Backdoor Roth IRA – Definition & How to Make These Contributions

Saving for retirement is important for everyone. It’s difficult to live off Social Security benefits alone, so most people will need to supplement their retirement income with their own savings.

Many people have access to retirement plans like 401(k)s through their employers. If you don’t have access to a 401(k), or simply want to save more or have more control over your retirement savings, you might consider opening an Individual Retirement Account (IRA).

An IRA is a special type of account that is designed for retirement savings. You can open IRAs at many banks and with most brokerage companies. If you put money in an IRA, you can receive tax benefits, but you also restrict your ability to withdraw that money.

One drawback of traditional IRAs and Roth IRAs is that they limit the amount that you can contribute and exclude some people from contributing based on their income. However, there are ways to get around these limits.

What Is a Roth IRA?

For Roth IRAs, you pay taxes as normal when you contribute money to the account. However, withdrawals from the account are completely tax-free. That means you don’t have to pay any tax on your investment gains or dividends you receive in the account.

This can save you a lot of money in taxes compared to investing in a taxable brokerage account.

For comparison, a traditional IRA lets you deduct your contributions from your income, reducing your income tax bill immediately. However, you have to pay income tax on all the money you withdraw, including earnings, meaning you are deferring your taxes to a later date.

Roth IRAs are designed for retirement savings, so there are rules about withdrawing from the account.

Because you’ve already paid taxes on the money you contribute to a Roth IRA, you can withdraw contributions without penalty or taxation. However, the earnings in the account — the gains from your investment activities — are subject to penalties if you withdraw them before you turn 59 ½.

If you’ve had the account open for fewer than five years, you have to pay a 10% penalty and income tax on any earnings you withdraw. If you’ve had the account open for at least five years, you may be able to avoid taxes but will have to pay the 10% penalty on early withdrawals.

In some situations, such as paying for a first-time home purchase or paying for medical expenses, you may be able to avoid these taxes and penalties.

Once you turn 59 ½, you can make withdrawals from the account freely as long as it has been open for at least five years.

Roth IRA Contribution and Income Limits

The government places limits on the amount of money that you can contribute to a Roth IRA each year. The limits are based on your age and your income.

In general, for 2020, you can contribute up to the lesser of your taxable income for the year or $6,000. If you are age 55 or older, you can contribute an additional $1,000.

If you have a high enough income, the amount that you can contribute will begin to decrease until it reaches $0. The income maximum varies depending on your filing status.

Full Roth IRA Contribution Allowed Partial Roth IRA Contribution Allowed No Roth IRA Contribution Allowed
Single or Head of Household tax filing status Earned less than $124,000 Earned $124,000 to $138,999 Earned $139,000 or more
Married, filing separately tax filing status, did not live with spouse during the year Earned less than $124,000 Earned $124,000 to $138,999 Earned $139,000 or more
Married, filing separately tax filing status, did live with spouse during the year Earned less than $10,000 N/A Earned $10,000 or more
Married, filing jointly, or qualified widower tax filing statuses Earned less than $196,000 Earned $196,000 to $205,999 Earned $206,000 or more

These income limits use your modified adjusted gross income (MAGI), which is your gross income minus certain deductions such as contributions to employer retirement plans and student loan interest.

What Is a Backdoor Roth?

A backdoor Roth is a strategy people use to get around the income limits on Roth IRA contributions by contributing to a traditional IRA and then converting the balance to a Roth IRA.

Imagine that you’re fortunate enough to have an income of $150,000 as a single person. You probably have a good amount of money to invest for retirement, but the government won’t let you contribute to a Roth IRA.

You can use a backdoor Roth to get funds into your Roth IRA without breaking the income maximum rules. Traditional IRA contributions, unlike Roth IRAs contributions, are not limited by your income.

That means that you can contribute money to a traditional IRA no matter how much you make, and then roll those funds into a Roth IRA.

Pro tip: Have you considered hiring a financial advisor but don’t want to pay the high fees? Enter Vanguard Personal Advisor Services. When you sign up, you’ll work closely with an advisor to create a custom investment plan that can help you meet your financial goals.

How to Make Backdoor Roth Contributions

Making a backdoor Roth contribution is relatively easy.

1. Contribute to a Traditional IRA

To start, contribute the amount that you want to put in your Roth IRA to a traditional IRA.

When you contribute money to a traditional IRA, you can usually deduct those contributions from your income when you file your tax return. However, like Roth IRAs, there are income maximums for deducting traditional IRA contributions.

If you make more than the maximum allowed, you can still contribute to a traditional IRA, but you cannot deduct that contribution from your income when filing your tax return.

Because you’re rolling your money into a Roth IRA anyway, you’ll have to pay taxes, meaning you don’t have to worry about making too much to take the deduction.

2. Roll Your Traditional IRA Into a Roth IRA

Once you’ve contributed to an IRA, you want to roll that money into a Roth IRA.

A rollover lets you convert some or all of your traditional IRA balance into a Roth IRA balance. In effect, you can completely dodge the income limit for Roth IRA contributions using this strategy. Your broker can typically help you with the rollover process, making it relatively easy.

When you roll your traditional IRA’s balance into a Roth IRA, you pay income taxes on the amount you roll over.

The Pro-Rata Rule

Before you make a backdoor Roth contribution, you need to keep in mind one rule surrounding traditional IRAs and rollovers: the pro-rata rule.

To understand the pro-rata rule, picture your traditional IRA as having two buckets. One bucket includes money you deducted from your income and thus haven’t paid taxes on yet. The other includes money you contributed that you could not deduct from your income, possibly because you made too much money that year.

You need to track the buckets separately because although you have to pay income tax on pre-tax contributions when you withdraw them, you don’t have to pay them on post-tax contributions. If you did, you’d be paying taxes on the same income twice.

The pro-rata rule states that you must roll a proportional amount of each bucket into a Roth IRA when performing a rollover, meaning you can’t choose which bucket of money to roll over. This can have significant tax implications depending on how much pre-tax money you already have invested.

Avoiding the Pro-Rata Rule

The only way to avoid the pro-rata rule is to roll over your entire traditional IRA balance. If you make too much to contribute to a Roth IRA in the first place, you’re in a high tax bracket, resulting in a large tax bill as part of the rollover if you already have funds in your traditional IRA.

Keep in mind, the pro-rata rule looks at all of your IRAs and other pre-tax accounts, even if you keep them at different brokerages. You can’t open accounts in different places to dodge the rule.

3. Pay the Taxes Owed

When you roll money from a traditional IRA, you have to pay income tax on the money you roll over, unless the rollover is entirely composed of nondeductible contributions. If you’re rolling a large amount, you’ll want to have some money set aside to cover this cost.

To keep costs low, it might be worth timing your rollover for a year where your income is low, which means you’ll be in a lower tax bracket when you owe the tax on the amount rolled from your traditional to your Roth IRA.

Ultimately, backdoor Roth IRA contributions work best if you have little or no money in your traditional IRA. Asking a tax professional or a financial planner is a good idea if you want help with the process.

Advantages of Backdoor Roth Contributions

There are a number of reasons to consider backdoor Roth contributions.

1. Avoid Income Limits

The obvious benefit of backdoor Roth contributions is that they let you get around the income limits imposed by the IRS.

If you make too much to contribute to a Roth IRA, you probably have some extra money to save for the future. A backdoor Roth lets you get all of the advantages of a Roth IRA despite the income limits.

2. Tax-Free Growth

Money in a Roth IRA grows tax-free. You don’t pay taxes when you take money out of the account and the money you earn from your investments isn’t taxed either.

If you’re planning to invest the money anyway, by putting it in a Roth IRA, you’re getting the benefit of tax-free growth and only losing the freedom to withdraw earnings before you turn 59 ½.

Disadvantages of Backdoor Roth Contributions

Before using a backdoor Roth, consider these drawbacks.

1. Complexity

Making backdoor Roth contributions involves a few steps. You have to put money into a traditional IRA, then initiate a rollover to a Roth IRA.

If you have your traditional and Roth IRAs at the same company, your brokerage can probably help with the process, but there are a few moving parts.

You also have to make sure you submit the correct forms when you file your taxes to indicate your contributions and rollovers.

2. Combining Pre- and Post-Tax Money Is Messy

The pro-rata rule for rollovers means that backdoor Roth contributions work best if you don’t have any money in a traditional IRA.

If you do have some funds in your traditional IRA and don’t want to move the full balance of the account to your Roth IRA, you’ll be rolling a combination of pre- and post-tax funds into your Roth and leaving a combination of both in your traditional IRA.

This means you have to be diligent with your recordkeeping to make sure you don’t pay taxes on your post-tax traditional IRA funds when you withdraw money from the account in retirement.

You also have to pay taxes on any money rolled from a traditional IRA to a Roth IRA in the year you perform the rollover, which you need to plan for.

The Mega Backdoor Roth

Related to the backdoor Roth IRA is the mega backdoor Roth IRA. In rare cases, people can use a quirk of their 401(k) plan to get past the Roth IRA contribution limit, putting tens of thousands of dollars into their Roth IRAs each year.

401(k) Contribution Limits

A 401(k) is a retirement plan provided by employers as a benefit for their employees. One of the advantages of 401(k)s is their much higher contribution limits compared to IRAs.

For 2020, the individual limit for a 401(k) is $19,500 when it comes to deducting contributions from your taxes.

However, the true limit for 401(k)s is triple that number, $58,500. This limit includes all contributions made by the individual and their employer. Employees can deduct the first $19,500 they contribute and employers can contribute another $39,000 without the employee paying taxes on those employer contributions.

A small number of employers allow their employees to make post-tax, non-Roth contributions to their 401(k)s. This is like making nondeductible contributions to a traditional IRA.

You put money into the 401(k) but still pay taxes on the contributions. If your employer allows these types of contributions, you can add your own post-tax money to the account up to the $58,500 limit.

Typically, when you leave an employer, you can roll the balance of your 401(k) into your IRA. Most employers don’t let you roll your 401(k) into an IRA or make withdrawals from the account while you’re still employed. However, a small number of employers do allow these in-service distributions.

Performing a Mega Backdoor Roth Rollover

If your employer lets you make both post-tax, non-Roth contributions and allows in-service distributions, you have access to the mega backdoor Roth IRA.

To make a mega backdoor Roth contribution, contribute post-tax, non-Roth funds to your 401(k), then perform an in-service rollover of that money from your 401(k) to your Roth IRA.

Using this strategy, you can put as much as $39,000 extra into your Roth IRA each year, increasing your tax-advantaged investments by a huge amount.

Unfortunately, 401(k) plans that allow both post-tax, non-Roth contributions, and in-service distributions are incredibly uncommon, meaning that most people won’t be able to use this strategy.

However, if you run your own business or are self-employed, there’s nothing stopping you from designing your retirement plan to offer these options.

Final Word

Roth IRAs are one of the best ways to save for retirement, but if you make too much money, the IRS won’t let you contribute to the account.

For those with incomes high enough that they can’t contribute to a Roth IRA but who want to save more toward retirement, a backdoor Roth IRA contribution can help get around the limits.

If you’d rather keep the money out of retirement accounts and easy to access, you can always consider opening a taxable brokerage account. If you’re a hands-off investor, you can also think about using a robo-advisor to manage your portfolio.


This Often-Overlooked Way to Fund Your Roth IRA Has Many Advantages

A Roth IRA is a uniquely powerful retirement savings tool, because you won’t pay taxes on the money you withdraw during retirement. An annuity is a way of generating guaranteed income. Put them together, and you have a powerful retirement protection tool that can provide guaranteed income for life, with a big plus: It’s completely tax-free.

Anyone may roll over part or all of an existing Roth to a Roth annuity.  You may transfer all or part of the funds in an ordinary Roth to a Roth annuity. While there are income and contribution limits for new money going into a Roth IRA, they don’t apply to rollovers — including rollovers to a Roth annuity.

Different types of annuities accomplish different things and have distinct pros and cons — like the Swiss army knife of personal finance. Since they’re so varied, one type or another can work well for a Roth IRA.  Investment choices, fees and contract provisions vary, so work with an annuity agent who will educate you about your choices and clearly lay out the pros and cons.

What kind of annuity works for a Roth? It depends on which stage of your financial life you’re in. In the accumulation stage, you’re building wealth for retirement. In your decumulation stage, you’re retired and receiving income from your savings.

Here’s how Roth annuities can work in each stage.

Building wealth for those approaching retirement

One attractive option is a fixed indexed annuity. With the stock market continuing to break records, it may be vulnerable to a major long-term downturn. When you’re young, you can ride out the ups and downs. But if you’re in your 50s or 60s, you may want to get growth potential without taking the risk of losing Roth money you’ll need during retirement. If so, an indexed annuity might be a good choice for you.

It pays interest based on an underlying market index, such as the S&P 500 or the Dow Jones Industrial Average. While the interest earnings are locked in, up to a stated cap (you may not get all of the upside) each year, you’ll never lose money when the index declines.

While indexed annuities are linked to one or more underlying market indexes, their value does not vary from day to day. Instead, they pay a varying amount of interest that is credited and locked in each year on the anniversary date of the contract. Since equity markets can be volatile, indexed annuities are designed to be held long-term, whether yoked to a Roth IRA or not.

A fixed-rate annuity — also called a multi-year guarantee annuity, or MYGA — is a more conservative choice. It works like a bank CD, paying a set interest rate for a set period. Fixed-rate annuities these days pay much more than CDs of the same term. As of April 2021, you can earn up to 2.90% a year on a five-year fixed-rate annuity and up to 2.25% on a three-year contract, according to AnnuityAdvantage’s online rate database. The top rate for a five-year CD is 1.25% and 1.05% for a three-year CD, according to Bankrate. 

Fixed-rate annuities can play a key role in asset allocation. Let’s say you decide to split your Roth assets up 50-50 between equities and fixed income. A fixed-rate annuity can give you a much higher rate of interest than you’d get today with safe fixed-income alternatives, such as CDs and Treasury bonds.

For current annuity rates, see this online annuity database. Interest is paid and compounded annually.

How to get tax-free lifetime income during retirement

Other than a traditional employer pension or Social Security, an income annuity is about the only vehicle that can guarantee an income for as long as you live. And by combining an income annuity with a Roth, that income is tax-free.

If you need income from your Roth very soon, consider an immediate income annuity. You can open a Roth annuity with a single payment (such as a tax-free rollover from an existing Roth IRA) to an insurance company. The insurer in turn guarantees you a stream of income. You can choose how long the payments will last — for instance, 15 years. Most people, however, choose lifetime payments as “longevity insurance.”

You can receive your first monthly income payment a month after your annuity contract is issued.

If you’re married, consider the joint-income option. With it, your spouse will receive regular monthly income payments for the remainder of his or her life too. Payments to a surviving spouse are always tax-free.

If you don’t need income right now, consider a deferred income annuity. Here, your income stream will begin at a future date you choose. By deferring payments, you let the insurer credit more interest over the years on your behalf, and you’ll ultimately get more monthly income. For instance, by delaying lifetime annuity payments from age 65 to 75, you’ll get about 85% to 90% more each month. On the other hand, you and/or your spouse won’t receive the deferred payments as long.

Another option is an indexed annuity with an income rider. The rider guarantees a certain income regardless of the performance of the annuity. It provides income like a deferred income annuity, plus the potential upside of an indexed annuity. It’s sometimes called a “hybrid” annuity.

The downside is cost. The rider typically costs about 1% of the annuity value annually. The insurer deducts this amount from your policy.

The advantage is retaining your money. Unlike an income annuity, which typically has no cash surrender value, an indexed annuity with an income rider lets you keep your money while guaranteeing lifetime income, starting on a date you choose.  You thus have flexibility. If you need the money, it will be there for you to withdraw or annuitize. (Wait until the surrender period is over to avoid any penalties.)  If you don’t need the money, you can pass on any remaining value to your heirs.

Is the extra cost worth it?  It all depends on your situation and goals and your desire to leave money to your heirs.

Whether you’re saving for future retirement or are currently retired or soon will be, annuities offer a range of often-overlooked strategies for the Roth IRA and amplify its advantage of tax-free retirement income.

A free quote comparison service with interest rates from dozens of insurers is available at or by calling (800) 239-0356.

CEO / Founder, AnnuityAdvantage

Retirement-income expert Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed and immediate-income annuities. It provides a free quote comparison service. He launched the AnnuityAdvantage website in 1999 to help people looking for their best options in principal-protected annuities.


The Potential Financial Silver Lining of the Pandemic

To say the last year has been unprecedented might be the understatement of the century. It is hard to imagine anyone who has not been impacted in some manner, some far more than others, by the pandemic. Personal finances are no exception as the volatility of the past year remains front and center for many despite recent market recovery.

However, something interesting is happening. Many people are doing what their financial professionals have been asking them to do since their first appointment! They are paying closer attention to their current and future finances. In fact, according to our 2021 Allianz Retirement Risk Readiness Study, two-thirds (65%) of those surveyed said they are paying more attention to what they are saving and spending, and nearly six-in-10 (58%) have cut back on their spending.

This is, no doubt, a step in the right direction. But — and there is always a “but”— risk readiness needs to be about much more than saving and spending. Although it’s understandably a good immediate approach, given the current environment, there is more to consider, specifically the long term. It might seem difficult to look at now, but retirement planning still needs to remain top of mind.

One area that is often overlooked in accumulating assets that deserves much more attention is income planning. Income planning is ensuring you have enough funds to support your lifestyle throughout your, and your spouse’s lifetime.  The value of income planning should never be underestimated. Without a written plan, which is regularly updated, your retirement dream is nothing but a work of fiction. However, a few simple steps now will set you up for future success. You’ll be much more confident when you reach the retirement reality and embark upon the next chapter of the story of your life.

Know your retirement risks

Significant events are often the triggers that convince people to take a more proactive approach. The pandemic is no exception. It exposed a whole new level of financial risks many people hadn’t recognized.

While it is fresh, use this same lens and think about risks in retirement: longevity, inflation, market volatility, the list goes on and on. We’re reminded of the day-to-day risks that pop up in retirement, such as increased health care needs and mobility issues. This “discovery” phase may be a painful reality check, but it is Step No. 1 in addressing your future income needs.

Review your expense categories

While it is sometimes difficult to predict your retirement spending, using your current expenses as a baseline is a great way to estimate expense categories. As a general rule, your essential expenses, such as food, clothing, shelter and health care costs, take priority over discretionary and legacy spending and require reliable guaranteed income. After all, you must cover essential expenses regardless of market conditions or other factors.

Identify your income sources

While retirement income can come from a variety of sources, most people immediately think Social Security. It is important to know all of the options when filing for Social Security benefits in order to get the most out of them. However, Social Security alone will not provide a complete source of retirement income.

Uncover any potential income gaps

Which brings me to the next point. If, by factoring in Social Security and pension income (if any) you discover that you don’t have sufficient guaranteed income to cover your essential expenses, you’ve uncovered a retirement income gap. This might be jarring, but it is actually good news, as you now know what needs to be done and can get ahead of the situation now rather than having an unpleasant surprise in retirement.

Develop a tailored solution

Working with your financial adviser, you can create a retirement income plan that could cover your essential expenses as well as potentially enhance your discretionary and legacy income. You will want to figure in things like travel, hobbies and other “fun” expenses in addition to the essentials. Retirement shouldn’t be something that is survived but something that is enjoyed.

If you, indeed, have the dreaded income gap, there are several products, such as annuities, that can help you put in place an additional stream of guaranteed income to help cover your needs. (Remember that guarantees are backed by the issuing insurance company.)

There seems to be light coming at the end of the proverbial tunnel. While it might not be an easy mindset shift, getting back on track now with your long-term financial planning will serve you well in the years ahead. The wake-up call has arrived, so what better time than the present to look ahead to better days.

Vice President, Advanced Markets, Allianz Life

Kelly LaVigne is vice president of advanced markets for Allianz Life Insurance Co., where he is responsible for the development of programs that assist financial professionals in serving clients with retirement, estate planning and tax-related strategies.


Turning 60? Ask Yourself These 4 Important Questions

The average American plans to retire in their late 60s. If you’re within five to 10 years of your target retirement age, it’s important you take planning seriously.

There are key questions to ask yourself as you enter this milestone decade of life. Answering honestly will help you avoid costly mistakes and allow you to make any necessary changes to your retirement plan while you’re still earning an income.

1 of 4

Do I have enough money saved?

A selection of many piggy banks in different sizes, shapes and colors.A selection of many piggy banks in different sizes, shapes and colors.

One of the biggest fears I hear from people approaching retirement is outliving their savings. A general rule of thumb is to have eight times your annual income saved by age 60, however, a financial adviser can help you refine that number and set savings goals unique to your situation.

Consider your lifestyle expectations in retirement when determining how much you need to save. While $1 million might be more than enough for some to retire and live the life they want, it might not be enough for others who plan to spend more in their golden years.

You’ll also want to determine exactly when you want to retire and how long you expect to live in retirement. It’s important to consider your current health and family history when predicting your life expectancy. It’s essential to budget for different scenarios, including unexpected health care expenses, to calculate whether you have enough saved or if you need to play catch-up.

2 of 4

Will my income fluctuate?

Stacks of coins on top of rolled up dollar bills.Stacks of coins on top of rolled up dollar bills.

Yes, it most likely will, so you’ll need to be prepared for that. To tell how much of your income might be subject to fluctuations, first determine your income sources in retirement. These include 401(k)s, traditional and Roth IRAs, annuities and any savings or investment accounts. Then figure out what percentage of your retirement income will stay the same as you grow older, such as pensions or Social Security. Compare that to the income that may ebb and flow as you take money out of different retirement accounts.

For example, if most of your retirement money is in tax-deferred accounts, it’s possible your tax bracket will change over time. In turn, your nest egg could be impacted. Your retirement savings may also be impacted by stock market swings if you have money invested in the market. This is why it’s important to evaluate your portfolio and dial back on risk as you get older and closer to retirement.

3 of 4

When should I collect Social Security?

Social Security cards next to a table of numbers.Social Security cards next to a table of numbers.

You can start collecting Social Security benefits as soon as you turn 62, but for many, it might be worth it to wait until full retirement age, which is 67 for those born in 1960 or later. If you decide to tap into Social Security before your full retirement age, your benefit could be permanently reduced by as much as 30%. If you can wait until age 70, you will receive 100% of your benefit plus an additional 32%.

Another way to increase your Social Security checks is by adding more high-earning years to your work record. Social Security is calculated based on the 35 years of your career where you earned the most money. If you work more than 35 years, you can drop your lowest earning years and receive a bigger benefit in the future.

It’s important to talk through claiming strategies with your financial adviser when you turn 60. Having a plan for your benefits and claiming at the right time typically means more money in your monthly check.

4 of 4

Is my family protected?

A young mom snuggles her baby.A young mom snuggles her baby.

The financial strain of caring for a loved one is staggering. On average, family caregivers spend 20% of their income on caregiving costs. Long-term care insurance helps cover the costs of nursing home care and home health care. It can also help families pay for chronic medical conditions, like Alzheimer’s or dementia. If you are eligible and in good health, the best time to examine your long-term care options is between the ages of 60 and 65.

You also want to take a look at your estate plan as you enter your 60s. If you haven’t created an estate plan yet, meet with an estate planning attorney to get your documents in order. If you have a plan already, make sure your family knows who your attorney is and that they have copies of the legal documents they need. Review your will or trust to make sure your beneficiaries are updated.

These four important questions will help you create a retirement budget and income plan and ensure your family is taken care of. If you haven’t met with a financial adviser before your 60th birthday to put a comprehensive plan in place, gift yourself with a meeting and peace of mind as you enter a new decade.

Founder & CEO, Drake and Associates

Tony Drake is a CERTIFIED FINANCIAL PLANNER™and the founder and CEO of Drake & Associates in Waukesha, Wis. Tony is an Investment Adviser Representative and has helped clients prepare for retirement for more than a decade. He hosts The Retirement Ready Radio Show on WTMJ Radio each week and is featured regularly on TV stations in Milwaukee. Tony is passionate about building strong relationships with his clients so he can help them build a strong plan for their retirement.


Taking a 401(k) Loan to Fill Income Gaps? Tips Before You Dip!

One of my first positions was in a 401(k) call center, where one of the most common questions people asked was about taking a plan loan to pay off their credit card debt.

When I went to my manager for guidance, I was told in no uncertain terms that we were never ever to broach this topic, as it bordered on financial advice. Throughout my career I have seen that employers refuse to discuss 401(k) plan loans as a source of debt financing. To the extent plan materials provide any advice regarding loans, the message is usually centered on the dangers of borrowing from your retirement nest egg.

The reluctance to communicate the prudent use of 401(k) plan loans can be seen in the number of people holding different types of debt.

While numbers vary, 22% of 401(k) plan participants have a 401(k) loan outstanding, according to T. Rowe Price’s Reference Point 2020. Compare this to 45% of families holding credit card debt and 37% having vehicle loans (source: U.S. Federal Reserve Board Summary of Consumer Finances). Yet the interest rate charged on 401(k) plan loans is typically far lower than other available options. The annual interest rate of plan loans is typically set at Prime Rate +1%. As of March 2021, prime +1 is 4.25%. The average annual percentage rate (APR) on credit cards as of March 2021 is 16.5%. And depending on your state, payday or car title loans have an APR varying from 36% to over 600%!

The basics of how it works

Participants in an employer-sponsored defined contribution program, such as a 401(k), 457(b) or 403(b) plan, can typically borrow up to 50% of their plan account balance, up to $50,000.

Loans other than for purchase of a personal residence must be repaid within five years. Repayments are credited to your own account as a way to replenish the amount borrowed, and there are no tax consequences so long as the loan is repaid.

What’s at stake

I still think about my call center experience and wonder why we couldn’t have been more helpful. I would never recommend tapping your retirement savings to pay for current expenditures, but the need for short-term borrowing is an unfortunate reality for many people.

If you have to borrow, why not at least examine the advantages of tapping your plan over other short-term financing options? Besides lower interest rates here are some potential advantages of 401(k) loans: 

  • A 401(K) loan is not reported to credit bureaus such as Equifax, TransUnion and Experian, and therefore not considered in the calculation of your credit score.
  • Your credit score will not suffer in the event that you “default” on a 401(k) loan by not repaying any outstanding balance if you leave your job.
  • In the event that you miss a payment (for example, by going out on an unpaid leave of absence), you are not charged any late fees. (However, the loan may be reamortized so repayments are completed within the original term.)
  • The interest rate on your plan loan is fixed through the term of the loan and can’t be raised.

Of course, there are disadvantages as well, including:

  • Beyond the interest payments, there is the cost of the investment gains you’re giving up on the outstanding loan balance, ultimately reducing your retirement assets.
  • Most plans charge fees of $25 to $75 to initiate a loan, as well as annual charges of $25 to $50 if the loan extends beyond one year. If you are borrowing small amounts, this may eliminate most if not all of the cost advantage over credit debt.
  • Since you make repayments using after-tax dollars, you are being double-taxed when you eventually receive a distribution from the Plan.
  • Unlike other consumer debt, you can’t discharge the debt in the event of bankruptcy.
  • If you leave your job during the repayment period, you may be required to make a balloon payment to repay the loan in full — either to the original plan or a Rollover IRA. Otherwise, the outstanding balance is then reported as taxable income, and you can also be assessed an additional 10% early withdrawal fee on the outstanding balance. (Although some plans do permit terminated participants to continue repaying their loans from their personal assets rather than through payroll deduction, but this is not the norm.)

Good news 

Final regulations have been issued by the IRS on a provision (Section 13613) of the Tax Cuts and Jobs Act of 2017 (TCJA) extending the time that terminated employees can roll over their outstanding 401(k) loan balance without penalty. Previously, you had 60 days to roll over a plan loan offset amount to another eligible retirement plan (usually an IRA). The new rules stipulate that effective with loan offset amounts occurring on or after Aug. 20, 2020, you have until the due date (with extensions) for filing your federal income tax return, to roll over your plan loan balances.

By way of example, if you leave your job in 2021 with an outstanding 401(k) plan loan, you have until April 2022 (without extensions) to roll over the loan balance.

Make the right choice – but tread carefully

After all other cash flow options have been exhausted — including such possibilities as reducing voluntary (unmatched) 401(k) contributions or reviewing the necessity of any subscription services which are automatically charged to your credit card – ,) — participants should compare plan loans to other short-term financing options. Some of the points to specifically consider include:

  1. Do you expect to remain in your job during the loan repayment?  As noted above, if you leave your job you may be required to make a balloon payment of the outstanding balance or face taxes and penalties on the outstanding balance. 
  2. If you are uncertain about remaining in your job, do you have the ability to pay off the outstanding balance if required?  The research behind plan loans shows there is real damage to your long-term retirement income adequacy from defaults, considering the accompanying taxes and penalties.
  3. If you take a plan loan, can you still afford to contribute to your retirement plan? In particular, you should strive to contribute enough to receive the maximum matching contribution provided by your employer. 
  4. If you are still considering a loan after answering these gating questions, you should compare the total cost of different debt options.  Vanguard has a tool available on its website that lets you compare plan loans to other debt options and includes the forgone investment experience during the term of the loan. (You should also include any loan fees in the cost comparison.)

Again, no one advocates this type of borrowing except if it’s more advantageous than your other alternatives. So, if your employer  isn’t walking you through the pros and cons of a taking a loan against your 401(k), investigate them for yourself.

Principal, Buck

Alan Vorchheimer is a Certified Employee Benefits Specialist (CEBS) and principal in the Wealth Practice at Buck, an integrated HR and benefits consulting, technology and administration services firm.  Alan works with leading corporate, public sector and multi-employer clients to support the management of defined contribution and defined benefit plans.


Why Target Date Funds Miss the Mark

Over the last decade, target date funds have increased in popularity among investors. Target date funds are especially prevalent within 401(k) plans, as they are often promoted to participants as a “set it and forget it” investment solution. According to the Investment Company Institute 2020 Fact Book, nearly $1.5 trillion is now invested in target date funds, the vast majority within 401(k) plans.

For those unfamiliar with target date funds, the fund automatically rebalances the asset mix for a predetermined time frame. Investors typically pick a target date that coincides with their anticipated date of retirement, with the fund reducing equity exposure the closer one gets to retirement. The appeal of target date funds is that they help simplify the complex. The portfolio rebalancing responsibility belongs to the fund manager, with no action required by the investor.  

Most investors would probably expect target date funds with the same target date to have roughly the same asset mix, but our experience shows funds with the same target date can have significantly different asset allocations.

Let’s look at four target date funds with the same target retirement date of 2025 from four large mutual fund companies (all data below is as of 12/31/20):

  T. Rowe Price Retirement 2025 Fund Vanguard Target Retirement 2025 Fund Fidelity Managed Retirement 2025 Fund Dimensional 2025 Target Date Retirement Income Fund
  Ticker: TRRHX Ticker: VTTVX Ticker: FIXRX Ticker: DRIUX
Asset Allocation 70% equity / 30% fixed 60% equity / 40% fixed 47% equity / 53% fixed 35% equity / 65% fixed
2020 annual return 14.7% 13.3% 13.1% 17.5%

As you can see, the asset allocations vary significantly, even though each fund has the same stated target date.

Here are several takeaways for investors using target date funds:

  • Be sure to look under the hood: Investors should explore the asset allocation of the fund. We prefer target date funds that incorporate international and emerging market equity exposure as well as U.S. equities.  
  • Expenses matter: Expenses are a direct reduction in return; the average target date fund’s expense ratio is 0.62%, according to ICI. Look for funds with expenses below the average. 
  • Don’t be too conservative: The old rule of thumb for asset allocation was subtract your age from 100 and that would be your equity allocation. But consider that for a married 65-year-old couple retiring in 2021, the probability that at least one person will live to age 95 is 50%. The rule of thumb may well be too conservative for maintaining purchasing power over a nearly 30-year retirement period.

Target date funds can be a valuable tool for investors, but remember, even funds that help simplify investing require due diligence and monitoring.

Managing Principal, Ark Royal Wealth Management

Mike Palmer has over 25 years of experience helping successful people make smart decisions about money. He is a graduate of the University of North Carolina at Chapel Hill and is a CERTIFIED FINANCIAL PLANNER™ professional. Mr. Palmer is a member of several professional organizations, including the National Association of Personal Financial Advisors (NAPFA) and past member of the TIAA-CREF Board of Advisors.


Why Your Taxes Could Go Up in Retirement and How to Prevent It

Many Americans assume they’re paying higher taxes now than they will in retirement. But what if that assumption turns out to be false?

Income taxes don’t go away in retirement. By structuring their taxes to minimize their burden today rather than in retirement, many Americans are raising the incline in an already uphill battle to save enough to live on when they’re no longer working.

As you form your retirement and financial independence plan, beware of the risk posed by income taxes. With the right planning now, you can minimize both your tax burden and your required nest egg for retirement.

Why Your Tax Bill Might Go Up in Retirement

Today’s tax rates aren’t written in stone. And there are many reasons to believe they’ll go up in the not-too-distant future.

Before you get too cozy with the idea of minimizing your taxes today at the expense of tomorrow, remember that tax rates change, and the U.S. faces significant economic and demographic challenges in the decades to come.

Even if tax rates remain frozen in place, your situation will change. So you need to plan not based on your current wealth but your future wealth.

Current Tax Rates Expire in 2025

The current federal tax rates, set by the Tax Cuts and Jobs Act of 2017, expire in 2025 unless Congress extends them.

Among other changes, the law nearly doubled the standard deduction from its previous high of $6,500 to $12,000 for individuals and $24,000 for families. And that was in 2017 — it’s continued to rise since.

A high standard deduction simplifies many middle-income earners’ returns by negating the need to itemize their deductions and helps reduce their taxable income.

The law also reduced the tax rates for most income brackets. For example, a single earner with $50,000 in annual income previously paid the IRS a top tax rate of 25% but today pays 22%.

That won’t last forever. And it’s hard to imagine tax rates dropping lower than they currently are.

Today’s Historically Low Tax Rates

Consider the historical context for federal income taxes. The maximum federal income tax rate today is 37%. In 1944, the top federal income tax rate was a dizzying 94% for anyone earning over $200,000. It only took an income of $8,000 to be taxed at the 37% level.

Even accounting for inflation, that was a high middle-class income — around $115,000 in today’s dollars. And someone earning the equivalent of today’s median income paid taxes at the 29% rate compared to today’s 22%.

After World War II, middle-income households continued paying relatively high rates. The highest federal income tax rate remained high in the ’50s, ’60s, and ’70s, never dropping below 70%. Tax rates changed dramatically in the ’80s under President Ronald Reagan, and they have remained relatively low in the decades since.

Don’t expect that to last either.

Ballooning Budget Deficit

In September 2020, the Congressional Budget Office projected an annual budget deficit — the difference between how much the federal government spends compared to how much they collect in revenue —  of $3.3 trillion. That’s $3,300,000,000,000 for numerical context, and a record.

As of early 2021, the U.S. national debt has exploded to $27.9 trillion for the first time. That comes out to $194,696 per taxpayer.

In short, the U.S. government faces record debt, and they must eventually pay the piper. And “they” means “you,” the taxpayer, in the form of higher taxes.

Aging Population

America is graying. By 2030, the entire baby-boom generation will be over 65, according to the U.S. Census Bureau. That means that 1 in 5 Americans will be at retirement age.

The bureau also notes that by 2035, there will be more seniors at retirement age than children under 18 due to declining birth rates. Already, native-born Americans have a negative birth rate  — in other words, the average number of children per woman falls below the population replacement rate.

In fact, 2018 marked the lowest birth rate in more than 30 years, per the CDC. The only reason the U.S. population continues to grow at all is immigration.

As of 2021, there will be three and a half working-age adults for every retirement-age adult — an already low ratio. Over the following 40 years, the bureau expects that to drop to two and a half working-age adults for each senior.

That means fewer workers to support more benefit recipients.

Entitlement Spending Increases

The 2020 Social Security Trustees report paints a grim picture.

In 2020, costs exceeded revenues for the first time since 1982. The government will deplete the reserve fund by 2035 based on current spending and revenue trends.

The numbers look even worse for Medicare. Claims will deplete Medicare’s hospital insurance fund by 2026, according to current projections.

All of this suggests tax hikes are on the horizon. Cutting spending on these entitlement programs remains politically unfeasible given the powerful senior lobby, and commonsense solutions to Social Security’s solvency problems may well go unheeded.

Don’t count on receiving the same kind of Social Security benefits in retirement that your parents pocketed.

Increased Personal Wealth in Retirement — Hopefully

The final reason you’re likely to face higher taxes in retirement has nothing to do with macroeconomics or the political landscape. The simple fact is you’ll be wealthier by the time you retire, at least if you continue to save for retirement diligently.

One of the ways retirement has changed over the last few decades is that you’re increasingly responsible for saving, investing, and planning for your own retirement. You save up a nest egg, you build passive income streams, and then you live on them happily ever after.

And you pay taxes on them too.

Retirement Planning Wealth Rising Businessmen Climbing Income Increase

How to Prevent Higher Taxes in Retirement

Retirees have no control over the federal tax rate, short of voting for a rare candidate who might actually curb spending and reduce the federal budget deficit.

But you do have control over structuring your retirement savings and income for minimal taxes.

Try these seven tactics to reduce your tax burden in retirement, which in turn reduces how much you need to save for retirement to create the same net income for living.

1. Roth Conversion

When you invest in a traditional IRA instead of a Roth IRA, you get the tax break this year but pay taxes later. You deduct the contribution from your taxable income now, but the government taxes the earnings and eventual withdrawals later.

The opposite is true for Roth IRAs. You don’t get the tax deduction right now, but your earnings and withdrawals are tax-free.

One easy step is to start contributing to a Roth IRA rather than a traditional IRA. This can easily be done through brokers like SoFi. You can do the same with a Roth 401(k) rather than contributing to a traditional 401(k).

You can take it a step further by moving money from your traditional IRA into your Roth IRA. It’s called a Roth conversion, and it requires you to pay taxes on the moved money now. But the money then starts growing tax-free. In retirement, you benefit from tax-free income.

To prevent a massive uptick in taxes now, consider gradually transferring your IRA funds over several years.

For example, if you’re a single filer with $70,000 in taxable income, you can transfer $14,000 in a Roth conversion this year, which prevents any of your income from crossing into the 32% tax bracket. In the following years, you can move more money over each year until you’ve converted your entire traditional IRA account into your Roth IRA.

It especially makes sense if you’re thinking about moving from a low-tax state to a high-tax state. Bite the tax bullet now before your new state starts charging you higher income taxes.

Note that you can also invest in Roth versions of your employee retirement plan, such as your 401(k) or 403(b). As an added bonus, Roth accounts give you more flexibility, with no required minimum distributions.

Pro tip: If you’re currently investing in an IRA or 401(k), make sure you sign up for a free analysis from Blooom. They look at your portfolio to make sure you have the right amount of diversification and proper asset allocation based on your risk tolerance. They also make sure you’re not paying too much in fees.

2. Move to a Lower-Tax State

Seven states charge no income taxes whatsoever: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Another two states — New Hampshire and Tennessee — don’t charge income tax on earned income but do charge taxes on investment income, such as dividends and interest.

State income taxes aren’t trivial. In California, for example, the top income tax is 12.3%. And it’s not just high earners who are slapped with high taxes, either. A person earning the median U.S. income of $61,372 still pays 9.3% of it in state income taxes to California, which comes to nearly $6,100.

Most people can think of a few things they’d rather do with $6,100 every year. Just imagine how much sooner you could retire if you invested an extra $6,100 every year.

Of course, income taxes don’t tell the whole story. States also impose property taxes, sales taxes, and excise taxes, so when evaluating lower-tax states, look at the states with the lowest total tax burden.

3. Move Abroad

When you live abroad, the first $105,900 you earn is tax-free, per the foreign earned income exclusion.

Granted, you still have to pay self-employment taxes if you own a small business or are self-employed. But you avoid federal and state income taxes, at least on the first $108,700 for tax year 2021. It’s how I minimize my own tax burden.

The financial perks don’t end there. Most countries have a lower cost of living than the U.S., and many have weaker currencies to boot, so your dollar stretches much further. In many countries, you can live a relatively luxurious lifestyle for $2,000 per month.

Moving abroad, even temporarily, has simply never occurred to most Americans. But moving to another country was one of the best financial moves my wife and I ever made. We benefit from a lower cost of living, affordable (and high-quality) health care, and lower taxes.

In many countries, you don’t even need a job to move there. You can buy residency or citizenship to set up shop permanently.

4. Use an HSA as a Stealth Retirement Account

More Americans are discovering health savings accounts (HSAs) offer better tax benefits than any other tax-sheltered accounts.

Unlike IRAs and Roth IRAs, HSAs offer tax protection both now and later. You can deduct contributions from your taxable income this year, they grow tax-free, and the withdrawals are also tax-free — for triple tax protection.

Yes, you have to use the funds for health-related expenses. But that’s a wide umbrella, including not just doctor’s visits and medications but also glasses, contacts, dentist appointments, birth control, acupuncture, therapy, and even home improvements to help you age in place safely.

Besides, you’ll have plenty of health care expenses in retirement. The average couple spends over $285,000 on medical expenses after the age of 65, per a Fidelity report. So why not cover those expenses with your HSA funds and reap the tax benefits?

If you have a high-deductible health plan, review the best places to open an HSA for maximum investing flexibility and minimum fees. One of our favorite HSA providers is Lively.

5. Optimize Your Dividends & Capital Gains

You have many tools at your disposal to avoid paying taxes on dividends. For example, below a certain income level — $80,800 for married couples in 2021, $40,400 for individuals — qualifying dividends aren’t taxed at all.

Likewise, you can also minimize your capital gains tax through a range of tricks and strategies. Holding an asset for at least a year reduces the tax rate from your regular income tax rate to the far lower capital gains rate. Even that you can sometimes avoid. For example, if you lived in a property for at least two of the last five years before selling, your first $500,000 in gains are tax-free if you’re married and $250,000 if you’re single.

The rules can get arcane and complex quickly, so talk through your tax strategy with a financial advisor if you have any doubts about how to move forward. If you don’t currently have a financial advisor, SmartAsset has a tool that will help you find a vetted advisor near you.

6. Consider Municipal Bonds in Retirement

As workers near retirement, conventional wisdom suggests they gradually shift their asset allocation to include more bonds, given their lower volatility and income-oriented returns.

And if you’re going to invest in bonds, why not save on taxes by including some municipal bonds?

Returns on municipal bonds are typically exempt from federal income taxes and often from state and local taxes as well. However, you often have to invest in local municipal bonds for your state and municipality to exempt the earnings from taxes.

After maxing out your annual tax-sheltered retirement account contributions, consider municipal bonds as another way to invest tax-free.

7. Harvest Losses

Even after retiring, don’t be afraid to harvest losses in your brokerage account to offset gains. Most robo-advisors, like Betterment, automatically provide tax-loss harvesting on your account throughout the year.

Imagine your investments have a strong year and earn enough in taxable gains to enter you into a higher tax bracket. You also have a few investments that have consistently underperformed for you that you’ve meant to sell off and reinvest elsewhere. That can be the perfect time to take those losses and move on as a year-end tax maneuver.

Just be careful not to sell fundamentally sound investments. Think of tax-loss harvesting as a way to clean out the deadwood in your portfolio. But avoid selling only for the tax benefits — only sell investments you truly no longer want.

Final Word

Far too many investors falsely assume their taxes will be lower in retirement. But just because you’re no longer earning a W-2 paycheck doesn’t mean you won’t pay taxes.

You still earn taxable income from Social Security, from your brokerage account and investments, from part-time gigs, and perhaps from a pension. And hopefully, you’ll be significantly wealthier by the time you retire as well.

Start laying the groundwork now for lower taxes in retirement. Capitalize on tax-sheltered accounts that let your investments grow and compound tax-free, such as Roth IRAs and health savings accounts. Talk to your financial advisor about other ways you can structure your investments to minimize your tax burden in retirement.

Because the less retirement income gets siphoned off to taxes, the less you need to save for retirement, and the earlier you can consider retiring.


Name Your Plan – Select Both Retirement Income & Legacy Target

Everyone has retirement goals, but the big question is, are they attainable?

Take the 70-year-old woman I wrote about recently. She has $2 million in retirement savings, and she’d like to use those savings to generate $70,000 in annual income increasing by 2% a year early in retirement, but still be able to leave her heirs a $2 million legacy at age 90. Can she do it?

That’s a question many financial advisers might have trouble answering, but after seeing the results of many, many plans over the years, I believe I’ve created a method that can answer her question using Income Allocation planning. While her legacy results will depend on market returns, this planning method incorporates annuity payments into the mix and lowers costs and taxes to deliver reliable income.

Happily, with technology and experience, that analysis is now available to you, too. After considering your personal and plan data, my team will enable you to Name Your Plan by using our tools at Go2Income to solve for the plan design and market return that achieves both your income and legacy objectives.

Our Retiree Names Her Plan

How does it work? To begin, you provide plan data, including your age and gender, marital status, your retirement savings, percentage of savings in your rollover IRA, desired inflation protection and your risk tolerance as measured by the percentage to be invested in stocks. Then we sift through (electronically, that is) the millions of possibilities.

The key driver of achieving both of your objectives is the long-term return in the stock market.

Now we zero in on the plan that will get you what you want. And you may be surprised that the stock market returns affect your results less than you might expect. When they do affect the plan, the impact will be on the legacy you leave, instead of your annual income.

How We Enable You to Name Your Plan

Here is how our retiree refined her objectives to set her twin goals for income and legacy:

  1. She revealed that 50% of her $2 million in savings is in a rollover IRA, and the balance is in personal after-tax savings.
  2. With her annual income goal of $70,000 growing by 2% per year, together with a Social Security check that also grows, she believes she will be able to live comfortably.
  3. Regarding her $2 million legacy goal, she understands that market results and plan design may prevent her from achieving that goal in every year and so is setting that legacy target at her approximate life expectancy of 90.

Recent studies would suggest that her twin goals are just not possible in today’s market. However, after using the Go2Income Income Allocation tool to create her income plan, she can now use the Legacy Planner below to estimate what stock market return it would take to deliver both her income and legacy targets.

Keep in mind that because her personal situation and plan objectives are unique to her, the Legacy Planner is personalized and developed results just for our retiree. (Sharing a “one-size-fits-all” planning tool just can’t get the best results for you.)

Graph charts how big of a stock market return is necessary to leave a desire legacy.Graph charts how big of a stock market return is necessary to leave a desire legacy.

ESMR is based on a sampling of plan. A counselor can create your plan.

Balance Your Needs

The Legacy Planner shows that it would take a long-term stock market return of between 6% and 7% to meet her legacy objective — and maintain her income goal. If returns fall short by the time of her passing, remember that her kids/grandkids will have their lifetimes for markets to recover.

In other words, my legacy-income planning method matched the targets of a “live off interest and leave the principal” plan from yesteryear — one that no longer works, given today’s low interest and dividend rates — without putting her retirement at risk.

You can do the same. Visit Go2Income for more information on how Income Allocation can help you reach your income and legacy goals, or contact me to discuss your situation.

President, Golden Retirement Advisors Inc.

Jerry Golden is the founder and CEO of Golden Retirement Advisors Inc. He specializes in helping consumers create retirement plans that provide income that cannot be outlived. Find out more at, where consumers can explore all types of income annuity options, anonymously and at no cost.


3 Alternative Asset Strategies to Diversify Your Retirement Portfolio

As you move toward retirement, the investments you’ve relied on to build a retirement savings portfolio may not be the best fit when it comes to generating retirement income.

If you’re like most near-retirees, you’ve worked hard to save through your company 401(k) plan, IRAs or Roth IRA accounts. Most company-sponsored retirement plans offer a mix of mutual funds made up of stocks and bonds. Some of the more growth-oriented funds likely have more stocks, while the more income-oriented funds likely have more bonds. Those options were solid while you were in the accumulation phase.

For many years, the conventional wisdom in retirement planning focused on a simple balanced stock-and-bond portfolio that slowly evolved over time toward more bonds and fewer stocks. The rationale behind such a recommendation was that this kind of portfolio created less volatility, the potential for growth and offered more income as retirees aged.

Today, this conventional wisdom may not work well for many retirees. That’s because extremely low bond yields generate very little income while increasing portfolio volatility. If you buy bonds or bond funds at current low rates, those bonds will lose value if interest rates rise in the future.

When you can’t depend on bonds or bond funds to generate a decent amount of income and lower the risks in your portfolio, it doesn’t make sense to rely on them as a major building block of a retirement income portfolio.

If you can’t rely on bonds or bond funds, you need to fill that gap in other ways. That’s where alternative assets come into play. Potential alternatives that we’ll explore include real estate, options and fixed index annuities.

What are alternative assets?

An alternative investment is a financial asset that does not fall into one of the traditional investment categories. Traditional categories include:

  • Stocks, such as stock mutual funds or exchanged-traded funds.
  • Bonds, such as bond mutual funds or ETFs.
  • Cash, a category that includes money market funds.

Alternative investments typically have a low correlation with those of standard asset classes. This low correlation means they often can generate returns regardless of market direction. This feature makes them a suitable tool for diversification.

Alternatives possess many other advantages, including hedging against inflation, which is the tendency for prices to increase over time. Alternatives may lower portfolio volatility and in today’s interest rate environment, potentially increase portfolio returns.

Alternative assets can also add needed income to retirement income portfolios while decreasing risk.

Of course, alternatives have their downsides. They can be less liquid than traditional investments, such as stocks and bonds, which means it can be difficult to turn those investments into cash should you experience a financial emergency. They aren’t immune from downturns either – no investment is. They may be more expensive than stocks and bonds, depending on which alternatives you choose and where you get them.

With that said, here are three strategies that can diversify your retirement income portfolio.

Diversification strategy #1: Real estate offers income and tax advantages

As an asset class, real estate has the potential to benefit retirement income portfolios when employed appropriately. You can invest in real estate locally by buying houses or apartments to rent out on a long or short-term basis. You can also invest in real estate through both publicly traded or non publicly traded real estate investment trusts (REITs) in any area of the United States or the world.

There are also a variety of property types to choose from, including office buildings, shopping centers, residential and industrial. Whether you invest in real estate locally or through publicly registered vehicle such as REITs or funds that own REITs, real estate can provide a steady stream of income and significant tax breaks. 

Before investing in real estate, it’s wise to consider the disadvantages. If you buy individual properties, real estate can be illiquid and leveraged. That means it can be hard to sell to convert into cash and that you may have to borrow money to buy the properties you are interested in. If you buy REITs or REIT funds, those can suffer from downturns in the real estate market, cutting down on the income you receive and depressing the value of the shares.

The easiest way to invest in real estate is through publicly traded REITs that trade on the stock market. The main disadvantage of these types of REITs is volatility. While the purpose of an alternative asset is to add diversification, it is wise to look for one that reduces volatility as well. Publicly traded REITs often have a high correlation to the stock market, which may be the opposite of what you are trying to achieve.

Instead, consider looking into non publicly traded REITS. They often have a much lower correlation to the stock market as they are not traded like stocks. They get most of their value from the underlying real estate itself and not stock market share prices. This in turn reduces volatility and increases consistent returns.

Diversification strategy #2: Options provide supplemental income

Options are a type of derivative financial instrument with a value based on an underlying asset, such as stocks. There are many ways to use options. Within a retirement income portfolio, options offer the potential to increase income while reducing risk.

One option strategy that can be productive is that of taking advantage of the natural time decay of short-term options. You see, when trading options you can be a buyer, often thought of as speculative investment, or a seller, often thought of as the premium collector.

One premium collection strategy is known as the credit spread strategy. This strategy can be complex and does carry risk, but can also provide regular income if traded successfully. By collecting options premium when selling you may be able to benefit as the value of options decline, which time decay measures. The goal is to collect premium and not have to give it back and for the option to expire worthless. If that happens you get to keep all the premium you received. If not, losses could occur. This strategy can create supplemental income without exposure to rising interest rates. Furthermore, you can target though probabilities, a probability of success that you feel most comfortable with. This type of flexibility is hard to find in other investments.

Options are highly liquid, which is a desirable attribute for a retirement income portfolio. Options also have their disadvantages, which include the potential to lose principal and taxation as short-term capital gains.

Diversification strategy #3: Fixed indexed annuities protect against market declines and provide income

Fixed indexed annuities (FIA), which are issued by an insurance company, are a contract between investors and insurance companies. As an alternative to bonds or bond funds, FIAs provide tax-deferred growth, protection from downside market risk and a regular stream of income.

Because FIAs are an insurance company product, they can offer the potential to capture some stock market gains while avoiding stock market losses. They can also offer guaranteed income in retirement. Unlike bonds or bond funds, partial distributions known as free withdrawals are common contractual guarantees in fixed indexed annuities that permit access to a portion of the account value each year that could be used to pay for ordinary household bills. This replaces the need to potentially liquidate bonds at a discount in a rising interest rate environment, reducing interest rate risk.

FIAs can be complex products that may offer additional options — known as riders — that can provide lifetime income for you or surviving spouses and ongoing income in case of age-related incapacity, among other benefits. These riders come at an additional cost to the underlying cost of the annuity.

Annuities can be expensive if not structured properly. They also have limited liquidity, meaning that your money is committed to the company for a certain period and not available to spend in other ways. Before purchasing an FIA, make sure that you fully understand the provisions, the time commitment and all the fees involved.

A final word

Alternative assets offer the potential to reduce volatility, enhance cashflow, improve diversification and boost returns, depending on how they are employed in a retirement income portfolio. Using any one or all of these techniques may help you achieve more diversification, reduce risk and create more income in retirement.

Investment Adviser Representative of and investment advisory services offered through Royal Fund Management, LLC an SEC Registered Investment Adviser.
This information is designed to provide a general overview with regard to the subject matter covered and is not state specific. The authors, publisher and host are not providing legal, accounting or specific advice for your situation. This information has been provided by a Licensed Insurance Professional and does not necessarily represent the views of the presenting insurance professional. The statements and opinions expressed are those of the author and are subject to change at any time. All information is believed to be from reliable sources; however, presenting insurance professional makes no representation as to its completeness or accuracy.

Co-Founder, Tru Financial Strategies

Nathan Chapel is the co-owner and co-founder of Tru Financial Strategies. Since his start in the insurance and financial industry in 2009, he has had the opportunity to serve hundreds of people with their retirement needs with the mantra, “Protect your wealth, provide for your future.”  Nathan holds the Series 65 securities license and serves as a fiduciary adviser.

Co-Founder, Tru Financial Strategies

Scott Svoboda is the co-owner and co-founder of Tru Financial Strategies. Since his start in the insurance and financial industry in 2012, he has had the opportunity to serve hundreds of people with their retirement needs with his mantra, “Protect your wealth, provide for your future.”  Scott holds the Series 65 securities license and serves as a fiduciary adviser.