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5 Things You Didn’t Know About IRAs

Written by Kyle Thompson, MBA

One of the most common questions I get is “should I contribute to a traditional IRA or a Roth IRA”? Actually, the question is so common you can find it all over Google. The most common answer, and the most common sense, is that you should go with traditional IRA if you think your tax rate will be lower in retirement than it is now, or a Roth IRA if you think they will be higher. While that is technically correct, things are a bit more nuanced than that, and, if planned correctly, can add up to hundreds of thousands of dollars in tax savings. Yes, you read that right!

  1. First off, no one stays in the same tax bracket their entire life. Earnings tend to rise throughout your 20s and 30s, peaking in your 40s and 50s. In fact, the average college-educated 45 year old earns roughly twice as much as their 25 year old counterpart, and is likewise in a higher tax bracket. Depending on your retirement goals, you will likely be in a higher tax bracket at 65 than you were at 25, but lower than at 45, so it wouldn’t make sense to defer taxes at 15% just so you can pay 25% later. If we take our common sense answer to the traditional/Roth question above, you should emphasize Roth accounts in your 20s and 30s, and pre-tax accounts in your 40s and 50s.
  2. What most people don’t know about pre-tax accounts (401k/403b/traditional IRA, etc) is that good ol’ Uncle Sam eventually wants you to pay taxes on that money, and will force you to start taking distributions at age 70. These distributions can actually be much more than you need for retirement income, potentially pushing you into a much higher tax bracket! To avoid this tax bomb, you can take distributions from your non-qualified and/or Roth accounts early on in retirement to keep your taxable income low, while doing Roth conversions on your pre-tax accounts to lock in those low tax rates!
  3. Married couples have some planning opportunities with retirement accounts that single people do not. For example, if one spouse decides to stay home to raise children and household income goes down, that means you are likely in a lower tax bracket. This creates a perfect opportunity to convert old pre-tax accounts to Roth for a much lower tax rate than when you first deferred it. Additionally, the stay-at-home spouse can still contribute to an IRA, despite not having any earned income.
  4. While it is not fun to think or talk about, divorce also creates some unique planning opportunities, particularly if one spouse has low or no income but receives part of the other spouse’s pre-tax accounts. Those pre-tax accounts are eligible for conversion to Roth accounts, likely at a lower tax rate than when he/she was married. However, there are complicated rules around this, so make sure you talk to your financial advisor and/or CPA before doing so!
  5. Last but not least, business owners have a whole host of unique opportunities! This could be an entire article itself, but I want to focus on one thing here- business losses. Every business has bad years, and most new business owners have negative income their first few years while they get off the ground. While you cannot contribute to retirement accounts in years where you have no earned income, you can still do Roth conversions. For example, if you have a $100,000 pre-tax IRA of some kind, along with $100,000 in business losses for the year, you can convert the entire account to Roth, tax free. TAX. FREAKING. FREE. How cool is that?!

I hope this article gave you a few ideas, because financial planning is way more than just how much to save and what to invest in. Done properly, it will save you piles of money on taxes, which means more income for you, along with less headaches and anxiety about your finances. This is the part of the article where I do a shameless plug for myself and my services as an advisor, so click the link below and let’s get started!

Schedule a meeting today!

This article is for information and entertainment purposes only, and does not constitute investment advice. Kyle Thompson, MBA is the founder of Leetown Advisors, a fee-only financial planning and asset management firm. For further inquiries or suggestions, please email Kyle at kylet@leetownadvisors.com.

MMB Episode 1- What is Your Business Worth?

Welcome to Money, Meaning, and Business, a podcast for business owners about personal finance, exit planning, and philanthropy, intended to help you make the most of your money, business, and impact. In this episode, Kyle covers some of the factors that influence business valuation along with some tips on how to maximize your company’s value so that you can retire with peace of mind. Visit leetownadvisors.com to get a conversation started with Kyle today.

If you are curious what your business might be worth, take this 10 minute valuation survey.

If you know what your business is worth and want to know where your financial situation stands, create your financial profile here.

Disclaimer: Kyle Thompson is the owner of Leetown Advisors, a Registered Investment Advisor. The opinions shared on this podcast are his own and are intended for informational use only, and does not constitute investment advice. Please consult a financial advisor before making investment decisions.

Money, Meaning, and Business Intro Episode

Welcome to Money, Meaning, and Business, a podcast for business owners about personal finance, exit planning, and philanthropy, intended to help you make the most of your money, business, and impact. In this inaugural episode, Kyle welcomes you to the podcast, shares his vision and gives a preview of all the content coming down the pipeline. Visit leetownadvisors.com to get a conversation started with Kyle.

If you are curious what your business might be worth, take this 10 minute valuation survey.

If you want to know where your financial situation stands, create your financial profile here.

Disclaimer: Kyle Thompson is the owner of Leetown Advisors, a Registered Investment Advisor. The opinions shared on this podcast are his own and are intended for informational use only, and does not constitute investment advice. Please consult a financial advisor before making investment decisions.

8 Ways To Give To Charity

Charitable giving can play an important role in many legacy and estate plans. Philanthropy cannot only give you great personal satisfaction, it can also give you a current income tax deduction, let you avoid capital gains tax, and reduce the amount of taxes your estate may owe when you die. Most importantly, you get to choose how you leave your stamp on the world.

There are many ways to give to charity. You can make gifts during your lifetime or at your death. You can make gifts outright or use a trust. You can name a charity as a beneficiary in your will, or designate a charity as a beneficiary of your retirement plan or life insurance policy. Or, if your gift is substantial, you can establish a private foundation, community foundation, or donor-advised fund.

Making outright gifts

An outright gift is one that benefits the charity immediately and exclusively. With an outright gift you get an immediate income and gift tax deduction.

Make sure the charity is a qualified charity according to the IRS. Get a written receipt or keep a bank record for any cash donations, and get a written receipt for any property other than money.

Will or trust bequests and beneficiary designations

These gifts are made by including a provision in your will or trust document, or by using a beneficiary designation form. The charity receives the gift at your death, at which time your estate can take the income and estate tax deductions.

Charitable trusts

Another way for you to make charitable gifts is to create a charitable trust. You can name the charity as the sole beneficiary, or you can name a non-charitable beneficiary as well, splitting the beneficial interest (this is referred to as making a partial charitable gift). The most common types of trusts used to make partial gifts to charity are the charitable lead trust and the charitable remainder trust.

There are expenses and fees associated with the creation of a trust.

Charitable lead trust

A charitable lead trust pays income to a charity for a certain period of years, and then the trust principal passes back to you, your family members, or other heirs. The trust is known as a charitable lead trust because the charity gets the first, or lead, interest.

A charitable lead trust can be an excellent estate planning vehicle if you own assets that you expect will substantially appreciate in value. If created properly, a charitable lead trust allows you to keep an asset in the family and still enjoy some tax benefits.

How a Charitable Lead Trust Works

John, who often donates to charity, creates and funds a $2 million charitable lead trust. The trust provides for fixed annual payments of $100,000 (or 5% of the initial $2 million value) to ABC Charity for 20 years. At the end of the 20-year period, the entire trust principal will go outright to John’s children. Using IRS tables and assuming a 2.0% Section 7520 rate, the charity’s lead interest is valued at $1,635,140, and the remainder interest is valued at $364,860. Assuming the trust assets appreciate in value, John’s children will receive any amount in excess of the remainder interest ($364,860) unreduced by estate taxes.

Charitable remainder trust

A charitable remainder trust is the mirror image of the charitable lead trust. Trust income is payable to you, your family members, or other heirs for a period of years, then the principal goes to your favorite charity.

A charitable remainder trust can be beneficial because it provides you with a stream of current income — a desirable feature if there won’t be enough income from other sources.

How a Charitable Remainder Trust Works

Jane, an 80-year-old widow, creates and funds a charitable remainder trust with real estate currently valued at $1 million, and with a cost basis of $250,000. The trust provides that fixed quarterly payments be paid to her for 20 years. At the end of that period, the entire trust principal will go outright to her husband’s alma mater. Using IRS tables and assuming a 2.0% Section 7520 rate, Jane receives $50,000 each year, avoids capital gains tax on $750,000, and receives an immediate income tax charitable deduction of $176,298, which can be carried forward for five years. Further, Jane has removed $1 million, plus any future appreciation, from her gross estate.

Private family foundation

A private family foundation is a separate legal entity that can endure for many generations after your death. You create the foundation, then transfer assets to the foundation, which in turn makes grants to public charities. You and your descendants have complete control over which charities receive grants. But, unless you can contribute enough capital to generate funds for grants, the costs and complexities of a private foundation may not be worth it.

A general guideline is that you should be able to donate enough assets to generate at least $25,000 a year for grants.

Community foundation

If you want your dollars to be spent on improving the quality of life in a particular community, consider giving to a community foundation. Similar to a private foundation, a community foundation accepts donations from many sources, and is overseen by individuals familiar with the community’s particular needs, and professionals skilled at running a charitable organization.

Donor-advised fund

Similar in some respects to a private foundation, a donor-advised fund offers an easier way for you to make a significant gift to charity over a long period of time. A donor-advised fund actually refers to an account that is held within a charitable organization. The charitable organization is a separate legal entity, but your account is not — it is merely a component of the charitable organization that holds the account. Once you transfer assets to the account, the charitable organization becomes the legal owner of the assets and has ultimate control over them. You can only advise — not direct — the charitable organization on how your contributions will be distributed to other charities.

 

Schedule a meeting today!

This article is for information and entertainment purposes only, and does not constitute investment advice. Kyle Thompson, MBA is the founder of Leetown Advisors, a fee-only financial planning and asset management firm. For further inquiries or suggestions, please email Kyle at kylet@leetownadvisors.com.

8 Things You Need To Know About Money That Will Change Your Life

8 Things You Need To Know About Money That Will Change Your Life

(Originally posted on Not Your Father’s Financial Advisor blog)

As some of you know, before my MBA I got a Bachelor’s degree in Philosophy, which at the time qualified me to ask why you want fries with your meal. Due to this educational background, I often get asked what my “philosophy” is with regards to money. This is not a short blog post, but in order to keep you awake, here are the main points:

1- Money has two purposes- to spend or give away
2- Investing is the conscious decision to spend/give less now so you can spend/give more later
3- Your first obligation is to yourself, then the world around you
4- The way we spend money fundamentally changes the world
5- The world has a dramatic impact on our lives and how we spend our money
6- Money represents freedom and power
7- The role of every individual (and business) is to create, extract, and redistribute value
8- Financial planning is not just planning for your life, but your impact on the world

 

1- Money has two purposes- to spend or give away

This may seem obvious (or maybe not), but it is worth getting out of the way. We work, get paid, then decide what to do with our money. Some will be spent on bills, some will be spent on food and entertainment, but we should (hopefully) have money left over that we don’t have an immediate need for. We can choose to save that money to be spent another time, or we can give it to someone who needs it more than we do. That may be our church, a family member in need, or a charitable organization that will make better use of it, especially if that use is a cause that we care about. The point is, there should be a plan for every dollar, because no one has the goal to be the richest person in the graveyard (except maybe Scrooge McDuck).

2- Investing represents the conscious decision to spend/give less now so you can spend/give more later

This is also fairly self-evident, but the whole reason to invest your money is so that is grows, allowing that initial capital to have greater impact in the future than it would now. Investing $1 now will allow you to have 5 times the impact in 30 years, which is why many wealthy families set up charitable trusts to distribute their money after they pass, rather than giving away more during their lifetime.

3- Your first obligation is to yourself, then the world around you

While it is probably obvious by now that I am a big advocate of charitable giving, there is something I must make abundantly clear: you can’t help anyone else if your own needs aren’t taken care of. I don’t just mean your immediate needs, but your future needs as well. If you aren’t financially secure in your long term goals, you have no business giving money to others, because if you give to the point of being bereft, then others will have to take care of you, which defeats the whole point of giving. With that said, I believe the purpose of life is to be fulfilled and to make the world a better place. So if you are financially secure enough to live life on your terms indefinitely, you are obligated to give in such a way to make your desired impact. This may mean leaving money to your family, business, charity, or any manner of things.

4- The way we spend money fundamentally changes the world

Think about how Wal-Mart has changed the retail landscape over the last few decades- this company uses its enormous economies of scale to offer a huge selection of items at a steep discount to the local mom & pop stores. Individually, millions of people made the decision that they would rather shop at Wal-Mart, and the local stores were forced to close. Wal-Mart is notorious for poor employment conditions and is economically detached from the region, while the owners of local stores likely treated their employees well and were involved in the community, spending their money at local businesses and giving to local organizations. Even though this economic consequence involved millions of people, those people made that decision individually, and it had a real, lasting effect on the world. You can extrapolate this out to every area of the world, you don’t need me to drone on any more!

5- The world has a dramatic impact on our lives and how we spend our money

The point here is the same as above, only reversed. If we spend our money supporting companies that pollute the environment, then eventually a disproportionate amount of our money will be spent on healthcare and other related expenses which could have been avoided in the first place. The way we spend money changes the world, which is then reflected back on us and influences our future decisions.

6- Money represents freedom and power

This statement may cause you to cringe, but it is true. And it isn’t a bad thing! Ultimately, in a capitalist society, we are bound to work in order to continue our existence at our preferred standard of living. While this may not be pleasant early in your career, if you are a diligent saver/investor, you will eventually get to the point where you no longer have to work, and can spend your time fishing, volunteering, or trying to beat your high score on Guitar Hero. If you save appropriately, you are giving your future self enormous freedom to act in the world as you please. You can accumulate enough wealth to start a non-profit, forgoing or taking a small salary in order to put the dollars you raise to their best use. You may decide to become an angel investor, giving innovative companies the capital they need to expand. Alternatively, you might just decide to live out the rest of your days in peace in comfort, leaving whatever wealth is left to your family and a select few charities. When you save diligently enough to create such wealth, you have enormous freedom and power.

7- The role of every individual (and business) is to create, extract, and redistribute value

This one I could write an entire book on, but I will keep it short and sweet. We all try our best to create the most value at work and in our businesses (ok, maybe not all, we all know that lazy coworker!). We should also be compensated appropriately for that value; if we aren’t, we should look for another employer/customer that does recognize and compensate that value. Just this year, I have counseled plenty of individuals to ask for raises and for businesses to raise prices. You should be compensated appropriately not just for your own personal gain, but because you have a moral obligation to do so. This is because when we are compensated according to our value, we will redistribute (spend/give/save) in proportion to that value. By maximizing the value we create and extract, we can then maximize the impact we have on the world. If you are still confused, go back and reread points 1 through 6.

8- Financial planning is not just planning for your life, but your impact on the world

One response I hate hearing more than anything when I tell someone what I do is “so you do investments?” Yes, I do investments, but that is such a miniscule part of financial planning. The real reason I began Leetown Advisors was to help good people live better lives, and to help impactors have greater effect, and ultimately I want to see people leave their fingerprint on the universe, as if to say “I was here and I made a difference”. Leetown is my effort to do the same, and the goal is to grow it into something that endures long beyond me and to leave a legacy of service and devotion to making the world a better place. That is what financial planning is! I wrote this because I am frequently asked why I started my own firm and what makes me different from everyone else. I hope the answer to that is now abundantly clear, and that I can continue to make a difference for many more decades.

If you made it this far and are interested in learning more, check out What We Do and Schedule a Consultation!

This article is for information and entertainment purposes only, and does not constitute investment advice. Kyle Thompson, MBA is the founder of Leetown Advisors, a fee-only financial planning and asset management firm. For further inquiries or suggestions, please email Kyle at kylet@leetownadvisors.com.

What Should I Do With My Tax Refund?

(Originally posted on Not Your Father’s Financial Advisor Blog)

No one likes taxes. Well, some people do. Those people are weird (I’m looking at you, CPA friends!). Everyone, however, likes getting money back from the government after tax time. The question is, what should you do with it? Should you invest it? Pay down debt? Or maybe put a down payment on a Ferrari body kit for your Pontiac Fiero? Yes, that is a real thing, unfortunately.

If your monthly budget isn’t strained (you have at least 10% of your after-tax income left), then any of these things are reasonable answers. Well, the investment in your Fiero is questionable, but I would guess the people that would even consider it reasonable probably aren’t reading this article. If you have high interest rate debt (more than 5-6%), then paying that down seems obvious. Otherwise, investing the money in an IRA or taxable account would be the easy answer. However, ask yourself the following questions:

Am I living paycheck to paycheck? Do I have less than 1-3 months of liquid savings?

If so, I’d like you to consider something else. Put that money in a separate account, then create monthly recurring transactions to your primary account, where you can decide what to do with that money each month. If you have credit card debt, start with paying that down. This method isn’t as efficient, mathematically speaking, as dumping a lump sum onto your debt (since you are still paying interest throughout the year), but it gives you more flexibility over your cash flow when your budget is tight. It may also give you peace of mind that you have a little extra in savings, in case an emergency of some kind happens.

This brings me to my last point: there are a lot of situations where there is a “mathematically correct” solution, but money is a deeply emotional topic for most people. Even though it is technically better to invest excess cash than paying down low interest debt (like a 3.5% mortgage), some people just feel better working towards being debt-free. In these situations, I look for a compromise between the “correct” answer and the client’s emotional inclination that the client is comfortable with.  I also run across individuals that experienced some market volatility and took their portfolio to cash, sometimes costing them hundreds of thousands of dollars in opportunity cost. Had they been working with an advisor, they would have had someone to be their emotional crutch to lean on, and to craft a solution and risk exposure they were comfortable with.

This article is for information and entertainment purposes only, and does not constitute investment advice. Kyle Thompson, MBA is the founder of Leetown Advisors, a fee-only financial planning and asset management firm. For further inquiries or suggestions, please email Kyle at kylet@leetownadvisors.com.

Rising Interest Rates and What It Means For Your Money

(Originally posted on Not Your Father’s Financial Advisor)

One of the best questions to ask a financial advisor right now is “how should I protect my portfolio against interest rate risk?” If they can’t answer this question, run the other way. The reason this question is particularly salient is because for the first time in almost 40 years, we are facing a rising interest rate environment, with the potential for high inflation as well. This is a problem because as interest rates go up, bond prices go down, and stocks lose their inverse correlation with bonds. If I just lost you, read more about the interest rate/bond price relationship here, and read about asset class correlation here.

Since 1980, interest rates have been slowly declining (for reasons beyond the scope of this article), which means bond prices have been going up ever since and investors have been well-rewarded. But with the Federal Reserve ending their Quantitative Easing programs over the last year, and with unemployment at record lows, we are in an environment that is ripe for inflation and rising rates. In this situation, Modern Portfolio Theory (MPT) breaks down.

MPT usually has two asset classes, stocks and bonds. It assumes the latter has little or no volatility, and that the two are not correlated. Both these assumptions are wrong, unless you consider nothing but ultra-short term treasury bonds in your portfolios. When you consider the bond market as a whole, there is certainly volatility (though less than stocks), and since 1980, there has been a negative correlation. This means that when stock prices go down, bond prices go up, protecting the portfolio from extreme price movements.

This is precisely why the 60/40 portfolio (60% stocks, 40% bonds) has been so popular over that time frame; due to shrinking interest rates and low inflation, a 60/40 portfolio has experienced staggeringly low volatility while maintaining positive expected returns of both asset classes on a real, inflation-adjusted basis. In contrast, an investor with the same portfolio from 1950-1980 would barely have kept pace with inflation. The latter investor would have seen low returns with high volatility, which is something that no one wants. Whether we are entering a similar period is up for debate, but to ignore its possibility would be entirely negligent.

If not bonds, what? First, let’s make one thing clear: there is no guarantee that bonds will underperform over the next 10-30 years, so we need to keep some allocation to it. We do know that our current situation is not favorable for the asset class, so it is prudent to find alternative investments with low correlations but positive expected returns, especially in an inflationary, negative real yield scenario. There are a few alternative assets that fit that bill-

Gold
Real Estate
Commodities
Precious Metals
TIPS (Treasury Inflation Protected Securities)

There are reasons to have allocations to all of these, but let’s pick on gold for the sake of simplicity and because of its popularity (for a full list of asset class returns since 1972, check out this table here). Gold has very low correlation to the market, is seen as a safe haven asset (much like bonds), and performs well in negative real interest rate environments. If we replace half of the bond allocation from the 60/40 portfolio with gold (making it 60/20/20), we get a return significantly higher and lower volatility than either the 60/40 portfolio or the market alone (since the year 2000). The graphics below simulate an investor that retired in 2000 with a $1 million portfolio and began taking $50,000 annual withdrawals. Portfolio 1 represents the traditional 60/40, Portfolio 2 represents our 60/20/20 model, and the last one represents a market index fund alone.

performanceReturns

As you can see, the index investor would have run out of money after only 16 years of retirement. Not the preferred result. The 60/40 portfolio still has more than $500,000 left and will likely last the entirety of the investor’s retirement, but rising rates may negatively impact his/her chances. The 60/20/20 portfolio has nearly 3 times the balance of the traditional portfolio, and the investor could actually afford to spend more!

I’m not saying that you should go out and move your money to the 60/20/20 portfolio listed above (gold prices actually have a more complicated story,  and this portfolio would not fare well if interest rates outpace inflation), but I am saying that you should consider alternative investments to supplement your portfolio. There are a multitude of strategies to mitigate interest rate risk, but different strategies require different time horizons, risk tolerance, and experience. Never put your money in something you don’t understand, and never let an advisor do so unless he/she can explain it to you.

This article is for information and entertainment purposes only, and does not constitute investment advice. Kyle Thompson, MBA is the founder of Leetown Advisors, a fee-only financial planning and asset management firm. For further inquiries or suggestions, please email Kyle at kylet@leetownadvisors.com.