How To Buy Real Estate In A Roth IRA

How To Buy Real Estate In A Roth IRA

Did you know you can actually buy real estate in a Roth IRA? And it’s completely legal too, not the least of which since you can hold just about any asset in an IRA account. Some real estate promoters seriously pitch this option. And while it is certainly possible, you need to be fully aware that it's also a very complicated process.

We're going to do a high-altitude report on how to buy real estate in a Roth IRA. But be advised this is not the kind of investment strategy you should ever enter on the basis of an online article. The number of potential pitfalls, and the severity of the IRS penalties, make this a very serious step. For that reason, you absolutely must consult with a knowledgeable CPA or tax attorney before moving forward. With that rule firmly in place, let's take a look at the basics of how to buy real estate in a Roth IRA.

Why Hold Real Estate in a Roth IRA?

At least since the 1970s, real estate has rivaled the stock market in investment returns. In some decades, one has outperformed the other, but on balance it's been a tight race. Either way, a large number of people have become millionaires by investing in real estate. The reliable performance of real estate makes it an excellent long-term investment.

There are tax breaks that come with investing in real estate. Depreciation is an example. It's a paper expense, that can be used to offset real income, giving the owner tax-free income. Another is the long-term capital gains tax advantage. If investment real estate is held for more than one year, and sold at a profit, the tax rate is between zero and 20% for most tax payers. But can you imagine holding investment real estate in a Roth IRA, where it will be fully tax-deferred–until you turn 59 1/2, when it will become completely tax-free? Whether tax-deferred or tax-free, neither the profit from rental income nor the windfall from capital gains will create a tax liability. Now think about how powerful that advantage will be over many years. That's reason enough to consider holding real estate in a Roth IRA.

The Diversification Angle

Still another advantage is that real estate represents a true diversification. Most retirement plans are loaded up with paper investments. That includes stocks, bonds, mutual funds, exchange traded funds, and certificates of deposit. Those are all solid investments, but they’re also intangible. It often makes sense to include some type of tangible asset in a retirement plan, particularly an IRA. They often perform better than paper investments, particularly during times of high inflation. Precious metals are an excellent example of a tangible investment. But the ultimate tangible investment is real estate. That's because it's not just an investment, but it also has a practical purpose. It provides shelter either for residential tenants or commercial businesses. That tends to give it staying power over the very long term.

Adding this kind of tangible investment to a portfolio of paper assets achieves a much greater level of diversification.

Buying Real Estate in a Roth IRA–The Downsides

No discussion of buying real estate in a Roth IRA is remotely complete without a solid discussion of the complications–and there are plenty. The first downside you'll encounter is finding an IRA trustee who will hold physical real estate in a Roth IRA account. If it's a trustee that has a well-known name, rest assured they won't be a candidate. Real estate related IRAs are a special breed, and you will need to work with trustees who specialize in the field. There are only a handful, and we’ll list a few shortly.

Second, because of the high price of real estate, it will be very difficult to diversify within the asset class. Most investors will do well to hold one or two properties, especially in the early years, unless you’re rolling over large sums from other retirement plans. This will limit your ability to spread your investment–and your risk–across several different properties, in a way similar to how you diversify across many securities in each paper asset class you hold in your portfolio.

Third, IRS rules on holding real estate in any type of IRA are stiff. If you violate even one of them, the IRS can completely invalidate the IRA. They can force a distribution subject to ordinary income tax and the 10% early withdrawal penalty. This is a major reason why the vast majority of IRA trustees don't accommodate physical real estate.

Specific Rules for Holding Real Estate in a Roth IRA

Here are some of the rules surrounding holding real estate in an IRA account:

  • You cannot be personally involved in the management of a real estate IRA. The account must be managed by the trustee. You and your real estate IRA will be completely distinct entities.
  • You cannot receive any benefits from the property held in the IRA. That means you can’t live in it, your family can’t live in it, and you can’t run a business out of it. There can be absolutely no personal use of the property.
  • The IRA cannot purchase property that is in any way connected with you or your family.
  • All financial activity, including both income and expenses, must go into or originate from the IRA. You cannot receive any income or pay any expenses for the property held in the Roth IRA.

In short, you can’t use real estate in a Roth IRA to build a personally directed real estate empire.You can only make the choice to start a real estate IRA, decide who the trustee will be, then fund the account. All management of the assets held in the account must be handled by the trustee. Violate that rule, and really bad things can happen.

How to Buy Real Estate in a Roth IRA

As you’ve probably already guessed, holding real estate in a Roth IRA is not nearly as simple as traditional paper assets.

First, you have to open a self-directed account with a trustee that specializes in real estate IRAs (see next section). Once you've made that selection, you'll set up your account much the way you would any other self-directed Roth IRA. Once again, you cannot be personally involved in the real estate investment process. You will direct the Roth IRA trustee to invest in real estate, fund your account, then step back from the entire process.

Any real estate held within the Roth IRA must be legally titled in the name of the IRA account. It cannot in any way be connected with you personally (yes, I'm repeating that point, because it's absolutely critical with real estate IRAs). You will have to complete forms specific to the IRA trustee, directing them to make property purchases within the account.

The funds to invest in real estate must come from the account. You will not be able to supplement the purchase or property management with funds from unrelated accounts. All income collected on the property must come into the IRA–not a single nickel can come to you personally. Similarly, all expenses must be paid out of the IRA account. Any profits generated by rental income must be retained within the account.

Selling Property Held in a Real Estate Roth IRA

When it comes time to sell property, your only input will be to approve the sale price. This is similar to the process of approving the sale of a stock at a certain price in a conventional IRA account. However, all proceeds from the sale of the property will once again be retained within the IRA account.

All records pertaining to each property held in the IRA are also retained by the trustee. As you can see, it's almost ironic saying that it's a self-directed account. Other than selecting the trustee, funding your account, and agreeing to the sale price of a property, there's really nothing self-directed about it. All activity and financial transactions are handled by the trustee.

IRA Trustees that Specialize in Real Estate IRAs

As already noted, very few IRA trustees will allow you to hold real estate in your Roth IRA. Not only is the process complicated, but the trustees themselves may also face various penalties for failing to get it right.

Below is a list of five trustees known to handle real estate IRAs. Please understand we are not making recommendations for any of these companies. Rather, we are offering this list as a starting point in your search for a suitable trustee.

Be sure to research each company through various third-party rating services, such as the Secretary of State, both in your state and the company's home state, as well as the Better Business Bureau, Yelp, and other sources.

Also, thoroughly investigate what the company offers. You'll need to know not only the degree of expertise they have in real estate IRAs, but also the specific processes they employ, and the fees they charge.

The five trustees known to specialize in real estate IRAs includes:

How Mortgage Financing Works with Real Estate in a Roth IRA

If investing in real estate in a Roth IRA is a complicated process, it's even more so if you attempt to borrow money to do it. It's not that borrowing money to purchase real estate in a Roth IRA is impossible, but there are hurdles.

Once again, we need to stress that you don't take this step without first consulting with either a CPA or a tax attorney. You should be aware that traditional mortgage financing for real estate is not available within an IRA account, traditional or Roth. This has much to do with the fact that any financing connected with an IRA account must be “non-recourse”. These are loans traditional mortgage lenders don't like to make.

Under a non-recourse loan, the lender will be limited to the real estate only as collateral for the loan. Unlike a typical real estate mortgage, the lender won't be able to pursue the other assets of the either the IRA account or of the account owner. And no mortgage lender will grant a loan without your personal guarantee, which you cannot provide without violating the IRA.

To finance the property in a Roth IRA, you must work with a non-recourse lender. Naturally, those are few and far between. They also have very stiff requirements. For example, a non-recourse lender will require a large down payment, typically 50% or more.

And since you will not be able to provide a personal guarantee, the lender will need to be satisfied that the property generates sufficient cash flow to meet the monthly mortgage payment, as well as utilities, repairs, maintenance and a reasonable estimate for a vacancy factor (times in which the property is without a tenant). And of course, the loan will be the obligation of the IRA, not of you personally.

A Financed Property in a Roth IRA May Be Required to Pay Tax

That leads to an even bigger complication. If you take financing, your real estate IRA may owe tax on unrelated debt-financed income (UDFI). The tax will be due on the percentage of the property value covered by the loan. So if 50% of the property value is financed, then 50% of the profits will be subject to the tax.

The IRA must then file a tax return (IRS Form 990-T). It will file as a trust, and pay trust tax rates, since an IRA is in fact a trust. If you don’t want to go the financing route (and be subject to the UDFI tax), you do have some other options.

The most obvious, of course, is to fund the property purchase completely out of the funds from your Roth IRA. Now it will be close to impossible to do this if you’re funding your IRA at the normal contribution rate of $5,500 per year. The alternative will be to do either a rollover of funds from another Roth IRA, or a conversion of plan assets from non-Roth accounts.

Still another is to work with one or more partners on the same property. Each partner will have an undivided interest in the property.

If Actual Real Estate Scares You–REITs to the Rescue!

The acronym for real estate investment trusts, REITs are a lot “cleaner” to own than physical real estate. They’re also much easier to hold in a Roth IRA. You can hold them in much the same way you do stocks and other paper investments. The returns on REIT have also been impressive for many years. For example, the average return between 1977 and 2010 was 12%, and has been about 9% since. REITs are a good way to invest in real estate in a Roth IRA, and with a lot less complication and risk.

So if you're thinking about holding real estate in your Roth IRA, first sit down and have a long, deep discussion with a CPA or tax attorney. Then consider if you have both the funds and the temperament to invest in physical real estate. If that all checks out, contact one of the real estate IRA companies that specialize in that investment, and move forward. But if you're not willing to endure the complication and the risk–
but you still want to hold real estate in your Roth IRA–take a good, hard look at REITs.

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How To Buy Real Estate In A Roth IRA

How Substantially Equal Periodic Payments (SEPP) Can Help Your Early Retirement

Maybe you’ve heard of substantially equal periodic payments, sometimes referred to as SEPP, or maybe more commonly “72(t)” or “72(t) distributions”. Most people probably haven’t, or if they have they have only a vague idea what they are about. It’s something of a complicated topic, but rest assured it can help your early retirement plans in different circumstances.

There are two fundamental dilemmas facing just about anyone who wants to retire early:

  1. Most people accumulate most of their savings through tax-sheltered retirement plans, and
  2. If you retire before turning age 59½, you’ll not only pay ordinary income tax on those withdrawals, but you also have to pay a 10% early withdrawal penalty.

Now before we get any deeper into SEPPs, let’s first state that the only way to create a flow of distributions from tax-sheltered retirement plans free from either ordinary income tax or early withdrawal penalties is to set up a Roth IRA conversion ladder. But even that strategy isn’t without tax consequences. In effect, you pay taxes early in the process (for the conversions), to generate tax-free withdrawals later.

But SEPPs can help if you’re in an employer-sponsored plan or if you’re unable to implement a Roth IRA conversion ladder. Alternatively, you can use a SEPP with a Roth IRA conversion ladder or other income sources, at least until you reach 59½ .

Confused? You’re hardly alone.

What are Substantially Equal Periodic Payments?

SEPPs, or 72(t) distributions, don’t come up often in early retirement discussions, probably because they’re complicated. But in some situations, they may be one of the best strategies to minimize withdrawals from tax-sheltered plans, and that’s why they need to be on your early retirement planning radar screen.

SEPPs are available for both IRA accounts and employer sponsored retirement plans. That includes 401(k) and 403(b) plans, as well as traditional IRA accounts. However, there are different ways employer plans are handled compared to IRAs.

You must take SEPPs for at least five years, or until the day you turn 59½, whichever is longer. For example, if you begin taking payments at 50, you’ll have to continue taking them until at least age 59½. If you begin taking distributions at age 56, you’ll have to take them until at least age 61–five years.

While that’s taking place, there can be no plan contributions, conversions, rollovers, or non-SEPP withdrawals from the plan in question. Put another way, your retirement plan must be inactive except for SEPP distributions, and ordinary plan investment activity.

Separation from service exception. You can begin a SEPP at any age you choose. But there is a special provision in the law that allows you to begin taking distributions penalty free if you are separated from employment for any reason during or after the year you reach age 55. (The age is 50 for public safety employees of the federal government, a state, or a political subdivision of a state, and participate in a governmental defined benefit plan). The separation from service exemption is for employer-sponsored plans only, and does not apply to IRA accounts.

How Substantially Equal Periodic Payments Can Help Your Early Retirement

Once again, the basic problems with having most of your money in tax-sheltered retirement plans is the tax burden involved in making withdrawals prior to turning age 59½. At the same time, you may be completely dependent on those withdrawals since you won’t be eligible for Social Security for several years. Like a Roth conversion ladder, this is where a SEPP can help your cause.

It’s important to restate the point that SEPPs don’t eliminate ordinary income tax on your distributions. But they do take out the 10% early withdrawal penalty, and that’s more important than it seems at first glance. If you’re in early retirement, your income is probably on the low side, and you’re in a low tax bracket. Paying only say, 12% in ordinary income tax on retirement plan distributions probably won’t be the early retirement deal-killer you might be imagining.

Setting up a SEPP basically involves creating a distribution method–we’ll take a look at specifically how to do that in the next section. We’ll be using examples of annual distribution amounts, but you can also divide those into regular monthly payments.

But before we get into that…

An Unexpected Benefit: Keeping a lid on Required Minimum Distributions (RMDs) at 70½

An advantage of the SEPP is that you have access to your retirement savings earlier than you normally would. That is, the benefit of having your retirement savings would be spread out to cover more years. That can be a big advantage when it comes to RMDs.

The IRS requires RMDs beginning at age 70½. Since they’re based on life expectancy, you’ll have to begin withdrawing something like 4% per year from all your plans (the exception is a Roth IRA).

Now if you’ve accumulated $2 million in retirement savings at that age, 4% will see you taking $80,000 per year. That may be more money than you want or need. It also holds the prospect that you’ll drain down funds you hoped to pass on to your heirs. But on a more practical level, it may also put you into a higher tax bracket. When added to Social Security and any pension income you might have, an additional $80,000 could put you into a much higher tax bracket.

What’s more, the percentage you’re required to withdraw will increase progressively each year, as your life expectancy gets shorter.

But if you’ve been using a SEPP to take distributions over a much longer period of time, you’ll have a smaller retirement portfolio by age 70½. That will make the RMDs smaller, and reduce the potential tax liability. After all, if you early retire, you won’t have Social Security and pension income inflating your income and tax liability.

How to Work a SEPP

SEPPs offer a choice of three different distribution methods:

    1. Required Minimum Distributions,
    2. Fixed Amortization, and
    3. Fixed Annuitization

Let’s look at each method individually (you can get more information from the IRS Q&A page but below is a summary):

Required minimum distributions (RMDs). This method bases your annual payment on your remaining life expectancy. For example, if you’re 55, and your life expectancy is 85, you’ll be required to take a distribution equal to 1/30th of your plan balance. The payment will therefore change each year with the annual payment being slightly higher each year based on a declining life expectancy at each age. Of course, since your plan will continue to earn investment income, and the distribution is based only on a percentage, it probably won’t be exhausted even once you turn 85. No problem, the distributions will continue based on your remaining life expectancy from age 85. If you choose this method, you’ll have to keep it for life.

Fixed amortization. Under this SEPP method, fixed payments will be distributed over a fixed term, for example 20 years. However, you do have the option to switch over to the RMD method after at least five years, but once you do you’ll be there for life.

Fixed annuitization. This is a combination of the other two. In effect, you set up an annuity of fixed payments based on your expected lifespan. This method also gives you the option to make a one-time switch to the RMD method, which again, you’ll have to keep for life.

Three Different Calculation Methods for the Three Different Distribution Methods

The IRS also has three different life expectancy tables you can choose for your distributions:

Uniform Lifetime Table. This will generally result in the lowest annual distribution amount.

Single Life Expectancy Table (see page 46 of link). The main benefit is it enables you to choose the highest SEPP payout rate, if that’s what you want.

Joint and Last Survivor Table (see page 47 of link). This method brings your spouse into the picture, mainly if there’s an age gap of more than 10 years between you. The greater the age gap, the lower the annual payment will be.

So far, we’ve been discussing life expectancy in connection with SEPPs. But as with anything related to the IRS, it’s never quite that simple.

The IRS also figures in interest rates under the Fixed Amortization and Fixed Annuitization methods. That rate is calculated as 120% of the federal midterm rate–which are US Treasury notes with terms of between four years and nine years. That roughly correlates to the average length of a SEPP distribution period. And of course, since Treasury yields change on a regular basis, the rate used will change as well.

You’ll have to choose an interest rate for the Fixed Amortization and Fixed Annuitization Distribution methods. But that rate is the maximum rate you can choose. You’re free to select a rate that’s lower. You can choose a rate based on either of the two months immediately preceding the month when distributions begin. That will give you at least some control over your distribution amount. The rate chosen will be in place for the life of the SEPP.

Using either SEPP method, you’ll have to combine remaining life expectancy with the interest rate.

SEPP Payment Examples

Let’s look at SEPP annual payments using all three methods. We’ll assume you’re 50 years old, have $400,000 in retirement savings, and a life expectancy of 34.2 years. We’ll assume a 5% annual rate of return on investment, which is not the same as 120% of the federal midterm rate (it’s not you–this is confusing!).

Using the RMD method, you simply divide $400,000 by 34.2 years. That gives you an annual distribution of $11,696. At age 51, your life expectancy falls to of 33.3. Your $400,000 adds $20,000 (5%) investment income, but it’s paid out $11,696 the previous year. Your remaining balance than is $408,304. Dividing that by 33.3 years, your annual payout at age 51 is $12,261. Because the annual distribution is rising each year, your account may deplete at the end of your life expectancy.

For the Fixed Annuity and Fixed Amortization distributions, you’ll have to add an interest rate factor. The annual distribution amount will be something very similar to a reverse mortgage calculation. With either distribution method, the annual distribution will remain fixed for the term.

If you begin taking distributions at age 50 from a $400,000 plan, you’ll have a life expectancy of 34.2 years. But you’ll also have to add the 120% of the federal midterm rate. If that’s 2.98%, your annual payout will be $18,649.

To get that number, you can use a mortgage calculator. You’ll have to enter a “loan amount” of $400,000, at 2.98%, for 34.2 years (not all mortgage calculators can accommodate the odd term, but try the one at Bankrate).

These are just rough examples. The specific payout amounts and percentages will vary based on the life expectancy table you use, the assumed interest rate, and when you actually begin taking distributions.

Doing a SEPP After Rolling an Employer Plan into a Traditional IRA

It’s usually easier to do a SEPP from a traditional IRA. This is because employer-sponsored plans usually have rules regarding distributions. Since a traditional IRA is completely self-directed, you have complete control over how you structure your SEPP.

More important, you can set up a SEPP based on a single dedicated IRA account. For example, let’s say you have $1 million sitting in a 401(k) plan, and you want to begin taking penalty-free distributions beginning at age 50.

You decide you need $40,000 per year to retire comfortably. You do a rollover of $400,000 from the 401(k) plan into a traditional IRA. That will provide you with the needed income level for 10 years. By then you’ll be 60 (rounding up from 59½), and you’ll be eligible for penalty-free withdrawals based on your age.

Meanwhile, the $600,000 remaining in your 401(k) plan can continue to accumulate investment earnings over the next 10 years. At that point, you can begin making penalty-free withdrawals from that plan.

In a perfect world scenario, the $600,000 remaining 401(k) will grow to $1 million by the time you turn 60. Using the safe withdrawal rate of 4% (explained in the next section), you’ll continue to receive distributions of $40,000 per year for the rest of your life ($1 million X 4%).

Using the SEPP to cover your early retirement years will not only enable you to create an income flow, but also to maintain it throughout your life.

The Potential Pitfalls of a SEPP

This is a good time to bring up a few caveats:

Choose the right distribution rate. You’ll need to choose a distribution rate that will ensure your plan continues to pay distributions throughout your life. It’s generally recommended that you use the safe withdrawal rate (SWR) to make withdrawals from retirement accounts. The SWR is just a theory, but it holds that if you withdraw no more than 4% of your portfolio each year, you’ll never outlive your money.

The theory part is that it assumes you will earn a combined average annual return on stocks and bonds of greater than 4%. That will make sure you have money for living expenses, but that your portfolio continues to grow to cover inflation.

Whatever distribution rate you come up with for your SEPP should be as close to 4% as possible. If it’s in the 6% to 7% range, you may find yourself running out of money later in life.

Don’t change distribution methods within five years. If you do, you’ll lose the exception to the 10% early withdrawal penalty. And it looks like the penalty will be retroactive to the beginning of the SEPP plan, plus interest.

Consult with a tax professional before moving forward. As you can see from some of the detail in this article, setting up a SEPP is a complicated process. We recommend you consult with both your plan administrator and a CPA before choosing any particular option. The (sometimes) lifetime nature of SEPP distribution options, as well as the tax consequences, have to be carefully considered before making a final choice. Hopefully, we’ve given you enough information here that you’ll at least be able to ask intelligent questions.

You Probably Don’t want to Rely on Your SEPP Alone for Early Retirement

It’s important to stress that a SEPP is just one method of generating income from tax-sheltered retirement assets in early retirement that’s at least exempt from the 10% early withdrawal penalty. It doesn’t have to be your only method, and probably shouldn’t be.

As discussed earlier, the Roth IRA conversion ladder will probably be a better method for most people. You will have to pay ordinary income tax on the retirement assets converted to a Roth IRA. But once you do, you’ll create a cash flow that’s not only penalty-free, but also tax-free before reaching age 59½.

It may also be desirable to live on taxable investments, at least until you turn 59½ and can access your retirement plans penalty-free. That will be easier to do if you retire at say 55, than it will be if you go out at 45. It can be tough to save up a large amount of money without the benefit of tax deferral.

However you work out the pre-59½ income situation, just make sure it will provide you with a definite cash flow for the many decades that early retirement creates.

If you’d like a more detailed discussion of SEPPs, feel free to download a copy of The Complete Guide to Substantially Equal Periodic Payments (SEPP).

How Substantially Equal Periodic Payments (SEPP) Can Help Your Early Retirement

You’re Debt Free, Now What?

Debt free

You’ve worked hard for months, possibly years, to become debt free. For some of you, this may mean you’ve paid off your student loans and credit cards. And for others, it means you have tackled your mortgage as well.

“Debt free” is a term that means different things to different people, but if you’ve been laser focused on a particular goal for a sizable amount of time and you’ve crossed the financial finish line to make your last payment, it can be slightly disorienting to figure out what comes next after debt–regardless of what it is!

If you’re now debt free and trying to figure out what you can do to further yourself down the path to financial independence, read on.

If you listen to the podcast, Brad and Jonathan often talk about different “levers” you can pull to save more money and optimize what you have. When or how you decide to pull these levers is up to you. Your financial situation will be unique, so these areas of focus will help you figure out what can be beneficial for you to focus on. And, remember, they can be implemented at different times in your journey.

Related: The Beginner's Guide To Reaching Financial Independence

First, Make Sure Your Spending Serves You

Like anyone who has been on a strict diet and finally shaved off those unwanted pounds, and you’re now free to eat carbs again–you might feel the urge to rebound and rebound hard! The same type of “deprive and reward” behavior relates to money. Your debts are paid off, so surely you will have more wiggle room in your budget to indulge!

But before you bite into the spending equivalent of a double chocolate chip cookie, or even devouring the whole box, take a minute to examine your behavior before you “treat yo’self.” Debt had you laser focused on getting your “amount owed” down to zero, and without it, you might start to feel a little lost.

Yes, you’ve been AWESOME at not pushing the “Buy Now” button on Amazon for months. But beyond telling yourself “no,” from now until forever which is not only hard, but darn near impossible, it might be worth understanding why you had to say “no” in the first place. Why does the urge keep coming up and is it serving you?

Did you spend because you had a stressful day at work? Because new clothes make you feel good at first but regretful later? Sit with your feelings–what purpose is the behavior serving for you?

You, likely, have room in your budget now to indulge, but if you don’t address the behavior that contributed to the debt, your will power will only last so long without that ugly looming debt stacking back up. When you’re debt free, treat yourself with intention so you don’t simply relapse.

Now, Build Your Cash Flow

If you have avoided relapsing to spending temptation–you can simply store your extra cash away in a savings account until you have decided where it should go. In the aforementioned “levers” of FI, you will need some cash to invest with, and it may take you some additional time of financial discipline, and some continuing education on what to do with the cash you accumulate.

Treat your budget just like you did while you were paying down your debts and instead of sending that monthly payment off to a loan company, sock it away. Keep treating that payment as real–except you’re paying yourself. At first, you may not have a plan for this cash; but as you accumulate dollars, keep learning and adding knowledge that will help you optimize your personal situation. Soon your stash, which will be safely waiting for you, will be ready for you to put those dollars to work .

At this early stage, you’ll want to keep the good habit of paying yourself and saving. You can figure out later if it should be put in a retirement account, towards a down payment on a home or investment property, or, part of an emergency fund in a savings account. There’s a lot to learn and a lot of tactics you can tinker with, so while you save, learn and learn some more.

Tax Optimization Is Sexy

You know what’s exciting? Saving serious money on groceries. You know what’s not exciting? Spending time with tax law to figure out how you can be smarter about how much you send to Uncle Sam. Well, it’s not sexy until you see those dollar signs!

Tax optimization can be a bit on the dry side for some of us, but it’s prudent to try and keep the cash you earn as much as possible. Tax optimization can be as easy as making steps to better track your medical expenses and document them accordingly to be written off later, to more sophisticated strategies like figuring out how to lower your taxable income by putting that aforementioned budgeted money into a 401k plan.

There are plenty of resources out there, and Episode 25 with the Wealth Accountant is a great primer for tax optimization strategies .

Hack Your Employment

If you’re working for an employer, how can you make the most of it? Now that you’re debt free and you have a wee bit more headspace to be thinking about other money savvy strategies, are you taking advantage of every nickel and dime of value your job provides you?

A few ideas would be to max out your 401k beyond the match. See if your employer offers discounts on any services you spend money on. Look over your health plan to ensure it’s meeting your needs (or exceeding your needs) and check to see if they offer a Health Savings Plan.

If your employer is a bit sparse on the benefits, maybe it’s a good time to pool together with some fellow employees and ask collectively for a subsidized gym membership or a flexible work from home policy to save on commuting costs.

Learn About Investing

If you’ve been throwing all of your money at your debt and now have cash to spare–where should you be investing it? Take a look at The Simple Path To Wealth and take time to learn what strategies would be best for you.

Since everyone’s different–you may want to max out your 401k, Roth IRA or start investing in stocks on your own. Episode 19 goes into how to start with index investing & VTSAX to boot. Others will choose a path of real estate investing or maybe a combination of methods. Now that you’re debt free, you can use your previously allocated funds to start building your own perpetual money making machine through investments. Now your money is working for you, instead of simply servicing your debts. Investing is an awesome tool to begin learning about, and your path is customizable for your needs!

So, if you’ve read this far, CONGRATULATIONS! on paying off your debt and taking the next steps towards financial freedom. Your community is here for you, and we are cheering for your FI success!

Want to read more from Shannyn? Check out the rest of her articles here.

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Are You Maxing Out Your 401(k)? Don’t Miss Out On The Employer Match!

Don't Miss Out On The Employer Match!

One super easy way to put an extra few percent toward your savings rate is earning a retirement savings match at your employer. Every additional percent of your income, or your employer’s match, that you put away puts you a few months or sometimes years closer to financial independence (FI).

If your employer offers a retirement savings plan at work, such as a 401(k), 403(b), 457, Thrift Saving Plan or other plan, you may be eligible for a retirement savings plan matching contribution to help you get to FI faster. Of course, not all workplaces have retirement saving plans and even those that do don’t always match.

That said, it’s super important that you’re aware of what options are available to you and how they work or you could be inadvertently missing out on essentially free money. Whether you have access to a plan now or may have access to a plan in the future, here are a few things you definitely need to be watching out for to make sure you get every penny of retirement matching funds that you can.

Retirement Savings Plan Matching Rules Can Be Tricky

In an ideal world, all retirement savings plans would be super straight forward. The matching formulas would be intuitive and companies would do the right thing and honor the match no matter how you contribute your money. Unfortunately, confusing rules could be costing you some of your retirement savings plan matching dollars.

Confusing Matching Formulas

If you’re just getting started contributing to your workplace retirement plan, you may not be able to max out your benefits. Even so, getting the employer match is a great way to get started when you have high interest rate debt that still needs to be paid off.

Unfortunately, matching formulas aren’t always as easy as matching dollar for dollar on the first 5% of your salary. Some employers have confusing formulas like matching 50 cents on the dollar for the first 5% you contribute and 25 cents on the dollar for the next 10% you contribute.

In total, you’d receive a 5% matching contribution from your employer, but in order to get that 5% you’d actually have to contribute 15% of your salary. No matter what your employer’s matching formula is, make sure you understand how much you have to contribute in order to get the full employer match.

Maxing Out Early in the Year Could Cost You

Some employers contribute the employer match dollars each paycheck, which is great. Be aware, if you max your retirement account out early in the year, instead of contributing equally throughout the year, you may not get the full employer match. Instead, you may only get the employer match each pay period where you had a retirement contribution and miss out on the employer match in those pay periods where you couldn’t contribute anymore because you had already maxed out for the year.

Thankfully, some companies realize this is crazy and make a true-up contribution at the end of the year to give you the full employer match, but not all companies do. Make sure you either spread your contributions out throughout the year to get the full employer match or make sure your company will give you a true-up contribution. You don’t want to miss out on free retirement matching dollars.

Vesting Schedules Mean You Don’t Always Earn Your Match Dollars

If you just started a job in the last few years and you’re thinking about leaving for greener pastures, you might be surprised to learn you may not get to take all of your retirement matching dollars with you. Some employers don’t actually give you your employer match dollars right away. While they’re invested just like regular employer match dollars, you only earn the match dollars on a year by year basis according to your employer’s vesting schedule.

For instance, some employers allow you to vest 20% per year for five years. At the end of your first year of employment, you’d get to keep 20% of the match dollars you’ve earned, 40% the second year and so on until you earn 100% of the match dollars after year five.

The vesting is retroactive on all match dollars earned, so once you hit year five you get 100% of the previous match contributions and all match contributions going forward. However, if you left after the end of year three, you’d only get to keep 60% of the match dollars contributed to your account to that point.

End of Year Match Contributions Could Result in No Match the Year You Leave Your Job

Not all employers match your retirement contributions each pay period. Instead, some choose to deposit match dollars into your retirement account once per year. For these employers, many require you to be an active employee as of a certain date, such as December 31st, to earn the match for the year. If you leave your job on November 30th, you wouldn’t get a penny of employer match dollars for the year even though you were an active employee contributing for 11 months.

Not All Employers Match Catch up Contributions

People age 50 and older can contribute extra money in most workplace retirement plans called catch up contributions. The catch is, not all employers will match those catch up contributions. This is another scenario when maxing out the regular portion of your workplace retirement plan early in the year could hurt you. Make sure to check with your plan to see how catch up contribution matching would work. Figure out a way to get the match and max out your catch up contribution, too.

Recheck Your Contributions Annually

While contributing to a workplace retirement plan should be easy enough that anyone could understand it, many plans have complicated rules when it comes to the employer match. Make sure you understand all the ins and outs of your plan’s employer match to make sure you don’t miss out on it. Then, check in once per year to make sure the rules haven’t changed. At that time, make sure you’ll still get the full employer match and, if the retirement plan contribution limits have increased, increase you contributions to max out your retirement account again to continue being a retirement savings rock star.

Want to read more from Lance? Check out the rest of his articles here.

Should You Pay Off Your Mortgage Or Invest?

mortgage or invest

When it comes to optimizing your money, one hotly debated topic is whether you should use your available income to pay off your mortgage faster or invest the money for the greatest return. The future is unknown, but there are emotional and logical arguments to be made for investing or paying off the mortgage first.

Planning for financial independence means you consider even more factors to find the right answers for yourself. To invest or pay off the mortgage, is the question. Let's take a look at the arguments so you can make an educated decision about which is better for you. After all, personal finance is personal and this is a decision you’ll have to make for yourself.

The Arguments for Paying Off the Mortgage

There’s something special about being completely debt free including the mortgage. When you’re debt free, not a penny of your income should go toward making interest payments. You no longer worry about setting aside a portion of your monthly income to pay for your housing. While you do still pay for things like repairs, maintenance, insurance and taxes, these costs won’t be nearly as big as the principal and interest on a mortgage payment, in most cases.

When you’re no longer making principal and interest payments for a mortgage each month, chances are your monthly expenses will decrease by quite a bit. This also reduces the amount of money you’d use in calculations to see how much money you need to set aside for FI like the 4% rule. If you have carefully planned to pay off your mortgage before you reach FI, the reduction in expenses due to no longer having a mortgage payment could play a big role in your plans.

While others would rather invest money to potentially earn a higher return, those that decide to pay their mortgage off have one major fact on their side. Paying down a mortgage gives you a certain return on your money. If you make extra principal payments on your mortgage, you don’t pay interest on that money you no longer owe. The certain return on the money you put into your mortgage will be the interest rate of your mortgage. Of course, this assumes your home value stays constant or is increasing. If the value of your home is decreasing, this may not hold true.

Emotionally, paying down your mortgage may make more sense, too. While investing to reach FI definitely speeds up the process rather than just putting money in a savings account, sometimes it’s harder to get excited about building up an investment account than it is to get excited about paying down a mortgage.

When my wife and I were paying down over $80,000 of student loan debt, we did everything we could to put a few extra dollars toward paying off that debt. I imagine there is a similar feeling when someone is trying to pay off their mortgage quickly. That same intensity may be more difficult to achieve when it comes to investing, resulting in putting more money toward paying down the mortgage than you would invest.

The Arguments for Investing

While paying off the mortgage may be the emotional option, investing is often seen as the logical option to optimize your money. Mortgage rates have recently been at all-time lows. Mortgage rates of under 5% make it easy to see how investing rather than paying down the mortgage could result in a higher return for your money. If your average rate of return on your investments is at least 8%, you have quite a bit of wiggle room above the 5% or lower rate you’re probably paying on your mortgage.

Related: M1 Finance Completely Free Automated Investing

Another reason why investing is the logical answer to the debate is the fact that the principal and interest portion of a fixed rate mortgage will remain the same each year as time goes on. So, you can use future dollars that are worth less than today’s dollars, due to inflation, to pay off your mortgage. You don’t have to lower your returns by the rate of inflation because your mortgage payment won’t be increasing with inflation like all of your other expenses will.

Here’s a quick chart that shows the difference in time it would take to pay off a mortgage between applying money toward a 5% interest rate mortgage versus investing that money at an 8% annual return. This also assumes a brand new 30 year fixed rate mortgage with a $200,000 starting balance.

Extra Principal PaymentsYears To Pay Off Mortgage With PrepaymentsYears For Investments To Reach Mortgage Balance Remaining With No Prepayments
Extra $50015 years 2 months13 years 11 months
Extra $1,00010 years 4 months9 years 6 months
Extra $1,5007 years 11 months7 years 5 months

Keep in mind, you may have to pay taxes on your investment earnings and dividends you may receive. On the other hand, you won’t be able to deduct your mortgage interest unless you’re one of the few people that will still itemize your deductions after the recent tax law change.

Ultimately, You Decide

What matters is you decide what is best for you and your situation. Keep open to adjusting as future needs and wants become evident. Compare the numbers; the interest rates, the time intended in the home, and your risk tolerance. And remember, you can do a little of both if you’d like or change your mind and switch methods later on. The decision is in your hands.

Want to read more from Lance? Check out the rest of his articles here.

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How To Build A Perpetual Money Machine

How would you live your life if you knew you were the owner of a money machine that perpetually put out enough for you to cover your expenses, year after year without having to work? As long as you maintain the machine, it keeps pumping out money to cover what you need to live.

Pretty fabulous isn’t it?

The concept of the perpetual money machine is essentially the bedrock concept of the FI community. Your perpetual money machine is the portfolio of investments that will fund your retirement. With enough money, that’s invested simply (meaning, no genius level stock picking or speculation) over time, you can safely withdraw about 4% yearly and still maintain the machine’s cash regeneration abilities. That stockpile will have enough firepower as an investment to maintain itself since you will only be skimming a little bit off the top. Essentially, you live off of your investments and the machine can still feed itself to maintain it all.

So, how can you build your money making machine? First calculate your numbers.

The money making machine is unique to each person in terms of how big it needs to be. How much money will you need in the machine to ensure it runs properly? To calculate your money machine number, do your best to estimate your annual expenses and multiply it by 25.

The number you land on (25x your annual expenses) will make up the total portfolio value needed to build the machine for passive income building. This number doesn’t include the value of your home or anything that counts as an asset but doesn’t generate cash (like a car, jewelry or gold doubloons you have buried in the yard)–so unfortunately, you machine is simply comprised of cold hard cash that generates more cash, usually by being invested in low-cost (meaning low-fee) index funds.

If you’re curious–many in the FI community are somewhat fanatical about the money making machine being invested in low-cost index funds (VTSAX) with Vanguard. Though, if you’re not jazzed about Vanguard, you can also take advantage of lower expense ratios with Schwab and Fidelity.

Related: The Beginner's Guide To Reaching Financial Independence

Okay, Now What? Save & Invest To Build The Machine

After you calculate how much you’ll need to save, you can work backwards to cut expenses and work your way up to a much heralded 40% (or more!) savings rate. 

Your goal will be to cut your cash hoarding timeline down by being strategic about your expenses. Cut any unnecessary recurring expenses and any excesses you don’t need. The more you can put away early, the easier it will become for the machine to be fully operational and self-sustaining so you can retire and begin your withdrawals.

Take any cash you can save and put it into low-cost index funds and wait. While most people are tempted to touch their funds or move them around to try and guess the market trends, to time the market is futile. Don’t hit it and quit it, put your money in and sit on it–for years.  

If that’s not enough action for you, you can do your best to find ways to get your savings rate up and your taxable income down with tax optimization strategies. 

How Do You Determine How Much You Need In The Machine?

While 25x your annual expenses seems pretty straightforward, it gives most of us plenty to ponder over. How much do you really need to be happy? Figuring out your personal number and how you’ll get there is highly personal. What factors do you need to take into consideration to properly tool your machine in your post FI life? There can be a lot that goes into the math to help you arrive at your specific number.

Some factors to consider:

– Will your primary residence be paid off by the time you reach FI?

– How old will your children be when you reach FI?

– Do you have any special health considerations that could impact your number?

– Would you consider relocating to a cheaper location later in life? How could this impact the total amount you need to save?

– How will your taxable income change over time? 

This is just the tip of the iceberg in terms of planning. Nobody can anticipate every factor that could impact their finances in the future, but it shouldn’t keep you from getting started in building your own perpetual money machine that will fund your post retirement life.

As your money making machine becomes more powerful, you can begin to explore other levers to pull and hacks to power your growth to save more and spend less. Tricks like tax optimization, geo arbitrage, side hustling will help you build your machine faster and reach a point you can let it work its magic to fund your post-retirement life. 

Want to read more from Shannyn? Check out the rest of her articles here.

Perpetual Money Machine

Why Investing Conservatively Is Better

Why Investing Conservatively Is Better

When doing work with clients, I have several ways to determine the correct allocation they should have to stocks and bonds. More often than not, I find that clients are over allocated to stocks and are therefore taking more risk in their portfolios than is needed. Today, I want to discuss why investing more conservatively is usually better at helping clients meet their financial goals.

 Having a lower allocation to stocks may seem counterintuitive but it would help you reach your goals with less risk. 

When we run simulations for clients, one of the items we check is the impact of the allocation on the success. By reducing the client’s stock allocation, they are usually surprised that their rate of success increases. The reason is twofold, by limiting risk you keep more of what you earn, and you are also more likely to stick to your investment strategy. Our planning model can quantify the effect of keeping more of what you earn, but it can’t quantify the likelihood that a client’s investment strategy will change during the downturn. Therefore, the increase to success is probably even greater than shown in our Monte Carlo simulations!

Defining Goals

When we are determining a client’s rate of success, we are rarely aiming for an infinite amount of money. Instead, we are trying to get the client through their lives while having enough money to meet their spending needs, while also leaving some assets to their heirs. Our goal is a number greater than zero. Some clients have an inheritance goal, say $1,000,000 per child, and this is still much easier to target than “as much money as possible.”

How Much Risk to Take?

Because we are shooting for an actual number, we can determine the minimum rate of return to reliably reach this figure. Any deviation from this rate of return can be defined as “risk.” To reach our goal, we want to stay as close to on track as possible.

Usually, investors don’t view above average returns as risk. Therefore, when stock markets are trending upwards, investors tend to increase their allocation to stocks in order to grab the higher returns. This, increases the percentage of stocks in their portfolio in two ways. Firstly, they are either selling other assets and moving them to stocks or they are simply adding more money to the stock portion of their portfolios. Secondly, the overall value of the stocks are increasing, which in and of itself would increase the percentage of stocks in their portfolio. This often makes investors over allocated to stocks in the latter part of a bull market.

When the downturn comes, those investors will likely experience outsized losses in their portfolios, especially compared to their original expectations. For example, if you started out investing 60% in stocks and the market increases by 100%, you will now have a 75% stock allocation if you did not rebalance. The normal portfolio decline in a bear market is 21% for a 60% stock investor. However, since the stock allocation is now at 75% this investor has an increased decline of 26%.

The takeaway here is to determine the required rate of return to meet your goals. It’s easy to find historical rates of return for stocks and bonds, so with the target rate of return, it should be fairly easy math to come to a portfolio allocation. In my planning process, this is one of the three pieces of the puzzle we use to come to a recommendation on portfolio allocation.

Keeping What You Earn

I would submit that limiting your risk allows you to keep more of what you earn, rather than giving a large portion of it back when the next downturn comes. With that in mind, lower stock allocations through rebalancing may limit the upside, but it also limits the downside and can actually increase terminal portfolio value after a full stock market cycle.

For argument’s sake, please endure my simplified math of investment returns. I have used a 12% rate of return for stocks and zero for bonds. I chose these numbers due to the “Rule of 72” which tells you how long it will take (approximately) for your money to double.

If you invested $10,000 with an original allocation of 60% stocks and 40% bonds, after a 100% increase in stocks over six years, your account will likely have $15,840 in it. If stocks then decline by 35%, you will end up with $11,700.

Alternatively, if you maintain your 60% allocation to stocks by rebalancing the portfolio at the end of the year that your allocation rises above 65% stocks, you will have a total account value of 15,300. If stocks now decline by 35%, your 60% allocation will limit portfolio losses to 21%, or a decline in portfolio value to $12,100.

By using a properly allocated and rebalanced portfolio, you will have less of a wild ride up, but save yourself the terror of the rollercoaster ride down.

Keeping Emotions in Check

With the above examples, would you have stuck it out during the downturn? In reading the first example, I’m sure you would have been emphatic that you would have stuck to your guns. However, after reading the second example, maybe you’re not so sure.

I think that educated investors know that their stocks are not going to go to zero. Therefore, during a downturn, they’re not thinking about losing all of their money forever. Instead, the siren song of “they’re not losing as much as me” or “maybe I was taking too much risk” creeps in and they change their allocation at or near the bottom. It’s the comparison game that comes in to bite us!

It’s important to manage your emotions as an investor. I think the easiest way to do so is to dial back your risk when times are good, so to limit your risk during those downturns. Sure, the loss of upside will be painful, but let me be clear, the pain in the downturns is exponentially worse!

The best way to systematically reduce risk is by rebalancing when your allocation gets out of whack. This works during the downturns as well, allowing you to replenish your stock allocation as markets are falling and stocks get cheaper. Once again, this takes emotions out of the picture, allowing you to maintain the target allocation and make purchases while others are running from stocks.

Academic literature would say that rebalancing hinders accumulation of wealth, since letting your stock allocation continue to rise will statistically increase future returns. The higher stock allocation is self perpetuating since stocks rise more often than they fall.

However, if your ultimate goal is to reach the end of your life with enough money to meet your spending needs and leave money to heirs, you don’t need to target infinity, just a number greater than $0. Limiting your risk, while eliminating the chance to reach infinity, will allow you to sleep better at night, all while helping you achieve your goals. Heck, it may allow you to live longer by reducing the chances of a heart attack when you open those brokerage statements way in the future!

Want to read more from FI-nancial Planner? Check out his other articles here.

Why Investing Conservatively Is Better

Beyond Stoicism, Building Your Unique Path To FI

Beyond Stoicism

On Episode 52, Brad and Jonathan sat down with Todd Tresidder from the Financial Mentor to discuss the FI State of the Union. They discussed that there was currently a one dimensional path to FI, popularized by Mr. Money Mustache and widely followed and his fan base that involved stoicism and low-cost index fund investing.

Stoicism from the Mustachian point of view, involves being happy with less and avoiding the endless hedonistic treadmill. Pete’s special spin involves a dose of bootstrapping–don’t just learn to live with less, learn to do things yourself. You can’t find easy, quick fixes, but by empowering yourself, you can be happier. A hallmark of the Mustachian stoicism is also riding a bike instead of driving a car.

When you are crafting your path to FI, we often focus on one approach to FI, but there’s more to the financial freedom path than just the numbers. Often, we fixate on the “F” of FI- the “finance,” but not the “I,” the “independence” part of the journey. Before numbers are crunched and you sign up with Vanguard, it's critical to really get down with how you define freedom for yourself.

What does freedom and independence feel like for you and your family? If pinching pennies and researching ways to save money by cutting your own hair or biking to work feels like the right way to approach your FI journey, awesome!

But, if stoicism isn’t the life philosophy that truly makes you feel fired up about FIRE, there are alternative paths that can be activated beyond a focus on index funds and a low cost of living to reach FI. Your vision and enthusiasm are critical to your success, and luckily there are many combinations of choice to get you there.

The key point that Todd describes, that he asks everyone to think about is beyond stoicism. If it feels personally empowering to bootstrap and relentlessly optimize, then that path may be for you. If the more popular forms of FI feel more stifling than freeing, then luckily–there are alternative paths.

While this path works for many, and Todd was clear that this path can absolutely be successful for many, he desired to explore other legs of the FIRE stool. For each of the below paths, you can customize your journey with different spending levels, different equity levels, asset classes & investment strategies.

Option One: Passive Index Fund or “Paper” Investing:

Traditional FI, as he previously outlined with influencers like Pete from Mr. Money Mustache, outlines a path of “low costs and passive investing.” Getting to FI is simply a matter of calculating your expenses and multiplying it by 25.

So, to achieve FI , you’d need to get your expenses down as low as possible. Lower your expenses, find happiness with that level and be able to retire early because low expenses are easier to cover overall. 

When you get to 25x your annual expenses, and you can begin a 4% withdrawal rate in passive index traditional asset/paper assets, you are at FI. Todd outlined this as “lean FI” and said while there’s nothing wrong with this approach, it’s not for everyone–especially those who do not ascribe to stoicism or have circumstances that don’t lend themselves to a frugal lifestyle.

The following two paths to FI differ in that they aren’t as focused on spending less, but earning more so that when you do achieve financial freedom, even if it doesn’t look like the “traditional FI model,” it will fit your needs and embody what true financial freedom means to you.

Option Two: Real Estate Asset Class Investing

While investing in real estate isn’t as seemingly straight forward as what Todd describes as “paper assets” or “passive investing,” he argues that it can get you to FI faster if you’re in a lower income bracket, as you can get creative with financing or implementing your own skills to develop your asset for less cash.

It can be challenging for a person who is living on a tight budget, let’s say, as a teacher, to be able to hit FI as quickly on a $35,000 a year salary, even with the most frugal of lifestyles. But, in terms of real estate investing–you can house hack, pool your assets with a family member to invest in a rental property, and also develop and improve an existing property while it’s earning you income.

Of course, while there are ways to utilize creativity to access this asset class, there are also barriers and problems. Being aware of your own risk with each property and the inevitable market rise and fall is key. 

You can’t time the market, but watching out for signs the bubble will pop (risky financing, high demand and hot markets that can’t be sustained) is a skill everyone should hone in on to make this lever of FI work for them.

Option Three: Business Asset Class

Starting your own business is the third lever of an alternative FI path that isn’t as often discussed in the FI world. To build wealth with the other two levers, your equity/assets must compound, but this isn’t the case with a business. With time, the other two assets classes will begin to compound and grow, but time is utilized a bit differently with a business. 

Here, you can create equity with your time–and little else, if you don’t have a huge margin to work with in term of your primary income. By keeping your financial investment low in your business asset, you can tinker, experiment and yes–even fail. It may take a few (or many) tries to get a business model that brings in the income you need, but if you have no money to lose, you have everything to gain.

In the end, your blend of FI should boil down to happiness, even if it doesn’t fit a mold or seem quickly summarized in a blog post. Respect your values and know that the path you take may change over time. 

Being clear on  what freedom means to you is where you should start, and always, the tactic you should come back to. Your definition of freedom, even if it’s a bit contrarian, dictates the path you can take to get there.

All in all, there isn’t just one path to FI. Your path may look like a combination of several levers , with a bit of penny pinching and a few areas you simply won’t cut corners. Adding complexity, and nuance to your plans better represents reality and you can be more successful with an outcome that’s personally tailored for your FI goals.

Want to read more from Shannyn? Check out her other articles here.


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How And Why To Set Up A Roth IRA Conversion Ladder

How And Why To Set Up A Roth IRA Conversion Ladder

A lot of people would love nothing better than to be able to retire early. But saving for it, and actually doing it, are two entirely different endeavors. The basic problem is the way most people save, and that’s through tax-sheltered retirement plans.

But that creates an early retirement dilemma: if most of your money is sitting in retirement plans, you won’t be able to access them early without incurring a 10% early withdrawal penalty, as well as ordinary income tax.

Now you could get around this issue by making sure you have plenty of non-tax-sheltered investments. You’d be able to tap those in the early years of retirement, without having to pay either income tax or a penalty.

But that’s not as easy as it sounds, since taxable investments don’t get the benefit of tax-deductible contributions, nor of tax-deferred investment income. Many people who have huge tax-sheltered retirement portfolios, have comparatively little in the way of taxable savings and investments.

But there is another solution…

The Roth IRA Conversion Ladder

Roth IRAs have become increasingly popular in recent years. As retirement plans go, they’re unconventional. You don’t get the benefit of tax-deductible contributions. But you will get tax deferral on your investment income.

The upshot is that once you reach age 59 ½, and you have been in the plan for at least five years, you can begin making withdrawals of both contributions and investment income fully tax-free. Got that? Tax-free income in retirement–not tax-deferred.

Not surprisingly, this has led to a massive wave of Roth IRA conversions. That’s where investors move money from regular retirement accounts–401(k), 403(b), and traditional IRA plans–into Roth IRAs.

This is referred to as a Roth IRA conversion. Unlike simple rollovers of funds from one retirement plan to another, Roth IRA conversions generally have tax consequences. You will have to pay ordinary income tax–but not an early withdrawal penalty–on any retirement savings transferred into a Roth IRA in the year of conversion.

For example, if you move $40,000 from an old 401(k) plan into a Roth IRA, and you’re in the 12% tax bracket, you’ll have to pay $4,800 in federal income tax on the amount converted–$40,000 X 12%. (Non-tax deductible contributions to the 401(k) plan would not be taxable, but that’s a complicated topic we don’t have time to discuss here.)

On the surface, that may seem scary. But if you’re looking to create a stream of tax-free income in retirement, that benefit usually outweighs the current year tax liability.

Because of the tax liability, it’s most common for people to do a Roth IRA conversion over several years. That will minimize both your tax bracket and your taxes in the years of conversion.

Creating a Roth IRA Conversion “Ladder”

Since withdrawals from a Roth IRA can be taken tax-free, this creates a potential source of tax-free income even in early retirement.

There’s a loophole with Roth IRAs that pertains only to Roth IRAs, and no other retirement plans. It’s a loophole that’s made to order for early retirement.

Since Roth IRA contributions are not tax deductible, they can be withdrawn tax-free at any time. That means even before you turn 59 ½ and are in the plan for at least five years.

This has to do with IRS Ordering Rules, that allows the first withdrawals taken from your Roth IRA to be regular contributions. You can withdraw those at any time without ordinary income tax or an early withdrawal penalty.

Now the situation is a bit different with Roth IRA conversions. The IRS requires that there is a five-year waiting period after each conversion. If you withdraw the converted balance before five years, you won’t have to pay ordinary income tax, but you will have to pay the 10% early withdrawal penalty.

This is where the Roth IRA conversion ladder enters the picture.

Why a Roth IRA Conversion and Not Annual Roth IRA Contributions>

Just in case you’re wondering why it’s necessary to do a conversion, and not simply make annual Roth IRA contributions, it has to do with dollar amounts.

Roth IRA contributions are limited to just $5,500 per year, or $6,500 if you’re 50 or older. It would take a very long time to accumulate a large Roth IRA account with such small contributions. As well, if you plan to use your Roth IRA for early retirement, there may not be enough years between the time you begin making contributions and you plan to retire.

Still a third factor is that a lot of people still don’t participate in a Roth IRA plan. The lack of tax deductibility of the contributions can be an obstacle.

A Roth IRA conversion makes more sense as a source of the kind of funds that would be needed for early retirement. Since it can be potentially several hundred thousand dollars–depending upon when you want to retire–it’s more likely you have that kind of money saved in other retirement plans. This is particularly true of employer-sponsored plans, like 401(k)s, where you have both higher contribution amounts and a potential employer match.

Creating Your Own Roth IRA Conversion Ladder for Early Retirement

Can you see where were going with this? If you start doing Roth IRA conversions at least five years before your planned early retirement, you’ll be able to begin withdrawing those contribution balances tax-free and penalty free by the time you early retire.

As an example, let’s say you plan to retire at 50. You decide that you need at least $40,000 in tax-free income at that age. At 45, you begin making annual Roth IRA conversions of $40,000. In each year you make the conversion, you pay the applicable tax on the amount converted.

By the time you turn 50–and your initial conversion is five years old–you’ll be able to withdraw the $40,000 conversion balance you made at age 45. If you do this for 10 years, beginning at age 45, you’ll have a steady tax-free, penalty free income of $40,000 per year through age 59.

At age 59 ½, you can begin tapping any and all other retirement plans you have available, penalty free, and subject only to ordinary income tax. And of course, any amounts you have remaining in your Roth IRA account can continue to be withdrawn on a tax-free basis.

We’re throwing out a lot of numbers, so let’s see how this works in the table below.

YearAge At The Time Of The ActionRoth IRA Conversion AmountRoth IRA Withdrawal AmountSource Of Funds Withdrawn
20235040,000$40,0002018 Conversion
20245140,00040,0002019 Conversion
20265340,00040,0002021 Conversion
20275440,00040,0002022 Conversion
20285540,00040,0002023 Conversion
20295640,00040,0002024 Conversion
20305740,00040,0002025 Conversion
20315840,00040,0002026 Conversion
20325940,00040,0002027 Conversion
Totals15 Years$400,000 Converted$400,000 Withdrawn

An Important Caveat on the Roth IRA Conversion Ladder

As you can see from the table above, a Roth IRA conversion ladder can do an outstanding job of providing you with tax-free, penalty free retirement withdrawals well before age 59 ½.

But there’s a Part B to this strategy that’s equally important. If you’re going to use a Roth IRA conversion ladder to fund your early retirement years, you have to make sure there’ll be plenty of retirement assets left by the time you reach 59 ½.

In the example above, the total amount of retirement capital used for the Roth IRA conversion ladder is $400,000. That’s a lot of capital to burn through before you even reach 60.

In order for the strategy to work, you’ll have to have enough other retirement savings to provide you with an income for the rest of your life. Exactly how much that will be will depend upon how much income you’ll need during the traditional retirement years.

Complicating this issue is the fact that you won’t be eligible for Social Security until age 62 at the earliest. And if you begin taking benefits then, it will be at a greatly reduced level. Full retirement age for Social Security purposes–the age at which you’re entitled to your full retirement benefit–doesn’t begin until age 67 for most people today.

That means you may continue to be entirely dependent on your retirement savings between the time you reach 59 ½ and you begin collecting Social Security benefits. That would take a very large retirement portfolio.

Lowering the Amount of Retirement Savings You’ll Devote to the Conversion Ladder

Two alternatives to consider include:

  1. Utilize SEPP withdrawals to avoid penalties.
  2. Expect less income from the Roth IRA conversion ladder, and rely on additional sources of income in early retirement.

The Roth IRA conversion ladder is an excellent strategy to provide income during the early retirement years. But it only makes sense if you have the kind of retirement savings that will also provide a generous income when traditional retirement arrives.

How And Why To Set Up A Roth IRA Conversion Ladder

M1 Finance Review-Completely Free Automated Investing!

M1 Finance Review--Completely Free Automated Investing!

It’s no secret that investing is complicated. So anytime it can be made easier, folks get pretty excited. That’s why there’s been a lot of hype about M1 Finance, a completely free automated investing robo-advisor brokerage hybrid.

Today, I’ll take a closer look at all that M1 has to offer.

What is M1 Finance?

M1 Finance was founded out of pure frustration by Brian Barnes. He (and many others) believe that most financial services are not acting with the investors interest at heart, even worse they are unnecessarily complicated and cumbersome. Brian researched the investment platforms that were out there but couldn't find what he was looking for

What I was trying to do seemed relatively basic. I wanted to be able to pick my investments, and have recurring deposits automatically added to those allocations. I hated the idea of idle cash, so I wanted a platform that put all my dollars to work. Unfortunately, the seemingly simple solution just didn’t exist.

So he created it–a totally free (more on that later), robo-advisor brokerage that lets investors manage their money through automated investing.

Why is this so revolutionary? Well, let’s dive into the details of M1 Finance to find out.

What M1 Finance offers

ETFs & stocks

M1 offers ETFs and stocks through three major exchanges: NYSE, NASDAQ, and BATS. Sure, this sounds like every other trading site, but, thanks to the site’s innovative design, it’s not.

When you first invest, you start by making a “pie” where each investment you choose makes up a slice. You then set up the target weight of each slice. Or, you can choose from already made pies that professional investors have designed. Now all you have to do is add money to your account and M1 assigns the money to each investment based on your asset allocation. That’s it.

You can add, remove, or edit these “slices” whenever you’d like. You can keep track of your investments on M1's easy to use app.

Free investing

Perhaps the best feature of M1 Finance is that it’s completely free for investors! No really, it is. Part of M1’s mission is to offer commission-free investing. There are also no maintenance fees on your account, so every penny you put in is fully invested.

You do have to have at least $100 in your account to invest, but that's nothing compared to similar services that require thousands. M1 Finance does this by allowing you to buy fractional shares of ETFs, which is one of Jonathan’s favorite things about M1.

Other investing options

Along with ETF and stock options, you can open a retirement account. M1 Finance supports Traditional, Roth, and SEP IRAs.

You can also open a Trust, LLC, or Corporate investment account. You must have a minimum of $5,000 to open an LLC account.

Customer service

You can reach M1 Finance’s team via:

Pros of M1 Finance

First things first, when you open up, you’ll notice how nicely designed the site is–it’s “just beautiful to look at,” says Jonathan. In addition, some more pros are:

  • Commission-free investing
  • No management fees
  • You can purchase fractional shares of ETF
  • Create your own portfolio or choose from one made by professionals–making M1 great for newcomers and investment veterans alike.
  • Automated investing–you choose your investments and M1 does the rest
  • Easy to use app
  • You’ll receive $10 to invest when you refer a friend

Cons of M1 Finance

While M1  is a truly great service, it’s not without its issues. The biggest drawback is one that Jonathan points out:

You can't access mutual funds, so you will not be able to get VTSAX on this platform. But one of the problems with the VTSAX has always been that you have to get a $10,000 minimum in order to buy into it.

While this may be a problem for seasoned investors, for anyone who can’t come up with the $10,000 minimum to invest, M1 Finance is still a perfect fit.

One other aspect of M1 Finance that may be an issue for some is that you can only see the assets you have with them. There’s no way to track all your accounts in different places, like you can with management sites like Personal Capital. While this can be annoying, it shouldn’t sway you against M1.

Luckily, you can use Personal Capital to manage all your accounts, including M1 Finance. So, using Jonathan’s suggestion, you can use Personal Capital as your dashboard, while still having the easy to use M1 Finance app for your accounts solely based with them.

How does M1 Finance make money?

So, if M1 is free for investors, how do they make money? That's a good question. Brian shared with us that M1 makes money through securities lending, payments for directed order flow, and cash management. In the near future M1 is planning to offer investors the option to get a fixed loan at a low 3.5% rate on up to 50% of assets in taxable accounts that are invested with them. This would be a game changer and be a huge improvement over a HELOC which typically offer a variable rate tied to the prime rate  and aren't an option for renters

Who should use M1 Finance?

So, now that I’ve highlighted the good and bad, you’re probably wondering: Should I use M1 Finance?

The short answer is yes! Jonathan agrees with the founder, Brian, that M1 Finance solves so many problems for so many people. It’s simple, straightforward, and truly free investing.

But, it's not for everyone. For beginning investors that don't feel comfortable leaving their portfolios solely up to the professionals that create select “pies,” additional research may be required before investing with M1 Finance. After all, it's meant for self-driven investors who want to choose their own investments initially.

It's also not best for traders. M1 investments are meant to be long-term buy and hold investments.

M1 Finance is best for investors who want to control what they invest in, but want the nitty gritty, everyday details left to someone else.

M1 Finance Review--Completely Free Automated Investing!