How the most volatile month of the year affected Spotify and Apple, and how to avoid volatile markets and sequence of returns risk affecting your required minimum distributions. Plus, should a self-employed small business owner contribute to a solo Roth 401(k)? If you max your Roth IRA contributions and receive a company match, is that over-contributing, and how is that match taxed? And what should you do about that variable annuity you’re locked into?

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Show Notes

(00:42) October is Historically the Most Volatile Month: This October, Spotify and Apple Felt It
(06:24) Retirement Contribution Limits Increasing for 2019
(09:50) Self-Employed Small Business Owners Can Save a Lot More for Retirement with a Solo 401(k) (video)
(14:50) Should I Contribute to a Solo Roth 401(k)?
(22:00) Am I Over-Contributing to My Roth IRA with the Company Match? How is the Match Taxed?
(27:00) How to Avoid Sequence of Returns Risk Affecting Required Minimum Distributions
(36:46) What Are My Options When Locked Into a Variable Annuity?
(44:41) Should I Keep An Annuity or Convert It to an IRA?

Transcription

Today on Your Money, Your Wealth, Joe and Big Al are all about answering your money questions: should a self-employed small business owner contribute to a solo Roth 401(k)? If you max your Roth IRA contributions and receive a company match, is that over-contributing? And how is that match taxed? How can you avoid volatile markets and sequence of returns risk affecting your required minimum distributions? What should you do about that variable annuity you’re locked into? Is my husband really in prison? The answer to that last one is absolutely not, but before we get to the rest of the answers, let’s talk about how the most volatile month of the year affected Spotify and Apple. Here are Joe Anderson, CFP® and Big Al Clopine, CPA.

00:42 – October is Historically the Most Volatile Month: This October, Spotify and Apple Felt It

JA: We finished October, Alan. Thank God.

AC: (laughs) Wasn’t a great October, was it?

JA: Historically it’s the most volatile month in the calendar year.

AC: Yeah. Why is that?

JA: I have no idea. (laughs) But some of the largest crashes have occurred in October: 1929, 1987.

AC: Yes, I remember that one.

JA: And you know, the most significant sell-offs happened in 2008 as well when the meltdown happened. That happened also in October. So if we look at this October, it kept up with its reputation.

AC: Right. But remember, for years we used to make fun of that because October was just as normal as any other month. But it reared its ugly head.

JA: Yes. The S&P 500 lost 6.9%, posting its worst monthly showing since 2011. This performance led to $1.9 trillion in losses – just gone.

AC: Here today, gone tomorrow.

JA: And guess what. It will come back.

AC: Yeah – so we’re making light of this, and you’re probably going, “why are you guys doing that?” The thing is, this is what markets do. This actually is pretty normal stuff.

JA: Similar struggles occurred in other domestic indexes. The Dow Jones gave 5.1%, the Nasdaq dropped 9.2, its largest monthly decline in nearly a decade. So there’s a lot of volatility. What is going on? I think volatile markets are normal and finally we’re seeing some volatile markets and it’s OK. It’s not time to freak out and sell, because there’s no way that you can time it to get back in.

AC: Yeah I think that’s got to be the biggest takeaway, which is, we haven’t had a lot of volatility the last few years. Volatility meaning up and down, up and down, up and down – it’s been fairly steady without big increases or big declines, and the fact that we’re having more volatility is consistent with the last hundred years. So this actually is fairly normal.

JA: There’s just a lot of noise I think, but the noise is always there. But for some reason, we get a little bit more jittery than other times.

AC: Yeah, when the market’s down.

JA: I’m saying there’s always noise. But look at last year, for instance: there was zero volatility. But there were things happening in the world. It wasn’t what’s happening today is nothing. It’s kind of the same stuff.

AC: No worse or better. It’s just stuff.

JA: “Well the Fed is increasing interest rates.” Well when the Fed increases interest rates, that means the economy is doing OK.

AC: They’ve been working on that the last six years. Is not new news.

JA: Right. It was already priced into the overall market.

AC: Correct. Well, you know why this is Joe. It’s because all of the…

JA: Midterm elections. (laughs)

AC: (laughs) Yeah. No, I was going to say all the financial pundits, which, I don’t know if we’re in that category or not. I would say no.

JA: Absolutely not.

AC: All the other pundits, they have to describe what happens daily. And so it’s almost like you have to make up something: “the market went up because of this or in spite of this, or this” – it’s like you drive yourself crazy listening to this stuff.

JA: And then it’s just trying to time markets too. You cannot look at good news or bad news. That’s the craziest thing. The news has to be as good or as bad as expected. Spotify for instance. They earned a profit. So it’s like, “wow, Spotify finally earned a profit!” Their stock plummeted.

AC: Because it was less than what they expected?

JA: No, it was because they were like, “What the hell are you doing earning a profit? You put all that money back into the company to get a larger valuation. You should not be profitable right now.”

AC: Yeah, you should be reinvesting.

JA: “You should be reinvesting everything. What are you doing, Spotify? Shame on you, we’re blowing up your stock.” (laughs) But the average person was like, “hey, they did a profit. That’s pretty good news, right?”

AC: I think was on Friday Apple went way down, and even though they beat earnings, so in essence, they beat expectations, but they decided to minimize their reporting, and they’re not going to disclose the individual unit sales for the iPhone, iPad and the like. And I guess the market didn’t like that.

JA: Yeah. What are you doing, Cook? You a great quarter but you’re holding stuff back on us? So we’re going to blow you up. I mean, it’s great news for the company. “Hey, we sold a lot of stuff. We’re very profitable.” But what does the market do? They react in a negative way.

AC: Yeah because it’s different. Something changed.

JA: Are they hiding something or something else? Because they react, it’s just such a sharp reaction and then next thing you know. Okay, I guess it’s OK. I guess the reporting is all right. They’re still selling some pretty cool stuff. (laughs)

AC: (laughs) They’re still making money, still growing. By the way, Apple did hit correction territory on Friday.

JA: It lost what, 6, 8, 9%?

AL: It went from 222 to 209.

JA: Did you know that Apple, they make like 30, 40% on those little apps that are on their phone.

AC: Now I don’t know the economics behind that but it does surprise me.

JA: Just news you can use.

AC: Good to know. Not going to change my investment portfolio.

JA: No, when you’re at a cocktail party this weekend with your CPA buddies. (Laughs)

AC: (laughs) That sounds fun, Joe, you wanna join me?

JA: No! I’m just giving you stuff that you might want to talk about! I’ll be watching football, drinking Coors Light and you’ll be at a tea party going, “hey, you know what?” (Laughs)

06:24 – Retirement Contribution Limits Increasing for 2019

AC: I’ll be at a tea party going, “Hey, what do you think about the new limits for the 401(k)s? (laughs) It’s really a good time.

JA: “I got big news, guys!”

AC: “Hold onto your seats. I want you to sit down. We got a $500 increase on the 401(k) contribution!”

JA: That’s it, huh? They’re pretty generous.

AC: Well, at least they did something because I don’t think we got much last year. 2019. So the contribution limit went from $18,500 to $19,000. It went up $500. That’s if you’re under 50. If you’re 50 and older, you can add another $6,000 to that, it would be $25,000. Now, this is 2019, don’t get ’em confused. We’re still in 2018.

JA: So they didn’t increase the catch-up?

AC: No they didn’t increase the catch-up. They kept that the same. They also increased the IRA from $5,500 to $6,000. Again, this is for 2019. So if you haven’t done your IRA yet, you have till April 15th of 2019. You could do $5,500 for 2018 and $6,000 for 2018.

JA: And the catch-up, only 500 bucks?

AC: Catch up is $1,000 still, so $7,000 instead of $6,500. So those are a couple things you ought to know. And then if you have a simple IRA, the contribution limit went from $12,500 to $13,000. And if you’re 50 and older it’s now going to be $16,000. This is again for 2019. If you have a SEP plan the maximum for next year will be fi$56,000, up from $55,000.

JA: 56. And then I see something here. What’s this $64,000?

AC: $64,000 the 25B(b)(1)(A) for determining retirement savings contribution credit. (editors note: actually it’s the 25B(b)(1)(C) and (D))

JA: Oh yeah. Just in case you guys wanted to know that, that’s now at $64,000. (laughs)

AC: It’s up from 63. So glad you brought that up. (laughs) Now that, my CPA buddies are going to get all over that one. “The retirement savings credit!” More people will qualify! You know, as a CPA that used to prepare returns, that was always a surprising credit. Because our tax software looked for that – none of us looked for it, and when it happened, it goes, “Oh, look at that, there’s a retirement savings credit.” In other words, if you have earned income and you put in retirement savings and your income is super low, then you get this credit.

JA: See? I’m just prepping you. You’re going to be awesome! (laughs)

AL: You actually do have CPA buddies! (laughs)

JA: You’re gonna shine at the party! (laughs)

AC: It’s unbelievable. We might have 100 people there! (laughs)

JA: “Oh man, Clopine was a hit this week!” (laughs)

AC: I could never invite you because they wouldn’t know what to do with you. (laughs)

Hey, this week on the Your Money, Your Wealth TV show these two lives of the party are showing you how to keep the volatile stock market from wiping out your retirement savings and we’ve got a free investing white paper called Pursuing a Better Investment Experience to go along with it. You can download the white paper, watch the TV show and subscribe at YourMoneyYourWealth.com, new TV episodes are available every Sunday. In the meantime, our email bag is overflowing with your questions – if you have a money question, comment or suggestion for the podcast, send it to us at info@purefinancial.com, then check the podcast show notes at YourMoneyYourWealth.com, we may have posted a video of your answer.

09:50 – Self-Employed Small Business Owners Can Save a Lot More for Retirement with a Solo 401(k)

JA: We have a complaint from Christy.

AC: (laughs) I don’t think it’s a complaint, she’s just supplementing one of our answers.

JA: She goes, “Hi Joe and Al. Love the show, especially the fact that you address tax and investing issues at the same time and all in a very straightforward and entertaining way. Thanks. I have a question but wanted to add something to your answer on the October 23 podcast about the benefits of a Solo 401(k).” So she goes to a very good explanation of a Solo 401(k). I think we might have just shortcut a Solo 401(k), just through passing, of maybe a recommendation that we made for a certain individual. I think our buddy Mac in Brookfield, Connecticut, about his wife being a dentist. And she has a solo 401(k), and so she went through a lot of great benefits of a Solo 401(k). So for those of you that don’t know what a Solo 401(k) is, Al, what is that?

AC: Well, you can actually set up your own private 401(k) if you have your own small business and you don’t have any other employees. Now, your spouse can be an employee, that counts as one, or solo, but if it’s just you, then you can set up your own private or they call it individual or Solo 401(k), and it’s just an account – very simple. You don’t need an actuary, there are no fees to set these things up or administer or even terminate. So very simple, and you can put a lot of money into it. $18,500 in 2018, and $24,500 if you’re 50 and older – and that’s the employee part.

JA: And then you can also put a little profit sharing on top of it.

AC: You can, and that’s 20% of your profits unless you’re an S-corporation, then it’s 25% of your salary.

JA: And so with that being said, you can put a lot more than $18,500 or $24,500.

AC: You can. If you look at the employee and employee part, you can actually put $55,000 into these plans, assuming that you have $275,000 of comp – that’s what you would need to do that.

JA: Right. So if you made $50,000, you couldn’t shelter $18,500 and $18,500. $18,500 is a dollar for dollar contribution on any 401(k) plan. So if you have a small business and you make $20,000, you can contribute $18,500 of almost your entire comp- you’ve got to pay payroll comp, so I don’t know what that computation is, but pretty dang close to 100% of your compensation. So what Christy was saying is that, hey, well, you guys kind of forgot to mention that you could put a lot more into it – and she’s absolutely right. We love the Solo 401(k) for that fact because what we see is that small business might have a SEP plan. So a SEP plan is just that same computation, it’s a percentage of profits if I’m a solo practitioner or a sole prop. But if I go with a Solo 401(k) plan I can go dollar for dollar, and then I can add on top of that, as my “match” if you will, to get more money up to that $55,000 limit.

AC: Yeah. And I will say one more thing, if you’re a business center and you’re 50 or older, you can also do the $6,000 catch up on top of the $55,000, so you can actually put in $61,000 if you have enough income to be able to justify that.

JA: She also went on to discuss another huge advantage is that there could be a Roth component of a Solo 401(k), which she is absolutely right. So you could go $18,500 into the Roth, and then you could put in the profit sharing or the match, and you can pre-tax that thing. So you can kind of toggle back and forth and get the best of both worlds. You can get a tax deduction and you can get a ton of money into a Roth 401(k) or a Roth plan.

AC: Yeah. And I think it’s important to mention, Joe, that on the employee part, you can do a regular 401(k) or a Roth 401(k), the employer part, profit sharing part, that’s always pre-tax. That’s the traditional 401(k) part.

JA: And then she goes on, “Finally, you can invest in a much wider range of investment options including individual stocks and so on and so forth.” So that is great information. Thank you, Christy. But now for her question.

14:15 – Should I Contribute to a Solo Roth 401(k)?

“I have a solo traditional 401(k). My husband is a W2 employee and has both Roth and traditional options in his 401(k) plan. This year he started contributing half of his retirement savings of the $24,500 into each of those after many years of contributing only to the traditional plans.” He’s 50, she’s 45, “we’re in the 24% tax bracket filing jointly. At current tax rates, we’ll likely be in the 22% bracket in retirement. So far the vast majority of my existing retirement savings amounting to about $165,000, like his, are traditional IRAs and traditional 401(k)s. Would there be any advantage for me also to put someone by contributions in the Solo Roth 401(k), especially when it comes to tax diversification in retirement and given the fact that I’m younger? I love the idea of Roth and ideally, I could invest relatively aggressively in a Roth and see a big benefit down the road, especially if tax rates go up in the future. Should I continue to contribute to my account based on my age and diversification situation, or should I not worry about that since we’re putting half of my husband’s savings in a Roth? Obviously, there are a lot of variables so this is kind of a philosophical question…” Ooh gosh, that was close. (laughs)

AC: (laughs) You got it though!

JA: I got ‘er done! “…about retirement income buckets and how much the spouse situation should inform a personal investment decision. Thank you very much.”

AC: Wow, that’s a well thought out question.

JA: Very well thought out Christy. Alan, let me see your calculator real quick. So if I look at Christy, she’s got $165,000 saved and she is putting $18,500 in. She’s 45 and she does that for the next 20 years at 7%, that is going to be $1.4 million.

AC: Right. And that’s not even including the employer match profit sharing.

JA: That’s not including an employer match. That is not including her husband’s contributions. So Christy, just taking a look in the future here, if you continue to do the things that you’re doing, as long as you have a globally diversified portfolio, and assuming the 7% rate, over 20 years that could be aggressive, that could be conservative, depending on what you want to do. I’m with you. I think you’re right on of looking at tax diversification. Two reasons. Alan’s going to give you the CPA math approach. I’m going to give you the real-life approach. You’re not going to remember the tax savings that you’re getting today – you’re 45 years old. You’ve got 20 more years, potentially, to work, and the couple of bucks you’re saving in taxes because you went pre-tax versus Roth, in 20 years when this $1.4 million is all in a Roth versus a retirement account that’s going to be taxed at ordinary income rates. you’re going to be like, “I am the happiest woman in the world!” 22% tax bracket in the future. Well, those tax rates are going to expire.

AC: Right. That’s how it’s currently stated. So you’re going to be, probably, in the 25% tax bracket or maybe 28 even.

JA: Correct. Now you got $1.4 million, let’s say your husband is doing the exact same thing. He’s got $1.4M. Now that’s a pretty big number. So depending on what you want, and if it’s all in deferred accounts? I love the fact that you’re in the 24% tax bracket now, you think you’ll be in the 22, the 22 is actually the 25, potentially, I like 24. I’d go Roth. I would go full Roth on both, and then with your profit-sharing component of it go pre-tax because you have to.

AC: Yeah, I actually agree with you 100%.

JA: Wow. Done.

AC: For the same reasons. So first of all, the CPA part of me says you’re going to be in a higher tax bracket in retirement because that’s what rates are scheduled to do.

JA: Allegedly.

AC: Well, that’s what they are scheduled to do. But who knows what will really happen.

JA: But she could blow up her investments. So that $1.4M, she could be broke. With the assumptions. I’m just being compliant here, Alan.

AC: Yes very good. OK. Let me try to spit out my comment. What was my comment? Anyway, so my comment is, I completely agree. So the tax rate will likely, or at least as it’s scheduled to be right now, you’ll be in a higher bracket in retirement. But I also agree Joe with what you said, which is what we find is people that do the traditional, they save a couple of bucks in tax, and then they spend it and they don’t remember it. And then in retirement, they got all this money, they got to pay all this tax. And so I completely agree with that thinking. The other part of this is the employer part, you call it the match and profit share, that part has to be pre-tax, so why don’t you just do the employee part as a Roth. I completely agree with that.

JA: So if you look at it – I’m not sure where Christie lives. But by putting the $18,500 pre-tax, she probably has a $5,000 tax savings. Give or take. If she’s in a higher tax state…

AL: I seem to remember she’s in Seattle.

JA: Seattle. Oh, hey. It’s a little rainy.

AC: (laughs) Yeah and there’s no state tax in Seattle so it’s only federal in that case.

JA: Yeah. And then maybe she would like to come down to San Diego with her husband to visit Joe and Big Al maybe ends up retiring in sunny Southern California. And then you’ve got 10% on the state. Maybe Roth might be a pretty good idea. So she’s probably saving $4,500. You’re not gonna remember the $4,500 20 years from now when you get o$1.4 million sitting in a Roth. Allegedly.

AC: And you bring up a good point, which is if you’re in Washington state, which has no taxes, so you’re not getting a huge benefit, just federal only. If you do move to another state, you want a little bit more sunshine in retirement, you’re gonna be paying taxes, so you would want more money in a Roth for that reason too.

JA: So yes, I love the tax diversification, for you saving that much, that you have excess cash flow, you’re seeing the light a little bit. “Hey, I got $165,000,” splitting that half in half. You could do it that way. I thought Alan was going to give more of a CPA approach to say, “well what tax bracket are you in?”

AC: Well she already told us.

JA: Well no, not necessarily. We don’t know what our taxable income is, is what I meant.

AC: I’m just going with this at face value.

JA: Right. So but I guess a more scientific approach could be this Christy if you really want to dive in the weeds and say, “well, what’s my taxable income. And then you look at, how much should I go pre-tax potentially to put me in that lower bracket, and then put everything else in a Roth, so you can kind of toggle this that way as well, or you could say, “I’m already saving for the future, and if I believe that the tax code is going to stay how it’s written today, that tax rates will go up and the Roth will continue to be tax free,” then that’s what I would do.

AC: Right. And now the final point I want to say, and when she already said this, which is if there’s more money in the Roth and you have a diversified portfolio, naturally some of those components are going to be more aggressive. You stick those components in the Roth. Obviously, they’re more volatile. They go up and down more, but over the long term they tend to outperform and you end up with keeping more of your investments that way.

JA: Right. So she’s right on, she talked about asset location, putting higher asset classes in a pool of money that’s going to grow tax-free. Congratulations. She looked at tax diversification. She looked at current rates versus future rates. She’s saving the maximum, and then she’s also doing some homework on a Solo 401(k) to say, “there’s a lot more that you can potentially do with this.”

AC: One of the best questions we ever had. I would say if you want a job, Christy, we need advisors… (laughs)

JA: We’re looking to hire, we might open an office in Seattle Washington. (laughs)

22:00 – Am I Over-Contributing to My IRAs with the Company Match? How is the Match Taxed?

JA: We got Marion from Fresno. Hello, Marion. Marion is 36. “I max contribute to my Roth 401(k) $18,500 and my Roth IRA $5,500. My question is am I over-contributing when my employer matches my Roth 401(k) contributions? How does the IRS tax the matching contributions?” Two things. First of all, the match is not part of the equation of your maximum contribution limit, so don’t worry about it. You’re doing the $18,500 if they match you another $18,500 you’re totally fine.

AC: It’s fantastic right.

JA: So don’t worry about that. How is the IRS taxing the matching contributions? It’s pre-tax to you because they’re getting a tax deduction for that contribution. So it’s going to be taxable when you pull it out.

AC: When you take it out, yeah. Something else that could happen is if she has a traditional 401(k) rather than a safe harbor, there may be top-heavy rules. And so maybe that’s why you’re having to pay some back, and so that’s a whole different discussion. That happens when you’re in a company and the highly paid people are contributing and the lower paid people are not. Then there are all these rules that they actually have to figure out and say, “All right, this plan is top heavy. So instead of putting in $18,500, you can only put it $16,500 and you gotta take some back.” So that could be going on here too, potentially.

JA: Could, but I think for the most part, if you’re looking at what’s the max I can put into my 401(k) plan, it’s $18,500 plus whatever match. The maximum contribution allowable limit for defined contribution plan for 2018 is what, $54,000?

AC: $54,000 yes.

JA: All right. So $54,000 is the maximum defined contribution amount that someone can put in. So if you’re self-employed and you have a self-employed pension plan, a SEP or something like that, or a profit sharing so on and so forth, that’s the maximum allowable. So you’re a few thousand dollar match on the $18,500, which is phenomenal, it’s not going to hurt you in any form, it’s just an added benefit that the employer is giving you. But the benefit is for them too. So they’re giving you cash. They’re getting a tax deduction for that cash. So when you do take those distributions out, just know that they’re going to be taxable. And then that leads to another topic real quick, Al. I have a Roth 401(k). So Marion’s putting in the $18,500 and she’s got the Roth IRA of $5,500, $18,500, $5,500, $24,000, pounding away, right? 36? Maybe she’s got a decent size balance. Is Marion a boys or girls name?

AL: I think it can be either, but…

JA: I’ll just say Marion then. Sorry.

AC: Yeah don’t say he or she. “Marion, you can do this.” (laughs)

JA: (laughs) Yes, right. But all of a sudden all that match starts building up. If Marion works for the company for a long time. “Now I’ve got Roth dollars, now I’ve got pre-tax dollars.” It’s pro-rata, taking dollars out. So let’s say you had $100,000 in your 401(k) plan, $75,000 of it was Roth, $25,000 of it was the match that was pre-tax, for a total of $100,000. You take a dollar out of the plan. Seventy-five cents is going to be tax-free, but 25 cents is going to be taxable. So that’s how that pro-rata ratio works. So just be aware, if you really love that 401(k) plan, just know it’s not going to be nearly as efficient when you start taking distributions from that plan versus rolling that money out into a separate Roth IRA and putting the pre-tax or the match dollars into an IRA.

AC: Yeah I agree with that. And of course, that only applies when you’re 59 and a half or when you’re retired. Because that’s when you’re pulling money out.

JA: But she’s 36 – or Marion is 36. I’m just saying long-term planning, the match could build up to something substantial.

AC: Right. So the point is when you get to that point where you’re ready to start distributing, then go ahead and do a rollover. So you take that Roth 401(k) part, that goes right to your Roth IRA. You take the other part, the employer match, and that goes to your regular IRA.

JA: Absolutely. So a couple of different things for you there.

Have you ever noticed how when you hear great strategizing like this it makes you think of questions about your own situation? Here’s your chance to get them answered – email info@purefinancial.com. Video of Joe and Al answering Christy’s email is now in the show notes at YourMoneyYourWealth.com. Be sure to subscribe to the podcast while you’re there, next week we’ll talk to Dr. Stephen Wendel, the head of Behavioral Science at Morningstar, about Easing the Retirement Crisis. Not sure how to subscribe to the podcast? You’ll find a video of that in the show notes too! Visit YourMoneyYourWealth.com.

27:00 – How to Avoid Sequence of Returns Risk Affecting Required Minimum Distributions

JA: We got April from New Lenox, Illinois. I don’t know where New Lenox is.

AL: I actually looked it up. It’s outside of Joliet. Yes. So Chicago. You know, where the prison is.

JA: I don’t know where prisons are. (laughs)

AC: Did you ever see The Blues Brothers movie?

JA: Yes I have.

AL: OK. They were in Joliet.

JA: Oh.

AC: But you don’t know where all the prisons are in the country?

JA: No. That’s where Andi’s husband is. (laughs)

AL: What?! (laughs)

JA: She goes Chicago often, now we know why. (laughs)

AL: That was completely made up, by the way.

JA: All right. This is from April. Hopefully, she’s not emailing us from…

AC: I like this, we’ve saved paper. It’s on a third of a sheet. We’re being green.

JA: So April says, “I don’t plan on taking any money out of retirement funds until I’m required to do so. I understand the damage that may be caused by sequence of returns risk, but what can I do when I have a required minimum distribution at the same time?” April, that’s a wonderful question and let’s first explain and dive into two different topics here. There’s sequence of return risk, and then there’s RMD. So I will talk about sequence of returns and you can talk about RMDs and then we can both tackle her question.

AC: Okay good.

JA: Okay. Sequence of return risk is this: I guess the industry likes to talk about average rates of return. If you average 6% over the next 20 years, you get X amount of dollars. So Alan you have a portfolio. I have a totally different portfolio. And maybe we average 6% over a 20 year time period, but our portfolios are going to react or do different things each and every year. Some years you might have a 20% rate of return, where I could have a -5% rate of return, and then the following year we could have the opposite effect, depending on what we’re invested in.

AC: Yeah. So let’s say I have a portfolio, and my portfolio went down the first several years, and yours went up. But by the time we got to 20 years, we both averaged 6%. We’re going to have a whole different investment experience and the amount of money to actually live off of.

JA: We will have the same exact amount of money at the end of that 20 years, but throughout that 20 year time period, we probably had different experiences if we didn’t pull any money out.

AC: Well yeah, let me qualify what I said: that’s when you’re taking distributions, right?

JA: When you’re adding money to a portfolio, an average rate of return means just that: you can use an average rate of return. So follow me here. You have a portfolio. I have a portfolio. It’s different. So if we accumulate wealth over a 20 year time period, we have a different investment experience but we have the same dollar figure at the end of the 20 years. Do you agree with that?

AC: If we started with the same amount and we didn’t add or take anyway.

JA: Correct.

AC: I agree with that. That was your point. I went ahead, sorry. (laughs)

JA: Now, you start taking dollars out, the sequence of those returns mean everything. Because now I’m taking distributions. I’m not just letting this thing ride, I’m taking dollars out of the overall portfolio. So if the market is down, I’m taking dollars out, and then guess what, oh, now I’ve lost money from the market and I’m pulling dollars out. It’s very difficult for me to get caught back up. I use this example quite often. But let’s say you lose 30% one year, you gain 30% the next year. Your average rate of return over those two years is zero. But if I have $100,000 and I lose 30%, that’s $70,000 Then I gain 30% on that $70,000, that’s only $21,000 so I don’t even have my $100,000 back so how could my average rate of return be zero? So you have to look at the geometric return if you will. It’s very complicated, Alan, I know. (laughs)

AC: (laughs) Yeah. You have to look at the cumulative rate of return, not one year and another and then average those. You want to be accurate.

AL: I’m still trying to figure out what a geometric return is.

JA: It is – you need to…

AC: It’s exactly what I said. (laughs) Anyway, so that’s sequence of returns. You want me to talk about RMDs?

JA: Please.

AC: Yes. RMD: required minimum distribution. The IRS allows you to put money into a 401(k) or an IRA, or a 403(b) but they want you to start taking out that money age 70 and a half. You can take it out earlier. 59 and a half is the earliest you can take it out without a 10% penalty. You can take it out actually at any point, pay the tax and penalty, if you’re over 59 and a half you don’t pay the penalty. 70 and a half is when you have to take it out. And the amount that you have to take out is based upon a factor, and it’s a little under 4% of the balance. So if you have $100,000 in your IRA, you’ve got to take out a little bit less than $4,000 in your first year, and then that will go up, generally, each and every year.

JA: So April’s question, going full circle, is if I have to take a required minimum distribution out of my overall account, so that means I have to take the investment out of my retirement account, and when the market is down that means I have to sell the investment while it’s down. So it’s a double whammy. I’m forced to take the money out, I gotta sell the investment, take it out of my retirement account, and then either spend it or reinvest it and then pay the tax. So now I’m selling it at a lower value, paying the tax on it, losing even more money. How do I avoid all of this? Well if it’s in an IRA, April, you do not have to sell the investment. So here’s what you do. You can journal shares out of the IRA into a brokerage account, so you don’t necessarily have to sell it. You have 15 shares of Apple, you just journal 15 shares out of your IRA into a brokerage account, so you’re not selling the overall investment while it’s low. You still have the same amount of shares. April 15th the following year, you have some cash, you just pay the tax there.

AC: Yes. So that way, you still have the same investments.

JA: If it’s in a 401(k), however, that cannot be done. You will have to take a full distribution out of the 401(k), you can’t journal shares because it’s in a 401(k) plan, it has to be distributed out of the 401(k) plan, and then you have to pay the tax, cash it out, and then reinvest it. So could be an opportunity for someone to roll their money into an IRA. So that’s one way that you can avoid some of that, but that’s usually it. I remember back in ’08-’09, the IRS did give a forgiveness on the required distribution, just because the market plummeted so much, and then people didn’t have to look at the balance on a certain year. I’m just going off a memory here.

AC: Yeah. It was sometime during the Great Recession. You are right.

JA: So usually you look at the balance of your account on December 31st and then you say, “OK well what is the balance?” and then you take your percentage as a required distribution out of the account, and you have to satisfy that required distribution over that twelve month period. So they have done this once before. I don’t know if they’ve done it before that, but they said, well, you don’t have to take that December 31st balance because it was a lot higher. Everyone lost a ton of money. And then you’re telling me I have to take let’s say 4% out of this lot larger balance – let’s say I had a million dollars. Now I have $500,000. You want me to pull $40,000 out of the thing when it’s worth $500,000, you’re killin’ me.

AC: Right. And I would say your answer is true if you don’t really need the funds, because in other words if it’s an IRA you can keep the same investment. Now if you do need the money, if you need the money for living expenses, well then maybe what you ought to look at is a little bit more balanced portfolio in your IRA that has a fair amount of safety – like bonds, for example, or cash-like investments, so that when the market’s down, when it goes down, you pull money from those accounts to spend instead of your stock accounts that are down.

JA: Yeah. And so that’s planning up to those retirement dates. What does your portfolio look like today? When do you need the money? And then making sure that you do the appropriate planning with the overall portfolio to make sure that it’s set up appropriately. And I think a lot of times people don’t necessarily do that. We’ve had a fairly good run in the overall markets, and it’s like, “hey, this is pretty cool, right? I’m making some good returns on my money. I know I should switch. I know I should probably get a little conservative, I know I should take some chips off the table.” But guess what, they don’t do it until what?

AC: Until it’s too late (laughs) because that’s human nature.

JA: Yeah, and then the market blows up and it’s like, “DAMN! I knew I should have done that.”

AC: And it’s always easy in hindsight to say, “well I should have done it.” But you could have said that a year ago, two years ago, three years ago, five years ago. I mean there are always reasons to do it and you didn’t. And then you waited and…

JA: Well I mean a balanced, diversified portfolio is the best thing in down markets and it’s like a very frustrating thing in up markets.

AC: Agreed. Yeah because you’re not getting market returns.

JA: You hear the Dow Jones, you hear the S&P and things like that. Well, they’re up 5%, 4%, 6% and you’re only up 1. It’s like, well this stinks.

AC: Yeah, this doesn’t work very well.

JA: But then all of a sudden when the market’s down 10 and you’re even or you’re down 4, it still sucks that you’re now at 4 but at least you’re not down 10. You got some downside protection.

AC: And the same thing happens when you have international stocks and international is not doing as well. They call that a tracking error. You think you should be getting S&P returns but you’re not because you’ve got a diversified portfolio.

If you’re in Southern California or will be visiting and want to hear more on how diversification helps in times of market volatility, you’re invited to our office in San Diego for a free Lunch ’n’ Learn on Thursday, November 29th at 11 am. Pure Financial Advisors’ Director of Research, Brian Perry, CFP®, CFA®, will go over the state of the markets, what’s predicted for 2019, end of year tax strategies, ways to reduce taxes in retirement and more. Visit the show notes for today’s episode at YourMoneyYourWealth.com for the link to sign up. The Lunch ’n’ Learn is free and lunch is included.

36:46 – What Are My Options When Locked Into a Variable Annuity?

JA: We got Merv from Tacoma, Washington. “What are my options when I’m locked into a variable annuity contract?” Okay Merv, let’s see what you got here. “Couple of years ago I decided to move my investment money into a different firm. One of their programs they sold us was to transfer some money out of my 401(k) plan into their variable annuities. I do admit that I didn’t fully understand that this is what they were selling. Apparently, the annuity is invested into ultra-conservative funds. My regular 401(k) made about 15% gains where the annuity is making somewhere like 2 to 3% during the same timeframe. I decided I want to withdraw from this annuity and the investment advisor that sold it to me and found out that there is a substantial penalty if I withdraw my money before five years. So essentially I’m stuck with it. I’ll be setting up a meeting with the advisor very soon and I need to know my options. Can I leave the money in the annuity so I don’t incur the penalty but manage it myself?” Merv. All right. So we got a little issue here.

AC: Yeah we do. Well, let’s go back one second. So how do you roll $75,000 out of your 401(k)?

JA: He just transferred his 401(k) into a variable annuity. Into an IRA.

AC: Oh, rolled to an IRA that buys an annuity. That’s the step I was missing.

JA: Yeah. It doesn’t say in the email here but I’m guessing that’s what happened. He moved money out of a 401(k) plan and he rolled it into an IRA. And then the individual sold him a variable annuity inside his IRA.

AC: So then the second point is he was making 15%, I guess per year, he didn’t say that, but I’m assuming- 15% gains. I guess that’s what that means. And the stock market has done rather well. But I guess the takeaway there is that’s not typical. So you can’t necessarily count on that.

JA: Well there is a tale of two things here. One is that he is mistaking rates of return with the product. If he was in the market in this 401(k) plan and if he’s in the market in the variable annuity, you could still get roughly 13-15% gains, especially last year. This year it’s a totally different story. If you’re in a globally diversified portfolio, you’re probably getting close to 2 or 3%. So Merv might be thinking, “I was in this great product because it was giving me 15%, now I’m in this other product. Now I’m only getting 3%.” It could be just a function of the overall allocation within the portfolio. The variable annuity is a wrapper. So let’s break this down a little bit. A variable annuity is an insurance contract, first of all, that you can invest in mutual-fund-like investments.

AC: So when he says that he’s in ultra-conservative funds in the annuity, he can probably change that.

JA: Sure. Yeah, I would say most variable annuity contracts have…

AC: They have from conservative to aggressive.

JA: It’s like almost like a 401(k) plan of choices. Sometimes I’ve seen 50 different stupid choices in those things. So I’m guessing this is what happened to Merv. I don’t know Merv, but he’s looking for options. I think you have to start with the education piece first. All right, why did he go into the variable annuity to begin with? And what a variable annuity contract does, it can allow for some guarantees. So maybe he was thinking, “hey, this market is pretty high. Maybe I want to be a little bit more conservative and I want some guarantees.” That could be one reason. So if Merv were to pass away there would be maybe a guarantee of principal at his passing that would go to his beneficiaries. There could be like a guaranteed income benefit rider within the variable annuity contract, so maybe that’s why he purchased it. Maybe the insurance agent or the advisor wanted to generate a large commission and maybe that’s why he bought it. (laughs) I’m not sure. I wasn’t there. So the question is, can he get out of the thing? Sure. You can’t get out of it. But he’s like, “Hey, I got this big sales charge.” If I were to look at the sales charge, I bet you he would be better off to take it out, rip the Band-Aid off and get out of the product if he truly wants to get out of the product, because the internal fees, he probably breaks even in a year and a half.

AC: Yeah probably. So, in other words, the internal charges, let’s just say they’re 3% for example.

JA: Hypothetically.

AC: Yeah hypothetically. And let’s just say it’s a 5% surrender. So in less than two years, you’ve made up those fees anyway.

JA: So do you want to hold on to the product for five years and pay 3% a year for the next five years?

AC: Yeah. So that’s 15 over that time.

JA: Or would you rather just pay the 5% and get out of it and then go to Vanguard and buy a no-load mutual fund?

AC: Yeah, low cost.

JA: I don’t know. You tell me. So the answer is yes, he can get out of this. Merv, yes, you can get out of it. You will have to pay that surrender charge, but it might be cheaper in the long term, depending on what your alternative is. You don’t get out of the annuity contract, pay the surrender charge, and then get into another high-cost product. That would be very bad. So you don’t want to do that. If you don’t want to pay the surrender charge, can you manage it? Yeah. But you’re still paying your advisor. He’s still getting paid on that thing. So you can do a 1035 exchange into a low-cost annuity, but you would still have to pay the surrender charge to get out of it. So that doesn’t make any sense.

AC: You could distribute 10% per year.

JA: Yes. Very good point.

AC: Without paying a penalty. So in other words, if you’ve got three years to go, you do 10% this year, 10% next year, 10% the following year. And then you’ve got 30% out, and then you surrender it at that point.

JA: So if you’re looking at apples to apples, versus a variable annuity, versus a mutual fund portfolio, there’s no reason to go into a variable annuity in my opinion if you’re just looking for the investment options. There are higher costs involved because of the guarantees involved within the annuity contract.

AC: Yeah. And to be fair, you’re getting something for those fees. You’re getting downside protection and things like that.

JA: Sure. Well, it depends on the variable annuity contract. I don’t know if he’s getting downside protection, maybe if he dies then that guarantee will come. There could be a benefit for income. So if he doesn’t want to worry about it and he’s fine with a lower rate of return and says, “All right insurance company, I want a guaranteed income for the rest of my life I’m going to turn this thing on.” And all of a sudden it spits out income for him. well you know that’s a benefit. Does it make sense? Within a vacuum, it’s very, very hard to tell. Alan and I are not huge proponents of this strategy of using a variable annuity. We feel that they’re fairly high in cost and the benefits don’t outweigh the fees.

AC: Well and I think, can we say as fee-only advisors, that we don’t ever get paid on a commission? Most fee-only advisors do not recommend variable annuities.

JA: Well, I disagree with that, because we have clients – we probably manage $20 million in variable annuities.

AC: Okay. But that wasn’t our recommendation.

JA: It was too.

AC: It was?

JA: Yes. And why would it be our recommendation? Because they were non-qualified variable annuities that were in a very high fee contract, and to get out of them they would have had to pay a ton of tax. So we exchanged them into a no-cost, no-load, no-commission variable annuity. (laughs)

AC: Yeah. Well, I agree with that. But we weren’t the first ones that said, “Here, take this chunk of money and put it into a variable annuity.” We have not done that. Just to be clear.

JA: That is very true. No, we have not. Got it. But just to be honest and transparent, we do have variable annuities – but they are a very low-cost options. What is it, Ameritas? Charges like $200 a year?

AC: Yeah. It’s low.

JA: All right. So is that pretty good on the variable annuity? Did we answer that? Did we beat that thing to death?

44:41 – Should I Keep An Annuity or Convert It to an IRA?

JA: Arthur from San Diego. “Should my wife keep her annuity from a previous job or convert it to an IRA?” That’s easy enough. “My wife just learned she has an annuity from a company she worked for over 20 years ago. She will be eligible to withdraw the funds in a couple of months. A friend told her that she should roll it into an IRA because there would be no penalties and she could withdraw the funds from an IRA also without penalties. Should she keep it an annuity or convert it to an IRA?” Well again, I think people get the shell and the investment a little confused. She’s got a 401(k), inside the 401(k), that’s an annuity. Is that what that’s telling us? Maybe it’s a TSA. I’m guessing maybe it was like a tax-sheltered annuity.

AC: It could be a profit sharing plan that has a payout or she could take the lump sum. I don’t know.

JA: But let’s just say it’s a retirement account through an employer, and the employer chose an annuity as the investment option for the plan. So the advice, or what Arthur’s asking us, is should she keep it in that particular plan, or should she roll it into an IRA? Well, what are you going to invest in the IRA, Arthur? If it’s going to be another annuity, don’t do it! (laughs) If it’s going to be stocks, bonds, mutual funds, cash, CDs?

AC: It goes back to Merv’s question. It depends a lot of things, but one is, is there a surrender? I mean maybe you don’t want it.

JA: 20 years ago I bet there was a surrender. She bought it 20 years ago, I think she could get out of it in eight years. (laughs)

AC: (laughs) Well, we’re making a million assumptions here. But yeah you’re right, Joe. And it may just be a profit sharing account. I don’t know. I have no idea. But the thing is, the IRA, you probably have more investment choices. But it depends whether there are surrender charges or not, depends upon the particulars of the annuity.

JA: Yeah. Arthur, go for it. Do it. Just roll the thing into an IRA. There you go. That’s it for us today, thanks for listening. For Big Al Clopine, I’m Joe Anderson. The show is called Your Money, Your Wealth®, we’ll see you next time.

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To learn more about annuities, check the podcast show notes at YourMoneyYourWealth.com for links to a previous episode and a blog post all about annuities and other insurance products. Join us next week on Your Money, Your Wealth® to hear Morningstar’s Head of Behavioral Science, Dr Stephen Wendel tell us how to ease the retirement crisis. Find links in the show notes to subscribe on Google Podcasts, Apple Podcasts, Spotify, Stitcher, Overcast, Player.FM, iHeartRadio, TuneIn, and now you can listen to the Your Money, Your Wealth® podcast on YouTube as well! Email your money questions to info@purefinancial.com, or call (888) 994-6257! Listen next time for more Your Money, Your Wealth, presented by Pure Financial Advisors. For your free financial assessment, visit PureFinancial.com.

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