How to Cover the Rising Cost of College

When planning for retirement, you need to look at multiple sources of income and be sure that some of the income sources are tax-free. The more, the better. So, how do you plan for a retirement income stream that minimizes overall taxation?

Four Instruments that Provide tax-free Retirement Income

Here are four great ways to provide yourself with tax-free.

1. Roth IRA is a great retirement investment that can result in a steady stream of tax-free retirement income as long as they are considered qualified. However, you must qualify for an IRA and the requirements are adjusted year by year as is the amount eligible for savings. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change.

If you do qualify, money put into a Roth IRA is taxed when you receive it, so it is not taxed again when it is withdrawn. In 2018, the eligibility requirements are:

1. Single or head of household, earning less than $120,000 to fully contribute to a Roth IRA.
2. Married filing jointly or a qualified widow(er) earning less than $189,000 to fully contribute to a Roth IRA.
3. Married filing separately earning less than $10,000 to fully contribute to a Roth IRA. (Note that those married but filing separately can use the limits for single people as long as they have not lived with their spouse in the past year)
4. Municipal Bonds and Funds provide income distributions not taxable by the federal government though they are may be subject to state income tax. Because they are not subject to federal income tax, interest paid on these bonds is typically less than taxable bonds.

There is no income limit to investing in tax-free municipal bonds and funds.

3. Health Savings Accounts (HSAs) are available if your employer offers health insurance using an HSA. Combined contributions by the employer and employee to this account as of 2018 can be as high as $6,900.00 for qualifying plans.

Following the rules about which expenses are reimbursable, no taxes are paid on withdrawals.

In addition, the HSA funds and earnings can be held until retirement then uses to provide tax-free income by reimbursing the holder for past and current allowable expenses which include Medicare premiums.

4. Roth 401(k) or 403(b) allow Roth contributions inside these accounts making those contributions and their subsequent retirement earnings, tax-free. These accounts are not subject to income eligibility limits but they are subject to taxes in the year that contributions are made.

Making the Most of Your Home

Another way to make a smart investment for your retirement is to pay off any mortgage that you have on your home before you retire which allows you to live in your home for the cost of property taxes and home insurance alone.

For many retirees, this is a huge reduction in their monthly expenses allowing the money be used elsewhere.

When it comes to choosing your 401(k) lineup, it’s easy to become overwhelmed by your options. It’s likely why more than 70% of 401(k) plans include at least one target-date fund. Also known as lifecycle or age-based funds, target date funds were created to simplify the investment choices for 401(k) plan contributors. Depending on your company’s 401(k) plan, they may be named something like Target Date Fund 2050, meaning you anticipate retiring around 2050. Target-date funds give employees the option of choosing one fund that diversifies their investments among stocks, bonds, and cash (the allocation) throughout their working life.

Considered a “set-it-and-forget-it” investment option, some investors choose target date funds as a default so they can avoid having to rebalance and update their portfolio allocations over time. The theory is that younger participants, having more years until retirement, can take higher risks in order to achieve higher expected returns. Since the funds focus on a selected time frame or target date (usually retirement), its asset allocation mix becomes more conservative as that date approaches. The percentage of stocks is reduced, and the percentage of bonds and cash is increased.

While target date funds may help encourage employees to participate in their company’s 401(k), there are a few misconceptions about how they work, and it’s important to understand these considerations before choosing your 401(k)’s investment lineup.

Target Date Funds Can Significantly Vary

Many investors get caught up in the year attached to a target date fund. If they change jobs and contribute to a different 401(k) plan, they may assume the target date fund is the same as their previous plan. Or, they believe that a 2050 target date fund is nearly identical to a 2055 target date fund.

However, target date funds with the same target date can significantly vary in their portfolio lineup. Fund families typically have their own unique approach with their target date funds, meaning a John Hancock target date fund likely won’t offer the same ratio of stocks and bonds as a Fidelity plan.

Take a look at this example from InvestorJunkie:

The percent of equities at age 65 significantly differs between target date families. When each of the target date funds has its own fee structure, mix of assets, and risk tolerance, it’s nearly impossible to measure performance between these funds.

Target date funds don’t just vary by their lineup. They can also have different fees.

As we can see in the chart above, the expense ratios considerably vary based on the target date and the target date family. Fidelity Freedom is more than 0.5% higher than Vanguard, which can take a toll on your portfolio when you’re investing for several decades.

Should I Invest in a Target Date Fund?

Like Though not a panacea, target date funds offer a reasonable alternative to the often confusing world of too many investment choices. Ultimately, there isn’t a single recommendation one can make for everyone. Each person has unique needs and circumstances, and they need to be taken into consideration when selecting their 401(k) lineup.

Before choosing a target date fund, there are a few factors to consider.

What do you want the fund to do for you?

Do you want a fund that is at its most conservative allocation when you retire or a fund that will take you through retirement? A target date fund’s allocation changes based on a set timeframe. If your fund is designed to help you get TO retirement, the amount invested in stocks will substantially decrease as you near your retirement date.

A fund that’s designed to get you THROUGH retirement changes allocations based on your life expectancy. These funds will have a greater amount in stocks at retirement than the to funds and thus be higher risk. Knowing which type of fund you own is critical to your ability to assessing its riskiness, along with its long-term expected returns if you are able to stay the course with it through troubled times.

What are the funds’ target allocations?

Whether it’s a to or a through plan, what are its target allocations? How are decisions about allocation made and do those choices complement your needs?

What's your risk tolerance?

Target-date funds can be more aggressive or more conservative than expected. During the 2008 financial crisis, many investors with 2010 target-date funds suffered severe losses because they didn’t realize their portfolio was invested in more stocks than they thought. Would you have stayed invested if the fund had struggled in 2008? If not, perhaps you should look at a more conservative option.

What are the fees?

Target-date funds can often cost more than other funds because they’re known for their long horizons, and their fees will vary by target date family and target date. If you are more cost conscious, you may prefer to invest in index funds.

Choosing Your 401(K) Lineup.

When there are a plethora of investment options from which to choose, take the time to understand what you want from them and find a fund that meets your needs. If you would like to discuss target date funds or other 401(k) options. I encourage you to reach out to me. Call my office at (949) 221-8105 x 2128, or email me at michael.loo@lpl.com.

The target date is the approximate date when investors plan to start withdrawing their money.

The principal value of a target fund is not guaranteed at any time, including at the target date.

No strategy assures success or protects against loss