6 Things to Consider If Your Next Employer Offers an Unmatched 401(k)

One of the first things a transitioning Senior Military Officer will have to make a decision about when starting a new career is participating in voluntary retirement plans.  Some times, the options include an unmatched Traditional 401(k) plan.  Do they make sense?  As in most cases…it depends.  But here are some things to consider…

1. How will the reduction in taxable income impact your overall tax picture?  This is not as obvious as it may seem.  Not only will the contribution reduce your taxes by the contribution amount times your marginal tax rate, but the reduction might make you eligible for credits you might not otherwise get or protect you from additional taxes and thus be much more valuable than you think.  Some specific ones a Senior Military Officer should consider in his/her financial plan are:
   • The American Opportunity Credit which starts to phase out at $160,000 (Married Filing Jointly) of Adjusted Gross Income (AGI).
   • The Medicare Surtax on Investment Earnings which starts at $200,000 AGI for Singles and $250,000 AGI for Married Couples.
   • While not a current-year tax benefit, Roth IRA eligibility starts to phase out at $178,000 AGI for married couples ($112,000 for singles).
2. Is there a more tax efficient way to invest?  Long-term capital gains earned outside a 401(k) are taxed at 15% for most of us (there are 15.8% and 23.8% scenarios if you are a high-income earner).  Proceeds from 401(k) plans are taxed at your marginal rate.  As a retired Senior Military Officer your first dollar of income above your military retirement will most likely be taxed at 25%.  So, if you want to own assets that will produce long-term capital gains and little to no current income, you may want to hold them outside a 401(k).
3. What are the fees?  Some 401(k) plans have very high fees.  Examine whether these fees will negate the tax advantages inherent in the 401(k).  Remember fees matter.  As demonstrated by John Bogle, 2% in fees over 50 years can equate to 63% less assets in your account.  Fees reduce the amount of “interest” you earn on “interest”.
4. Do you want mandatory withdrawals at age 70 1/2?  Roth IRAs (if eligible) or taxable accounts don’t force withdrawals and therefore taxes on money you don’t need at the moment.  You won’t owe taxes on Roth IRA balances ever or taxable balances (excluding current income) until you sell assets.
5. Do you have asset protection fears?  Assets inside a qualified account are protected from claims of others.  Other investment accounts are not protected to the same level.  IRA accounts, for example, are generally only protected from claims of others up to $1 Million.  Taxable accounts are not protected at all.
6. Will I be able to roll the funds into TSP?  If you kept/keep TSP open, when you leave your job at Company X you will be able to roll the 401(k) funds into TSP if you desire.  TSP has very low fees and this could negate the fear above.

As with all things financial related, there are two or three layers of effects you should consider.  Certainly don’t waive off on the 401(k) just because there is no matching.  There are a lot of other things to weigh in making your decision.

Breaking News: IRS Will Accept Form 8863 Soon

The IRS just announced that it will start accepting the Form 8863 on Sunday, 10 Feb 13.  The 8863 is required to claim Education Credits (American Opportunity Credit, Lifetime Learning Credit).

This is good news.  The IRS previously stated the forms would not be accepted until late February or early March (See more here).

Now you can spend your weekend working on your taxes…

Planning on Claiming an Education Credit this Year? Take Your Time

The IRS announced today that it will not start processing Form 8863 on 30 January along with other tax forms.  Processing of Form 8863 will not begin until late February or early March.  Here is what that means to you.

If you were hoping to take the American Opportunity Credit or Lifetime Learning Credit for the 2012 tax year, your tax filing will be delayed.  On Sunday 27 Jan 13, the IRS starting rejecting tax returns that contained the Form 8863 (the Form required to claim the two education credits above).  It appears that tax returns with the Form 8863 will not be accepted until late February at the earliest.  If you try to file electronically earlier than that date, your return will most likely be rejected.  If you file on paper, you won’t improve your situation either.

Best case if you are in a refund situation and your return includes the Form 8863 is that you  won’t be able to get your refund until mid-March.  For those that owe money, you still will have to pay on time (even though your filing is delayed).

Didn’t Save Enough For College? There Are Ways to Soften the Blow…

Fall must be just around the corner.  I just received my first friendly note from the Virginia Tech Bursar.  The note is friendly because the Bursar wants me to pay tuition and expenses for my Sophomore son.  It seems the Bursar only writes when he wants money.  I can’t say that he is one of the people I look forward to receiving emails from.  So like many of you, I’m faced with college expenses…again.

Hopefully, you’ve saved and planned for college expenses or have sufficient disposable income to pay for the expenses.  But if faced with more college expenses than you’d like (whether you saved or not) there are ways you can soften the blow.

Take Advantage of Tax Breaks. 

Even if you have the money saved in a tax advantaged account like a 529 plan or a Coverdell Educational IRA you may want to pay some of your expenses with post tax dollars to take advantage of the tax breaks that may be available.  Many of these tax breaks are limited by Adjusted Gross Income (AGI) so you will want to carefully manage your income if you can.  Increasing your 401(k) contributions or selecting which year to take income from investments could keep your AGI below phase out limits.

The American Opportunity Credit.  The American Opportunity Credit is a dollar for dollar reduction in your taxes of up to $2,500.  The credit is based on 100% of the first $2,000 paid in tuition and qualified fees and 25% of the next $2,000 in tuition and fees.  The credit phases out between $160,000 and $180,000/$80,000 and $90,000 of AGI (Married/Single).  If your AGI is below the $160,000/$80,000 AGI limit you will definitely want to take advantage of this credit.  Even if you have a tax advantaged account, pay $2,000 of tuition and fees with after tax dollars (not from a 529 or Educational IRA).  You’ll in effect get a $2,000 reduction in tuition.  You would also want to determine if it makes sense to pay the second $2,000 of tuition with post-tax dollars to receive the additional $500 credit — This would depend on how much money you have in tax advantaged funds (remember under current law, this is the last year that the American Opportunity Credit will be available) and your tax bracket.

The Lifetime Learning Credit.  The Lifetime Learning Credit allows you to take a credit for 20% of the first $10,000 of qualified education expenses per year.  To qualify for the full credit, your AGI must be less than $122,000/$61,000 (Married/Single).  Unlike the American Opportunity Credit, the Lifetime Learning Credit may be used for education other than the first four years of post-secondary education (Post-Graduate, Job Skills Improvement).

Student Loan Interest Deduction. You can deduct Student Loan Interest of up to $2,500 if your AGI is below $120,000/$60,000 (Married/Single).  The deduction phases out by $150,000/$75,000 (Married/Single).  There are two significant things with regard to this deduction.  First, the deduction is “above the line”, which means you do not need to itemize to get this deduction.  And since this deduction is used to calculate AGI, it could potentially also increase your itemized deductions that are limited by AGI (Medical Expenses and Miscellaneous Deductions are two deductions that are limited by AGI).  Second, room and Board are considered qualified expenses for the Student Loan Interest Deduction and are not qualified expenses for the credits above.

Income Shifting.

Another thing you can do to reduce the sting of college expenses is to shift income to lower tax bracket individuals who then use the income to fund their education.

Gift Appreciated Assets.  Sometimes parents have appreciated assets that they plan to cash-in to pay for college expenses.  Instead of cashing the assets in, it may make more sense to gift the assets to the college student and let the student cash the assets in.  This scenario makes sense (for 2012 depending on what happens with the Bush Tax Cuts) if the parent is in the 25% or higher tax bracket and the student is in the 10% or 15% tax bracket.  In this scenario, the gains would be taxed at 15% for the parent and 0% if the college student cashes the assets in.  There are limits.  If the amount of gain exceeds $1,900, then the amount that exceeds the limit is taxed at the parent’s rate.  This is the so-called the Kiddie Tax (The calculations are different if the child has earned income).  But if you can gift assets with $1,900 worth of long-term capital gains to your child, you’re looking at a Federal Tax savings of $285.  Remember, though the total amount you can gift in a year without being subject to gift tax is limited.  Also, a gift is a gift…if Junior runs off to join the circus after you gift the asset, you can’t do anything to get the asset or money back.

Use your business to shift income.  If you are self-employed or have a business, you can hire your college student to work for you and earn money for college.  Besides getting help with your business, the wages you pay to your child are deductible to you/your business and taxable income to your child.  Most likely your child is in a lower tax bracket than you are.  There are two things to watch for here.  First, the pay has to be reasonable (not too high and not too low).  Second, make sure that the Income Tax decrease is greater than the amount you will have to pay in payroll and other employment taxes.  This is probably only the case if the parent is in the 25% or higher bracket.

Look at State Tax Deductions

There may be opportunities to reduce your state tax bill as well.

Route your money through a 529 plan.  Once you have retired from the military and are no longer a Texas or Florida resident you have the joy of experiencing State Income Taxes.  You may be able to reduce your State Income Tax by contributing to a State Sponsored 529 plan.  Many states offer tax deductions or even credits for money contributed to 529 plans.  Some allow you to carry deductions forward if you contribute more than the amount you can deduct.  So, you might be able to contribute funds to a State Sponsored 529 and reduce your state income taxes for this year and for years to come.  The rules vary from state to state, so confirm that your state doesn’t have a minimum time that the funds have to be invested in the 529 Plan or limitations if the child is currently a college student for the deductions/credits to apply.

GI Bill

Plan Your GI Bill Use.  If you qualify and have transferred your Post 9/11 GI Bill Benefits to your children you can of course use this to pay for college.  But before you split your benefits equally between your children take a look at the effects of scholarships and differing tuition levels.  For more information on this topic, see my blog post by clicking here.

Now, none of the techniques above are a Miracle Cure for College Expenses but they can help you keep a little bit more of your own money.  Take some time to sit down with your planner/tax advisor to see which options for paying for college result in the most money in your pocket when Junior gets the old sheep’s skin.