Monday, April 14, 2014

Know Your Marginal Tax Bracket

In 2014, the federal tax brackets are 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%. For a taxpayer who is married and filing jointly, regardless of how much the household makes, the first $18,150 of income after accounting for deductions and exemptions will only be taxed at the 10% rate. Similarly, any income the household makes that is more than $18,150 but less than $73,800 is taxed at the 15% rate. At that point, the next $75,050 is taxed at 25%, and so on. Consequently, not all income a household makes during the course of the year is taxed at the same rate. A marginal tax bracket is the tax rate that applies to the last dollar the household made.

It is crucial for all taxpayers to know their marginal tax rate. This information can help a client identify which type of investment accounts fits their situation best, how to structure an investment portfolio, and how to determine the value of certain deductions when filing their tax return.

Roth or Traditional Retirement Accounts

Traditional retirement accounts like IRAs and 401(k)s allow taxpayers to avoid recognizing income earned during the tax year and push the need to acknowledge the revenue into a future year.  This is valuable because many people are in a higher tax bracket during their working years than they are during retirement. For instance, for a person who is currently in the 25% marginal tax bracket, it may be advantageous to delay recognizing the income until the investor retires and has less income, causing him to be in only the 15% marginal tax bracket. Doing this would enable the taxpayer to avoid paying taxes at 25% and allow him to pay taxes at only 15%.

Alternatively, a Roth IRA or Roth 401(k) allows an investor to pay taxes on income during the year it was earned but the money then grows tax-free. Consequently, a Roth retirement account is great for someone who believes they may be in a higher marginal tax bracket in the future. For example, a young employee in the early stages of his career who is in the 15% tax bracket but believes he may be in the 25% or 28% bracket in the future would benefit from paying all taxes on the income at his current rate of 15% and then getting tax-free investment growth. This would prevent the investor from having to pay the higher future tax rate of 25% or 28% on the invested dollars.

Knowing your marginal tax bracket can help you determine if you would favor paying taxing on your invested dollars at your current tax rate or if you believe you may benefit from pushing the need to recognize the income into a future tax year. This is a critical decision when planning for retirement and it can't accurately be made without knowing your marginal tax rate.

Capital Gains Rate

A long term capital gains tax rate is the rate that applies to the growth of any asset held for longer than a year that is not within a tax-advantaged account. If you buy stock outside a tax-advantaged account, or purchase investment property, any growth in the value of the investment will be taxed as capital gains.

An investor's capital gains tax rate is determined by the investor's marginal tax rate. For most taxpayers the long term capital gains tax rate is 15%. However, if a taxpayer is in the 10% or 15% marginal tax bracket, the long term capital gains tax rate is an amazing 0%! Additionally, many taxpayers in either the 35% or 39.6% tax bracket may end up paying capital gains at a rate of 20%.

Clearly, knowing your marginal tax bracket will help you analyze the appeal of making investments outside of tax-advantaged accounts. People who qualify for the 0% capital gains tax should actively search for ways to take advantage of this benefit.

Additionally, knowing your marginal tax rate can help you determine the best time to recognize long-term capital gains. If your marginal tax rate will be 25% in 2014 -- leading to a capital gains tax rate of 15% -- but you believe your marginal rate will be 15% in 2015 -- leading to a capital gains tax rate of 0% -- it would save you money and lower your tax bill to defer recognizing long-term capitals gains until next year.


Annuities are promoted as a way for invested dollars to obtain tax-deferred growth. However, when money is withdrawn from an annuity it is taxed at the investor's marginal tax rate as opposed to his long term capital gains tax rate. Knowing your marginal tax bracket can help determine whether an annuity adds any value to your portfolio, or whether it could actually be detrimental.

Suppose an investor is in the 15% marginal tax bracket. If this person invests in an annuity, he will avoid paying taxes on any of the investment's growth until the funds are withdrawn from the annuity. However, at that point the investment's growth will be taxed at the taxpayer's marginal income tax bracket of 15%. Alternatively, if this same investor utilized a taxable investment account rather than an annuity, the investment's growth would be taxed at the investor's capital gains tax rate of 0%. In this case, investing in an annuity actually created a tax bill for this investor!

Clearly, knowing your marginal tax rate and your resulting capital gains tax rate can help you determine the best type of investment accounts for your personal situation.

Itemized Deductions

The value of your itemized deductions is essentially determined by your marginal tax bracket. For a simplified example, consider a taxpayer who could generate an additional $10,000 of deductions. Doing so would mean the individual would pay taxes on $10,000 of income less than he would without the deduction. If the individual is in the 15% tax bracket, generating the deduction would lower the person's tax bill by $1,500 dollars ($10,000 x 15%). However, if the individual is in the 25% tax bracket, the same deduction would lower the person's tax bill by $2,500 ($10,000 x 25%).

Consequently, knowing your marginal tax bracket can help determine when large itemized deductions should be taken. If you would like to donate funds to your favorite charitable institution, knowing which year you will be in the highest marginal tax bracket can help you determine the best time to make the contribution.

Marginal Tax Rates Change

Many people's income is relatively constant year-after-year. For these people, there may not be much fluctuation in their marginal tax bracket. However, any time you have a significant increase or decrease in income recognized during a year, your marginal tax rate may change. Whenever possible, it is best to anticipate how your current marginal tax rate might compare to your future marginal tax rate. This is another strong factor that can impact all the key financial decisions effected by your marginal tax rate.

Tuesday, March 25, 2014

What You Should Know About 401(k) Loans

According to, about 20% of Americans eligible for a 401k loan have one, and the average outstanding loan balance is $7,600. As 401k loans are an option for many, it is a good idea to familiarize yourself with this tool. Additionally, be aware that not all 401(k) plans allow employees to borrow from their accounts. Check with your H.R. department before you even begin to consider a loan.

The maximum loan amount allowed is restricted to the lesser of half the vested account balance or $50,000. While interest rates vary by plan, the most common rate is the prime rate plus one percent. Unless lent funds are used to purchase a home, most 401k loans must be fully repaid within five years.

The Advantages:

  • Loans are not subject to income tax or early withdrawal penalties (unless the loan defaults).
  • Loans are convenient. There is no credit check or long application form.
  • Loans have low interest rates. Most 401k loans are cheaper than rates charged by credit cards.
  • Interest paid on the loan is paid to yourself, not a bank or other lender.

The Disadvantages:

  • Borrowed money will not be invested in the market so potential investment gains will be forfeited.
  • Borrowed funds will be taxed twice! Borrowers earn wages, pay taxes on those wages, and use those after-tax funds to repay the loan. During retirement, the retiree will again pay taxes on withdrawn funds. Consider an investor who is in the 25% federal tax bracket – being tax twice would be extremely expensive.
  • Investors with a 401k loan ultimately contribute less to their retirement plan because a portion of new contributions will go towards paying off the loan.
  • If you cease working with your current employer, your entire loan is usually due within 60 days. If you can’t repay the loan, it is considered defaulted and you will be taxed on the outstanding amount and subject to a 10% early withdrawal penalty if you are under age 59½.
Generally, I feel that a 401(k) loan should be considered only if it’s essential and all other financial resources have been exhausted. However, there are instances when a 401(k) loan can be a fantastic solution. For instance, I have a client who expects to receive an inheritance within the next few months. However, this client would like to purchase a new home immediately and needs funds for a down payment. It makes sense for this client to borrow from his 401(k) plan in order to cover the initial cost of the home loan and repay the loan in full once the inheritance is received. This enables this individual to borrow funds inexpensively but then not forfeit the great benefits provided by his retirement plan.

Monday, March 17, 2014

Habits of the Wealthy

As published by Thomas Corley in Rich Habits: The Daily Success Habits of Wealthy Individuals, 2010:
  • 44% of the wealthy wake up at least three hours before work
  • 80% are focused on accomplishing some single goal
  • 81% maintain a to-do list, and 67% write down that list
  • 88% of the wealthy read 30 minutes or more each day for education or career reasons
  • 78% network five hours or more each month
  • 76% exercise aerobically four days a week
  • 70% eat less than 300 junk food calories per day
  • 67% watch one hour or less of TV per day
  • The wealthy show self-restraint: only 6% always say what's on their mind
  • Only 23% gamble
  • Only 6% admit to gossiping

Wednesday, March 12, 2014

How Obama’s 2015 Proposed Budget Impacts Retirement Accounts

President Obama recently unveiled his proposed budget for 2015. Included in the proposal were the following potential changes to investor retirement accounts:

Apply Required Minimum Distribution Rule To Roth IRAs

There are currently two main reasons to invest in a Roth IRA – to pay taxes at your current rate in anticipation of being in a higher tax bracket in the future, and to invest in an account that does not require minimum distributions when the investor reaches age 70½. However, President Obama’s 2015 budget calls for Roth accounts to be subject to the same RMD rules as other retirement accounts.

This change would make Roth IRA accounts much less appealing for a good portion of the investment community. Additionally, the rule would dramatically reduce the benefit for many individuals to convert their traditional retirement accounts to Roth accounts. Lastly, this rule would essentially betray all investors who already converted their accounts to Roths by taking away a benefit they were counting on.

Eliminate Stretch IRA

Non-spouse beneficiaries of retirement accounts currently have the option of either withdrawing the funds from the retirement account within five years of the original IRA owner’s death or stretching IRA distributions over their expected lifetime. Obama’s proposal would eliminate non-spouse beneficiaries’ ability to stretch distributions over a period of more than five years.

If implemented, this change would have severe tax implications on people inheriting a retirement account and drastically reduce the value of tax-deferred accounts as estate planning tools.

Cap on Tax Benefit for Retirement Account Contributions

Currently, investors obtain a full tax-deferral benefit on all contributions to retirement accounts. Under Obama’s proposal, the maximum tax benefit that would be allowed on retirement contributions would be 28%. Consequently, an investor in the 39.6% tax bracket would only be able to deduct 28% and would still need to pay taxes at 11.6% (39.6% - 28%) on all contributions made.

Eliminate RMDs For Retirement Accounts Less Than $100k

Quite simply, individuals whose retirement accounts have a total value of less than $100k would no longer be subject to required minimum distribution rules. This would enable retirees with less in their retirement accounts to take greater advantage of the tax-deferral benefit an IRA provides.

Retirement Account Value Capping New Contributions

Under the new proposal, once an individuals’ retirement account value grew to a certain cap, no further contributions would be allowed. This cap would be determined by calculating the lump-sum payment that would be required to produce a joint and 100% survivor annuity of $210,000 starting when the investor turns 62. Currently, this formula would indicate a cap of $3.2 million. This cap would be adjusted for inflation.

Proposal, Not Law…

Keep in mind that these potential changes are currently just proposals and are not certain to be implemented into law. In fact, with the exception of RMDs for Roth accounts, all of these suggested adjustments were proposed by Obama last year and none were approved by congress. Consequently, history suggests that Obama may have a hard time getting these changes implemented. Still, examining the proposals provides some insight into the direction President Obama would like to proceed.

Tuesday, February 25, 2014

Critical Question: Who Taught Your Financial Planner What He Knows?

If you have read my blog long enough, you are likely aware that I have a certain pessimism regarding my own industry. Of course, I have no doubt about the value true comprehensive financial planning can provide to clients, and I’m very proud of the service I supply. Rather, it is the actual terms “financial advisor” or “financial planner” that creates a concern for me.

According to a 2012 study conducted by the U.S. Department of Labor, there are 929,700 U.S. citizens who refer to themselves as financial advisors. However, the sad reality is that 411,500 of these individuals are really just insurance salesman when you examine what they do, and 312,200 are nothing more than stockbrokers who get paid to sell investment products. I believe the term “financial advisor” is used by these individuals to avoid the negative connotations that accompany the more traditional terms of “insurance salesman” and “stockbroker."

I am certainly not contending that there is anything wrong with these professions, but I would argue that individuals in these industries referring to themselves as “financial advisors” or “financial planners” is a bit misleading. At the end of the day, these individuals are very unlikely to conduct any actual planning on behalf of their clients and are likely to focus their efforts simply on selling a product and collecting a commission. Consequently, a consumer utilizing the services of these professionals hoping to benefit from any type of objective financial planning are likely to be disappointed.

So when you meet someone who refers to himself as a financial planner, how can you tell if the person is capable of providing exactly the service you are looking for? A key indicator revolves around where the individual received his education and training.

Jason Zweig of the Wall Street Journal recently provided an excellent example. He obtained two emails a firm called Table Bay Financial Network of San Diego sent out to its trainees. Table Bay specializes in training certified public accountants and financial advisors across the country. The first email offered a Maserati to advisers who sell at least $7.5 million in annuities in 2014 and a BMW, Range Rover or Porsche for at least $6 million in sales. The second email hyped up an index annuity paying a 9% commission.

I’d contend that awarding luxury cars for selling expensive products might incentivize a financial advisor to recommend investments that aren’t in a client’s best interest. Upon further investigation, Mr. Zweig found that the founder of Table Bay had a settlement with the Department of Labor in 2008 costing him $500,000 in which he was permanently barred from serving as a fiduciary to a retirement plan.  Of course, this information can be difficult for a consumer to obtain. As Mr. Zweig writes: “all this is a reminder that when you hire a retirement advisor, don’t just ask what he knows. Ask who taught him what he knows."

Referring back to the 2012 Department of Labor study, of the 929,700 individuals who refer to themselves as a financial planner, only 67,323 (7.2%) are Certified Financial Planners (CFPs). The CFP designation is what I consider to be the gold standard in the education of financial advisors. In addition, only 2,400 (.3%) are members of the National Association of Personal Financial Advisors (NAPFA), which is the nationwide organization for fee-only financial planners.  Fee-only planners never collect a commission on the products they recommend and receive no compensation other than what they obtain directly from their client.  This method of compensation ensures that the advisor always has the client’s best interest in mind.

The CFP Board recently published a clever 30-second commercial driving home the point of making sure your financial planning professional received adequate, ethical training:

As the ad says: “unless they are a CFP pro, you just don’t know.”

Wednesday, February 12, 2014

Recent Market Losses: How Concerned Should We Be?

Many investors viewed January 2014 as a pretty scary month. Over a period of just 12 trading days (1/15-2/3), the S&P 500 lost -5.76%. This spurred conversations online and in the media about the end of a long bull market run and even the possibility of a bubble. However, since the end of that tough stretch, the market has responded strongly and is now less than 1.5% off its all time high.

So what happened in January to cause such a response? Was it a concern about the health of emerging markets that caused such a scare, or perhaps the threat of rising interest rates? Did the uncertainty of having a new Fed chairman cause a pullback in the market, or maybe the concern of a terrorist attack in Sochi during the Olympics? These are all clearly issues that will obtain a good amount of short-term attention, but I’d contend that none of them were the root cause of the market decline.

History illustrates time and again that market volatility leads to memory problems for many investors.  Check out this chart (click to zoom in) itemizing all market corrections of 5% or more since the bull market began:

As you can see, although the market has increased in value from 676.53 on March 9th, 2009 to 1,819.75 on February 11, 2014, the S&P 500 has endured nine pullbacks of over 5% during that time frame. As illustrated by the lengths of the red lines associated with each correction, many of these market declines happened over a similarly short time span. Consequently, despite the S&P increasing in value by 169% over the last five years, the market has experienced a decline of at least 5% every six and half months on average. In fact, nearly a third of the months since the bull market began have seen the market decline, and by an average of 3% per month.  Considering this information, January wasn’t particularly unusual.

These periodic market pullbacks aren’t specific to the recent strong run. Historically, we typically see three stock market dips of 5% or more every year and one correction of more than 10% every 20 months. Yet, for some reason, the same conversations and concerns are repeated during every market correction. Investors wonder if this is the beginning of an extended market decline or even a crash. People consider selling their assets and taking their money out of the market. It is so easy to forget that we have seen similar circumstances in the past and that very rarely has anyone benefitted from selling. Refer back to the chart itemizing all market corrections over the last five years. There wasn’t a single market decline that didn’t recoup all value in a short period of time. Even the 20% decline that occurred in 2011 only took nine months to go from peak to trough to new all time high.

As a result, I’d suggest that the January decline in the markets is not only nothing to be concerned about, but it is expected and healthy. In fact, if you have done your homework as an investor and have a well diversified portfolio with a stocks/bonds ratio that matches your risk tolerance, you’ll be hard-pressed to find a market reaction that justifies dramatic action. Of course, there will always be market corrections (even the occasional crash), but as long as your portfolio is built to accurately match your investment time horizon, market values are likely to recover before the pullback is catastrophic to your retirement goals. Next time the market endures a short-term correction, remember it isn’t anything we haven’t seen before.