#retirementplanning

By:  Henry VanBuskirk, CFP®, Wealth Manager

“Who can it be knocking at my door?” It’s the Men at Work and Women at Work in Congress(¹) with new retirement legislation, SECURE Act 2.0. While this new legislation has many positive changes, many of those changes come with added complexity to how the Traditional IRA and Roth IRA contribution limits and catch-up contribution amounts are calculated. For example, the $1,000 catch-up contribution amount for persons aged 50 and older will now be indexed for inflation starting in the 2024 tax year. Further, persons aged 60-63 have an even higher catch-up contribution amount, and then persons aged 64 and older revert back to the $1,000 catch-up contribution amount indexed for inflation rule. The exact wording in the SECURE 2.0 Act is in Sections 108-109 and reads as follows:

Those familiar with the Medicare prescription drug coverage gap usually referred to as the “Medicare Part D donut hole”, know that coverage starts out good, then not so good, and then goes back to being good again. The new catch-up contribution rules in SECURE Act 2.0 for persons aged 50 and older give us a “Reverse Donut Hole”, where catch-up contributions to your Traditional IRA or Roth IRA start off okay, then really good, then go back to being okay. As I’m writing this and thinking through it, a reverse donut hole doesn’t make much sense, so I’m just going to call this catch-up contribution phenomenon created by Congress a donut with no hole. A wise man once said that “…A donut with no hole is a Danish”(²⁾.

Whether you are Danish American, Asian American, African American, or prefer not to specify, chances are you probably want to maximize the potential of your Traditional IRA and/or Roth IRA accounts throughout your lifetime. You also most likely want to also take advantage of the new contribution limits applied by Congress.

The advice that’s generally given is that lower-income earners should contribute to a Roth IRA and higher-income earners should contribute to a Traditional IRA regardless of whether or not that Traditional IRA contribution is deductible or not. However, there is no catch-all solution to this catch-up contribution question for higher-income earners. Our team of CFP® professionals at BFSG can help answer that question for you through a customized financial plan.

If you are a high-income earner that cannot take a deduction on a Traditional IRA contribution and cannot contribute to a Roth IRA (read here for current phaseouts), it may be worth considering a Backdoor Roth IRA strategy. I will illustrate how this strategy works through a case study.

Case Study

Ray Barone (age 40) is a sportswriter for a local Long Island paper making $80,000 per year and is married to Debra Barone (age 40), a homemaker that takes care of their three children. Ray has a Traditional 401(k) at work that he contributes to and does not contribute to any other retirement accounts. Debra does not have any retirement accounts that she contributes to and believes that she is not eligible to contribute to a Traditional IRA or Roth IRA since she doesn’t have any earned income. Ray gets an unexpected call from Sports Illustrated saying that they loved reading his article on the career of retired New York Mets baseball player, Art Shamsky, and offered Ray a job as their Editor in Chief. His salary at Sports Illustrated would be $400,000 per year and full benefits, including a 401(k) plan. Ray almost fell out of his chair when he heard this news since he knew it would mean a significant increase in pay. Ray then asked if he could take time to discuss this job offer with his family and call them back in the morning.

Ray then proceeds to tell Debra, cynical brother Robert, and doting parents Frank and Marie the news and asks what they all think. They have the following conversation:

Debra: “I think this is a great opportunity, go for it, Ray!”

Frank: “Congratulations son, I say take the job.”

Marie: “This is great, Ray! I always knew that one of my sons would be successful!”

Robert: [With a long sigh] “Everybody Loves Raymond.”(³)

Marie: “Robert! Don’t be jealous of Ray’s talent.”

Robert: [Nefariously] “Sorry Ray, I’m happy for you. I really am. Just remember, the higher up the corporate ladder you climb, the further down you have to fall.”

Frank: “Robert, don’t be a jerk to Ray! Maybe I should climb up that corporate ladder and knock some sense into that big head of yours.”

Robert: “Please forgive me, King Ray. I didn’t mean to upset your loyal subjects.”

Ray: “Stop it, everyone! I’ll call Sports Illustrated in the morning and accept their job offer.”

Ray accepts the new job offer but is nervous about making sure his wife and kids have a prosperous future. After Ray starts his new job, Ray and Debra then decide to meet with their advisor, Phil Rosenthal, to have him run a financial plan for them. Ray and Debra’s main goal is to have the greatest possible account value in their retirement accounts so that they can pass on a legacy to their kids. They also know that they need to make sure that Ray continues to contribute to his 401(k) at work.

The Meeting

The first thing Phil recommends is for Ray to maximize his 401(k) contributions at work, which was not a surprise to hear from Ray and Debra. Phil then recommends that Debra start to contribute to a Traditional IRA and make the maximum contribution each year that Ray has earned income. This confuses Debra since she believes that since she has no earned income of her own, she cannot contribute to a Traditional IRA or a Roth IRA. Phil then exclaims, “A non-earning spouse can contribute to a Traditional IRA or Roth IRA as long as the other spouse has earned income.”(⁴⁾ Debra thinks to herself that this is great since with the extra money that Ray is earning, they will be able to afford to contribute to a Traditional IRA for her and Debra asks Phil to run an analysis of what the account could be at her age 100 assuming that she only takes the Required Minimum Distributions (RMDs) in her account and that because of SECURE Act 2.0, her starting age to take RMDs will be age 75. Ray wants to retire at 65 and Ray and Debra want to see the analysis run until their age 100. Phil then proceeds to run the analysis with the following assumptions:

Here is a summary of the results of that analysis based on the assumptions above:

• Total RMDs throughout Debra’s lifetime: $1,087,987.46
• Total Tax on RMDs: $335,644.13

While Phil was running the analysis, Debra reads on the IRS website that they would not be able to take a tax deduction for the contributed amount to her Traditional IRA because Ray makes too much money and also is covered by a 401(k) plan at his work. This leads to the following conversation:

Debra: “Why would anyone contribute to a Traditional IRA now, not be able to deduct the contributed amount, and then pay taxes on their RMDs later in life? I don’t understand the purpose of a nondeductible Traditional IRA.”

Phil: “That’s a great point, Debra. I do recommend contributing to a tax-advantaged account like a Traditional IRA or Roth IRA since the assets in the account will grow tax-deferred. Assets in nonqualified accounts do not grow tax-deferred and taxes could be owed on any dividends, interest, or capital gains earned in the account. The main difference between the Traditional IRA and how you would be able to fund a Roth IRA, you either pay the taxes later in the case of a Traditional IRA or pay taxes now, in the case of a Backdoor Roth IRA strategy. For you and Ray, a Backdoor Roth IRA strategy would be more beneficial to you both in the long run.”

Ray: “What is this Backdoor Roth IRA strategy?”

Phil: “The strategy would be that Debra would contribute to a nondeductible Traditional IRA. She would then immediately convert any amount into a Roth IRA and would repeat this process each year until you retire at 65.”

Ray: “What do you mean by, convert to a Roth IRA?”

Phil: “You establish a Roth IRA and transfer funds from the Traditional IRA. Any funds that are transferred from the Traditional IRA to the Roth IRA are taxable to you as ordinary income. After the funds are in the Roth IRA, they will grow tax-free, and distributions are tax-free as long as the account has been established for 5 years and you are at least age 59.5. A Roth IRA also does not have Required Minimum Distributions.”

Debra: “According to the IRS website, Ray also makes too much money to contribute to a Roth IRA. We can’t do what you are suggesting, Phil.”

Phil: “You are right in that you cannot contribute to a Roth IRA. However, the IRS does allow you to convert existing assets in a Traditional IRA to a Roth IRA. This is referred to as a Backdoor Roth IRA since you have to go through this extra hoop to fund a Roth IRA account because you are above the Roth IRA contribution limit.”

Phil: “What is going on mechanically is you are making after-tax contributions. Instead of receiving a tax deduction for the contribution, your adjusted gross income will stay the same as if you were to never take a tax deduction on the converted amount. You aren’t paying taxes on that nondeductible contribution itself. For example, if a married couple is in the 35% tax bracket with an AGI of $500,000 and decides to make a nondeductible contribution of $5,000 their AGI would still be $5,000. If they could receive a deduction, their AGI could be reduced to $495,000 and their tax bill would be reduced by $1,750. The “tax due from the backdoor Roth” would be this $1,750.”

Debra: “Can you show us the same analysis, but with this Backdoor Roth Strategy?”

Phil: “I’d be happy to.”

Phil then proceeds to run the analysis on the Backdoor Roth Strategy and uses the following assumptions:

The analysis using the assumptions above concluded that the total tax on Roth conversions would be $88,560.43.

Here are a couple of conclusions that we can draw from this analysis:

1. Since Debra would not be subjected to RMDs in a Roth IRA, she would not need to pay taxes on those distributions. That difference in tax savings over their lifetimes is $247,083.70. This is the difference between the total taxes for the Traditional IRA of $335,644.13 and the total taxes for the Backdoor Roth Strategy of $88,560.43.
2. If Ray and Debra decide not to do the Backdoor Roth strategy and did not need the funds from the RMD to live on, they could always reinvest those proceeds in a nonqualified investment account. The nonqualified investment account could grow, and taxes could be owed on any dividends, interest, or capital gains earned on that account. If they needed the funds from the RMDs to live on, they would still owe taxes regardless because they are required to take RMDs on a Traditional IRA.
3. With the Roth IRA strategy, they are able to keep it in a tax-free bucket and not be subjected to RMDs. If they need cash from the Roth IRA to live on in retirement, distributions would be tax-free.
4. Another key factor to consider is that any amount still in the Traditional IRA or Roth IRA at Ray and Debra’s passing would go to their children. Their children would be subjected to the inherited IRA and inherited Roth IRA rules, which declare as of SECURE Act 2.0’s passing, that inherited IRA and inherited Roth IRA accounts are subjected to RMDs on the beneficiary’s life and that the inherited IRA or inherited Roth IRA account must be depleted within 10 years of the original depositor’s death. Inherited IRA distributions are taxable at ordinary income and inherited Roth IRA distributions are tax-free. Not only do Ray and Debra get to enjoy tax-free growth and distributions with a Roth IRA in retirement, but their kids would as well.

Debra and Ray are delighted by the analysis and eager to start the Backdoor Roth Strategy. They proceed to thank Phil for his work and proceed to end the meeting. The next day at work, Ray then thinks about his own 401(k) and if there are additional long-term planning opportunities that they can do. He believes that his plan at work will start to offer employer-matching Roth contributions and not require RMDs from Roth 401(k)s because of the new SECURE Act 2.0 legislation. His thinking comes from the following two sections in the SECURE Act 2.0:

Ray then proceeds to call Phil and ask about this. Phil states, “There might be a financial planning opportunity for you and Debra with a Mega Backdoor Roth strategy. A Mega Backdoor Roth Strategy works similarly to the regular Backdoor Roth Strategy. I am happy to run the numbers for you.” Ray declines since he believes it’s too premature to run the numbers since his company has yet to amend its current 401(k) plan and may not offer matching Roth contributions⁽⁵). Ray feels content for now with Phil’s answer and believes that his financial plan is solid.

Pro-Rata Rule

You may be asking yourself, what if I want to implement a Backdoor Roth strategy or Mega Backdoor Roth Strategy and my existing IRA has some deductible contributions and some nondeductible contributions? In that case, we would need to account for the pro-rata rule. To illustrate the pro-rata rule for an IRA and for a 401(k), we have the following two examples.

IRA: Tom has an IRA worth $100,000 with $30,000 from nondeductible contributions and $70,000 from deductible contributions. If Tom wants to implement a Backdoor Roth Strategy and convert $10,000 from his IRA to a Roth IRA, $3,000 of that converted amount is from nondeductible contributions and $7,000 would be from deductible contributions. Tom would then need to pay tax at ordinary income rates on $7,000 of the $10,000 total converted amount.

This rule is in place so that people implementing Backdoor Roth or Mega Backdoor Roth Strategies aren’t able to pick and choose what converted amounts get taxed and what converted amounts don’t. You will need to make sure to track any nondeductible contributions with the IRS Form 8606 and we strongly recommend working with a trusted tax professional when implementing a Backdoor Roth or Mega Backdoor Roth Strategy.

Conclusion

After reading through this article, you may be thinking why Congress adjusted the catch-up contributions the way they did, why they increased the RMD age to 73 for persons that will be 73 before 01/01/2033 and age 75 for persons that will be 75 after 01/01/2033, or why they had Roth 401(k) RMDs before but now they are getting rid of them. If you are upset about these changes that Congress made, you are free to fill in the following blanks to blame Politician _______ from the ________ Political Party who has Machiavellian intentions to do _________. We aren’t here to judge why Congress does what they do. We just work with the facts that we’re given and plan accordingly. What we do know is that even after the new SECURE Act 2.0, the Backdoor Roth strategy is still available. It may be more beneficial now than ever to consider a Backdoor Roth strategy if your situation is similar to what was described in this article.

Our team of Certified Financial Planners work with you to craft your comprehensive financial plan to understand whether or not a Backdoor Roth strategy is right for you. Please feel free to reach out to us at financialplanning@bfsg.com or 714-282-1566 and let us know how we can be of help. Thank you.

Footnotes:

1. From the ‘80s band, Men at Work, and their song, “Who can it be now?”
2. That great philosopher was Chevy Chase in the movie Caddyshack: https://www.imdb.com/title/tt0080487/.
3. The characters in the case study are from the sitcom, “Everybody Loves Raymond”: https://www.imdb.com/title/tt0115167/.
4. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits
5. If you are interested in learning more about a Mega Backdoor Roth strategy and how it impacts your financial plan, our team of CFP® professionals are happy to analyze how this strategy affects your long-term financial goals.

References:

1. https://www.finance.senate.gov/imo/media/doc/Secure%202.0_Section%20by%20Section%20Summary%2012-19-22%20FINAL.pdf
2. https://www.irs.gov/retirement-plans/amount-of-roth-ira-contributions-that-you-can-make-for-2023
3. https://www.irs.gov/retirement-plans/2023-ira-deduction-limits-effect-of-modified-agi-on-deduction-if-you-are-covered-by-a-retirement-plan-at-work
4. https://www.medicare.gov/drug-coverage-part-d/costs-for-medicare-drug-coverage/costs-in-the-coverage-gap

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Company), will be profitable or equal any historical performance level(s). Please see important disclosure information here.

Please Note: The above projections are based upon historical data and should not be construed or relied upon as an absolute probability that a different result (positive or negative) cannot or will not occur. To the contrary, different results could occur at any specific point in time or over any specific time period. The purpose of the projections is to provide a guideline to help determine which scenario best meets the client’s current and/or current anticipated financial situation and investment objectives, with the understanding that either is subject to change, in which event the client should immediately notify BFSG so that the above analysis can be repeated.

The SECURE 2.0 legislation included in the $1.7 trillion appropriations bill passed late last year builds on changes established by the original Setting Every Community Up for Retirement Enhancement Act (SECURE 1.0) enacted in 2019. SECURE 2.0 includes significant changes to the rules that apply to required minimum distributions from IRAs and employer retirement plans. Here’s what you need to know.

What Are Required Minimum Distributions (RMDs)?

Required minimum distributions, sometimes referred to as RMDs or minimum required distributions, are amounts that the federal government requires you to withdraw annually from traditional IRAs and employer retirement plans after you reach a certain age, or in some cases, retire. You can withdraw more than the minimum amount from your IRA or plan in any year, but if you withdraw less than the required minimum, you will be subject to a federal tax penalty.

These lifetime distribution rules apply to traditional IRAs, Simplified Employee Pension (SEP) IRAs and Savings Incentive Match Plan for Employees (SIMPLE) IRAs, as well as qualified pension plans, qualified stock bonus plans, and qualified profit-sharing plans, including 401(k) plans. Section 457(b) plans and Section 403(b) plans are also generally subject to these rules. If you are uncertain whether the RMD rules apply to your employer plan, you should consult your plan administrator, a tax professional, or your financial adviser.

Here is a brief overview of the top five ways that the new legislation changes the RMD rules.

1. Applicable Age for RMDs Increased

Prior to passage of the SECURE 1.0 legislation in 2019, RMDs were generally required to start after reaching age 70½. The 2019 legislation changed the required starting age to 72 for those who had not yet reached age 70½ before January 1, 2020.

SECURE 2.0 raises the trigger age for required minimum distributions to age 73 for those who reach age 72 after 2022. It increases the age again, to age 75, starting in 2033. So, here’s when you have to start taking RMDs based on your date of birth:

Your first required minimum distribution is for the year that you reach the age specified in the chart, and generally must be taken by April 1 of the year following the year that you reached that age. Subsequent required distributions must be taken by the end of each calendar year (so if you wait until April 1 of the year after you attain your required beginning age, you’ll have to take two required distributions during that calendar year). If you continue working past your required beginning age, you may delay RMDs from your current employer’s retirement plan until after you retire.

2. RMD Penalty Tax Decreased

The penalty for failing to take a required minimum distribution is steep — historically, a 50% excise tax on the amount by which you fell short of the required distribution amount.

SECURE 2.0 reduces the RMD tax penalty to 25% of the shortfall, effective this year (still steep, but better than 50%).

Also, effective this year, the Act establishes a two-year period to correct a failure to take a timely RMD distribution, with a resulting reduction in the tax penalty to 10%. Basically, if you self-correct the error by withdrawing the required funds and filing a return reflecting the tax during that two-year period, you can qualify for the lower penalty tax rate.

3. Lifetime Required Minimum Distributions from Roth Employer Accounts Eliminated

Roth IRAs have never been subject to lifetime Required Minimum Distributions. That is, a Roth IRA owner does not have to take RMDs from the Roth IRA while he or she is alive. Distributions to beneficiaries are required after the Roth IRA owner’s death, however.

The same has not been true for Roth employer plan accounts, including Roth 401(k) and Roth 403(b) accounts. Plan participants have been required to take minimum distributions from these accounts upon reaching their RMD age or avoid the requirement by rolling over the funds in the Roth employer plan account to a Roth IRA.

Beginning in 2024, the SECURE 2.0 legislation eliminates the lifetime RMD requirements for all Roth employer plan account participants, even those participants who had already commenced lifetime RMDs. Any lifetime RMD from a Roth employer account attributable to 2023, but payable in 2024, is still required.

4. Additional Option for Spouse Beneficiaries of Employer Plans

The SECURE 2.0 legislation provides that, beginning in 2024, when a participant has designated his or her spouse as the sole beneficiary of an employer plan, a special option is available if the participant dies before required minimum distributions have commenced.

This provision will permit a surviving spouse to elect to be treated as the employee, similar to the already existing provision that allows a surviving spouse who is the sole designated beneficiary of an inherited IRA to elect to be treated as the IRA owner. This will generally allow a surviving spouse the option to delay the start of required minimum distributions until the deceased employee would have reached the appropriate RMD age, or until the surviving spouse reaches the appropriate RMD age, whichever is more beneficial. This will also generally allow the surviving spouse to utilize a more favorable RMD life expectancy table to calculate distribution amounts.

5. New Flexibility Regarding Annuity Options

Starting in 2023, the SECURE 2.0 legislation makes specific changes to the required minimum distribution rules that allow for some additional flexibility for annuities held within qualified employer retirement plans and IRAs. Allowable options may include:

• Annuity payments that increase by a constant percentage, provided certain requirements are met
• Lump-sum payment options that shorten the annuity payment period
• Acceleration of annuity payments payable over the ensuing 12 months
• Payments in the nature of dividends
• A final payment upon death that does not exceed premiums paid less total distributions made

It is important to understand that purchasing an annuity in an IRA or an employer-sponsored retirement plan provides no additional tax benefits beyond those available through the tax-deferred retirement plan. Qualified annuities are typically purchased with pre-tax money, so withdrawals are fully taxable as ordinary income, and withdrawals prior to age 59½ may be subject to a 10% federal tax penalty.

These are just a few of the many provisions in the SECURE 2.0 legislation. The rules regarding required minimum distributions are complicated. While the changes described here provide significant benefit to individuals, the rules remain difficult to navigate, and you should consult with a tax professional or your financial adviser to discuss your individual situation.

Footnotes:

1. A technical correction is needed to clarify the transition from age 73 to age 75 for purposes of the required minimum distribution rule. As currently written, it is unclear what the correct starting age is for an individual born in 1959 who reaches age 73 in the year 2032.

Prepared by Broadridge. Edited by BFSG. Copyright 2023.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Company), will be profitable or equal any historical performance level(s). Please see important disclosure information here.

(This is the fourth article in a four-part series. Click here to read Part 1, Part 2, and Part 3.)

By:  Henry VanBuskirk, CFP®, Wealth Manager

Everyone’s had that story of their friend or family member that said they got shafted by some seedy financial advisor. However, there is a huge difference between what is legal and what is ethical. The majority of these “seedy” financial advisors are still following the law as constructed, but unfortunately, most of the time it’s up to you to ask questions and know what you’re buying even when buying a product as intangible as financial advice. It’s important to work with a team that is legally required to act ethically and know that they are in danger of losing their business and professional licenses if they don’t put your interests ahead of their own.

Take, for example, Mr. and Mrs. Impulsive. They are emotionally driven decision-makers that have $200,000 across investment accounts and bank accounts and spend $100,000 per year. Mr. and Mrs. Impulsive make $120,000 per year but are under duress since they want to pay for their 5-year-old’s college tuition in the future and aren’t sure how. On a whim, Mr. and Mrs. Impulsive meet with a financial advisor her friend recommended and he recommends buying a $750,000 cash-value life insurance policy and paying for the future college tuition through cash-value loans on the life insurance policy. There are no mentions of alternative savings vehicles for minors, such as 529 plans or UTMA accounts, just a life insurance illustration. The specifics on why the life insurance recommendation is not appropriate are not important for purposes of this whitepaper, but what is important is to illustrate why the recommendation may have been made in the first place (the example I am using is based on a real client we met with recently). Here are two pages of the illustration that illustrates why:

If your eyes glazed over these diagrams and the Charlie Brown Teacher “wha wha whaaa wha” started going off in your head, don’t worry. The reason this recommendation is most likely not appropriate is simple. Notice the TP and Target Premium numbers of $20,078. That’s how much the financial advisor would be paid upfront in gross commissions if the client agreed to move forward with the life insurance recommendation. The insurance agent would then get a residual gross commission of around 2% ($401.56/yr.) or so after the first year. Not a bad payday for a couple of hours of work and usually explains why it is generally hard to have ongoing life insurance servicing 5+ years later. Also, Mr. and Mrs. Impulsive would have to pay $53,018.81 for 7 years to fund this policy and they won’t have the liquid cash available to do so. Some other alternatives to save for college are a 529 plan or a UTMA account, which can be done for a fraction of the cost. Note: BFSG does not sell any product, nor do we receive any compensation from any source other than our clients. This helps us strive to always put our clients’ interests first and to remain objective. 

Annuities:

Mrs. Impulsive knows that she needs to talk to her husband before signing the paperwork.  Mr. Impulsive during their conversation thinks about their plans to retire in 10 years but is concerned about the current market volatility.  He likes the sales pitch by the financial advisor and decides to meet with him to discuss this. The financial advisor asks, “Did you want to move forward with the life insurance recommendation?”. Mr. Impulsive says, “Mrs. Impulsive and I need more time to think about this. I wanted to ask you about our retirement plans in 10 years, but I am concerned about market volatility.  Do you have any suggestions?”. The financial advisor then proceeds to recommend moving $200,000 to a Fixed Indexed Annuity and taking withdraws from it in 10 years. The financial advisor exclaims, “The withdrawals of $10,935 would be guaranteed for the rest of your life. Keep in mind that you would be subjected to surrender charges if you took more than 10% of the contract value in any one year within the first 10 years (this is called a surrender schedule).”. Here is an illustration (again a real client situation).

Again, the reasoning why the recommendation may not be appropriate is just as important as why the recommendation may have been made. A fixed indexed annuity commission is paid out in schedules that the advisor chooses. Since the annuity is a 10-year annuity, the commission schedule is 10% over that 10-year period and most likely would be one of the following schedules (as permissible by the insurance agent’s brokerage firm). The annuity commission over a 10-year period is 10% regardless of what Schedule is chosen:

1. Schedule A: 10% upfront gross commission and no trailing gross commission
2. Schedule B: 7% upfront gross commission and 0.333% trailing gross commission starting in year 2
3. Schedule C: 3.5% upfront gross commission and 0.667% trailing gross commission starting in year 2
4. Schedule D: 1% upfront gross commission and 1% trailing gross commission starting in year 2

The calculus on which Schedule the agent wants to choose is frankly dependent on how long the agent actually wants to work with the annuity purchaser. Annuities, like cash value life insurance, are not inherently bad recommendations, but they are typically oversold since they are easy money for the agent or advisor selling them. The financial advisor didn’t mention that annuities can come in the form of advisory annuities, where no commissions are paid out and the advisor is paid based on an agreed-upon percentage of the annuity’s account value and there is no surrender schedule.  The financial advisor might not be properly licensed to sell advisory products, so this might be the reason why this was not mentioned. In any case, Mr. Impulsive stops thinking with his amygdala and starts utilizing his frontal lobe. He tells the financial advisor, “So let me get this straight.  For meeting with us for 4 hours, you’re about to make at least $40,078 off of us if we sign this paperwork. Thanks, but no thanks. We will find a different financial advisor to work with.”.

Mr. and Mrs. Impulsive then learn that there are alternative methods for saving for retirement. They also learn that crafting a comprehensive financial plan can help indicate how to save for retirement in a realistic way and how aggressive or conservative you want or need to be. The issue with annuities is advisors that pigeonhole everyone nearing retirement to make them buy an annuity or obfuscate the story to make it seem like the prospective client has to be conservative near retirement in order to make their financial plan work. This leads to advisors who overuse and oversell the annuity, leading to upset prospective or current clients that may have never needed an annuity in the first place. This is not illegal, just unethical from our point of view. To distance ourselves from this potential conflict of interest, BFSG does not sell annuities or life insurance.

Key Takeaways from this Series:

The problems that we’ve addressed in this series are:

• Advisors sometimes do not know the ramifications of the advice given.
• Clients sometimes do not question the validity of advice received.
• Clients not understanding how the person giving the advice gets paid. 

Comprehensive financial planning is a meticulous, collaborative process between planner and client. If you’ve seen yourself in one of the examples we listed in this series, we offer you to reach out to us for a complimentary financial planning meeting so we can discover what your unique needs are, what assets you have to work with, and how realistic your financial goals are. We offer objective advice and are a fee-only RIA. We do not sell any product, nor do we receive any compensation from any source other than our clients.

We are a team of CFP® professionals, CPAs, CFA® charterholders, and PhDs ready and willing to help you on your journey.  We look forward to working with you to help you achieve your financial goals and grow our wealth of financial planning knowledge with you.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Company), will be profitable or equal any historical performance level(s). Please see important disclosure information here.

(This is the third article in a four-part series. Click here to read Part 1 and Part 2.)

By:  Henry VanBuskirk, CFP®, Wealth Manager

Mr. Hill arrived in Texas and is eager to talk to his parents about the Roth Conversion idea that he overheard his boss talking about at work last week. Mr. Hill does not know his parents’ finances and just believes that a Roth Conversion will be a good idea for them and for anyone else their age. This is important to understand that while the recommendations that we give are not gospel, there are very few universal financial planning recommendations that can be given. We will show throughout this article why it is important to go through the financial planning discovery process to understand the household’s unique needs, what assets they have to work with, and how realistic their financial goals are before making a Roth Conversion recommendation.

As Mr. Hill heard over the phone, a Roth Conversion is when someone takes funds from an IRA, pays taxes on the distributed amount, and transfers the distributed amount into a Roth IRA. As long as the person is over age 59.5 and waits 5 years before taking money from the Roth IRA, distributions are tax-free. Mr. Hill knows that his parents do not have an advisor and do all of their financial planning work themselves on their financial planning software. Mr. Hill then proceeds to call his parents and they decide to run the numbers. Here is a summary of their financial plan (which we will call the Base Case):

• Hank and Peggy are 68, live in Texas, and are projected to live to age 100.
• Hank and Peggy are retired, but Hank still works part-time at Strickland Propane earning $5,000 per year. Hank plans to work part-time until age 70.
• Peggy earns a pension of $25,000 per year that grows at 2% per year and will pay out throughout both of their lives¹.
• Hank will receive $46,000 per year in Social Security benefits starting at age 70. Peggy does not receive any Social Security benefits.
• They have $25,000 in cash earning 1.55% per year.
• Hank has an IRA worth $102,000 earning 4.66% per year.
• Peggy has an IRA worth $87,000 earning 4.66% per year.
• Their home is worth $480,000 and there is no debt on the property.  The home value is expected to appreciate by 2.5% per year.
• $3,000 per year for Alamo Beer, indexed to inflation at 2.5%
• $30,000 every 10 years to buy a new truck starting in 2025, indexed to inflation at 2.5%

Hank and Peggy want to see the effect of converting both of their IRAs to Roth IRAs. They run the numbers and get the following result:

Hank and Peggy are pleased to see that their total assets are $229,889 greater ($865,087 vs. $635,198) at age 100 by doing the Roth Conversion this year.  Hank and Peggy understand that by doing a Roth Conversion, they would be treating any amount that they convert from their IRA as ordinary income in the year of the conversion.  Therefore, they run the scenario in their tax planning software and get the following result:

Hank and Peggy like what they see and understand that they can pay $32,126 in taxes this year to have an additional $229,889 at the end of their financial plan since they will not be required to take any RMDs (Required Minimum Distributions) during their lifetimes. Hank and Peggy decide to meet with a local advisor, Mr. Handshake that checks their work and commends them for their plan. Mr. Handshake mentions that they have no problem with their planning. The advisor thanks Hank and Peggy for their time and the meeting concludes. Hank has an uneasy feeling about Mr. Handshake since his handshake was not firm. Hank mentions this uneasy feeling to Peggy about Mr. Handshake’s handshake and says he can’t trust a person who doesn’t have a firm handshake. Peggy rolls her eyes and then obliges Hank’s concern and decides to schedule a meeting with another advisor, Mr. Rock, to get a second opinion.

Mr. Rock meets with Hank and Peggy to review their financial plan and their Roth Conversion scenario. He mentions that while their assumptions are correct, there are a couple of items that he wants to make sure that they are aware of. Hank has been listening intently the entire meeting since Mr. Rock’s handshake at the onset of the meeting was very firm. They have the following conversation:

Mr. Rock: “Hank, Peggy, your plan for a Roth Conversion does help out your financial plan in the long run, but it looks like you missed projections for the Medicare Part B and Part D increase when doing a Roth Conversion. I took the liberty of adding a couple of line items to your report:

Mr. Rock: “If you are going to do the Roth Conversion, you are going to need to pay in 2025 an additional $66 per month in Medicare Part B premiums and $12 in Medicare Part D premiums. This threshold that you passed is called IRMAA and was created to help fund the Medicare program². What if I showed you a financial plan that would allow you to convert your IRAs to Roth IRAs over a 5-year period, increase your ending portfolio value by $36,136, and not have to worry about any increase in Medicare Part B or Part D premiums?

Hank and Peggy: “We’re listening.”

Mr. Rock: “First off, here is your updated plan with the new strategy for converting your IRAs to Roth IRAs over a 5-year period.

“As you can see, instead of a portfolio ending value of $865,087 from converting everything in 2023, you can instead have a portfolio ending value of $901,223 from the 5-year Roth Conversion strategy.”

Peggy: “Mr. Rock, hold on. I’m reviewing your tax planning projections for the 5-year Roth Conversion strategy and our plan to Roth convert everything in a 5-year period (for those interested in the calculations and assumptions used, please see the Appendix at the end of this article). Just so we understand correctly if we follow the 5-year Roth Conversion plan we would pay the following taxes:

• $4,059 in 2023
• $4,161 in 2024
• $8,971 in 2025
• $8,507 in 2026
• $9,511 in 2027

For a total tax of $35,209

and if we were to instead Roth convert everything in 2023, we would pay the following taxes if we were to Roth convert everything in 2023:

• $32,126 in 2023
• $0 in 2024
• $1,483 in 2025
• $572 in 2026
• $642 in 2027

For a total tax of $34,823

Why would we do the 5-year Roth Conversion plan if we would be projected to pay more in taxes?”

Mr. Rock: “You are right that you would pay more in taxes to the IRS over the next 5 years if you decided to do a Roth Conversion over the next 5 years instead of Roth convert everything in 2023, but you would also avoid any increase in Medicare Part B and Part D premiums by doing the Roth Conversion over a 5-year period. If you did Roth convert everything at once, you would owe an additional $936 in Medicare Part B and Part D premiums, which is the IRMAA discussion that I had with you earlier. You actually would owe less out of pocket over your lifetimes over the 5-year Roth Conversion plan and since you would be spreading that tax liability over a 5-year period, there is less strain on your portfolio and won’t need to withdraw as much in 2023, which leads to a higher ending portfolio value doing the 5-year Roth Conversion plan.”

Hank: “Can you explain that again?”

Mr. Rock: “Think of IRMAA as a tax, just one that is administered by the Social Security Administration, not the IRS. A tax in my book is any money that you need to pay from your earnings to a government entity to receive services from that government entity. Paying additional money each month for Medicare services whether or not you actually use those services is still money out of your pocket. Breaking down Peggy’s numbers from earlier, your total tax bill looks like this:

• 5-year Roth Conversion plan:
  • $4,059 in 2023
  • $4,161 in 2024
  • $8,971 in 2025
  • $8,507 in 2026
  • $9,511 in 2027

For a total tax of $35,209

• Roth convert everything plan:
  • $32,126 in 2023 + $936 IRMAA increase due in 2025 = $33,062
  • $0 in 2024
  • $1,483 in 2025
  • $572 in 2026
  • $642 in 2027

For a total tax of $35,759

You save $550 over this 5-year period by avoiding any Medicare Part B and Part D increases, increase your ending portfolio value by $36,136, and avoid RMDs during your lifetimes since all of your IRA assets would be in Roth IRAs by the time you reach your RMD age of 73.” 

Hank: “That sounds great to me. What do you think Peggy?”

Peggy: “Sounds great to me. Thank you, Mr. Rock.”

Hank: “Thank you, Mr. Rock.”

Mr. Rock: “You’re welcome. Have a good day.”

Hank and Peggy decide to follow Mr. Rock’s advice and decide to have Mr. Rock manage their finances. There’s only one additional mistake that Hank and Peggy made. They didn’t ask how Mr. Rock was compensated. Luckily, Mr. Rock is a fee-only advisor, and his full title is Mr. Dwayne Rock, CFP®. A CFP® professional has a fiduciary duty, meaning that they strive to put their client’s interest ahead of their own at all times. Further, to be called a fee-only advisor, the advisor must adhere to the following rules (by the CFP Board’s definition)³: (a) the CFP® professional and the CFP® professional’s firm receive no sales-related compensation; and (b) related parties receive no sales-related compensation in connection with any professional services the CFP® professional or the CFP® professional’s firm provides to the client. It is important to note that just because an advisor can earn commissions, doesn’t make them nefarious. However, it is important to know how an advisor gets paid to understand whether or not they actually do have your best interest in their heart at all times when making a recommendation⁴. Tune in next week to see what potential issues can arise if you work with an advisor that puts their bank account ahead of your needs.

Footnotes:

1. This pension benefit was awarded to her for winning “Substitute Teacher of the Year” three years in a row.
2. You can find the IRMAA brackets here https://www.medicareadvantage.com/costs/medicare-irmaa
3. https://www.cfp.net/-/media/files/cfp-board/standards-and-ethics/compliance-resources/cfp-board-guidance-for-fee-only-advisors.pdf
4. BFSG is a fee-only Registered Investment Advisor.

Appendix:

Assumptions used in the tax calculations in the 5-year Roth Conversion plan:

• The pension income increases by 2% compounded interest each year
• The assumed values of the IRA values and the Roth Conversion amounts assume that Hank and Peggy’s IRA balances total $189,000 and increase by 4.66% per year.  The Roth Conversion amount increases by 2.5% per year until the final year has the full remaining balance of $48,627.15 in Traditional IRAs be converted into their Roth IRAs.  Here is the balance in a spreadsheet:

• Hank’s wages increase by 2.5% per year and stop at 2025
• Taxable interest increases by 1.55% per year
• Social Security starts in 2025 and increases by 1.5% per year
• The standard deduction does not sunset back to the proposed 2017 values (adjusted for inflation)

Assumptions used in the ‘Roth convert everything’ plan:

• The pension income increases by 2% compounded interest each year
• The entire combined IRA balance of $189,000 is converted into Roth IRAs in 2023
• Hank’s wages increase by 2.5% per year and stop at 2025
• Taxable interest increases by 1.55% per year
• Social Security starts in 2025 and increases by 1.5% per year
• The standard deduction does not sunset back to the proposed 2017 values (adjusted for inflation)

Disclosures:

Past performance is no guarantee of future results.  Different types of investments involve varying degrees of risk.  Therefore, there can be no assurance that the future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by Benefit Financial Services Group [“BFSG”]), or any consulting services, will be profitable, equal any historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  BFSG is neither a law firm, nor a certified public accounting firm, and no portion of its services should be construed as legal or accounting advice. Moreover, you should not assume that any discussion or information contained in this document serves as the receipt of, or as a substitute for, personalized investment advice from BFSG. A copy of our current written disclosure Brochure discussing our advisory services and fees is available upon request or at www.bfsg.com. The scope of the services to be provided depends upon the needs and requests of the client and the terms of the engagement. Please see important disclosure information here.

Please Note: The above projections are based upon historical data and should not be construed or relied upon as an absolute probability that a different result (positive or negative) cannot or will not occur. To the contrary, different results could occur at any specific point in time or over any specific time period. The purpose of the projections is to provide a guideline to help determine which scenario best meets the client’s current and/or current anticipated financial situation and investment objectives, with the understanding that either is subject to change, in which event the client should immediately notify BFSG so that the above analysis can be repeated.

(This is the second article in a four-part series. Click here to read Part 1).

By:  Henry VanBuskirk, CFP®, Wealth Manager

We last left off our story with Mr. Fox understanding that the stock market doesn’t predictably earn a set 4% per year. While you may be able to predict the day that you retire, the market is indifferent to your projected retirement date and will do whatever it’s going to do in the future. We will guarantee that the market will be predictably unpredictable in the days, weeks, and months leading up to, on, and following your projected retirement date. This is Sequence of Returns risk and is the risk of simply having bad luck at the time of your retirement. After all, we’ve all heard the horror stories of friends or family that retired right when 2008 happened. If your portfolio has a large loss in the early years of your retirement, then your retirement may be less comfortable as your account balance may never fully recover. Mr. Fox understands this risk but cannot quantify it. He proceeds to ask a new advisor to the story, Ms. Sequence, to run the numbers for him.

Ms. Sequence knows that Mr. Fox isn’t trying to spend his twilight years repeating, “Welcome to Walmart”, thousands of times a day to aloof passers-by to make ends meet. Ms. Sequence also knows that assuming a return of 4% per year into perpetuity doesn’t paint an accurate financial portrait. To account for sequence of returns risk, Ms. Sequence takes Mr. Fox’s financial plan and runs two different scenarios:

Let’s assume that Mr. Fox lives to age 100 (distribution period of 20 years) and this investment return pattern repeats every 5 years. As illustrated above, both scenarios have a 4% average return. At the end of the 20 years, Scenario 1 shows an account value of $11,326 and Scenario 2 runs out of money when you are 94. Here are the numbers:

Mr. Fox reviews the two scenarios and is surprised by the huge discrepancy in his financial plan’s success rate. He is also concerned that the $80,000 per year distribution plan does not seem feasible unless the stock market starts off on a good note. After meeting with both Mr. Valuation and Ms. Sequence, Mr. Fox would feel more comfortable withdrawing $70,000 per year rather than $80,000 per year. To dive deeper into why Sequence of Returns Risk is in a category of paramount risks to consider, please feel free to watch our short video on Sequence of Returns Risk.

Mr. Fox asks Ms. Sequence, “This is amazing that you can run these different scenarios. How does your Financial Planning Software Work?”. Ms. Sequence gives Mr. Fox a blank stare and says, “I don’t know”. Mr. Fox calls a friend, but she also isn’t sure how to help him. For many people like Mr. Fox, their stories end here and are just told, “The financial planning software is always right.” I guess as long as we don’t continuously chant, “Four legs good, two legs bad” as an unconscious response, our financial advice and retirement infrastructures will be fine. After all, if you bought a Big Mac at McDonald’s and ask the franchisee what goes in it and they respond, “I don’t know.”, would you want to take a second bite?¹. It is important to know that the financial planning software is not infallible, and assumptions have to be made. Mr. Fox is curious to learn what assumptions are used in Ms. Sequence’s financial planning software and goes through his list of contacts, thinking who he should call for help. Mr. Fox decides to call his friend, C. Montgomery “Monty” Carlo, who Mr. Fox believes can help him answer his questions.

Monty is the old miserly owner of a nuclear power plant who spends most of his days tinkering with his Financial Plan on his Financial Planning Software, Krusty Co. He is too engrossed in scenarios showing a 100% success rate to learn where that 100% probability of success comes from. His only other hobby besides tweaking his own financial plan is siccing his attack hounds on strangers asking Monty for money. Monty agrees to help Mr. Fox since Monty wants to make sure he understands why his plan is always 100% successful, regardless of the various scenarios he puts into his financial plan. He calls Krusty Co. and has the following conversation to ask where the assumptions come from:

Krusty Co. Representative: “Hi, this is Waylon.  Thank you for calling Krusty Co., how can I help you?”

Monty: “Hi Waylon, my name is Monty and I have a few questions for you.”

Waylon: “How can I help you, Monty?”

Monty: “What is a Monte Carlo Simulation and how is this implemented into the Financial Planning Software?”

Waylon: “The Financial Plan uses a Monte Carlo simulation of 1,000 randomly generated market returns and volatility assumptions called trial runs and aggregates these trial runs into a percentage probability of success.”

Monty: “So since the scenarios are random and do not incorporate current stock market valuations, the Financial Planning Software does not factor in whether or not the stock market is in a bull or bear market at the time of the trial?”

Waylon: “Correct. This is an assumption we have to use. Financial Planning Software is not robust enough to also factor in current market valuations on top of generating a Monte Carlo simulation for a Financial Plan.”

Monty: [To himself: This is nice to know, but I want to make sure my plan is bulletproof] “I use Standard Deviation to gauge portfolio risk. Is there an issue with relying on Standard Deviation to gauge portfolio risk?”

Waylon: “Yes. Sequence of Returns risk addresses a very real concern.  Standard Deviation at the tails (very high unexpected returns or very low unexpected returns) is not factored into a Monte Carlo simulation because the number of trials we would need to run is much too high, and the program is not robust enough to do this. We believe that 1,000 trials are sufficient. Enough trials where we get a satisfactory result without needing to take an hour to run each scenario.”

Monty: “The last question that I have is I have some Series I bonds that I bought this year and as you know they are only taxed at the federal level and not at the state level. I live in a state that has a state income tax². I’m likely to move to Florida where there is no state income tax, but I would like to understand the tax implications on the Series I bonds if I don’t move. How would I model this into the program?”

Waylon: “There currently isn’t a way to model this in. It would be best to assume that the bond is also taxable at the state level so that your financial plan is more conservative than it actually is.”

Monty: [To himself: In reality, I would not need to pay as much in taxes over my life than what the financial plan is projecting if I don’t move to Florida, but I like the conservative approach to this workaround]. “Those are all of the questions that I had. Thank you, Waylon, for your time.”

Waylon: “You are welcome, Monty. Have a good day.”

Monty: “Thank you. You as well.”

After hanging up the phone, Monty then strangely mumbles “Excellent” to himself in a Machiavellian tone, delighted to get answers to his questions. The next day, Monty proceeds to call Mr. Fox to discuss the conversation that Monty and Waylon had about the Financial Planning Software assumptions. Mr. Fox thanks him for the information and then mentions the phrase “Roth Conversion” to Monty. Mr. Fox says that it’s a way to take money from your IRA, pay taxes, and then convert that amount into a Roth IRA. As long as you are over age 59.5 and wait 5 years before taking money from the Roth IRA, distributions are tax-free. Monty appreciates the information but mentions he only has $10,000 in an IRA and doesn’t see the benefit of converting his IRA since Monty’s net worth is $100,000,000 and Monty only spends $5,000 per month. Monty and Mr. Fox then end their phone conversation. Unbeknownst to Monty, his janitor, Mr. Hill, was in the room and heard the full conversation and thought a Roth Conversion might be a good idea for his parents. Mr. Hill decides to discuss this when he goes to visit his parents in Texas next week, which is when we will pick this story back up.

Footnotes:

1. Snowball is not an ingredient in a Big Mac and Napoleon is not the CEO of McDonald’s. Big Macs use 100% all-beef patties. Snowball was last seen on Foxwood Farm (or was it Pinchfield farm? I can’t remember). Napoleon was last seen in the Bahamas fighting extradition to the United States for his (alleged) multi-billion-dollar fraud scheme through his now-bankrupt cryptocurrency exchange, Windmill.
2. We know that Monty currently lives in Springfield, but we do not know exactly which Springfield it is since Monty is a very private person.  All we know is that it is a Springfield in a state with state income tax.

Disclosures:

Past performance is no guarantee of future results.  Different types of investments involve varying degrees of risk.  Therefore, there can be no assurance that the future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by Benefit Financial Services Group [“BFSG”]), or any consulting services, will be profitable, equal any historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  BFSG is neither a law firm, nor a certified public accounting firm, and no portion of its services should be construed as legal or accounting advice. Moreover, you should not assume that any discussion or information contained in this document serves as the receipt of, or as a substitute for, personalized investment advice from BFSG. A copy of our current written disclosure Brochure discussing our advisory services and fees is available upon request or at www.bfsg.com. The scope of the services to be provided depends upon the needs and requests of the client and the terms of the engagement. Please see important disclosure information here.

Please Note: The above projections are based upon historical data and should not be construed or relied upon as an absolute probability that a different result (positive or negative) cannot or will not occur. To the contrary, different results could occur at any specific point in time or over any specific time period. The purpose of the projections is to provide a guideline to help determine which scenario best meets the client’s current and/or current anticipated financial situation and investment objectives, with the understanding that either is subject to change, in which event the client should immediately notify BFSG so that the above analysis can be repeated.