Financial Planning Stuff You Need to Know

With the first rebate checks arriving this week, I want to let some of my clients know that they will not be getting a rebate.

For joint filers the rebate begins to get phased out when you Adjusted Gross Income (AGI) is greater than $150,000. After that you lose $50 for every $1,000 your income is over the threshold.  For example, if you AGI is $160,000 you rebate is reduced by $500.

For those filing as single the threshold for a reduced rebate begins at $75,000.  Your $600 rebate would be reduced to $0 once your AGI reaches $87,000.

For those of you getting a rebate below are 5 great things to do with it:

1. Increase your contribution to your employer’s 401k/403b to get the full match. For an employer that matches $.50 for every $1 you contribute your $600 rebate is instantly worth $900.

1. Contribute to a Roth IRA.  With a Roth IRA your earnings grow tax free. In 25 years that $600 could be worth $4800 with no tax due when you withdraw it!

1. Pay off high interest credit card debt.  If you are paying 24% interest on a credit card paying it off is like getting a 24% return on your investment.  Paying $600 would save you $144/year in interest payments

1. Start an emergency fund.  This is the money you use when the car breaks down etc. instead of running up a credit card debt.  Open a high yield internet savings account at www.ingdirect.com, www.emigrantdirect.com or check www.bankrate.com for the latest savings rates.
2. Open a 529 account for college savings.  The Bright Start Illinois Plan was ranked as one of the best in the nation by the Wall Street Journal.  Plus Illinois residents get a state tax deduction for any money they contribute. See www.brightstartsavings.com

For years, I have told my clients regardless of income to rollover their 401k plan into an IRA when they change jobs.

Main Advantages to Rolling Over Your 401k Plan to an IRA:

• Consolidates all of your retirement assets in one place (especially if you have several jobs all with 401k plans)
• You control your investments especially important if your old employer had poor investment choices in their plan

Now for some higher income earners you may be better off keeping the money in your old plan or rolling directly to your new employers plan.

Here’s why:

• Beginning in 2010 the $100,000 income limit to convert a Traditional IRA to a Roth IRA is lifted.
• But if you do convert your Traditional IRA to a Roth all of your Traditional IRAs are treated as one IRA for the purposes of conversion. If you have a large Rollover IRA with no basis, and a smaller Traditional IRA that no made non-deductible contributions to they will be treated as one IRA and you will have to pay tax on most of the conversion.
• If you don’t rollover your 401k to a IRA the only Traditional IRA you would have is the one you made non-deductible contributions to.  When you convert to a Roth IRA you would only pay taxes on the earnings of your Traditional IRA.

Example 1:

Jane has a 401k worth $200,000 and a Traditional IRA that she made non-deductible contributions to of $20,000.  She rolls the 401k into a Traditional IRA so now she has:

Rollover IRA $200,000 (Basis = 0) All of her 401k contributions were tax deductible

Traditional IRA $20,000 (Basis = $18,000) Non-deductible contributions =$18,000, earnings = $2,000

She decides to convert $20,000 to a Roth IRA in 2010.

Since all of her IRAs are added together for the purpose of conversions $18,000 of the conversion will come from her Rollover IRA and $2,000 will come from her Traditional IRA.

Assume Jane is in the 25% tax bracket.

Taxes = $18,000 X 25% (Rollover IRA) + $2,000 X 10% (portion of Traditional IRA that is taxable) X 25% = $4,500+50 or $4,550

Example 2:

Jane does not rollover her 401k into a Rollover IRA but either leaves it in her old employer plan or rolls it into her new employer plan.  Therefore she only has her Traditional IRA

She decides to convert her $20,000 Traditional IRA to a Roth IRA

Taxes = $20,000 X 10% (Portion of Traditional IRA that is taxable) X 25% =

$500

By not rolling over her 401k into an IRA Jane would save over $4,000 in taxes.

In my last blog I discussed how a high cost retirement plan can cost employees a significant amount of their retirement savings.  So what if you are responsible for the retirement plan at your organization — What questions do you need to ask to find a low cost plan that won’t saddle your employees with hidden fees?

1.  What is the total cost of this plan including administrative fees, advisor fees (also known as ‘wrap-fee’ or asset management fee), and mutual fund fees?

Most employers look at administrative fees only.  In the long-term the asset based advisor and mutual fund fees will comprise the vast majority of the costs.  Most of these fees are hidden in that they are taken from the investment returns — most employees never know they are paying them.  In general the fewer and lower the asset based fees in the plan the lower the overall cost to employees in the long-run.

2.  Are there a wide variety of asset classes represented in the investment options?

Often employers get confused between the number of funds and the number of asset classes.  A plan could have 20 different investment options from a variety of mutual fund companies but if all invest in large domestic companies the plan does not have diversification among asset classes.

Some key asset classes a plan should include are: Large Company Domestic Stock, Mid/Small Company Domestic Stock, International Stock, Bonds, Cash, and Real Estate.  It is not necessary to include a large number of funds in the plan to achieve this goal.  Nor is it necessary to have funds from multiple mutual fund companies.

3. Are your investment choices too complex?

In order to cover themselves and to offer a lot of choices, many plans are way to complex for most employees.  Research on human behavior indicates that when presented with a large number of choices people will choose nothing or put everything in an investment that they understand.

The best 401k and 403b plans have very, very few choices.  Reducing complexity through the reduction of the number of fund choices makes it easier for the employees to see the big picture and will increase the likelihood that they will invest in multiple asset classes.

The US Government defined contribution plan consists of only four (4)main investment options :US Stock Index Fund (Large/Mid/Small Domestic Stock), International Stock Index Fund (International Stock), Bond Index Fund (Bonds), Money Market (Cash).  I think this plan is almost ideal.  The only option I would add would be a Real Estate Index Fund.

Having a few investment options may upset the employees who like to “play the market” by trading in their retirement accounts frequently; however , this is not the purpose of the plan and reducing the number of choices will likely improve the investment choices of most employees.

4. What are the motivations and interests of the person who is advising you about your plan?

Many plan advisors are employees of an insurance company, stock brokerage, or mutual fund company.  All of these people have a fundamental conflict of interest with you.  They get compensated for selling you something so the advice that they provide you may not be objective.  They may also neglect to explain all of the hidden costs involved with any investment recommendations they make. Many of the “free” services they provide come with a high long-term cost.

5. What type of fund is best for a retirement plan?

I almost always recommend that the plan choices be comprised of index funds.  The major advantage of index funds is their low cost.  The annual fee on an index fund may be over 1% less than a comparable non-index or actively managed fund. Since there is no difference in long-term performance between index and actively managed funds in almost all asset classes, the lower fees add up to higher returns in the long run.

6.  How do you find people to help evaluate your current plan or set up a new one?

Hire an independent Fee-Only advisor to do the following:

- Evaluate your current plan (including all costs)

- And/or make investment recommendations for your current or new plan

- Write an investment policy statement for your plan

- Try and find an advisor who will work for an hourly or flat fee vs % of the assets managed.

- Provide employee education sessions to help them make good investment choices

Hire a plan administrator that: (this is the company that get the employee contributions and make sure they are invested as desired, they also work with you on compliance issues, and provide a website for the employees to see their balances and change their investment allocations.  In bundled plans both the advisor and administrator role are handled by one company)

- Charges a flat or per-employee fee vs. an asset management fee

- Offers low cost index funds as investment options

- Your plan advisor may be able to recommend a plan administrator

No, this is not another Enron, WorldCom, or other corporate scandal but a perfectly legal way that many 401(k) and 403(b) plan advisors and administrators charge excessive fees that can cost the plan participants a big chunk of their retirement savings. The real shame is most employers and plan participants never realize what has happened or how much it has cost them.

In the beginning . . .

In 2003 the 403(b) plan at a non-profit organization I volunteered for was typical of high cost plans. It was invested in variable annuities sponsored by a large insurance company. Many of the employees suspected the plan might be costing them a lot of money but did not know how.

How High Are the Fees

They were right. According to Morningstar the average variable annuity has an annual fee of 2.08%. This fee does not include any one-time sales charges known as loads of up to 5.75% that many funds in charge, or additional annual fees of up to 1% or more charged by the plan advisor.

These fees significantly reduce the overall investment return to the plan participants. In the example above, if the underlying investments in the plan returned 9% and the total fees were 3.08% the participants would receive a return of 5.92%. In addition, the fees would not be disclosed on the statements provided to plan participants. This insidious practice is very common in employer sponsored retirement plans.

What does this mean to the average participant?

If a particiapant invested $10,000/year (adjusted for inflation) for 40 years with a 9% return (before fees), she would accumulate approximately $2,400,000 but pay fees of almost $875,000, assuming an annual annuity fee of 2.08% and an additional advisor fee of 1%.

Contrast this dismal example with a plan composed of low-cost index funds with an annual fee of 0.25% in which the plan advisor and plan administrator charge a flat fee which is not based on the assets in the plan. For an organization with 100 employees, this could be around $13,000/year. In this case, the employee would have almost $4,800,000 and paid total fees of only $120,000.

In the variable annuity plan the participant would only have accumulated half of the retirement assets that she would have in the low-cost index fund plan.

Click below to see a graph of estimated retirement savings
Retirement Savings Comparison

Next Blog — Part 2: How do “Bad” investment options end up your retirement plan?

Find out more about low cost 401k and 403b plans