How Will the 2018 Tax Changes Affect You?

How Will the 2018 Tax Changes Affect You?

As I’m sure most are aware by now, 2018 is bringing with it some new, big tax changes. But what exactly does that mean for you? While some regulations are still “in the works,” we have highlighted ten changes that are most likely to affect you this year:

1) Individual Tax Rates:

Most will see a decrease in their marginal tax rate in 2018. For example, if your taxable income was $315,000 in 2017 (MFJ), you were in the 33% bracket. In 2018, you would be in the 24% bracket. Big difference!

2) The Standard Deduction:

In an attempt to simplify filing for taxpayers, the standard deduction was increased ($12,000 for single, $24,000 for married filing joint), and personal exemptions repealed. These changes will result in fewer taxpayers being able to itemize deductions.. thereby “simplifying” their taxes.

3) The $10,000 “SALT” (State And Local Tax) Deduction:

Individual state, local, sales & property tax deductions will now be capped at a combined $10,000. You may have heard about taxpayers lining up to try and pre-pay property taxes for 2018 in 2017 – and this is why. If you pay more than $10,000 in combined state & local income taxes in 2018, you essentially receive no additional deduction/benefit for any property taxes paid.

4) Miscellaneous Itemized Deductions

Those subject to the 2% AGI limitation are being suspended. You may no longer itemize expenses such as unreimbursed employee business expenses (including the home office deduction), tax prep fees, investment advisor fees, etc.

5) Child Tax Credit:

This credit is being increased from $1,000 to $2,000 for each qualifying child under age 17. More importantly, though, the income phase out limits for the credit have been increased significantly: $200,000 for individuals (up from $75,000) and $400,000 for married filing joint (up from $110,000). There is also a new $500 credit for non-qualifying children such as those over age 17, elderly parents being cared for, etc. This credit is subject to the same income limitations (phased out at $200k Indiv/$400k MFJ).

6) Mortgage Interest:

The mortgage interest deduction has been decreased for NEW debts (taken out after December 15, 2017). You may now only deduct interest on the first $750,000 of your mortgage debt instead of the previous $1M. Also, the deduction for home equity indebtedness has been eliminated. Previously, you were able to deduct interest for up to $100,000 in home equity debt – this will no longer be allowed. Unlike the mortgage debt interest, this also applies to existing home equity debt – no existing debts are grandfathered.

7) Business Taxation:

    Corporations (and PSC’s) are being taxed at a new, flat rate of 21% – a huge decrease!

    Pass through businesses (LLC, Sole Proprietorship, S Corp) are allowed a new below-the-line deduction: the Qualified Business Income (QBI) deduction. QBI is essentially the net income of the business (not including any investment income), and eligibility may be subject to income & other limitations depending on the type of business. Generally, they may deduct 20% of their QBI. This introduces some new planning issues/items for consideration. Specifically:

      – Employees will be incentivized to shift toward an independent contractor set-up to take advantage of the QBI deduction
      – Those in service businesses who are above the income limits for the QBI deduction might consider filing as a C Corp (QBI deduction fully phased out at $207,500 for individual and $415,000 for married filing joint)

    8) 529 College Accounts:

    Previously, 529s could not be used for pre-college expenses. The new law allows for a tax-free, qualified distribution of up to $10,000/year for elementary & secondary school expenses.

    9) AMT (Alternative Minimum Tax):

    AMT was retained but the exemption amount has been increased to $70,300 for single/HOH and $109,400. Further, the phase-out of exemption increased to $500,000 for single/HOH and $1M for MFJ. The combination of the increased AMT exemption and phaseouts plus the limited itemized deductions will make it less likely for individuals to trigger the AMT tax.

    10) Alimony:

    For agreements dated December 31, 2018 or later, alimony is no longer included as income for the recipient, and no longer allowable as a deduction for the individual paying.

These changes will affect taxpayers differently – there is not a “one size fits all” strategy. If you’re curious about learning more or finding out how this might affect you, please reach out to us! We’re happy to review your individual situation and help you navigate 2018.

You can see the full text of the new legislation here and the summary notes here.

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2018 © Wrenne Financial Planning | Crafted by Harris & Ward

Wrenne Financial Planning LLC (“WFP”) is a registered investment adviser offering advisory services in the State of KY, TX, TN and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. The presence of this website on the Internet shall not be directly or indirectly interpreted as a solicitation of investment advisory services to persons of another jurisdiction unless otherwise permitted by statute. Follow-up or individualized responses to consumers in a particular state by WFP in the rendering of personalized investment advice for compensation shall not be made without our first complying with jurisdiction requirements or pursuant an applicable state exemption. All written content on this site is for information purposes only. Opinions expressed herein are solely those of WFP, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation.

Save More for Retirement – Contribution Limits Increased for 2018!

Save More for Retirement – Contribution Limits Increased for 2018!

The IRS has announced that they are increasing annual contribution limits for 2018 – for those of you maxing out your retirement plans and/or HSAs – this is especially important for you!

Retirement Accounts

The annual contribution limit for 401k, 403b, 457 (most), & TSP plans has increased from $18,000 up to $18,500. If you’re age 50 or older at any time during the year, you can also make additional catch-up contributions up to $6,000 (no change to this amount) for a maximum annual contribution of $24,500.

Health Savings Accounts

For those enrolled in a medical plan that allows for HSA contributions, these limits have increased for 2018 as well. The annual HSA contribution limit for a family plan is now $6,900 – up from $6,750. For individuals, the contribution limit is now $3,450 – up from $3,400.

IRAs

The annual maximum for IRA’s and Roth IRA’s did not change – those remain at $5,500 (plus $1,000 catch up for those age 50 and older). However, the income levels used for determining eligibility for contributions have increased. The new income phase-out ranges for deductible IRA contributions are:
Single taxpayer covered by work retirement plan: $63,000 – $73,000
Married filing jointly where the IRA contributor is covered by work plan: $101,000 – $121,000
Married filing jointly where the IRA contributor is NOT covered by a work plan, but their spouse is: $189,000 – $199,000

And the new phase-out ranges for Roth IRA contributions are:
Single & Head of Household: $120,000 – $135,000
Married filing Jointly: $189,000 – $199,000

Take Action!

For those planning on maxing out these plans, now is the time to make adjustments to get on pace to max these out for the 2018 calendar year. Let us know how we can help!

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2018 © Wrenne Financial Planning | Crafted by Harris & Ward

Wrenne Financial Planning LLC (“WFP”) is a registered investment adviser offering advisory services in the State of KY, TX, TN and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. The presence of this website on the Internet shall not be directly or indirectly interpreted as a solicitation of investment advisory services to persons of another jurisdiction unless otherwise permitted by statute. Follow-up or individualized responses to consumers in a particular state by WFP in the rendering of personalized investment advice for compensation shall not be made without our first complying with jurisdiction requirements or pursuant an applicable state exemption. All written content on this site is for information purposes only. Opinions expressed herein are solely those of WFP, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation.

The Complete Guide To Physician Mortgage Loans

The Complete Guide To Physician Mortgage Loans

On the surface, physician mortgage loans look great. No money down. No jumbo limits. No private mortgage insurance (PMI). Finally, it seems like a product exists to reward you for your time training to be a physician. After all, it’s been tough. For the past few years, you’ve watched many of your friends become homeowners.

While they were posting their latest photo of a fun, DIY home renovation, you were stuck in the library studying pathology. While they hosted a summer barbeque in their own backyard, you were sitting through an 8 hour board exam (and timing your breaks perfectly so you could scarf down a protein bar.)

But, let’s be real. Lenders are in business to make money, and they can’t just give you a free ride. So, how do physician mortgage loans stack up against everything else that’s available? Are they really as good as they sound? Let’s find out.

At this point in the home buying process, you’ve already made a solid decision about how much to spend on your home and you have your financial ducks in a row. So, the next step is to decide how to finance your home and whether a physician mortgage loan is the best option for you.

To help you make an informed decision, we’ll cover:

  • How Physician Mortgage Loans Work
  • Alternatives and How They Compare
  • Deciding On The Best Mortgage For Your Situation

Physician Mortgage Loans

First, let’s talk about why physician mortgage loans even exist. The reason is that physicians are extremely profitable customers for lenders. They take out big loans early in their careers and almost always pay them off. Lenders use physician mortgage loans to lock in early-career physicians by lending them more money with fewer stipulations than their competitors. They make it even more appealing by marketing it as a “special program” just for physicians.

Keep in mind, though, that their ultimate goal is to get you in the door and sell you other products as your needs change. A medical student transitioning into residency with zero earnings history, no cash and a boatload of student loans would normally never qualify for a mortgage if it wasn’t for physician mortgage loans. However, there’s no such thing as a free lunch. These loans are appealing at first, but often end up being more expensive than the alternatives. That’s why it’s so important to compare physician mortgage loans to other types of mortgage loans before making your decision.

What’s So Special?

So how is the physician mortgage loan different than a typical mortgage? Here are some of its common features:

  • Zero (or very low) down payment required
  • No private mortgage insurance “PMI”
  • No rate increases on jumbo loans (typically, loans larger than $417K)
  • Lending based on a physician’s signed employment contract
  • Less critical of student loan debt

Who Counts as a Qualified Borrower?

A “qualified borrower” is normally a medical resident, fellow or attending physician with a signed contract for employment. Some lenders also include dentists, veterinarians, and other doctors.

Who Offers Physician Mortgage Loans?

There’s a growing list of lenders offering physician mortgage loans, including:

Also, please note that we do not have a financial relationship with any of these lenders. If you’re a lender and would like to be added to our list, please let us know.

Mortgages Expenses:

So, now that I’ve explained why physician mortgages are different and why they appeal to many young physicians, it’s time to take a look at mortgage expenses. Many people focus on the monthly payments when considering buying a home, but there are several costs that make up your total mortgage expenses:

  • Interest – The cost of interest is based on the interest rate, loan balance and loan repayment term
  • Closing costs – A one-time, out-of-pocket expense paid at closing, wrapped into the loan balance or wrapped into the loan in the form of a higher interest rate
  • PMI – The monthly fee typically paid until reaching 20% equity

Closing costs and interest rates are kind of like a teeter totter: reducing closing costs on a mortgage increases the interest rate. Or if you want the lowest rate possible, you’ll have higher closing costs. You can see how this works in this breakdown from the Mortgage Professor website.

Pic 1

As for PMI, you either have it or you don’t. It’s typically going to cost between 0.3% to 1.5% of the original loan amount per year. A surefire way to avoid PMI is to put 20% down. Some loans, however, like the physician mortgage loan, do allow you to avoid PMI even though you don’t have 20% equity.

Another way to avoid PMI is to get two mortgages – one that finances 80% of the deal and the second that covers the remaining debt (up to 20%). But keep in mind that all of these PMI avoidance tactics come with additional costs.

Rates and Costs – An Example

Let’s assume you’re a physician considering a $500,000 home. You have fantastic credit but no cash for a down payment. What are your options for mortgages with no PMI? Here are the most popular:

  • Physician Mortgage Loans: 30 yr fixed rate – 4%
  • Physician Mortgage Loans: 7/1 ARM – 3.25%
  • Conventional 80/20:
    – First mortgage (80%) – 30 yr fixed – 3.5%
    – Second mortgage (20%) – Interest only HELOC (prime + .5% or 4% today)
  • VA Mortgage (must be military): 30 yr fixed rate – 3.25%

Which Option Should You Choose?

If you’re in the military, the VA Mortgage is usually a home run, especially if you’re considered disabled.

Physician mortgage loans have the highest interest rate but it’s locked in. The ARM has a better rate than the 30-year physician mortgage, but the rate becomes variable after seven years.

The conventional 80/20 offers the best rate on the primary mortgage, but the second one has a variable rate.

Assuming you’re not in the military and can’t get a VA Mortgage, you should base this decision on how long you’ll own the home and how much you plan to pay on the mortgage. Let’s go over the best options based on these factors:

  • 0-7 years – If you don’t foresee yourself living in the home for at least seven years, the Physician Mortgage Loan 7/1 ARM is your best option. But, really, if you plan on living in it for fewer than five years, you should be renting.
  • 7+ Years (and average income and savings) – In this case, the Physician Mortgage Loan with 30-year fixed rate is the better choice. But this should be revisited when you have 20% equity, you drop below the jumbo limits or if rates drop in general. Once you fit the profile, you can often refinance into a new, non-physician loan that’s much more competitive.
  • 7+ Years (and ability to pay the HELOC off very quickly) – The Conventional 80/20 typically provides the best deal if you can get the home equity line of credit knocked out within a year or two.

To simplify the math, we didn’t include closing costs. We always suggest asking lenders to provide an estimate with as close to zero closing costs as possible – at least for starters. That way, compare apples to apples. It’s much easier to compare mortgages structured similarly from a cost standpoint.

Should You Put Cash Down?

What if you have some cash to put down or are considering waiting until you have the cash? In that case, you’ll be comparing the physician mortgage with the conventional 20% down mortgage. Once again, we’ll assume both are structured to wrap closing costs into the loan to make the math simpler. To give you a clear comparison, let’s structure the 20% down conventional loan to have the exact same payments as the physician mortgage loan. The only difference is the down payment and the interest rate.

Option #1 – $100K down payment conventional loan

  • $400,000 balance
  • 18.1183 year fixed rate at 3%
  • $2,387.08 per month principal and interest

Option #2 – $0 down payment physician mortgage loan

  • $500,000 balance
  • 30 yr fixed rate at 4%
  • $2,387.08 per month principal and interest

Looking at those numbers, you’re probably thinking you’d take the $0 down option. Maybe you don’t have that much cash available or maybe you think there are smarter ways to use that $100,000. You could use it to pay off loans or start investing. And 4% is still a really good rate. But how does it really compare to the 20% down option?

Pic 2

Pic 3

The total lifetime interest costs:

  • Option 1 – $118,998
  • Option 2 – $359,348

As you can see on the charts above, putting $100,000 down will end up saving you over $240k in interest. Plus (and this is a huge plus), you’ll get your mortgage paid off almost 12 years sooner.

Additionally, don’t forget that having equity in your home will provide greater security and flexibility, especially if something unexpected happens. With the 100% financed physician mortgage loan, you should expect to start out underwater. If something doesn’t work out and you’re forced to sell quickly, you should be prepared to write a potentially large check for up to 10% of the purchase price just to get out of the home.

On the flip side, if you do come up with the $100,000, you could finance 100% using the physician mortgage loan and invest the cash. If you run those numbers, the end result will look much better. But not only does this require an aggressive investment, it also requires greater leverage on your home, which further adds to the risk. It will also require many years of disciplined investing and assumes you never spend any of it. That’s not impossible, of course, but it’s much easier said than done.

At the end of the day, getting the conventional mortgage and paying it off more quickly is a much better deal. If you don’t have the cash for a down payment, however, the physician mortgage loan is a solid alternative worth considering. Still, it’s not always automatically best solution.

What if You Already Have a Physician Mortgage?

If you already have a physician mortgage loan but you’re not paying attention to it, there’s a good chance you’re throwing away good money. You should review your options for refinance if any of the following occur:

  • Interest rates drop
  • You reach 20% equity
  • You get below the jumbo limits
  • Your plans change

In the past few years there’s a good chance all four of these things have happened for many of you.

Here’s a scenario that illustrates one of the most common money saving opportunities for physician mortgage loan borrowers:

Dr. Smith bought her home using a 100% financed physician mortgage loan at 4.75% in July of 2013. The original loan amount was $500,000 with monthly principal and interest payments of $2,608.24. The lifetime interest for that loan would have been $438,965.21. Fast forward three years to today and Dr. Smith’s property has appreciated to around $600,000 in value and she owes $475,712 on her original mortgage.

When she bought the home, she had no cash to put down and very few options. The physician mortgage loan was probably her best bet. But now that she has over 20% equity and a healthy earnings history, all sorts of options have opened up. Odds are she’d be able to qualify for the best deal around.

If she had the initiative to refinance and wanted to keep the payment similar to the one she was already used to, she’d be looking at a new 20-year fixed mortgage at 3%. The monthly principal and interest payment on the $475,712 new mortgage would come up to $2,638.29. More importantly, she’d be shaving seven years off her repayment term with only a $30/mo increase in payment. Now that’s a home run!

She could also consider refinancing into a new physician mortgage loan. That would have been better, but nowhere near as appealing as the conventional mortgage. She’s now in the sweet spot for traditional mortgages and she should take advantage of it.

Pic 4

When you’re considering a refinance, be sure to check out a few different lenders.

And remember, while refinancing into a new physician loan may be a good deal, it’s not always the best one. Doing your homework before refinancing your physician mortgage loan will pay off. Ideally, you also have someone, like a financial planner, who can help you analyze your options objectively.

When Should You Avoid Physician Mortgage Loans?

Perhaps by now, you’re more excited than ever about buying a house, especially now that you know an option exists where you can get a home with $0 down and no PMI. However, in order to cover all my bases, I did want to point out that you should probably stay away from physician mortgage loans if any or all of these conditions apply:

  • The ease of getting a physician mortgage loan is tempting you to consider buying too much house
  • You have (or will have) at least 20% to put down on the home. In this situation, a conventional mortgage is best.
  • You’re in the military. In this situation, look at a VA loan instead
  • You expect a large influx of cash shortly after buying and are using the physician mortgage to get the deal done now
  • You aren’t comfortable with the prospect of starting out 5-10% underwater on your home (in other words, you don’t want to write a big check to get out of it if your circumstances change)

Alternatives to Consider Before Signing

In my opinion, it’s best to wait until you have at least 20% to put down on the home. That way, you’ll to get the best deal possible. Plus, you don’t have to take on any of the risks that come with financing anything 100%.

If you like that idea, go ahead and rent for now and start stashing away some cash in preparation for buying your first home. If you already own a home and plan to upgrade, the best way to save for your future down payment is by paying your current mortgage off more quickly. You might even consider refinancing your current mortgage into a shorter term to get used to monthly payments. You can also structure the new loan so that it allows you to build equity to the amount necessary to have 20% by the time you plan to upgrade.

There are several other types of loans we didn’t cover that could come into play. Here are some of them:

1) The Conventional Loan with PMI typically requires at least 10% down. If you have 10% to put down, this may be a better option than the physician mortgage loan, if you plan to own the home long enough for the PMI to stop.

2) The FHA Loan typically requires 3% down and has very competitive rates, but it also comes with a monthly permanent fee similar to a PMI. The monthly FHA fee makes it way less appealing for most borrowers.

3) The Jumbo Loan with PMI typically requires at least 10% down. This type of loan would be worth comparing to larger physician mortgage loans. Often, it comes down to how long you plan to own the home. The Jumbo might have a lower rate but it also comes with PMI.

Other Mortgage Resources

There are many online resources to help you learn more about mortgages. Some examples include:

  • The Mortgage Professor: A site with several mortgage calculators and spreadsheets to help analyze mortgage options.

Also, if you’re feeling overwhelmed by all of these options or have any questions about anything mentioned in the post above, please reach out to us. We help clients navigate these types of decisions all the time. We’re happy to set up a free consultation to find out whether we’re a good fit.

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2018 © Wrenne Financial Planning | Crafted by Harris & Ward

Wrenne Financial Planning LLC (“WFP”) is a registered investment adviser offering advisory services in the State of KY, TX, TN and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. The presence of this website on the Internet shall not be directly or indirectly interpreted as a solicitation of investment advisory services to persons of another jurisdiction unless otherwise permitted by statute. Follow-up or individualized responses to consumers in a particular state by WFP in the rendering of personalized investment advice for compensation shall not be made without our first complying with jurisdiction requirements or pursuant an applicable state exemption. All written content on this site is for information purposes only. Opinions expressed herein are solely those of WFP, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation.

Study Reveals Physicians In-training are Failing Financially

Study Reveals Physicians In-training are Failing Financially

Are physicians bad with money? This recent study helps answer the question using data collected from 422 medical residents and fellows at Washington University and the University of Arizona. The participating physicians completed a quiz on basic personal finance knowledge and answered additional questions on financial status, behaviors and professional advice. And the results aren’t pretty.

They scored a big fat F (52%) on the quiz section. Only 65.4% knew Roth IRA’s allowed for tax-free withdrawals in retirement, 19.9% knew bond prices fall when interest rates rise and 16.1% knew why different mutual fund share classes existed (to provide the same investment with a different expense structure).

Their feelings about financial status, behaviors and dealings with professional advisors are equally concerning. They gave themselves a score of 4.8 out of 10 in regards to their satisfaction with their personal finances. Only 14% of residents with children have a will. Of those surveyed, 46.7% or 197 residents and fellows obtained professional financial advice in past 5 years. However, the overwhelming majority didn’t actually pay anything for the professional financial advice (maybe they’re getting what they paid for). Insurance and investment advice topped the list of the type advice received. Coincidentally, most financial professionals, especially those that don’t charge fees, only get paid when they sell insurance and investment products.

Professional Financial Advice Is Not Working

It’s clear from the study that physicians in-training are failing financially. And I’m not surprised. After all, when you’re working 80+ hours per week learning medicine, everything else takes a back seat. Before we talk about solutions, let’s talk about what’s not working.

As the data suggests, plenty of financial professionals are actively providing free financial advice to help address the problem. But it’s not working because it turns out these financial professionals are really salespeople paid to sell insurance, not give advice. In fact, most financial advisors chasing residents are explicitly required per their employment contract NOT to give financial advice. Why would they call themselves “advisors”? Because anybody can call themselves a financial advisor and it’s easier to sell product as a “professional advisor”.

Financially inexperienced and illiterate physicians in training aren’t qualified to sniff out salespeople vs true advisors. It’s the perfect opportunity for aggressive salespeople to disguise themselves as advice providers offering free “education”. Every day, financial advisor-salespeople deliver financial lectures to residents and fellows across the country. They gladly offer attendees no-cost financial advice, planning and one-on-one meetings. In fact, they’re going to chase every single attendee until they agree to schedule a one-to-one meeting.

The real damage happens in these one-on-one meetings. Young physicians lacking experience and financial knowledge are at a serious disadvantage when they sit face to face with a highly trained salesperson disguised as a financial advisor. Many don’t understand the danger of conflicts of interest and naively assume people are looking out for their best interests. They need all kinds of financial advice: when to buy disability insurance, what type mortgage to get or how to manage student loans. Why not get it all from the free trusted advisor that’s offering to come to you? I know this process well because I used to be one of these advisors. Eventually, I realized how this was misleading, quit my sales job and started my business.

What’s The Solution?

Quality, unbiased financial education is the starting point. The author implies that it’s the medical educators’ and ACGME’s responsibility to improve financial wellness for in-training physicians. He suggests that medical educators should incorporate financial education into curricula. And that it be measured for effectiveness. All great ideas!

The question is: who is capable of providing the quality unbiased financial education to medical residents and fellows? It’s certainly not financial advisor-salespeople.

What about the educators themselves? This cuts out most of the conflicts of interest. Money is a tricky topic – especially when you consider the behavioral components. However, these medical educators have no experience with delivering financial education and coaching. Plus. it’s taking them away from their expertise of teaching medicine. I don’t see this as the ideal solution either.

For this to work, it must be provided by a third-party company with expertise and experience with delivering objective and actionable content to physicians in-training. Conflicts of interest must be avoided by using a company that’s strictly fee-for-service (no commissions or kickbacks) with concentration in financial wellness for physicians. These financial wellness programs should be incorporated into curricula and be paid for by the institution. Incentives similar to health wellness programs could be built in to drive participation. The program would include workshops, tools and other resources tailored to in-training physicians and delivered by the objective experts. The educational campaign should be measured along the way for effectiveness at improving financial literacy and desired outcomes.

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2018 © Wrenne Financial Planning | Crafted by Harris & Ward

Wrenne Financial Planning LLC (“WFP”) is a registered investment adviser offering advisory services in the State of KY, TX, TN and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. The presence of this website on the Internet shall not be directly or indirectly interpreted as a solicitation of investment advisory services to persons of another jurisdiction unless otherwise permitted by statute. Follow-up or individualized responses to consumers in a particular state by WFP in the rendering of personalized investment advice for compensation shall not be made without our first complying with jurisdiction requirements or pursuant an applicable state exemption. All written content on this site is for information purposes only. Opinions expressed herein are solely those of WFP, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation.

Mega-Deduct and Convert: Save Thousands On Roth IRA Contributions

Mega-Deduct and Convert: Save Thousands On Roth IRA Contributions

This article from the Finance Buff explains a great way to save hundreds on Roth IRA contributions.

But I wanted to expand upon this idea and highlight an even bigger way to save using a similar strategy. Thanks to changes in tax law, the “deduct and convert” strategy has become much more beneficial. Before you read on, if you’re pre-retirement age, you must reside in Illinois or Kentucky for it to work well. For all Kentucky and Illinois residents, pay close attention!

The Original Strategy

This strategy exists thanks to Kentucky and Illinois favorable IRA rules. Both states allow state income tax deductions on IRA distributions (including Roth conversions) up to state specific limits. They also allow state income tax deductions on qualified Traditional IRA contributions.

The strategy involves contributing to a traditional IRA, taking the tax deduction (assuming you qualify), and then converting it to a Roth IRA. Kentucky has a progressive state income tax which ranges from 2% to 6%. Most people are paying closer to the top.

For example, in Kentucky if you contribute to an IRA and qualify for the deduction, you’re able to deduct the contribution for state income taxes. So no state income tax going in. You’re also able to convert Traditional IRA’s to Roth (aka Roth conversion) at any age and avoid Kentucky income tax on the converted amount. So no state income tax on a conversion to a Roth IRA.

By taking the extra step, you avoid state income tax on the Roth IRA contribution. For someone in the top KY tax bracket, this strategy effectively saves them 6% on the contribution amount when compared to contributing directly to a Roth IRA. For a $5,500 contribution, that’s $330 in tax savings. With two IRA’s maxed out at $11,000, the max household benefit would be $660.

Although $660 is better than a poke in the eye, it may not be worth the hassle to many taxpayers. And most don’t even qualify in the first place because they don’t live in Kentucky or Illinois and/or cannot deduct IRA’s. We’re talking about a small benefit for a small group.

However, since the article was written, new laws now allow 401k’s to offer in-plan Roth conversion. This effectively opens up the strategy to 401k participants and raises the stakes with much higher contribution limits!

Mega-Deduct And Convert

Greg and Jane live in Kentucky and plan to maximize Roth 401k’s in 2017 ($18,000 each) for a total household contribution $36,000. Instead, they contribute $36,000 to traditional pre-tax 401k’s and in the same tax year convert $36,000 to a Roth 401k. The Traditional 401k contribution is pre-federal and state income tax. The Roth conversion causes additional federal income tax but avoids state income tax. Basically, the federal income tax offsets and ends up the same as if they had contributed directly to Roth. However, they save 6% in state income tax by taking the extra step thanks to the favorable Kentucky IRA tax laws. This saves them $2,160 of state income tax. Now we’re talking about a pretty serious benefit.

The net effect for Kentuckians is a 6% boost on Roth 401k contributions (3% for Illinois). This works especially well for those already planning to contribute to Roth 401k. However in reality, most people aren’t 100% certain that the Roth is better than simply going with the traditional 401k. There are several additional factors to consider as detailed in this article by Michael Kitces on making the Roth vs Traditional decisions. Also, there is also the fact that state income taxes are potentially deductible if you itemize deductions. If this is the case, the effect of this benefit will be reduced based on the tax savings of the deduction.

There’s also the step transaction doctrine to consider. This IRS catch-all rule says you cannot take multiple steps to circumvent the rules. This might be viewed as a violation under audit. Therefore, because of this and because in reality most people aren’t sure if the Roth is actually best (even with potential for up to 6% boost), an even better strategy would be to go ahead and contribute to the traditional 401k. Wait and see how the year shakes out. And decide on the Roth Conversion at the end of the year. Doing this actually gives you a much better idea of what your marginal tax bracket will be which factors heavily into the decision. This allows you to make the decision based on the maximum amount of information. It also lessens the chance of it being considered a violation of the step transaction doctrine.

As with any potentially taxable transaction, you should ultimately consult your tax advisor before moving forward.

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