you will receive matching contributions from your agency based on your regular employee contributions. Unlike most private companies, matching contributions are not subject to vesting requirements.

FERS or BRS participants receive matching contributions on the first 5% of your salary that you contribute each pay period. The first 3% of your contribution will receive a dollar-for-dollar match. The next 2% will be matched at 50 cents on the dollar. Contributions above 5% of your salary will not be matched.

Consider contributing at least 5% of your base salary to your TSP account so that you can receive the full amount of matching contributions.

Matching schedule

TSP Matching contribution
Source: tsp.gov

Opening your TSP account

FERS Employees

If you are a federal employee hired after July 31, 2010, your agency has automatically enrolled you in the TSP.  By default, 3% of your base salary will be deducted from your paycheck each pay period and deposited in the traditional balance of your TSP account.  If you decide, you have to make an election to change or stop your contributions.

If you are a FERS employee who started before August 1, 2010, you already have a TSP account with accruing 1% automatic contributions. In addition, you can make contributions to your account from your pay and receive additional matching contributions.

CSRS Employees

If you are a Federal civilian employee who started before January 1, 1984, your agency will establish your TSP account after you make a contribution election using your agency’s election system.

BRS Members of the Uniformed Services

Members of the uniformed services who began serving on or after January 1, 2018, will automatically enroll in the TSP once you serve 60 days. By default,  3% of your basic pay is deducted from your paycheck each pay period and deposited in the traditional balance of your TSP account. You have can always select to change or stop your contributions.

New Year Financial Resolutions for 2021

New Year Financial Resolutions for 2021

New Year Financial Resolutions for 2021. Let’s kick off 2021 with a bang. It’s time to hit the refresh button.  2020 was very challenging. The covid pandemic brought enormous shifts to our daily lives.  Social distancing. Working from home. Digital transformation. 5G. Many of these changes will stay with us permanently. It’s time to open a new chapter. Take control of your finances. Become financially independent

Here are your New Year Financial Resolutions for 2021

1. Set your financial goals

Your first  New Year Financial Resolutions for 2021 is to set your financial goals. Know where you are going. Build milestones of success.  Be in control of your journey. Setting and tracking your financial goals will help you make smart financial decisions in the future. It will help you define what is best for you in the long run.

2. Pay off debt

Americans owe $14.3 trillion in debt. The average household owes  $145,000 in total debt, $6,270 in credit cards, and $17,553 in auto loans. These figures are insane. If you are struggling to pay off your debts, 2021 is your year to change your life. Check out my article How to Pay off your debt before retirement. With interest rates are record low today, you can look into consolidating debt or refinancing your mortgage. Take advantage of these low-interest options. Even a small percentage cut of your interest can lead to massive savings and reductions of your monthly debt payments.

3. Automate bill payments

Are you frequently late on your bills? Are you getting hefty late penalty fees? It’s time to switch on automatic bill payments. It will save you time, frustration, and money. You should still review your bills for unexpected extra charges. But no need to worry about making your payments manually. Let technology do the heavy lifting for you.

4. Build an emergency fund

2020 taught us an important lesson. Life can be unpredictable. Economic conditions can change overnight. For that reason, you need to keep money on a rainy day. Your emergency fund should have enough cash to cover 6 to 12 months of essential expenses. Start with setting up a certain percentage of your wage that will automatically go to your savings account. Your rainy-day cash will hold you up if you lose your job or your ability to earn income. By maintaining an emergency fund, you could avoid taking debt and cover temporary gaps in your budget.

5. Monitor your credit score

In today’s world, everything is about data. Your credit score measures your financial health. It tells banks and other financial institutions your creditworthiness and ability to repay your debt. Often. The credit score methodology is not always perfect. That said, every lender and even some employers will check your credit score before extending a new line of credit or a job offer.

6. Budget

Do you find yourself spending more than you earn? Would you like to save more for your financial goals? If you are struggling to meet your milestones, 2021 will give you a chance to reshape your future. Budgeting should be your top New Year Financial Resolutions for 2021. There are many mobile apps and online tools alongside old fashion pen-and -aper to track and monitor your expenses. Effective budgeting will help you understand your spending habits and control impulse purchases.

7. Save more for retirement

One of your most important New Year Financial Resolutions for 2021 should be maximizing your retirement savings. I recommend that you save at least 10% of your earnings every year. If you want to be more aggressive, you can set aside 20% or 25%.  A lot depends on your overall income and spending lifestyle.

In 2021, you can contribute up to $19,500 in your 401k. If you are 50 and older, you can set an additional $6,500. Furthermore, you can add another $6,000 to your Roth IRA or Traditional IRA.

8. Plan your taxes

You probably heard the old phrase. It’s not about how much you earn but how much you keep. Taxes are the single highest expense that you pay every year. Whether you are a high-income earner or not, proper tax planning is always necessary to ensure that you keep your taxes in check and take advantage of tax savings opportunities. But remember, tax planning is not a daily race; it’s a multi-year marathon.

9. Review your investments

When was the last time you reviewed your investments? Have you recently checked your 401k plan? You will be shocked to know how many people keep their retirement savings in cash and low-interest earning mutual funds.  Sadly, sitting in cash is a losing strategy as inflation reduces your purchasing power. A dollar today is not equal to a dollar 10 years from now. While investing is risky, it will help you grow your wealth and protect you from inflation. Remember that time and time again; long-term investors get rewarded for their patience and persistence.

10. Protect your family finances from unexpected events

2020 taught us a big lesson. Life is unpredictable. Bad things can happen suddenly and unexpectedly. In 2021, take action to protect your family, your wealth, and yourself from abrupt events. Start with your estate plan. Make sure that you write your will and assign your beneficiaries, trustees, and health directives.

Laslly, you need to review your insurance coverage. Ensure that your life, disability, and other insurance will protect your family in times of emergency.

Charitable donations: 6 Tax Strategies

Charitable donations

Charitable donations are an excellent way to help your favorite cause, your church, a foundation, a school, or any other registered charitable institution of your choice. Americans made $373.25 billion of charitable donations in 2015, which was 4.1% higher than in 2014. The average annual household contribution was $2,974. In 2015, the majority of charitable dollars went to religious institutions (32%), educational organizations (15%), human services (12%), grantmaking foundations (11%), and health organizations (8%).

Charitable donations are also a powerful tool to reduce your overall tax liability to the IRS. By carefully following the tax law and IRS rules you can substantially increase the impact of donations. Here is what you can do.

1. Meet the requirements for charitable donations

In order to receive tax deductions for your gift, donations need to meet certain requirements. Some of the most important rules are:

  • You have to give to qualified charitable organizations approved by the IRS. The charity can be public or private. Usually, public charities receive more favorable tax treatment.
  • You need to have a receipt for your gift.
  • You need to itemize your tax return.
  • Donations apply for the same tax year when you make them. For most individuals the tax year and calendar year are the same. For some companies, their tax year may end on a different date during the calendar year (for example, November 1 to October 31)
  • All gifts are valued at fair market value. Depending on your donation, the fair market value may not be equal to the initial cash value.
  • You have to transfer the actual economic benefit or ownership to the receiver of your gift.

There are many ways to give. Some are straightforward, others are more complex and require professional help. Each one of them has its rules, which you need to understand and follow strictly to receive the highest tax benefit.

2. Give Cash

Giving money is by far the easiest way to make contributions to your favorite charitable cause. IRS allows for charitable donations for as much as 50% of your aggregated gross income. Any amounts of more than 50% can be carried over in future years. However, it’s imperative that you keep a record of your cash donations.

3. Give Household goods

You can donate clothes, appliances, furniture, cars, and other household items in good condition. The items will be priced at fair value, In most cases, the value will be lower than what you paid for them. This category is also subject to the 50% limit of the AGI.

Donating household items is a perfect way to clean your closet from old clothes and shoes that you haven’t worn for years. You can even donate your old car that has been collecting dust in the garage. Moreover, if you plan to do a kitchen remodel, you can give your old cabinets and appliances to charities like the Salvation Army. Remember to keep the receipts of these items in case the IRS asks you for them.

4. Donate Appreciated assets

One of the most popular tax-saving strategies is donating appreciated assets directly to charitable organizations. This approach is subject to 30% of AGI for donations given to qualified public charities. Appreciated assets can include publicly traded stocks, restricted stocks, real estate, privately help companies, collectibles, and artwork. The main caveat to receiving the highest tax benefit is to give the appreciated asset directly to the charitable donations instead of selling it and gifting the remaining cash amount.  This way you will avoid paying a capital gain tax on the sale of your asset and deduct the full fair value of your asset.

 Let’s look at an example. An investor at a 28% tax bracket is considering donating an appreciating stock to her favorite charity. She can sell the stock and give the proceeds or donate the shares directly. The current market value of the stock is $100,000. She purchased it more than one year ago for $20,000. The total capital gain is $80,000.

 By giving the stock directly to her favorite, the investor is achieving three major goals. First, she is not paying a capital gain tax on the proceeds of the sale. Second, she can use the full fair value of the stock (instead of the proceeds from the sale) to reduce her tax liabilities. Third, the charitable organization receives an asset with a higher value, which they can sell tax-free.

 5. Make direct IRA charitable rollover

Donations made directly from your IRA, and 401k accounts are another way of reducing your tax bill. If you reached 70 ½, you could make up to $100,000 a year in gifts to a charity directly from your IRA or 401k accounts. Those contributions count towards the required annual minimum distributions you must take once you reach 70 ½, They also reduce your adjusted gross income. To be compliant, you have to follow two simple rules.

Your plan administrator has to issue a check payable to your charity of choice. Therefore the funds have to transfer directly to the charitable organization. If the check is payable to you, this will automatically trigger a tax event for IRS. In that case, your IRA distribution will be taxable as ordinary income, and you will owe taxes on them. The second rule, you have to complete the transfer by December 31 of the same calendar year.

6. Consolidate your donations

Tax Cuts and Jobs Act of 2017 increased the standard deduction for all individuals and families.  Therefore relatively small charitable donations may not be tax-deductible at all.

Standard deduction amounts

2019 tax year 2020 tax year
Individuals $12,200 $12,400
Married couples filing jointly $24,400 $24,800
Heads of households $18,350 $18,650

If you want to increase the tax impact of your donations you may have to consolidate the small annual donations in a single year.

5 smart 401k moves to make in 2020

Smart 401k moves in 2020

5 smart 401k moves to make in 2020. Do you have a 401k? These five 401k moves will help you empower your retirement savings and ensure that you take full advantage of your 401k benefits.

2020 has been a challenging year in many aspects. Let’s make it count and put your 401k to work.

Retirement Calculator

What is a 401k plan?

401k plan is a workplace retirement plan that allows employees to build and grow their retirement savings. It is one of the most convenient and effective ways to save for retirement as both employees and employers can make retirement contributions. As an employee, you can set up automatic deductions to your 401k account directly through your company payroll.  You can choose the exact percentage of your salary that will go towards your retirement savings. Most 401k will provide you with multiple investment options in stocks and fixed income mutual funds and ETFs. Furthermore, most employers offer a 401k match up to a certain percentage. In most cases, you need to participate in the plan to receive the match.

1. Maximize your contributions

The smart way to ignite your retirement savings is to maximize your contributions each year.

Did you know that in 2020, you can contribute up to $19,500 to your 401k plan? If you are 50 or over, you are eligible for an additional catch-up contribution of $6,500 in 2020. Traditional 401k contributions are tax-deductible and will lower your overall tax bill in the current tax year.

Many employers offer a 401k match, which is free money for you. The only way to receive it is to participate in the plan. If you cannot max out your dollar contributions, try to deduct the highest possible percentage so that you can capture the entire match from your employer. For example, if your company offers a 4% match on every dollar, at the very minimum, you should contribute 4% to get the full match.

2. Review your investment options

When was the last time you reviewed the investment options inside your 401k plan? When is the last time you made any changes to your fund selection? With automatic contributions and investing, it is easy to get things on autopilot. But remember, this is your money and your retirement savings. With all the craziness in the economy and the stock market in 2020, now is the best time to get a grip on your 401k investments.

Look at your fund performance over the last 1, 3, 5, and 10 years. Make sure the fund returns are close or higher than their benchmark. Review the fund fees. Check if there have been new funds added to the line up recently.

3. Change your asset allocation

Asset allocation tells you how your investments are spread between stocks, bonds, money markets, and other asset classes. Stocks typically are riskier but offer great earnings potential. Bonds are considered a safer investment but provide a limited annual return.

Your ideal asset allocation depends on your age, investment horizon, risk tolerance, and specific individual circumstances.

Typically, younger plan participants have a longer investment horizon and can withstand portfolio swings to achieve higher returns in the future.  If you are one of these investors can choose a higher allocation of stocks in your 401k.

However, if you are approaching retirement, you would have a much shorter investment horizon and probably lower tolerance to investment losses. In this case, you should consider adding more bonds and cash to your asset allocation.

4. Consider contributing to Roth 401k

Are you worried that you would pay higher taxes in the future? The Roth 401k allows you to make pretax contributions and avoid taxes on your future earnings. All Roth contributions are made after paying all federal and state income taxes now. The advantage is that all your prospective earnings will grow tax-free. If you keep your money until retirement or reaching the age of 59 ½, you will withdraw your gains tax-free. If you are a young professional or you believe that your tax rate will grow higher in the future, Roth 401k is an excellent alternative to your traditional tax-deferred 401k savings.

5. Rollover an old 401k plan

Do you have an old 401k plan, stuck with your former employer? How often do you have a chance to review your balance? Unfortunately, many old 401k plans have become forgotten and ignored for many years.

It is a smart move to transfer an old 401k to a Rollover IRA.

The rollover is your chance to gain full control of your retirement savings. Furthermore, you will expand your investment options from the limited number of mutual funds to the entire universe of stocks, ETFs, and fund managers. Most importantly, you can manage your account according to your retirement goals.

Grow your retirement savings with the Thrift Savings Plan

Thrift Savings Plan

The Thrift Savings Plan (TSP) is a retirement savings plan for federal employees. The purpose of the TSP is to provide federal workers with a platform for long-term retirement savings where you can make regular monthly payroll contributions. In many ways, TSP resembles the 401k plans used by private corporations.

Retirement Calculator

TSP Eligibility

Most employees of the United States Government are eligible to participate in the Thrift Savings Plan. You qualify if you are:

  • Federal Employees’ Retirement System (FERS) employees (started on or after January 1, 1984)
  • Civil Service Retirement System (CSRS) employees (began before January 1, 1984, and did not convert to FERS)
  • Members of the uniformed services (active duty or Ready Reserve)
  • Civilians in specific other categories of Government service including some congressional positions and judges

Contribution Limits for 2020

Federal employees can contribute up to $19,500 in their Thrift Savings Plan in 2020. Additionally, all federal employees over the age of 50 can make a catch-up contribution of $6,500 per year.
Members of the uniformed services, receiving tax-exempt pay that is subject to the combat zone tax exclusion, can make contributions up to the combined limit of $57,000 per year.

TSP Matching

TSP participants receive matching contributions on the first 5% of your salary that you contribute each pay period. The first 3% of your contribution will get a dollar-for-dollar match. The next 2% will be matched at 50 cents on the dollar. Contributions above 5% of your salary do not receive an additional match.

Federal agencies can make a matching contribution up to the combined limit of $57,000 or $63,500 with the catch-up contribution. If you contribute the maximum allowed amount, your agency match cannot exceed $37,500 in 2020.  Receiving a match on your contributions is free money. You must contribute at least 5% of your base salary to your TSP account to get the full match from your agency.

Matching schedule

The table below illustrates how your agency makes a matching contribution to your TSP account based on your own selection. Even if you choose not to contribute to TSP, you will still receive 1% of your base pay. If you put aside 5% of base pay, you will get the full 5% match from your agency.

TSP Matching schedule

Source: opm.gov

TSP Vesting

For vesting purposes, there are two types of agency contributions.

Agency Automatic Contributions (1%)

All eligible TSP participants will automatically receive deposits into your account equal to 1% of your basic pay each pay period, even if you do not contribute your own money. After three years of Federal civilian service (or two years in some cases), you are vested in these contributions and their earnings.

Agency Matching Contributions (0% – 4%)

All eligible federal employees will receive a dollar for dollar matching contribution for the first 3% that you contribute each pay period. Each dollar of the next 2% of basic pay will be matched with 50 cents on the dollar. All matching contributions are vested immediately.

How to grow your retirement savings with TSP

The Thrift Savings Plan allows you to save for retirement and become financially independent. Even small annual contributions paired with the agency match can make a big difference in your financial future.

Here is an example:

Let’s assume that your base pay is $100,000 per year. You want to save for retirement and take advantage of your agency match. Saving 5% or $5,000 per year will guarantee you another (free) $5,000 in your TSP account. That is a total of $10,000 annually. Assuming a modest return of 7% every year, you will have savings worth $1,000,000 in your TSP in 30 years. (For the 30 years between 1990 and 2019, the US stock market has earned a 9.84% average annual return. By setting aside $150,000 in 30 years, you have the potential of making a million dollars in your retirement. Being patient and consistent in combination with the power of compounding can boost your financial freedom in the long run.

TSP Savings Growth

Tax Treatment

For tax purposes, there are two types of individual contributions.

Tax-deferred TSP

Most federal employees opt to make tax-deferred contributions to their Thrift Savings Plan account. These contributions are tax-deductible. They will lower your tax bill for the current tax year. Your TSP investments will grow on a tax-deferred basis. You will only owe federal and state taxes when you start withdrawing your retirement savings.
If you are a uniformed services member making tax-exempt contributions, your contributions will be tax-free; only your earnings will be subject to federal and state tax at withdrawal.

Roth TSP

Roth TSP contributions are pretax. You pay all federal and state taxes before making your contributions. The advantage of Roth TSP is that your retirement savings will grow tax-free. As long as you keep your money until retirement, you will withdraw your investment earnings tax-free. Roth TSP is an excellent alternative for young professionals and federal workers in a low tax bracket.

TSP Fund options

As a TSP participant, you can choose between several fund options.

TSP Fund Performance 2019

C Fund

The C fund tracks the performance of the S&P 500 Index; a broad market index made up of stocks of the top 500 largest U.S. companies. The C fund owns companies such as Apple, Microsoft, Amazon.com, Facebook, Berkshire Hathaway, JPMorgan Chase, Alphabet, Johnson & Johnson, and Visa. The fund has earned an annualized 13.59% average 10-year rate of return.

S Fund

The S fund matches the performance of the Dow Jones U.S. Completion Total Stock Market Index; a broad market index made up of stocks of small-to-medium size U.S. companies. These are stocks that are not included in the S&P 500 Index. The S fund owns companies like TSLA Tesla Motors, Blackstone Group, Lululemon Athletica, Workday, Splunk, Palo Alto Networks, CoStar Group, Square, Dexcom, and Liberty Broadband Corp. The fund has earned an annualized 13.08% average 10-year rate of return.

I Fund

The I fund invests in foreign stocks and follows the performance of the MSCI EAFE (Europe, Australasia, Far East) Index. The I fund owns companies such as Nestlé, Roche, Novartis, Toyota Motor, HSBC, SAP, Total, AstraZeneca, LVMH, and BP. The fund has earned an annualized 5.85% average 10-year rate of return.

F Fund

The F fund tracks the performance of the Bloomberg Barclays U.S. Aggregate Bond Index. The fund invests in a broad range of US bonds, including US treasuries, investment-grade corporate bonds, and agency mortgage pass-through bonds. Nearly 70% of the fund portfolio is in the highest quality AAA-rated bonds. The fund has earned an annualized 2.23% average 10-year rate of return.

G Fund

The G fund invests in nonmarketable US Treasury bonds specially issued to the TSP. The payment of G Fund principal and interest is guaranteed by the U.S. Government. The G fund is the most stable and safe investment option in the TSP fund list. It has an investment objective to produce a rate of return that is higher than inflation while avoiding market price fluctuations. The fund has earned an annualized 3.99% average 10-year rate of return.

The L Funds

The L funds are lifecycle funds that invest automatically according to a professionally designed mix of stocks, bonds, and government securities. You can select your L Fund based on your age and investment time horizon. Your expected future retirement date will determine which fund assignment. For example, if you plan to retire in 2039, you will be assigned to L 2040 fund.

The L Fund roaster includes L 2065, L 2060, L 2055, L 2050, L 2045, L 2040, L 2035, L 2030, L 2025, and L Income.

All L funds own a mix of the five individual funds. TSP participants with a longer investment horizon will own more stocks and fewer bods. Those approaching retirement will move to a higher allocation to bonds and a smaller allocation to stocks.

L Funds Glide Path

Investing your Thrift Savings Plan


The L fund is an easy and convenient investment option. If you choose the lifecycle fund, you do not have to spend too much time guessing the stock market and periodically rebalancing your retirement savings. Your savings will be invested automatically. Your asset allocation will move from more aggressive to more conservative as you get closer to retirement.

Individual fund mix

If you prefer a more active approach, then you can invest directly in any of the five individual funds. I recommend that you allocate your account depending on your age:

Recommended Fund Mix

You will notice that my recommendations differ considerably from the current L funds allocation. I established the age-based fund mix based on the actual fund performance and current economic conditions. Before investing, you need to consider your investment horizon, individual circumstances, and risk tolerance level. I assume that younger participants would have a long (30-40 years) investment horizon and high-risk tolerance. On the other hand, participants approaching retirement would have a much shorter investment horizon and lower risk tolerance as they will depend on their retirement savings in the near future. Choosing individual funds gives you the flexibility to make any changes at any point in time.

Plan Your Taxes

The physician’ roadmap to secure and healthy retirement

physician retirement

I talk to physicians every day and know that retirement is a sensitive subject. For many physicians retiring is an extremely personal decision. And it is not an easy choice to make. You must take into account a wide range of financial, professional, and individual factors before you make the final call.

Retirement will change your lifestyle dramatically. Your salary and healthcare benefits will be different. You might experience an unexpected change of pace. You may lose touch with colleagues and friends. At the same time, you can travel and do things that matter most to you. Your stress level will go down, and you will spend more time with your family and loved ones.

I compiled a list of suggestions that will help you prepare on your journey to retirement. Don’t wait until the last moment. Get ahead of the curve so that you can take the financial stress out of your retirement plans.

Take advantage of your employee benefits

The first step to a happy retirement is knowing your employee benefits inside and out. Most public and private healthcare systems offer competitive physician retirement benefits packages with a wide range of perks, including pension, 401k match, profit sharing, healthcare coverage, life insurance, disability insurance, and loan repayment. Some employers even offer an early retirement option at 55.

These benefit packages vary significantly from one employer to the next. Take some time to learn and understand your options. Ask your colleagues and attend benefit seminars. If retirement is your priority, consider an employer that will give you the best shot in achieving this goal.

Pay off your student loans

The US student debt has skyrocketed to $1.6 trillion. Seventy-five percent of medical students graduated in their class of 2018 with student debt. The average loan per student is $196,520. It’s not uncommon that some physician couples owe over half a million dollars in student debt.

A crucial step in your journey to a happy retirement is paying off ALL YOUR DEBT, including student loans, credit cards, and mortgage. It might seem like an uphill battle, but it’s not impossible.

There are several options you can consider when tackling your student loans – loan forgiveness, loan consolidation, refinancing with lower interest rates, and income-driven repayment. Find out what is the best option for you and get started.

Maximize your physician retirement savings

Some physicians are fortunate to have an employer who offers a pension plan. Others need to save aggressively for their own retirement. In many cases, a corporate pension and social security may not be enough to cover all your essential expenses after you retire.

One way to cover the gap is through your personal retirement savings. Most employers nowadays offer either a 401k, a 403b, or a 457-retirement plan. When you join your physician retirement plan, you can save up to $19,500 per year as of 2020. If you are 50 or older, you can save an additional $6,500 for a total of $26,000 per year. An additional benefit to you is that these contributions are tax-deductible and will lower your tax bill. Many employers also offer a match that can further boost your retirement savings.

Have an emergency fund

You need an emergency fund. Keep at least six months’ worth of essential living expenses in cash or a savings account. This emergency fund will serve you as a buffer in case of sudden and unexpected life events.

Secure your healthcare coverage

One of the main challenges, when planning your retirement, is healthcare coverage. Depending on your employer, some doctors have excellent medical and dental benefits. In some cases, these benefits are completely free or heavily subsidized by your employer.  In order to attract talent, some hospitals offer free lifetime healthcare if you commit to working for them for a certain number of years.

Do not underestimate healthcare costs. According to estimates, a 65-year old couple retiring in 2020 can expect to spend $290,000 in health care and medical expenses throughout retirement. For single retirees, the health care cost could reach $150,000 for women and $140,000 for men.

Consider working per diem

If you are short of retirement savings or bored of staying at home, you may consider working per diem or locum tenens. You can work on an hourly basis at your own pace. The extra work will boost your retirement income and will keep your knowledge up to date.

Create a budget

You must adhere to a budget before and after you retire. Before retirement, you need to pay off your debt and save for retirement aggressively. Depending on your earnings, these payments can cut through your family budget. You may have to make some tough choices to avoid or delay large purchases and curb discretionary spending.

Once you retire, your income may go down. True, you don’t have to drive to work, but some of your expenses might still be the same.

Have a plan

A happy retirement comes with a good plan. It may require some self-discovery but ultimately will lead to finding a purpose and fulfilling your life dreams. You can travel and volunteer. Write a book. Teach. Learn a new hobby or language. Find out what makes you happy outside of your daily routine and make the most out of your free time.

The bottom line

Physician retirement is an achievable goal that requires a great deal of planning and some personal sacrifice. If you want to retire one day, you need to start planning now. Don’t leave some of the most critical decisions for the final stretch of your career.

Your family can be a big influencer for your decision to retire.  You might have a partner who wants to stay active. Perhaps, you have children who are going to college. Every family is different, and every situation is unique. Be proactive, plan ahead, do the number crunching, and find what makes the most sense to you.

15 Costly retirement mistakes

15 Costly retirement mistakes

15 Costly retirement mistakes… Retirement is a major milestone for many Americans. Retiring marks the end of your working life and the beginning of a new chapter. As a financial advisor, my job is to help my clients avoid mistakes and retire with confidence and peace of mind.  Together we build a solid roadmap to retirement and a gameplan to achieve your financial goals. My role as a financial advisor is to provide an objective and comprehensive view of my clients’ finances.  As part of my process, I look for any blind spots that can put my clients’ plans at risk.  Here is a list of the major retirement mistakes and how to avoid them.

1. Not planning ahead for retirement

Not planning ahead for retirement can cost you a lot in the long run. Delaying to make key decisions is a huge retirement mistake that can jeopardize your financial security during retirement. Comprehensive financial planners are more likely to save for retirement and feel more confident about achieving their financial goals.  Studies have shown that only 32% of non-planners are likely to have enough saved for retirement versus 91% of comprehensive planners.

Reviewing your retirement plan periodically will help you address any warning signs in your retirement plan. Recent life changes, economic and market downturns or change in the tax law could all have a material impact on your retirement plans. Be proactive and will never get caught off guard.

2. Not asking the right questions

Another big retirement mistake is the fear of asking the right question. Avoiding these

Here are some of the questions that my clients are asking –

  • “Do I have enough savings to retire?”
  •  “Am I on the right track?”.
  • “Can I achieve my financial goals?”
  • “Can I retire if the stock market crashes?”.
  • “Are you fiduciary advisor working in my best interest?” (Yes, I am fiduciary)

Asking those tough questions will prepare you for a successful retirement journey. Addressing your concerns proactively will take you on the right track of meeting your priorities and achieving your personal goals

3. Not paying off debt

Paying off debt can be an enormous burden during retirement. High-interest rate loans can put a heavy toll on your finances and financial freedom. As your wages get replaced by pension and social security benefits, your expenses will remain the same. If you are still paying off loans, come up with a plan on how to lower your debt and interest cost. Being debt-free will reduce the stress out of losing viable income.

4. Not setting goals

Having goals is a way to visualize your ideal future. Not having goals is a retirement mistake that can jeopardize your financial independence during retirement. Without specific goals, your retirement planning could be much harder and painful. With specific goals, you have clarity of what you want and what you want to achieve. You can make financial decisions and choose investment products and services that align with your objectives and priorities. Setting goals will put you on a successful track to enjoy what matters most to you.

5. Not saving enough

An alarming 22% of Americans have less than $5,000 in retirement savings. The average 401k balance according to Fidelity is $103,700. These figures are scary. It means that most Americans are not financially ready for retirement. With ultra-low interest rates combined with constantly rising costs of health care,  future retirees will find it difficult to replace their working-age income once they retire. Fortunately, many employers now offer some type of workplace retirement savings plans such as 401k, 403b, 457, TSP or SEP IRA. If your employer doesn’t offer any of those, you can still save in Traditional IRA, Roth IRA, investment account or the old fashioned savings account.

6. Relying on one source for retirement income

Many future retirees are entirely dependent on a single source for their retirement income such as social security or pension.  Unfortunately. with social security running out of money and many pension plans shutting down or running a huge deficit, the burden will be on ourselves to provide reliable income during our retirement years.  If you want to be financially independent, make sure that your retirement income comes from multiple sources.

7. Lack of diversification

Diversification is the only free lunch you can get in investing and will help decrease the overall risk of your portfolio. Adding uncorrelated asset classes such as small-cap, international and emerging market stocks, bonds, and commodities will reduce the volatility of your investments without sacrificing much of the expected return in the long run.

A common mistake among retirees is the lack of diversification. Many of their investment portfolios are heavily invested in stocks, a target retirement fund or a single index fund.

Furthermore, owning too much of one stock or a fund can cause significant issues to your retirement savings. Just ask the folks who worked for Enron or Lehman Brothers who had their employer’s stocks in their retirement plans. Their lifetime savings were wiped out overnight when these companies filed for bankruptcy.

8. Not rebalancing your investment portfolio

Regular rebalancing ensures that your portfolio stays within your desired risk level. While tempting to keep a stock or an asset class that has been on the rise, not rebalancing to your original target allocation can significantly increase the risk of your investments.

9. Paying high fees

Paying high fees for mutual funds and high commission insurance products can eat up a lot of your return. It is crucial to invest in low-cost investment managers that can produce superior returns over time. If you own a fund that has consistently underperformed its benchmark,  maybe it’s time to revisit your options.

Many insurance products like annuities and life insurance while good on paper, come with high upfront commissions, high annual fees, and surrender charges and restrictions.  Before signing a contract or buying a product, make sure you are comfortable with what you are going to pay.

10. No budgeting

Adhering to a budget before and during retirement is critical for your confidence and financial success. When balancing your budget, you can live within your means and make well-informed and timed decisions. Having a budget will ensure that you can reach your financial goals.

11. No tax planning

Not planning your taxes can be a costly retirement mistake. Your pension and social security are taxable. So are your distributions from 401k and IRAs. Long-term investing will produce gains, and many of these gains will be taxable. As you grow our retirement saving the complexity of assets will increase. And therefore the tax impact of using your investment portfolio for retirement income can be substantial. Building a long-term strategy with a focus on taxes can optimize your after-tax returns when you manage your investments.

12. No estate planning

Many people want to leave some legacy behind them. Building a robust estate plan will make that happen. Whether you want to leave something to your children or grandchildren or make a large contribution to your favorite foundation, estate, and financial planning is important to secure your best interests and maximize the benefits for yourself and your beneficiaries.

13. Not having an exit planning

Sound exit planning is crucial for business owners. Often times entrepreneurs rely on selling their business to fund their retirement. Unlike liquid investments in stocks and bonds, corporations and real estate are a lot harder to divest.  Seling your business may have serious tax and legal consequences. Having a solid exit plan will ensure the smooth transition of ownership, business continuity, and optimized tax impact.

14. Not seeing the big picture

Between our family life, friends, personal interests, causes, job, real estate properties, retirement portfolio, insurance and so on, our lives become a web of interconnected relationships. Above all is you as the primary driver of your fortune. Any change of this structure can positively or adversely impact the other pieces. Putting all elements together and building a comprehensive picture of your financial life will help you manage these relationships in the best possible way.

15. Not getting help

Some people are very self-driven and do very well by planning for their own retirement. Others who are occupied with their career or family may not have the time or ability to deal with the complexities of financial planning. Seeking help from a fiduciary financial planner can help you avoid retirement mistakes. A fiduciary advisor will watch for your blind spots and help you find clarity when making crucial financial decisions.

TSP contribution limits 2020

TSP contribution limits 2020

TSP contribution limits for 2020 is 19,500 per person. Additionally, all federal employees over the age of 50 can contribute a catch-up of $6,500 per year.

Retirement Calculator

What is TSP?

Thrift Saving Plan is a Federal retirement plan where both federal employees and agencies can make retirement contributions. Moreover, this retirement plan is one of the easiest and most effective ways for you to save for retirement. As a federal employee, you can make automatic contributions to your TSP directly through your employer’s payroll. You can choose the percentage of your salary that will go towards your retirement savings. TSP provides you with multiple investment options in stocks, fixed income, and lifecycle funds. Additionally, most agencies offer a TSP match up to a certain percentage. In most cases, you need to participate in the plan in order to get the match. For more information about investment options in your TSP account, check my article – “Grow your retirement savings with the Thrift Savings Plan“.

Who is Eligible to Participate in the TSP?

Most employees of the United States Government are eligible to participate in the Thrift Savings Plan. You are eligible if you are:

  • Federal Employees’ Retirement System (FERS) employees (started on or after January 1, 1984)
  • Civil Service Retirement System (CSRS) employees (started before January 1, 1984, and did not convert to FERS)
  • Members of the uniformed services (active duty or Ready Reserve)
  • Civilians in certain other categories of Government service

How much can I contribute to my TSP in 2020?

TSP contribution limits change every year. IRS typically increases the maximum annual limit with the cost of living adjustment and inflation. These contribution limits apply to all employees who participate in the federal government’s Thrift Savings Plan,  401(k), 403(b), and 457 plans. Additionally, the limits apply to both tax-deferred and Roth contributions combined. 

  • Employees can contribute up to $19,500 to their TSP plan for 2020,  $500 more than  2019.
  • Employees of age 50 or over are eligible for an additional catch-up contribution of $6,500 in 2020,  $500 higher than  2019
  • Employee compensation limit for calculating TSP contributions is $285,000, $5,000 more than 2019
  • For participants who contribute to both a civilian and a uniformed services TSP account during the year, the elective deferral and catch-up contribution limits apply to the combined amounts of traditional (tax-deferred) and Roth contributions in both accounts.
  • Members of the uniformed services, receiving tax-exempt pay (i.e., pay that is subject to the combat zone tax exclusion), your contributions from that pay will also be tax-exempt. Your total contributions from all types of pay must not exceed the combined limit of $57,000 per year.

There are two types of contributions – tax-deferred traditional TSP  and tax-exempt Roth TSP contributions.

Tax-deferred TSP

Most federal employees, typically, choose to make tax-deferred TSP contributions. These contributions are tax-deductible. They will lower your tax bill for the current tax year. Your investments will grow on a tax-deferred basis. Therefore, you will only owe federal and state taxes when you start withdrawing your savings.

Roth TSP

Roth TSP contributions are pretax. It means that you will pay all federal and state taxes before making your contributions. The advantage of Roth TSP is that your retirement savings will grow tax-free. As long as you keep your money until retirement, you will withdraw your gain tax-free. It’s a great alternative for young professionals and workers in a low tax bracket.

TSP Matching

Federal agencies can make a matching contribution up to the combined limit of $57,000 or $63,500 with the catch-up contribution. If you contribute the maximum allowed amount, your agency match cannot exceed $37,500 in 2020.

If you are an eligible FERS or BRS employee, you will receive matching contributions from your agency based on your regular employee contributions. Unlike most private companies, matching contributions are not subject to vesting requirements.

FERS or BRS participants receive matching contributions on the first 5% of your salary that you contribute each pay period. The first 3% of your contribution will receive a dollar-for-dollar match. The next 2% will be matched at 50 cents on the dollar. Contributions above 5% of your salary will not be matched.

Consider contributing at least 5% of your base salary to your TSP account so that you can receive the full amount of matching contributions.

Matching schedule

TSP Matching contribution
Source: tsp.gov

Opening your TSP account

FERS Employees

If you are a federal employee, hired after July 31, 2010, your agency has automatically enrolled you in the TSP.  By default, 3% of your base salary will be deducted from your paycheck each pay period and deposited in the traditional balance of your TSP account.  If you decide, you have to make an election to change or stop your contributions.

If you are a FERS employee who started before August 1, 2010, you already have a TSP account with accruing 1% automatic contributions. In addition, you can make contributions to your account from your pay and receive additional matching contributions.

 

CSRS Employees

If you are a Federal civilian employee who started before January 1, 1984, your agency will establish your TSP account after you make a contribution election using your agency’s election system.

BRS Members of the Uniformed Services

Members of the uniformed services who began serving on or after January 1, 2018, will automatically enroll in the TSP once you serve 60 days. By default,  3% of your basic pay is deducted from your paycheck each pay period and deposited in the traditional balance of your TSP account. You have can always select to change or stop your contributions.

IRA Contribution Limits 2020

IRA contribution limits 2020

The IRA contribution limits for 2020 are $6,000 per person with an additional $1,000 catch-up contribution for people who are 50 or older.

Retirement Calculator

What is an IRA?

IRA or Traditional IRA is a tax-deferred retirement savings account that allows you to make tax-deductible contributions to save towards retirement. Your savings grow tax-free. You do not owe taxes on dividends and capital gains. Once you reach retirement age, you can start taking money out of the account. All distributions from the IRA are taxable as ordinary income in the year of withdrawal.

IRA income limits for 2020

The tax-deductible IRA contribution limits for 2020 are based on your annual income. If you are single and earn $124,000 or less, you can contribute up to the full amount of $6,000 per year.  If your aggregated gross income is between $124,000 and $139,000 you can still make contributions but with a lower value.

Married couples filing jointly can contribute up to $6,000 each if your combined income is less than $196,000.  If your aggregated gross income is between $196,000 and $206,000 you can still make reduced contributions.

Spousal IRA

If you are married and not earning income, you can still make contributions. As long as your spouse earns income and you file a joint return, you may be able to contribute to an IRA even if you did not have taxable compensation. Keep in mind that, your combined contributions can’t be more than the taxable compensation reported on your joint return.

IRA vs 401k

IRA is an individual retirement account.  401k plan is a workplace retirement plan, which is established by your employer. You can contribute to a 401k plan if it’s offered by your company.  In comparison, starting in 2020, anyone who is earning income can open and contribute to a traditional IRA regardless of your age.

IRA vs Roth IRA 

Traditional and Roth IRA have the same annual contributions limits.  The Traditional IRA contributions can be tax-deductible or after-tax depending on your income. In comparison. Roth IRA allows you to make after-tax contributions towards retirement. Another difference, your Traditional IRA retirement savings grow tax-deferred, while Roth IRA earnings are tax-free.

 

Roth IRA Contribution Limits 2020

Roth IRA contribution limits for 2020

The Roth IRA contribution limits for 2020 are $6,000 per person with an additional $1,000 catch-up contribution for people who are 50 or older.

Retirement Calculator

Roth IRA income limits for 2020

Roth IRA contribution limits for 2020 are based on your annual earnings. If you are single and earn $124,000 or less, you can contribute up to the full amount of $6,000 per year.  If your aggregated gross income is between $124,000 and $139,000 you can still make contributions but with a lower value.

Married couples filing jointly can contribute up to $6,000 each if your combined income is less than $196,000.  If your aggregated gross income is between $196,000 and $206,000 you can still make reduced contributions.

What is a Roth IRA?

Roth IRA is a tax-free retirement savings account that allows you to make after-tax contributions to save towards retirement. Your Roth investments grow tax-free. You will not owe taxes on dividends and capital gains. Once you reach retirement your withdrawals will be tax-free as well.

Roth vs Traditional IRA

Roth IRA allows you to make after-tax contributions towards retirement. In comparisons. Traditional IRA has the same annual contributions limits. The Traditional IRA contributions can be tax-deductible or after-tax depending on your income. Additionally, your Traditional IRA savings grow tax-deferred. Unlike Roth Roth, you will owe income taxes on your withdrawals.

Roth IRA Rules

The Roth IRA offers a lot of flexibility and few constraints.  There are Roth IRA rules that can help you maximize the benefits of your tax-free savings account.

Easy and convenient

Opening a Roth IRA account is a great way to start planning for your financial future. The plan is an excellent saving opportunity for many young professionals with limited access to workplace retirement plans. Even those who have 401k plans with their employer can open a Roth IRA.

Flexibility

There is no age limit for contributions. Minors and retired investors can invest in Roth IRA as well as long as they earn income.

No investment restrictions

There is no restriction on the type of investments in the account. Investors can invest in any asset class that suits their risk tolerance and financial goals.

No taxes

There are no taxes on the distributions from this account once you reach 59 ½. Your investments will grow tax-free. You will never pay taxes on your capital gains and dividends either.

No penalties if you withdraw your original investment

While not always recommended, Roth IRA allows you to withdraw your original dollar contributions (but not the return from them) before reaching retirement, penalty and tax-free. Say, you invested $5,000 several years ago. And now the account has grown to $15,000. You can withdraw your initial contribution of $5,000 without penalties.

Diversify your future tax exposure

Roth IRA is ideal for investors who are in a lower tax bracket but expect higher taxes in retirement. Since most retirement savings sit in 401k and investment accounts, Roth IRA adds a very flexible tax-advantaged component to your investments. Nobody knows how the tax laws will change by the time you need to take out money from your retirement accounts. That is why I highly recommend diversifying your mix of investment accounts and take full advantage of your Roth IRA.

No minimum distributions

Unlike 401k and IRA, Roth IRA doesn’t have any minimum distributions requirements. Investors have the freedom to withdraw their savings at their wish or keep them intact indefinitely.

Earnings cap

You can’t contribute more than what you earned for the year. If you made $4,000, you could only invest $4,000.