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Investing Blog Roundup: Suing for Lower 401(k) Costs

After last year’s ruling by the Supreme Court in Tibble vs. Edison International, lawsuits have been brought against several large 401(k) plans, alleging that the plan fiduciaries have not done a good enough job of selecting the lowest-cost share classes available.

As Morningstar’s John Rekenthaler wrote in a recent article, participants in Anthem’s 401(k) plan have brought an especially ambitious suit, alleging that the plan’s funds are more expensive than they need be, despite the fact that they are mostly relatively low-cost Vanguard funds. It will be interesting to see how such cases play out in the next few years — and whether or not they bring any significant changes to the industry.

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Is Tax Planning a Good Reason to Delay Social Security?

A reader writes in, asking:

“I have a Social Security strategy that I have not read of or heard about. I am interested in your feedback. Given the size of my tax-deferred accounts, when I am 70 1/2, RMDs will make it such that I will pay tax on the maximum 85% of my Social Security benefits regardless of when I start benefits. I am considering taking benefits at age 62, so I can pay no taxes on the benefits for 8 years, then pay the full tax on the benefits at age 70 1/2 and beyond.”

Unfortunately, tax planning with regard to Social Security is a very case-by-case sort of thing.

Also unfortunately, a comprehensive analysis tends to be very time-consuming. In my opinion, the only way to do it appropriately is to use actual tax planning/preparation software and run through several years of simulations using Strategy A and several years using Strategy B, then compare the results (often in a spreadsheet). When I see people trying to do a DIY spreadsheet-only analyses rather than using tax software, they often end up leaving out something important (e.g., a credit for which they’re eligible in one case, but not in the other — or a tax to which they’re subject in one case but not in the other).

As such, I am convinced that this is one of the areas in which working with a financial planner can be most worthwhile.

With the above caveats, I would say that tax planning tends to be a point in favor of delaying Social Security, for two reasons.

First, each dollar of Social Security income is, at most, 85% taxable. So if a person has the option to, for example, spend down their IRA to delay Social Security and the net result is $100,000 less of IRA distributions over their lifetime but $100,000 more of Social Security benefits, that ends up being a “win” from an after-tax perspective.

Second, increasing the portion of one’s income that is made up of Social Security often results in a smaller portion of Social Security being taxable (because only 50% of benefits are included in the “combined income” figure that determines Social Security taxability).

That is, for many people, delaying Social Security results in:

  1. a larger portion of their lifetime income being made up of tax-advantaged dollars of Social Security and
  2. a smaller portion of those Social Security dollars being taxable.

But the above points don’t always apply. For instance, for the reader who wrote in with the question, it appears that even if he delays benefits and spends down tax-deferred accounts in the meantime, 85% of his benefits will still be taxable.

And there are other factors involved as well. Ultimately, the best claiming strategy often depends on whether there are other tax breaks you’re looking to qualify for or other taxes you’re looking to avoid. For instance, for a person who retires prior to age 65 and who will be buying health insurance on the exchange, keeping “household income” very low until Medicare eligibility kicks in may be very desirable, as Affordable Care Act subsidies can be quite large. And that typically means delaying Social Security (at least until 65) while spending primarily from taxable accounts and Roth accounts.

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Investing Blog Roundup: Picking Funds with High “Active Share”

Over the last few years, one strategy that has been proposed for finding actively managed funds that are likely to outperform index funds has been to find funds with a high “active share” — that is, funds that have holdings very different from the index to which their performance is compared. A recent bit of research from Vanguard suggests exactly what you might expect: Yes, picking funds with a high active share results in a greater chance of finding one that outperforms, but it also increases the likelihood of selecting funds that significantly underperform.

Of note, the Vanguard research only looks at a relatively brief period of time, so more work is needed. But it’s a start in the right direction.

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Can I Take a Loan from my IRA?

A reader writes in, asking:

“A friend recently told me that he took a loan from his IRA so he could take money out for a short time without having to pay penalty. I had never heard of that, so I called Vanguard and asked about it. They said that only 401k accounts have loans, not IRAs. Is that true? Was my friend wrong?”

The Vanguard representative is correct that IRA accounts do not have loan provisions, whereas many 401(k) plans do have such an option. (For more on 401(k) loans, see this MarketWatch article from Elizabeth O’Brien.)

Perhaps your friend was talking about the ability to “borrow” from an IRA by using the 60-day rollover provision.

To back up a step, there are two ways to move money from one IRA to another:

  1. Via a direct “trustee-to-trustee transfer,” in which you never have possession of the money, as it goes directly from one financial institution to the other, and
  2. Via a “60-day rollover.”

With a 60-day rollover, the first financial institution sends the money to you, and as long as you deposit an equal amount of money into an IRA within 60 days from the day you receive the distribution, it will be treated as if the distribution did not occur.

The 60-day rollover option exists so that you can move money from one retirement account provider to another. But it can also be used as a sort of short-term “IRA loan” mechanism, because it’s possible to simply deposit the appropriate amount of money back into the same account (rather than into an IRA with a different financial institution).

There is, however, one very important point to be aware of: You can only do one such 60-day rollover per year. So if you have executed such a rollover within the last year, you cannot “borrow” from your IRA in this manner, because you would not be able to put the money back into an IRA. (That is, the distribution would simply count as a normal distribution, potentially subject to the 10% penalty.) Similarly, if you do “borrow” from your IRA in this manner, you won’t be able to do so again within the next year, nor would you be able to do a normal 60-day IRA-to-IRA rollover during that period.

Of note, the one-per-year limit does not apply to:

  • Roth conversions (i.e., rollovers from a traditional IRA to a Roth IRA),
  • Direct trustee-to-trustee transfers, or
  • Rollovers involving an employer-sponsored plan (e.g., from a 401(k) to an IRA or vice versa).

Also, the one-per-year limit is no longer one rollover per IRA per year as it used to be, but rather one rollover per year regardless of how many IRAs you have.

Investing Blog Roundup: Things to Do When the Stock Market Drops

The past week hasn’t been a good one for the stock market, with declines in both domestic and international “total market” indexes. Author and financial planner Roger Wohlner provides us with a few good reminders this week about how to deal with a stock market decline.

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Tax Changes: Protecting Americans from Tax Hikes Act of 2015

Late last month, Congress passed (and President Obama signed) the Protecting Americans from Tax Hikes Act of 2015. The Act makes quite a lot of changes (click the previous link to see the full list), but from a personal finance standpoint, the most important thing it did was to make permanent several tax breaks that were expiring in the near future (or already expired in some cases).

Expired Provisions Brought Back

With regard to investing, likely the most important change is that the ability to make “qualified charitable distributions” from an IRA is now permanent. (It had previously expired at the end of 2014.)

With a qualified charitable distribution, a taxpayer over age 70.5 has his/her RMD for the year distributed directly to a qualified charitable organization, and the distribution satisfies the annual RMD requirement while being excluded from gross income. The benefit is that this is an exclusion from gross income rather than an itemized deduction (which is what you would ordinarily get for a charitable donation). This is relevant because it means that:

  • This income will not be included in your adjusted gross income (which plays a role in determining many things such as how much of your Social Security benefits will be taxable and whether you qualify for numerous credits/deductions), and
  • You can take advantage of this tax break even if you use the standard deduction.

Another tax break that had expired in 2014 but which is now brought back and made permanent is the ability to elect a deduction for state and local sales taxes instead of state and local income taxes. (This is of course particularly helpful for people who live in states with no income tax.)

Finally, the increased exclusion for employer-provided mass transit benefits is now made permanent. (Prior to the passing of this Act, the monthly limitation would have reverted to a $130 limit beginning in 2015. With the passing of the Act, it will be $250 for 2015 and $255 for 2016.)

Scheduled-to-Expire Provisions Made Permanent

Another important change is that the American Opportunity Credit is also made permanent. (It was previously scheduled to expire at the end of 2017.) The American Opportunity Credit is a credit of up to $2,500 per year for paying qualified higher education expenses for yourself, your spouse, or your dependent.

Similarly, the “enhanced” version of the child tax credit (which is simply a change to the calculation of the child tax credit that increases the amount of credit many taxpayers receive) is now made permanent rather than expiring at the end of 2017.

Likewise, the “enhanced” version of the earned income credit (which increases the amount of the earned income credit for married taxpayers and taxpayers with 3 or more children) is now made permanent rather than expiring at the end of 2017.

Changes to 529 Plans

The Act also makes two important changes to 529 accounts.

First, the definition of “qualified higher education expenses” for 529 accounts has been expanded to include the cost of computers, related equipment, software, and internet access if such equipment is to be used primarily by the beneficiary during any of the years the beneficiary is enrolled at an eligible educational institution.

Second, for 529 ABLE accounts (for disabled individuals), the residency requirement has been eliminated. Previously, a beneficiary was required to use the plan established by his/her state of residence.

Again, to be clear, these are just a few of the provisions which I am assuming are most likely to be relevant to a large number of readers. There are many provisions in the Act that I have not mentioned. If you’re interested in perusing the full list, see here.

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Book6FrontCoverTiltedBlue

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

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