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Financial Planning Information for Military Professionals

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Get Efficient! Do More With Less (Earn More With Less Tax)

Form 1040Do you think about taxes before you make investments?  You should.  Controlling your tax bill is easier when you think about taxes before you “buy”.  What I’m talking about is tax efficient investing.  Today, I’m going to discuss a basic level of tax efficient investing…selecting tax-efficient Mutual Funds and ETFs.

When you look at a Mutual Fund’s (or ETF’s) advertising materials you will normally see the fund’s returns.  You will see the same or similar numbers on many “independent” fund ranking sites.  But, what you’re not seeing is the after-tax return and the difference can be significant.

The reason comes down to how the fund earns its money.  If a fund is actively managed, then normally there are more transactions and because of those transactions capital gains are recognized throughout the year.  The capital gains will be distributed to the mutual fund shareholders in December and those distributions are taxable (assuming the funds are held in a taxable account).  On the other hand, a passive/index fund will not have as many transactions and have lower capital gains to distribute in December.

So let’s take a look at a couple of examples.  I’m not recommending any of these funds, but have selected them only to illustrate the point.  We’ll look at some funds using on-year return as a determining factor (again, not recommending that you use one-year return as a determining factor but some do).  Two asset classes that are illustrative are Large-Cap Blend and Small-Cap Value.

  • Large Cap (Name of Fund/Return)
    • Dreyfus Large Cap Equity Fund/27.36%
    • Schwab US Large Cap ETF/24.77%
  • Small Cap Value (Name of Fund/Return)
    • Hotchkis & Wiley Small Cap Value Fund/32.06%
    • Vanguard Small Cap Value ETF/28.23%

Using the returns above, you might be tempted to select the fund listed first.  If you’re putting these funds in a taxable account, that might be a mistake.  Let’s look at the same funds’ after-tax return (after tax returns are based on the highest tax bracket).

  • Large Cap (Name of Fund/After-tax Return)
    • Dreyfus Large Cap Equity Fund/19.89%
    • Schwab US Large Cap ETF/23.77%
  • Small Cap Value (Name of Fund/After-tax Return)
    • Hotchkis & Wiley Small Cap Value Fund/22.04%
    • Vanguard Small Cap Value ETF/27.20%

In both cases, the higher earning fund distributed more earnings (due to portfolio turnover) in December and as a consequence of the resulting taxes, their returns were reduced by almost 1/3 to below the after-tax return of the index ETFs.

What can you do about it?  First ask your advisor if he/she considers tax efficiency when he/she builds your portfolio.  If not, ask why and then ask yourself why he/she is your advisor.  If you don’t have an advisor and don’t want one, information of funds’ tax efficiency is available through Morningstar.

Tax efficiency matters.  There is a concept called “Tax Alpha” which basically describes the additional return that can be achieved through tax-efficient investing.  Some studies put “Tax Alpha” at around 1-2%.  Something to think about…

Curt Sheldon is an Independent Fee-only Financial Planner located in Alexandria VA with clients throughout the US.

He specializes in assisting transitioning Senior Military Officers reach their financial goals.


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But Wait! There’s More! Tax-Efficient Investing

MarketIn my last post, I talked about how a non-deductible Traditional IRA can be an effective tool to minimize taxes especially when the assets in the IRA “throw-off” a significant amount of income and the income is taxed at your marginal rate.  What if that isn’t the case?  Well…that is the topic for this post.  What if you were to deposit your Large-Cap Stock Funds into a Traditional IRA?  Let’s take a look.

First the assumptions that I’ll use.

  • We will use the average return of the S&P 500 from 1950 – 2009
    • The total return is 11%
    • 3.6% of the total return is from dividends
  • The dividends are “Qualified” so they are taxed at 15% (current tax code)
  • The marginal tax rate throughout the scenarios is 25%
  • IRA distributions are taxed at the marginal rate
  • For this illustration ObamaCare Surtaxes are ignored

In the first scenario, you can contribute $5,500 to a tax-deductible Traditional IRA or $4,125 ($5,500 - $5,500 x 25%) to a taxable account.  So which one wins?  The ability to contribute pre-tax dollars to the Traditional IRA outweighs the lower tax rate paid on the investments in the taxable account every year.  After 30 years the after-tax account values are …

  • Deductible IRA:      $911,266
  • Taxable Account:    $800,278

So the Deductible IRA puts more money in your pocket.

In the second scenario, you can contribute $5,500 to a non-deductible Traditional IRA or $5,500 to a taxable account.  In this case, even though you pay taxes on the dividends as they are paid, the taxable account is worth more than the non-deductible Traditional IRA each year.  After 30 years the after-tax account values look like this…

  • Non-Deductible IRA:  $952,517 (higher than above because the IRA has “basis”)
  • Taxable Account:  $1,067,038

So, the bottom line?  As the Weapons School Instructors used to say, “It depends”.  Think about what tax strategy will put the most money in your pocket before you allocate your assets to separate accounts or get someone who can help you figure it out for you.

Curt Sheldon is an Independent Fee-only Financial Planner located in Alexandria VA with clients throughout the US.

He specializes in assisting transitioning Senior Military Officers reach their financial goals.

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No Respect! The Much Maligned Non-Deductible IRA

OLYMPUS DIGITAL CAMERAA lot of Senior Military Officers at some point in their career lifetime find (or think) that they have limited retirement plan options.

While on Active Duty they are most likely not eligible to contribute to a Traditional IRA  and take a tax deduction.  They may be eligible to contribute to a Roth IRA and their spouse may be able to contribute to a deductible Traditional IRA.

After starting their second career their options are often even more limited.  Like while on Active Duty the Senior Military Officer will most likely not be able to contribute to a deductible Traditional IRA.  The retired Senior Military Officer will now often find that he/she will not be able to contribute to a Roth IRA and the officer’s spouse may not be eligible to contribute to a Roth or deductible Traditional IRA either.

But in both cases there is an alternative - the non-deductible Traditional IRA.  But I find that often when the immediate tax deduction is eliminated most people lose interest in the non-deductible Traditional IRA.  That could be a mistake…

Tax deferral is still a powerful tool.  Let’s look at an example.  Here are the assumptions:

  • Contributions to non-deductible Traditional IRA start at age 50 and continue to age 65.
  • Contributions are maxed out at $6,500 per year
  • Distributions are started at age 70 (Required Minimum Distributions start)
  • Tax rate during accumulation 36.8% (33% Marginal Bracket + ObamaCare Surtaxes) for funds outside IRA
  • IRA distributions are taxed at 33% and 25% (IRA distributions not subject to ObamaCare Surtaxes)
  • Capital Gains are ignored and all income is assumed to be taxed at marginal rate (REITs would be a good example)
  • Return is 8% and is based on historical data for Vanguard REIT ETF

So, after 20 years (15 years of contributions and 5 years of further appreciation)…

  • The taxable account will be worth $198,561 with no further taxes due
  • If the IRA is taken out and the marginal rate stays at 33%
    • The account will be worth $292,039
    • Taxes of $62,053 will be due (remember taxes are only due on the earnings)
    • Available cash is $229,986
  • If distributions can be stretched to lower the marginal tax rate to 25% then
    • The account will still be worth $292,039
    • Taxes of $47,009 will be due
    • Available cash will be $245,029

In both cases, the non-deductible IRA puts more money in your pocket than paying taxes as you go along in the taxable account.

Capital Gains can potentially change the results since capital gains, in most cases, are taxed at a lower rate than the individual’s marginal tax rate.  So you wouldn’t want to do this with assets that primarily produce capital gains.  That is called Tax Efficient Investing and is a topic for another day.


Curt Sheldon is an Independent Fee-only Financial Planner located in Alexandria VA with clients throughout the US.

He specializes in assisting transitioning Senior Military Officers reach their financial goals.

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Roth TSP/401(k)…Thought it Through?

401(k) statement

Invest after-tax income now and pay ZERO taxes when you retire!  Sounds pretty enticing doesn’t it?  This is the promise of the Roth Account whether TSP, 401(k) or 403(b).  For some of you it makes sense.  For some of you it doesn’t.  Fortunately, there are some Rules of Thumb…

  • If your tax bracket is lower now than it will be in retirement, then chose the Roth
  • If you are above the threshold to contribute to a Roth IRA, contribute to the Roth
  • If you don’t have a Roth Account you’ll pay a huge hit on taxes in retirement…so take the Roth

I’m guessing that you’re not Average, so why would you base a decision on a recommendation for the Average American?

Here’s my rule

It isn’t how much you pay in taxes…

it is how much you keep

Let’s look at a specific case.  Suppose your employer offers matching on the first 5% of income contributed.  Let’s say you have $7,500 of discretionary income and $7,500 equals 5% of your income.  You can do one of two things with the $7,500.

  1. Invest $7,500 in TSP/401(k)
  2. Pay $1,875 in taxes (25% of $7,500) and contribute $5,625 to a Roth account


Which should you do?  The rules of thumb above may lead you to the Roth TSP/40(k).  But apply my rule and let’s see what happens.

In scenario #1 you’ll get $7,500 in matching funds.  If we assume around 7% return for 20 year your contributions plus matching will equal $52,432.  After you pay taxes (25%) on the $52,432 distribution you will have $39,324 in your pocket

In scenario #2 you’ll get $5,625 in matching funds contributed to TSP/401/(k) (matching funds are non-Roth).  If we keep all the assumptions the same, you will pay taxes of $4,951 (25% x value of employer’s contributions) and have $34,408 in your pocket

Last time I checked, $39,324 (#1) is greater than $34,408 (#2).

O.K.  So it works if tax rates stay the same.  What if tax rates go up?  The rule of thumb says to go for the Roth.  If we keep the scenario the same and increase the tax rate at retirement to 39.6% here are the results.

Scenario #1:  $31,668

Scenario #2: $31,537

Scenario #1 still puts more money in your pocket

As a reminder, 39.6% is currently the highest tax bracket.

So, don’t invest in the Roth TSP/401(k), right?  No, this is a very specific example.  My point is that Rules of Thumb generally don’t apply to YOU.  It is worth it to get opinions/rules that account for your individual situation.


Curt Sheldon is an Independent Fee-only Financial Planner located in Alexandria VA with clients throughout the US.

He specializes in assisting transitioning Senior Military Officers reach their financial goals.

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Just What is a Retirement Account?

closeup of a Last Will and testament documentWhen is a retirement account not a retirement account?  No…this is not a question like “Who is buried in Grant’s tomb?”.  A retirement account is not a retirement account when it is an inherited Individual Retirement Account (actually an IRA is technically called an Individual Retirement Arrangement).

This was recently determined in a Supreme Court ruling.  In a unanimous decision the Supreme Court ruled that while inherited IRAs maintain the word retirement in their name, they are not retirement accounts.

So what? Well, one of the advantages of an IRA is that it is generally protected from bankruptcy.  There are limits at the federal level of how much money is protected, but for most of us the money is protected.  Since an inherited IRA is not a retirement account it is not protected from bankruptcy.

OK…so what?  You may want to re-think your estate plan.  If your children (or anyone else for that matter) are contingent beneficiaries or are your primary beneficiaries to your IRA, you might to play out some “worst-case” scenarios.  If your child has some problems managing money and could be subject to bankruptcy designating a trust as the contingent or primary beneficiary may make sense.  This will protect your assets from bankruptcy if the trust is structured properly.

You’ll also want to make sure the trust is set-up correctly to give the trustee the option of spreading the pay-outs over the life of the beneficiary.  If you don’t set the trust up correctly the funds will have to be paid out in 5 years.

As I always say, don’t do estate planning without a net.  But even if you’ve done your estate plan with a competent Financial or Estate Planner, if you’re concerned about Junior’s exposure to bankruptcy it might be time to revisit your estate plan.

Curt Sheldon is an Independent Fee-only Financial Planner located in Alexandria VA with clients throughout the US.

He specializes in assisting transitioning Senior Military Officers reach their financial goals.

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TSP/401(k) Loan? Step Away From the Paperwork, Please…

401(k) statementLet’s say you’re sitting on $10,000 of Credit Card debt and you can take a loan from your TSP/401(k) to pay it off.  The credit card is at 12% interest and the interest on the loan from your retirement plan is only 7%.  Take the loan right?  Simple math…7% interest is less than 12% interest so take the lower rate.  Well, you’ve not finished reading the “story problem”.  Your not sure of the train from Philadelphia’s speed (so to speak).

There is more to the story problem.  The first issue is opportunity cost and the second (and bigger issue) is tax ramifications.  Let’s look at the numbers.

Opportunity Cost.  When you take money out of your 401(k) you are “selling” your investments and losing the underlying investment return.  For example, you would give up the following returns (10 year average)

    • Emerging Markets:  16.9%
    • Real Estate:  11.8%
    • Small-Cap US Stock:  9.7%
    • Developed Countries International Stock: 8.7%
    • US Large-Cap Stock: 7.1%

There are, of course, asset classes that provided less return.  But giving up significant returns for the 5-year term of the loan can make a huge difference.  But the impact of the opportunity cost of the loan might be outweighed by the tax ramifications of the loan.

Tax Ramifications. Now, someone out there is saying, “Wait a minute.  I don’t pay taxes on the loan!”.  You’re right.  But that doesn’t mean there aren’t tax ramifications.  Let’s work this out.  Some assumptions:

    • Tax rate is constant and stays at 25%
    • You take out $10,000 to pay off the credit card

 Now let’s go back to the beginning and talk through this transaction

    1. You deposit $10,000 into your TSP/401(k) and saved $2,500 on your taxes.  So your net investment is $7,500
    2. You withdraw $10,000 from your TSP/401(k) and pay off the credit card debt
    3. To pay off the loan, you need to earn $15,841($15841 – 25% = $11,881 Principal & Interest)
    4. So to get back to where you were, you paid $6,460 in taxes ($2,500 in “lost” tax benefit from initial contribution plus $3,960 in taxes on money earned to repay the loan).
    5. Upon withdrawal, you’ll pay taxes on the interest, which was paid with post-tax dollars and the$2,500 “lost” tax deduction.  The taxes you will pay on the previously taxed income is $1,095


So, what to do? The numbers supporting taking the loan may make sense depending on the exact interest rates involved or they might not.  Regardless when you combine the opportunity cost with the tax ramifications, it may make less sense than what you thought when you  considered the loan to start with.  This is the perfect thing to discuss with an objective independent Financial Planner.


Curt Sheldon is an Independent Fee-only Financial Planner located in Alexandria VA with clients throughout the US. He specializes in assisting transitioning Senior Military Officers reach their financial goals.

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Give away $14,000, No Problem! Right?

Charity 2If you spend much time reading financial publications (you know the names) or watching financial TV shows, you’ve probably heard, “You can give away $14,000 to anyone in a year and have ZERO gift tax ramifications and if you’re married your spouse can too!”  I don’t know how many times I have heard that.  The problem is, it isn’t exactly true.

The reality is that you can gift up to $14,000 in a present interest per year and exclude the gift from any gift tax.  What is a present interest?  It means the person who receives the gift can use the money now.  If you put the money into something where the recipient can’t get the money now, you lose the exemption and the gift becomes potentially subject to gift tax (since the current lifetime Unified Tax Credit is large most people won’t owe taxes) and you must file a gift tax return.

Now there is a way around the present interest problem.  If the gift has been deposited to a trust (the most likely way to make the gift non-present interest) and the trust has Crummey powers the gift is eligible for the annual exclusion.  What are Crummey powers?  It basically means that during a limited amount of time the beneficiary of the trust has the right to withdraw the money and then the window closes.

It’s complicated.

So…be careful when you read things in the financial presses.  Especially when you are dealing with estate planning issues.  It is worth the time and money to work with a Financial Planner and Estate Planning Attorney.



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