Roth Conversion of a TSP Account: A Case Study

I’ve written several articles about Roth conversions, particularly tax planning considerations & marginal tax rate impacts.  This article serves as a case study to help visualize how a Roth conversion strategy could work, and how the tax liability can fluctuate based upon the timing of Roth conversions.   There are many variables that affect tax liability for Roth conversions, including:

  • Time horizon: The more time you have before required minimum distributions (RMDs) begin, the more years you can spread conversions.  This can allow you to maximize conversions during years with low taxable income & lower conversions during years of high taxable income
  • Amount to be converted
  • Total taxable income: The lower your taxable income, the more you can take advantage of conversions at the lowest tax brackets.  Additionally, the lower your income is WITHIN your current bracket, the more you can convert without spilling over into a higher bracket
  • Investment returns on the traditional account: The higher your investment returns, the more you will have to convert.  For example, if you start with $500,000, you not only have to account for that amount, but for the future gains in that account.
  • We’re also disregarding the Medicare Tax on Investment Income, which is 3.8% of income over $250K.

In this article, we’ll use a fictional example of a military family looking to do a Roth conversion from their traditional TSP account to an IRA as they transition to post-military life.  However, we won’t focus on the WHY.  Instead, we will solely focus on three ways they could do so, and which manner presents the lowest overall tax liability–the HOW.

In real life, the comparison of current and anticipated future tax brackets plays a very important role in the Roth conversion decision.  As a result, the decision on whether to perform a Roth conversion depends on a variety of factors that we won’t discuss here.  However, if you’re looking for a financial planning ‘rule of thumb,’ the below picture represents a close estimate from one of the financial planning profession’s thought leaders, Michael Kitces.

Roth conversion 'buckets,' as conceptualized by industry thought leader, Michael Kitces.

As you can see, there appears to be an inflection point at the 28% tax bracket.  In the 10%, 15%, and 25% brackets, it appears that Roth conversions may be warranted.  In the 33%, 35%, and 39.6% brackets, it seems that Roth conversions should be avoided.  However, without context on what post-retirement tax bracket you’ll be in, it’s hard to make this an absolute rule.

Disclaimer

There are a lot of complexities involved in tax planning.  To avoid getting off-topic, I will make a lot of tax planning assumptions in this article.  Additionally, I will round numbers (such as salary or pension amounts) where possible.  As a result, this situation will seem overly simplistic.

I will do my best to account for these variables, but there may be something that I omit.  Accordingly, this article should be read for educational purposes, not instructional purposes.

Tax planning in real life is much messier than in this example, and is not a static process.  Proper tax planning should incorporate a tailored approach for each individual situation, and should be reviewed periodically.  While it’s possible to do so yourself, you may find the need to work with a tax professional or fee-only financial planner.

Final disclaimer:  This article was written to be a work-in-progress.  The intended point is to highlight the benefits of converting to a Roth account at the lowest possible tax-rate.  However, I’ve enclosed the a copy of the Roth Conversion spreadsheet that I used to come up with the information below.  If you have any suggested edits, comments, critiques, or concerns, PLEASE post a comment below, or email me.  This is not a perfect document, and I expect that it will only improve if you help me identify mistakes so I can correct them.  I will do my best to update this article as quickly as possible.

Introduction

Let’s welcome the Smiths.  The Smiths are retiring from the military and expect to settle down in their home of record.  John is retiring as an O-5, and expects his pension to be around $40,000 per year.  They also expect their pension to increase at the same rate of inflation.  For planning purposes, they’re using 3.77%, which is the historical average post-WWII inflation rate.   In their home of record (with no state income tax), they expect John’s new salary to start at $50,000 per year, with average salary increases of 2% per year.  The Smiths have saved $500,000 in their traditional TSP account, and would like to convert to a Roth before retirement to avoid RMDs.  They plan to do their TSP conversions to an IRA.  They don’t know if they will be in a higher tax bracket in retirement, but they would rather pay their taxes now so they can live worry-free later on.  The Smiths just turned 45, so they have about 25 years before RMDs become a concern, and are trying to figure out how to convert their account in a way that gives them the largest after-tax Roth balance at age 70.

We will compare several scenarios, which dictate the top marginal tax rate at which the Smiths are willing to do a Roth conversion:

Scenario 1:  Immediate conversion.  This means that the Smiths will immediately convert to a Roth IRA.  Due to their income & conversion amount, this will push them into the top tax bracket, 39.6%.  In addition, they’ll incur the Medicare tax on investment income over $250,000, which is not calculated here.

Scenario 2:  25% rate.  This means that the Smiths will convert as much as possible up to the 25% rate each year.  Since they do not want to pay more, they will wait until the following year to convert additional amounts.  In 2017, this amount is $153,100 for a married couple filing jointly.

Scenario 3:  28% rate.  Same as Scenario 2, except the Smiths will convert at the 28% rate as well.  In 2017, this amount is $233,350 for a married couple filing jointly.

Scenario 4:  33% rate.  Same as Scenario 3, except the Smiths will convert at the 33% rate as well.  In 2017, this amount is $416,700 for a married couple filing jointly.

Scenario 5:  35% rate.  Same as Scenario 4, except the Smiths will convert at the 35% rate as well.

Assumptions

Here’s where we’re going to make some assumptions strictly for the purposes of simplifying this scenario.  Doing so is the only way that I can provide supporting documentation (in the form of an enclosed spreadsheet that anyone can use for their purposes).

While some of these assumptions may be true, it’s highly unrealistic to expect most (or any) of these factors to remain the same over a 25-year period.  It’s also unrealistic to attempt to make some projections (future IRS tax brackets, for example), so I’ve kept them constant for this article.

In a true planning situation, these factors would be re-evaluated on a regular basis to account for changes:

  • Income growth. We’re assuming zero change in employment status, other than consistent annual raises.  Also, we assume zero additional income from other sources, like after-tax investments or capital gains (like from an accidental rental).  We’re also assuming a flat, 2% raise in salary.
  • Inflation (COLA raises) remain the same over time. For this scenario, I used 3.77% for annual pension increases.  Although this is the post WWII average inflation rate, this rate has fluctuated, and would change annually.
  • A consistent annualized return on investment. This return is after account management fees.  Investment results depend on a variety of factors, and it is not possible to predict future rates of return.  For projection purposes, financial planners often use an annual rate of return, based upon expected long-term results that are consistent with the investment selection.  In this case study, we’re using 7% as an average long-term return.  This is probably lower than most projected returns.
  • Tax brackets remain the same over time. The IRS typically updates tax brackets annually to account for inflation.  In this case, I’ve kept them the same.

Additionally, it is possible for many servicemembers to use the 10% & 15% tax brackets for tax planning purposes.  In fact, if you’re still on active duty, you should look at taking advantage of these lower tax brackets for Roth conversions.

However, this working document does not include these tax brackets because in most cases, transitioning military personnel (especially those with pensions), will find their taxable income above the 15% bracket.  In this situation, the Smiths’ starting income precludes them from converting at the 10% or 15% rate.  The tax brackets that we will use (for a married couple filing a joint 2017 return) are as follows:

25% $    75,901.00 $  153,100.00
28% $  153,101.00 $  233,350.00
33% $  233,351.00 $  416,700.00
35% $  416,701.00 $  470,700.00

Scenario 1:  Immediate Roth conversion of the entire TSP account.

In this scenario, the Smiths convert 100% of the TSP account to a Roth IRA, without regard to tax liability.  This approach will allow them to avoid RMDs, and will allow them to enjoy their retirement account growth on a tax-free basis.  Additionally, they can withdraw their conversion amounts at any time without penalty, as long as the account has been open for 5 years.  If they’re opening a new Roth account for a rollover & conversion, they would have to wait 5 years to start withdrawals.

In doing this, the Smiths would pay $167,533.30 in taxes to convert the entire $500K amount.  This represents an effective tax rate of 33.51% on the conversion.  If this money were to be left alone and grow at the stated rate (7% annually), it would reach a total of $1,686,393 by age 70.  This money would be tax-free and free of RMDs, so it could continue to grow tax-free infinitely.

Scenario 2:  Roth conversion at no higher than the 25% rate.

Under this scenario, the Smiths will convert a portion of their Roth account every year, but only to the point at which they fill out the 25% tax bracket.  Since their combined income exceeds the 15% tax bracket ($75,900 in 2017), we can assume that all of their conversions will occur in the 25% tax bracket.  For a married couple filing jointly in 2017, the 25% tax bracket ranges from $75,901 to $153,100.  In year 1, their combined $90,000 in income would leave them with $63,100 to convert before they ‘bump up’ to the 28% tax bracket.  In year 2, their combined income increases to $91,800, leaving them with $61,300 to convert.

Should the Smiths consistently apply this approach, they will have completed their TSP conversion by age 57.  However, after year 19, the Smiths’ income will have grown to the point where they can no longer convert at the 25% bracket.  As a result, they will still have a little over $111K remaining in their TSP account.  By age 70, their $111,000 this will have grown to over $167,000.

The Smiths would pay $171,144.77 in taxes for their Roth conversions.  This is more than the total amount converted in Scenario 1.  However, it also includes the conversion of income growth within TSP account.  As a result, the Smiths will have a total of $684,579 over the course of 19 years.  This represents an effective tax rate of 25% on the entire conversion.

Accounting for inflation, the Smiths will have paid a net present value (NPV) of $137,658.60.  In other words, using the inflation figure in the scenario, $137,658.60 represents the current value of the $171,144.77 tax liability paid over 19 years.  Conversely, the $167,533.30 in Scenario was paid in Year 1, so there is no inflation impact.

If allowed to grow over time, the Smiths will have accumulated a little over $1.7 million in their Roth account.  When combined with their TSP account, their combined retirement accounts come to a little over $1.95 million.

While this represents the most accumulated wealth of any scenario, the Smiths will have to deal with RMDs under this scenario (see summary table below).

Scenario 3:  Roth conversion at no higher than the 28% rate.

This scenario resembles Scenario 2, except the Smiths now convert at the 25% and 28% marginal rates.  Since they’re able to convert more of their income each year, they’re able to finish their conversions by Year 4.

Scenario 4:  Roth conversion at no higher than the 33% rate.

This scenario resembles Scenario 3, except the Smiths now convert at the 25%, 28%, and 33% marginal rates.  Since they’re able to convert more of their income each year, they’re able to finish their conversions by Year 2.

Scenario 5:  Roth conversion at no higher than the 35% rate.

This scenario resembles Scenario 3, except the Smiths now convert at the 25%, 28%, 33%, and 35% marginal rates.  Since they’re able to convert more of their income each year, they’re able to finish their conversions by Year 2.  This essentially is no faster than Scenario 4, but a little more expensive, since there is income that’s converted at 35% instead of at 33%.

Side-By-Side Comparison & Observations

Below is a breakdown of the numbers from each scenario.

Maximum Conversion RateTotal Tax LiabilityInflation Adjusted Tax LiabilityAverage Tax RateRoth Account at Age 70TSP Account at Age 70Total AccountsYears
25%$171,144.77$137,658.6025.00%$1,785,068.10$167,019.16$1,952,087.2619
28%$146,937.90$139,350.1026.71%$1,858,855.61$1,858,855.614
33%$152,006.87$147,265.8229.52%$1,787,201.54$1,787,201.542
35%$151,839.47$151,839.4729.71%$1,781,723.38$1,781,723.382
40%$167,533.30$167,533.3033.51%$1,686,393.10$1,686,393.101

Observation 1All scenarios allowed for Roth conversions before RMDs were to begin.  The only limitation was in the 25% scenario, because the Smiths’ income eventually exceeds the 25% tax bracket.  Realistically, this probably would have stretched out a few years longer because the IRS normally adjust tax brackets for inflation.  It’s feasible that when tax bracket adjustments are taken into account, the Smiths could have completely converted before age 70 ½.

In a real-world scenario, it might be worthwhile to evaluate Roth conversions in the context of retirement planning.  Odds are the Smiths could have been in a position to retire in their 60s.  If that’s the case, they could have done much of their conversions in the 15% tax bracket.  Retirement years can be a great opportunity to take advantage of low tax brackets for Roth conversions…just ask Doug Nordman.  He’s been retired since his early forties.

Observation 2:  The Smiths actually paid more in taxes under the 25% scenario than any other scenario.  However, when you account for the tax-deferred growth INSIDE the TSP account, you’re paying taxes on those earnings as well.  In the 25% scenario, the Smiths convert $684,000 from their TSP account, which is over a third more than the original amount.

In real life, the total amount that is converted would depend on the investment performance on the pre-conversion assets over time.

Observation 3:  When adjusted for inflation, the tax liability for the 25% scenario was actually less than any other scenario.  When accounting for the time-value of money, the net present value of Year 18’s tax bill ($2,012.50), actually ended up being roughly half:  $1,072.79.  Even though more taxes are paid over a longer period of time, the value of future taxes goes down in today’s dollars.

The higher the inflation rate, the more important it is to account for inflation in your projections.

Observation 4:  There is a direct correlation between converting at the lower tax bracket & having the most overall wealth.  Although there was less money in the Smiths’ Roth IRA under the 25% scenario than under the 28% scenario or the 33% scenario, that’s because the Smiths were unable to convert the full TSP amount.  In a scenario where the Smiths are able to convert 100% of their TSP into a Roth account (see figure below), converting at the 25% ensures the highest Roth account balance at age 70.

Observation 5:  The more room you have within your tax bracket, the faster you’ll be able to make Roth conversions.  This sounds intuitive, but the more that you’re able to convert within your desired tax bracket, the less you’ll have to convert next year.  Not only will you convert less of your principal, but you’ll convert less of the earnings upon that principal.

Below is a projection using the same figures except that the Smiths start at a lower salary (conveniently at $35,900, which puts them at the 25% tax bracket).  This scenario would have allowed them to convert faster at the 25% bracket than in the original case study, since they had more room within their bracket to do so each year.

Maximum Conversion RateTotal Tax LiabilityInflation Adjusted Tax LiabilityAverage Tax RateRoth Account at Age 70TSP Account at Age 70Total AccountsYears
25%$161,744.95$139,877.3325.00%$1,902,137.61$1,902,137.6110
28%$143,434.96$136,956.5726.37%$1,866,855.00$1,866,855.004
33%$149,402.60$145,098.8229.07%$1,798,377.44$1,798,377.442
35%$149,235.20$149,235.2029.25%$1,792,899.28$1,792,899.282
39.6%$165,474.70$165,474.7033.09%$1,696,835.08$1,696,835.081

Conclusion

While there are many factors that go into Roth conversions, it’s important to recognize the impact that your marginal tax rate can play in the timing of those conversions.  In each of these hypothetical situations, the Smiths had plenty of time in order to implement their Roth conversion strategy.

I hope this article helped conceptualize the concept of spreading Roth conversions over a multi-year period.  However, it should not be considered a substitute for a financial plan that accounts for all the variables in your life.  If you have questions, you should talk with a fee-only financial planner or tax professional in your area.

Posted in Retirement, Taxes | Leave a comment

Why I Became a Financial Planner

As my financial planning practice grows, I’ve noticed that people are asking me how to become a financial planner.  The other day, I answered an email from someone asking how to become a financial planner.  It was at that point that it occurred to me that my “About Me” page doesn’t really explain my journey from the military to becoming a financial planner.

This article is a first step towards outlining my path to becoming a financial planner.

Why I Became a Financial Planner

I’ve made one major career choice throughout my entire adult life.  My first career choice, to join the Navy, was a decision that I made a week after I turned 17.  I went to the recruiter’s office, signed up for the delayed entry program, and that was that.

Deciding to become a financial planner took a little more time.  The story that I tell everyone is the same one that I outlined in a previous article.  However, that’s a succinct way of summarizing a lifetime of decisions, observations, and other factors that helped me to discover that financial planning could be my calling.  The truth is, I could name any number of stories that could have served as the pivot point for my financial planning focus.  Here are a few of those stories.

Camp Lejeune

For example, when I was 18, I finished boot camp and hospital corpsman training, then reported to my first duty station at Naval Hospital Camp Lejeune.  Being a junior corpsman, I was assigned to the barracks.  At the time, you could live in town if you had permission from your chain of command.  A lot of people did send requests (presumably to collect BAQ & VHA, now known as BAH, as well as BAS in lieu of eating at the hospital galley).  A lot of these people also drove cars, which were probably expensive.

Most of this stuff didn’t really interest me.  Also, there were a lot of places designed to separate Marines (and Sailors) from their money.  While some of the bars, adult establishments, and one tattoo parlor did separate me from some of my money, I was able to send money back home, and I set aside money to purchase one $100 EE bond per month.  In the 90s, I was able to clear at least $200 to $300 per paycheck, which was great for me.  All in all, I define that as a successful tour.  No arrests, no mysterious medical issues, no unplanned dependents, and no debt…high standards for a new 21-year old.

Annapolis

I left Camp Lejeune because I wanted the Navy to pay for my college education.  As it turns out they had a college for people who wanted to stay in the Navy…so I went there.  Being a midshipman turned out to be not much different from my last tour at Camp Lejeune, except my pay got cut drastically.  They also had some academic stuff that I had to do as well, but the in-your-face yelling actually got easier.  Instead of career gunnery sergeants, I had upperclassmen who were younger than me yelling.  Got me in some trouble at times, but I was able to get through plebe year.

Four significant things happened to me during my Naval Academy Years:

  1. Once I finished plebe year, I ran into another problem. It turns out that when you’re able to legally drink, but you don’t have a lot of money, you might pick up a credit card or two.  Long story short, I accumulated a modest amount of credit card debt.  I kept in check with summer jobs and the low-interest loan that every midshipman or cadet can receive.
  2. Roth IRAs came into existence. I helped my mother enroll in a Roth IRA, although the bank told her it was a bad idea.  Once my grandmother saw how involved I became with my mother’s affairs, she asked me to help her make sure things were in line.  For my grandmother, whom I always felt was very smart in her financial affairs, to trust me with her finances was a surprise.  However, none of this (and all of this), helped me to formulate my own thoughts about finances.
  3. I walked out of my first (and only) USPA & IRA (now First Command) briefing. I couldn’t put my finger on it at the time, but I thought the guy was full of crap.  20 years later, I haven’t seen much to change my mind.
  4. When I graduated, my grandmother surprised me by handing me all the money she’d saved for my college. It was a huge surprise, and taught me one of the biggest financial planning lessons I’d ever learn.  You can read more in this article about my college education.

Supply Corps School

After graduation, I went to Athens, Georgia, for Supply Corps school training.  I’m not sure why the Navy ever put a school down there, but in the fall, there probably aren’t too many places that are better.  A college town, in the South, with lots of bustling activity.  At this point, I was engaged.  Instead of going out, I just bought a Playstation and stayed in the cheapest apartment that I could find.  That Playstation was probably the best investment I‘ve ever made, since it kept me from getting into trouble.

I also decided to take invest half of the money my grandmother gave me in the stock market.  This was in 1999.  A couple of lessons here:

  • Daytrading in the middle of class because you don’t like what they’re teaching sets you up for failure in two ways.
  • A very bad way to make $5,000 in the stock market is to put $10,000 into it.
  • I learned about dividend reinvestment programs. I found a Home Depot program, put some money into it, then forgot about it.  It ended up being one of the better investments that I’ve made over the past two decades.

My First 5 Years as an Officer

After Supply Corps School, I went through a variety of different commands.  In an effort to spare detail, I’ll summarize the high points here:

  • Got married
  • Saved some deployment money
  • Bought a house
  • Got my MBA (on my own, since I thought I was getting out and didn’t want to take tuition assistance)
  • Got a boring Joint Staff internship and made some money speculating on TSP.
  • Quickly learned that making money in this venture was as a result of luck, not any analysis on my part.
  • Had our first child

USS Cole

My tour on USS Cole was probably the most formative tour that I’ve had.  Professionally, I have not had a more challenging or rewarding tour, before or since.  However, it was my experience in working with Sailors that really opened my eyes to financial planning.  I was now helping Sailors deal with a lot of the problems that I avoided when I was younger.

I’m not sure how I avoided those issues, but it seemed like people were doing one of three things:

  • Trying to keep up with other folks by buying stuff
  • Getting into life-altering situations (unexpected babies, DUIs, etc.)
  • Not paying attention to the money they were spending

While I spent a lot of time working with folks to get out of these situations, it occurred to me that there are plenty of financial counselors who help them with those decisions.  However, when someone like me went to those places, I couldn’t really get ‘next-level’ advice.  Other than maxing out TSP, I couldn’t find a financial counselor who could tell me where to open an IRA, or what securities to buy.  Other than SGLI (which isn’t always enough life insurance), I couldn’t find someone to give a good recommendation.

Simultaneously, I realized that a lot of people who get in trouble, stay in trouble.  I quickly developed a personal guideline:  “I will not care more about someone else’s problem than they do.”  It’s a personal rule that I still hold today.  But I also figured that if someone worked hard, did the right things, and still needed guidance on those ‘next steps,’ then perhaps I could help them.

Even though I was still 10 years from retirement, this was the first time where I this might be a calling for my life after the military.  However, I also knew that 10 years could change a lot, so I just kept it in the back of my mind.  These themes would remain in the back of my mind and became the foundation for my post-military career plan, which I’ll discuss in the next segment.

Conclusion

Are you thinking of helping other people with their finances?  Where do you think you could add value…helping people get out of trouble, or helping them with their ‘next-level’ problems?  Is there a particular interest that you have, like taxes, estate planning, or budgeting?  Feel free to contact me or schedule an appointment to discuss.

Posted in Westchase Financial Planning | Leave a comment

5 Tax Planning Considerations of a Roth Conversion for Your TSP Account

Introduction

Many people have taken advantage of the Roth TSP option since its inception in 2012.  However, there are still many federal employees and service members with most of their retirement savings in traditional accounts.  Naturally, this begs the question: “How do I convert my traditional account to a Roth account?”  This is also known as a Roth conversion.

The more appropriate approach should be to ask two questions:

  • Should I convert my traditional account to a Roth account?
  • If so, how do I do this in the most effective manner?  Effective manner indicates minimal loss of money through fees, taxes, etc.

As with most questions, the correct answer is not straightforward.  Rather, it’s an answer that depends on the person’s (or family’s) particular financial situation, goals, and values. Continue reading

Posted in Retirement, Taxes, Thrift Savings Plan | 1 Comment

TSP Rollover to an IRA Account—Should I do it or Not?

This is a question that I received the other day from someone who has a lot on his plate.  He’s getting his financial life in order and was trying to figure out whether a TSP rollover was the right thing.  While everyone has different perspectives and situations, there is one constant:

Any financial decision you make should be consistent with a financial plan that reflects your values and goals.

This article will discuss the pros and cons of rolling your TSP account into an IRA.  However, any decision you make should be consistent with the long-term plan or strategy you have in place.

TSP Rollover Reasons For:

There are pros to doing a TSP rollover.  Some of those benefits are listed in more detail below.

Account aggregation:  As people depart the military, they may find themselves trying to get their financial house in order.  Part of that process includes account consolidation.  If you’ve already been contributing to an IRA AND you’re departing the military, it might be convenient to transfer your TSP account into that IRA.

Investment choices:  Although you could argue that TSP has plenty of diversification for any investor, there are several situations in which TSP is not the right savings vehicle.  Two specific examples come to mind.

First, there are people who want to have a self-directed IRA to manage real estate or a closely-held business.  Due to the tax treatment of leveraged investments inside retirement accounts, both of these ventures would receive maximum benefit from a consolidation of retirement assets.  Since TSP doesn’t allow for self-directed investments, an IRA is the only other logical investment vehicle.

Second, there are people who might benefit from purchasing a qualified longevity annuity contract (QLAC).  QLACs are for people who are approaching the age for required minimum distributions (RMDs), but do not need the income.  The benefit of a QLAC is that it allows the account owner to defer RMDs until a later date.  While this article won’t discuss specifics, a QLAC can be an effective tax-planning tool and a long-term care planning tool.  While you can purchase a QLAC in an IRA, you cannot do so from TSP.

TSP Rollover: Reasons Against

There are also some cons with rolling TSP into an IRA.  Let’s look into those as well.

Costs:  There’s just no getting around this.  Although Vanguard is the lowest-cost IRA provider, it still costs more than TSP.  How much more?  Let’s look at this hypothetical chart of 20-year returns.

This chart used the following numbers:

  • Stock market returns. Literally, numbers I pulled out of my head.  You can do this yourself with any set of numbers.  The focus should be on the comparison between TSP, Vanguard, and the industry average.
  • TSP: TSP’s expense ratios equal 2.9 basis points, or .029%.
  • Vanguard: Vanguard’s webpage cites that their average ETF fees are .12%, or 12 basis points.
  • Industry average: 53 basis points, or .53%, also according to Vanguard.

The cost difference between TSP & the industry average might make you think twice before doing a TSP rollover to an IRA

This chart indicates three things:

  • Not even TSP is an exact proxy for market returns. You can see that the 2.9 basis point annual fees take their toll over time.
  • However, TSP is closer to the pure stock market return than Vanguard.
  • Both TSP and Vanguard are pretty close to the pure market return. However, many people who aren’t fee-conscious might see their returns eroded in the long-term.

Account aggregation:  Huh?  Wasn’t this a positive to moving your money into an IRA?  However, you can just as easily consolidate your IRA and other retirement plans under TSP.  This is a great idea for families who have multiple IRAs or 401(k) plans, but who see TSP as a cornerstone of their financial future.  You can find more information on rolling accounts into TSP on the TSP website.

Tax planning:  This is a tough one, so try to follow me here.

For those who have significant amounts of combat-zone deferrals, you’re probably aware that the eventual distribution from those deferrals are tax-exempt, even though the earnings on those contributions are not.  This information is easily produced by TSP, and you can look on your account statements to know exactly where you stand.

When you transfer this account to an IRA, most likely, your IRA custodian will have NO idea how to segregate your tax-free and taxable contributions.  Combat zone contributions are the only type of contributions that are tax free.  TSP is the only retirement plan that accounts for combat zone contributions.  Other plans are primarily focused on pre-tax and after-tax contributions, not tax-free.

What this means is that when you shift your TSP to an IRA account, your IRA custodian will likely treat your account in the following manner:

  • Traditional accounts will be considered pre-tax
  • Roth accounts will be considered after-tax

Your eventual distributions will have required withholdings by the IRA custodian.  This means that your tax-free distribution MAY have tax withholdings, even though they’re tax-free.  You can eventually claw back the withheld money when you file your tax return.

However, the burden of proof is on you to clearly identify that the transferred money originally came from contributions that you made when you were in a combat zone.  This means you’ll have to maintain records that clearly indicate:

If you’re not familiar with IRS Notice 2014-54, it’s a doozy.  In essence, it means that when you withdraw from a retirement account plan (such as a 401(k) or TSP), and you have both pre-tax and after-tax (or tax-free) contributions, then you MUST make your withdrawals in proportional amounts.

For example, let’s say you have $100,000 in TSP ($80,000 in traditional and $20,000 in Roth).  When withdrawing from this account (or rolling over), you must withdraw equally from each account.  If you’re rolling over the entire balance, there’s no problem.  However, let’s say you’re only drawing out $20,000.  You cannot just cherry-pick $20,000 in Roth just to avoid paying taxes.

The IRS mandates that your $20,000 must be in equal proportions from each account.  In this case, you would take 80% from the traditional & 20% from the Roth account, or $16,000 and $4,000, respectively.  (BTW, TSP accounts for this and will distribute proceeds from your accounts in this manner).

Tired yet?  Just wait until you try to manage this on your own, without any assistance from TSP (who is no longer managing your account).  You might spend a lot of money to hire an accountant, enrolled agent, or fee-only financial planner to help you wade through this correctly, or even more time & frustration (and possibly money if done incorrectly) doing it on your own.  This might be a situation where you decide to leave your money in TSP. 

Note:  We haven’t yet gotten to the point where there are a lot of TSP accountholders who are managing distributions of combat zone contributions.  However, when we do, it will be quickly apparent that this will be a big deal for those people who rolled their TSP over into IRA accounts.  Perhaps the bigger IRA custodians will incorporate procedures to amend this gap.  However, since TSP rollovers count for such a small portion of the overall IRA rollover market ($443 billion for TSP vs. $4.8 trillion for 401(k)s), I wouldn’t hold my breath.

Conclusion:  TSP Rollover Timing

Whether or not you decide to do a TSP rollover into an IRA depends completely upon your circumstances.  However, it’s important that you not make this decision too quickly.  The last thing that you want to do is jump from the frying pan into the fire.  Instead, the decision to roll your TSP into an IRA should be part of a methodical, long-term financial plan that is consistent with your values and financial goals.

Posted in Taxes, Thrift Savings Plan | 1 Comment

Six Steps to Hire a Military-Focused Financial Planner

As you know, I am a financial planner.  With that said, there are many people who do not need a financial planner to live their best lives.  However, there are probably many more who could benefit from professional financial advice in at least one aspect of their lives.  This article is for them.

Introduction

In the military, we’re pretty familiar with the financial counseling resources that are available, either through our commands or the installation’s support services.  However, there comes a time when we’ve paid off our credit cards, established an emergency savings account, and started putting money away for retirement.

At this point comes a logical question:  “Even though I feel like I’m doing all the right things, could I be doing more?”  This is where a financial planner can help you out.  However, with almost 300,000 financial advisers in the United States, finding one that meets your needs can be difficult.

Here are six steps to help you select the right planner for you.

Start with ‘self-help’ first. 

No one will ever know more about your situation than you do.  There are plenty of Facebook groups with servicemembers, military families, etc. who are willing to share with their community.  There are also some very good personal finance blogs focused on servicemembers.

Sometimes it’s just a matter of connecting with someone, or reading an article that answers that one question that will help you put everything together.  Some FaceBook groups include:

  • Personal Finance for Military Service Members & Families:  Led by Rob Aeschbach, this is a great place for people to hang out, post questions, and receive expert advice.
  • Veteran 2 Veteran Info:  If you’re looking for information related to the VA or veteran’s programs, this is a good place to go.  Even if you don’t find what you’re looking for in the group, there are over 300,000 members…odds are, you might find someone who can help you with what you’re looking for.
  • Military Landlords:  You might be an accidental landlord.  If that’s the case, you might find some useful help in this group.

You might find what you’re looking for in one of these groups, or by further research.  However, you might decide that you still want to work with a financial planner anyway.  That’s perfectly fine.  Let’s go to the next step.

Figure out what you want from an adviser.

There are many reasons people form a relationship with their financial adviser.  Here are a couple of the top reasons:

  • Building confidence. Perhaps you’ve been doing all the right things all along.  You just need a review & some validation from a professional.
  • Better Use of your time. You might know what you’re doing, but personally managing your personal finances isn’t an efficient use of your time.  You’d rather focus on your career, family, or personal pursuits.
  • Getting organized. Many times, personal finances are a reflection of one’s personal life.  Many people feel overwhelmed by taking that first step that they never start.  Hiring a professional can be that first step, which allows you to know that it’s a step in the right direction.

Whatever the expectation, you should be able to define that expectation before you start looking for a financial planner.  If you don’t, it will probably be harder to find a planner who is the right fit for you.

Figure out who you can trust.

You don’t have to blindly start interviewing people you don’t know.  Most financial planners work with people who are referred by mutual contacts.  This could be through friends, family, or trusted professionals such as accountants, real estate agents or estate planning attorneys.

Odds are, if you know people who already have a good relationship with a financial planner, you’re probably going to be a happy customer as well.

If you don’t know anyone who can connect you, a good place to start is the National Association of Personal Financial Advisors (NAPFA).  NAPFA is the world’s largest organization of fee-only financial planners.  A fee-only financial planner is someone who doesn’t receive commissions on any insurance or investment recommendations.  That way, you know that the planner’s advice is aligned with your best interests.

NAPFA has a search tool that allows you to find registered advisors in close proximity to where you live.  If you don’t have any idea how to find a planner, NAPFA is a good place to start.  If possible, select 3-5 planners to research.

Do your research.

If someone is referring you to a financial planner, you might not need to do much research.  You’ll still want to ask your referrer some basic questions about their relationship.  This way, you’ll have a better idea if your initial meeting or phone engagement is in line with your expectations.

If you’re having to research NAPFA advisors, you can learn a lot just by looking at their website.  Every NAPFA advisory firm is a registered investment advisor.  Registered investment advisors have two distinctions.

First, they must uphold the fiduciary standard.  This means they are legally obligated to hold their clients’ interests before their own.

Second, registered investment advisors must file a form known as an ADV.  An ADV, which is filed with the adviser’s state or the SEC, is a plain-language document that informs clients:

  • What the adviser does (or doesn’t do)
  • How the adviser is paid (NAPFA advisers must clearly state they do not accept commissions, since they are fee-only)
  • How that fee is structured (retainer, assets under management, etc.)
  • Adviser’s education & experience

Financial advisers are legally required to present their clients with a copy of their ADV when their contract is signed.  However, you can research this online either through the adviser’s website, or through the state regulatory agency.  That way, you’ve got a pretty good idea of what the adviser does before you decide you want to meet with them.  Enclosed is an example of an an ADV (it’s the ADV for my firm, Westchase Financial Planning, which is registered with the state of Florida).

Interview your prospects.

Once you’ve researched the people you’d like to talk with, then you should set up times to talk with them.  Most financial planners, or their firms, will offer some sort of introductory phone appointment to discuss their services.  This is your opportunity to discuss the ‘wave-top’ issues that concern you, and determine if the firm can help you.

However, don’t expect to go into depth on solving your problems.  Financial planners aren’t keen on doing so, unless your needs are too basic to warrant a relationship.  In that case, the planner might give you similar advice to what you would see in one of the above forums or refer you to another planner.

During your initial appointment, you should cover the following:

  1. Ask for a copy of their ADV (if you haven’t already reviewed it). Going through the ADV and asking informed questions will allow you to gauge how a planner will respond to your financial situation.
  2. Ask about the firm’s experience working with people like you. Financial planners usually try to relate to their clients by communicating their experience.  You should ask the planner situation-specific questions that will allow you to determine whether their skillset will be sufficient for your situation.
  3. Ask about the process. Financial planning isn’t about a desired end state.  There’s a process involved, which usually adheres to the following professional standards outlined by the CFP® Board:
  • Establish a relationship with the client
  • Gather information from the client
  • Analyze information with the client
  • Develop recommendations
  • Implement recommendations
  • Monitor

If you’re going to work with a planner, it’s worth understanding how their process works.

Once you select someone, trust them until they give you reason not to.

You’re going to put a lot of work and effort into hiring a planner.  However, once you’ve decided that they’re worth hiring, that’s when you should trust that they know what they are doing.  You might not solve all of your issues & concerns overnight.  However, within your first year, you should definitely feel as though you’re well on your way, or that most of your concerns are behind you.

With that said, you may have some indications that your planner’s not doing their job.  Here are some guidelines:

  • Non-responsiveness. While you might not always have access to YOUR planner, you should expect timely response from the admin staff, paraplanner, or another planner in the firm.  Most firms have a policy of returning phone calls and emails within 1-2 business days.  They should also be able to set up appointments within a reasonable time to address unexpected concerns.
  • Complacency.  Your concerns are serious, even if they might be relatively simple.  Your planner should take your concerns seriously as well.  If not, that’s a concern.
  • Attitude.  Clients are the reason that financial planning firms exist.  Your financial planning firm should definitely keep that in mind.

Conclusion

Hiring a financial professional is not something to take lightly.  In a true relationship with a financial planner, many people disclose information they would never tell their own family members.  If you feel that you are in a position to hire a financial planner, it’s definitely worth taking a little time and effort to ensure that your relationship will be a fruitful one.

Posted in Westchase Financial Planning | Leave a comment

Back to Basics: The Real Costs of a DUI

Preface

In the civilian world, there are professions where the impact of DUI conviction might not have an effect on the person’s career.  Not so with the military.  In the military, a DUI conviction is only the beginning, as it will have a direct career impact on the servicemember.

As you know, driving under the influence is extremely dangerous and is a leading factor in many car accidents. But you already know that. We are going to focus on the military aspects of a DUI, particularly its impact on your ability to accumulate long-term wealth over the course of a career.  After all, the best financial planning advice is this:  Avoid bad decisions that lead to life-changing incidents.  Continue reading

Posted in Military Life | Leave a comment

FAQ: Which is Better, a 30 Year Mortgage or a 15 Year Mortgage?

One of the most common questions that I’ve been asked (and one of the most popular debates that I’ve seen), is the question about whether it’s better to have a 30 year mortgage or a 15 year mortgage.  There are several versions of this question, such as:

  • Should I pay down my mortgage early?
  • Can I put additional money towards my mortgage each month?
  • Is it better for me to prepay my mortgage?

However, today’s question is strictly as stated:

Which is better, a 30 year mortgage or a 15 year mortgage?

Answer:  It depends.  

No, not really, and I’ll outline the difference in numbers below.  The reason that I wrote, “it depends,” is because the best financial answer in any situation is the one that helps you sleep at night.  If paying off your mortgage gives you peace of mind, then you should continue to do so and disregard this article.  However, in this article we’ll break down the numbers and come up with a recommendation.

If you’re still reading, then you’re interested in looking at the numbers, breaking down the difference between a 30 year mortgage & 15 year mortgage and seeing a recommendation.  Let’s get to it!  We’ll use a case study about a hypothetical military couple, Mr. & Mrs. Smith.

Mr. & Mrs. Smith have recently retired from active duty, and have decided to buy a house in the Tampa area.  They’ve found the house that they want, and are going to buy it, either with cash they’ve saved, a 15 year mortgage, or a 30 year mortgage.  They want to know which decision is the best one if they want to accumulate long-term wealth.

Let’s start with some facts, assumptions, and declarations.

Mortgage facts

  • Home purchase: $250,000
  • Proposed mortgage: $200,000
  • 30 year mortgage rate (3.375% fixed rate with 0 points as of 8/5/16)
    • Quote from bankrate.com
  • 15 year mortgage rate (2.75% fixed rate with 0 points as of 8/5/16)
  • Pension & salary: $100,000 per year
  • Annual salary increases: 5% per year
    • It’s hard to estimate salary increases. However, let’s assume they keep in line with inflation over the long run.  This obviously doesn’t include bonus compensation, incentives, or other types of compensation.
  • Investment earnings: 7% per year
    • According to historical data, since 1928, S&P 500 index’ geometric average (a more accurate means of calculating averages than the arithmetic approach) is 9.50%. Since 2006, the average is closer to 7%.  Since the most recent numbers are more conservative, let’s use 7%.
  • Savings rate: 10% of salary
    • Why not?  In a previous article, I’ve already outlined why you should pay yourself first, and discuss the reasons you should save at least 10% of your salary.  Let’s stick with it.
  • In addition to the 10% savings rate, the Smiths have budgeted for a 15-year mortgage, even though that’s a higher payment. If their monthly payment is less than this amount, the Smiths have committed to putting that difference into their investments as well.  Below is how that will look like:
    • 30-year option: Additional savings is the difference between the 15-year & 30-year mortgage payment.
    • 15-year option: Additional savings is 0 for the first 15 years.  Then the savings becomes the entire 15-year mortgage payment.
    • Cash: Additional savings is the 15-year mortgage payment for the full 30-year period.
  • Home price inflation: 5%
    • According to the U.S. Census, National Association of Realtors, and the Case-Schiller Index, long-term housing price changes generally track with inflation rates over time. Obviously, real estate markets are subject to local conditions, but for this article, we’re going to use the long-term inflation rate.  Since 1913, the average inflation rate is around 3.2%, according to annual inflation data from the Federal Reserve Bank.  We’ll round up and use 3.5%

Assumptions

  • The Smiths stay in their house for 30 years.
  • Job stability is constant. The Smiths may change their job(s), but their income is relatively stable, and rises consistently over time.

Declarations

  • Tax impact of mortgage interest will not be calculated in this case study. Although there is a tax impact of home ownership, calculating that impact requires a LOT more detail than is provided in this case study.  There is no negative tax impact from mortgage interest, and there may be a positive one if that causes your itemized deductions to exceed the standard deduction.  Since 30 year mortgages generally have more mortgage interest over their lifetimes (and certainly in the first 10 years), the scales would tip in the favor of a longer mortgage.  However, the tax benefit will not be factored in this case study.
  • Calculations are compounded on an annual basis. Feel free to calculate on a monthly basis, but you’ll get a slightly more defined recommendation, not a different one.

Results

I’ll let the results speak for themselves below.

30 Year Mortgage Vs 15 Year Mortgage Vs Cash Comparison

As you can see, the 30-year mortgage ends up creating the most overall value over time, when compared to the 15-year or cash options.  In fact the 30-year mortgage created an additional $100,000 of wealth over the 30-year time frame when compared to the 15-year mortgage, and over $500,000 when compared to the cash option.

There are a couple of observations that I’ll make, then we’ll discuss the reasons why the longer mortgage creates a higher net worth.

Observations

No matter what, at the end of 30 years, the home equity is the same. Having a mortgage has no bearing on how much your house is worth.  If your long term goal is to stay in the same house, and you are able to make a 20% down payment, then you should be able to weather real estate market fluctuations.

Compounding interest is REAL power. (Learn More about the power of compound interest).

As you can see below, the 15 year mortgage plan starts off much stronger than the 30 year plan.  This is because the mortgage payment is paying down more principal at first.  But then, something neat happens.

Between years 12 & 13, the 30 year mortgage starts to surpass the 15 year mortgage.  This is because the additional savings (the difference between the two mortgage payments that the Smiths decided to save) have increased their investment earnings over time.

Two years  later, the 15-year mortgage is completely paid off, and the Smiths are able to plow the entire mortgage payment amount towards their investments.

However, the 15-year mortgage plan never catches up to the 30-year plan, which continues to pull away.

By the end of 30 years, it’s clear that the 30-year plan is continuing to put distance between itself and the other plans.  In fact, now that the mortgage is paid off, there’s even more money to set aside for investments, meaning there’s no looking back.

If extrapolated to 40 years, this scenario ends up with the following numbers:

  • 30-year plan:  $8,205,141.32
  • 15-year plan:  $8,004,033.74
  • Cash plan:        $7,181,837.81

The all-cash plan is not competitive at any point.  The mortgaged plans start off with $200,000 in investments that take advantage of compounding interest from the very beginning.  Even though the all-cash plan is able to start putting money away instantly, it’s not competitive.  Until there is enough saved away to move the needle, the only true increase in value is related to the rise in house prices, which has a positive effect in all three situations.

Which is better, a 30 year mortgage or a 15 year mortgage. This is a comparison of a 30 year mortgage vs 15 year mortgage, in terms of Home Equity & Investments comparison

Analysis

A couple of things to point out here:

People often argue about how much interest you pay over the life of a 30 year mortgage, versus a 15 year mortgage.  That’s true.  In this situation, the Smiths would pay almost $75,000 more in interest over the life of their $200,000 mortgage ($118,310 vs $44,303.94).  However, during that same 30 years, investment accounts under the 30 year plan ended up out-earning the 15 year plan by over $100,000, and the cash-only plan by over $500,000.

People argue that you’re paying ALL interest up front, and only paying principal on the back end.  This is somewhat true, but misunderstood.  When you calculate the annual interest you’re paying in comparison to the outstanding balance at that time, you’ll find that the year-over-year interest rate is roughly in line.  However, each year, you are paying off some principal, which reduces the balance (thus the interest) for the next year.  This keeps the annual interest rate at around the APR.  For example, at year 1, you’re paying a total of $6,689.74 on an outstanding average balance of $197,887.31, which is roughly 3.8 percent (a more exact calculation would bring you closer to the 3.75% APR, but this is the best I can do in Excel).  At year five, you’re paying $6,123.91 on an average balance of $181,075, or 3.81 (again, Excel limitations), and so on.  By year 30, you’re paying $191.49 on an average balance of $4,805 (3.9%).

Over the long term, investing in equities has outpaced inflation and the cost of a mortgage. It’s this ability to generate a long-term return while borrowing at a lower rate that produces wealth.  That’s what banks do.  Does this mean that you will always come out on top if you take out a mortgage just to invest in the stock market?  No.  If taken out of context, there are exceptions to just about any rule.  For example:

  • If you over-leverage your house just to invest, you’re running a credit risk.
  • If you have an immediate need to liquidate your long-term investments, you might encounter market risk.
  • Any time you own a home, you incur liquidity risk.

Conclusion

Does this mean that a 30 year mortgage is always the right choice?  No.  I know many people who would rather just not have a mortgage.  They don’t care about the numbers.  They care about going to bed knowing that their house is paid for.  That goes back to my original point:  The best financial answer is the one that helps you sleep at night.

Posted in VA | 2 Comments

7 Emotional Aspects About Updating Your Will in the Military

Recently, my wife and I discussed updating our will as we look towards our transition. Basically, it’s a matter of making the time to go to the Legal Office at MacDill to actually do it.  It’s the same old story:

“We will make an appointment as soon as the kids get back in school.” Ironically, in June I told myself that I would accomplish a litany of items “as soon as the kids finished up school for the summer.”  Well, here we are trying to knock out all of the fun things so that we can say we “had a great summer.”

As I was making plans, my wife and I happened to talk with a good friend about estate planning, specifically about what would happen to our children should something happen to us. She comes from a very non-traditional home.  In in her case, she feels the care of her children would be better with a close family friend rather than either set of divorced, remarried, re-divorced and then re-married parents.

I had originally planned to research “updating your will” and the technical details that accompany the process. After all, we understand the importance of updating your will as major changes happen (our children getting older, change in marital status, etc.).  However, our discussion made me wonder about the emotional aspects of estate planning. Something that seemed unusual to me might seem like a better solution to someone else.

Below are seven emotional aspects that I never considered about updating your will:

1. Sometimes, having your kids go to your family isn’t always the greatest place for them. Consider that sometimes as military families we forge friendships that transcend the family relationships we have. Will having your aging parents take care of your toddling son and newborn baby girl be practical? Will having your senior in high school leave all of her friends, teachers and routine be the best decision? Should you include some sort of stipulation that says your children should remain the current residence until they graduate from high school?

2. It’s important to take time to ensure that our sentimental items go to the right place. Throughout our travels within the military, a lot of us acquire priceless items and memories. Don’t forget to allocate those specific things to the appropriate child. For example, a hand-painted ceramic table from Sicily might not be appropriate to will to the child who wasn’t even born yet.  My mother in law jokes that she goes through her house and marks items with an “L” (for my sister-in-law) and a “T” for my wife. Whether that is true or not, it gives my wife and her sister-in-law a clear understanding of our her intent.

3. If you gift a sentimental item to a family member, how sure are you that they will value it the same way? Something that may have a significant meaning to you may become clutter to your child. Can you trust that the item is going to be taken care of responsibly? With regard to items that are handed down for generations, will the family member remember the “story” or its significance? Or, are you willing to let that go?

4. Creating a will can help heal wounds or make them deeper. The will-writer gives a very clear message to whom they want to designate certain items. Feelings can potentially get hurt here.

5. Do you need to revisit your will because you wrote it at an emotional time? Or, are you updating your will during an emotional time? Remember, you might make a knee-jerk reaction.  If that reaction is recorded in a will, it might have an unintended impact.  Sometimes, an ugly truth about ourselves manifests itself when writing a last will and testament.

6. Are you emotionally prepared for the finality of a Last Will and Testament? A will needs to be prepared no matter how old you are. Some people find its preparation depressing, but the fact is that it is one of those things that needs to be done.

7. Updating your will while you’re dealing with major changes in your life is more difficult than you think. Deployments, military transition, PCS—we all deal with these stressful times.  Even though will updates are a part of any deployment checklist, do you think that you’ll be making the clearest decisions while you’re checking off ‘updating your will’ on your to-do list?

I guess I have my work cut out for me. A will is much more than a legal piece of paper. It’s the message you send after you are no longer able to send it.

What emotional experiences have you gone through when updating your will?  Please leave a comment below!

Posted in Personal Finance | 2 Comments

Back to Basics – College 529 Plans

This is the next article in my ‘Back to Basics’ series, and is meant for people who may have heard about college savings plans and would like to know a little more.  College planning for your children is a topic that can cover a wide variety of beliefs, options, programs, government incentives and savings vehicles.  While college planning can cover a lot of different topics, this article will focus on:

  • Defining what a 529 plan is
  • Describing the two types of 529 plans
  • Pros and cons of each 529 plan
  • Outlining how a 529 plan can be used in conjunction with other military benefits

So, what are 529 plans?

Great question.  According to the Securities & Exchange Commission, a 529 plan is: “a tax-advantaged savings plan designed to encourage saving for future college costs.”  Section 529 of the Internal Revenue Code provides for this savings plan to:

  • Be sponsored at the state level
  • Provide tax-deferred growth and tax-free gains on qualified distributions
  • Allow for greater savings than previous plans, like Coverdell (formerly known as education IRAs)
  • Allow account holders to control funds in the event the beneficiary doesn’t go to college

In other words, a 529 plan is one of the ways that the government encourages investment in higher education.  The federal government doesn’t tax income for investment that are earmarked under the 529 plan.  Each state government sponsors an individual plan, which encourages people to invest and go to college in their state.

Regardless of which type of plan you choose, there are some things to point out:

  • You don’t have to be the parent of a beneficiary to establish or contribute to 529 plans. 529 plans allow for relatives, such as grandparents, aunts and uncles, or other members, to contribute.  This is great if you have a lot of family members who want to contribute or give presents but don’t know how.
  • You control the money, even if your child doesn’t go college. Unlike the Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA), both of which revert to the beneficiary’s control when they reach legal age)
  • Rich relatives can help, A LOT!
    • Contribution ceilings: First, most 529 plans have very high contribution ceilings.  For example, Texas allows you to contribute up to $370,000 per beneficiary.  Even after the ceiling is reached, most plans allow for earnings to accrue…you just can’t contribute any more to them.
    • Special gift tax rules: Most people are familiar with the annual exclusion for taxable gifts.  If not, here it is in a nutshell:  In 2016, you can give up to $14,000 to any person without having to file a gift tax return.  Any amount above that, and there are gift tax implications.  For 529 plans, there is a special rule that allows you to gift up to 5 year’s of contributions at once.  The donor will still have to file a gift tax return, but this is great if you have a rich uncle (or grandparent) who wants to help you supercharge your child’s savings.  I would advise anyone making such a large gift to seek the advice of a tax professional, but anyone who is in a position to do this is probably already working with one tax professional.

Types of 529 plans – Prepaid Tuition Plan and College Savings Plan

There are two types of 529 plans:  prepaid tuition plans and college savings plans.  Let’s break down each one and look at the pros and cons.

Prepaid tuition plan

A prepaid tuition plan allows you to purchase credits from a state’s sponsored plan, which would then allow you to send your child to a public school from that state.  Depending on the plan, you lock in tuition at a certain price, then you make payments for a certain time.  This allows you to plan and execute a long term budget for the tuition plan.  Here are some of the pros and cons:

Prepaid Tuition Plan – Pros:

  • Tuition stability. As long as you continue paying into the plan, you’re guaranteed to lock in tuition at current or near-current rates.  This does offer peace of mind for people concerned about inflation.
  • Investment risk. Since prepaid tuition plans purchase tomorrow’s tuition at today’s prices, you do not invest in the market.  Most state plans are guaranteed by the full faith and backing of the respective state, or that there is a state sponsored process to ensure that your plan keeps pace with tuition.  However, some plans offer no such guarantees, so you will want to make sure that the plan you’re paying into does.
  • Supplemental plans. In addition to prepaid tuition, some states offer supplemental plans.  Supplemental plans can include expenses such as room and board, meals, or administrative fees that seem to find their way into those college bills.

Prepaid Tuition Plan – Cons:

  • The biggest con is that tuition stability comes at the expense of flexibility.  If your child chooses to go to a college that is not covered, you can pull your money out of the plan.  However, you’ll most likely find that the real rate of return (return after inflation) is very low.  For people who are not attached to their state of residence (like military families who PCS often), this lack of flexibility is very important to consider.
  • You might find that some plans do not actually protect against inflation, but force you into paying more at today’s prices than you might on your own.  For example, the Florida Prepaid Tuition plan came under fire several years ago for having prepaid tuition rates that ended up costing more than the projected tuition itself!  You’ll want to do your own due diligence before you start paying into the plan.
  • If, for some reason, you pull your money out of a plan, the plan will refund your contribution.  However, most plans will only give you your original contribution, with a reduced amount of interest.  You can also expect to pay a cancellation fee.

529 College savings plan

A college savings plan allows you to save money into a plan, which can then be used to pay qualified college expenses.  Unlike a prepaid tuition plan, a college savings plan can be used to pay for a variety of non-tuition expenses, such as books, fees, room and board, etc.  While you do not lock in tuition at a certain rate, a college savings plan offers flexibility and the opportunity to make investments that may maximize long-term value.  Let’s look at the pros and cons:

529 College Savings Plan – Pros:

  • Flexibility. As long as you continue paying into the plan, you’re guaranteed to lock in tuition at current or near-current rates.  This does offer peace of mind for people concerned about inflation.
  • Investment options. Most savings plans allow for a broad variety of investment options.  Many of these plans include target-date funds (similar to TSP’s Lifecycle Funds).  Target-date funds automatically rebalance towards more conservative investments as you get closer to withdrawing your money.  This allows you
  • Supplemental plans. In addition to prepaid tuition, some states offer supplemental plans.  Supplemental plans can include expenses such as room and board, meals, or administrative fees that seem to find their way into those college bills.

529 College Savings Plan – Cons:

  • Inflation risk. The benefit of a prepaid plan is the exact weakness of a savings plan.  While you are able to control your investments, you are responsible for ensuring that they are able to cover college costs.  If you underestimate college cost inflation, you might find that your savings plan isn’t enough to cover all the costs.
  • Investment risk. Having control over your investments means that you are ultimately responsible for investment risk.  While target-date funds help to mitigate this risk, there is no guarantee that a ‘black swan’ event won’t disrupt your planning.

To summarize, the relationship between prepaid tuition plans and college savings plans comes down to risk.  In this regard, this relationship is very similar to that between defined contribution and defined benefit retirement plans.  Your choice should reflect how comfortable you are with the relationship between risk, opportunity, and flexibility.

Coordinating 529 Plans With Other Options

Many people consider 529 plans as an ‘all or none’ type solution.  Having access to the post-9/11 GI Bill opens a whole lot of options to ensure that you are comfortable with your college planning.  Below are a couple of ways to ensure that your 529 plan achieves the best benefit:

Talk to your kids early and often about college. The number one factor in making sure you can afford college is communication.  What do you talk about?  For starters, talk about setting reasonable expectations.  Discuss what resources you’re willing to set aside, and what they’re expected to contribute.  Be sure to emphasize that cost is a consideration.  Telling your child that you’re willing to pay for whatever they want to do will lead to an uninformed decision.

We don’t do it when buying their first car, so why should you do it just because you think education is important?  If your children know that cost is a factor, you might be surprised at how they approach college.  Also discuss the importance of responsibility.  If your children know that they are ultimately responsible for their education, they’ll take the responsibility of paying for it more seriously.  If they think their parents are paying the bills and taking care of everything, they might not.

Discuss the importance of high school success. While we all strive to maintain a balance as parents, our children should know that there are plenty of high school opportunities that can mitigate college costs.  Dual enrollment, AP courses, varsity sports, community involvement, and extracurricular activities can help your child eliminate easy courses or obtain scholarships that help mitigate your out-of-pocket costs.

Community college could help considerably. Most states allow for the transfer of community college credits to public state schools.  The opportunity to pay 30-50% less for the same course is a no-brainer.  Encourage your children to look into this opportunity.

Educate your children on the GI Bill. If you have more than one child, or you’ve already used some of your benefit, you might need to figure out how much you plan to give them.  Make sure they understand how GI Bill benefit should be used for the biggest bang for your buck.  A semester of community college is covered the same way as a semester of a master’s program, so you should save the GI Bill for the most expensive one.

Conclusion

At the end of the day, you should choose the 529 plan that makes the most sense in your family’s situation.  Early in your parenthood, take the time to figure out how that plan makes sense for you.

Posted in GI Bill | 6 Comments

5 Military Considerations About a Debt Management Plan

There are a lot of military families who end up needing help with managing their debt.   Although many people are able to buckle down and work their way out of debt, others may need external help.  One of the most common resources people turn to is a debt management plan.

A debt management plan is a relationship that you establish with a counseling agency who might be able to negotiate a lower payment or lower interest rate to your creditors.  In exchange, you pay the agency, who then pays the creditors directly.  All this is done for a nominal set up fee, as well as a monthly fee to continue the plan, which usually lasts from 36-60 months.

Sounds great, huh?  Before you sign up, there are several things you should consider before entering into a debt management plan.

Debt Management Plan Point #1

Debt management plans should not be considered ‘one-size fits all’ type solutions.

Many providers who administer debt management plans seem to push a boiler-plate solution to anyone who might be able to afford it.  This happens even if a debt management plan is not the right solution for that person’s particular situation.  Some people might not need a debt management plan, while others might have debts that cannot be covered.  For example, secured debts (car loans or mortgages) cannot be covered under a debt management plan.  Before you sign up, you’ll want to make sure that a DMP is the right solution for your particular situation.

Debt Management Plan Point #2

Pay attention to the fees involved with debt management plans. 

You might save money by paying less in credit card interest.  However, that’s small consolation if DMP fees cancel out your savings.  You can expect to pay an initial fee, as well as monthly fees for as long as you’re in the program.  According to Military.com, you should avoid plans that require an initial fee higher than $50, or monthly fees higher than $25.

Debt Management Plan Point #3

Your credit score might take a hit.

First of all, you can expect some (or all) of your credit card providers to do any of the following:

  • Stop extending you credit
  • Not allow you to open new credit accounts
  • Not allow you to use your credit card at all

When credit card companies start to close your accounts, the credit agencies reflect that as a lower amount of available credit.  This is what lowers your score.

Second, creditors have been known to report to credit agencies that you’re not making the full agreed-upon payments.  This might occur even after the creditors accept the reduced payment as part of your debt management plan.  Keep your eyes on your credit report while you’re in a DMP so you know what’s happening.  You’ll want to be in constant communication with your credit counselor on next-steps if you notice something wrong with your credit report.

Debt Management Plan Point #4

Debt management plan completion rates are pretty low.

Although debt management plans are supposed to last 36-60 months, most people quit before the program ends.  This means they’ve paid the fees and may have already had their credit accounts frozen.  However, they’ll eventually have to start over to pay down that debt or file bankruptcy.

Perhaps it’s optimistic to think that these people may have finished the program early, or started paying it off on their own.  However, Cambridge Credit Counseling, a leading DMP provider, states that 38% of its clients leave due to either bankruptcy or financial problems.

Debt Management Plan Point #5

You might be able to achieve the same thing on your own.

First of all, you’ve got to determine whether you’re serious.  If you know that you’re going to set aside as much money as possible to pay down your debt and get back into the black, then you should look into whether you actually need a DMP.  You might find that with a little work and discipline, you can get the same effects (lower payments, gradual debt payoff) without having to rely upon a credit counselor.  Below are a couple of options:

  • You might be able to transfer your balance to a zero-interest card. A lot of credit card companies offer an introductory 0% APR (annual percentage rate) for a certain period of time.  You’ll want to be careful that you know if there are any account transfer fees, and exactly what period of time you’re able to do this for.  However, this might be a quick win if you’ve got one or two cards that you could pay off in a year or less.
  • You can also contact your credit card company to negotiate a lower rate. This could work especially in cases where you can demonstrate that you have a proven history with that credit card company and that you’ve paid your bills on time.  Most companies will work with their valued customers to prevent them from moving their accounts.
  • You could use a lower-interest form of debt, such as home equity. However, using a home equity line of credit (HELOC) will probably encourage you to make bad decisions.   If you get used to using a HELOC to bail you out every time you feel a financial pinch, you’ll pay down debt.  The only way you can avoid this is by establishing a plan and sticking to it.  Most people have great intentions, but fail to follow through after the first few months.  This is one of the reasons I do not recommend a HELOC as a substitute for emergency savings.
  • Here are more tips for a DIY debt consolidation plan.

Fortunately, in the military, you don’t even need to try this on your own.  You’ve got other available options before you resort to a debt management plan.  You should definitely talk to your installation’s financial counselor BEFORE making any type of commitment into a DMP.  Your financial counselor will give you an honest assessment and help you make the right decision for your situation.  While this may or may not include enrolling in a debt management plan, you can rest assured that your advice comes from someone who doesn’t have a conflict of interest.

Posted in Personal Finance | 2 Comments