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Ultimate Guide to Maximizing Your 401(k)

The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities.

You’re probably familiar with the basics of a 401(k).

You know that it’s a retirement account and that it’s offered by your employer. You know that you can contribute a percentage of your salary and that you get tax breaks on those contributions. And you know that your employer may offer some type of matching contribution.

But beyond the basics, you may have some confusion about exactly how your 401(k) works and what you should be doing to maximize its benefits.

That’s what this guide is going to show you. We’ll tell you everything you need to know in order to maximize your 401(k) contributions.

The 4 Types of 401(k) Contributions You Need to Understand

When it comes to maximizing your 401(k), nothing you do will be more important than maximizing your contributions.

Because while most investment advice focuses on how to build the perfect portfolio, the truth is that your savings rate is much more important than the investments you choose. Especially when you’re just starting out, the simple act of saving more money is far and away the most effective way to accelerate your path toward financial independence.

There are four different ways to contribute to your 401(k), and understanding how each one works will allow you to combine them in the most efficient way possible, adding more money to your 401(k) and getting you that much closer to retirement.

1. Employee Contributions

Employee contributions are the only type of 401(k) contribution that you have full control over and are likely to be the biggest source of your 401(k) funds.

Employee contributions are the contributions that you personally make to your 401(k). They’re typically set up as a percentage of your salary and are deducted directly from your paycheck.

For example, let’s say that you are paid $3,000 every two weeks. If you decide to contribute 5% of your salary to your 401(k), then $150 will be taken out of each paycheck and deposited directly into your 401(k).

There are two different types of employee contributions you can make to your 401(k), each with a different set of tax benefits:

  1. Traditional contributions – Traditional contributions are tax-deductible in the year you make the contribution, grow tax-free while inside the 401(k), and are taxed as ordinary income when you withdraw the money in retirement. This is just like a traditional IRA. All 401(k)s allow you to make traditional contributions, and in most cases your contributions will default to traditional unless you choose otherwise.
  2. Roth contributions – Roth contributions are NOT tax-deductible in the year you make the contribution, but they grow tax-free while inside the 401(k) and the money is tax-free when you withdraw it in retirement. This is just like a Roth IRA. Not all 401(k)s allow you to make Roth contributions.

For more on whether you should make traditional or Roth contributions, you can refer to the following guide that’s specific to IRAs but largely applies to 401(k)s as well: Guide to Choosing the Right IRA: Traditional or Roth?

Maximum personal contributions

The IRS sets limits on how much money you can personally contribute to your 401(k) in a given year. For 2017, employee contributions are capped at $18,000, or $24,000 if you’re age 50 or older. In subsequent sections we’ll talk about how much you should be contributing in order to maximize these contributions.

2. Employer Matching Contributions

Many employers match your contributions up to a certain point, meaning that they contribute additional money to your 401(k) each time you make a contribution.

Employer matching contributions are only somewhat in your control. You can’t control whether your employer offers a match or the type of match they offer, but you can control how effectively you take advantage of the match they do offer.

Taking full advantage of your employer match is one of the most important parts of maximizing your 401(k). Skip ahead to this section to learn more on how to maximize your employer match.

3. Employer Non-Matching Contributions

Non-matching 401(k) contributions are contributions your employer makes to your 401(k) regardless of how much you contribute. Some companies offer this type of contribution in addition to, or in lieu of, regular matching contributions.

For example, your employer might contribute 5% of your salary to your 401(k) no matter what. Or they might make a variable contribution based on the company’s annual profits.

It’s important to note that these contributions are not within your control. Your employer either makes them or not, no matter what you do.

However, they can certainly affect how much you need to save for retirement, since more money from your employer may mean that you don’t personally have to save as much. Or they could be viewed as additional free savings that help you reach financial independence even sooner.

4. Non-Roth After-Tax Contributions

This last type of 401(k) contribution is rare. Many 401(k) plans don’t even allow this type of contribution, and even when they do, these contributions are rarely utilized.

The big catch is again that most 401(k) plans don’t allow these contributions. You can refer to your 401(k)’s summary plan description to see if it does.

And even if they are allowed, it typically only makes sense to take advantage of them if you’re already maxing out all of the other retirement accounts available to you.

But if you are maxing out those other accounts, you want to save more, and your 401(k) allows these contributions, they can be a powerful way to get even more out of your 401(k).

Here’s how they work:

Non-Roth after-tax 401(k) contributions are sort of a hybrid between Roth and traditional contributions. They are not tax-deductible, like Roth contributions, which means they are taxed first and then the remaining money is what is contributed to your account. The money grows tax-free while inside the 401(k), but the earnings are taxed as ordinary income when they are withdrawn. The contributions themselves are not taxed again.

A quick example to illustrate how the taxation works:

  • You make $10,000 of non-Roth after-tax contributions to your 401(k). You are not allowed to deduct these contributions for tax purposes.
  • Over the years, that $10,000 grows to $15,000 due to investment performance.
  • When you withdraw this money, the $10,000 that is due to contributions is not taxed. But the $5,000 that is due to investment returns — your earnings — is taxed as ordinary income.

This hybrid taxation means that on their own non-Roth after-tax 401(k) contributions are typically not as effective as either pure traditional or Roth contributions.

But they can be uniquely valuable in two big ways:

  1. You can make non-Roth after-tax contributions IN ADDITION to the $18,000 annual limit on regular employee contributions, giving you the opportunity to save even more money. They are only subject to the $54,000 annual limit that combines all employee and employer contributions made to a 401(k)..
  2. These contributions can be rolled over into a Roth IRA, when you leave your company or even while you’re still working there. And once the money is in a Roth IRA, the entire balance, including the earnings, grows completely tax-free. This contribution rollover process has been coined the Mega Backdoor Roth IRA, and it can be an effective way for high-income earners to stash a significant amount of tax-free money for retirement.

How to Maximize Your 401(k) Employer Match

With an understanding of the types of 401(k) contributions available to you, it’s time to start maximizing them. And the very first step is making sure you’re taking full advantage of your employer match.

Simply put, your 401(k) employer match is almost always the best investment return available to you. Because with every dollar you contribute up to the full match, you typically get an immediate 25%-100% return.

You won’t find that kind of deal almost anywhere else.

Here’s everything you need to know about understanding how your employer match works and how to take full advantage of it.

How a 401(k) Employer Match Works

While every 401(k) matching program is different, and you’ll learn how to find the details of your program below, a fairly typical employer match looks like this:

  • Your employer matches 100% of your contribution up to 3% of your salary.
  • Your employer also matches 50% of your contribution above 3% of your salary, up to 5% of your salary.
  • Your employer does not match contributions above 5% of your salary.

To see how this works with real numbers, let’s say that you make $3,000 per paycheck and that you contribute 10% of your salary to your 401(k). That means that $300 of your own money is deposited into your 401(k) as an employee contribution every time you receive a paycheck, and your employer matching contribution breaks down like this:

  1. The first 3% of your contribution, or $90 per paycheck, is matched at 100%, meaning that your employer contributes an additional $90 on top of your contribution.
  2. The next 2% of your contribution, or $60 per paycheck, is matched at 50%, meaning that your employer contributes an additional $30 on top of your contribution.
  3. The next 5% of your contribution is not matched.

All told, in this example, your employer contributes an extra 4% of your salary to your 401(k) as long as you contribute at least 5% of your salary. That’s an immediate 80% return on investment.

That’s why it’s so important to take full advantage of your 401(k). There’s really no other investment that provides such an easy, immediate, and high return.

How to Find Your 401(k) Employer Matching Program

On a personal level, taking full advantage of your 401(k) employer match is simply a matter of contributing at least the maximum percent of salary that your employer is willing to match. In the example above that would be 5%, but the actual amount varies from plan to plan.

So your job is to find out exactly how your 401(k) employer matching program works, and the good news is that it shouldn’t be too hard.

There are two main pieces of information you’re looking for:

  1. The maximum contribution percentage your employer will match – This is the amount of money you’d need to contribute in order to get the full match. For example, your employer might match your contribution up to 5% of your salary as in the example above, or it could be 3%, 12%, or any other percentage. Whatever this maximum percentage is, you’ll want to do what you can to contribute at least that amount so that you get the full match.
  2. The matching percentage – Your employer might match 100% of your contribution, or they may only match 50%, or 25%, or some combination of all of the above, and this has a big effect on the amount of money you actually receive. For example, two companies might both match up to 5% of your salary, but one might match 100% of that contribution, and one might only match 25% of it. Both are good deals, but one is four times as valuable.

With those two pieces of information in hand, you’ll know how much you need to contribute in order to get the full match and how much extra money you’ll be getting each time you make that contribution.

As for where to find this information, the best and most definitive source is your 401(k)’s summary plan description, which is a long document that details all the ins and outs of your plan. This is a great resource for all sorts of information about your 401(k), but you can specifically look for the word “match” to find the details on your employer matching program.

And if you have any trouble either finding the information or understanding it, you can reach out to your human resources representative for help. You should be able to find their contact information in the summary plan description.

Two Big Pitfalls to Avoid When Maximizing Your 401(k) Employer Match

Your 401(k) employer match is almost always a good deal, but there are two pitfalls to watch out for: vesting and front-loading contributions. Both of these could either diminish the value of your employer match or cause you to miss out on getting the full match.

Pitfall #1: Vesting

Clock time deadline

Employer contributions to your 401(k) plan, including matching contributions, may be subject to something called a vesting schedule.

A vesting schedule means that those employer contributions are not 100% yours right away. Instead, they become yours over time as you accumulate years of service with the company. If you leave before your employer contributions are fully vested, you will only get to take some of that money with you.

For example, a common vesting schedule gives you an additional 20% ownership over your 401(k) employer contributions for each year you stay with the company. If you leave before one year, you will not get to keep any of those employer contributions. If you leave after one year, you will get to keep 20% of the employer contributions and the earnings they’ve accumulated. After two years it will be 40%, and so on until you’ve earned the right to keep 100% of that money after five years with the company.

Three things to know about vesting:

  1. Employee contributions are never subject to a vesting schedule. Every dollar you contribute and every dollar that money earns is always 100% yours, no matter how long you stay with your company. Only employer contributions are subject to vesting schedules.
  2. Not all companies have a vesting schedule. In some cases you might be immediately 100% vested in all employer contributions.
  3. There is a single vesting clock for all employer contributions. In the example above, all employer contributions will be 100% vested once you’ve been with the company for five years, even those that were made just weeks earlier. You are not subject to a new vesting period with each individual employer contribution.

A vesting schedule can decrease the value of your employer match. A 100% match is great, but a 100% match that takes five years to get the full benefit of is not quite as great.

Still, in most cases it makes sense to take full advantage of your employer match, even if it’s subject to a vesting schedule. And the reasoning is simply that the worst-case scenario is that you leave your job before any of those employer contributions vest, in which case your 401(k) would have acted just like any other retirement account available to you, none of which offer any opportunity to get a matching contribution.

However, there are situations in which a vesting schedule might make it better to prioritize other retirement accounts before your 401(k). In some cases, your 401(k) employer contributions might be 0% vested until you’ve been with the company for three years, at which point they will become 100% vested. If you anticipate leaving your current employer within the next couple of years, and if your 401(k) is burdened with high costs, you may be better off prioritizing an IRA or other retirement account first.

You may also want to consider your vesting schedule before quitting or changing jobs. It certainly shouldn’t be the primary factor you consider, but if you’re close to having a significant portion of your 401(k) vest, it may be worth waiting just a little bit longer to make your move.

You can find all the details on your 401(k) vesting schedule in your summary plan description. And again you can reach out to your human resources representative if you have any questions.

Pitfall #2: Front-Loading Contributions

In most cases, it makes sense to put as much money into your savings and investments as soon as possible. The sooner it’s contributed, the more time it has to compound its returns and earn you even more money.

But the rules are different if you’re trying to max out your 401(k) employer match.

The reason is that most employers apply their maximum match on a per-paycheck basis. That is, if your employer only matches up to 5% of your salary, what they’re really saying is that they will only match up to 5% of each paycheck.

For a simple example, let’s say that you’re paid $18,000 twice per month. So over the course of an entire year, you make $432,000.

In theory, you could max out your annual allowed 401(k) contribution with your very first paycheck of the year. Simply contribute 100% of your salary for that one paycheck, and you’re done.

The problem is that you would only get the match on that one single paycheck. If your employer matches up to 5% of your salary, then they would match 5% of that $18,000 paycheck, or $900. The next 23 paychecks of the year wouldn’t get any match because you weren’t contributing anything. And since you were eligible to get a 5%, $900 matching contribution with each paycheck, that means you’d be missing out on $20,700.

Now, most people aren’t earning $18,000 per paycheck, so the stakes aren’t quite that high. But the principle remains the same.

In order to get the full benefit of your employer match, you need to set up your 401(k) contributions so that you’re contributing at least the full matching percentage every single paycheck. You may be able to front-load your contributions to a certain extent, but you want to make sure that you stay far enough below the annual $18,000 limit to get the full match with every paycheck.

Now, some companies will actually make an extra contribution at the end of the year to make up the difference if you contributed enough to get the full match but accidentally missed out on a few paychecks. You can find out if your company offers that benefit in your 401(k)’s summary plan description.

But in most cases you’ll need to spread your contributions out over the entire year in order to get the full benefit of your employer match.

When to Contribute More Than Is Needed for Your Employer Match

Maxing out your 401(k) employer match is a great start, but there’s almost always room to contribute more.

Using the example from above, the person with the $3,000 per-paycheck salary would max out his or her employer match with a 5% contribution. That’s $150 per paycheck. Assuming 26 paychecks per year, that individual would personally contribute $3,900 to his or her 401(k) over the course of a year with that 5% contribution.

And given that the maximum annual contribution for 2017 is $18,000 ($24,000 if you’re 50+), he or she would still be eligible to contribute an additional $14,100 per year. In fact, this individual would have to set his or her 401(k) contribution to just over 23% in order to make that full $18,000 annual contribution.

3 big questions to answer:

  1. Do you need to contribute more in order to reach your personal goals?
  2. Can you afford to contribute more right now?
  3. If the answer is yes to both #1 and #2, should you be making additional contributions to your 401(k) beyond the employer match, or should you be prioritizing other retirement accounts?

Questions #1 and #2 are beyond the scope of this guide, but you can get a sense of your required retirement savings here and here.

Question #3 is what we’ll address here. If you’ve already maxed out your employer match and you want to save more money for retirement, should you prioritize your 401(k) or other retirement accounts?

Let’s dive in.

What Other Retirement Accounts Are Available to You?

Your 401(k) is almost never the only retirement account available to you. Here are the other major options you might have.

IRA

An IRA is a retirement account that you set up on your own, outside of work. You can contribute up to $5,500 per year ($6,500 if you’re 50+), and just like with the 401(k) there are two different types:

  1. Traditional IRA – You get a tax deduction on your contributions, your money grows tax-free inside the account, and your withdrawals are taxed as ordinary income in retirement.
  2. Roth IRA – You do not get a tax deduction on your contributions, but your money grows tax-free and can be withdrawn tax-free in retirement.

You can read more about making the decision between using a Roth IRA or a traditional IRA here: Guide to Choosing the Right IRA: Traditional or Roth?

The big benefit of IRAs is that you have full control over the investment company you use, and therefore the investments you choose and the fees you pay. While some 401(k)s force you to choose between a small number of high-cost investments, IRAs give you a lot more freedom to choose better investments.

The only catch is that there are income limits that may prevent you from being allowed to contribute to an IRA or to deduct your contributions for tax purposes. If you earn more than those limits, an IRA may not be an option for you.

Health Savings Account

Health savings accounts, or HSAs, were designed to be used for medical expenses, but they can also function as a high-powered retirement account.

In fact, health savings accounts are the only investment accounts that offer a triple tax break:

  1. Your contributions are deductible.
  2. Your money grows tax-free inside the account.
  3. You can withdraw the money tax-free for qualified medical expenses.

On top of that, many HSAs allow you to invest the money, your balance rolls over year to year, and as long as you keep good records, you can actually reimburse yourself down the line for medical expenses that occurred years ago.

Put all that together with the fact that you will almost certainly have medical expenses in retirement, and HSAs are one of the most powerful retirement tools available to you.

The catch is that you have to be participating in a qualifying high-deductible health plan, which generally means a minimum annual deductible of $1,300 for individual coverage and $2,600 for family coverage.

If you’re eligible though, you can contribute up to $3,400 if you are the only individual covered by such a plan, or up to $6,750 if you have family coverage.

Backdoor Roth IRA

If you’re not eligible to contribute to an IRA directly, you might want to consider something called a Backdoor Roth IRA.

The Backdoor Roth IRA takes advantage of two rules that, when combined, can allow you to contribute to a Roth IRA even if you make too much for a regular contribution:

  1. You are always allowed to make non-deductible traditional IRA contributions, up to the annual $5,500 limit, no matter how much you make.
  2. You are also allowed to convert money from a traditional IRA to a Roth IRA at any time, no matter how much you make.

When you put those together, high-earners could make non-deductible contributions to a traditional IRA, and shortly after convert that money to a Roth IRA. From that point forward the money will grow completely tax-free.

There are some potential pitfalls, and you can review all the details here. But if you are otherwise ineligible to make IRA contributions, this is a good option to have in your back pocket.

Taxable Investment Account

While dedicated retirement accounts offer the biggest tax breaks, there are plenty of tax-efficient ways to invest within a regular taxable investment account as well.

These accounts can be especially helpful for nearer term goals, since your money isn’t locked away until retirement age, or for money you’d like to invest after maxing out your dedicated retirement accounts.

How to Decide Between Additional 401(K) Contributions and Other Retirement Accounts

With those options in hand, how do you decide whether to make additional 401(k) contributions, beyond the amount needed to max out the employer match, or to contribute that money to other accounts?

There are a few big factors to consider:

  • Eligibility – If you’re not eligible to contribute to an IRA or HSA, a 401(k) might be your best option by default.
  • Costs – Cost is the single best predictor of future investment returns, with lower cost investments leading to higher returns. You’ll want to prioritize accounts that allow you to minimize the fees you pay.
  • Investment options – You should prioritize accounts that allow you to implement your preferred asset allocation, again with good, low-cost funds.
  • Convenience – All else being equal, having fewer accounts spread across fewer companies will make your life easier.

With those factors in mind, here’s a reasonable guide for making the decision:

  1. Max out your employer match before contributing to other accounts.
  2. If your 401(k) offers low fees and investments that fit your desired portfolio, you can keep things simple by prioritizing additional contributions there first. This allows you to work with one account, at least for a little while, instead of several.
  3. If your 401(k) is high-cost, or if you’ve already maxed out your 401(k), a health savings account may be the next best place to look. If you can pay for your medical expenses with other money, allowing this account to stay invested and grow for the long term, that triple tax break is hard to beat.
  4. An IRA is likely your next best option. You can review this guide for a full breakdown of the traditional versus Roth debate.
  5. If you’re not eligible for a direct IRA contribution, you should consider a Backdoor Roth IRA.
  6. If you maxed out your other retirement accounts because your 401(k) is high-cost, now is probably the time to go back. While there are some circumstances in which incredibly high fees might make a taxable investment account a better deal, in most cases the tax breaks offered by a 401(k) will outweigh any difference in cost.
  7. Once those retirement accounts are maxed out, you can invest additional money in a regular taxable investment account.

The Bottom Line: Maximize Your 401(k)

A 401(k) is a powerful tool if you know how to use it. The tax breaks make it easier to save more and earn more than in a regular investment account, and the potential for an employer match is unlike any opportunity offered by any other retirement account.

The key is in understanding your 401(k)’s specific opportunities and how to take maximum advantage of them. If you can do that, you may find yourself a lot closer to financial independence than you thought.

Matt Becker
Matt Becker |

Matt Becker is a writer at MagnifyMoney. You can email Matt at matt@magnifymoney.com

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Guide to Liability Insurance: What It is and Why You Need It

The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities.

When it comes to protecting yourself financially, things like an emergency fund, health insurance, and life insurance are typically some of the first topics that come up. And rightfully so, given that each is an important part of a secure financial foundation.

Liability insurance is a protection that often gets overlooked. If you have an auto, homeowners, or renters insurance policy, then you likely already have some level of liability insurance in place. But it may not be enough to fully protect you, and in this guide you’ll learn how to make sure you have the right coverage for your needs.

What Is Liability Insurance and Why Is It Important?

Liability insurance protects you financially in case you accidentally injure someone or damage their property. Common situations include:

  • You’re at fault in a car accident, and the other party experiences neck pain as a result.
  • Someone slips and falls in your driveway and breaks their tailbone.
  • You accidentally back your car into someone else’s mailbox.
  • Your dog bites someone while you’re out for a walk.

Each of those situations are accidents in which someone else experiences either an injury or property damage that will cost them money to fix. And in each case, they could legally hold you responsible for paying those bills.

That’s where liability insurance kicks in. Instead of having to spend your own money, your insurance company would cover the bill as long as it fell within the limits of your coverage. Any costs beyond those limits would be yours to bear.

And truth is that some of these situations could be very expensive. Imagine, for example, a car accident in which multiple other passengers are seriously injured.

That kind of situation isn’t fun to think about. But it could happen, and at the very least you can protect yourself from the financial impact. Otherwise, you could be on the hook for:

  1. Medical bills.
  2. Fixing or replacing the other person’s property.
  3. Lost income if the other person is forced to miss work.
  4. Legal bills for both you and the other person if there is any disagreement about who is at fault.

That’s why liability insurance is so valuable. It ensures that even if the financial impact of an accident is high — such as someone being forced to miss work for an extended period of time — you won’t be on the hook for the cost.

Who Needs Liability Insurance?

Just about everyone should have some level of liability insurance, but the truth is that the more money you have, the more likely you are to need it.

The simple reason is that if you have either a sizable income or a significant amount of savings and investments, there’s more for the other party to go after. They know that you can afford it, so they’re more likely to push for getting it.

On the the other hand, if you don’t have much savings and you don’t earn much money, there’s less potential for the other party to get a financial benefit, and they may therefore be less likely to pursue it.

Still, you can be held financially liable for your actions no matter how much money you have, and in certain situations you can even be required to pay a part of your income to the injured party. Plus, with liability insurance in place, you get the benefit of an insurance company handling all the procedural aspects of dealing with a claim, which can make the entire process a lot easier.

So again, just about everyone should have some base level of liability insurance. But if you’re a high-earner, and especially if you have significant assets, you’ll probably want to make sure you have at least enough coverage to protect your entire net worth.

Four Major Types of Liability Insurance

There are four major types of liability insurance policies, two of which are simply part of insurance policies you may already have in place.

1. Auto Insurance

You typically face the greatest risk of financial liability when driving. The simple reality is that driving is risky, accidents are common, and even careful drivers make mistakes that could leave them financially liable for fixing someone’s car and paying their medical bills.

Most states require you to have a minimum amount of liability coverage as part of your auto insurance policy, typically covering the following things:

  1. Property damage
  2. Per person bodily injury
  3. Per accident bodily injury (for when more than one person is injured)

Some states also require you to have uninsured motorist bodily injury coverage, which actually covers you and other passengers in your car if you’re in an accident and the other driver is at fault, but either doesn’t have liability coverage or doesn’t have enough to satisfy your claim.

For example, the minimum coverage requirements in New York currently look like this:

  • $10,000 for property damage
  • $25,000 bodily injury and $50,000 for death per person
  • $50,000 bodily injury and $100,000 for death per accident
  • $25,000 uninsured motorist coverage per person
  • $50,000 uninsured motorist coverage per accident

The minimum required coverage is often enough to cover the most common scenarios, but typically doesn’t provide sufficient protection in the case of major accidents. When you consider the medical bills and potential lost income in an accident involving multiple people, the total cost could be much higher than even the amounts listed above.

And given that the main value of your coverage is the protection against financially ruinous outcomes, it often makes sense to increase your coverage above the minimum. Most auto insurers allow you to get up to $250,000 of coverage per person and $500,000 per accident.

Unfortunately, it can be fairly expensive to secure liability coverage through your auto insurance policy, ranging anywhere from a couple of hundred dollars per year to $1,000 or more at the upper limits. The cost depends on the amount of coverage you want and on your driving history, so a clean record could lead to lower premiums.

2. Homeowners or Renters Insurance

Like auto insurance, liability coverage is a standard part of both homeowners and renters insurance policies, although it’s not always required. And the good news is that it usually provides broad coverage at a relatively low cost.

First, it covers any accidents that happen while someone is on your property, from falling down the stairs to tripping over your toddler’s walker. If someone is injured while at your house, your liability insurance has you covered.

Second, it covers non-auto-related accidents that happen away from your home as well. If your dog bites someone while you’re out for a walk, you accidentally bump into your neighbor’s ladder while they’re cleaning the gutters, or your child damages someone’s property, your liability insurance has you covered.

And all of that coverage comes at a relatively low cost too, with even several hundred thousand dollars of coverage typically only costing a couple of hundred dollars per year.

Most homeowners and renters insurance policies start with $100,000 of liability coverage, though you can typically increase it to $300,000.

3. Umbrella Liability Insurance

An umbrella insurance policy provides additional liability coverage above the limits in your auto and homeowners or renters insurance policies. And you typically have to do two things before you can get a policy:

  1. Secure your auto insurance and homeowners or renters insurance with the same company you’re getting your umbrella policy with. Not all insurers require this, but most do.
  2. Increase the liability coverage in both your auto insurance and homeowners or renters policies to a minimum level set by your umbrella policy insurer, which is often $300,000 for homeowners or renters insurance and $250,000/$500,000 for auto insurance. This is to make sure that your umbrella coverage only covers situations in which there are extraordinarily significant damages.

Because of that second point, umbrella liability insurance is typically more than most people need. Unless your income is high enough or you have more than $500,000 in net worth, it’s probably not worth considering this additional coverage. Your auto and homeowners or renters policies are likely enough.

But if you have significant income or assets to protect, an umbrella policy can provide substantial coverage at a small cost. Coverage typically starts at $1 million, and according to the Insurance Information Institute typically costs $150-$300 per year for the first $1 million in coverage and increases by $50-$75 per year for every additional $1 million in coverage.

4. Business Liability Insurance

If you run a business, even if it’s a small side hustle, the insurance policies listed above will not cover those business activities. You will need to get a separate policy.

The tricky part here is that liability coverage varies from profession to profession, so it’s not as easy as going out and getting a generic liability insurance policy like it is on the personal side of things.

Business liability insurance is beyond the scope of this guide, but if you’re in a business where you could be held financially liable for your mistakes, getting the right liability coverage in place could be well worth your time and money.

Business liability insurance can vary so much profession to profession. For example, doctors have a completely different type of liability insurance than lawyers. And even within those professions, it will vary by specialty. So it’s pretty difficult to give a price range or even offer general resources.

Three Ways to Get Liability Insurance

When it comes to actually getting liability insurance in place, you have three main options

1. Your Current Auto and Homeowners or Renters Insurance Policies

If you already have auto insurance in place, then you already have some amount of liability insurance. You just need to check your policy to see how much you have, and ask your insurer about the cost of increasing your coverage if you’d like more.

The same is true if you have homeowners or renters insurance. Check what you have in place now, and, if necessary, ask your insurer what the cost would be to either add liability coverage or increase it.

If you’re renting and you don’t already have renters insurance, you can check with your auto insurance company about adding it. You can also refer to this guide to help you find a policy that meets your needs: Guide to Renters Insurance: When You Need it and When You Don’t.

2. Shop Around

While sticking with your current insurance company is the easiest way to secure liability insurance, it may not be the most cost-effective. You could save a lot of money by shopping around, especially if you’d like to add an umbrella policy, which would likely require you to have all three insurance policies with the same company.

Here’s a process you can follow, borrowed from the renters insurance guide mentioned above:

  1. Google “auto insurance” plus your city/state. Almost every company that offers auto insurance also offers homeowners, renters, and umbrella insurance, so this will give you a solid list to start with.
  2. Get a phone number for each of the major insurers providing coverage in your state.
  3. Call each insurance company directly and ask for quotes for both auto insurance and either homeowners or renters insurance, making sure to include the amount of liability coverage you’d like to have for each.
  4. If you are looking for umbrella liability coverage, make sure to ask for a quote on that policy as well.
  5. If you have any possessions that are particularly valuable, such as jewelry or artwork, ask how much it would cost to get additional coverage for those possessions in your homeowners or renters policy.
  6. Make sure to ask if they offer a multi-policy discount and, if so, to get the premiums quoted with that discount applied.
  7. If there are any particular threats in your region, such as flooding or earthquakes, ask about their coverage of those specific threats.
  8. Compare the coverage and cost from each insurance company, including your current insurer. If you can get a better deal elsewhere, it should be relatively easy to switch.

3. Independent Insurance Agent

A good independent insurance agent will be able to help you evaluate your need for coverage and find that coverage at the best possible price given your needs and situation.

To find one in your area, you can Google “independent property and casualty insurance agents” + your city/state.

It won’t cost you any extra to work with an agent, but you should be aware that some agents may try to direct you to higher levels of coverage than you need, simply because it provides them a better commission. You should interview a few to make sure you find someone you trust.

The Forgotten Insurance

Unless you’re running a high-risk business, liability insurance probably doesn’t need to be at the top of your list of financial priorities.

But it provides valuable protection, and it’s something that shouldn’t be forgotten. It’s typically easy to add or increase the coverage you have through your existing policies, and doing so ensures that no accident will put you in a situation where you can’t reach your other financial goals.

Matt Becker
Matt Becker |

Matt Becker is a writer at MagnifyMoney. You can email Matt at matt@magnifymoney.com

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Life Events

The Ultimate Guide to Creating an Estate Plan

The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities.

Estate planning is probably the last thing you want to think about as you start your family.

You’re bringing life into the world, which is joyous and happy. But estate planning is all about what happens when life ends, which is morbid and depressing.

You may also think that estate planning is only for rich people. If you haven’t yet built up much savings, or if you’re still working your way out of debt, you might wonder whether it’s actually important to tell people what to do with your money.

The truth is that estate planning is both important and empowering, no matter how much money you have. And that’s especially true when you have young children, because your estate plan is how you ensure that your family will always be taken care of, no matter what.

In this guide you’ll learn everything you need to know about estate planning so that you can make sure your family’s future is secure.

Why You Need an Estate Plan

The main reason to create an estate plan is to make sure that your family will be taken care of both physically and financially after you’re gone.

Physically, you get to decide ahead of time who would take care of your children — and other dependents — if you and your spouse or partner are no longer able to do it yourselves.

Financially, you get to make sure that there’s money available for your children, and you get to decide who would be in charge of managing that money until they’re old enough to do it themselves.

In other words, your estate plan is how you get to keep being a parent after you die. Your kids will continue to be taken care of because you set it all up ahead of time.

And if that isn’t enough, Bomopregha Julius, an estate planning attorney in New York City, suggests two other reasons to create an estate plan:

  1. It’s really for your family, not for you. Whether you have an estate plan or not, your surviving family members will have to figure out what financial assets you have and what to do with them, all at a point in time when they’ll be grieving your death. By creating an organized estate plan, you give them the tremendous gift of making that process as easy as possible.
  2. Build generational wealth. An estate plan is how you break the cycle of poverty and build generational wealth. By being intentional about leaving money behind to the people you care about, you create a stronger foundation for the next generation to build upon.

With that as your motivation, let’s talk about what goes into a good estate plan.

8 Key Components of a Solid Estate Plan

1. Your Will

A will serves two main purposes.

First, and most important, it’s the only place where you can name guardians for your children. This is why a will is essential for all young families, regardless of your financial situation.

Second, your will is how you pass on assets and possessions that don’t allow you to designate a beneficiary (more on beneficiaries below). Things like cars, furniture, and jewelry can all be passed down through a will.

The downside of a will is that it has to go through a process called probate. Probate is the court process of reviewing and executing your will, and it can be time-consuming and expensive. Family and friends can also challenge your will during probate, with the final decision up to the judge, which can lead to outcomes that may not be exactly what you intended.

For that reason, it’s usually a good idea to pass on as much of your money and possessions as possible through other avenues. Which brings us to…

2. Your Beneficiary Designations

Many bank and investment accounts, as well as life insurance policies, allow you to name beneficiaries or make payable on death designations. These designations allow you to specify who the money in those accounts would go to upon your death.

The benefit of these designations is that they allow the money to be transferred without going through probate, which means your family can get the money quicker, easier, and with more certainty.

You just need to be aware that these designations take precedence over anything you have in your will. That’s what allows them to skip probate, but it also means that updating your will often isn’t enough to keep your estate plan up to date. You need to make sure you keep your beneficiary designations current as well.

3. Life Insurance

Life insurance is one of the best ways to make sure that there will always be enough money for your surviving family members. This is particularly true when you have young children, since there is a long time between now and the point at which they’ll be able to support themselves.

Typically, both working and non-working parents should have at least some amount of life insurance.

For working parents, it primarily serves to replace lost income. For non-working parents, it helps the family pay to replace all of the duties they perform. And in all cases it can help the surviving family members navigate a challenging transition period without worrying about how they’ll pay their bills

Term life insurance is the type that most people need, but you can get a detailed breakdown of the options available to you here: Term vs Whole Life Insurance.

4. Financial Power of Attorney

A financial power of attorney designates someone to handle your finances in the situation where you’re temporarily incapacitated. This could, for example, allow someone to access your checking account and pay your bills.

You could set this up as a permanent right or you could make it conditional upon certain medical diagnoses. You can also limit which accounts the person is able to access and which actions he or she is able to perform.

Regardless, this ensures that your financial obligations can be handled even when you’re not able to do it yourself.

5. Health Care Power of Attorney

A health care proxy is essentially the same as a financial power of attorney, but for health care instead of finances.

It designates someone to be in charge of your medical decisions in case you’re ever not able to make them for yourself. Designating someone you trust as your health care proxy will make it easier for your doctors to care for you in a way that aligns with your personal values.

6. A Living Will

Your living will allows you to decide ahead of time how you’d like end-of-life decisions to be made. That might sound pretty morbid, but this helps ensure that you’re treated the way you want to be treated AND takes some of the responsibility off the shoulders of your family members to make some of those difficult decisions for you.

7. List of All Your Important Accounts

One of the most difficult jobs for surviving family members is often simply finding and accessing your bank and investment accounts. If they don’t know where they are, it’s pretty challenging to claim the money.

So at the very least, making a list that details which accounts you have at which institutions can eliminate a lot of the struggle. For some accounts, it may also make sense to securely share your username and password so that there’s always someone who can access them if needed.

8. A Written Summary of Your Wishes

While your estate plan should always be laid out formally using the tools above, it can also be helpful to provide a written summary of what you want to happen.

While it won’t be legally binding, it can help to explain your wishes in an easily understood format, which could make it easier for your survivors to execute your plan correctly.

When to Consider a Living Trust

While the eight items above are essential for any good estate plan, some people might also benefit from creating a revocable living trust.

A revocable living trust is a legal entity that you create and control. You can then transfer ownership of certain assets to the trust, and those assets are then bound by the terms of the trust, which specify how those assets should be disbursed upon your death.

For example, it’s common for spouses to create a living trust in which they are both trustees, meaning that they both have full access to all the assets owned by the trust and can modify the terms of the trust at any time.

Then they will transfer checking accounts, savings accounts, and non-retirement investment accounts to the trust. They can also name the trust as the beneficiary of their life insurance policies. And because they are trustees, they can manage those assets in the exact same way as if they owned them individually, with the difference being that those assets will now automatically pass to surviving family members according to the terms of the trust.

That might sound like a lot, and it may also sound redundant with the purpose of your will and your beneficiary designations. But there are two big benefits to this approach.

The first is that all assets owned by the trust skip probate. Probate can be a long and expensive process, and skipping it means that your money is passed on to your family members quicker, at a smaller cost, and with less chance for your desires to be overturned.

The second is that you have more control over certain decisions, such as when your children get access to your money. Instead of them inheriting your life insurance proceeds at age 18, for example, you can stipulate that they wouldn’t receive the money until age 25, when they might be better prepared to handle it. You can even put in provisions that protect the money from a messy divorce or from creditors. Trusts are flexible tools with a lot of room for you to set them up as you please.

The Cost

The big downside is the upfront cost. A will and all the other documents might cost anywhere from $50 to a few hundred dollars to set up, while a living trust will usually cost a couple of thousand dollars. The flip side is that it may actually save your family money in the long run by cutting out most of the probate process, but that doesn’t make it any easier to afford the bill now.

In general though, a living trust is a good idea if you can afford the upfront cost without sacrificing your basic financial security. It makes things quicker, easier, less expensive, and more certain for your surviving family members.

And remember that even if you don’t have much in the way of savings, your children might stand to inherit significant life insurance money. A living trust can make sure that that money is managed properly by the right people until your children are old enough to manage it themselves.

Hiring an Estate Planning Attorney vs. Doing It Yourself

Armed with all that information, there’s still one big question left to answer: how should you get it all in place?

It used to be that you had to go through an estate planning attorney, but as the world turns digital there are now a number of online tools that can help you get these documents in place quickly and inexpensively.

So which route should you take? Let’s look at the pros and cons of each approach.

The Pros and Cons of Doing It Yourself

There are a number of websites now that offer guided, DIY estate planning packages with all the essential documents. Some of the biggest are Nolo, LegalZoom, and Rocket Lawyer.

The biggest appeal of these tools is typically the cost. They currently range from $54.99 to $149 per person, which in some cases could be significantly cheaper than working with an attorney.

They’re also quick. Working with an attorney likely requires at least one in-person meeting, and often more to get everything handled, while the online tools might allow you to complete everything in just a couple of hours.

And for simple situations, many attorneys use a template similar to what these tools offer anyway, so you may not be getting a much different product.

The biggest downside is that you don’t get the guidance that comes from working with a good estate planning attorney. Given the importance of getting your estate plan right, that could be costly.

The DIY tools aren’t great for more complicated situations either, such as setting up a living trust or creating a plan for a second marriage. Those situations have more moving parts, and that’s where an experienced attorney can be very helpful.

The Pros and Cons of Hiring an Estate Planning Attorney

Working with an estate planning attorney has essentially the opposite set of pros and cons.

The biggest downside is simply the cost. It’s typically at least a few hundred dollars to work with an attorney, and it may be upward of $1,000. It really depends on where you live though, and even then there’s often a wide range, so it’s worth calling around.

The main reason to work with an estate planning attorney is for the guidance they offer. A good attorney will take the time to get to know you, to understand what’s important to you, and to explain all of the options available to you. The decisions you’re making are not always simple or easy to understand, so that kind of guidance can be invaluable.

Along with that comes the confidence of knowing that your plan is done right, both in terms of being set up the way you want and in terms of adhering to specific state laws that the online tools may or may not be aware of.

Similarly, your surviving family members may be in a better position to carry out everything with the guidance of the attorney who helped you create your plan and knows exactly what you wanted and how everything should work. Again, anything you can do to make things easier for your family is a huge gift.

Finally, working with an attorney may make it easier for you to make changes and updates as you move along, since he or she will already be familiar with your plan and have all the documents you originally created. So if you have a child, get divorced or remarried, or want to update the guardians in your will, your attorney can help you make those changes efficiently within the context of your overall estate plan.

Questions to Ask Before You Hire an Estate Attorney

Can you afford the cost of the attorney without sacrificing your financial security?

Can you find an attorney who cares about getting to know you personally and helping you craft a personal estate plan?

If the answer to both of those questions is yes, the cost of hiring an attorney is well worth it. Otherwise, the DIY tools are probably sufficient as long as your situation is relatively simple.

How to Find an Estate Planner

  1. You may have access to discounted legal services through your employee benefits.
  2. The National Association of Estate Planners & Councils has a search tool you can use.
  3. WealthCounsel is another organization that offers a helpful search tool.
  4. You can always simply Google “estate planning attorney” + your city/state to find one near you.

Where to Keep Your Estate Planning Documents

Once you have your estate planning documents in place, there’s still one big question to answer: where should you keep them?

This may sound trivial, but it’s actually pretty important. Remember, these documents tell everyone else how your family and your money should be cared for after you die, meaning you won’t be around to help them figure it out. So your main goals here are two-fold:

  1. Ensuring that there are always up-to-date copies stored somewhere.
  2. Making it easy for your surviving family and friends to access those documents if needed.

Here are a few options.

1.Your Attorney

If you work with an attorney, he or she will usually be able to keep a copy of all of your important documents on hand. This is a great way to make sure that those documents will always be available, even if something happens to your copies.

It’s also a good way to make sure that someone who knows what they’re doing is leading the way. Your attorney will already know who’s in charge of what and should be able to guide everyone else to make sure that things run smoothly.

2. A Safe

Even if you’re relying on an attorney, you’ll walk away with a number of physical copies of all your documents that you should hold onto in case originals are eventually needed. And it may be a good idea to keep them in a fireproof and waterproof safe, just to make sure they won’t get damaged in an accident.

3. With Friends and/or Family

Throughout the estate planning process, you’ll be naming a number of people who would be in charge of taking care of your children and handling your financial affairs if you die. You should already be talking these decisions through with them so that they know what’s expected of them, and it may also be a good idea to give them a copy of important documents so that they’re easily accessible if the need arises.

4. Digital File Share

Storing your files digitally using a service like Google Drive or Dropbox is a great way to make sure you always have backup copies, and it also makes sharing those documents with others easy.

You could also looked into a paid service like Everplans, which is specifically designed for storing and sharing sensitive estate planning documents. They also offer some customer support that may be helpful if you need a little guidance.

The Gift of a Good Estate Plan

If you’re like most people, you’ll probably procrastinate on putting your estate plan in place. It’s not an enjoyable topic, and it’s a cost that’s not easy to take on when you’re already paying for child care and everything else.

But a good estate plan is a gift, both to you and your family.

You get the gift of knowing that your family will be taken care of, no matter what. And your family gets the gift of having the transition period after your death be as easy as possible, giving them space to grieve and get their lives together without worrying about the financial side of things.

That’s the value of a good estate plan.

Matt Becker
Matt Becker |

Matt Becker is a writer at MagnifyMoney. You can email Matt at matt@magnifymoney.com

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Health, Life Events

The Complete Guide to Disability Insurance

The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities.

Quick quiz: What’s the most valuable financial asset you own as a young professional and a provider for your family?Here are some hints: It’s not your home. It’s not your 401(k). And it’s definitely not your car.

The answer? It’s your future income. The money you earn in the years to come will allow you to pay your bills, save for the future, and create a secure financial foundation for you and your family.

Really, all the plans you’re making both for today and the future rely on the assumption that you’ll continue earning money. Which is exactly why it’s so important to protect that income and make sure you receive it no matter what.

That’s where disability insurance comes in.

Disability insurance ensures that you’re able to continue paying your bills and putting food on the table even if your health prevents you from working for an extended period of time. By sending you a monthly check that replaces some or all of your income, it protects your biggest financial asset from those worst-case scenarios.

It’s something that just about every working parent should have, but it’s a complicated product that can be difficult to understand and get right.

So in this post you’ll learn all about how disability insurance works and what kind of policy you should be looking for.

Why You Need Disability Insurance

Disability insurance is often ignored both because the prospect of becoming disabled seems remote and because the premiums can be hard to swallow, especially for young families who are already struggling to pay for child care and all the other expenses that come with having young kids.

But extended disability is a lot more common than most people think.

According to WebMD, your odds of becoming disabled before you retire are about 1 in 3.

The leading causes of disability include:

  • Arthritis
  • Back pain
  • Heart disease
  • Cancer
  • Depression
  • Diabetes

For the most part it’s chronic illness that causes disability, not the kind of major accident that typically comes to mind. And the odds of it happening before you’re financially independent are fairly high, though there are some situations in which your personal odds may be lower.

So the big question is this: If you’re one of the 33% of people who faces an extended disability, where would the money come from to pay your bills and put food on the table? How long would your savings be able to support you, and what would you do if you needed help past that point?

Most people would struggle to make it more than a few months, which is exactly why disability insurance is so valuable. By replacing your income for potentially years at a time, it ensures that you’ll be able to continue taking care of your family no matter what.

Short-term disability insurance vs. long-term disability insurance

There are two main types of disability insurance: short-term and long-term.

Both can be helpful, but they play very different roles in your financial plan. Here’s an overview of each.

Short-Term Disability Insurance

Short-term disability insurance only offers benefits for a relatively limited amount of time. Most short-term disability insurance policies cover you for 3-6 months, though they can provide coverage for up to two years.

There is typically a waiting period of up to 14 days before the insurance kicks in to prevent it from covering minor illness and injury. After that waiting period, it will typically start to pay 50%-100% of your regular income until you either return to work or your coverage period ends.

One of the most common uses of short-term disability insurance is during maternity leave. Many, though not all, short-term disability policies cover the latter parts of pregnancy and the period after childbirth, which can help replace your income while staying home with your newborn.

Most short-term disability insurance policies are offered as an employer benefit, and in some cases that coverage may even be free. Private coverage is also an option if you aren’t able to get coverage through work, though those policies can be expensive. For example, a healthy 38-year-old male might pay a $2,300 annual premium for a $5,000 monthly benefit and 12 months of coverage.

One alternative to short-term disability insurance is building an emergency fund. A 3-6 month emergency fund would provide the same protection as a 3-6 month short-term disability insurance policy, with the added benefit of not having a monthly premium.

Long-Term Disability Insurance

Long-term disability insurance is where you typically find the most value. Because while a short-term disability could be covered by a healthy emergency fund, an extended disability is much more likely to deplete your family’s savings and put you in a difficult position unless you have some way of replacing your lost income.

Long-term disability insurance picks up where your emergency fund or short-term disability insurance leaves off. There’s typically a 3-6 month waiting period during which you would have to replace your income by other means.

But once you’re past that waiting period, your long-term disability insurance would start replacing your monthly income and would continue to do so for years at a time, as long as you remain disabled.

This is a big potential benefit. A long-term disability policy that replaces $5,000 per month in income will potentially pay you $60,000 per year for as long as you’re disable. That would go a long way toward keeping your family on the right track.

Given that potential value, it’s usually more important for families to secure long-term disability insurance than short-term disability insurance. For that reason, the rest of this guide will focus primarily on long-term disability insurance.

10 Questions To Ask When Shopping for a Long-Term Disability Insurance Policy

Long-term disability insurance is a complicated product with a lot of terms and conditions that vary policy to policy. Finding a good, independent disability insurance agent who isn’t beholden to any particular insurance company can help you secure the right policy at the right price for your specific situation.

But whether you’re looking on your own or with the help of an agent, there are 10 key features you’ll want to evaluate.

1. Your Monthly Benefit

Your monthly benefit is the amount of money your long-term disability insurance policy would pay you each month in the event of disability. And there are a few key factors that go into deciding how big a benefit you need:

  1. What are the monthly expenses you would have to cover if you lost your income? Consider the fact that you may be able to cut back on certain discretionary expenses, but also that you may have additional medical expenses in order to treat the disability.
  2. What other income sources do you have? You can factor in your spouse or partner’s income, your savings, and possibly even help from family.
  3. Would your benefit be taxable or tax-free? The benefit from an individual policy you purchase on your own would almost certainly be tax-free. The benefit you get from an employer policy would likely be taxable. The difference affects how much money you would actually have available to spend.

2. How They Define ‘Disability’

Believe it or not, there is no one way of defining disability. There are a lot of variations, but most policies fall into one of three main groups:

  • Any occupation – This is the most restrictive of the three definitions. It defines disability as the inability to perform any job, no matter what it is or how much it pays. It’s hard to qualify for benefits under this definition.
  • Own occupation – This is the broadest of the three definitions. It defines disability as the inability to perform the main duties of your current job. It’s easiest to qualify for benefits under this definition.
  • Modified own occupation – This is a middle ground that defines disability as the inability to perform a job for which you are reasonably suited based on education, training, and experience. In other words, not just any job will do. You have to be able to work in a job that fits your level of experience and expertise before benefits stop.

Understanding your policy’s definition of disability is key to understanding the protection you’re actually receiving. A big benefit with a strict definition of disability may be less valuable than a smaller benefit with a definition that’s easier to meet.

3. The Elimination Period

The elimination period is that amount of time you have to be disabled before you can start to collect your benefit.

Typical elimination periods range from 60 to 180 days, with longer elimination periods leading to a smaller premium. You should consider how long your savings and/or short-term disability insurance would cover you when deciding how long an elimination period to choose.

4. The Benefit Period

This is the maximum amount of time you would be able to collect benefits as long as you continue to meet the policy’s definition of disability.

Many long-term disability insurance policies pay out until age 65 or 67 to coincide with the standard Social Security retirement age. Other policies will only pay benefits for 5-10 years.

Longer benefit periods are more valuable, but also more expensive. You should consider the likelihood of being able to replace your income in other ways, such as transitioning to a different job, when deciding how long you’d like your benefit period to last.

5. What isn’t Covered

Most long-term disability insurance policies will exclude certain types of conditions from coverage. For example, mental health conditions are often not covered or are subject to a shorter benefit period.

Sometimes the exclusions will only last for a period of time, such as the first two years of the policy being in place. Sometimes they last for the life of the policy. You should evaluate these exclusions in relation to your personal and family health history to understand how likely you might be to run into them.

6. Premium Guarantee

Some long-term disability insurance policies are non-cancelable, which means that you are guaranteed a fixed premium until your coverage period ends. The insurance company cannot cancel your coverage and cannot raise your premium.

Other policies are guaranteed renewable, which means that the insurance company can’t cancel your policy, but they can increase the premium as long as they increase the premium for all policies across an entire class of policyholders (such as all policyholders in a given state or all policyholders in a given occupation category).

If you don’t have either of those guarantees, it means that your premium could increase each and every year and that those changes are at the discretion of the insurance company.

7. Residual Benefit

A residual benefit feature means that you could receive partial benefits if you return to work at a reduced salary.

This feature can help you build your workload over time, making for an easier and smoother transition.

8. Cost-of-Living Adjustment (COLA)

Policies that come with a cost-of-living adjustment will increase your benefit each year based on the rate of inflation. This is meant to ensure that you are able to pay for the same amount of goods and services each year, even as the cost of those things increase over time.

Some COLA riders have a maximum annual increase and/or a limited amount of time for which they are applied. For example, a policy might cap the annual increase at 3%, and it may only increase the benefit for a certain number of years before leveling off.

9. Future Purchase Option

Many long-term disability insurance policies guarantee you the right to increase your coverage in the future if your income increases, without any medical underwriting. This is a valuable benefit because it eliminates the risk that a decline in health could prevent you from getting more coverage when you need it.

10. Insurer’s Financial Rating

Finally, you should make sure that the insurer is in good financial condition. The last thing you want is to have the insurance company flake out on you when it’s time to collect.

You can look up an insurer’s rating through any of the following companies: A.M. Best, Fitch Ratings, Moody’s, and Standard & Poor’s.

The Pros and Cons of Group Disability Insurance

There are two ways you can get long-term disability insurance:

  1. Through your employer as an employee benefit (referred to as group disability insurance)
  2. On your own through an insurer of your choice

Both have their pros and cons. Here’s a breakdown.

The Pros of Group Coverage

1. Cost

Group disability insurance is often less expensive, and the premiums are typically tax-deductible. Many employers even offer a base level of long-term disability insurance coverage for free.

The lower premium can come with some negative trade-offs, as you’ll see below, but in the best cases it simply makes the insurance easier to afford.

2. No Medical Underwriting

Your ability to get group coverage is in no way affected by your current health. Eligibility is solely dependent on your employment status with the company.

This can be an especially big benefit if you have significant health issues that would make individual coverage either prohibitively expensive or impossible to get.

3. Simplicity

Group coverage is easy to get in place. All you have to do is sign up during open enrollment, choose the level of coverage you’d like, and you’re done.

The Cons of Group Coverage

1. Benefits Are Taxed

In most cases, your group disability insurance premiums are tax-deductible, and the benefits you receive are taxed. Which means that you won’t actually receive the full benefit.

So while group long-term disability insurance can be affordable on the front end, sometimes that comes at the cost of smaller benefits on the back end.

2. May Not Cover You Completely

In addition to the benefits being taxable, your employer may not offer enough coverage to meet your full need to begin with. You may need to get an additional policy if you want to be fully insured.

3. Lack of Control

Your group disability insurance policy is what it is, and you don’t have much, if any, say in the features it offers.

Sometimes this won’t matter, since the policy will have everything you want. But sometimes it will be lacking in certain areas, which could leave you with weaker coverage than you’d like.

4. Can’t Take It with You

You typically can’t take your group disability insurance coverage with you when you leave the company, and your employer could also choose to stop offering it at any time.

All of which means that you could find yourself without coverage somewhere down the line. And if your health status has declined or your next employer doesn’t offer group coverage, you may find it hard to get affordable disability insurance elsewhere.

The Pros and Cons of Individual Disability Insurance

The Pros of Individual Coverage

1. Portability

Individual long-term disability insurance policies are portable, meaning that they’re yours as long as you continue to pay the premiums, even if you change jobs. This is crucial to making sure that you always have coverage when you need it.

2. Definition of Disability

With an individual disability insurance policy, you have the opportunity to choose a broader definition of disability that increases your chances of receiving benefits. This can be particularly helpful if you work in a highly specialized field where having an own occupation definition would be beneficial.

3. Tax-Free Benefits

Individual disability insurance premiums are not tax-deductible, but the upside is that any benefits you receive are tax-free. This ensures that you get as much money as possible when you really need it.

4. Control over Other Features

You have a lot more control over all the policy features when you buy individual coverage. You can often pick and choose whether you want residual benefits, cost-of-living adjustments, and the like, allowing you to customize your coverage to your specific needs.

The Cons of Individual Coverage

1. Cost

Individual disability insurance is typically more expensive than group coverage, particularly if you have pre-existing medical conditions or you work in a high-risk occupation.

While it can vary greatly depending on the specifics of your circumstances, a reasonable rule of thumb is to expect $2-$2.50 in monthly benefits for every $1 in annual premium.

2. Complexity

Long-term disability insurance is a complicated product, and unfortunately, it’s hard to shop around and get a true apples-to-apples comparison of policies.

Your best bet is to look for a truly independent disability insurance agent who isn’t tied to any particular insurance company, and who can guide you through the process and help you understand the pros and cons of the various policies offered by different companies.

3. Medical Underwriting

Applying for individual long-term disability insurance includes a medical exam and a review of your medical history, after which the insurance company may ask more questions to get a better understanding of your current medical condition.

This can be time-consuming, can feel invasive, and in some cases can lead to a more expensive policy or even a denial of coverage altogether. It can also lead to an attractive offer if you’re in good health, but regardless, it’s a cumbersome process you have to go through.

A Quick Note on Social Security Disability Coverage

While Social Security does offer long-term disability coverage, it’s generally not a good idea to rely on it.

The main reason is that it has a strict definition of disability, requiring you to be unable to work in any job for at least one year. It only pays out under the most extreme of circumstances.

You also need to have worked long enough to qualify for any coverage at all, and even if you do qualify, it often won’t meet your full benefit need.

All of which is to say that if you truly want financial protection from disability, getting some combination of group and individual coverage is likely the way to go.

Are You Protected?

No one likes to think about the possibility of being sick or disabled, but protecting your income is a crucial part of building true financial security.

Disability insurance can be an effective way to get that protection. When it’s done right, it ensures that you’ll have money coming in no matter what, allowing you to continue providing for your family even in the most difficult of circumstances.

Matt Becker
Matt Becker |

Matt Becker is a writer at MagnifyMoney. You can email Matt at matt@magnifymoney.com

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Life Events

Guide to Renters Insurance: When You Need it and When You Don’t

The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities.

If you’re currently renting, you may not have given much thought to buying insurance for your place. After all, your landlord is the one who owns it. Shouldn’t he be the one buying insurance?

The truth is that while your landlord almost certainly does have insurance, it doesn’t cover all the risks that you personally face. And that’s where renters insurance comes in.

Renters insurance is inexpensive and provides a number of financial protections you can’t get elsewhere. It’s something that just about every renter should consider, and in this guide we’ll cover the following:

  • What Is Renters Insurance?
  • What Does Renters Insurance Cover?
  • How to Get Renters Insurance

What Is Renters Insurance?

If there was a fire in your place, or if someone broke in and stole something, who would be responsible for the damages?

Your landlord almost certainly has an insurance policy that would cover the cost of repairing the apartment itself. His insurance would pick up the tab for fixing or replacing the walls, floors, ceilings, and other structural components of the apartment. He would restore it to the empty apartment that existed before you moved in.

But, of course, you don’t live in an empty apartment. You own most of what’s inside it, furniture, clothes, your laptop, and everything else.

That’s where renters insurance comes in. Renters insurance covers the financial loss you could personally face if your apartment was damaged or burglarized.

Specifically, renters insurance covers:

  1. The cost of replacing your possessions.
  2. The cost of living somewhere else if your rental becomes temporarily unlivable.
  3. Your financial liability if someone gets injured while at your apartment, or if you accidentally injure someone or their property while you’re away from your apartment.

And the good news is that all of that coverage comes pretty cheap. According to the National Association of Insurance Commissioners, renters insurance premiums average just $15-$30 per month, though your specific premium will depend on where you live and what you’re covering.

So, how exactly do each of those protections work? Let’s dig in.

Renters insurance only protects you from certain kinds of damages. These are called named perils, and while every policy differs, here’s a list of common perils that are covered:

  • Fire and lightning
  • Windstorm or hail
  • Accidental discharge or overflow of water or steam
  • Earthquake
  • Explosion
  • Smoke
  • Aircraft
  • Vehicles
  • Collapse of building
  • Theft
  • Vandalism and malicious mischief
  • Riot and civil commotion
  • Falling objects
  • Sudden and accidental tearing apart, cracking, burning, or bulging
  • Freezing
  • Sudden and accidental damage from artificially generated electrical current
  • Volcanic eruption

This is just a generic list, and your specific policy may name different perils or define them slightly differently. Whatever your named perils are though, your renters insurance will only cover damages that result from one of those perils that is specifically listed in the policy. If damage results from some other cause, it will not be covered.

Certain types of perils, like flooding, may not be covered by your base policy but could be covered by an additional policy. You’ll have to review the details of your policy to see what is specifically covered, and what, if any, additional perils you may want to insure against.

Now let’s get into the specific protections that renters insurance offers.

Protection #1: Your Property

While you don’t own your home, you do own most of what’s inside of it. And when you add up the value of all your clothes, furniture, electronics, dishes, appliances, and everything else, you probably own a significant amount of property.

If any of that property was damaged or stolen, your renters insurance would help pay to replace it. Your landlord’s insurance would not.

When you buy renters insurance, you buy a certain amount of personal property coverage. For example, you might get $30,000 of coverage, in which case your renters insurance would reimburse you up to $30,000 for damage caused to your personal property. Without that coverage, you would have to foot the bill yourself.

Wisconsin’s Office of the Commissioner of Insurance offers a Personal Property Home Inventory form that can help you determine how much personal property coverage you need and create a record that can be used if you ever need to file a claim. Keeping photos of particularly valuable items is also a good idea, just in case your insurance company asks for more proof.

It’s worth noting that most renters insurance policies have coverage limits for certain types of property like jewelry and artwork. For example, it’s common for the policy to limit its jewelry coverage to $1,000 per item.

In that case, you can add a rider that covers specific pieces of property that exceed those limits. So if you have a $5,000 engagement ring, you would have to ask the insurance company to add coverage specifically for that item, which would come with a small increase in premium.

You will also likely have a deductible on your policy, which is the amount of money you would have to pay out of pocket before your insurance kicks in. For example, a $500 deductible means that you would be responsible for paying the first $500 in damages, and your renters insurance would reimburse you past that amount, up to your total personal property limit.

Protection #2: Your Cost of Living

Let’s say that there was a fire and your home became temporarily uninhabitable. While you wouldn’t be responsible for repairing the house or apartment, you would be responsible for finding somewhere else to live in the meantime.

This is the second big area where your renters insurance would kick in.

Renters insurance has something called loss of use coverage that would provide payments to help you cover that cost. Essentially, it would pick up the tab for any excess expense above what you would normally pay while living in your home.

For example, let’s say that your rent is $1,500 per month and you’re temporarily forced to stay in a hotel that charges $150 per night. That’s an excess cost of about $3,000 per month, which would be covered by your loss of use coverage.

You may also face additional food, utility, and transportation expenses, which could all be reimbursed under that same coverage.

Typically there’s a maximum dollar amount that will be paid out under this coverage and a maximum time limit for payments, and your insurer will likely also set limits on what constitutes reasonable additional expenses.

Payments will end once your home is habitable, once you find a new place to live, or once you’ve hit your coverage limits.

Protection #3: Your Liability

In addition to protecting your property and making sure you can afford a place to live, renters insurance can provide a substantial amount of liability coverage.

Liability coverage protects you from the financial consequences of accidentally injuring someone or damaging their property. And your renters insurance coverage protects you both against incidents that happen in your home and against certain incidents that happen away from it.

For example, imagine that your landlord sends someone to fix your refrigerator and that person trips over your child’s walker and seriously injures himself. That could be a significant financial loss for him, both in terms of medical bills and missed work, and he would have the right to seek reimbursement from you. In that case, the liability coverage on your renters insurance policy would kick in to pay the financial damages and to pay any legal costs you might face.

As another example, maybe you’re out for a walk with your dog and he bites someone. Again, you could be financially responsible for the consequences, and your renters insurance would be there to pick up the bill.

While the odds of something like this leading to a major financial liability are likely pretty small, the potential costs could be high. And with renters insurance you can get several hundred thousand dollars of liability protection for an average of $15-$30 per month.

It’s inexpensive coverage that protects you from the risk of a big financial loss.

How to Get Renters Insurance

If you don’t have renters insurance, how can you go about getting it?

If you already have auto insurance, the easiest way to get renters insurance is through that same company. They will almost certainly provide renters insurance as well, and you may be able to get a discount for having multiple policies with the same company.

But getting renters insurance is a good opportunity to shop around. Because you may be able to get a better deal on both your renters insurance AND your auto insurance by switching insurance companies. We have some recommendations for the best renters insurance, but if you really want to be thorough, you’ll want to do even more homework.

Here’s how to do it:

  1. Google “renters insurance STATE”, replacing STATE with your state of residence.
  2. Get a phone number for each of the major insurers providing coverage in your state.
  3. Call each insurance company directly and ask for quotes for both renters insurance and auto insurance. You should have a copy of your current auto insurance policy on hand so that you can get a quote for the same level of coverage.
  4. If you have any possessions that are particularly valuable, such as jewelry or artwork, ask how much it would cost to get additional coverage for those possessions.
  5. Make sure to ask if they offer a multi-policy discount and, if so, to get the premiums quoted with that discount applied.
  6. If there are any particular threats in your region, such as flooding or earthquakes, ask about their coverage of those specific threats.
  7. Compare the coverage and cost from each insurance company, including your current insurer. If you can get a better deal elsewhere, it should be relatively easy to switch.

Other than the work needed to shop around, getting renters insurance should be relatively quick and easy.

Are You Covered?

Renters insurance is one of those things you hope you never need but could pay off significantly if you did. In a worst-case scenario, it would help you replace all of your possessions and maintain a place to live without depleting your savings or resorting to debt.

It’s big protection at a small cost.

Matt Becker
Matt Becker |

Matt Becker is a writer at MagnifyMoney. You can email Matt at matt@magnifymoney.com

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Investing, Life Events, Strategies to Save

Guide to Choosing the Right IRA: Traditional or Roth?

The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities.

Guide to Choosing the Right IRA: Traditional or Roth?

The Roth IRA versus traditional IRA debate has raged on for years.

What many retirement savers may not know is that most of the debate about whether it’s better to contribute to a traditional IRA or a Roth IRA is flawed.

You’ve probably heard that young investors are better off contributing to a Roth IRA because they’ll likely be in a higher tax bracket when they’re older. You’ve probably also heard that if you’re in the same tax bracket now and in retirement, a traditional IRA and Roth IRA will produce the same result.

These arguments are part of the conventional wisdom upon which many people make their decisions, and yet each misses some important nuance and, in some cases, is downright incorrect.

The Biggest Difference Between Traditional and Roth IRAs

There are several differences between traditional and Roth IRAs, and we’ll get into many of them below.

The key difference is in the tax breaks they offer.

Contributions to a traditional IRA are not taxed up front. They are tax-deductible, meaning they decrease your taxable income for the year in which you make the contribution. The money grows tax-free inside the account. However, your withdrawals in retirement are treated as taxable income.

Contributions to a Roth IRA are taxed up front at your current income tax rate. The money grows tax-free while inside the account. And when you make withdrawals in retirement, those withdrawals are not taxed.

Whether it’s better to get the tax break when you make the contribution or when you withdraw it in retirement is the centerpiece of the traditional vs. Roth IRA debate, and it’s also where a lot of people use some faulty logic.

We’ll debunk the conventional wisdom in just a bit, but first we need to take a very quick detour to understand a couple of key tax concepts.

The Important Difference Between Marginal and Effective Tax Rates

Don’t worry. We’re not going too far into the tax weeds here. But there’s a key point that’s important to understand if you’re going to make a true comparison between traditional and Roth IRAs, and that’s the difference between your marginal tax rate and your effective tax rate.

When people talk about tax rates, they’re typically referring to your marginal tax rate. This is the tax rate you pay on your last dollar of income, and it’s the same as your current tax bracket. For example, if you’re in the 15% tax bracket, you have a 15% marginal tax rate, and you’ll owe 15 cents in taxes on the next dollar you earn.

Your effective tax rate, however, divides your total tax bill by your total income to calculate your average tax rate across every dollar you earned.

And these tax rates are different because of our progressive federal income tax, which taxes different dollars at different rates. For example, someone in the 15% tax bracket actually pays 0% on some of their income, 10% on some of their income, and 15% on the rest of their income. Which means that their total tax bill is actually less than 15% of their total income.

For a simple example, a 32-year-old couple making $65,000 per year with one child will likely fall in the 15% tax bracket. That’s their marginal tax rate.

But after factoring in our progressive tax code and various tax breaks like the standard deduction and personal exemptions, they will only actually pay a total of $4,114 in taxes, making their effective tax rate just 6.33% (calculated using TurboTax’s TaxCaster).

As you can see, the couple’s effective tax rate is much lower than their marginal tax rate. And that’s almost always the case, no matter what your situation.

Keep that in mind as we move forward.

Why the Conventional Traditional vs. Roth IRA Wisdom Is Wrong

Most of the discussion around traditional and Roth IRAs focuses on your marginal tax rate. The logic says that if your marginal tax rate is higher now than it will be in retirement, the traditional IRA is the way to go. If it will be higher in retirement, the Roth IRA is the way to go. If your marginal tax rate will be the same in retirement as it is now, you’ll get the same result whether you contribute to a traditional IRA or a Roth IRA.

By this conventional wisdom, the Roth IRA typically comes out ahead for younger investors who plan on increasing their income over time and therefore moving into a higher tax bracket or at least staying in the same tax bracket.

But that conventional wisdom is flawed.

When you’re torn between contributing to a traditional or Roth IRA, it’s almost always better to compare your marginal tax rate today to your effective rate in retirement, for two reasons:

  1. Your traditional IRA contributions will likely provide a tax break at or near your marginal tax rate. This is because federal tax brackets typically span tens of thousands of dollars, while your IRA contributions max out at $5,500 for an individual or $11,000 for a couple. So it’s unlikely that your traditional IRA contribution will move you into a lower tax bracket, and even if it does, it will likely be only a small part of your contribution.
  2. Your traditional IRA withdrawals, on the other hand, are very likely to span multiple tax brackets given that you will likely be withdrawing tens of thousands of dollars per year. Given that reality, your effective tax rate is a more accurate representation of the tax cost of those withdrawals in retirement.

And when you look at it this way, comparing your marginal tax rate today to your effective tax rate in the future, the traditional IRA starts to look a lot more attractive.

Let’s run the numbers with a case study.

A Case Study: Should Mark and Jane Contribute to a Traditional IRA or a Roth IRA?

Mark and Jane are 32, married, and have a 2-year-old child. They currently make $65,000 per year combined, putting them squarely in the 15% tax bracket.

They’re ready to save for retirement, and they’re trying to decide between a traditional IRA and a Roth IRA. They’ve figured out that they can afford to make either of the following annual contributions:

  • $11,000 to a traditional IRA, which is the annual maximum.
  • $9,350 to a Roth IRA, which is that same $11,000 contribution after the 15% tax cost is taken out. (Since Roth IRA contributions are nondeductible, factoring taxes into the contribution is the right way to properly compare equivalent after-tax contributions to each account.)

So the big question is this: Which account, the traditional IRA or Roth IRA, will give them more income in retirement?

Using conventional wisdom, they would probably contribute to the Roth IRA. After all, they’re young and in a relatively low tax bracket.

But Mark and Jane are curious people, so they decided to run the numbers themselves. Here are the assumptions they made in order to do that:

  • They will continue working until age 67 (full Social Security retirement age).
  • They will continue making $65,000 per year, adjusted for inflation.
  • They will receive $26,964 per year in Social Security income starting at age 67 (estimated here).
  • They will receive an inflation-adjusted investment return of 5% per year (7% return minus 2% inflation).
  • At retirement, they will withdraw 4% of their final IRA balance per year to supplement their Social Security income (based on the 4% safe withdrawal rate).
  • They will file taxes jointly every year, both now and in retirement.

You can see all the details laid out in a spreadsheet here, but here’s the bottom line:

  • The Roth IRA will provide Mark and Jane with $35,469 in annual tax-free income on top of their Social Security income.
  • The traditional IRA will provide $37,544 in annual after-tax income on top of their Social Security income. That’s after paying $4,184 in taxes on their $41,728 withdrawal, calculating using TurboTax’s TaxCaster.

In other words, the traditional IRA will provide an extra $2,075 in annual income for Mark and Jane in retirement.

That’s a nice vacation, a whole bunch of date nights, gifts for the grandkids, or simply extra money that might be needed to cover necessary expenses.

It’s worth noting that using the assumptions above, Mark and Jane are in the 15% tax bracket both now and in retirement. According to the conventional wisdom, a traditional IRA and Roth IRA should provide the same result.

But they don’t, and the reason has everything to do with the difference between marginal tax rates and effective tax rates.

Right now, their contributions to the traditional IRA get them a 15% tax break, meaning they can contribute 15% more to a traditional IRA than they can to a Roth IRA without affecting their budget in any way.

But in retirement, the effective tax rate on their traditional IRA withdrawals is only 10%. Due again to a combination of our progressive tax code and tax breaks like the standard deduction and personal exemptions, some of it isn’t taxed, some of it is taxed at 10%, and only a portion of it is taxed at 15%.

That 5% difference between now and later is why they end up with more money from a traditional IRA than a Roth IRA.

And it’s that same unconventional wisdom that can give you more retirement income as well if you plan smartly.

5 Good Reasons to Use a Roth IRA

The main takeaway from everything above is that the conventional traditional versus Roth IRA wisdom is wrong. Comparing marginal tax rates typically underestimates the value of a traditional IRA.

Of course, the Roth IRA is still a great account, and there are plenty of situations in which it makes sense to use it. I have a Roth IRA myself, and I’m very happy with it.

So here are five good reasons to use a Roth IRA.

1. You Might Contribute More to a Roth IRA

Our case study above assumes that you would make equivalent after-tax contributions to each account. That is, if you’re in the 15% tax bracket, you would contribute 15% less to a Roth IRA than to a traditional IRA because of the tax cost.

That’s technically the right way to make the comparison, but it’s not the way most people think.

There’s a good chance that you have a certain amount of money you want to contribute and that you would make that same contribution to either a traditional IRA or a Roth IRA. Maybe you want to max out your contribution and the only question is which account to use.

If that’s the case, a Roth IRA will come out ahead every time simply because that money will never be taxed again.

2. Backdoor Roth IRA

If you make too much to either contribute to a Roth IRA or deduct contributions to a traditional IRA, you still might be eligible to do what’s called a backdoor Roth IRA.

If so, it’s a great way to give yourself some extra tax-free income in retirement, and you can only do it with a Roth IRA.

3. You Might Have Other Income

Social Security income was already factored into the example above. But any additional income, such as pension income, would increase the cost of those traditional IRA withdrawals in retirement by increasing both the marginal and effective tax rate.

Depending on your other income sources, the tax-free nature of a Roth IRA may be helpful.

4. Tax Diversification

You can make the most reasonable assumptions in the world, but the reality is that there’s no way to know what your situation will look like 30-plus years down the road.

We encourage people to diversify their investments because it reduces the risk that any one bad company could bring down your entire portfolio. Similarly, diversifying your retirement accounts can reduce the risk that a change in circumstances would result in you drastically overpaying in taxes.

Having some money in a Roth IRA and some money in a traditional IRA or 401(k) could give you room to adapt to changing tax circumstances in retirement by giving you some taxable money and some tax-free money.

5. Financial Flexibility

Roth IRAs are extremely flexible accounts that can be used for a variety of financial goals throughout your lifetime.

One reason for this is that your contributions are available at any time and for any reason, without tax or penalty. Ideally you would be able to keep the money in your account to grow for retirement, but it could be used to buy a house, start a business, or simply in case of emergency.

Roth IRAs also have some special characteristics that can make them effective college savings accounts, and as of now Roth IRAs are not subject to required minimum distributions in retirement, though that could certainly change.

All in all, Roth IRAs are more flexible than traditional IRAs in terms of using the money for nonretirement purposes.

3 Good Reasons to Use a Traditional IRA

People love the Roth IRA because it gives you tax-free money in retirement, but, as we saw in the case study above, that doesn’t always result in more retirement income. Even factoring in taxes, and even in situations where you might not expect it, the traditional IRA often comes out ahead.

And the truth is that there are even MORE tax advantages to the traditional IRA than what we discussed earlier. Here are three of the biggest.

1. You Can Convert to a Roth IRA at Any Time

One of the downsides of contributing to a Roth IRA is that you lock in the tax cost at the point of contribution. There’s no getting that money back.

On the other hand, contributing to a traditional IRA gives you the tax break now while also preserving your ability to convert some or all of that money to a Roth IRA at your convenience, giving you more control over when and how you take the tax hit.

For example, let’s say that you contribute to a traditional IRA this year, and then a few years down the line either you or your spouse decides to stay home with the kids, or start a business, or change careers. Any of those decisions could lead to a significant reduction in income, which might be a perfect opportunity to convert some or all of your traditional IRA money to a Roth IRA.

The amount you convert will count as taxable income, but because you’re temporarily in a lower tax bracket you’ll receive a smaller tax bill.

You can get pretty fancy with this if you want. Brandon from the Mad Fientist, has explained how to build a Roth IRA Conversion Ladder to fund early retirement. Financial planner Michael Kitces has demonstrated how to use partial conversions and recharacterizations to optimize your tax cost.

Of course, there are downsides to this strategy as well. Primarily there’s the fact that taxes are complicated, and you could unknowingly cost yourself a lot of money if you’re not careful. And unlike direct contributions to a Roth IRA, you have to wait five years before you’re able to withdraw the money you’ve converted without penalty. It’s typically best to speak to a tax professional or financial planner before converting to a Roth IRA.

But the overall point is that contributing to a traditional IRA now gives you greater ability to control your tax spending both now and in the future. You may be able to save yourself a lot of money by converting to a Roth IRA sometime in the future rather than contributing to it directly today.

2. You Could Avoid or Reduce State Income Tax

Traditional IRA contributions are deductible for state income tax purposes as well as federal income tax purposes. That wasn’t factored into the case study above, but there are situations in which this can significantly increase the benefit of a traditional IRA.

First, if you live in a state with a progressive income tax code, you may get a boost from the difference in marginal and effective tax rates just like with federal income taxes. While your contributions today may be deductible at the margin, your future withdrawals may at least partially be taxed at lower rates.

Second, it’s possible that you could eventually move to a state with either lower state income tax rates or no income tax at all. If so, you could save money on the difference between your current and future tax rates, and possibly avoid state income taxes altogether. Of course, if you move to a state with higher income taxes, you may end up losing money on the difference.

3. It Helps You Gain Eligibility for Tax Breaks

Contributing to a traditional IRA lowers what’s called your adjusted gross income (AGI), which is why you end up paying less income tax.

But there are a number of other tax breaks that rely on your AGI to determine eligibility, and by contributing to a traditional IRA you lower your AGI you make it more likely to qualify for those tax breaks.

Here’s a sample of common tax breaks that rely on AGI:

  • Saver’s credit – Provides a tax credit for people who make contributions to a qualified retirement plan and make under a certain level of AGI. For 2017, the maximum credit is $2,000 for individuals and $4,000 for couples.
  • Child and dependent care credit – Provides a credit of up to $2,100 for expenses related to the care of children and other dependents, though the amount decreases as your AGI increases. Parents with young children in child care are the most common recipients of this credit.
  • Medical expense deduction – Medical expenses that exceed 10% of your AGI are deductible. The lower your AGI, the more likely you are to qualify for this deduction.
  • 0% dividend and capital gains tax rate – If you’re in the 15% income tax bracket or below, any dividends and long-term capital gains you earn during the year are not taxed. Lowering your AGI could move you into this lower tax bracket.

Making a Smarter Decision

There’s a lot more to the traditional vs. Roth IRA debate than the conventional wisdom would have you believe. And the truth is that the more you dive in, the more you realize just how powerful the traditional IRA is.

That’s not to say that you should never use a Roth IRA. It’s a fantastic account, and it certainly has its place. It’s just that the tax breaks a traditional IRA offers are often understated.

It’s also important to recognize that every situation is different and that it’s impossible to know ahead of time which account will come out ahead. There are too many variables and too many unknowns to say for sure.

But with the information above, you should be able to make a smarter choice that makes it a little bit easier to reach retirement sooner and with more money.

Matt Becker
Matt Becker |

Matt Becker is a writer at MagnifyMoney. You can email Matt at matt@magnifymoney.com

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Life Events

Term vs Whole Life Insurance

The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities.

Term vs Whole Life Insurance

If you’re shopping for life insurance, there are two main types you’ll likely encounter: term life insurance and whole life insurance.

Depending on who you talk to, you’ll hear different arguments for and against both types, which can make it difficult to figure out which type of life insurance will provide the right protection for you and your family.

This guide breaks it all down so that you can make the best decision for your specific situation.

What Is the Purpose of Life Insurance?

Before getting into the debate over term versus whole life insurance, let’s take a step back and remind ourselves why life insurance is important to begin with.

While there are some rare exceptions, life insurance primarily serves one main purpose: to provide financial protection to people who are financially dependent upon you.

In other words, life insurance makes sure that there will always be money available for the people who depend on you financially, even if you’re no longer there to provide for them.

A good example of this is a couple with young children. A toddler obviously cannot support herself financially, and life insurance makes sure that there would be financial resources to care for her no matter what happens to the parents.

Other examples of financial dependents might include a spouse who would struggle to handle all the bills on his or her own, or parents who have co-signed for your student loans.

So before you start thinking about which type of life insurance you need, ask yourself the following two questions to better understand why you’re getting life insurance at all:

  1. Is there anyone who would struggle financially without your support? If not, you probably don’t need life insurance.
  2. If so, for how long will they be dependent upon you? Is it a fixed time period or is it relatively permanent?

Your answers to those questions will help you sort through the term versus whole life insurance debate with a clearer, more personal viewpoint.

The Basics of Term Life Insurance

Term life insurance is coverage that lasts for a set amount of time, typically 5-30 years. Once that period is up, the policy expires and your coverage ends.

That expiration may sound like a problem, but it’s actually similar to most other types of insurance. Things like auto insurance and homeowners insurance are typically annual policies that have to be renewed each year, and you would cancel your coverage if you no longer had a need. Similarly, term life insurance is meant to provide coverage only for as long as you actually need it.

Let’s look at the pros and cons.

The Benefits of Term Life Insurance

It’s Inexpensive

Term life insurance is typically the most cost-effective way to get the protection you need. In fact, it’s often 10 times less expensive than whole life insurance for the same amount of coverage, especially if you’re relatively young and healthy.

The main reason for the price difference is that term life insurance eventually expires, meaning it has a smaller chance of paying out. And again, that may look like a downside, but…

The Coverage Period Lines Up with Your Need

Most people only have a temporary need for life insurance. Your kids will eventually grow up and be self-sufficient. Your spouse can eventually rely on retirement savings and Social Security income. Your joint debt will eventually be paid off.

Term life insurance provides financial protection for the amount of time that you need it and no more. You should hope it doesn’t pay out, because that just means that you didn’t die early. Like your car insurance, it’s good to have in case of an emergency, but the best case scenario is never having to file a claim.

In addition, if for some reason your situation changes and you no longer need life insurance, you can simply cancel your term life insurance policy and be done with it. Again, it’s coverage for as long as you need it and no more.

It’s Easy to Shop Around

Term life insurance policies are fairly simple and therefore pretty generic. As long as you’re looking at insurance companies with a strong financial rating, you can largely shop on price alone.

My two favorite sites for comparison shopping for term life insurance policies are PolicyGenius and Term4Sale, both of which only list policies from reputable companies.

For example, using the Term4Sale quote engine, a 34-year-old nonsmoking male in New York City with “Preferred” health status could get a $1 million 30-year term life insurance policy for as little as $939.98 per year or as much as $1,255.30 per year. And again, because term life insurance is fairly generic, you can compare those premiums with the confidence that your policy would be just as good either way.

You Can Typically Convert to Whole Life

What happens if you end up needing life insurance coverage longer than you originally thought? Since term life insurance eventually runs out, wouldn’t that be a problem?

It is a risk, but most term life insurance policies allow you to convert your policy to whole life insurance without medical underwriting as long as you do it before the policy expires. Your premium would increase significantly upon such a conversion, reflecting the increased liability the insurance company is taking on by providing permanent coverage. And if for some reason your policy did require medical underwriting at the time of conversion, there would be the risk of an even bigger premium increase if your health has declined since you originally got the policy.

Not all policies have this conversion feature, but those that do remove the risk that you wouldn’t be able to get permanent coverage later on if you need it.

The Downsides of Term Life Insurance

It’s More Expensive as You Get Older

Term life insurance is typically inexpensive if you’re relatively young, but it gets more expensive as you get older, especially if you’re looking at policies with longer terms. And the reason is simply that your odds of dying increase as you age, which means the insurance company faces a bigger risk.

For example, a 54-year-old male looking for the same $1 million, 30-year term life insurance policy we mentioned above is looking at an annual premium of $5,894 to $6,780 per year.

If you’re in your 50s or above and looking for life insurance, a term policy may or may not end up being a cost-effective way to get it.

It May Not Last as Long as You Need

Life is hard to predict, and it’s certainly possible that you end up needing life insurance for longer than you originally expected. If that happens, your term life insurance policy likely won’t have a lot of flexibility that allows you to extend it, beyond converting it to whole life.

There are also some insurance needs for which permanent protection is simply better. Those are rare, but we’ll talk about them below.

The Basics of Whole Life Insurance

Whole life insurance has two primary features:

  1. It provides permanent coverage, meaning that it will never expire as long as you continue to pay the premiums.
  2. It includes a savings component that builds up over time and can eventually be used for a variety of purposes.

There are several types of whole life insurance that have slightly different features and serve different purposes, like universal life insurance, variable life insurance, and equity-indexed life insurance. For the purposes of this article we’ll focus on the basic whole life insurance that most people will come across, and for the most part, all of the following pros and cons would apply no matter which type you’re talking about.

The Benefits of Whole Life Insurance

It Can Handle a Permanent Need

If you have a permanent or indefinite need for life insurance, whole life insurance is the way to get it.

For example, if you have a child with special needs who will likely be dependent upon others for his or her entire life, whole life insurance may make sense. Or if you will have multiple millions of dollars to pass on to your heirs, whole life insurance can help with estate taxes and preserve your family’s wealth.

Most people don’t have these kinds of permanent needs, but if you do, then whole life insurance can be valuable.

It Can Be a Form of Forced Savings

For people who struggle to consistently save money, whole life insurance can be a way to force yourself to build long-term savings while also providing financial protection.

It may not be the most efficient savings account, as we’ll talk about below, but having some savings is better than having none, and the savings you do accumulate can be withdrawn for any reason. Taxes are also deferred while the money is inside the account, which can be a benefit for high-income earners who have already maxed out their other tax-advantaged savings accounts.

It’s Can Be Structured to Meet Your Goals

If you work with a life insurance professional who really knows what they’re doing, you can specially structure a whole life insurance policy to serve specific purposes.

For example, if your main goal is permanent life insurance protection, you can structure it to minimize the savings component and make that protection as cheap as possible. If your main goal is to build savings, you can structure it to minimize other costs and front-load your contributions to grow your savings as quickly as possible.

If you can find a life insurance agent who’s willing to work with you in a fiduciary capacity, meaning they put your interests ahead of their own, you can get fairly creative and structure your whole life insurance policy to meet your specific needs.

The Downsides of Whole Life Insurance

It’s Expensive

Whole life insurance is an expensive way to get the financial protection you need. For example, remember the 34-year-old male who would pay $939.98 per year for a $1 million 30-year term life insurance policy? According to LLIS, a team of independent insurance advisers, a $1 million whole life insurance policy for the same individual would be $11,240 per year. That’s 12 times more expensive for the same amount of coverage. (Though, to be fair, for a longer coverage period.)

There are also a lot of hidden fees that add to the cost, from the sizable commission paid to the agent who sells you the policy to the management fees associated with the policy’s savings account.

Unless you truly have a permanent need for coverage, whole life insurance is probably not the most cost-effective way to get it.

Most People Don’t Have a Permanent Need

The simple fact is that most people don’t have a need for permanent life insurance coverage. As your children age and your savings grow, the financial impact of your death decreases until there’s little to no risk.

It might be nice to know that whole life insurance will eventually pay out, but is that something you need? And if not, is it worth paying those big premiums over all those years instead of putting that money elsewhere?

Don’t be fooled into thinking that your insurance has to pay out for it to be valuable. If you don’t have the need for permanent coverage, you shouldn’t pay for it.

It’s Not an Efficient Savings Vehicle

The savings component of whole life insurance might sound attractive, but the truth is that it’s not an especially efficient way to save money.

It takes a long time for the cash value to build up. It’s often 7-10 years just to break even, and even over long periods of time in the best of circumstances the return is likely to be low.

Not only that, but withdrawals from your account are actually loans, meaning you’re typically charged interest for the right to use your own money. Can you imagine if your savings account at the bank charged you interest each time you took money out?

Finally, unlike other savings accounts where you can simply decide to pause or decrease your contributions for a while if you hit a rough patch, your whole life insurance premiums are due like clockwork no matter what. Your policy can lapse if you fail to pay your premiums, losing you both the protection you need and the savings you’ve built up.

The truth is that unless you’ve already maxed out all your other tax-advantaged savings accounts — like your 401(k), IRAs, health savings accounts, and 529 accounts — the tax benefits of saving within a life insurance policy likely aren’t worth it. And even then you may be better off using a taxable brokerage account, depending on your specific goals and circumstances.

Which Type of Life Insurance Is Right for You?

If you’re purely looking for the financial protection that life insurance provides, and if your need is temporary, then term life insurance is likely the best option for you. It’s the cheapest way to get the protection you need, leaving more room in your budget for your other goals and obligations.

And for most people, quite honestly, that’s the end of the discussion. Most people don’t have a need for permanent coverage and will be better off putting their savings elsewhere, like regular savings accounts for short-term needs and dedicated retirement accounts for long-term investments.

But there are a few situations in which some kind of whole life insurance can make sense.

If you have a truly permanent need for life insurance, such as a child with long-term special needs, then a whole life insurance policy specially designed to provide the protection you need at the lowest cost possible may be well worth it.

And if your income is very high and you’re already maxing out all other tax-advantaged investment accounts, a whole life insurance policy can be a way to get some additional tax-deferred savings. Again, you’d ideally want it to be specially designed to minimize fees and maximize the amount that goes toward savings.

In any case, remember to focus on the reason why you’re getting life insurance in the first place and to make decisions around that need. The right type of life insurance will likely be pretty clear as long as you keep your personal goals at the forefront.

Matt Becker
Matt Becker |

Matt Becker is a writer at MagnifyMoney. You can email Matt at matt@magnifymoney.com

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Student Loan Consolidation vs. Student Loan Refinancing

The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities.

Student Loan Consolidation vs. Student Loan Refinancing

I haven’t met a single person with student loans who doesn’t want them gone as soon as possible. It’s hard enough to start a career or raise a family, and when a large chunk of your income is going toward student loans every month, it can feel downright impossible.

To help ease the burden of student loan payments, many borrowers opt to consolidate or refinance their student loans. Both options have the potential to help you pay your student loans off quicker and pay less interest along the way, but there’s a lot of confusion around how they work, how they differ, and whether they’re right for you.

By the end of this post you will understand both options and have a good idea whether one, or both, are right for you.

The terms student loan consolidation and student loan refinancing are often used interchangeably, but they actually mean two very different things, and they have very different sets of pros and cons. Lenders often add to the confusion by using the term consolidation when they’re actually talking about refinancing.

So before we dive into the specifics of each option, let’s first clear up what they are.

Student Loan Consolidation: The Basics

Student loan consolidation refers specifically to the federal student loan consolidation program, a process through which you can combine one or more federal student loans into a single Direct Consolidation Loan. You cannot use this program with private student loans. Refinancing, on the other hand, is done by private lenders. Unless you’re dealing directly with the U.S. Department of Education, you’re talking about refinancing, not consolidation.

We’ll get into the details below, but the primary reason to consolidate your federal student loans is to qualify for beneficial income-driven repayment plans you wouldn’t otherwise be eligible for. And the major downside is simply that consolidating won’t get you a lower interest rate, which is often a big point of confusion.

The Benefits of Student Loan Consolidation

Given that consolidation won’t improve your interest rate, why should you consider consolidating your federal student loans? How can it benefit you?

Here are three of the biggest reasons to consider consolidating your federal student loans.

1. You can qualify for better income-driven repayment plans

The government offers a number of income-driven repayment plans for federal student loans, and these plans are a real bargain for three main reasons:

  1. Your monthly payment is determined by your income, which means it will decrease during periods where your income is low.
  2. They all offer some kind of forgiveness as long as you make the required payments for a certain number of years.
  3. If you work for a qualifying nonprofit or government organization, these repayment plans qualify you for Public Service Loan Forgiveness, which takes even less time and offers more forgiveness.

The catch is that only Direct federal student loans are eligible for some of these repayment plans. Federal Family Education Loans (FFEL), which were all given out prior to 2010, are only eligible for income-based repayment (IBR), which is certainly good but often not as beneficial as Pay As You Earn (PAYE) or Revised Pay As You Earn (REPAYE).

So, if you would otherwise be eligible for those better repayment plans, you can consolidate your FFEL loans and turn them into Direct Loans, thereby opening up your eligibility. And keep in mind that you can consolidate a single loan all on its own, so you don’t need multiple FFEL loans to take advantage of this.

If you wouldn’t otherwise be eligible for those repayment plans, or if you already only have Direct Loans, then consolidation won’t help you here.

2. You can lock in low, fixed interest rates

Prior to July 1, 2006, most federal student loans were issued with variable interest rates that reset each year. Since then, all federal student loans have been issued with fixed interest rates.

If you have older loans with variable rates, consolidating them now can lock in a relatively low, fixed interest rate.

For example, according to Nelnet, variable rate federal student loans currently have interest rates ranging from 2.05% to 3.80%, depending on the type of loan and year of disbursement. By consolidating and locking in those low rates, you can ensure that your loans won’t get more expensive over time if interest rates rise.

3. You can get your loans out of default

If your federal student loans are in default, which typically means that you have missed payments for 270 days, you can consolidate your loans to get out. This can be an incredibly effective way to avoid the negative consequences of default, such as your loan immediately being due in full, taxes and wages potentially be garnished, and a big hit to your credit report, among others.

The catch is you can typically only use it once in your lifetime. So you should be confident that you won’t default again in the near future before proceeding. Otherwise, you may want to consider alternative ways to get out of default, such as rehabilitation.

The Downsides of Student Loan Consolidation

While all of the above are good reasons to consider consolidating your federal student loans, here are four things to watch out for.

1. You Won’t Get a Better Interest Rate

Consolidating your federal student loans won’t improve your interest rate. In fact, it’s likely that your interest rate will increase by just a tiny bit.

When you consolidate, the interest rate of your new loan is the weighted average of all of the loans included in the consolidation, rounded up to the nearest ? percent. What that means is that at best you’ll end up with the same combined interest rate that you had before, and at worst your interest rate will increase by about 0.125%.

You can use the following calculator to see what your interest rate would be after consolidation: FinAid Loan Consolidation Calculator

FinAid Loan Consolidation Calculator

The bottom line, though, is that student loan consolidation is NOT a route to a better interest rate. You need to refinance if that’s what you’re after, and we’ll talk more about that below.

2. You won’t be able to target your highest interest loans first

If you have two federal student loans with very different interest rates, you can pay them off faster and save yourself money by putting extra payments toward the loan with the higher interest rate first. But if you consolidate those two loans together, you end up with a blended interest rate and lose the ability to pay off the higher-interest loan quicker.

In this type of situation, it can make a lot of sense to consolidate those loans separately. Doing so would preserve the condition of having one high-interest rate loan and one low-interest rate loan, and would therefore allow you to keep prioritizing the high-interest rate loan.

3. You’ll lose any progress you’ve made toward qualifying for loan forgiveness

One of the benefits of enrolling in an income-driven repayment plan is the opportunity to have some of your student loan balance forgiven. Basically, with each plan you have to both be enrolled in the plan and make your minimum payment for a certain number of years. If you still have a balance at that point, it will be forgiven.

Here’s a quick overview of how long it takes to earn forgiveness with each repayment plan:

  • Income-Based Repayment = 20-25 years
  • Pay As You Earn = 20 years
  • Revised Pay As You Earn = 20-25 years
  • Public Service Loan Forgiveness = 10 years

Keep in mind that Public Service Loan Forgiveness is the only program that offers tax-free forgiveness. In all other cases, the amount of money forgiven would be considered taxable income.

If you’re already enrolled in an income-driven repayment plan and have made progress toward forgiveness, consolidating your loan means you’re likely starting over from scratch.

Depending on how much progress you’ve already made, and whether you could qualify for quicker forgiveness after consolidating, this might be a reason to avoid it.

4. Watch out for Parent PLUS loans!

Parent PLUS loans are federal student loans taken out by parents, and they are not eligible for the most generous income-driven repayment plans, even after consolidation.

What that means is that you need to be very careful NOT to mix Parent PLUS loans with other loans when consolidating. You should always consolidate them separately, if at all, to make sure that your other federal student loans remain eligible for the best income-driven repayment plans.

When Student Loan Consolidation Makes Sense

In general, federal student loan consolidation can make a lot of sense when you have one or more FFEL loans and your debt-to-income ratio is high, meaning you stand to significantly benefit from one of the more generous income-driven repayment plans.

It may also make sense if you have older, high-interest, variable rate loans and want to lock in a low, fixed interest rate.

Just be careful not to mix high-interest loans with low-interest loans, and not to consolidate Parent PLUS loans with other student loans. And make sure you’re not giving up on significant progress you’ve already made toward forgiveness on your current loans.

How to Consolidate Your Student Loans

If you’d like to consolidate your federal student loans, you can start the process here: Direct Consolidation Loan Application.

Student Loan Refinancing: The Basics

Student loan refinancing refers to the process of taking out a new private student loan to replace one or more existing student loans. You can refinance both federal student loans and private student loans, and there are specific pros and cons to each that we’ll talk about below.

The Benefits of Student Loan Refinancing

1. You can get a lower interest rate

The main reason to consider refinancing your student loans is the opportunity to lower your interest rate. A lower interest rate likely means lower monthly payments, a lower lifetime cost, and a quicker path to being debt-free.

Of course, refinancing doesn’t guarantee a lower interest rate. You still have to go through an approval process, during which the lender will evaluate your financial situation and offer you a loan, or not, based on the information they find. Some people go through this process only to get an offer that’s worse, or at least not much better, than the loans they already have.

The people who are most likely to get a better interest rate than what they have now are people who:

  1. Have high-interest rate student loans, and
  2. Have a credit score that’s significantly higher than when they took out their current loans.

If that’s the situation you’re in, you may benefit significantly from refinancing.

2. You may find a new private loan with better protections than your old private loans

For many years, most private student lenders offered very few protections to their borrowers. For the most part you had to make every payment on time and in full or you were in real trouble.

But that’s started to change. Newer lenders like SoFi and CommonBond have started offering greater protections, such as unemployment protection where your payments are forgiven during periods of unemployment, and disability protection where payments are forgiven during disability.

If you have older private student loans, refinancing may offer greater security. Every lender is different though, so you should carefully read the terms and conditions and compare each offer to see what kinds of protections are available to you.

The Downsides of Student Loan Refinancing

As tempting as it is to grab that lower interest rate, there are some big potential downsides to refinancing your student loans that need to be considered.

Here are four of the biggest.

1. You may lose federal student borrower protections

Refinancing your federal student loans is a big decision that needs to be made very carefully. You’re giving up a lot in the refinancing process, and in some cases you’re better off with the protections offered by federal student loans than you are with a lower interest rate.

Despite some improvements to borrower protections, private student loans still offer significantly fewer protections than federal student loans. Specifically:

  • They are not eligible for income-driven repayment plans
  • They do not offer the opportunity for forgiveness
  • They do not offer deferment
  • Many still do not offer things like unemployment or disability protection

2. Variable rates can be a tease

Some lenders will offer an incredibly low interest rate to entice you to refinance without emphasizing that the rate is variable and that it can change in the future.

If you have the money to pay your loans off quickly, taking advantage of a teaser rate like this can be a good idea. But if it will be a while before your loans are paid off, you should be careful about signing up for a variable interest rate loan that you may not be able to afford several years down the line.

3. Fees could eat away at your potential savings

Some lenders will charge application fees, origination fees, prepayment fees, and all kinds of other fees that can really add to the cost of the loan.

Just keep an eye out for fees when reviewing your refinance options. The more you have to pay, the less attractive that lower interest rate will be.

4. It could take you longer to pay off your loan

In some cases, refinancing will extend your loan repayment period. This may feel like a win given that it lowers your monthly payment, but it can end up costing you more over the long term, even with a lower interest rate.

When Student Loan Refinancing Makes Sense

So, when should you refinance your student loans and when should you take a different route?

In most cases, the answer is pretty simple if you’re talking about refinancing your private student loans. If you can get a better interest rate by refinancing, it will usually make sense to do it. You should always compare all the details of the loans, including the protections they offer and other fees involved. But given that lenders have generally improved their standards over the past few years, it will usually make sense to refinance your private student loans to get a better interest rate.

It’s a lot more complicated if you’re considering refinancing your federal student loans. You shouldn’t give up those protections lightly, especially if your budget is tight and any change in your situation might make it difficult to afford your payments.

Generally, refinancing your federal student loans makes the most sense if you meet all of the following four conditions:

  1. You have high-interest federal student loans
  2. You have excellent credit that will qualify you for the best refinancing deals
  3. You have a high, stable income that makes it unlikely you’ll run into trouble paying off the loan
  4. You don’t qualify for Public Service Loan Forgiveness

If that’s you, then refinancing can be a great move. Qualifying for a lower interest rate could help you pay your loans off sooner, and you have little risk of running into financial trouble.

If that’s not you, you may be better off sticking with your federal student loans, even at a higher interest rate.

Where to Find the Best Student Loan Refinancing Deals

It always makes sense to shop around before making any decision to refinance, just to see what offers are available and how they compare. You can look at interest rates, borrower protections, application fees, and other requirements, and even get pre-approval from certain companies.

MagnifyMoney has a comprehensive page that makes it easy to compare many of the leading lenders and get a sense of what’s available to you.

Here are our top three picks. Each of these lenders has earned an A+ MagnifyMoney transparency score for excellent transparency and ease of use.

SoFi:

  • No origination fee or prepayment fee
  • Fixed interest rates range from 3.35% to 7.125%, and variable interest rates range from 2.815% to 6.740%
  • Flexible repayment terms
  • Strong borrower protections relative to other private lenders

Earnest:

  • No origination fee or prepayment fee
  • Fixed interest rates range from 3.35% to 6.39%, and variable interest rates range from 2.81% to 6.19%
  • Customizable loan terms where you choose the interest rate/length of loan combination
  • Unemployment protection

CommonBond:

  • No origination fee or prepayment fee
  • Fixed interest rates range from 3.37% to 7.74%, and variable interest rates range from 2.80% to 6.73%
  • No maximum loan amount and flexible loan terms

You can also check out your local credit unions, since they are member-owned and often offer loans with favorable terms and conditions.

Consolidation vs. Refinancing: Which One Is Right for You?

Student loan consolidation and student loan refinancing are very different processes with very different pros and cons. Each one can be the right choice, depending on your situation, and in some cases you may want to use both.

In the end, it’s all about your specific loans and the specific goals you’re trying to achieve. Use the information above to weigh pros and cons and make the right decision for yourself.

Matt Becker
Matt Becker |

Matt Becker is a writer at MagnifyMoney. You can email Matt at matt@magnifymoney.com

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The Basics of a Backdoor Roth IRA

The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities.

The Basics of a Backdoor Roth IRA

One of the nice things about making more money is that you have the opportunity to save more money.

But one of the downsides of making more money is that you eventually run into some restrictions on where you can save it.

Specifically, the IRS limits the amount you can contribute to a Roth IRA and the amount you can deduct for contributions to a Traditional IRA based on your income. Once your income reaches a certain point, those accounts are limited in their use.

However, there’s a loophole that can allow you to keep contributing to a Roth IRA no matter how much money you make.

It’s called the backdoor Roth IRA. Here’s how it works.

The Basics of a Backdoor Roth IRA

For 2017, Roth IRA contributions are not allowed once your modified adjusted gross income exceeds $196,000 for married couples, or $133,000 for single filers (source). And if you’re participating in an employer retirement plan like a 401(k), you would also be prohibited from deducting Traditional IRA contributions at that income level.

But there are two additional provisions that, when used together, can allow you to work around these limits:

  1. You’re allowed to make nondeductible contributions to an IRA no matter how much money you make.
  2. You’re allowed to convert money from a Traditional IRA to a Roth IRA no matter how much money you make.

So let’s say that between you and your spouse, you make more than the $196,000 limit for contributing to a Roth IRA. And let’s say that you also participate in a 401(k), meaning you can’t deduct Traditional IRA contributions.

Here are the workaround steps you could take to get money into a Roth IRA:

  1. Open a new Traditional IRA.
  2. Contribute to your new Traditional IRA. You won’t get a tax deduction for the contribution, but as you’ll soon see, that won’t matter.
  3. Wait until you receive your first statement from your new Traditional IRA, which should be in about one month. There is some disagreement around how long you should wait, but one month seems to be a fairly safe bet.
  4. Convert the money in your new Traditional IRA to a Roth IRA. Whichever company you have your IRA with can help you do this (it’s pretty straightforward).
  5. As part of the conversion you will be taxed on any growth that’s happened since contributing to the Traditional IRA, but since it’s only been a month or so, that should be minimal. You won’t be taxed on the amount you contributed, since that was already after-tax money.

And that’s how a backdoor Roth IRA works. And now that your money is inside a Roth IRA, you’ll eventually be able to withdraw it tax-free.

Of Course, There’s Always a Catch…

If you don’t have any existing Traditional IRAs, SEP IRAs, or SIMPLE IRAs, then it really is that simple. But if you do, there’s a big caveat you need to be aware of.

When you convert from a Traditional IRA to a Roth IRA, the IRS considers all of your IRAs to be part of one big pot, and it considers the money you convert to come proportionally from each part of that pot.

Here’s an example to show you what that means:

  • James has $20,000 in a Traditional IRA. All contributions to that IRA were deductible, so this money has never been taxed.
  • This year James makes too much to deduct contributions to a Traditional IRA, but he likes the idea of a backdoor Roth IRA. So he opens a new Traditional IRA, completely separate from his old one, and makes a $5,000 nondeductible contribution.
  • He converts the $5,000 in that new, nondeductible Traditional IRA to a Roth IRA.
  • From the perspective of the IRS, that $5,000 conversion was actually made from a single $25,000 IRA, even though James has two separate accounts.
  • Since 80% of James’ combined IRA money has never been taxed, 80% of his Roth IRA conversion will be taxed.
  • This means that $4,000 of James’ conversion will be taxed. Assuming James is in the 28% tax bracket, he will owe $1,120 on the conversion. And it may be more when you include state income taxes.

In other words, having an existing Traditional IRA that you’ve made deductible contributions to throws a big wrench in your plans to do the backdoor Roth IRA by subjecting a potentially significant portion of your conversion to taxes.

The Way Around the Catch

All hope is not lost. There’s a way to do the backdoor Roth IRA tax-free even if you have money in an existing Traditional IRA, SEP IRA, or SIMPLE IRA.

All you have to do is roll all of that existing IRA money into a 401(k) or other employer retirement plan BEFORE executing the backdoor Roth IRA. Then, when you convert your nondeductible contributions to a Roth IRA, there won’t be any other IRA money to look at and you’ll avoid the big tax hit.

Now, this may or may not be possible depending on your situation. First, you have to currently be participating in an employer retirement plan. And second, your plan has to accept rollovers from all of your existing IRAs, which they may or may not do. You can ask your employer for specific details.

It may also not be desirable for other reasons. Many 401(k)s are littered with high fees, and one of the advantages of having your money in an IRA is that you have much more control over both your investment options and how much you pay.

But if it’s allowed and if your 401(k) has reasonable investment options at a reasonable price, it can be a worthwhile move that frees you up to do the backdoor Roth IRA.

Tread Carefully

The backdoor Roth IRA is a legitimate tactic that’s used by a lot of people every single year.

But there are a number of moving parts and a number of potential hang-ups, so it makes sense to tread carefully and potentially even seek out the help of a professional before making any final moves. A financial planner could help you decide whether it’s the right move, and an accountant could help you navigate the tax issues.

Still, when it’s done right, a backdoor Roth IRA gives you access to a significant amount of tax-free money you wouldn’t have otherwise had.

Matt Becker
Matt Becker |

Matt Becker is a writer at MagnifyMoney. You can email Matt at matt@magnifymoney.com

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Hidden Fees That Could Ravage Your Investments

The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities.

Hidden Fees That Could Ravage Your Investments

Most of the time higher quality things cost more money. As the saying goes, “you get what you pay for.”

But the opposite is true when it comes to investing. Research has shown again and again that lower cost investments perform better. Quite simply, the less you pay, the more likely you are to get better returns.

And the great thing is that cost is one of the few investment variables you can really take charge of. You can’t control or predict how the markets will perform, but you can definitely control how much you pay to be in the market.

The bottom line is that finding lower cost investments is one of the easiest and most effective ways to increase your investment returns. Here’s how to do it.

Two Big Investment Costs to Watch Out For

For most people, the majority of their investment costs will come from the following two places. If you can minimize these two things, you’ll be in good shape.

1. Expense Ratio

Every mutual fund or exchange-traded fund (ETF) has something called an expense ratio, which is simply the annual cost of investing in the fund. That money is used to pay for the cost of managing and administrating the fund for you.

The expense ratio is charged as a percent of the money you have invested in the fund. So if a particular mutual fund has an expense ratio of 1%, that means that 1% of the money you have invested in that fund will be taken out as a fee each year.

And while 1% may not sound like much, it can add up to a huge difference over a long period of time. Assuming you contribute $5,500 per year and earn an 8% annual return, a 1% difference in fees will likely lead to more than a $100,000 difference in retirement savings over a 30-year period.

In other words, you’ll want to pay close attention to your expense ratios and minimize them as much as possible. Most good mutual funds these days have expense ratios of 0.2% or lower, though some specialized funds might go as high as 0.5%.

2. Sales Loads

Sales load is a fancy term for commission. It’s a percent of your investment that goes to the person who sold it to you.

For example, if you contribute $1,000 to a mutual fund that has a 5% sales load, only $950 will actually go into the fund. The other $50 will go to the person who sells you that mutual fund. And that will be true for every additional contribution you make to that fund in the future.

There are two big things to understand about sales loads:

  1. Not all mutual funds or ETFs have them. In fact, it’s pretty easy to avoid them.
  2. Research has shown that mutual funds with sales loads underperform those that don’t have them.

For those reasons, it will usually make sense to avoid mutual funds that have a sales load. There are simply better options out there.

Four Other Investment Costs to Watch Out For

While expense ratios and sales loads are the two biggest costs to watch out for, there are plenty more to keep an eye on. Here are four of the most common.

  1. Trading Fees

Depending on the company you use to do your investing, you may be charged a fee each time you buy or sell an investment. For example, E*TRADE currently charges $9.99 per ETF trade (with some exceptions) and between $0 and $19.99 for mutual fund trades.

And while that may not sound like much, it can add up pretty quickly. If you make monthly contributions to three ETFs, you’ll end up paying about $360 per year just for the privilege of contributing.

Of course, there are ways around this. For example, major investment companies like Vanguard, Schwab, and Fidelity allow you to trade their own funds for free. And many ETFs are commission-free on certain platforms. So there are plenty of ways to eliminate or at least minimize this cost.

  1. Taxes

If you’re investing in a retirement account like a 401(k) or IRA, you don’t need to worry about taxes until you start taking withdrawals.

But every trade within a taxable account is subject to potential taxes, and the more you trade, the more you may have to pay. And even if you never sell anything, the mutual funds you own will make trades, and those tax consequences will be passed on to you.

We all have to pay our fair share in taxes, but there’s no need to take on more than that. In general, the less often you trade, and the more tax-efficient your investments, the less you’ll have to pay in taxes.

  1. Management Fees

Whether you work with an investment adviser who manages your money for you or you invest through a company like Betterment, there’s a cost to having someone else in charge of your investments.

And while that cost can be worth it, make sure you know what you’re getting and that you’re not paying more than you should.

  1. Account Maintenance Fees

Some companies will charge you a monthly or annual fee simply for the service of providing you with an account.

These can often be avoided by meeting certain conditions. For example, Vanguard charges a $20 annual fee for IRAs, but it’s waived if you either sign up for e-delivery of statements or you have a certain total account balance with them.

In some cases, like with health savings accounts, a small maintenance fee might be unavoidable. But in most cases there’s no need to incur this kind of cost.

The Bottom Line: Lower Costs = Better Returns

Watching out for fees may sound kind of boring, but it’s one of the easiest and most effective ways to improve your investment returns.

Remember, not only does a smaller fee mean that more of your money is invested, but the research shows that lower cost investments actually perform better.

It’s a double win that you should definitely be taking advantage of.

Matt Becker
Matt Becker |

Matt Becker is a writer at MagnifyMoney. You can email Matt at matt@magnifymoney.com

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