Roth IRA Contribution Limits 2024

Roth IRA Contribution Limits for 2024

The Roth IRA contribution limits for 2024 are $7,000 per person, with an additional $1,000 catch-up contribution for people who are 50 or older. There is a $500 increase from 2023.

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Roth IRA income limits for 2024

Roth IRA contribution limits for 2024 are based on your annual earnings. If you are single or a head of household and earn $146,000 or less, you can contribute up to $7,000 per year. If your aggregated gross income is between $146,000 and $161,000, you can still make a partial contribution with a lower value.

Married couples filing jointly can contribute up to $7,000 each if their combined income is less than $230,000. You can still make partial contributions if your aggregated gross income is between $230,000 and $240,000.

What is a Roth IRA?

A 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 retire, your withdrawals will be tax-free as well.

Roth vs. Traditional IRA

The Roth IRA and Traditional IRA have the same annual contribution limits. Roth IRA allows you to make after-tax contributions towards retirement. In comparison, 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. These are some of the 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 plan your financial future. The plan is an excellent saving opportunity for many young professionals with limited access to workplace retirement plans. Even those with 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 a Roth IRA if 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.

There are no penalties if you withdraw your original investment

While not always recommended, a Roth IRA allows you to start your original dollar contributions (but not the return from them) before reaching retirement, penalty and tax-free. Say you invested $10,000 several years ago. And now the account has grown to $20,000. You can withdraw your initial contribution of $10,000 without penalties.

Diversify your future tax exposure.

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

No minimum distributions

Unlike 401k and IRA, Roth IRA has no minimum distribution requirements. Savers can withdraw their savings as they wish or keep them intact.

Legacy Planning

A Roth IRA is a great tool for general wealth transfer planning. If you decide to leave your Roth IRA to your heirs, they will not pay taxes on their distributions.

Earnings cap

You can’t contribute more than what you earned for the year. If you made $6,000 in 2024, you could only contribute $6,000 to your Roth.

Roth IRA and why you probably need one – Updated for 2022

Roth IRA

Roth IRA is a tax-exempt investment account that allows you to make after-tax contributions to save for retirement. The Roth IRA has a tax-free status. It is a great way to save for retirement and meet your financial goals without paying a dime for taxes on your investments. It offers you a lot of flexibility with very few constraints.

Roth IRA is an excellent starting point for young professionals. It can help you reach your financial goals faster. So open your account now to maximize its full potential. Investing early in your career will lay out the path to your financial independence.

1. Plan for your future

Opening a Roth IRA account is a great way to plan for retirement and build financial independence. This tax-free account is an excellent saving opportunity for many young professionals and anyone with limited access to workplace retirement plans. Even those with 401k plans with their employer can open a Roth IRA.

If you are single and earn $129,000 or less in 2022, you can contribute up to $6,000 per year to your Roth IRA. Individuals 50 years old and above can add a catch-up contribution of $1,000. If you are married and filing jointly, you can contribute the full amount if your MAGI is under $204,000.

There is a phaseout amount between $129,000 and $144,000 for single filers and $204,000 and $214,000 for married filing jointly.

2. No age limit

There is no age limit for your contributions. You can contribute to your Roth IRA at any age as long as you earn income.

Minors who earn income can also invest in Roth IRA. While youngsters have fewer opportunities to make money, many sources of income will count – babysitting, garden cleaning, child acting, modeling, selling lemonade, distributing papers, etc.

3. No investment restrictions

Unlike most 401k plans, Roth IRAs do not have any restrictions on the type of investments in the account. You can invest in any asset class that suits your risk tolerance and financial goals.

4. No taxes

There are no taxes on the distributions from this account once you reach the age of 59 ½. Your investments will grow tax-free. You will never pay taxes on your capital gains and dividends, either. Roth IRA is a great saving tool for investors at all income levels and tax brackets.

With an average historical growth rate of 7%, your investment of $6,000 today could bring you $45,674 in 30 years, completely tax-free. The cumulative effect of your return and the account’s tax status will help your investments grow faster.

If you are a California resident, your maximum tax rate on ordinary income can be over 52.5% – 37%  for Federal taxes, 13.3% for State Taxes, and 2.35% for Medicare. This figure excludes Social security and self-employment tax.

The maximum long-term capital gain tax in the US is 23.68%. California residents could pay up to 13,3% on their capital gains as California doesn’t differentiate between long-term and short-term gains.

5. No penalties if you withdraw your original investment

While not always recommended, Roth IRA allows you to withdraw your original dollar contribution (but not the return) 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.

6. Diversify your future tax exposure

Most of your retirement savings will likely be in a 401k plan or an investment account. 401k plans are tax-deferred, and you will owe taxes on any distributions. Investment accounts are taxable, and you pay taxes on capital gains and dividends. In reality, nobody can predict your tax rate by the time you need to take out money from your retirement and investment accounts. Roth IRA adds this highly flexible tax-advantaged component to your investments.

7. No minimum distributions

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

8. Do a backdoor Roth conversion

Due to recent legal changes, investors who do not satisfy the requirements for direct Roth IRA contributions can still make investments in it. The process starts with a taxable contribution, up to the annual limit, into a Traditional IRA. Eventually, the contributions are rolled from the Traditional IRA to the Roth IRA.

9. Roth conversion from Traditional IRA and 401k plans

Under certain circumstances, converting your Traditional IRA and an old 401k plan to Roth IRA could make sense. If you expect to earn less income or pay lower taxes in a particular year, it could be beneficial to consider this Roth conversion. Your rollover amount will be taxable at your current ordinary income tax level. An alternative strategy is to consider annual rollovers in amounts that will keep you within your tax bracket.

10. Estate planning

Roth IRA is an excellent estate planning tool. Due to its age flexibility and no minimum required distributions, it is a good option for generation transfer and leaving a legacy to your beloved ones.

Maximizing Roth savings for high-income earners

Maximizing Roth savings for high income earners

Maximizing your Roth savings is a terrific way to save for retirement for both high-income earners and professionals at all levels. Roth IRA is a tax-free retirement savings account that allows you to make after-tax contributions to save towards retirement.

Key Roth benefits for high earners

  • Roth IRA offers tax-free retirement growth. All contributions are pre-tax. In other words, you pay taxes before you make them. Once your dollars hit your Roth IRA, they grow tax-free.
  • You won’t pay any taxes on future capital gains and dividends.
  • Roth IRA is not subject to required minimum distributions at age 72.
  • You can always withdraw your original contribution tax and penalty-free.
  • Maximizing your Roth savings, especially for high-income earners, is an effective way to diversify your future tax exposure
  • High earners can incorporate their Roth savings as part of their estate planning strategy

How much can I contribute to my Roth IRA?

You can contribute up to $6,000 to your Roth IRA in 2022 or $7,000 if you are 50 years or older. For 2023, you can contribute $6.500 or or $7,500 if you are 50 years or older

Income limits for Roth contributions

Roth IRA contribution limits for 2022 are based on your annual earnings. If you are single or a head of household and earn $129,000 or less, you can contribute up to the full amount of $6,000 per year. If your aggregated gross income is between $129,000 and $144,000, you can still make contributions with a lower value.

Married couples filing jointly can contribute up to $6,000 each if their combined income is less than $204,000. You can still make reduced contributions if your aggregated gross income is between $204,000 and $214,000.

If you are a high earner, you will not meet the income limits to make direct Roth contributions. However, you still have some options. Here are some ideas that can help you boost your Roth savings

Speak with a financial advisor to find out what Roth strategies make sense for you

Backdoor Roth IRA for high-income earners

The Backdoor Roth IRA is a multi-step process that allows high-income earners to bypass the Roth Income limits. The strategy comes with some conditions. While the IRS has kept the rules vague, it’s easy to make mistakes while following the process. I had seen more than one client who had made some mistakes when they followed the backdoor steps.

Here are the general guidelines. Remember that everyone’s circumstances are unique, and this article may not address all of them.

Backdoor Roth IRA steps

  1. Contribute to a non-deductible IRA. Roth IRA and Traditional IRA have the same income limits. If you do not qualify to make direct Roth contributions, you don’t qualify for tax-deductible IRA savings. When you contribute to a non-deductible IRA, you are making an after-tax contribution to an IRA. Theoretically, you will pay taxes on your future gain but the original amount.
  2. Convert your contribution to a Roth IRA. In the second step of the process, you must transfer your assets from the non-deductible IRA to your Roth IRA. Your IRA administrator or financial advisor will give you the instructions and paperwork. Every broker requires a slightly different process.
  3. File your taxes and submit Form 8606. You must file form 8606 to report your non-deductible contributions to traditional IRAs. Please consult your CPA or tax accountant for the exact requirements for filling out and submitting the form. Pay attention to this form when you file your taxes using tax software.
  4. The Pro-Rata Rule. The pro-rata rule has one of the biggest implications in the backdoor process. The rules stipulate that ALL Roth conversions must be made on a pro-rata basis. In other words, if you have an outstanding Traditional RA, SEP IRA, or Simple IRA, your Roth conversion must be pro-rated between all existing IRA accounts, not just the non-deductible IRA from which you want to make the transfer. In other words, the Backdoor Roth strategy could trigger a substantial taxable event for you if you own tax-deferred IRA savings.

Roth conversion from IRA and 401k

Roth conversion involves the transfer of the tax-deferred savings in your IRA or 401k accounts into tax-exempt investments in your Roth IRA. Roth conversion can be a brilliant move for high-income earners in the right circumstances.

Your current and future taxes are critical elements of any Roth conversion decision-making. The strategy becomes viable 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.

With some proactive planning, Roth IRA offers substantial tax-free benefits. Due to income limits, many high-income 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 and subject to required minimum distributions.

Learn more about Roth conversion here

Roth 401k

Most corporate 401k plans allow you to make either traditional tax-deferred or Roth 401k contributions. Roth 401k is similar to Roth IRA as both accounts are funded with after-tax dollars.

The contribution limits for 2022 are $20,500 per person. All 401k participants over the age of 50 can add a catch-up contribution of $6,500.

Roth 401k vs. Roth IRA

Roth 401k and Roth IRA are very similar, but Roth 401k has major advantages for high-income earners

  1. No income limits – Unlike Roth IRA, the Roth 401l doesn’t have income limits. Anyone eligible to participate in their company’s 401k plan can make Roth 401k contributions.
  2. Higher Contribution limits – You can save a lot more in your company’s Roth 401k plan versus a personal Roth IRA. You can save up to $20,500 in your Roth 401k and $6,000 in your Roth IRA. If you are 50 or older, you can stash $27,000 vs. $7,000
  3. Company match – You are eligible for a company match even if you make Roth 401k contributions. All employer matching contributions will be tax-deferred and placed in a separate account
  4. Investment options – Roth IRA offers a broader range of investment options vs. 401k plans with a limited list of funds.
  5. Distributions rules – Roth 401k savings are subject to required maximum distributions at age of 72. You can avoid this rule by rolling over your Roth 401k into a Roth IRA once you stop contributing to the plan.

What Is a Mega Backdoor Roth 401k?

Mega Backdoor 401k is an acronym for after-tax Roth conversion within your 401k plan. Many high-income earners cannot make direct Roth contributions. At the same time, they may prefer traditional tax-deferred 401k contributions, which reduce their current taxes. Mega backdoor 401k allows you to get the best of both worlds. There is one caveat — your 401k plan must allow for after-tax contributions and in-plan conversions. Depending on your plan design, setting up a Mega backdoor 401k can be pretty complex or relatively simple.

For 2022, maximum 401k contributions of any kind (tax-deferred, Roth, after-tax, and employee match) is $61,000, up from $58,000 for 2021. If you’re 50 or older, the limit is $67,500, up from $64,500 in 2021. If you maximize your 401k allowance and receive an employee match, you can choose to make after-tax contributions up the annual limit. Without any conversion, you will pay taxes on all your gains. Since your original contribution was after-tax, you don’t pay taxes on that amount. Furthermore, the IRS limits the compensation eligible for 401k contributions to $305,000 or 2022. Depending on your specific circumstances, the final contribution amount to your 401k plan may vary,

Here is how Mega Backdoor Roth 401k works

  1. Maximize your 401k contributions for the year
  2. Opt-in for after-tax 401k contributions. Your plan must allow for this election
  3. Convert your after-tax contributions into Roth 401k as soon as possible to avoid possible taxable gains. Some plans may allow you to choose automatic conversions versus manual.
  4. Watch your Roth savings grow tax-free

Final words

Maximizing Roth savings can be highly advantageous for high-income earners and hard-working professionals. Since Roth IRAs have strict income limits, not everyone will qualify automatically for direct contributions. You will need careful planning to maneuver all the different rules and a long-term view to enjoy the benefits of your Roth savings.

Ten Successful tips for surviving a bear market

Survive bear market

Surviving a bear market can be a treacherous task even for experienced investors. If you are a long-term investor, you know that the bear markets are common. Since 1945, there have been 14 bear markets—or about every 5.4 years. Experiencing a bear market is rough but an inevitable aspect of the economic cycle.

What is a bear market?

A bear market is a prolonged market downturn where stocks fall by 20% or more. Often, bear markets are caused by fears of recession, changes in Fed policy, political uncertainty, geopolitics, or poor macroeconomic data. There have been 26 bear markets in the S&P 500 Index since 1928. However, there have also been 27 bull markets—and stocks have risen significantly over the long term. The average length of a bear market is 289 days or about 9.6 months. For comparison, the average length of a bull market is 991 days or 2.7 years.

A bear market doesn’t necessarily indicate an economic recession. There have been 26 bear markets since 1929, but only 15 recessions during that time. Bear markets often go alongside a slowing economy, but a weakening market doesn’t necessarily mean an imminent recession.

How low can stock go down during a bear market?

Historically, stocks lose 36% on average during a bear market. For comparison, stocks achieve a 114% return on average during a bull market.

The largest-ever percentage drop by the S&P 500 index occurred on October 19, 1987 (known as The Black Monday), when the S&P 500 dropped by -20.47%. The next biggest selloff happened on October 15, 2008, when the S&P 500 lost –9.03%. In both cases, the stock market continued to be volatile for several months before reaching a bottom. Every time, the end of the bear market was the start of a new bull market. Both times, the stock market recovered and reached historic highs in a few years.

What can you do in the next bear market?

The first instinct you may have when during a sharp market drop is to sell your investments. In reality, this may not always be the right move. Selling your stocks during a bear market could limit your losses but also lead to missed long-term opportunities. Emotional decisions do not bring a sustainable long-term outcome.

Dealing with declining stock values and market volatility can be challenging. The truth is nobody likes to lose money. The bear markets can be treacherous for seasoned and inexperienced investors alike. To be a successful investor, you must remain focused on the strength of your portfolio, your goals, and the potential for future growth. I want to share ten strategies that can help you survive the next bear market and preserve the long-term growth of your portfolio.

1. Stay calm during a bear market

Although it can be difficult to watch your stock portfolio decline, it’s important to remember that bear markets have always had a temporary role in the investment process. Those who survive the bear market and make it to the other side can reap huge benefits.

It’s normal to be cheerful when the stock prices are going higher. And it’s even more natural to get anxious during severe bear markets when stocks are going down.

Here is an example of the typical investor experience during a market cycle. The average investor sells near the bottom of the bear market and goes all in at the top of the bull cycle.

Market cycle
 

Significant drops in stock value can trigger panic. However, fear-based selling to limit losses is the wrong move

Overall, markets are positive the majority of the time. Of the last 92 years of market history, bear markets have comprised only about 20.6 of those years. Put another way; stocks have been on the rise 78% of the time.

If you are making sound investment choices, your patience and the ability to tolerate paper losses will earn you more in the long run.

2. Focus on your long-term goals

A market downturn can be tense for all investors. Regardless of how volatile the next bear market correction is, remember that “this too shall pass.”

Market crises come and go, but your goals will most likely remain the same. In fact, your goals have nothing to do with the market. Your investment portfolio is just one of the ways to achieve your goals.

Your personal financial goals can stretch over several years and decades. For investors in their 20s and 30s financial goals can go beyond 40 – 50 years. Even retirees in their 60s must ensure that their money and investments last through several decades.

Remain focused on your long-term goals. Pay off your debt. Stick to a budget. Maintain a high credit score. Live within your means and don’t risk more than you can afford to lose.

3. Don’t try to time the market

Many investors believe that they can consistently time the stock market to buy low and sell high. However, timing the market is a myth.

You need to be right twice

When you try to time the market, you have to make two crucial decisions – when to get in and when to get out. With a small margin of error, you must be consistently right all the time.

Missing the best days

Frequently the market selloffs precede broad market rallies. A V-shape recovery often follows a market correction.

Half of the S&P 500 Index’s best days in the last 20 years occurred during a bear market. Another 28% of the market’s best days took place in the first two months of a bull market—before it was clear a bull market had begun. In other words, the best way to survive a bear market is to stay invested since it’s difficult to time the market’s recovery.

 

Missing the best days of the market
Missing the best days of the market

4. Diversify your portfolio

Diversification is essential for your portfolio preservation and growth. Diversification requires that you spread your investments among different asset classes such as domestic versus foreign stocks, large-cap versus small-cap equity, treasury and corporate bonds, real estate, commodities, precious metals, etc.).

Uncorrelated asset classes react uniquely during market downturns and changing economic cycles. For example, fixed income securities and gold tend to rise during bear markets when stocks fall and investors seek shelter. On the other hand, equities rise during economic expansion and a bull market,

Achieving divarication will lower the risk of your portfolio in the long run. It is the only free lunch you can get in investing.

5. Rebalance your portfolio regularly

Rebalancing your portfolio is a technique that allows your investment portfolio to stay aligned with your long terms goals while maintaining a desired level of risk. Typically, portfolio managers will sell out an asset class that has overperformed over the years and is now overweight. With the sale proceeds, they will buy an underweighted asset class.

Hypothetically, if you started investing in 2010 with a portfolio consisting of 60% Equities and 40% Fixed Income securities, without rebalancing by the end of 2021, you will hold 85% equities and 15% fixed income. Due to the last decade’s substantial rise in the stock market, many conservative and moderate investors may be holding significant equity positions in their portfolios. Rebalancing before a bear market downturn will help you bring your investments to your original target risk levels. If you reduce the size of your equity holdings, you will lower your exposure to stock market volatility.

6. Dollar-cost averaging

Picking the bottom during a bear market is impossible. If you are not willing to invest all your money at once, you can do it over a period of time. By using the dollar-cost averaging method, you invest your cash in smaller amounts at regular intervals, regardless of the movements in the market. When the stock market is down, you buy more shares. And it’s up you buy fewer shares.

If you regularly contribute to your 401k, you are effectively dollar-cost averaging.

Dollar-cost averaging takes the emotion out of investing. It prevents you from trying to time the market by requiring you to invest the same amount regardless of the market’s conditions.

7. Use tax-loss harvesting during bear markets

Tax-loss harvesting is a tax and investment technique that allows you to sell off stocks and other assets that have declined to offset current or future gains from other sources. You can then replace this asset with a similar but identical investment during a bear market to position yourself for future price recovery. Furthermore, you can use up to $3,000 of capital losses as a tax deduction from your ordinary income. Finally, you can carry forward any remaining losses for future tax years.

To take advantage of this option, you must follow the wash sale rule. You cannot purchase the same security in the next 30 days. To stay invested in the market, you can substitute the stock with another stock that has a similar profile or buy an ETF

The actual economic value of tax-loss harvesting lies in your ability to defer taxes into the future. You can think of tax-loss harvesting as an interest-free loan by the government, which you will pay off only after realizing capital gains. Therefore, the ability to generate long-term compounding returns on TLH strategy can appeal to disciplined long-term investors with low to moderate trading practices.

8. Roth Conversion

A bear market creates an excellent opportunity to do Roth Conversion. Roth conversion is transferring Tax-Deferred Retirement Funds from a Traditional IRA or 401k plan to a tax-exempt Roth IRA. The Roth conversion requires paying upfront taxes with the objective of decreasing your future tax burden.

The lower stock prices during a bear market will allow you to transfer a larger portion of your investments while paying lower taxes. For more about the benefits of Roth IRA read here. And for more information about Roth conversion, you can read our Roth conversion article.

9. Keep your emergency fund

I always recommend that my clients and blog readers keep at least six months of essential living expenses in a checking or a savings account. We call it an emergency fund. It’s rainy-day money, which you need to keep aside for crises and unexpected life events. Sometimes bear markets coincide with recessions and layoffs. If you lose your job, you will have enough reserves to cover your essential expenses and stay on your feet. Using your cash reserves will help you avoid dipping into your retirement savings.

10. Be opportunistic and invest

Bear markets create lifetime opportunities for buying stocks at discounted prices. One of the most famous quotes by Warren Buffet is, “When it’s raining gold, reach for a bucket, not a thimble.” Bear market selloffs rarely reflect the real long-term value of a company as they are triggered by panic, negative news, or geopolitical events. For long-term investors, bear markets present an excellent opportunity to buy their favorite stocks at a discounted price. If you want to get in the market after a selloff, look for established companies with strong secular revenue growth, experienced management, a strong balance sheet, and a proven track record of paying dividends or returning money to shareholders.

Final words

A bear market can take a massive toll on your emotions, investments, and retirement savings. The lack of reliable information and the instant spread of negative news can influence your judgment and force you to make rash decisions. Bear market selloffs can challenge even the most experienced investors. Don’t allow yourself to panic even if it seems like the world is falling apart. Prepare for the next market downturn by following my list of ten recommendations. This checklist will help you “survive” the next bear market while still following your long-term financial goals.

Inflation is a tax and how to combat it

Inflation is a tax

Inflation is a tax. Let me explain. Inflation reduces the purchasing power of your cash and earnings while simultaneously redistributing wealth to the federal government.

When prices go up, we pay a higher sales tax at the grocery store, restaurants, or gas stations. Even if your employer adjusts your salary with Inflation, the IRS tax brackets may not go up at the same pace. Many critical tax deductions and thresholds are not adjusted for inflation.

For example, the SALT deduction remains at $10,000.

We have a $750,000 cap on total mortgage debt for which interest is tax-deductible. There is a $500,000 cap on tax-free home sales. We also have a  $3,000 deduction of net capital losses against ordinary income such as wages.

The income thresholds at which 85% of Social Security payments become taxable aren’t inflation-adjusted and have been $44,000 for joint-filing couples and $34,000 for single filers since 1994

And lastly, even if interest rates on your savings account go up, you still have to pay taxes on your modest interest earnings.

Effectively we ALL will pay higher taxes on our future income

Here are some strategies that can help you combat Inflation.

(Not) keeping cash

Inflation is a tax on your cash. Keeping large amounts of cash is the worst way to protect yourself against Inflation. Inflation hurts savers. Your money automatically loses purchasing power with the rise of Inflation.

Roughly speaking, if this year’s Inflation is 8%, $100 worth of goods and services will be worth $108 in a year from now. Therefore, someone who kept their cash in the checking account will need an extra $8 to buy the same goods and services he could buy for $100 a year ago.

Here is another example. $1,000 in 2000 is worth $1,647 in 2022. If you kept your money in your pocket or a checking account, you could only buy goods and services worth $607 in 2000’s equivalent dollars

I recommend that you keep 6 to 12 months’ worth of emergency funds in your savings account, earning some interest. You can also set aside money for short-term financial goals such as buying a house or paying off debt. If you want to protect yourself from inflation, you need to find a different destination for your extra cash.

Investing in Stocks

Investing in stocks often provides some protection against Inflation. Stock ownership offers a tangible claim over the company’s assets, which will rise in value with Inflation. In inflationary environments, stocks have a distinct advantage over bonds and other investments. Companies that can adjust pricing,  whereas bonds, and even rental properties, not so much

Historical data has shown that equities perform better with inflation rates under 0 and between 0 and 4%.

Inflation is a tax
Higher Inflation deteriorates firms’ earnings by increasing the cost of goods and services, labor, and overhead expenses. Elevated inflation levels can suppress demand as consumers adjust to the new price levels.

Inflation is a tax

Historically, energy, staples, health care, and utility companies have performed relatively better during high inflation periods, while consumer discretionary and financials have underperformed.

While it might seem tempting to think specific sectors can cope with Inflation better than others, the success rate will come down to the individual companies’ business model. Firms with strong price power and inelastic product demand can pass the higher cost to their customers. Furthermore, companies with strong balance sheets, low debt, high-profit margins, and steady cash flows perform better in a high inflation environment.

You also need to remember that every economic regime is somewhat different. Today, we are less dependent on energy than we were in the 1970s. Corporate leadership is also different. Companies like Apple and Google have superiorly high cash flow margins, low debt, and a smaller physical footprint. Technology plays a more significant role in today’s economy than in the other four inflationary periods.

Investing in Real Estate

Real Estate very often comes up as a popular inflation hedge. In the long-run real estate prices tend to adjust with inflation depending on the location. Investors use real estate to protect against inflation by capitalizing on cheap mortgage interest rates, passing through rising costs to tenants.

However, historical data and research performed the Nobel laureate Robert Shiller show otherwise. Shiller says, “Housing traditionally is not a great investment. It takes maintenance, depreciates, and goes out of style”. On many occasions, it can be subject to climate risk – fires, tornados, floods, hurricanes, and even volcano eruptions if you live on the Big Island. The price of a single house also can be pretty volatile. Just ask the people who bought their homes in 2007, before the housing bubble.

Investors seeking inflation protection with Real Estate must consider their liquidity needs. Real Estate is not a liquid asset class. It takes a longer time to sell it than a stock. Every transaction involves paying fees to banks, lawyers, and real estate agents. Additionally, there are also maintenance costs and property taxes. Rising Inflation will lead to higher overhead and maintenance costs, potential renter delinquency, and high vacancy.

Investing in Gold and other commodities

Commodities and particularly gold, tend to provide some short-term protection against Inflation. However, this is a very volatile asset class. Gold’s volatility, measured by its 50-year standard deviation, is 27% higher than that of stocks and 3.5 times greater than the volatility of the 10-year treasury. Other non-market-related events and speculative trading often overshadow short-term inflation protection benefits.

Furthermore,  gold and other commodities are not readily available to retail investors outside the form of ETFs, ETNs, and futures. Buying actual commodities can incur significant transaction and storage costs, making it almost prohibitive for individuals to own them physically.

In recent years the relationship between gold and Inflation has weakened. Gold has become less crucial for the global economy due to monetary policy expansion, benign economic growth, and low and negative interest rates in Japan and the EU.

 Having a Roth IRA

If higher Inflation means higher taxes, there is no better tool to lower your future taxes than Roth IRA. I have written a lot about why you need to establish a Roth IRA. Roth IRA is a tax-exempt retirement savings account that allows you to make after-tax dollars. The investments in your Roth IRA grow tax-free, and all your earnings are tax=emept.

If you are a resident of California, the highest possible tax rate you can pay are

  • 37% for Federal Income taxes
  • 13.3% for State Income taxes
  • 2% for Social Security Income tax for income up to $147,000 in 2022
  • 35% for Medicare Taxes
  • 20% Long-term capital gain tax
  • 8% for Net Investment income tax (NIIT) for your MAGI is over $200,000 for singles and $250,000 for married filing jointly

Having a Roth IRA helps you reduce the  tax noise on your earnings and improves the tax diversification of your investments

Here is how to increase your Roth contributions depending on your individual circumstances:

  • Roth IRA contributions
  • Backdoor Roth contributions
  • Roth 401k Contributions
  • Mega-back door 401k conversions
  • Roth conversions from your IRA

Roth IRA Contribution Limits 2023

Roth IRA Contribution Limits for 2023

The Roth IRA contribution limits for 2023 are $6,500 per person with an additional $1,000 catch-up contribution for people who are 50 or older. There is $500 increase from 2022.

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Roth IRA income limits for 2023

Roth IRA contribution limits for 2023 are based on your annual earnings. If you are single or a head of household and earn $138,000 or less, you can contribute up to the full amount of $6,500 per year.  If your aggregated gross income is between $138,000 and $153,000 you can still make contributions but with a lower value.

Married couples filing jointly can contribute up to $6,500 each if their combined income is less than $218,000.  If your aggregated gross income is between $218,000 and $228,000 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

The Roth IRA and Traditional IRA have the same annual contributions limits. Roth IRA allows you to make after-tax contributions towards retirement. In comparison, 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 taking 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 $5,000 in 2023, you could only contribute $5,000 in your Roth

Roth IRA Contribution Limits 2022

Roth IRA Contribution Limits for 2022

The Roth IRA contribution limits for 2022 are $6,000 per person with an additional $1,000 catch-up contribution for people who are 50 or older. There is no change from 2021.

Retirement Calculator

Roth IRA income limits for 2022

Roth IRA contribution limits for 2022 are based on your annual earnings. If you are single or a head of household and earn $129,000 or less, you can contribute up to the full amount of $6,000 per year.  If your aggregated gross income is between $129,000 and $144,000 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 $204,000.  If your aggregated gross income is between $204,000 and $214,000 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

The Roth IRA and Traditional IRA have the same annual contributions limits. Roth IRA allows you to make after-tax contributions towards retirement. In comparison, 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 taking 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.

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.

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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.

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.

Retirement Calculator

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 2022

IRA Contribution Limits for 2022

The IRA contribution limits for 2022 are $6,000 per person with an additional $1,000 catch-up contribution for people who are 50 or older. Contribution limits remain the same as 2021.

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 2022

The tax-deductible IRA contribution limits for 2022 are based on your annual income. If you are single and earn $129,000 or less, you can contribute up to the full amount of $6,000 per year.  If your aggregated gross income is between $129,000 and $144,000 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 $204,000.  If your aggregated gross income is between $204,000 and $214,000 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.

 

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.

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 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.

 

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.

How to Survive the next Market Downturn

How to survive a market downturn

Everything you need to know about surviving the next market downturn: we are in the longest bull market in US history. After more than a decade of record-high stock returns, many investors are wondering if there is another market downturn on the horizon. With so many people saving for retirement in 401k plans and various retirement accounts, it’s normal if you are nervous. But if you are a long-term investor, you know these market downturns are inevitable. Market downturns are stressful but a regular feature of the economic cycle.

What is the market downturn?

A market downturn is also known as a bear market or a market correction. During a market downturn, the stock market will experience a sharp decline in value. Often, market downturns are caused by fears of recession, political uncertainty, or bad macroeconomic data.

How low can the market go down?

The largest-ever percentage drop by the S&P 500 index occurred on October 19, 1987 (known as The Black Monday), when the S&P 500 dropped by -20.47%. The next biggest selloff happened on October 15, 2008, when the S&P 500 lost –9.03%. In both cases, the stock market continued to be volatile for several months before reaching a bottom. Every time, the end of the market downturn was the start of a new bull market. Both times, the stock market recovered and reached historic highs in a few years.

What can you do when the next market downturn happens?

The first instinct you may have when the market drops is to sell your investments. In reality, this may not always be the right move. Selling your stocks during market selloff may limit your losses, may lock in your gains but also may lead to missed long-term opportunities. Emotional decisions do not bring a rational outcome.

Dealing with declining stock values and market volatility can be tough. The truth is nobody likes to lose money. The volatile markets can be treacherous for seasoned and inexperienced investors alike. To be a successful investor, you must remain focused on the strength of your portfolio, your goals, and the potential for future growth. I want to share nine strategies that can help you through the next market downturn and boost the long-term growth of your portfolio.

1. Keep calm during the market downturn

Stock investors are cheerful when the stock prices are rising but get anxious during market corrections. Significant drops in stock value can trigger panic. However, fear-based selling to limit losses is the wrong move. Here’s why. Frequently the market selloffs are followed by broad market rallies. A V-shape recovery often follows a market correction.

The hypothetical table below looks at the performance of $10,000 invested in the S&P 500 between January 4, 1988, and December 31, 2018. It’s important to note this hypothetical investment occurred during two of the biggest bear markets in history, the 2000 tech bubble crash and the 2008 global financial crisis. If you had missed the ten best market days, you would lose 2.4% of your average annual return and nearly half of your dollar return.

As long as you are making sound investment choices, your patience and the ability to tolerate paper losses will earn you more in the long run.

2. Be realistic: Don’t try to time the market

Many investors believe that they can time the market to buy low and sell high. In reality, very few investors succeed in these efforts.

According to a study by the CFA Institute Financial Analyst Journal, a buy-and-hold large-cap strategy would have outperformed, on average, about 80.7% of annual active timing strategies when the choice was between large-cap stocks, short-term T-bills, and Treasury bonds.

3. Stay diversified

Diversification is essential for your portfolio preservation and growth. Diversification, or spreading your investments among different asset classes (domestic versus foreign stocks, large-cap versus small-cap equity, treasury and corporate bonds, real estate, commodities, precious metals, etc.), will lower the risk of your portfolio in the long-run. Many experts believe that diversification is the only free lunch you can get in investing.

Uncorrelated asset classes react uniquely during market downturns and changing economic cycles.

For example, fixed income securities and gold tend to rise during bear markets when stocks fall. Conversely, equities rise during economic expansion.

4. Rebalance your portfolio regularly

Rebalancing your portfolio is a technique that allows your investment portfolio to stay aligned with your long terms goals while maintaining a desired level of risk. Typically, portfolio managers will sell out an asset class that has overperformed over the years and is now overweight. With the proceeds of the sale, they will buy an underweighted asset class.

Hypothetically, if you started investing in 2010 with a portfolio consisting of 60% Equities and 40% Fixed Income securities, without rebalancing by the end of 2019, you will hold 79% equities and 21% fixed income. Due to the last decade’s substantial rise in the stock market, many conservative and moderate investors are now holding significant equity positions in their portfolio. Rebalancing before a market downturn will help you bring your investments to your original target risk levels. If you reduce the size of your equity holdings, you will lower your exposure to stock market volatility.

5. Focus on your long-term goals

A market downturn can be tense for all investors. Regardless of how volatile the next stock market correction is, remember that “this too shall pass.”

Market crises come and go, but your goals will most likely remain the same. In fact, most goals have nothing to do with the market. Your investment portfolio is just one of the ways to achieve your goals.

Your personal financial goals can stretch over several years and decades. For investors in their 20s and 30s financial goals can go beyond 30 – 40 years. Even retirees in their 60s must ensure that their money and investments last through several decades.

Remain focused on your long-term goals. Pay of your debt. Stick to a budget. Maintain a high credit score. Live within your means and don’t risk more than you can afford to lose.

6. Use tax-loss harvesting during the market downturn

If you invest in taxable accounts, you can take advantage of tax-loss harvesting opportunities. You can sell securities at depressed prices to offset other capital gains made in the same year. Also, you can carry up to $3,000 of capital losses to offset other income from salary and dividends. The remaining unused amount of capital loss can also be carried over for future years for up to the allowed annual limit.

To take advantage of this option, you have to follow the wash sale rule. You cannot purchase the same security in the next 30 days. To stay invested in the market, you can substitute the depressed stock with another stock that has a similar profile or buy an ETF.

7. Roth Conversion

A falling stock market creates an excellent opportunity to do Roth Conversion. Roth conversion is the process of transferring Tax-Deferred Retirement Funds from a Traditional IRA or 401k plan to a tax-exempt Roth IRA. The Roth conversion requires paying upfront taxes with a goal to lower your future tax burden. The depressed stock prices during a market downturn will allow you to transfer your investments while paying lower taxes. For more about the benefits of Roth IRA, you can read here.

8. Keep a cash buffer

I always recommend to my clients and blog readers to keep at least six months of essential living expenses in a checking or a savings account. We call it an emergency fund. It’s a rainy day, which you need to keep aside for emergencies and unexpected life events. Sometimes market downturns are accompanied by recessions and layoffs. If you lose your job, you will have enough reserves to cover your essential expenses. You will avoid dipping in your retirement savings.

9. Be opportunistic and invest

Market downturns create opportunities for buying stocks at discounted prices. One of the most famous quotes by Warren Buffet is “When it’s raining gold, reach for a bucket, not a thimble.” Market selloffs rarely reflect the real long-term value of a company as they are triggered by panic, negative news, or geopolitical events. For long-term investors, market downturns present an excellent opportunity to buy their favorite stocks at a low price. If you want to get in the market after a selloff, look for established companies with strong secular revenue growth, experienced management, solid balance sheet and proven track record of paying dividends or returning money to shareholders.

Final words

Market downturns can put a huge toll on your investments and retirement savings. The lack of reliable information and the instant spread of negative news can influence your judgment and force you to make rash decisions. Market selloffs can challenge even the most experienced investors. That said, don’t allow yourself to panic even if it seems like the world is falling apart. Prepare for the next market downturn by following my list of nine recommendations. This checklist will help you “survive” the next bear market while you still follow your long-term financial goals.

9 Smart Tax Saving Strategies for High Net Worth Individuals

9 Smart Tax Saving Strategies for High Net Worth Individuals

The Tax Cuts and Jobs Act (TCJA) voted by Congress in late 2017 introduced significant changes to the way high net worth individuals and families file and pay their taxes. The key changes included the doubling of the standard deduction to $12,000 for singles and $24,000 for married couples filing jointly, the elimination of personal exemptions, limiting the SALT deduction to $10,000, limiting the home mortgage interest deduction to loans of up to $750,000 versus $1,000,000 as well as comprehensive changes to itemized deductions and Alternative Minimum Tax.

Many high net worth individuals and families, especially from high tax states like California, New York, and New Jersey, will see substantial changes in their tax returns. The real impact won’t be completely revealed until the first tax filing in 2019. Many areas remain ambiguous and will require further clarification by the IRS.

Most strategies discussed in this article were popular even before the TCJA. However, their use will vary significantly from person to person.  I strongly encourage you to speak with your accountant, tax advisor, or investment advisor to better address your concerns.

1. Home mortgage deduction

While a mortgage tax deduction is rarely the primary reason to buy a home, many new home buyers will have to be mindful of the new tax rule limiting mortgage deductions to loans of up to $750,000. The interest on second home mortgages is no longer tax-deductible.  The interest on Home Equity Loans or HELOCs could be tax-deductible in some instances where proceeds are utilized to acquire or improve a property

2. Get Incorporated

If you own a business, you may qualify for a 20 percent deduction for qualified business income. This break is available to pass-through entities, including S-corporations and limited liability companies. In general, to qualify for the full deduction, your taxable income must be below $157,500 if you’re single or $315,000 if you’re married and file jointly. Beyond those thresholds, the TJLA sets limits on what professions can qualify for this deduction. Entrepreneurs with service businesses — including doctors, attorneys, and financial advisors — may not be able to take advantage of the deduction if their income is too high.

Furthermore, if you own a second home, you may want to convert it to a rental and run it as a side business. This could allow you to use certain tax deductions that are otherwise not available.

Running your business from home is another way to deduct certain expenses (internet, rent, phone, etc.). In our digital age, technology makes it easy to reach out to potential customers and run a successful business out of your home office.

3. Charitable donations

All contributions to religious, educational, or charitable organizations approved by the IRS are tax-deductible. The annual limit is 50% of your AGI (aggregate gross income) for most donations and 30% of AGI for appreciated assets.

While most often people choose to give money, you can also donate household items, clothes, cars, airline miles, investments, and real estate. The fair value of the donated items decreases your taxable income and therefore will reduce the amount of taxes due to IRS.

The TCJA made the tax planning for donations a little bit trickier. The new tax rules raised the standard deduction to $12,000 for singles and $24,000 for married couples filing jointly. In effect, the rule will reduce the number of people who are itemizing their taxes and make charitable donations a less attractive tax strategy.

For philanthropic high net worth individuals making charitable donations could require a little more planning to achieve the highest possible tax benefit. One viable strategy is to consolidate annual contributions into a single large payment. This strategy will ensure that your donations will go above the yearly standard deduction threshold.

Another approach is to donate appreciated investments, including stocks and real estate. This strategy allows philanthropic investors to avoid paying significant capital gain tax on low-cost basis investments. To learn more about the benefits of charitable donations, check out my prior post here.

4. Gifts

The TCJA doubled the gift and estate tax exemption to almost $11.18 million per person and $22.36 per married couple. Furthermore, you can give up to $15,000 to any number of people every year without any tax implications. Amounts over $15,000 are subject to the combined gift and estate tax exemption of $11 million.  You can give your child or any person within the annual limits without creating create any tax implications.

Making a gift will not reduce your current year taxes. However, making gifts of appreciated assets with a lower cost basis can be a way to manage your future tax payments and pass on the tax bill to family members who pay a lower tax rate.

5. 529 Plans

The TCJA of 2017 expanded the use of 529 plans to cover qualifying expenses for private, public, and religious kindergarten through 12th grade. Previously parents and grandparents could only use 529 funds for qualified college expenses.

The use of 529 plans is one of the best examples of how gifts can minimize your future tax burden. Parents and grandparents can contribute up to $15,000 annually per person, $30,000 per married couple into their child college education fund. The plan even allows a one–time lump-sum payment of $75,000 (5 years x $15,000).

Parents can choose to invest their contributions through a variety of investment vehicles.  While 529 contributions are not tax-deductible on a federal level, many states like New York, Massachusetts, Illinois, etc. allow for state tax deductions for up to a certain amount. The 529 investments grow tax-free. Withdrawals are also tax-free when used to pay cover qualified college and educational expenses. 

6. 401k Contributions

One of the most popular tax deductions is the tax-deferred contribution to 401k and 403b plans. In 2020 the allowed maximum contribution per person is $19,500 plus an additional $6,500 catch-up for investors at age 50 and older. Also, your employer can contribute up to $36,500 for a maximum annual contribution of $57,000 or $63,500 if you are older than 50.

The contributions to your retirement plan are tax-deductible. They decrease your taxable income if you use itemized deductions on your tax filing form. Not only that, but the investments in your 401k portfolio also grow tax-free. You will owe taxes upon withdrawal at your current tax rate at that time.

7. Roth IRA

Roth IRA is a great investment vehicle. Investors can contribute up to $6,000 per year. All contributions to the account are after-tax.  The investments in the Roth IRA can grow tax-free. And the withdrawals will be tax-exempt if held till retirement. IRS has limited the direct contributions to individuals making up to $124,000 per year with a phase-out at $139,000. Married couples can make contributions if their income is up to $196,000 per year with a phase-out at $206,000.

Fortunately, recent IRS rulings made it possible for high net worth individuals to make Roth Contributions.  Using the two-step process known as backdoor Roth you can take advantage of the long-term tax-exempt benefits of Roth IRA. Learn more about Roth IRA in our previous post here. 

8. Health Spending Account

A health savings account (HSA) is a tax-exempt saving account available to taxpayers who are enrolled in a high-deductible health plan (HDHP) The funds contributed to this account are tax-deductible. Unlike a flexible spending account (FSA), HSA funds roll over and accumulate year over year if not spent. HSA owners can use the funds to pay for qualified medical expenses at any time without tax liability or penalty. The annual contribution limits for 2018 are $3,450 per person, $6,900 per family, and an additional $1,000 if 55 or older. The owner of HSA can invest the funds similar to the IRA account.

In effect, HSAs have a triple tax benefit. All contributions are tax-deductible. Investments grow tax-free and. HSA owners can make tax-free withdrawals for qualified medical expenses.

9. Municipal bonds

Old fashioned municipal bonds continue to be an attractive investment choice of high net worth individuals. The interest income from municipal bonds is still tax-exempt on a federal level. When the bondholders reside in the same state as the bond issuer, they can be exempted from state income taxes as well.

Final words

If you have any questions about your existing investment portfolio, reach out to me at [email protected] or +925-448-9880.

You can also visit our Insights page where you can find helpful articles and resources on how to make better financial and investment decisions.

Investing in Small Cap Stocks

Small Cap Stocks

Small cap stocks are an important part of a diversified investment portfolio. They had provided high historical return and diversification, which are key factors in the portfolio management process.

Many flagship companies started as small businesses in a local market and evolved to large multinational corporations. Some of these success stories include McDonalds, which opened its first restaurant in Des Plaines, Illinois to become one of the biggest food chains in the world.

Research has shown that small-cap stocks overperformed a large cap over an extended period.

The below chart shows 15-year performance between IWM, Russell 2000 Small Cap ETF and SPY, S&P 500 Large Cap ETF. For that period IWM surged by 164% while SPY rose by 67%.

 

Once we include dividends, the 15-year annualized return of a small cap blend strategy becomes 8.66% versus 6.71% for a large cap strategy.

If we extend our period to 40 years (1975 – 2015), the small cap generated 14.25% annualized return while large cap produced 11.66%.

Investing in small companies comes with many caveats.  Even though they bring potentially high returns, they also impose high risk and uncertainty.

Small cap stocks market capitalization

Small cap companies have a market capitalization between $300 million and $2 billion dollars. Overall, the small size market is very fragmented. There are thousands of publicly traded small-size companies, but they only make 10-15% of the total market. The definition of a small-cap company varies widely among index providers and portfolio managers. Standard & Poor’s tracks their own S&P 600 Small Cap Index while FTSE Russell tracks the Russell 2000 Small Cap Index.

Very often, small companies are managed by their original founders.  They are usually new and innovative companies with competitive strengths in a particular local market or a specific product. It is not uncommon for companies to go back and forth between small, mid and large-cap rankings depending on their business cycle.

Niche market

Small cap companies often operate in a niche market where they have a distinct competitive advantage. Small businesses have a unique product or service, which they offer on either national or local level.  Unlike their bigger counterparts, which offer a variety of products in different geographies, small size companies tend to be more focused, with one or two flagship products. A particular example can be Coca Cola versus Red Bull. Coca-Cola offers hundreds of varieties of beverages worldwide while Red Bull offers only one type of energy drink.

Regularly small companies will start from a local market and grow nationwide.  Starbucks is a great example of a local coffee shop that moved up the ranks and became one of the top 100 large company in the USA and the world.

Small businesses with a unique product will often become an acquisition target for a larger corporation that wants to gain a presence in a growing higher margin market. Great example for that is PepsiCo acquiring Gatorade. PepsiCo wanted to get access to the fast growing market of sports drinks and instead of developing their own line; they decided to purchase an already established brand.

Growth potential

Small cap companies often have higher revenue growth than large size ones. Their competitive advantages, innovative strategy, flexibility and market positioning allows them to grow faster. It is easier to increase 25% when you start at $10 million of revenue versus $25% at $ 1 billion of revenue. Many times small companies do not even have a competition in their market niche. Think of Facebook before they went public. It is common for small firms to grow their revenue between 25% and 50% annually for several consecutive years.

Volatile prices

Investing in small cap stocks is risky. The high potential return of small caps comes with greater risk. The share price of small companies is more volatile and subject to larger swings than those of bigger companies.

IWM, the biggest small-cap ETF, has a beta of 1.22 to the equity market. As the comparison, the beta of SPY, the most traded large-cap ETF, is equal to 1. Beta measures the volatility of a security compared to the market as a whole. IWM beta of 1.22 shows that the ETF is historically 22% more volatile than the overall market.

Another measure of volatility is a standard deviation. It illustrates how spread out are the historical returns compared to the average annualized return of the investments. In our case, the 15-year standard deviation of IWM is 19.73% versus 14.14% for SPY.

As I mentioned earlier, the average 15-year return for a small cap stock is 8.66%. With a standard deviation equal to 19.73%, an average annual return can go between -11.07% and 28.39%. For SPY the average range is between -7.43% and +20.85% with annualized return of 5.25%. Based on this historical data we can claim that the small cap market has a much wider probability of returns. The high upside comes with a bigger downside.

Limited access

Small cap stocks lack the liquidity and trading volume of the large public corporations. This makes them more vulnerable to large price swings in short periods.

In times of economic recession, small companies can take a bigger hit in their earnings and may take a longer time to recover. Ten or fifteen percent decline in revenues can have a much more adverse impact on a small company than a larger one.

Due to their limited access to equity markets and loan financing, small size companies have a higher risk to go into bankruptcy if they run out of money.

Many small firms are start-ups with one innovative product and untested business models. Their dependency on just one product or service puts them in a very high-risk category in cases when the product or service does not appeal to their target customer base.

Inefficient market

Traders and portfolio managers often ignore small-cap companies. The focus is usually on large size companies, which frequently have 5 to 10 analysts following their earnings.  In fact, research analysts cover very few of the 2,000 stocks in the Russell 2000 index. Therefore, it is common that a small company does not have a full coverage by any industry analysts. This lack of interest and publicity produces conditions for inefficient pricing.   Active investors with a focus on the small cap market can scan the universe for undervalued and mispriced stocks and generate higher returns based on their valuation techniques and knowledge of the market.

Diversification

Investing in small cap companies can significantly contribute to the diversification of your portfolio.  Even though small stocks have a higher risk than larger ones, their correlation to the overall market is lower. A small blend strategy has 0.86 correlation to the overall US stock market and 0.56 to the broader international stock market.

A correlation equal to 1 shows the highest strength of the relationship between two asset categories. In the case of small cap, the correlation of 0.86 shows a weaker link with the overall market. Small cap prices does not fluctuate in the same magnitude and pace as the large cap companies.  While there is some influence by S&P 500, they follow an independent path.

 

How to invest in small cap stocks

Individual stocks

You can invest in small size companies by buying them directly on the open market. There are over 2,000 listed small size companies in various industries and stages of their business cycle. Naturally, you cannot invest in all 2,000 stocks. You have to find a way to narrow down your criteria and select stocks based on certain factors. Very few small companies have analyst coverage. Therefore investing in small caps stocks will require doing your own research, analysis, and valuation.

When you invest in any company directly, being that a small or large size, you have to keep in mind that concentrated positions can adversely affect your portfolio performance if that company has a bad year or goes bankrupt. While everyone’s risk sensitivity is different, I would recommend limiting the range of each individual stock investment to 1% – 2% of your portfolio.

Tax Impact

For the best tax impact, I recommend putting small cap stocks either in taxable or Roth IRA accounts. Small cap companies have higher expected return combined with a higher expected volatility. If you hold your stocks in a taxable account, you can take advantage of tax loss harvesting opportunities if a particular stock in your portfolio is trading at lower levels than original purchase price. Tax loss harvesting is not available in Roth IRA, Traditional IRA, and 401k accounts. I

If you have small-cap stocks with solid long-term return prospects, keeping them in a taxable account will also allow you to pay the favorable long-term capital gain tax when you decide to sell them.

Having stocks in a Roth IRA account will have even better tax treatment – zero tax at the time of sale.

Passive indexing

ETFs and index mutual funds are the top choice for passive small cap investing. They provide a low-cost alternative for investors seeking a broader exposure to the small cap market. Small cap ETFs come in different shapes and forms. The table below shows a list of the most traded small cap ETFs with AUM above $500 million:

List of Small Cap ETFs

TICKER

FUND NAME EXPENSE RATIO AUM SPREAD % 1 YEAR 5 YEAR 10 YEAR SEGMENT

AS OF

IWM iShares Russell 2000 ETF 0.20% $27.79B 0.01% 5.69% 12.28% 6.01% Equity: U.S. – Small Cap 10/26/2016
IJR iShares Core S&P Small Cap ETF 0.07% $20.83B 0.03% 7.35% 14.16% 7.56% Equity: U.S. – Small Cap 10/26/2016
VB Vanguard Small-Cap Index Fund 0.08% $13.94B 0.03% 5.59% 13.14% 7.40% Equity: U.S. – Small Cap 10/26/2016
VBR Vanguard Small Cap Value Index Fund 0.08% $8.16B 0.04% 7.31% 14.20% 6.77% Equity: U.S. – Small Cap Value 10/26/2016
IWN iShares Russell 2000 Value ETF 0.25% $6.72B 0.01% 9.39% 12.17% 4.82% Equity: U.S. – Small Cap Value 10/26/2016
IWO iShares Russell 2000 Growth ETF 0.25% $6.35B 0.02% 1.92% 12.31% 7.01% Equity: U.S. – Small Cap Growth 10/26/2016
VBK Vanguard Small-Cap Growth Index Fund 0.08% $4.93B 0.04% 3.50% 11.36% 7.25% Equity: U.S. – Small Cap Growth 10/26/2016
IJS iShares S&P Small-Cap 600 Value ETF 0.25% $3.85B 0.03% 10.26% 14.31% 6.57% Equity: U.S. – Small Cap Value 10/26/2016
SCHA Schwab U.S. Small-Cap ETF 0.06% $3.78B 0.04% 5.46% 13.03% Equity: U.S. – Small Cap 10/26/2016
IJT iShares S&P Small-Cap 600 Growth ETF 0.25% $3.47B 0.08% 4.41% 13.74% 8.42% Equity: U.S. – Small Cap Growth 10/26/2016
DES WisdomTree SmallCap Dividend Fund 0.38% $1.59B 0.12% 11.96% 14.36% 6.35% Equity: U.S. – Small Cap 10/26/2016
FNDA Schwab Fundamental US Small Co. Index ETF 0.32% $1.04B 0.06% 6.38% Equity: U.S. – Small Cap 10/26/2016
SLYG SPDR S&P 600 Small Cap Growth ETF 0.15% $807.64M 0.27% 4.61% 13.74% 9.00% Equity: U.S. – Small Cap Growth 10/26/2016
VTWO Vanguard Russell 2000 Index Fund 0.15% $675.74M 0.06% 5.67% 12.19% Equity: U.S. – Small Cap 10/26/2016
XSLV PowerShares S&P SmallCap Low Volatility Portfolio 0.25% $651.46M 0.09% 12.43% Equity: U.S. – Small Cap 10/26/2016
SLYV SPDR S&P 600 Small Cap Value ETF 0.15% $610.42M 0.21% 10.46% 14.43% 7.38% Equity: U.S. – Small Cap Value 10/26/2016
SLY SPDR S&P 600 Small Cap ETF 0.15% $512.80M 0.25% 7.10% 13.99% 8.19% Equity: U.S. – Small Cap 10/26/2016

Benchmark

One of the main differences between small-cap ETFs is the index they track. Each of the three main Small Cap Indexes is constructed differently.

Russell 2000 (IWM) includes the bottom 2,000 of the largest 3,000 publicly traded companies. The average market cap of the constituents of Russell 2000 is equal to $1.9 billion. The median is 698 million. And the largest stock has a market cap of $6 billion.

S&P 600 Index (IJR) tracks a smaller subset of the market. It includes only 600 companies.  As of April 2016, the market capitalization of companies included in the Index ranged from US$ 400 million to US$ 1.8 billion. S&P 600 also sets additional requirements for liquidity, public float, sector and financial viability.

CRSP SmallCap index (VB) tracks the 2%-15% percentile of the total market. It has 1,462 companies. The smallest company has a market capitalization of $21 million; the largest has $7.9 billion. The average size is $1.85 billion. The median is $1.44 billion. It is worth noting that VB tracked Russell 2000 Index through May 16, 2003; MSCI US Small Cap 1750 Index through January 30, 2013; CRSP US Small Cap Index thereafter

Focus

Another big difference between Small Cap ETFs is their segment focus. There are three main segments – small cap blend, growth, and value. The blend strategy invests in the wide universe of small caps, which mechanically tracks the designated index. The value strategy tracks a specific group of companies that have a  certain level of Price to Earnings, Price to Sales, Price to Book, dividend yield, and other fundamental ratios. Growth strategy invests in a group of stocks that meet certain criteria for price, revenue and earnings growth.

Tax Impact

ETFs and index funds have more favorable tax treatment than actively traded mutual funds. Due to their passive nature and legal structure, these funds rarely release capital gains and losses to their shareholders. Therefore, investors looking to optimize taxes in their investment portfolio should consider these type of funds.

Active investing

This strategy includes investing in actively managed mutual funds. These funds are run by management teams. They normally charge higher fees than comparable ETF to cover for the trading, administrative, marketing and research expenses.  Mutual funds follow a benchmark, which is usually one of the three main indices described earlier – S&P 600, Russell 2000 or CSRP Small Cap Index. Because of their higher fees than comparable ETFs, fund managers are often expected to outperform their benchmark.

Active funds normally focus in one of the three main segments – blend, growth or value. The fund managers utilize a formal selection process that identifies a number of companies, which meet certain proprietary criteria. The end goal is to select those companies that will achieve a higher return than the undying benchmark. Since the characteristics of value vs. growth strategy can be subjective, it is not an unusual that the same company is owned by both value and growth oriented funds.

In the past 7-8 years, many of the active managers have been criticized for underperforming the market. Part of the reason is that we experienced a very long market rally driven by a small number of flagship companies.

Tax Impact

Actively managed mutual funds have a more complex tax structure. They must transfer most of their dividends and capital gains and losses to their shareholders. Mutual funds will often have large amounts of long or short-term gains and losses released in December regardless how long you had kept in your portfolio, to avoid paying additional taxes I recommend placing your actively managed mutual funds in tax deferred and tax exempt accounts. Another alternative is to look for tax-managed funds. They tend to have a low turnover ratio and tend to report long-term gain and losses less frequently.

 

A beginner’s guide to retirement planning

uide to retirement planning

Many professionals feel overwhelmed by the prospect of managing their finances. Often, this results in avoidance and procrastination– it is easy to prioritize career or family obligations over money management.  Doing so puts off decision making until retirement looms.  While it is never too late to start saving for retirement,  the earlier you start, the more time your retirement assets have to grow.  There are several things you can do to start maximizing your retirement benefits.  In this posting, I will present my beginner’s guide to retirement planning.

Start Early 

It is critical to start saving early for retirement. An early start will lay the foundation for healthy savings growth.

With 7% average annual stock return, $100,000 invested today can turn into almost $1.5m in 40 years. The power of compounding allows your investments to grow over time.

The table below shows you how the initial saving of $100,000 increases over 40 years:

Year 0        100,000
Year 10        196,715
Year 20        386,968
Year 30        761,226
Year 40     1,497,446

Not all of us have $100k to put away now. However, every little bit counts. Building a disciplined long-term approach towards saving and investing is the first and most essential requirement for stable retirement.

Know your tax rate

Knowing your tax bracket is crucial to setting your financial goals. Your tax rate is based on your gross annual income subtracted by allowable deductions (ex: primary residence mortgage deductions, charitable donations, and more).

See below table for 2016 tax brackets.

Guide to retirement planning

 

Jumping from a lower to a higher tax bracket while certainly helpful for your budget will increase your tax liabilities to IRS.

Why is important?  Understanding your tax bracket will help you optimize your savings for retirement.

Knowing your tax bracket will help you make better financial decisions in the future. Income tax brackets impact many aspects of retirement planning including choice of an investment plan, asset allocation mix, risk tolerance, tax level on capital gains and dividends.

As you can see in the above table, taxpayers in the 10% and 15% bracket (individuals making up to 37,650k and married couples filing jointly making up to $75,300) are exempt from paying taxes on long-term capital gains and qualified dividends.

Example: You are single. Your total income is $35,000 per year. You sold a stock that generated $4,000 long-term capital gain. You don’t owe taxes for the first $2,650 of your gain and only pay 15% of the remaining balance of $1,350 or $202.5

Conversely, taxpayers in the 39.6% tax bracket will pay 20% on their long-term capital gains and qualified dividends. A long-term capital gain or qualified dividend of $4,000 will create $800 tax liability to IRS.

Tax bracket becomes even more important when it comes to short-term capital gains. If you buy and sell securities within the same year, you will owe taxes at your ordinary income tax rate according to the chart above.

Example: You make $100,000 a year. You just sold company shares and made a short-term capital gain of $2,000. In this case, your tax bracket is 28%, and you will owe $560 to IRS. On the other hand, if you waited a little longer and sold your shares after one year you will pay only $300 to IRS.

Know your  State and City Income Tax

If you live in the following nine states, you are exempt from paying state income tax:  Alaska, Florida, Nevada, South Dakota, Texas, Washington, Wyoming, New Hampshire and Tennessee.

For those living in other states, the state income tax rates vary by state and income level.  I’ve listed state income tax rates for California and New York for comparison.

California income tax rates for 2016:

1% on the first $7,850 of taxable income.

2% on taxable income between $7,851 and $18,610.

4% on taxable income between $18,611 and $29,372.

6% on taxable income between $29,373 and $40,773.

8% on taxable income between $40,774 and $51,530.

9.3% on taxable income between $51,531 and $263,222.

10.3% on taxable income between $263,223 and 315,866.

11.3% on taxable income between $315,867 and $526,443.

12.3% on taxable income of $526,444 and above.

 

New York State tax rates for 2016:

4% on the first $8,400 of taxable income.

4.5% on taxable income between $8,401 and $11,600.

5.25% on taxable income between $11,601 and $13,750.

5.9% on taxable income between $13,751 and $21,150.

6.45% on taxable income between $21,151 and $79,600.

6.65% on taxable income between $79,601 and $212,500.

6.85% on taxable income between $212,501 and $1,062,650.

8.82% on taxable income of more than $1,062,651.

 

City Tax

Although New York state income tax rates are lower than California, those who live in NYC will pay an additional city tax. As of this writing, the cities that maintain city taxes include New York City, Baltimore, Detroit, Kansas City, St. Louis, Portland, OR, Columbus, Cincinnati, and Cleveland. If you live in one of these cities, your paycheck will be lower as a result of this added tax.  The city tax rate varies from 1% and 3.65%.

Create an emergency fund

I recommend setting up an emergency fund that will cover six to 12 months of unexpected expenses. You can build your “rainy day” fund overtime by setting up automatic monthly withdrawals from your checking account. Unfortunately, in the current interest environment, most brick and mortar banks offer 0.1% to 0.2% interest on saving accounts.

Some of the other options to consider are saving account in FDIC-accredited online banks like Discover or Allied Bank, money market account, short term CD, short-term treasuries and municipal bonds.

Maximize your 401k contributions

Many companies now offer 401k plans to their employees as a means to boost employee satisfaction and retention rate. They also provide a matching contribution for up to a certain amount or percentage.

The 401k account contributions are tax deductible and thus decrease your taxable income.  Investments grow tax-free. Taxes are due during retirement when money is withdrawn from the account.

Hence, the 401k plan is an excellent platform to set aside money for retirement. The maximum employee contribution for 2016 is $18,000.  Your employer can potentially match up to $35,000 for a total joint contribution of $53,000. Companies usually match up to 3% to 5% of your salary.

401K withdrawals

Under certain circumstances, you can take a loan against your 401k or even withdraw the entire amount.  Plan participants may decide to take a loan to finance their first home purchase. You can use the funds as last resort income during economic hardship.

In general, I advise against liquidating your 401k unless all other financial options are exhausted.  If you withdraw money from your 401k, you will likely pay a penalty.  Even if you don’t pay a penalty, you miss out on potential growth through compounded returns.

Read the fine print

Most 401k plans will give you the option to rollover your investments to a tax-deferred IRA account once you leave your employer. You will probably have the opportunity to keep your investments in the current plan. While there are more good reasons to rollover your old 401k to IRA than keep it (a topic worth a separate article), knowing that you have options is half the battle.

Always read the fine print of your employer 401k package. The fact that your company promises to match up to a certain amount of money every year does not mean that the entire match is entirely vested to you.  The actual amount that you will take may depend on the number of years of service. For example, some employers will only allow their matching contribution to be fully vested after up to 5 years of service.   If you don’t know these details, ask your manager or call HR. It’s a good idea to understand your 401k vesting policy, particularly if you just joined or if you are planning to leave your employer.

In summary, having a 401k is a great way to save for retirement even if your employer doesn’t match or imposes restrictions on the matching contributions. Whatever amount you decide to invest, it is yours to keep. Your money will grow tax-free.

Maximize your Roth IRA

Often neglected, a Roth IRA is another great way to save money for retirement.  Roth IRA contributions are made after taxes. The main benefit is that investments inside the account grow tax-free. Therefore there are no taxes due after retirement withdrawals. The Roth IRA does not have any age restrictions, minimum contributions or withdrawal requirements.

The only catch is that you can only invest $5,500 each year and only if your modified adjusted gross income is under $117,000 for single and $184,000 for a couple filing jointly. If you make between $117,000 and $132,000 for an individual or $184,000 and $194,000 for a family filing jointly, the contribution to Roth IRA is possible at a reduced amount.

 

How to decide between Roth IRA and 401k

Ideally, you want to maximize contributions to both plans.

As a rule of thumb, if you expect to be in a higher tax bracket when you retire then prioritizing Roth IRA contributions is a good move.  This allows you to pay taxes on retirement savings now (at your lower taxable income) rather than later.

If you expect to retire at a lower rate (make less money), then invest more in a 401k plan.

Nobody can predict with absolute certainty their income and tax bracket in 20 or 40 years.  Life sometimes takes unexpected turns. Therefore the safe approach is to utilize all saving channels. Having a diverse stream of retirement income will help achieve higher security, lower risk and balanced after tax income.

I suggest prioritizing retirement contributions in the following order:

  1. Contribute in your 401k up to the maximum matching contribution by your employer. The match is free money.
  2. Gradually build your emergency fund by setting up an automatic withdrawal plan
  3. Maximize Roth IRA contributions every year, $5,500
  4. Any additional money that you want to save can go into your 401k plan. You can contribute up to $ 18,000 annually plus $6,000 for individuals over 50.
  5. Invest all extra residual income in your savings and taxable investment account

 

About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.