Category: Investing

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Investing

What Veterans Need to Know About Corporate LTIs

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Photo Credit: Markus Spiske

As a financial planner, I focus on helping veterans transition into the corporate world following their military career. Veterans are often unfamiliar with the many types of compensation and benefits the corporate world offers.  An often confusing type of compensation in the private sector is “long-term incentives,” or LTIs.  Here’s what veterans need to know about corporate LTIs.

LTIs can take many forms, such as restricted stock, stock options, and profits interests, and tend to vary depending on the type of company. For example, start-ups, privately-owned companies, and public corporations may offer different LTIs suited to their goals and legal structures.

At their core, LTIs are designed to inspire employees to make a long-term commitment by giving them an interest in the company’s success. When employees put in dedicated, collective efforts over time, they earn additional pay as a reward… at least in theory.

But LTIs aren’t guaranteed to yield a significant profit over time.  Veterans must understand the LTIs the company is offering in order to effectively evaluate a compensation package and to manage their incentives.

What Veterans Get Wrong About LTIs

Veterans new to the corporate world make three common mistakes.

First, they don’t take the time to fully understand the language surrounding LTIs and how incentive programs work at different companies. Terminology like vesting, strike price, expiration dates, and milestones all have specific effects on when an employee can receive the actual benefit of their LTIs.

Similarly, many veterans confuse stock and stock options. Their potential payoffs can be quite different, and mistaking one for the other can mean a serious loss of opportunity.

Second, these misunderstandings lead veterans to place an unrealistic value on the incentives they receive. In popular culture, people seem to become wildly rich when they receive an award of company stock or stock options. However, that’s not the case for most employees, most of the time.

Instead, it’s important to lay out the potential scenarios for the future value of your LTIs, depending on your specific incentive plan. In some scenarios, incentives can become completely worthless—something for which it makes sense to be prepared.

Lastly, veterans may not understand how taxes work with respect to incentive plans.  Taxes can have a major impact on the LTI’s true value. While we tend to avoid focusing on taxes as the dominant factor in how we manage LTIs, it’s also unwise to ignore the tax consequences completely.

Key Terms

The jargon associated with LTIs can make them intimidating, but it’s important to familiarize yourself with the most common terms before diving into how each type of LTI works. If you ever feel lost, refer to this list.

Here’s the basic terminology you need to understand LTIs:

  • Stock/Stock shares: Ownership of a small part of the company that issues the stock shares, entitling one to a portion of the assets, earnings, and dividends of that company. Companies can issue different amounts of stock, so it’s not possible to directly compare the stock price of one company to another without referencing other metrics.
  • Stock Option: The right (but not the obligation) to purchase a share of the company’s stock at a predetermined price (strike price). Options must be exercised before their expiration date, at which point they are no longer valid and cannot be exercised.
  • Strike Price: The predetermined price at which an owner of a stock option can purchase the stock. The strike price for a given option will not change, but the market price can.
  • In-the-money: When the market price of a stock is greater than the strike price of the stock option. The employee would profit from exercising a stock option in this situation.
  • Out-of-the-money: When the market price of the stock is less than the strike price of the stock option. In this case, the employee would lose money if they exercised their stock option.
  • Award/Grant Date: Date that the company gives LTIs to an employee. Employees who stay with a company for a long time may receive multiple awards, each with its own award date.
  • Vest/Vesting: The time at which LTIs actually belong to an employee. Vesting occurs on a schedule following the award date, generally giving an employee a percentage of their total awarded LTIs at each stage. An employee who leaves the company before the LTIs vest will likely forfeit them.
  • Vesting Schedule: Time frame over which LTIs vest. These schedules vary from company to company, and LTIs rarely vest all at the same time.
  • Long-term Capital Gain: An investment return subject to taxation according to the long-term capital gain tax rates. “Long-term” is typically defined as one year or more, with some exceptions to that definition.
  • Short-term Capital Gain: An investment return that is not a long-term capital gain. Usually one year or less.
  • Disqualifying Disposition: The sale of an asset in a time frame that causes it to lose special tax treatment. For example, selling certain shares too soon and having your profits taxed as earned income instead of capital gains.
  • Post-termination Exercise Period: The period of time after an employee terminates their relationship with a company during which they can still exercise their stock options.

Types of LTIs

In this section, we will look at some of the most common types of LTIs, specifically stock options, restricted stock, and profits interests, and examine how they work, how they affect income taxes, and what risks veterans should consider when evaluating offers from companies.

Stock vs. Stock Options

First, let’s clear up the differences between stock and stock options.

Stock is an ownership share in a corporation. It gives you the right to vote in shareholders’ meetings, and may also entitle you to dividends of the company’s profits, either in the form of cash or additional shares. Even if a stock doesn’t provide dividends, you can still potentially sell your shares for a profit.

 

Stock options, on the other hand, give you the right to purchase shares of a certain stock at a specific price at some point in the future. You aren’t obligated to exercise your options—but if you wait too long, they’ll expire and become unusable.

Restricted Stock vs. Stock Options

Before we get into the details of how restricted stock and stock options work, here’s a quick overview of their differences:

Restricted Stock

  • Shares of a company that you own as soon as the stock is awarded
  • Cannot sell shares until they vest
  • No expiration date
  • Taxed when the stock vests and again when sold

Stock Options

  • Right to buy shares of stock in the future at a specified price
  • Cannot buy shares until the options vest
  • Have an expiration date
  • May be taxed upon exercise and when you make a profit, depending on the type of stock option and other factors

Restricted Stock and Restricted Stock Units

Restricted stock and restricted stock units (RSUs) are some of the simplest LTIs: they are employee ownership shares granted by a company as further compensation. Beyond that definition, however, they differ in some major ways.

Restricted Stock

Let’s start with restricted stock. Also called a restricted stock award (RSA), this type of incentive is typically associated with executives and can be automatically forfeit if one fails to meet certain corporate expectations.

An individual owns these shares when they are granted, but is restricted from selling the shares until they vest. The vesting schedule of restricted stock will vary by company. Some vesting schedules require you to meet performance milestones, but most vesting schedules are time-based.

A common example is 25% vest per year for four years, giving the employee ownership of a quarter of their awarded stock once per year. Other plans may front-load some of the vesting as a short-term incentive.

Restricted Stock Units (RSUs)

Restricted stock units (RSUs) share many features with restricted stock, including their vesting schedules and taxation. If you’re not an executive or other high-level employee, you’re more likely to be granted RSUs than restricted stock.

The biggest difference: an employee doesn’t own their shares until they vest. This means that you can forfeit those shares if you leave the company before their vesting date. If you stick around until your shares vest, however, you have full ownership and can sell them.

Restricted stock and RSUs provide an employee with extra compensation while encouraging them to stay at the company for at least several years. Hypothetically, this aligns the long-term interests of company and employee—but veterans should remember that a company’s stock is not guaranteed to increase in value.

Taxes on Restricted Stock and Restricted Stock Units

With both restricted stock and RSUs, the employee is taxed when the stock vests. This income is treated as earned income, requiring that you pay federal income tax, state/local income tax (if applicable), as well as Social Security and Medicare (FICA) on the value of the vested stock on the vesting date.

For example, an employee with a $10,000 restricted stock award and 25% vesting would receive 25% of the market value of that stock after 1 year following the award date.

At the award date, that 25% of market value is $2,500. Supposing the market value of the restricted stock remains the same 1 year later, the employee would owe income taxes on that $2,500 of additional income.

Employees can pay those taxes out of pocket or sell some of the vested shares to cover them. How to actually execute those transactions will vary with your employer.

You also have the option to initiate an 83(b) election when your shares are granted. However, that applies to many types of LTIs, so I’ll discuss that in a later section.

Stock Options

Stock options are the right to buy a share of a specific stock at a specific price (the strike price). Similar to restricted stock units, you don’t own any shares when your stock options are awarded and can’t exercise your stock options until they vest.

Like other LTIs, the vesting schedule for stock options may be based on meeting performance goals or just a matter of time.

So your stock options vest, and you can finally buy the stock—but should you? Exercising your stock options will only benefit you if the market price of the stock is higher than the strike price. This is because, relative to other investors, you’re paying less for the same stock.

By contrast, restricted stock has value for an employee as long as the company doesn’t go bankrupt before the stock vests.

Stock options also have an additional feature: an expiration date. This is typically ten years after the award date, after which an employee can no longer use the option to buy company stock. 

However, some companies set their options’ expiration date based on when an employee leaves the company, with some as near as 3 months after you leave. This period is known as the post-termination exercise period, and it’s an important thing to consider before leaving your job.

Stock options are often associated with smaller startup companies, but most large companies offer them as well. As you might imagine, startups may bet high on the possibility of their stock price rising, incentivizing employees to stay and work to make that vision a reality.

Taxes on Stock Options – NSOs vs. ISOs

How your options are taxed depends on which kind you have. Employees can receive two types of stock options: non-statutory stock options (NSOs) and incentive stock options (ISOs).

Non-statutory Stock Options

Non-statutory stock options (NSOs) are the ones military veterans are most likely to encounter when transitioning into corporate employment.

NSOs are first taxed upon exercise of the option and taxed again upon the sale of the stock, but only if the employee realizes further profits through that sale.

When the option is first exercised, the difference between the strike price and the market price of the stock is called the “bargain element.” The bargain element is then multiplied by your number of shares:

(Market Price – Strike Price) x Number of Shares = Amount Taxed as Income

This value is taxed as earned income, requiring you pay federal, state/local, and FICA taxes on this amount.

Once you exercise your NSOs, you can hold onto the company stock and sell it later. If you sell your stock later on and realize additional investment profits thanks to an increased stock price, then you will also owe capital gains taxes on this further profit.

If an employee holds the stock for less than one year, this profit would be taxed as a short-term capital gain; profits on stocks held for more than a year would be taxed as long-term capital gains.

Incentive Stock Options

Incentive stock options (ISOs), sometimes also called statutory stock options, are often offered to executives and other high-level employees. They differ from NSOs in how they are taxed.

You won’t pay any income taxes on ISOs when you exercise them. But, you may need to pay alternative minimum tax (AMT) on the bargain element instead. This depends heavily on your financial situation, including your yearly income and the bargain element of your shares.

If you hold your shares for more than a year after you exercise your ISO and more than two years after your ISO’s award date, your profits upon selling them will be taxed as capital gains. You can use the same calculation described above to determine what amount will be taxed.

On the other hand, if you sell your shares early, your profits will be taxed as earned income. This loss of special tax treatment is called a disqualifying disposition, and it’s generally worth making efforts to avoid it.

For some companies, ISOs may be a more valuable long-term incentive because employees need to hold them for longer to pay the least in taxes on their profits. However, AMT can complicate things. Consult a financial planner or tax advisor to help manage tax consequences of your ISOs.

Profits Interests

Profits interests are a relatively unusual type of LTI. They are sometimes issued by private companies (especially in the Private Equity space) instead of issuing stock or stock options. They allow employees to participate in the success of their employer but without taking direct ownership in the company.

Profits interests are structured in many different ways, yielding a variety of benefits for an employee. They may or may not vest. You may have voting rights as a partner, or you may only be entitled to receiving distributions. This makes profits interests difficult to generalize.

Unlike capital interests (such as stock), profits interests do not entitle employees to a distribution if the company liquidates. Capital interests entitle you to a piece of a company’s current value. Profits interests entitle you only to future profits.

If you are awarded or may be awarded profit interest units, closely study the offering documents and presentations. You may also consider consulting with tax planners and financial advisors with experience in profits interests.

The 83(b) Election

The 83(b) election may help an employee reduce tax costs and maximize potential profits of LTIs. This election refers to a provision of the Internal Revenue Code that allows employees to elect to pay taxes on the market value of their equity at the time of award. 

Only equity that vests, like restricted stock, RSUs, and stock options, qualify for 83(b) election. In the case of profits interests, you may be required to take an 83(b) election just in case your profits interests don’t qualify under the relevant taxation safe harbor rules.

To take advantage of an 83(b) election, you will file an 83(b) form within 30 days of share grant date.  Provide a copy to your employer as well.

The strategic value of taking an 83(b) election relies on the value of your shares increasing in the future. If they do, then you will have paid less in taxes overall on your transactions. But if their value decreases, you will have overpaid—and you can’t get that money back.

Note that you’ll still  pay capital gains tax on your profits from selling your shares. Ideally, an 83(b) election allows you to pay income tax on lower-value stock.  Then you will pay only capital gains tax when you sell the stock at, hopefully, a higher value.

Don’t Lose Out on Growing Your Wealth with LTIs

Long-term incentives are designed to keep employees at a company for years and motivate them to propel the company’s success. However, the value of corporate LTIs is never guaranteed—a far cry from what you might see on TV.

Veterans who expect to leave a company in the near future may put themselves in a disqualifying disposition by selling early or losing their LTIs entirely. Employees may have some leeway when it comes to managing their shares after they leave a company, frequent job-hoppers are the most likely to lose out on future profits.

Veterans must carefully consider the incentive packages a company offers. That’s why I help veterans evaluate LTIs.  With a focus on future goals and tax considerations Veterans are empowered to manage their LTI’s effectively.

If you need help with LTIs or any other financial matter during your transition, reach out to an MFAA advisor that specializes in working with military and veteran families!

Categories
Investing

Series I Bonds: Is it time for an exit strategy?

Picture of an array of I Bonds

Series I Bonds: Is it time for an exit strategy?

When it comes to inflation and our financial lives, inflation receding is a good thing.  Over the past 18 months, the Federal Reserve has aggressively raised interest rates in a focused effort to tap the breaks on post-pandemic inflation, and they’re beginning to see some results.  As of July, the US consumer price index, the primary measure of inflation, was down to just 3.2 percent.  This is good news for your high-yield savings accounts and certificates of deposit, but bad news for inflation-adjusted Series I savings bonds.  

What’s the Deal with Series I Bonds? 

Looking back to the fall 2021, just as we were turning the corner on COVID lockdowns, inflation soared to record highs which drove Series I Bond interest rates to 7.12% on November 1st, 2021.  Suddenly, for the first time in more than a decade, Series I Bonds sparked our curiosity, especially in comparison to our savings accounts which were paying a meager 0.01%.  Then on May 1st, 2022, the Treasury Department set the new Series I Bond inflation-based interest rate at 9.62% prompting even more of us to purchase our $10,000 per year allowance of these inflation-based bonds.  

Now that inflation is finally ticking down, Series I Bonds interest rates are suddenly less compelling.  Because Series I Bonds pay interest based on a fixed rate plus an inflation-adjusted rate, we find ourselves at a crossroads between lower interest rates on I Bonds and higher interest rates on other short-term savings vehicles.

The Fed’s actions to raise interest rates have dramatically increased mortgage and auto loan rates while having the secondary effect of increasing the rates that some banks pay on personal savings accounts.  This is especially true of some high-yield savings accounts, money market accounts, and certificates of deposit.   

Now that the balance has shifted to favor these short-term savings rates, it may be a good time to trade those Series I Bonds in favor of a high-yield savings (HYS) account, certificate of deposit (CD), or a money market account.  A quick check of today’s yields shows HYS accounts paying over 4% and 12-month CDs over 5%.  

Series I Bonds Rules of Engagement

As we consider a Series I Bonds exit strategy, it’s important to remember some of the basic “rules of engagement” associated with these bonds:

  1. The stated interest rate includes 2 rates: a fixed rate for the life of the bond and an inflation-based rate that adjusts every 6 months (May 1st and November 1st) based on current inflation.
  2. Your interest rate resets to the current interest rate every 6 months based on the date you purchased the bond.  
  3. There is a minimum term of 12 months with a holding period of 5 – 30 years.  If you sell a Series I Bond after 12 months but before meeting the 5-year holding period, you incur a 3-month interest rate penalty.
  4. Interest is credited to your account at the end of each month.
  5. The interest earned is tax deferred until the year you sell the Series I Bonds. 

Series I Bond Example

Here’s an example to help illustrate how your interest rate might adjust every six months:

On February 3rd, 2022, you purchased $10,000 in Series I Bonds when the current rate was 7.12%, your interest rate reset on the following dates:

2/3/2022 7.12%

8/3/2022 9.62%

2/3/2023 6.48%

8/3/2023 3.38%.

In this example, as of August 2023, you’ve met the absolute minimum holding period of 12 months and your interest rate recently reset to 3.38%.  Suddenly, your Series I Bond is earning a lower annual percentage rate than a high-yield savings account or the current CD Rate.  

With this shift between inflation and interest rates, it may be time to consider selling your Series I Bonds and moving the funds to a higher-yielding investment like a HYS account or CD.  

What About the 3 Month Interest Penalty?

In the example above, you have not met the 5-year holding period, meaning you’re subject to a 3-month interest rate penalty.   If you sold your Series I Bonds in August 2023, you would forfeit the interest earned in the three previous months which was credited at the 6.48% annual rate.  To avoid forfeiting interest earned at this higher rate, you want to wait until the beginning of the fourth month at the new lower rate. 

HUH?? I know, still confusing. If you’re going to pay an interest penalty, you want to pay it at a lower rate. Back to our example: if you wait until at least December 1st to sell the Series I Bonds, you forfeit your September, October, and November interest earned at 3.38% instead of the higher 6.48%.    

Because everyone’s purchase dates, timelines, tax rates, and motivations are different, it’s difficult to nail down the perfect strategy for everyone.  The best we can do is provide a general guideline for the earliest you might consider selling your Series I Bonds.  It is also important to remember that this strategy to optimize your short-term savings rate requires that you follow through and reinvest the cash from your Series I Bond in a higher interest-bearing savings option.  If you sell your Series I Bonds and then let the cash sit in your non-interest-bearing checking account, you’ll miss out on the additional interest you could earn in a CD, money market or high-yield savings account.  

Finally, this is a good opportunity to remember that selling your Series I Bonds is a taxable event; you will receive a Form 1099-INT from the IRS reflecting the interest earned over the holding period.  Earned interest is taxed at your regular income tax rate.  

The table below reflects the earliest date you should consider selling Series I Bonds purchased between November 2021 and October 2022.  Series I Bonds purchased beginning November 2022 carry a fixed interest rate of 0.4% and bonds purchased beginning May 2023 carry a fixed rate of 0.9% in addition to the fluctuating inflation rate.  This fixed rate provides an additional bonus on top of the inflation rate for the 30-year life of the bond making the decision of when to sell them even more complicated and beyond the scope of this discussion.

For now, let’s focus on the Series I Bonds you might consider selling as part of a strategy to achieve a higher rate of return. 

 

Month Purchased Earliest Date to Consider Selling
2021
November August 2023
December September 2023
2022
January October 2023
February November 2023
March December 2023
April January 2024
May August 2023
June September 2023
July October 2023
August November 2023
September December 2023
October January 2024

To learn more about Series I Bonds, visit Treasury Direct.gov.  

As always, personal finance is by definition – personal.  Your unique financial situation determines the appropriate financial decisions for your personal financial success.  This information is provided for educational purposes and is not intended to represent an individual investment recommendation.  If you’d like to talk to one of our military financial advisors, you can find them here.  

 

Categories
Investing Taxes

New Year IRA Tips

New Year IRA Tips

New Year IRA Tips

Still want to save for retirement in 2022? You can!

Wait, what?  Did you say I can still save for retirement last year?

Maybe you arrived in January 2023 feeling like you didn’t make good on your 2022 goal to save more for retirement.  It was a rough year and keeping cash in the bank probably made a lot of sense while the economy did what it did in 2022.  Maybe you always had the cash, but you just didn’t have the discipline.  Or maybe you only just now have the cash and wish you could go back in time to contribute.  I have some good news for you:  you can still make annual retirement contributions to the 2022 bucket, in some cases even tax-deductible ones!

Am I too late to make a retirement contribution for 2022?

The good news:  you are not too late to contribute to your IRA for the 2022 tax year.  You may continue to contribute up to the annual maximum of $6,000 per year ($7,000 if over age 50) until the tax filing deadline [Monday, April 18, 2023].  This limit applies regardless of how much you have contributed to your employer-sponsored plan such as TSP, 401(k), 403(b), SIMPLE, and SEP-IRA.

The bad news:  Your employer-sponsored plan contributions for the 2022 tax year are over.  The deadline for annual contributions to your employer-sponsored retirement savings plan is always December 31 of the year.  Your employee contribution to these types of plans must come directly from your paycheck each month.  You cannot write a check or initiate a transfer from your bank account to be deposited into an employer-sponsored plan.  This means any deductions from your pay toward those accounts after January 1st of the new year are now counting toward the new year’s limit.  TSP, 401k, and 403b accounts have a new annual limit for 2023: $22,500 per person and an extra $7,500 “catch-up contribution” for those over age 50 ($30,000 total).  For a SIMPLE account, the limits are $15,500 (under 50) and $19,000 (50 & over).

How do I make sure my contribution will count for 2022 if it is already 2023?

Nearly every investment custodian has provisions for designating the tax year for your contribution during this “in-between time” when two years are possible.  When you sign-in to an online account to contribute, you should see both the 2022 and 2023 tax years listed, along with your allowable contribution based on age and the amount you have contributed so far to each of those tax years.

For instance, Captain Sue Savemore is 30-years-old and made an $800 contribution to her Roth IRA in June 2022.  When she logs in to her online account information, it says she can still contribute $5,200 for 2022 ($6,000 – $800) and the full $6,500 for 2023.

There will be a place to designate which tax year and how much she wants to contribute.   She would enter the amount she wants to contribute in the space for the 2022 tax year, up to the available remaining limit for 2022.  If she wanted to contribute more than $5,200, she would need to enter any further amount as a 2023 contribution.

So, if Captain Sue Savemore has $7,000 sitting in her bank account and wants that full sum to go to IRA contributions, she would put $5,200 in the designated space for the 2022 contribution and $1,800 in the designated space for 2023 contribution.

Why do I want to make a 2022 IRA contribution now?

You may be asking yourself why you would want to make 2022 contributions instead of 2023, especially if you are someone who does not typically “max out” their IRA each year.  Filling up the bucket whose window of opportunity is closing (2022) preserves your full capacity to save in the bucket that has the longer window of opportunity (2023).

Consider these scenarios:

  1. You or your spouse have a job where you regularly “max out” your employer’s plan (make the maximum allowable contributions as listed above).  You know and appreciate the value of saving early for retirement.  However, you do not have enough cash flow to also max out your IRA each year.  Then you find yourself leaving a job in 2022 and moving to an employer who does not have a retirement savings plan.  By contributing to the 2023 IRA right now and leaving the 2022 bucket unfilled, you have just robbed yourself of some of your capacity to save.
  2. You may find yourself in a situation with an unexpected raise or bonus or other windfall later in 2023 and want to earmark it all for playing catch-up with retirement savings.  Again, if you leave your 2022 bucket less than full and start using up the capacity in your 2023 bucket, you just shorted yourself on that opportunity.

Does it matter if the contribution is Roth or Traditional?

The remaining 2022 contribution amount can be either Roth or Traditional, no matter what you may have already contributed in 2022.  The annual limit applies only to the total IRA contributions, not the tax treatment of the contribution.  Back to our example using Captain Sue Savemore:  if she should decide she wants to make the remaining 2022 contribution of $5,200 to a Traditional IRA, that is perfectly OK.  If she did not already have a Traditional IRA account, she could open one and fund it before the tax deadline and it would still count for the 2022 tax year.  Her combined contribution for 2022 would be $800 Roth + $5,200 Traditional = $6,000 annual limit.

How do I choose between Roth to Traditional contributions?

One of the beauties of making an IRA contribution late in the tax year is that you have a better sense of your tax scenario for that year.  Choosing between Traditional or Roth tax treatment most often depends on your expected marginal tax rate.  [if you need a quick primer on this, see this video from a recent Military Saves campaign, produced by yours truly].

However, there are two more decision points to consider when making IRA contributions:  (1) whether or not you are covered by an employer’s plan, and (2) what you modified adjusted gross income (modified AGI) is expected to be.

First, let’s define “modified AGI”.  This definition can be found on the IRS website:

“For most taxpayers, MAGI is adjusted gross income (AGI) as figured on their federal income tax return before subtracting any deduction for student loan interest.”

This means that for most military families, if your income has stayed more or less the same in 2022 as it was in 2021, look back at your 2021 tax return, line 11 and add in any amount found on Schedule 1, line 21 to get a rough guess on your modified AGI.  You can take a look at your 2022 W-2(s), add interest, and do a quick calculation of your modified AGI using this free 1040 tax calculation tool found on the Office of Financial Readiness website – a great educational resource for servicemembers on a whole host of financial topics.

If you are COVERED by an employer sponsored plan, your ability to make a tax-deductible Traditional IRA contribution is limited.  Being “covered” is not the same at “participating”.  Every servicemember is covered by an employer plan (TSP), whether they have ever contributed any money or not.  If you are covered, then these covered employee IRS limits will tell you if your contribution is deductible.

Looking back at the example of Captain Sue Savemore:  In 2022, Sue is a “single” tax filing status.  With eight years of service as an O-3, her taxable income for 2022 was $81,684.  This puts her above the limit for single taxpayer ($78,000 MAGI) and unable to make a tax-deductible Traditional IRA contribution, even if she did not contribute a single dollar to TSP.

So now you are thinking, “well, just make a Roth contribution instead, since Roth contributions are not tax deductible anyway.” This would be an equivalent tax situation, and Roth contributions are not limited by coverage under an employer plan.  The only limit on Roth contributions would be her MAGI.  Thankfully, that MAGI limit is higher for single Sue ($129,000 for 2022), and she could indeed make the full Roth contribution for 2022.

But what if Sue had gotten married and were “married filing jointly” tax status for 2022?  And what if she were marrying Barry Businessman, who separated from service in 2021 and had almost no income in his new business in 2022?  Maybe Sue and Barry could use a little more cash flow right now but still want to save for retirement.  Even though Sue is still covered by an employer plan, the deductible IRA contribution limit for married filing jointly is much higher, $109,000.  And the good news for Barry is for some time to come, he will be able to make tax-deductible contributions due to different IRS limits for those who are NOT covered by an employer plan.

But what if these IRS limits exclude us from ANY kind of IRA contribution?

Is there some loophole?  I really want to save more!  (this is music to any CFP’s ears)

Yes, there is a little loophole called a Backdoor Roth IRA.  If you are seeking to create more tax-free income in retirement but are a high-income earner with limited means of doing so, this could be a good strategy.  The simplest explanation of the process is:

  1. Make a non-deductible 2022 contribution to a Traditional IRA account.  This contribution should be reported in your 2022 tax return on Form 8606.  There is no MAGI limit or employer plan limitation for NON-DEDUCTIBLE contributions.
  2. Do a “Roth conversion” of the contribution.  A Roth conversionrefers to taking all or part of the balance of an existing traditional IRA and moving it into a Roth IRA.  This could be a taxable event if you have a balance in the Traditional IRA from previous deductible
  3. The IRA custodian will report the “recharacterization” on form 1099-R for the 2023 tax year.
  4. When you file your 2023 taxes, you will include the information from the 1099-R on good ole Form 8606 again.

NOTE:  this is an extremely simplified explanation of the Backdoor Roth.  Please discuss this option with your tax pro and/or financial planner before taking any action.

Whew, many details, lots of things to consider! If you need to talk this over with a financial professional, please check out the list of MFAA professionals on the website.

Happy savings!

Categories
Investing Taxes TSP

Which is Better—A Roth or a TSP?

Roth Versus TSP

Which is Better—A Roth or a TSP?

If my math is correct, half of the readers of this article’s title are about ready to blow up my inbox, half would just like to know the answer, and half haven’t read this far.  Clearly my math isn’t correct, but let’s dive into this question, and the real question that’s usually behind it— “Which is better—Roth or Traditional?”

If you’ve been in the military for a minute, you probably have heard that question, “Which is better—a Roth or a TSP?”  It comes from the very real confusion cluster that is the financial world.  Few primary schools teach personal finance and the topic is at best optional in college.  Most of us learn it through trial and error if we learn it at all.

The answer to the question “Which is better—Roth or TSP” is the same as the answer to “Which is better—Tesla or cars?”  There’s no direct comparison because one is a subset of the other.

TSP Basics

Let’s start with the TSP (Thrift Savings Plan) which is an employer-sponsored, qualified (read: tax advantaged) retirement savings plan.  It’s similar to civilian 401(k) plans (Which doesn’t mean much if you’re still back at the Roth or TSP question, I know).  The TSP allows you to defer part of your paycheck each month, receive preferential tax treatment, and grow the dollars through compounding until you need to use them in retirement.

If you joined the service after 2017, then you’re eligible for the government to match your contributions up to 5% after 2 years of service—which is free money!

The TSP limits your contribution to a certain amount each year based on IRS guidelines and it’s $20,500 in 2022.  Participants over age 50 can contribute an extra $6,500.

What is Roth?

Roth is the last name of the senator that sponsored the legislation creating Roth retirement accounts.  Roth is a synonym for “after-tax,” meaning that you’ll pay your typical income tax on the dollars that you contribute to a Roth account such as the Roth TSP.  The benefit of Roth treatment is that contributions grow without being taxed each year.  Then in retirement (generally after age 59.5), you get to access those dollars tax-free.

Roth treatment is incredibly powerful in that it allows savers to pay a generally low tax rate on dollars when they’re young or in the military and not making much and then avoid higher tax rates in retirement when their tax rates are higher after a lifetime of earning and saving.

Roth treatment can also be though of as “tax insurance.”  We don’t know what future tax rates will be.  Many experts predict that they will have to be higher to afford programs like Medicare and interest on the national debt.  Roth dollars won’t be taxed in retirement, so savers can mitigate future tax risk.

What is Traditional?

Before Roth came along, there was just “TSP” and no need for the adjective “Traditional.” Traditional is a synonym for “pre-tax” or even “tax-deferred.”  With a Traditional retirement account like the TSP, savers skip paying taxes on the contributions as the money is earned, but have to pay taxes when they access the money in retirement after age 59.5.

Savers are allowed to contribute to either or both Roth and Traditional “sides” of their TSP account in a given year, but they can’t exceed the IRS limit unless they’re in a combat zone.  I.e., you can put $10,250 into Roth TSP and Traditional TSP in 2022, but you can’t put $10,251 into both.

Which is Better—Roth or Traditional TSP?

Now that we’ve got the right question squared away, we’ll look at the indigestible answer… it depends.  The most general way to start answering this question for each taxpayer (or family if filing jointly) is to ask, “Do I want more money in my pocket this year, or in my retirement years?”

A contribution to the Traditional TSP puts extra dollars in your wallet this year.  If you’re in the 22% bracket and you contribute $1,000 this year, you’ll have $220 extra in your pocket because you deferred the tax bill until sometime in retirement.

Moving past the most basic question, some families will want to evaluate, “Am I in a temporarily higher tax bracket this year?” Let’s say you receive a large bonus and will have outsized income in a certain year.  It might be appealing to hold on to more of your pay by making Traditional contributions in a high-income year.

An even more sophisticated approach would be to evaluate whether a Traditional contribution might lower your tax bracket for the year.  For example, in 2022, the cutoff between the 12% tax bracket and 22% bracket for a married-filing-joint couple is $83,550, which is really $109,450 after adding the $25,900 standard deduction.  If income before a TSP contribution is $109,450 and the planned TSP contribution was $5,000, then taxable income becomes:

$109,450 – $5,000 – $25,900 = $78,550

$78,550 is squarely in the 12% tax bracket and the tax savings on the year is $600.  So, by choosing to put at least part of the TSP contribution into the Traditional “side,” it’s possible to lower one’s overall tax bracket and tax bill.

Dialing up the sophist-o-meter a bit, let’s address capital gains.  Capital gains tax is the tax we pay when we sell something for more than we paid for it.  If you sell a stock at $100 per share, but you paid $50, then you have a $50 capital gain per share.

Uncle Sam taxes capital gains in one of two ways—long-term or short-term.  Long-term capital gains receive preferential treatment in that they’re taxed at 0%, 15%, or 20%.  These are lower than ordinary income tax rates for most people paying capital gains tax.  Short-term capital gains are taxed at ordinary income tax rates.

It just so happens that the cutoff between the 0% and 15% long-term capital gains brackets is $83,350 for a married-filing-joint couple…essentially the same as the 12% to 22% transition for ordinary income.

The “so what?” is that by using a traditional TSP contribution to lower taxable income into the 12% bracket, one also can take advantage of the 0% long-term capital gains tax bracket.  If you have stock with capital gains and need to sell some for a goal, you can do so right back up to the top of the 0% long-term capital gains bracket and pay $0.00 on those gains!

The Real Question

While it is important to evaluate the tax opportunities in a given year to assess Roth versus Traditional, the real question is this, “Am I in a higher tax bracket today, or will I be in a higher tax bracket in retirement when I access my TSP savings?”

Let’s say you’re in a 25% bracket this year and you also expect to be in a 25% bracket in retirement when you withdraw money, then there is no mathematical difference between Traditional and Roth TSP.  Want proof?  Plug the following formulas into Excel.

  • =FV(0.1,30,-1000,0,0)*0.75
  • =FV(0.1,30,-750,0,0)

The first is the future value of pre-tax contributions of $1,000 compounding for 30 years at 10% and then taxed at 25% upon distribution in retirement.

The second is the future value of after-tax contributions of $750.  We use $750 to model the effect of a 25% tax as the money is earned.

They both return $123,370.52.  But there’s a hidden twist here—would you really contribute less just because you had to pay tax on the dollars as you earned them?  Probably not.  Most of us will find a way to contribute the same amount regardless of the tax in the year of the contribution.

Thus, =FV(.1,30,-1000,0,0) = $164,494.02 and we can see that we end up with a significantly increased nest egg for choosing Roth.

But how do you know what tax bracket you’ll be in during retirement?  The reality is you’ll need a crystal ball, time machine, or other imaginary tool.  We can only make estimates.  Estimating our income, spending, and savings seems daunting, but it’s likely the easy part.  Estimating future tax rates, including state income tax rates is a bit more difficult.

A common technique is to just use current tax law and then revise projections as tax law changes.  Using that method, let’s look at Figure 1. This example illustration incorporates a family’s projected income, savings, and spending over their remaining life time.  The result is that we can see that the family will pay tax rates from the mid 20% range until retiring early at age 55.   At that point, the expected tax rate is 15% until age 70 when Social Security kicks in and creates a new income floor and higher tax bracket.

Roth versus Traditional 1

This family has a couple of options.  By contributing to Traditional accounts pre-retirement, they can hope to Roth-convert some or all of their Traditional dollars during their low tax years.  They would skip paying 22% to 25% in hopes of paying 15%.

Any Traditional dollars remaining after age 70 would, at-worst, be taxed at about the same rate they would have been at the contribution.  This choice requires an estimation not just of earning, saving, spending, and tax rates, but also how many dollars can be Roth-converted during the early-retirement window before ending right back up in a higher tax bracket.

If instead, the family contributes to Roth accounts prior to retirement, then several additional considerations arise:

  • From age 55 to 70, there could be a missed opportunity to “fill up” low tax brackets like 15%. The family might have unnecessarily paid 25% on some dollars.
  • After age 72, Roth IRA dollars don’t have to be distributed, but Traditional dollars do. These “Required Minimum Distributions (RMD)” create a higher income floor.  (Note that Roth TSP/401(k) accounts do have RMDs.  Roth IRAs don’t. Most people will rollover their Roth TSP/401(k) to an IRA prior to RMD age.)

Figure 2 shows a different family’s profile.  Prior to retirement at age 67, the family earns in the mid-20% to low-30% tax rate range.  They have a small “bathtub” from age 67 to 72 where they can do Roth conversions, but after that, they’ll be trapped in the 30%-plus range for their remaining years.

Roth versus Traditional 2

This family would likely want to mainly contribute to Roth accounts in order to minimize the impact of a high-income floor in retirement.

You can imagine that slight changes in a family’s planned earning, spending, saving, and estimated tax rates have drastic effects on their future tax profile.  This brings us to the key questions that we must answer to make the Roth versus Traditional decision:

  • Do I need extra cash in my pocket this year? Is it worth the risk of higher taxes later?
  • Can I change my tax bracket with a Traditional contribution this year? What benefit do I gain?
  • Do I expect my tax rates to be higher or lower in retirement?
    • If higher, more Roth dollars are your friend.
    • If lower, you leave a tip for the tax man by contributing to Roth today.
  • Do I generally think tax rates will be higher in the future? Roth contributions are an insurance policy against those tax rates.

Cleared to Rejoin

The Roth versus Traditional decision can be complicated.  We have to decide if we want more income this year, or lower taxes in a few decades.  To be as accurate as possible, we need to have reasonable estimates of our lifetime earnings, saving, spending and tax rates.  Ultimately, we have to answer, “What is the effect this year… and all of my retirement years?”  That’s no small task.

A few additional concepts to consider may help:

  • The current tax brackets are very low by historical standards, implying higher rates at some time(s) in the future
  • Interest on the national debt and support of Medicare for the Baby Boom generation will require higher government revenue in the coming years.
  • 30 years after you contributed, are you likely to regret having estimated wrong by a couple percent on your future tax rate, or are you more likely to really like that a sizeable chunk of your retirement income is tax-free?

Fight’s On!

 

Author’s Note:  This article focused almost exclusively on Roth versus Traditional for TSP (and 401(k)) contributions.  There’s a good deal more to know about IRA considerations, so please don’t extrapolate Roth TSP directly to Roth IRA without diving into the nuances.

Categories
Financial Planning Goals Investing Savings

I Learned Everything I Needed to Know about Investing in Kindergarten

Investing lessons learned from kindergarten

Investing Lessons from Childhood

I had one of those “Aha!” moments recently. You know – the ones where you figure something out after a really long time. The thing I figured out was that if I had believed the parables and fables I had been taught when I was a child, I might have achieved success earlier as an adult. I was thinking about investing at the time, so in my Aha! moment I was making the connection to investing.

The two children’s stories I was thinking about were The Tortoise and The Hare, and The Little Engine That Could. They are both very simple stories that you probably know. They both also contain very valuable lessons about investing if you are ready to believe them.

In The Tortoise and The Hare, the hare is very fast and challenges the slower tortoise to a race. The tortoise accepts. On race day the hare takes such a commanding lead he decides to take a nap. The diligent tortoise is able to overtake him and win the race.

In The Little Engine That Could, there is a train of toys that needs to get to the girls and boys on the other side of the mountain. There are a freight locomotive and a passenger train locomotive available. Both are large and strong enough for the task, but they are too proud and self-important to carry a meer train of toys over the mountain. Instead, a small switcher train, not built to haul cargo over mountains, steps up and agrees to try. With faith, persistence, and the infamous, “I think I can, I think I can,” cadence, the Little Engine gets that train of toys over the mountain.

Understand the Lesson

The moral of each story is obvious; be persistent, diligent, faithful, and believe in yourself. If you do, you can accomplish great things. I understood these lessons as a child. I understood them, but I did not feel them. I didn’t want to be the tortoise, winning the race with my slow and steady pace. I wanted to be a less foolish hare. I wanted to have tons of natural ability and some common sense, too. I wanted to win the race and then go back and cheer the tortoise on to keep trying as hard as he could!

I didn’t want to be the little engine that could, grinding away to achieve relatively modest goals. I wanted to be a less proud freight locomotive. I wanted to be big and strong, effortlessly moving the heavy loads without breaking a sweat. Working hard was for people who lacked natural ability. They had to try harder. That was OK for them, but it wasn’t who I wanted to be.

Fast forward about two decades. I was on active duty in the military and someone showed me a compound interest table. I was intrigued. I busted out my calculator and ran some numbers. With a very reasonable 8% rate of return and a little discipline every month, I could dollar cost average my way to a million-dollar portfolio before I was 50. Given where I was at the time, that seemed like all the money in the world.

Unfortunately, it also seemed like all the time in the world. I didn’t want to get rich slowly. That was fine for other people, but I was the less foolish hare. I was the less proud locomotive. If I could beat the market returns – and how hard can that be? – then I could get richer faster. Who wouldn’t want that?

My wife was less enthusiastic. She was willing to let me try my hand at investing with some of our money, but not all of it. I didn’t argue. I was confident in a few years she would be persuaded by my talent. It was only a matter of time before she would be begging me to personally manage the entire portfolio.

Picking Stocks Didn’t Work Out

I tried picking my own stocks for a while, but the markets are rigged against the individual investor, everybody knows that. (I fervently believed this for a while.) Then I decided to find the gurus who were beating the markets consistently and do what they were doing. Why reinvent the wheel? Just find the smartest wheelwright and ride on his wagon. They weren’t hard to find, self-proclaimed experts have been littering the internet with their drivel since the internet was born. I followed a few systems that worked right up until they didn’t. When they were working I was a genius, and I told everyone who would listen. When they weren’t I could always find an excuse, which I usually kept to myself.

About ten years into my grand plan I noticed something. That portion of our portfolio that I wasn’t actively managing was growing nicely. That part I was actively managing was lagging badly. That was a bitter pill to swallow, but facts are facts. I was about to go on deployment (back when we didn’t have the internet on deployments), so I dumped the active portion of the portfolio in with the passive portion. That was about 2 decades ago, and I’ve never really looked back.

Bringing it All Back Together

I didn’t make the connection between investing and the children’s stories until recently. There are some additional lessons in there I may have missed. The hare didn’t know he was foolish. The freight locomotive didn’t know he was too proud. We are not always skilled at assessing our strengths and weaknesses. What we want and what we need are not always aligned. Quick riches are a nice dream, but they are not a substitute for a financial plan that involves sensibly investing with patience, diligence, and faith in the plan.

I still have those compound interest tables from 30 years ago. They remain quite accurate today. They didn’t require any updating. That was all on me. I needed updating. Happily, I continue to grow and learn. I no longer want to be the fastest or the biggest or the strongest. I want to be the one with faith and persistence. I want to be the hardest worker. I want to have the discipline required to achieve any goal, be it modest or grand. I feel that now. I feel it and I understand.

 

Categories
Investing Real Estate Savings Taxes

Top 7 FAQs for Military Real Estate Investing

Top 7 FAQs for Military Real Estate

Understanding Real Estate Investing for Military

There are numerous ways to engage in real estate investing. There’s flipping, commercial offices, wholesaling, investing in notes, and the most popular among military families – residential rentals. Becoming a landlord may be the most popular form of real estate investing for military families by default. With steady incomes and incentives to buy houses heaped on service members, many become homeowners. When you own a house and receive military orders to another city your choices are limited. You either sell it, or you turn it into a rental property. Whether by plan or by fate, becoming a landlord is a solution often chosen.

Real estate investing also has a natural appeal to many military folks. Military families are do-it-yourself, ‘bootstrap’ people. There’s an air of self-determination around real estate investing. A sense that you are more in control of your destiny with real estate than you are with traditional investments.

Initiative and hard work seem like they can be turned into profit with a property on Main Street in a way that can not be realized with securities on Wall Street. Financial professionals describe it as inefficiencies in the real estate market that can be profitably exploited. I believe it is true, although more difficult to master than it seems.

The major obstacle to getting started in real estate investing is typically the initial cost. You can get started in TSP for 1% of your paycheck. With an app like Acorns you can open a brokerage account with your spare change.

To get into real estate investing takes capital, often tens of thousands of dollars of capital. It’s a big commitment. 

Big financial commitments generate questions. Access to VA loans and other programs lowers the barriers to entry into real estate investing, but most military families have at least one member with enough sense to know you don’t spew cash at an idea like becoming a landlord without looking a little before you leap. I am asked about it frequently.

Following is a list of the seven most common questions I am asked by people who are contemplating investing in residential real estate rentals. Each of them probably merits its own article, but I’ll try to give you some useful short answers here. 

Is real estate a good investment?

Let me break this news to you gently; it’s not about the real estate, it’s about you. Money can be made in real estate investing, but the path to it isn’t for everyone. In addition to technical know-how, a successful investor must have the ability to avoid frustration and derailment when people disappoint you. Because in residential rental real estate you have to deal with people, and people disappoint.

Sooner or later you will discover some tenants are vandals, some property managers are lazy idiots, and some contractors are thieves. If you believe the hype I see all over the internet about how easy it is to make money in real estate, you should not invest in real estate.

The successful landlords I know are hustling every day for their profits. The rest are trying to get back to even.

What are the tax benefits of real estate investing?

With respect to being a landlord, OWNING rental properties can have many tax benefits. SELLING rental properties usually has significant (and painful) tax consequences. Landlords are business owners. They own and operate residential real estate for the purposes of collecting rents.

The biggest expenditure in such a business is the cost of the property being let to the tenant(s). As a business owner, you can recover the cost of the buildings on your property by deducting them from your taxes over the lifetime of the building. This cost recovery process is known as ‘depreciation’, and its effects can make a tremendous impact to your bottom line while you own the building. However, if you sell the property you will likely owe the IRS for all the depreciation previously claimed on the building.

In addition to depreciation you can deduct all the ordinary and necessary operating expenses of a business. There are numerous ways to take advantage of this situation, but none of them will turn a bad investment into a good investment.

If you are thinking about getting into real estate investing do so because you want to make money from the investments and then take advantage of the tax benefits to maximize your profits. DO NOT get into real estate investing with the primary motive of reducing your taxes.   

Why don’t financial advisors give real estate investing advice?

First – a few of us do. But, I get it. We are so difficult to find as to be indistinguishable from non-existent. Take heart, our numbers are growing! The primary reason there are so few of us is related to how the financial planning field evolved.

Financial planning, so the story goes, was the love child of a few insurance salesmen and stock brokers trying to do the right thing. All the first generation planners came from one of those two fields. You sold insurance and did financial planning or your sold stocks and did financial planning. Nobody sold real estate and did financial planning. The second generation of financial planners were nearly all “investment managers”. They took a piece of the action (a percentage) of all the assets they could gather and manage. Still no real estate.

The third wave is coming. In this wave we take a more holistic approach to financial planning. Some are even calling it ‘life planning’. Some advisors have observed that in life many people invest in real estate, so we are starting to include it in the plans we build with our clients. We are mostly self-taught, though. For example, the inclusion of real assets in a portfolio is not covered in the CFP (R) curriculum. (I am working to get that changed, btw.) 

Should I form an LLC for my rental property?

Many people believe you must have your houses in an LLC to qualify for certain tax benefits. This is not true. There are no tax benefits to placing your rental properties in an LLC. 

Zero. 

None. 

Your rental property business is a business whether it is within an LLC or not. Your ability to deduct business expenses is not impacted by forming an LLC.

There may be legal considerations for forming an LLC in terms of limiting your liability. That is a question for a lawyer. I am licensed to give tax advice. I am not licensed to give legal advice. 

When is the best time to sell my rental property?

In terms of tax strategy – never. As I wrote above, OWNING rental properties can have significant tax benefits. SELLING rental properties frequently turns those significant benefits into significant burdens.

In many cases the most efficient tax strategy for rental properties is probate. When you die owning depreciated property your heirs inherit it with a cost basis reset to current market value. The tax burden is transferred to the government and is no longer a problem for you or your family. 

If you absolutely must get rid of the property, then the second-best time to sell is likely today. The tax burden on the property is most likely going to grow over time, so getting rid of it now is like ripping off the band-aid. Just get it over with.

That said, every case is different. You should have a tax professional knowledgeable in real estate issues evaluate your situation before you act. 

How does the ten-year extension for military people work?

Home sellers can exclude a significant amount of capital gain (frequently all the capital gain) from the sale of their primary residence as long as they meet certain guidelines. The short version of how to qualify for that exclusion is called the ‘2-in-5’ rule. You must live in the house for 2 of the 5 years immediately prior to the sale. There are additional rules, but those are the basics. That means you could move out of your house and turn it into a rental property for up to 3 years, then sell it, and still qualify for the exclusion from capital gains. (Because in the 5 years immediately preceding the sale you lived in the house for at least 2 of them.) 

Military families receive up to an additional 10 years to this ‘2-in-5’ rule if they were moved more than 50 miles from the residence on military orders. This means military families could live in a house for 2 years, take a PCS move to another state, turn the house into a rental property and sell it up to 13 years later AND still qualify for the capital gains exclusion. It’s a pretty nifty benefit!

A related question I frequently get is ‘how long do we have if the military member retires while living at the other duty station?’. The answer is that once the service member retires the extended period stops. Military families receive UP TO 10 years. When you retire your extension stops and you essentially have 3 years from the retirement date to sell the property before you will have to pay capital gains on the sale.

My depreciation is wrong on my prior tax returns, how do I fix it?

The short answer is to hire a professional to do it for you. 

The medium answer is that you can only fix a depreciation issue by amending returns if it was wrong on only one filed return. Once it’s been wrong on two filed tax returns you must submit an application to the IRS to change your method of accounting. This is done on form 3115, and it is a very complicated form. On the last page of the instruction book for form 3115 it estimates that it takes more than 36 hours to learn and prepare form 3115.

Save your time, hire a professional. If you prepared your own tax return and you didn’t get the depreciation right, then it is unlikely you will get form 3115 right.

The outcome of filing the form 3115 depends on how your depreciation was wrong. If you had been under depreciating the property, then you would get an adjustment allowing you to take a one-time additional beneficial depreciation adjustment on your tax return. (You get to claim an additional expense that year.)

If you had been over depreciating the property then you also get to take a depreciation adjustment to your tax return, but you won’t like it as much. The amount of over depreciation gets declared as additional income that year and you must pay tax on it. There are some strategy elements regarding the timing of these adjustments, so you should consult a tax professional knowledgeable in real estate investing before you act.

The Bottom Line

Real estate investing can be financially and emotionally satisfying when done well. At Redeployment Wealth Strategies we have some military families who are profiting nicely with their real estate investments. Unfortunately, we have a larger number of clients who got on that real estate investing highway before they thoroughly researched their situation, and now they’re looking for the off-ramp.

We urge you to carefully consider whether real estate investing is right for you before you make that large capital commitment to participate. Learning the hard way can be very expensive.

As financial advisors, members of the MFAA help people just like you navigate the questions, challenges, and planning opportunities related to investing in real estate. We would love to be of help and have a free consultation.

Find an advisor here!

Categories
Financial Planning Investing Savings Taxes

Do Military Families Really Need a Financial Planner?

military families financial advisor

Do Military Families Really Need a Financial Planner?

I am frequently asked some form of this question, and my short answer is, “Yes, military families need a financial planner.” You may think I believe military families need a financial planner because I am a financial planner. And while I would never turn away a new prospective client, my reasoning might be even sneakier than you think!

Every military family needs someone to do the things a financial planner does. These include, but aren’t limited to:

  1. Develop specific and measurable financial goals consistent with their values
  2. Develop saving, spending, investing, and tax strategies to efficiently meet those goals.
  3. Develop risk mitigation strategies for the unexpected: 1) Insurance against loss of income;  2) Insurance against catastrophic loss;  3) Contingencies to reach plan goals even if the planner isn’t there to see it
  4. Accountability to execute the steps of the plan
  5. Establish efficient asset transfer when the plan has ended
  6. Periodic review and update the plan as life happens

It is not always necessary to outsource those duties to a professional financial planner. The person performing those tasks can be a family member. There is an endless supply of free information about financial planning on the internet. Much of it is good enough to help individuals do a creditable job managing their family’s financial plan. If you do it yourself, the price is right, there are no issues of trust, and (you don’t need to tell me) financial planning can be fun!

Therefore, my sneaky response that every military family needs a financial planner is just me having a bit of word fun.

You need a financial planner. You just don’t need to hire one if you’re willing to do the work yourself. However, even if you’re willing to be your own financial planner, you might still want to hire one. Here are a few reasons why.

You Prefer to Pay for the Service

I know how to change the oil in my truck. I can change the oil in my truck for less than it costs me to pay someone else to do it. When I was a young sailor, I used to get under my vehicles every 5,000 miles and change the oil and the filter. I’m 55 now, and I’m not crawling under that truck ever again. There are hundreds of things I’d rather do.

Likewise, you can be your own financial planner. You can read and study on personal finances to stay abreast of the trends, opportunities, and ever-changing tax laws. You can burn a Saturday or two each year reviewing your overall financial situation and making some tweaks to your plan to keep it on track. Or, you can hire someone else to do it and go and do hundreds of things you’d rather do.

Professional Financial Advisors have Greater Objectivity about Your Money

There used to be a fellow on public radio named Garrison Keillor. He told humorous stories about his hometown where “all the women are strong, all the men are good looking, and all the children are above average.” The joke is that only the people from that town believe in their superiority – and they believe it because their emotional attachment to their town causes them to lose their objectivity.

The same is true for people and their money. Money evokes strong emotions in people. (Not having money evokes even stronger emotions!) I’ve too often seen successful, well-adjusted people make emotionally-fueled decisions when the markets are gyrating like they were when the pandemic first hit. It can be helpful to have a professional advisor take a more objective view of your finances when the ride gets bumpy.

There’s Something to Be Said for Experience

Have you ever been the licensed passenger with a teen and a new permit? That’s some white-knuckle fun! They kinda know what they are doing, but they don’t know what they don’t know. They haven’t seen things like the car beside them changing lanes without signaling, or an emergency vehicle trying to make a left in front of them, or a gaggle of bicyclists blowing through stop signs. You have seen things like this; hence, the white knuckles!

If you are your own financial planner, then you are a bit like that teenager. You may have studied diligently and learned many things, but you don’t know what you don’t know. You may have studied for many hours, but you’ve only ever seen one financial plan – yours! Professional financial planners have seen hundreds of financial plans. They’ve seen rental homes, student loans, SBP, and tax law changes. They’ve dealt with the things you’re dealing with, and that experience can be useful.

Financial Advisors can Provide Continuity

“Jim” was adept at personal finance. After his military career, he worked in management for a Fortune 500 company. He amassed a portfolio of stock and real estate worth more than $2 million. My very first client was his widow. I was volunteering at a free financial clinic. She was literally the first person I ever tried to advise. She came to the financial clinic because she wanted to learn how to handle money. Jim had always taken care of it when they were married, and she had no clue what to do. When I first met her she was inhabiting only the upstairs of her house because the downstairs zone heater was broken and she didn’t know how to get the money to have it repaired. She was working in the lunchroom of the public school to have money to pay for her daughter’s tuition. She had $2 million, but she was living like a pauper because she was scared to death to access the assets for fear she would screw up something.

I envisioned Jim looking down from Heaven with his face in his palm. There was no way this is what he intended. If they had worked with a financial advisor while Jim was still alive, they could have had a plan to deal with him unexpectedly passing. A plan that kept the heat on and the tuition money flowing without his widow slinging hash in the school lunchroom. A plan that provided simple peace of mind.

Military families do need a financial planner, and the first step in that plan is who will orchestrate it. An individual family member can take on the responsibility of making sure all the required elements of the financial plan are accomplished, but a military family may want to hire a professional financial planner. If they do, we hope they first consider a member of the Military Financial Advisors Association. We believe the education, experience, and fiduciary standards we require of our members are exactly what military families deserve.

Contact one of our advisors to learn more with a free consultation

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Investing TSP

TSP Lifecycle Fund Changes

TSP Life Cycle Funds

What’s the Deal with TSP L Funds and their new updates?

Unicycles, bicycles, lifecycles – The Thrift Savings Plan (TSP) Lifecycle (L) Funds are evolving again. Beginning on July 1, 2020 the L Funds are going through some changes. Here’s the lowdown on what the L Funds are, how they are changing, and a bonus benefit you might not have considered.

TSP has core funds and lifecycle funds you can invest in. The five core funds are:

  1. Government Securities Investment (G) Fund – invests in short-term U.S. Treasury bonds.
  2. Fixed Income Index Investment (F) Fund invests in government, corporate, and mortgage-backed U.S. bonds.
  3. Common Stock Index (C) Fund – invests in large companies that trade on U.S. Stock Exchanges.
  4. The Small Capitalization Stock Index Investment (S) Fund is invested in small to medium-sized US companies not included in the C Fund.
  5. International Stock Index Investment (I) Fund invests in international stocks of more than 20 developed countries.

Each of the TSP L Funds, sometimes called target date funds, are designed to meet your needs based on when you plan to tap your TSP retirement savings. If you plan to start spending your TSP savings starting in 2030, the L 2030 Fund is designed for you. You can choose whichever L Fund that matches your situation. New servicemembers in the Blended Retirement System that do not make a choice will automatically be put in an L Fund based on their age.

When choosing an L Fund year, pick a fund target date that matches the year you plan to start spending your TSP savings. This will most likely NOT be the year you could retire from the military. In most cases, if you draw from TSP before age 59 ½ you will pay a 10% penalty. Very few servicemembers will be allowed to serve long enough to retire after that age. Your fund target date maybe the year you plan to finish second career or when you become eligible for Social Security in your mid-sixties.

Each L Fund is made up of the five core TSP Funds—G, F, C, S, and I—in different proportions. The L Funds are target date funds, meaning the proportions of the core funds in each L Fund automatically adjust (also called a “glidepath”) as you get closer to the year you plan to retire (your target date). The L Funds are set up based on the idea that when your retirement is far in the future, you can take more risk (market ups and downs), while seeking greater reward (higher growth in value). You have time to recover from any market downturns before you’ll need your money. When your target date is close, you may want to be more conservative (lower risk, lower rewards) with your investments.

To make the gradual adjustment from riskier to more conservative investments on your own, you can regularly shift some of the money in your TSP account from the more aggressive C, S, and I Funds to the more conservative G and F Funds as you approach retirement. The beauty of the L Funds is that TSP does all that work for you, it’s “fire and forget”.

What is changing?

More choices! TSP is introducing six new L Funds to the lineup.

Right now there are four L Funds in ten-year increments – L 2020, L 2030, L 2040, L 2050 and the L Income Fund. When a target year arrives, it is rolled into the L Income Fund, the most conservative L Fund designed for your retirement years. So, July 1, 2020, the L 2020 is being retired. On that date TSP is also adding five new funds: L 2025, L 2035, L 2045, L 2055, L 2060, and L 2065. The five-year intervals give you more options to more closely match your investment time line. Also, the new L 2055, L 2060, and L 2065 are designed for our youngest servicemembers with long saving horizons.

TSP Life Cycle Funds

As you can see in this chart, L 2065, L 2060, L 2055 will be invested 99% in higher risk/higher reward stocks (C,S,I Funds) and just 1% in less risky/lower reward bonds (G and F Funds). L Funds with sooner target dates have less risk. The L 2025 Fund will be invested in 50% stocks (C,S,I Funds) and 50% bonds (G and F Funds). Each month, TSP adjusts the proportions of each L Fund to gradually become less risky as the target date approaches. For example, the investment proportions of the L 2050 Fund will gradually change over time so that in 20 years it will look like the L 2030 Fund in the chart above.

More aggressive. In the past, the TSP L Funds were sometime criticized for being too conservative compared with outside target date funds and didn’t consider service members may also get a pension. In response, beginning July 1, 2020 all the TSP L Funds proportions will gradually change to invest a bit more in stocks (C, S, I Funds) and a bit less in bonds (G and F Funds). The percentage of stocks in the L Income Fund will gradually rise from 20% to 30% over a 10-year period. For the funds in between L 2055 and L Income, the stock allocations will not increase on July 1, 2020, but they will be frozen until they eventually come in line with the glide path planned for the newest L Funds.

More international. Starting April of this year, all the L Funds now have a slightly higher allocation of international stocks (I Fund) than they used to. One planned change to include stocks from less developed (emerging market) countries in the TSP I Fund had been put on hold. Watch for more news on that later this year.

Bonus L Fund Benefits

Hands-off rebalancing. Another great feature of the L Funds is that by design they are constantly taking advantage of changes in the market to buy low and sell high. As we’ve already seen, each L Fund has a certain target proportion of the five core TSP Funds. As markets go up and down, the value of each core fund changes. For example, this year when markets initially reacted to the Coronavirus, the C, S, I Funds’ values dropped significantly, while the G and F Funds held pretty steady. In order for the L Funds to maintain their target proportions, the L Funds had to sell some G and F Fund bonds to buy the now lower priced C, S, I Fund stocks.

A few months later, when the markets went back up, they sold back some of the C, S, I Fund stocks at a profit and put that money back into G and F Fund bonds. This is known as “rebalancing”. The TSP L Funds make these buy and sell adjustments every day. Over time this maintains the funds target riskiness (proportions of the core funds), while earning a higher return than if they had just bought once and held those investments. If you own just the core TSP Funds, you can log into TSP and do your own rebalancing. But you can only rebalance among all the funds two times a month. The L Funds do this for you every day, hands off.

Overall, TSP L Funds are a great choice for anyone who just wants to choose a plan once and let the TSP experts do all the work. Decide what year you think you will begin spending your retirement savings and choose an L Fund closest to that year. If your plans change or you decide you want to be more hand-on, you can log on and make changes to your TSP anytime.

Do you have questions or wonder how best to optimize your TSP? Contact one of our advisors to maximize your retirement savings!

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Investing TSP

Military Thrift Savings Plan Essentials

thrift savings plan essentials

Understanding the military thrift savings plan essentials

The Thrift Savings Plan (TSP) is the government long-term retirement savings and investment plan, similar to a civilian 401(k). Together TSP, Social Security, and military pension make up the three pillars of the military retirement system. Service members can make voluntary contributions to TSP through automatic payroll deductions. If you are in the Blended Retirement System (BRS), you will receive contributions paid by the military into your TSP account as well. These contributions are invested for you and are intended (but not guaranteed) to grow over time and provide you with income in retirement.

Contribute

Service Contributions – BRS members (only) receive an automatic contribution by the military to their TSP account every month equal to 1% of your basic pay, regardless of whether you make any contributions yourself or not. This money becomes yours (vested) after two years in the service.

Payroll deduction – BRS members who began or rejoined service on January 1, 2018 or later are automatically enrolled in TSP. 3% of your basic pay is automatically deducted from your paycheck every month and deposited in your TSP account. You can change your contribution if you want. Everyone else must proactively elect their own TSP contributions. For 2020 you can contribute up to $19,500 to your TSP. Service members age 50 or older can make an additional $6,500 Catch Up contribution each year.

Service Matches – BRS members (only) also receive matching contributions (additions to your TSP account) on the first 5% of the pay you contribute each month.

TSP Essentials Tip – Steady Wins the Prize. Matching contributions for BSR members are made month-to-month. If you elect to make large payroll contributions int the beginning of the year and hit the annual limit early, you could lose out on matching contributions later in the year. Consider spreading your payroll contributions out evenly to the end of the year to get all your due.

TSP Essentials Tip – Don’t Leave Money on the Table. BRS members should consider increasing your contributions to at least 5% so you get the full-service match.

Pay Taxes – Or Not

There are two kinds of TSP accounts, Traditional and ROTH. Services will make the automatic and matching contributions for BSR members to their Traditional TSP account. You can choose to make your contributions to a Traditional or ROTH TSP account. The main difference between the two is how they are taxed.

Traditional TSP -Traditional TSP contributions that you make reduce your taxable income, so the amount of taxes that come out of your paycheck now are less. When you withdraw money from TSP, usually in retirement, the entire amount (contributions and investment earnings) is taxable as regular income. For many people their tax rate in retirement will be less than when they’re working and they would pay less taxes overall with a Traditional TSP.

ROTH TSP – With ROTH TSP you pay taxes now on your contributions just like regular income. But when you withdraw money from your ROTH TSP it is completely tax-free (including earnings) as long as it’s withdrawn at least five years after your initial Roth contribution and you are at least 59 1/2 years old, permanently disabled, or deceased.

Tax-exempt contributions – Contributions you make to Traditional TSP while earning tax-exempt pay in a combat zone are not taxed when you make the contribution or when you withdraw it. However, the earnings that grow in your Traditional TSP will be taxed as normal income when you withdraw it. For contributions you may make to a ROTH TSP with tax-exempt pay, the contributions AND the earnings are completely tax-free as long as you meet the withdrawal requirements in the ROTH TSP paragraph. Servicemembers 50 and older can make catch-up contributions with tax-exempt pay only to a ROTH TSP. Catch-up contributions to a Traditional TSP cannot be made with tax-exempt pay.

TSP Essentials Tip – Pay Now, Pay Less. Service members with lower income, such as early in your career, should consider making ROTH TSP contributions. If your tax bracket is lower now than when you retire, you will pay less tax in total with the ROTH.

TSP Essentials Tip – Pay No Tax. You should consider making your TSP contributions to ROTH TSP while you’re deployed to a combat zone. As long as you meet the ROTH withdrawal requirements (59 ½ and 5 years), both the contributions you make to ROTH TSP with tax-exempt pay and the earnings that grow over the years are not taxed. Ever.

Invest Two Ways

TSP offers you two ways to invest your money. The first way is with “Lifecycle” L Funds. These funds are a professionally designed mix of stocks, bonds, and government securities. You select your L Fund based on your “target date,” the year in the future that you plan to start withdrawing your money. Depending upon your plans, this may be as soon as you leave the service or further in the future. The second way is to invest in individual TSP funds. This way you make your own decisions about your investment mix by choosing from any or all of the individual TSP investment funds (G, F, C, S, and I Funds).

When you start TSP contributions, you designate which TSP Funds you want your contribution to go to. If you are a BRS member and do not make a selection, all contributions TSP receives for you will go into an L Fund appropriate for your age.

L Funds – Your target year is when you will expect to start withdrawing money from TSP. For example, the TSP Fund L 2040 has a target year of 2040 and is designed for those who will begin withdrawals in years 2035 through 2044. L Funds assume that if you who won’t need your money for quite a long time, you are able to tolerate more risk (ups and downs) while seeking an overall higher return (increase in value).

The L Funds invest in mix of individual TSP investment Funds (G, F, C, S, and I Funds) and automatically adjust the mix to reduce risk (and returns) as you get closer to your target year. If the target year is a long time from now, that L Fund will be more exposed to risky assets, such as stocks in the C, S, and I Funds. The L Income Fund is designed for those who are already withdrawing from TSP and offers lower risk and lower growth. As the value of stocks and bonds go up and down, each of the L Funds is automatically rebalanced to restore its intended investment mix. In practice this rebalancing forces the L Funds to “buy low and sell high” for you each business day, boosting your return and while maintaining the same level of risk.

TSP Essentials Tip – Rebalance. For those of you in L Funds your set, TSP rebalances for you. If you choose to invest in the individual TSP Funds, you can rebalance among any of the TSP funds yourself up to 2 times a month. Determine what target percentage of each fund you want to maintain, then periodically log into TSP and do an inter-fund transfer by typing in your target percentages.

Individual Funds – TSP has five individual funds you can invest your TSP dollars in. The Government Securities Investment (G) Fund is invested in short-term U.S. Treasury securities. This is the only fund that guarantees you will not lose money. Your contributions (principal) and interest are guaranteed by the U.S. Government. The trade-off is the growth in value will be quite low and might not keep up with inflation.

Each of the other four individual funds (F, C, S, and I Funds) are invested to track separate market indexes. For example, the Common Stock Index (C) Fund seeks to invest in the same stocks as the Standard & Poors (S&P 500) Stock Index. This index includes 500 large companies that trade on U.S. Stock Exchanges. One dollar you invest in the C Fund buys you a tiny portion of each of those large companies. This helps reduce (but not eliminate) your overall risk by diversification, that is “putting your eggs” in many, many baskets.

The Small Capitalization Stock Index Investment (S) Fund is invested in small to medium-sized US companies not included in the C Fund, and tracks the Dow Jones U.S. Completion Total Stock Market (TSM) Index. The International Stock Index Investment (I) Fund invests in international stocks of more than 20 developed countries and tracks the MSCI EAFE (Europe, Australasia, Far East) Index. The Fixed Income Index Investment (F) Fund invests in a government, corporate, and mortgage-backed bonds U.S. Bonds and tracks the Bloomberg Barclays U.S. Aggregate Bond Index.

TSP Essentials Tip – All L Fund or None. The L Funds are already made up of the five individual TSP funds (G, F, C, S, and I Funds), so you will duplicate your investments if you invest in an L Fund and the individual TSP funds at the same time. Consider choosing only an L Fund for simplicity and hands-off investing, or build and mange your own custom portfolio from among the other G, F, C, S, and I Funds.

TSP Essentials Tip – Early Bird Gets the Worm. Making and maintaining investment choices can seem intimidating. Don’t let that keep you from getting started. You can start now with an L Fund, let the pros work it for you, and start watching your nest egg grow. As your knowledge and confidence grows, you can always make changes and take more control if you want to.

Withdrawals

Retirement – TSP is a qualified retirement plan designed for long-term saving for retirement. You will be able to make retirement withdrawals from TSP once you reach age 59 ½. Generally, if you withdraw money before that time, you will be hit with a 10% penalty, in addition to any taxes due. When you are eligible, you will be offered a choice of regular “installment” payments from your balance, a single lump-sum payment, or purchasing an annuity that guarantees a set monthly benefit for life to you (or your survivor).

In-service – There are two types of withdrawals you can make while you are still in the service, financial hardship and age based “59 ½”. You can make a financial hardship withdrawal if you
can certify you have a financial hardship as a result of a recurring negative cashflow, legal expenses for separation or divorce, medical expenses, or a personal casualty loss. You can only withdraw contributions you made and earnings on those contributions. You can request $1,000 or more; but, the amount cannot exceed the actual amount of your certified financial hardship.
You can make age-based in-service withdrawals any time after you reach age 59½. You can withdraw it all, or part of your account balance up to four times per calendar year.

TSP Essentials Tip – Don’t Eat Your Seed Corn. Early TSP withdrawals can have steep penalties and taxes due. Even penalty-free withdrawals permanently deplete your retirement savings and any future earnings those saving would have made. Consider building an emergency fund and separate accounts for short-term savings that you can tap when you need it. Then your retirement savings will still be there when you need it.

Loans – You can borrow up to $50,000 of your contributions from your TSP account while you are still in the service. There is a $50 processing fee and most loans must be paid back with interest within 5 years. You can get up to 15 years to pay back a loan for a primary residence. If you don’t pay your TSP loan back on time, there will be a 10% withdrawal penalty and the IRS will charge you income tax.

End Note

It’s never too early to start saving for retirement. The key to growing a mighty oak from a seed? Time. Even small amounts put away now will have a major impact on your financial future. Start by tracking your income and expenses, making a spending/saving plan (budget), and then carving out some TSP contributions to seed your future.

One “Final” TSP Essentials Tip – Name a Beneficiary. A beneficiary is the person (or people) that will receive your TSP funds when you die. If you have not designated someone as your beneficiary for your TSP, government law determines who gets it. You can designate the beneficiary you want with TSP, just be sure to update it with life changes like a marriage or divorce.

For more information on TSP, go to www.tsp.gov

Do you have questions or wonder how best to optimize your TSP? Contact one of our advisors to maximize your retirement savings!

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