In May 2019, the House of Representatives passed a bill known as the SECURE Act (Setting Every Community Up for Retirement Enhancement Act of 2019) with overwhelming bipartisan support (417-3) that looked like it would quickly be approved by the Senate and President.  Other legislative matters derailed the Senate and it was late December 2019 before the SECURE Act finally reached and passed a Senate vote. 

A lot has been made of the SECURE Act and its widespread changes but, to be fair, many of the Act’s new provisions will have minimal impact both in dollars and in applicability. Rather than touch on every nuanced change of the Act, the following is intended to summarize a few of the more impactful financial planning ramifications.

1) Increase in Beginning Age for Required Minimum Distributions (RMDs)

Under current law, individuals are required begin minimum distributions from retirement accounts starting at age 70.5 (with a few exceptions). The SECURE Act changes the beginning age from 70.5 to 72 to keep up with increased life expectancies.

Planning Implications: This is a valuable change by delaying required IRA distributions and the resulting taxes (and/or higher Medicare premiums) by 1-2 years for everyone under age 70.5 as of 12/31/19.

It is important to note that the bill does not impact the qualified charitable distribution (QCD) age which will remain 70.5 (and unlike the RMD, not the calendar year in which you turn 70.5 but the day on which you turn 70.5). This means that individuals who reach age 70.5, even though they will not be subject to required minimum distributions, can still make gifts from Traditional IRA accounts directly to charities without the distributions being treated as income for tax purposes.

2) Expansion of Qualified Section 529 Plan Uses

The final version of the SECURE Act expanded qualified Section 529 education savings account usage to include apprenticeships and student loan repayment – up to a $10,000 lifetime limit.

Planning Implications (Student Loan Repayment): Individuals occasionally ask whether 529 Plan assets can be used to pay off student loans. Up to now the answer was yes, but not without incurring a 10% penalty and taxes on any growth attributable to the 529 Plan distribution. The SECURE Act permits distributions of up to $10,000 from a 529 Plan with no taxes or penalties for student loan principal and interest payments.

It’s worth noting that:

• The $10,000 limit is a lifetime limit per 529 Plan beneficiary, not an annual limit;
• Any student loan interest payments made with funds distributed from a 529 Plan will not qualify for the student loan interest deduction;
• The law also allows 529 Plan assets to also be used to repay student loans for the beneficiary’s siblings, but still subject to the $10,000 lifetime limit per sibling.

The student loan repayment provision is an interesting one but likely to have limited applicability since it’s generally not the case that someone has savings in a 529 account and student loans (It is highly recommended that individuals use 529 balances before amassing student loans and/or pay off existing student loans in their entirety before investing in a 529 Plan for their children.  The possible exceptions are individuals with highly subsidized loans where the interest rate is <3% or individuals who expect to qualify for loan forgiveness). 

One noteworthy usage of this new provision might be the case where a grandparent funded multiple 529 accounts – one for each grandchild. Imagine the scenario of grandparents who funded separate 529 accounts for their two grandchildren – Sally and Timmy.  Sally graduated college without using all of her balance.  Timmy spent through his 529 balance in the first two years of college and had to assume loans to cover the remainder.  The grandparents could elect to use the balance in Sally’s account to help Timmy pay down $10,000 of loans.

Another noteworthy opportunity is for individuals burdened with student loans who live in 529 tax deduction states such as Georgia and South Carolina.  Individuals in such states ought to consider establishing a 529 plan in their home state and running their next $10,000 of student loan repayments through the account.  The caveats to this advice are: 1) it loses its appeal for individuals who qualify for the federal student loan interest deduction; and 2) individuals in 529 tax deduction states where the state has elected not to go along with federal code (by continuing to treat 529 distributions used for student loan repayment as non-qualified distributions) will do more harm than good by using this strategy.

3) Modifications to Required Minimum Distribution Rules

Whereas the other items described above provide expanded benefits, this is the revenue provision that will help pay for all the benefits in the bill. Non-spousal beneficiaries of inherited IRA accounts, 401k accounts, or other retirement plan accounts are and were required to take minimum annual distributions from these inherited accounts. This is not changing. However, the required distribution amount for accounts inherited before January 1, 2020 are based on the beneficiary’s age such that distributions can be “stretched” over decades, especially for relatively young beneficiaries. This stretch benefit can be worth millions of dollars if employed effectively. 

The new law requires that beneficiaries are generally required to fully distribute the retirement account by the end of the tenth calendar year following the year of the account owner’s death. There are exceptions for surviving spouses, disabled individuals, children of the account owner who have not yet reached the age of majority, or beneficiaries who are within 10 years of age of the account owner.

This 10-year provision severely hampers the “stretch IRA” – a financial planning strategy to maximize the tax efficiency of inherited IRA and other inherited retirement accounts.           

It is worth noting here that this change does not impact existing inherited retirement plan accounts or inherited accounts for anyone who died before January 1, 2020. No need to panic if you are already the beneficiary of an inherited IRA as nothing changes during your lifetime. 

Planning Implications:

• Naming young grandchildren as retirement account beneficiaries, which was highly effective under the old rules, loses much of the benefit. 
• For anyone who desires to leave assets of any size to a charity at death, using a tax-deferred IRA or retirement account as the source of funding makes far more sense now.
• Conduit look-through trusts that used to be an excellent option as a retirement account beneficiary need to be revisited. With the wrong language, these trusts that are typically created after death by a will, can be a disaster if named as a retirement account beneficiary.
• Qualified Charitable Distributions (QCDs) become even more valuable. Notably, this strategy is only applicable for individuals over age 70.5 and that age doesn’t change. Any dollars remaining in an IRA at death become less valuable because of the new accelerated distribution rules. That inherently makes it more beneficial to get those dollars out of the IRA during life by way of the QCD if you were already planning to make charitable contributions. With a few exceptions, almost everyone over age 72 who does charitable giving would benefit from using qualified charitable distributions to complete their giving – even if it’s only a few hundred dollars.
• For anyone who desires to leave assets to siblings (within 10-years of age), naming the sibling as beneficiary of an IRA or retirement account now tends to make more sense as opposed to leaving assets to the sibling through a will.
• Naming an accumulation trust or special needs trust as retirement account beneficiary should become more common since the currently unfavorable tax treatment is now less unfavorable (relative to naming a person or persons directly as beneficiaries).
• One “stretch IRA light” solution to consider – but only for charitably inclined individuals – will be to name a charitable remainder trust (CRT) as Traditional IRA beneficiary. Naming a CRT as beneficiary preserves the tax deferred treatment of the IRA and sets up regular (monthly, quarterly, or annual) annuity payments to the intended living beneficiary or beneficiaries which often is a desire of parents or grandparents. After a fixed period (up to 20 years) or the annuity beneficiary’s lifetime, any assets remaining in the trust would be passed to a charity of the deceased’s choosing. For example, a parent might name a CRT as IRA beneficiary of a $1 million IRA with his/her child receiving $56,000/year over 20 years. All taxes from the IRA would be deferred and the child would receive a total of $1,120,000 over the 20 years. Assuming 6.0% growth of the trust assets over the 20 years, the intended charity also receives $1,147,142 at the end of the trust’s term.
• Late-in-life Roth conversions still have utility but start to make less sense since the benefit of tax free growth has a more limited window of 10-years rather than the beneficiary’s lifetime.
• Roth account beneficiaries subject to the new 10-year payout requirement are best served (from a tax perspective) to avoid taking any distributions until the 10th calendar year following the owner’s death.
• Traditional IRA and retirement account beneficiaries need to be thoughtful and careful in taking distributions over the 10-year period. Waiting to take distributions until the end of the period could have negative tax ramifications for some and beneficial tax ramifications for others but it will be highly dependent on the unique circumstances. Given the increased flexibility of distributions under the new law, wise distribution planning is likely to add significant post-tax value, when done well.  

Have comments on these changes, questions about these planning strategies, or additional tax/financial planning suggestions? Please do not hesitate to share in the comments section below.

In the good ole days of “stretch IRAs” (i.e. before 2020 – more on that to come), children or grandchildren could inherit an IRA or other retirement account and stretch distributions over their respective lifetimes, thereby exploiting the tax-favored treatment of these accounts well beyond the original owner’s lifetime – often an additional half century or longer. One commonly recommended strategy for individuals with a meaningful IRA (or other retirement plan) balance was to name a “look-through” trust for their children and/or grandchildren as beneficiary of the account rather than the individuals, directly. Although this approach was not ideal for all situations, these qualifying trusts generally delivered a win-win-win scenario.

Such trusts directed that the required minimum distributions (RMD) set by the IRS for an inherited retirement account would pass through to the underlying beneficiary(ies) each year. Properly setting up the look-through trust as the beneficiary of a retirement account with the necessary language ensured that the inherited account would qualify for the most tax-favored distribution schedule (the so-called “stretch”). This resulted in deferring taxes as long as possible or, in the case of an inherited Roth account, retaining the benefit of tax free growth as long as possible. The approach helped avoid the high tax rates within the trust, created a multi-year tax-efficient legacy that was hard for the beneficiary to mess up, and added an element of creditor protection. The win-win-win result meant that the ideal estate plans often included a look-through trust unless unique circumstances warranted something different.

When the SECURE Act recently became law in December 2019, it effectively squashed the stretch strategy by requiring that most non-spouse retirement account beneficiaries distribute retirement accounts inherited after December 31, 2019 within a 10-year period (qualified with “most non-spouse beneficiaries” because there are eligible designated beneficiaries such as siblings and disabled individuals who still qualify for stretch treatment).

To be clear, this is not a favorable development and will effectively reduce the benefit of IRAs, Roth IRAs, and other retirement accounts as estate planning vehicles.

By significantly changing retirement plan distribution rules, the SECURE Act has an immediate impact on future estate planning and on existing estate plans. There is another article to write on beneficiary designation planning after the SECURE Act – the intent here is to explain the important impact it has on existing look-through trusts.

From a big-picture perspective, look-through trusts can be set up in one of two ways: as conduit trusts or as accumulation trusts. The conduit trust setup is what has been described thus far – required minimum distributions from the retirement account go into the trust and then are passed through to the beneficiary during the same tax year.

Alternatively, the accumulation trust still qualifies as a look-through trust for required distribution purposes but does not mandate that the required distributions pass through to the beneficiary. The trustee has discretion on whether to retain funds from the required distribution in the trust or distribute to the beneficiary. Leaving retirement account or IRA distributions in the trust results in higher tax rates but has clear utility if the beneficiary is a child with disabilities, spending problems, or drug dependency issues.

Importantly, there is a potential big problem with conduit look-through trusts under the SECURE Act distribution rules. Imagine someone names a conduit look-through trust as beneficiary of a $1 million IRA and then dies in 2020. Furthermore, the trust language directs that required minimum distributions from the IRA, starting in the year after death, be paid to the trust and passed through to the individual beneficiary.

Except now there is no required distribution in 2020. Or 2021. Or 2022. Or any of the first 9 years after death. Only in the 10th year is there a required distribution and all the funds in the IRA get paid in that one year, likely creating a massive tax liability and terribly tax-inefficient planning. So, the tax benefit that was intended with the look-through trust is basically non-existent and the idea of parsing out distributions over the beneficiary’s lifetime is destroyed.

The result of most accumulation look-through trusts is only slightly better. There remains the issue of no required minimum distributions until one massive lump-sum distribution in the 10th year. This results in the same unavoidable mess of a massive tax liability in year 10. There is, however, still a control benefit as the beneficiary does not necessarily receive the full $1 million plus the 10-years of growth all in one payment. Because the trustee has discretion, he/she can choose to distribute from the trust over time, as he/she deems appropriate.

Does this all mean that retirement account owners should no longer name look-through trusts as beneficiaries of these accounts? No – but It does mean that the language of any look-through trusts named as beneficiaries needs to be carefully examined. If the trust language simply mandates that the retirement account required minimum distributions be paid to the trust each year without any discretion, there is likely a big problem that needs to be immediately addressed.

Language that gives some discretion to the trustee offers a much better solution under the new law. Consider the following language:

If any trust created under my Will becomes the beneficiary of death benefits under any qualified retirement plan, my Trustee shall withdraw from the trust’s share of the plan, in each year, the required minimum distribution required under Section 401 (a)(9) of the Internal Revenue Code. My Trustee may withdraw such additional amounts from the trust’s share of the plan as my Trustee deems advisable; but, only if the dispositive terms of the trust authorize my Trustee to immediately distribute the withdrawn amount as provided below.

Note that the part in bold here gives the trustee discretion to withdraw additional funds from the retirement account beyond the required minimum distribution. Even though there may not be any required distribution in the first nine years after death, the trustee has authority to more evenly withdraw funds from the retirement account in each of those years and pass them through to the beneficiary so that the tax impact is potentially spread over 10 years at lower tax rates.

The bottom line is that the new law has a dramatic impact on IRA and retirement plan beneficiary designations. Trusts that worked perfectly well in 2019 as beneficiaries may be disastrous in 2020. And because of the dramatic change, it’s not just trusts as beneficiaries that need to be re-examined – it’s the entire big picture of how IRAs and retirement accounts now fit into the estate plan.

The modern world of instant-everything means a 24-hour, never-ending barrage of polarizing news headlines and alerts.  One hour, it is the China trade negotiations.  Another hour, it is impeachment hearings or presidential election jockeying.  A few hours later, you get news alerts about Ukrainian phone calls, Turkey’s military offensive in Syria, and escalating riots in Hong Kong.  You open your Twitter feed or your blog subscriptions and read about the inverted yield curve, slowing economic growth, and the Federal Reserve’s latest actions.  Hello 21^st century news cycle.

Several years ago, I hosted a monthly conference call for advisors who subscribed to get a monthly update on the markets, economy, tax policy updates, etc.  After I finished summarizing the current landscape each month, one advisor (always the same one) inevitably remarked about how “there seems to be a lot of uncertainty and elevated risk right now” – or some variation of that sentiment.  Nearly every single month.  It eventually became something that we both could joke about.

The reality that I tried to politely convey each month is that there has never been a shortage of risks or reasons for caution.  Never.  Ever.  Point to any month or any day in history and, while it might seem in hindsight as if that was a period of calm, there were substantial risks at that time.  Lots of them.  We easily forget about grave risks of yesterday like the spreading contagion of Detroit’s bankruptcy or the Ebola scare or oil prices at $110/barrel or the fiscal cliff and sequestration or Russia invading Crimea or Iran’s nuclear capability advancements.  There’s an enormous list that could keep us here awhile longer. 

We forget about these risks as just a little time passes but in the here and now, they’re of momentous concern because we are overly influenced by recent events, the latest economic data, or today’s attention-grabbing political headlines.

Not only do we get bombarded daily with risks but we then dramatically overestimate the probability of them escalating into something really bad.  Our brains are molded by more than 200,000 years of adaptation to survival optimization.  That is, our ancestors evolved to instinctively reduce uncertainty by reacting to a rustle in the weeds and retreating to safety.  Even if 99 times out of 100, the rustle was merely caused by a wind gust, our ancestors survived by treating all 100 occurrences as if a saber-toothed tiger was approaching.  Great for survival.  Not good for investing.  

A real-life example occurred in the months following the tragic events of September 11^th, 2001.  Americans reacted to the recency of the disaster and altered their behavior – avoiding air travel in favor of the roads.  Passenger miles in the US increased by 12-20% during the final months of 2001 although highway driving was and still is roughly 100x more deadly than flying per mile travelled.  Researchers suggest that an additional 1,595 Americans died in car accidents during the final quarter of 2001 from this change in behavior and the reliance on a much riskier means of transportation.        

So, we are overly influenced by the most recent events rather than by centuries of data, we overestimate the probability of these events having a material impact, and then we act as if we are above average in our ability to interpret and respond to the risks.  That is, we are overconfident in our abilities. 

Consider an individual investor who reads about the recent yield curve inversion, the slowdown in GDP growth, the weaker manufacturing data, and the uncertain impact of next year’s Presidential election.  He then interprets that these risks are likely to be bad for the stock market and reduces his stock exposure.  The reality is that none of this news is proprietary or just available to him.  Moreover, there is a better than 90% probability that the buyer on the other side of the trade is an institutional investor – a professional trader with far more information, experience, and analytical resources than our retail investor.  So when our naïve investor is selling stock because he interprets the data to be bad for stocks, the likely buyer is a large pension fund or hedge fund with overwhelmingly more data, resources, skill, and experience.

What can we do about our tendencies that help us survive but not invest well?  The keys are self-awareness and humility.  To be successful investors, we must recognize the tendency of our brains to make stupid investment decisions.  We must accept our predisposed risk tolerance and not try to stretch it.  We should turn off the financial pornography – all the business news channels business news channels that saturate us with the noise of today and then pretend to know what’s going to happen tomorrow.  We should be humble in our abilities and appreciate that we likely know much less than the institution on the other side of the trade.  And we should differentiate the forest from the trees such that we avoid getting lost in the irrelevant details of today’s headlines.    

The long-delayed passage of the SECURE Act by the Senate last week makes for significant tax law changes with perhaps the biggest impact being the death of most “stretch IRAs”.  The CBO estimates that added tax revenue over the next 10 years (2020 – 2029) from this provision will be $15.7 billion. Nothing else in the plan even comes close to this kind of economic impact. Although the CBO only scores the revenue impact for the next 10 years, the financial cost for beneficiaries in the 2nd and 3rd decades after the law changes will be a dramatically larger number than the $15.7 billion in the first decade. If you’re looking for the one tax law change with the most financial impact (revenue for the government, cost for taxpayers), look no further.  

Up until now, a Traditional IRA, Roth IRA, or other qualified retirement account could be left to living beneficiaries who could then “stretch” the distributions over their respective lifetimes. Such a technique took advantage of extended tax deferral for inherited Traditional IRAs and of extended tax-free growth for inherited Roth IRAs.

A 30-year old who inherited an IRA, for example, could systematically distribute the IRA over the next 54 years (based on a statutory table provided by the IRS) rather than distribute everything soon after the inheritance. With wise distribution planning by a young beneficiary (i.e. child or grandchild), this exploitation of the tax law and extended compounding effects of tax deferred or tax-free growth could literally result in millions of dollars in extra tax savings on a $500,000 IRA account. All the while, the stretch IRA created a lifetime annuity. 

While existing inherited IRAs (or any IRAs that are inherited before Jan 1, 2020) can still take advantage of the stretch benefits, the SECURE Act effectively ends (or dramatically curtails) the stretch IRA strategy in the future by requiring that all retirement accounts for beneficiaries inherited in 2020 or thereafter be distributed within 10 years of death (notably, there are exceptions such as surviving spouses and disabled beneficiaries). 

Following passage of the Act, several planning articles suggested that the end of the stretch IRA now makes Roth conversions more favorable. An InvestmentNews article last week recommended that “the time is ripe to convert traditional, pretax retirement accounts to Roth-style accounts” and predicts that “Investment advisers are going to put a premium on Roth conversions.” Another article suggests that “it is going to be critical to execute Roth conversions on the highest scale possible.”

But here’s the glaring issue – Roth conversions become less favorable, not more favorable, under the new law. Recall how Roth conversions work: when you convert tax-deferred “Traditional” assets to a tax-free Roth account, the conversion amount is treated as ordinary income and you face an immediate tax liability on that amount of income. You then enjoy the benefits of tax-free growth on the converted amount such that when you (or your beneficiaries) withdraw the funds from the Roth, there is no additional tax. 

As nice as “tax-free growth” sounds and is, Roth conversions are not a free lunch and should not get a free pass. The mathematical evaluation of Roth conversions hinges on a comparison of the initial up-front cost of the conversion (the immediate tax) to the expected future benefit (of tax avoidance in the future). While it is a not-so simple net present value calculation that depends on a number of variables, the result of this evaluation is largely determined by tax rates – the tax rate at the time of conversion versus the anticipated tax rate when the assets are expected to be withdrawn. If the current tax rate is lower than the expected future tax rate when the assets are going to be distributed, then the conversion math makes sense. If the current tax rate is higher than the expected future tax rate, then a conversion should be avoided. 

The fundamentals of that evaluation do not change. A Roth conversion that made economic sense before the SECURE Act, makes sense after it. And vice versa. But the Act’s new 10-year mandatory distribution period for IRA beneficiaries reduces the time period over which the benefit of tax-free growth can accrue. And that’s extremely important – especially when the beneficiary may be a child or grandchild with a time horizon of 40 years or more. It’s not that there stops being a benefit to Roth conversions in the right situations – it is most Roth conversions just become less beneficial under the new law.

Consider the case of a 68-year old IRA owner who is considering a $10,000 Roth conversion with the eventual goal of leaving the Roth IRA to his 12-year old granddaughter, Amy. By his projections, he will be able to convert at a 25% tax rate (tax of $2,500) and eventually leave the IRA to Amy who is projected to face a 35% tax rate in the future. The grandfather converts $10,000 from IRA to Roth IRA, pays the $2,500 tax and the Roth account grows for another 18 years until his death when Amy is now 30-years old. 

Under the current (until Jan 1, 2020) distribution rules, Amy can let the tax-free compounding of the Roth IRA accrue for another 54 years while taking required annual distributions over that time period. Under the new distribution rules, Amy inherits the Roth account and is then forced to distribute it entirely within 10 years – dramatically reducing the tax-free compounding period from 54 years to 10 years.

Notably, the Roth conversion is beneficial in both scenarios – under the current law and the new law. It is – again – just that the conversion is less beneficial under the new 10-year distribution rule. Under the current law, Amy winds up with 44% more dollars from her grandfather having done the conversion than not converted. Under the new law, that advantage drops to 23%[i].      

What’s the takeaway? To be clear, it is not that Roth conversions should be avoided under the new tax law. When the expected future tax rate – for you or your beneficiaries – is higher than your current tax rate, Roth conversions serve a valuable purpose. But, there seems to be this new promotion of Roth conversions in light of the accelerated beneficiary distribution rule. Any such promotion is either misinterpreting or misunderstanding the results. The takeaway is that Roth conversions are generally less beneficial under the new law with the shorter time period to accrue the tax-free growth benefit. 

Kudos to advisors and consumers who were already evaluating and executing annual Roth conversions in low tax years. Advisors and consumers who are just beginning to evaluate or promote Roth conversions in light of the SECURE Act have simply been missing out on an outstanding opportunity – an opportunity that still continues in the future – albeit with a diminished benefit. The idea that investment advisors expect a pickup in conversion of traditional IRAs to Roth IRAs as a result of the SECURE Act, if true, is an embarrassing statement about the investment advisor community. Said differently – if you ask your advisor whether you should begin to consider annual Roth conversions in light of the tax law change and he or she says yes, the real question that needs to be addressed is why you have not been exploiting this opportunity in the past.

[i] There are a number of assumptions here. In this evaluation, it is assumed that the $2,500 upfront tax liability is paid with non-IRA assets such that in the “no-conversion” control scenarios, a side account is tracked with the $2,500 that was saved from avoiding the tax liability. We assumed a 7.0% pre-tax rate of return for the invested assets and a 6.5% after-tax rate of return. Increasing the difference between the pre-tax return and after-tax return increases the benefit of conversion in both scenarios but more so under the old (pre-2020) distribution rules. It’s assumed that minimum required distributions are withdrawn minus any associated tax liability and invested in a taxable account. In the case of the inherited IRA accounts under the new SECURE Act rules, we assume that Amy distributes the IRA accounts at the end of the 10th year. While the benefit percentages will change when any of these assumptions change, the important point is the concept that the Roth conversion becomes less beneficial in the future.  

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Over the past two decades, doctors have overwhelmingly turned to evidence based medicine (EBM) – the conscientious use of clinical experience and research to make decisions about the care of patients.  Evidence based medicine is about applying the current best evidence, systematic reviews, and the scientific method to the treatment of patients.  The result has been more informed decisions and better outcomes.  `

Evidence based investing (EBI) – the foundation of Golden Bell’s investment approach – judiciously applies the same concepts of evidence based medicine to investing.  We use the long-term evidence of capital markets to formulate optimal investment solutions and apply an objective discipline to achieve better outcomes.  

Even though there is robust and nearly irrefutable evidence that investors overwhelmingly achieve better results by rejecting actively managed funds, market timing strategies, individual stock selection, macroeconomic forecasts, and subjective decision making, most investors still rely on such sub-optimal and under-performing strategies.  These investors follow unscientific models based on untested hypotheses and the idea that they have some special knowledge that is largely unknown to the market or the professional investment community.  Fear and greed – rather than evidence – dictate investment decisions.  As Albert Einstein said, “The definition of insanity is doing the same thing over and over again but expecting different results.”

At Golden Bell, we maintain enough humility to appreciate that we are not immune to the same behavioral shortcomings of all humans.  Just because we may be smart, experienced, and have unique access to information does not mean we are better at predicting short-term market movements. 

Our evidence based investing approach – one that has been stress-tested by researchers at the University of Chicago, Yale, MIT, and other academic institutions – applies a systematic discipline to remove emotion and filter out the never-ending avalanche of forecasts, opinions, and noise.  It is not about predicting the next market swing – it is about avoiding the most common of investor mistakes.  While overwhelmingly simple and unexciting, it is a discipline that exploits investment diversification, employs low cost, passive investments, in a tax-efficient manner, and seeks to capture historically reliable long-term risk premiums.  

At the end of the day, our evidence based approach is intended to maximize growth and consistency while minimizing risk, taxes, and emotion.  You will have to get your emotional fix elsewhere. 

Instructing my youngest son to simply “go clean his room” creates all sorts of problems. First, there is a gap in definitions. His version of clean and my version of clean are worlds apart. Parents, start nodding if not already. Cleaning his room generally requires parental assessment of the current situation to map out a plan of attack. At this point, even if he is given clear and explicit instructions like “put all the games away”, there’s an implementation problem. Putting the games away for him might mean simply shoving everything under his bed or could take the more creative approach of hiding the Monopoly pieces into his laundry bin so they’re “put away”. Finally, there’s the maintenance problem of keeping things clean so that clean now equals clean in an hour from now.

The reality is that these challenges arise all the time in financial planning. Generic advice, even if sound, rarely ever should be blindly applied. Each situation is unique and it can be challenging to know whether “go clean your room” instructions even makes sense in your unique situation. Furthermore, implementation poses a challenge given the subtleties of each unique situation. 

As an example, consider the “mega backdoor Roth contribution” strategy. 

What is the mega backdoor Roth contribution strategy?

You may have heard of the backdoor Roth contribution – an increasingly popular tax-saving strategy over the past decade since a 2010 tax law change. The backdoor Roth contribution lets some high income earners contribute $6,000 – $7,000 each year to a tax-free Roth account. The mega backdoor Roth contribution is a distant cousin that lets high income earners contribute as much as $37,000 each year to a tax-free Roth account. 

Most employees who are eligible to contribute to a 401k plan are limited to annual contributions of $19,000 or $25,000 for individuals age 50 and over (2019 limits). These elective employee deferrals can be either traditional pre-tax contributions or they are Roth post-tax contributions. 

Beyond these employee contributions, there may be an employer match or employer profit sharing. The IRS sets another limit on the aggregate amount of annual contributions – what gets referred to as the 415 limit (defined in Section 415(c)(1)(A) in the IRS tax code). In 2019, the 415 limit on all contributions to a 401k plan is $56,000 for employees under 50 and $62,000 for employees age 50 and over. 

That means there is $37,000 of space between Roth/traditional 401k deferrals and the aggregate 415 limit ($56,000 minus $19,000 or $62,000 minus $25,000). Some or all of this $37,000 may be filled by employer contributions. To the extent it is not filled, employees can be permitted to make after-tax 401k contributions to absorb whatever remains of the 415 limit. And this is where the mega-backdoor Roth contribution strategy begins – with employees making after-tax contributions, beyond their elective deferral limits of $19,000/$25,000, to their employer’s 401k plan.

Let’s pause here because there is the potential for confusion. After-tax 401k contributions are not the same as Roth 401k contributions. Both are made with post-tax dollars but Roth 401k contributions are subject to the elective deferral limit of $19,000 (or $25,000) whereas non-Roth, after-tax contributions are simply subject to the 415 limits ($56,000 or $62,000). Moreover – and this will be really important as we explain things further down – the growth on any after-tax 401k contributions is subject to taxation as ordinary income when distributed. Alternatively, any growth on Roth 401k dollars is tax-free.

Should I make mega backdoor Roth contributions?

There is plenty of written personal finance advice effectively saying “The mega backdoor Roth contribution is a great idea – you should do it.” Standard, boilerplate advice that equates to me telling my son to go clean his room. Except that he may not need to clean his room. Or his big brother locked the door so that he can’t clean his room. Or cleaning his room without first evaluating what needs to be cleaned will cause more harm than good. All of those concepts apply here in relation to determining whether you should make mega backdoor Roth contributions.

A mega backdoor Roth contribution can be extremely useful for some people and terribly counterproductive for others – resulting in more taxes (and fees), rather than less. The first step is to assess whether you’re eligible for mega backdoor Roth contributions and whether such contributions ought to be considered. All, not just some, of the following conditions must be met for the mega backdoor Roth to be a worthwhile strategy:   

• Your employer must permit after-tax retirement plan contributions beyond the elective deferrals. That is to say that employers do not have to permit these contributions – and many do not.
• You must have the capacity and/or desire to save more than the elective deferral limits of $19,000/$25,000. If you are a high income earner looking to save extra dollars in a more tax-friendly way, check this box. 
• Your 401k plan needs to provide reasonably good investment options without high investment and/or administrative fees. If the plan lacks low-cost investment options, the math on after-tax 401k contributions works against you, not for you. (Notably, this factor doesn’t apply if your plan permits periodic in-service distributions that gives you the ability to entirely remove funds from the plan as explained in #5 below).
• If you work for a generous employer, there must be room to make after-tax contributions under the 415 limit without cannibalizing employer contributions. Consider the example of a large, Atlanta-based airline that provides substantial employer contributions to its pilots such that many pilots hit the 415 limits each year just by way of employer contributions or with traditional/Roth 401k deferrals plus the employer contribution. In such cases, a pilot making after-tax 401k contributions actually reduces the “free money” he/she receives from the employer because the total contributions cannot exceed $56,000 (or $62,000). In an extreme example where a 45-year old pilot defers $19,000 to her 401k of traditional pre-tax dollars and then contributes $37,000 in after-tax contributions up to the $56,000 limit, the airline (employer) would not have any room to make its contributions to her account, saving the airline from providing this generous benefit.
• Your employer needs to permit periodic “in-service distributions” or “in-plan rollovers” for after-tax contributions and any related earnings. The alternative is that you intend to leave your current employer relatively soon which would then permit you to distribute funds from the plan at the time of separation and get the same result. 

Remember from earlier that the growth on after-tax 401k contributions is, unlike Roth 401k dollars, subject to tax as ordinary income when distributed. Ideally, what happens is that you make the after-tax 401k contribution and then immediately (or soon thereafter) rollover/convert those dollars to a Roth IRA (in the case of in-service distributions) or rollover those dollars to the Roth 401k (in the case of in-plan rollovers). If done immediately after the contribution, there is no growth and so there is no tax. If the conversion or rollover is not immediate but happens relatively soon after the contribution, the growth should be minimal and so the resulting taxes are minimal. Moreover, the dollars are now in the Roth account which means all future growth is tax-free. 

And there you have the mega backdoor Roth contribution. 

If one of these five conditions is not met, then either you cannot use the mega backdoor Roth or it is not likely to make economic sense. There is an argument that if you check the boxes for the first four items but not the fifth, that you should go ahead and make the contributions, anyway. This math depends on several variables (time until conversion/rollover, time until distribution, investment return, dividend yield, capital gain rate, tax rates, holding period, and a few others) but it is generally the case that if the time until conversion is a few years or longer, you come out better off by investing in tax efficient funds in a brokerage account rather than making any after-tax 401k contributions. 

What if I meet all five conditions?

If all five of these conditions are met, then you’re an excellent candidate for mega backdoor Roth contributions. But as with my son cleaning his room and knowing what needs to be cleaned, there can still be an implementation problem that destroys all the value. Provided that all conditions above are met, here is the basic implementation strategy (in this example, assuming age >50): 

1. Determine how much you can expect to receive in employer matches and other contributions over the course of the year if you make only the $25,000 of 401k deferrals. Let’s assume total employer contributions to be $10,000. 
2. Start with the 415 limit of $62,000. Subtract your $25,000 of deferrals and the $10,000 of expected employer contributions. This leaves you with $27,000 of room remaining.
3. Elect to contribute $27,000 of after-tax contributions to your 401k over the course of the year.
4. Once the contributions are made – or soon, thereafter – you need to either rollover these after-tax dollars to a Roth 401k account or to a Roth IRA (in the case of in-service distributions).

Now you’re ready to invest these mega Roth accounts and take advantage of the tax-free growth. What you have effectively done here is taken $27,000 of post-tax dollars which would have otherwise been invested in a regular brokerage account and shifted those dollars to a Roth account. Whereas any income, dividends, or capital gains from the $27,000 in the brokerage account would have been subject to taxes, now it grows and earns free of taxes forever.

What if I want to make mega backdoor Roth contributions but my employer does not permit after-tax contributions or does not allow in-service distributions/in-plan rollovers?

Make sure that they understand this option exists and that it is not hard to implement. It often just requires an update to the 401k plan agreement to add some permissions. But many employers – especially small employers – don’t even know the option exists.  

Any closing thoughts?

It’s complicated. That’s not to say that everyone needs help evaluating their own situation or implementing. It is just to say this is complicated. In reality, the calculus is even more complex than I have outlined above. I provided five conditions that need to be met to proceed with the mega backdoor Roth contributions. Yet for simplicity, I ignored relevant factors like whether adequate funds already exist outside the retirement plan accounts or whether retirement before age 55 might be a possibility.

Moreover, it can make sense to make the after-tax contributions even if there is no in-plan rollover or in-service distribution option. I alluded to the math depending on a number of variables and the expected value (positive or negative) can be calculated – it’s just that there are too many variables for generalized advice.

All that said, if you meet the five conditions laid out above and you’re not already exploiting the mega backdoor Roth contribution strategy, it is probably time to go clean your room.