The Pragmatic Planner

Which State’s 529 Plan Should I Use?

If you have a child, you’ve probably put some thought into their future. And a big part of that future, at least for many kids, will be a college education.

When we calculate the future cost of a four-year education at an in-state public institution for a newborn, we are finding that it’ll take nearly $250,000 for them to earn a bachelor’s degree. Talk about expensive!

Luckily, children have multiple ways to fund education either through part-time jobs, grants, scholarships, or student loans and they have many earning years ahead of them to afford financing education.

However, you can begin saving toward their education now to help pay for some of those future expenses and reduce the amount of debt your child will have to incur.

While there are many ways to save for your kid’s education (savings accounts, UGMA & UTMA accounts, Roth IRAs), my opinion is that a 529 plan is the best.

What is a 529 Plan?

A 529 is an education savings plan. It allows you to invest money into an account, let it grow tax-deferred, and then withdraw it for qualified education expenses without having to pay taxes on it. It’s a pretty sweet deal.

There are two types of 529 plans: prepaid tuition plans and education savings plans. This post will focus solely on the education savings plans as they can be used for any qualified college or university.

Select My State’s Plan or Shop Around?

Contrary to popular belief, you can use almost any State-sponsored 529 plan. Not just the state you live in. With so many choices, it can be hard to decide whether to use your own State’s 529 plan or another one’s.

There are a few things that you should consider when determining which State’s plan is right for you: the investment options that are available to you, the fees associated with the plan, and any tax incentives that your State offers.

Investments

You might hear a lot of emphases put on evaluating the past performance (3-yr, 5-yr, 10-yr average annualized returns) to determine if you should go with a plan. While you do want a plan that has a good track record, this backward-looking metric has no indication of how well the funds will perform in the future.

Instead, you’ll want to focus on the managers of the funds themselves and the way they are positioning the funds for long-term financial gains. This will help you determine if the plan has viable investment options that are suitable for you to achieve your goals.

Fees

Probably more important than the performance numbers are the fees for the plan. Fees have a huge impact on ending account value. The higher the fee, the less money you have in the future. Carefully evaluate the overall fees for the plans you are comparing.

It isn’t always wise to select the cheapest option either. It is possible that the plan manager is offering a higher level of investment management, which aligns more closely with your investment style, making the higher cost worth it to you.

Tax Incentives

Many states offer tax incentives to its taxpayers who contribute to 529 plans. For example, in Indiana, taxpayers are eligible for a state income tax credit of 20% of contributions to its 529 accounts, up to $1,000 credit per year. That means you’ll need to contribute at least $5,000 per year to take full advantage of the credit.

Tax incentives shouldn’t really be a factor when determining which State’s plan to go with if you won’t be contributing enough to get it in the first place.

Always Direct.

No matter which State’s plan you go with, you are going to have the option to go through a broker to open the account (advisor-sold) or do it yourself (direct-sold). You’ll always want to go with a direct-sold plan. The advisor-sold plans have higher annual costs because the broker is getting paid a commission for doing the same work that you can easily do.

If you have questions about selecting the right 529 plan, or how to evaluate a plan’s fees and investments, I recommend seeking out a fee-only financial advisor for help. They’ll be able to help you determine a savings goal and then evaluate which State’s plan matches your needs.

Did You Contribute Too Much to a Roth IRA?

For the 2019 tax year, a single filer can contribute up to $6,000 to a Roth IRA ($7,000 for age 50 and older) if their modified adjusted gross income (MAGI) is less than $122,000.

As their income goes above that, the allowed contribution amount begins to decrease until they become totally ineligible at $137,000. The limits for those who are married and filing jointly are $193,000 and $203,000 respectively.

So what can you do if you saved diligently to your Roth IRA last year but as you are gathering all of the documents to file your taxes you find that your income was too high to actually contribute to a Roth IRA?

There are three fairly straightforward options to remedy this problem.

Withdraw the Excess Contribution

The first solution is to simply withdraw the excess contribution so it doesn’t count toward that year’s contributions.

According to the IRS:

“For purposes of determining excess contributions, any contribution that is withdrawn on or before the due date (including extensions) for filing your tax return for the year is treated as an amount not contributed. This treatment only applies if any earnings on the contributions are also withdrawn. The earnings are considered earned and received in the year the excess contribution was made.”

What this means is that withdrawals are not treated as distributions — it’s as though the contributions were never made. But earnings on the contributions will be counted as income and you’ll owe taxes on that amount (you’ll also owe the 10% tax for an early withdrawal if you are under the age of 59 1/2).

For example, if you contributed $6,000 and that $6,000 earned $100 you will need to withdraw $6,100 when removing the excess contribution. Only the $100 of earnings will be considered income though.

You can withdraw contributions from a Roth IRA up until the Oct. 15 extended deadline if you’ve requested an extension of time to file your return. If you already filed your tax return, you can still withdraw contributions, but you’ll need to file an amended tax return after withdrawing the funds.

Move the Money to a Traditional IRA

Another option is to “re-characterize” the Roth IRA contribution to a Traditional IRA contribution.

According to the IRS:

“You may be able to treat a contribution made to one type of IRA as having been made to a different type of IRA. This is called re-characterizing the contribution. To recharacterize a contribution, you generally must have the contribution transferred from the first IRA (the one to which it was made) to the second IRA in a trustee-to-trustee transfer. If the transfer is made by the due date (including extensions) for your tax return for the tax year during which the contribution was made, you can elect to treat the contribution as having been originally made to the second IRA instead of to the first IRA.”

The IRS says that you must also:

“Include in the transfer any net income allocable to the contribution. If there was a loss, the net income you must transfer may be a negative amount. Report the recharacterization on your tax return for the year during which the contribution was made. Treat the contribution as having been made to the second IRA on the date that it was actually made to the first IRA.”

Apply the Roth Contribution to the Following Tax Year

If you expect your income will be low enough that you can contribute to a Roth IRA going forward, you also have the option of applying the excess contributions to the next tax year. This allows you to keep the funds invested in the Roth IRA.

The IRS says:

“If contributions to your Roth IRA for a year were more than the limit, you can apply the excess contribution in one year to a later year if the contributions for that later year are less than the maximum allowed for that year.”

what if you don’t take action

If you don’t take any of the actions above, the IRS is going to determine that you made excess contributions and assess an excise tax of 6% to the amount that exceeds your limit for the year. This amount is calculated and reported on Form 5329.

You might say to yourself, “6% doesn’t seem so bad”. But the tax doesn’t just apply to one year, it will continue to be assessed each year for as long as the excess contributions remain in the Roth IRA.

It can be easy to inadvertently contribute too much to your Roth IRA. Luckily, there are a number of easy to administer solutions to fix the problem. Just make sure you take the necessary action so you don’t end up paying the government more money than you need to!

Don't Just Set Goals, Make Habits

The start of the new year brings new beginnings and for a lot of people that can take the form of a new year’s resolution.

Losing weight, getting healthy, saving money… these are a few common new year’s resolutions that all have something in common. They’re all very broad goals.

What’s wrong with a goal? Well, nothing. But something I’ve noticed is that a lot of goals are never fully fleshed out and fall to the wayside after a short period of time.

Some anecdotal evidence of this is currently happening at my gym. Every January the place is a madhouse. The parking lot is always full and good luck trying to find a machine to work on. Come February though, it’s all back to normal.

So what happened to all of these people? They had a goal they wanted to achieve, but they didn’t develop a habit in order to make it happen.

The Problems With Goals

When we want to change an aspect of our lives, setting a goal is often the logical first step. But there are some problems with this approach.

Goals require work. Humans by nature are generally lazy creatures. Why hunt and gather when I can just farm and cultivate my food? If we perceive something is taking too much of our energy, with not a lot of benefit, we stop doing it!

Goals rely on factors that we do not always have control over. Sometimes reaching a goal isn’t possible, no matter how much effort we put into it. An injury might derail a fitness goal. An unexpected expense might sabotage a financial goal.

Goals have an end. This is the reason many people go back to their old ways after attaining a certain goal. We’ve done what we set out to do and now it’s time to relax or treat yourself.

The Benefits of Habits

Are goals completely useless? Of course not. I’ve found that goals are good for planning your progress and habits are good for actually making progress.

The benefit of creating habits is that it helps us reach our goals in incremental steps and literally rewires our brains.

Habits are easy to complete. Once we develop a habit, our brains actually change to make the behavior easier to complete.

Habits are for life. Our lives are structured around habits. Once you develop one, they are hard to break and they happen automatically.

Habits can be as small as necessary. You can make incremental adjustments to your behavior to build a habit. Once you start, the changes start to compound on one another and at some point, it just becomes part of your routine. It’s like a snowball going down a hill, gathering momentum as it goes.

Say you want to read more. A goal might be for you to read a book a month. Instead, say you are going to read 5 minutes a day for 30 days. By the end of the 30 days, it’s become a habit.

Goals can provide direction and even push you forward in the short-term, but eventually, a well-designed system of habits will always come out on top.

Having a system is what matters. Committing to the process is what makes the difference.

If you have something that you want to do, don’t just focus on a specific goal, rather take the time to form habits that help you achieve it.

My Take On The SECURE Act

48% of U.S. households led by someone 55 or older have no money saved for their retirement, according to a report released by the Government Accountability Office.

To make matters worse, 29% of those households don’t have access to a pension or other defined benefit plan that would help provide some source of income during retirement, leaving these families to live solely off of Social Security benefits.

It’s a very complex problem, driven in part by a shift away from traditional pensions toward a do-it-yourself savings system.

So what can be done to change people’s savings behavior and prevent them from facing their own retirement crisis?

Research has shown one of the most effective ways to get people to save is through a workplace retirement plan such as 401(k)s, 403(b)s, etc. — also known as defined-contribution plans.

However, millions of people do not have access to these plans either, especially at small businesses where the cost and complexity preclude the employers from establishing one.

There is currently a bill that aims to help workers save more for retirement by incentivizing small businesses to offer defined-contribution plans and making it easier for workers to save within those plans (along with some other stuff).

So, What is the bill?

The Setting Every Community Up for Retirement Enhancement Act, known as the SECURE Act, includes 30 provisions that seeks to reform the retirement savings landscape.

I’ll run through a few of the current provisions of the SECURE Act that I find particularly interesting and provide my opinions on if it really helps accomplish what they’re setting out to do — which is to help the average American save more for retirement.

It is important to note that the SECURE Act is not yet law, but it was attached to the year-end spending bill that it is likely to be signed by the President and go into effect January 1, 2020.

Section 102 & 105

Section 102 and 105 of the bill almost go hand-in-hand. Section 102 would allow an employer to automatically deduct money from an employee’s wages toward retirement — up to 15% of their salary — unless the employee opts out or to contribute a different amount. Basically, your employer determines how much you save to your Plan unless you tell them otherwise.

I actually really like this provision for defined-contribution plans and think it could go along way in helping individuals build wealth. Unfortunately, automatic enrollment already exists (with the current cap at 10% of an employee’s salary) and most employers don’t use it.

To help incentive businesses to include auto-enrollment in their Plan, Section 105 would create a $500 per year tax credit that would be available for three years to help offset the cost of including the provision in the Plan.

I really don’t think this credit will make a difference in the adoption rate of the auto-enrollment provision. Instead, I think employers should be given more tools to ensure that their participants are saving at sufficiently high levels to enjoy a secure retirement.

Section 107

Current IRS rules say that if you are older than 70 1/2, you can’t contribute to a traditional IRA (but you can still contribute to a Roth IRA). This piece of legislation would repeal that and doesn’t put an age limit on contributions.

The reasoning behind the change is that Americans are living longer, and an increasing number of people continue to work beyond traditional retirement age.

The current age cap for IRA contributions doesn’t make much sense so I am in favor of repealing it. But aside from some tax planning opportunities, this doesn’t do much to help those struggling to build substantial retirement assets do so.

This provision also includes language that coordinates deductible contributions to IRAs after age 70 1/2 with qualified charitable distributions (QCDs).

Here is what the provision says,

“The amount of distributions not includible in gross income by reason of the preceding sentence for a taxable year (determined without regard to this sentence) shall be reduced (but not below zero) by an amount equal to the excess of – (1) the aggregate amount of deductions allowed to the taxpayer under section 219 for all taxable years ending on or after the date the taxpayer attains age 70 1/2, over (2) the aggregate amount of reductions under this sentence for all taxable years preceding the current taxable year.”

Talk about confusing! What this is essentially saying is that QCDs must be reduced by the cumulative amount of deductible IRA contributions you made after age 70 1/2, that have not already reduced an earlier QCD amount.

Here is an example:

You made deductible IRA contributions at age 71, 72, and 73 for a total of $21,000 ($7,000 per year). At age 74, you make a qualified charitable distribution of $30,000 from your IRA. Only $9,000 of this amount will be treated as a QCD. The first $21,000 doesn’t count because you already took a deduction for it.

This makes sense otherwise you’d be getting a tax break on the money going in and an equivalent amount going out.

section 112

Under current law, employers generally may exclude part-time employees (employees who work less than 1,000 hours per year) when providing a defined contribution plan to their employees.

These rules can be especially detrimental to women since they are more likely to work part-time than men.

Section 112 would make it harder for employers to exclude part-time employees from Plans by expanding the eligibility requirements to include anyone who has worked three consecutive years of service with at least 500 hours of service.

I like this provision a lot and think it goes a long way to help the average working American save for retirement.

section 114

Current law requires individuals to begin required minimum distributions (RMDs) from their retirement accounts once they reach age 70 1/2. The SECURE Act would delay this to age 72.

Something to keep in mind is this only applies to those who are not age 70 1/2 by the end of 2019. If you’re already age 70 1/2, you’ll have to continue taking your RMDs as you would have. There is no grandfather clause.

Honestly, this does nothing but add a few more years for tax planning opportunities (like Roth conversions) for those who already have substantial traditional retirement assets.

section 204

Section 204 is my least favorite provision of this bill. It essentially makes it easier for employers to offer annuities in their 401(k) lineup.

While I’m not against using annuities for lifetime income planning, I am against wrapping them into retirement accounts so insurance companies can charge egregious fees. If you want proof, look at the current 403(b) market!

I recommend reading Tony Isola’s article on why he is against this provision as he’s an expert in the 403(b) space and has researched this thoroughly.

section 302

The Section would allow 529s to be used for student loan payments.

I wrote an article about how this change opens the door for some unique tax planning opportunities, but this doesn’t help the average person prepare for retirement.

section 401

This Section would make substantial changes to inherited retirement plans like 401(k)s and IRAs.

Currently, non-spouse beneficiaries must begin distributions from an inherited retirement account one of two ways:

spreading distributions over their lifetime, or
distribute the balance of the account within 5 years of the original account holder passing away

The bill would take away the first option completely and instead requires most beneficiaries to distribute the account over a 10-year period.

Inherited accounts aren’t meant to be retirement accounts so I can why the government would want to implement this provision — it accelerates the taxes the government is owed.

From a planning perspective, it makes proper estate planning and tax planning far more important for families with significant wealth. Does it help the average person with accumulating retirement assets? I think not.

Final thoughts

While the SECURE Act makes a few positive changes, it doesn’t do anything to help accelerate the retirement security of those who most need it.

Not surprisingly, many of the changes appear to be a clear result of the insurance companies having great lobbyists.

Needless to say, it will take further work by financial planners to help change the way people save for retirement, one family at a time. We can only hope that, in time, this also influences the way the government makes rules surrounding this topic for the better.

Avoid A Ticking Tax Time Bomb

You’ve probably been told that the best way to save for retirement is with your employer’s 401(k), or similar retirement plan. The reasoning, you usually receive some sort of matching contribution from your employer and you receive an immediate “tax break” for the amount you contributed.

In general, this is good advice. However, putting all of your long-term savings into a tax-deferred account can be a serious mistake that doesn’t come to fruition until retirement.

That is because when the account is tapped for income, the withdrawals are subject to the highest possible tax rates, and IRS mandated distributions makes the problem even worse by causing taxation of income you may not even need until later in retirement.

The Time Bomb

Take for example a 70-year-old who has been living on $50,000 per year during their retirement. They have been receiving Social Security benefits of $24,000 per year so they were only taking around $26,000 per year from their investment portfolio to supplement.

They did a great job saving during their working years and have a balance of tax-deferred assets of around $1.5 million. Unfortunately for them, they turn 70 1/2 this year and the IRS has required they begin taking minimum distributions from the account. Based on the IRS’s Required Minimum Distribution worksheet, this person will need to take out nearly $55,000 from their assets this year alone! To compound the problem, the required minimum distribution gets larger the older you get.

These excess distributions will cause their adjusted gross income to increase, which can lead to their Medicare premiums to rise and a larger portion of their Social Security benefits being taxed. Not to mention their overall tax liability increases!

So how do you mitigate this tax time bomb? The same way we manage most risks in finance…diversification.

Tax Diversification Basics

When you boil down the dozen or so ways you can own assets, there are only three basic ways your assets are treated for taxes: Taxable, Tax-Deferred, and Tax-Free.

“Taxable” accounts are simply individual, joint, and trust investment accounts in which you pay taxes on the income and capital gains generated each year. You receive preferential tax treatment on assets that you hold longer than one year in these types of accounts.

“Tax Deferred” accounts include traditional IRAs, 401(k) plans, SEP-IRAs, profit-sharing plans, 403(b) plans and similar accounts. Contributions to these accounts are often tax deductible, but not always. Withdrawals are taxed at your highest marginal income tax rates and the accounts are subject to mandatory distributions beginning at age 70 ½.

“Tax Free” accounts include Roth IRAs and Roth 401(k) plans, as well as Health Savings Accounts (HSA). Roth contributions are made after-tax, while HSA contributions are tax deductible. Withdrawals are tax free and are not subject to required distributions.

The ideal ratios are to have one-third of your assets in each of the three tax types as you enter retirement. But this is not easy to achieve because the default path for most investors is excess tax-deferred holdings due to:

The default election is for contributions to go into a tax-deferred 401(k) plan.
A tax-free Roth 401(k) plan might not be available.
Employer contributions are made into a tax-deferred profit sharing plan.
If your income is too high, you can’t directly contribute to a tax-free Roth IRA.
Saving to a taxable account takes being proactive.

Extra attention has to be put into building tax-free and taxable accounts since the default accumulation path is having the majority of assets in tax-deferred accounts.

Strategies To Achieve Diversification

The following strategies can be used to aid in tax diversification. Many of them can be used in conjunction with one another, but be aware that they become increasingly complex as you move through the list.

If you are eligible for a Health Savings Account (HSA), fund it to the maximum every year and invest it. Don’t make withdrawals for current health expenses. An HSA is the best tax account type in the U.S. (tax deductible, tax-deferred, and tax-free). You’ll have plenty of health expenses in retirement to begin using the account after years of tax-free accumulations.
If your 401(k) plan has a Roth option, use it. There are no income limits on a Roth 401(k), so even high-income earners can accumulate tax-free assets here.
Fund a Roth IRA each year if you are eligible.
Begin funding of a taxable individual, joint, or trust account.
If you have maxed out your 401(k) plan and are not eligible for a Roth IRA, contribute the maximum ($5,500/$6,500) to a non-deductible IRA. By carefully coordinating your IRA and 401(k) plan balances and eligibility requirements, you can convert these IRA contributions to a Roth IRA at a later date with minimal tax liability. This is often referred to as a “backdoor” Roth IRA.
If you have a particularly flexible 401(k) plan — or are a business owner/partner with the ability to control the features of your 401(k) plan — you can make after-tax non-Roth contributions to your plan, which can be subsequently converted to a Roth IRA with minimal tax liability. This would be the “mega backdoor” Roth IRA.
If you are nearing or entering retirement and feel behind on achieving tax diversification, there are some additional techniques you can use to enhance your tax diversification. This can be accomplished with partial Roth IRA conversions in concert with Social Security timing and other income and deduction timing strategies. If properly planned, your tax bracket can be pushed to very low levels for a single year, allowing a low-cost partial Roth conversion to occur. And it may be possible to repeat the technique every few years.

By implementing any number of the above strategies, most people can achieve reasonable tax diversification as they build wealth. Just make sure you are re-examining your current and projected tax diversification each year to make adjustments as needed.

The Benefits of Diversification

It is unlikely you will achieve perfect equalization between the three asset types, but aiming for tax diversification will help:

minimize tax rates
prevent the double taxation of Social Security benefits
avoid higher Medicare premiums
allow for tax-free payment of health care expenses and long-term care insurance premiums
facilitate conversion of asset from tax-deferred to tax-free with nominal taxation
pass wealth tax-free to heirs
aximize tax deductions and standard exemptions and credits every year
preserve ability to balance and time income sources
add to your after-tax income and total lifetime wealth

You will find plenty of opinions claiming one asset type is better than another, but these are always based on certain assumptions that may not come true.

The bottom line is that no one can predict the future, especially decades in advance. That’s why it’s wise to have assets spread across different asset types.