How to Choose a Financial Adviser

adviserIf I were handing over my life’s savings to someone else to manage, I would like to know as much as I can about that individual and the company he or she works for. You should too. In the next few paragraphs, we will explore how to choose a financial adviser based on the issues that matter most. Thanks to modern technology, everyone has instant access to the greatest investigative tool on the planet, . . . the internet.

Every major financial services organization out there spends an incredible amount of money ($billions$) on marketing and sales training to make your decision about who to hire an emotional one rather than one based on facts and logic. Sales reps are trained to believe they have the very best products in the industry, that they have an incredible marketing and ethical edge on their competition, and an obligation to share this new-found opportunity with people they care about. First contacts (sometimes even before licensed) are always family, friends, neighbors, and church members. The company trains representatives to rely on the emotional bond with the prospect rather than the relative merits of the products or strategies they are pitching. The company trains “advisers” on how to build and manage relationships, gather assets, and sell products, not how to best serve their clients.

We all want to do business with people we know and trust. But there is nothing more disappointing than being misguided by a family member or close friend. If you want to be confident in your adviser decision, do your homework.

0805_fire-financial-advisor-salesman_340x340The first step is to check out your financial adviser. Regardless of how well you think you know the person or how reputable you think the firm is that he/she represents, you need to check them out before you commit. Obviously, he/she needs to have credentials or education that qualifies them for the work they are doing. The industry is awash with credentialing organizations whose primary business is making salesmen look like they know something. The most prevalent and reliable is the CFP designation. Even the CFP can be earned with a $2500 fee, six months study, and passing grade on the exam. A four year bachelor’s or advanced degree in finance from a credible institution plus extensive industry experience (ten years or more) is much better. Check out his or her standing in the industry (regulatory action, civil suits, jail time, firms he/she has associated with, etc.) at FINRA’s broker check. Don’t stop there. Do a local search in google by typing “adviser first and last name” + “your city and state” in the search window. If he/she has been around a while you should find lots of local references.

The next step is to check out the firm your adviser represents. Again, google is your best tool. Type “firm name” + litigation in the search window. Be prepared, almost every major name in the financial services industry is covered up with lawsuits. Their representatives are coached on how to field inquiries, but the fact remains that these suits are brought and judgments are levied because they are very likely breaking the laws that were put in place to protect you! Find out if they dual register their advisers as registered representatives and investment adviser representatives.

The root of most complaints is breach of trust. Someone you trust sells you something you don’t understand is not in your best interest. This occurs often due to the widespread practice of dual registration or the “hybrid RIA”. Big firms will try to make a distinction between the two as a smokescreen, but its still the conflict of interest that is at the core of the problem. A registered rep. or insurance agent is a salesman whose loyalty and obligation is to their employer. A Registered Investment Adviser has a legal fiduciary obligation to his/her client. Obviously, these are competing agendas. You can be an adviser or a salesman, but you can’t be both.

While the internet is a great investigative tool, you still have to exercise common sense and good judgement when evaluating information that you find. If you do a search on “hybrid RIA” or “dual registration”, you will find articles geared mostly toward advisers who are considering a career change. The industry promotes this business model very positively and makes it sound very attractive to recruits without setting off an alarm for other readers. However if you do a search on “suitability vs fiduciary” you will get a very different and more realistic view of how most firms abuse the law, claiming to adhere to a high standard of trust in order to lower the consumers guard when selling products.

upd_becomeaclientIf you want to work with a real adviser, someone who really does “have your back”, look for a fee-only Registered Investment Adviser.


ROTH The Magic of ROTH

Most folks who’ve heard of the ROTH IRA think they already know everything they need to know about it, i.e. “It’s boring and doesn’t deliver the immediate tax deferral of a 401k or traditional IRA.”  True, setting up a ROTH IRA won’t make anyone rich.   Like any other tool, it’s only as good as the strategy or plan behind it, which is why I’ve listed below some of the little-known features of the ROTH that make it a super-tool for building tax-free wealth. However, like any valuable tool, it’s how you implement these features that make it powerful! The key to realizing the benefits of a ROTH is to be intentional about strategy, design a plan that best suits each client, and remind them regularly how and why we did it.

  1. Anyone with earned income (adjusted gross income up to $181,000 for couples filing jointly or $129,000 for singles) can contribute to a ROTH even if you have a 401k or pension with your employer. This can be W2, 1099, or self-employment income.
  2. You can contribute 100% of earned income up to a maximum of $5,500 per year or $6,500 per year for anyone over age 50.
  3. A ROTH is an individual account, so the limits for a couple would be $11,000 and $13,000 per year respectively.
  4. Contributions are made with after tax income, so there is no immediate tax benefit. However, earnings from dividends, capital gains, and interest are tax free.
  5. You can continue to make contributions after age 70 ½  for as long as you have earned income. Contributions must stop at that age for traditional IRAs and as well as for other tax deferred accounts, such as 401k, Simple IRA, or SEP .
  6. There are no required minimum distributions at any age for a ROTH (for the original owner). You must begin taking required minimum distributions from a traditional IRA or other tax deferred accounts at age 70 ½.
  7. Earnings from interest, dividends, or capital gains are effectively tax free forever, even to heirs. Caveat – earnings distributed before age 59 ½ or earnings on assets in the account that are less than five years may be subject to a 10% early withdrawal penalty. However, all distributions are taken contributions first, so there is rarely a penalty assessed on any distributions.
  8. You and your heirs can take distributions from a ROTH tax-free and with no penalties at any age. Your designated beneficiary (if other than spouse) must take minimum distributions based on their life expectancy. Create a tax-free college (or any other use) fund for grandchildren. This can work for multiple heirs if structured properly.
  9. Distributions from ROTH accounts do not count against MAGI (modified adjusted gross income) for calculating taxes on Medicare surcharge tax (for higher wage earners, greater than $125k single or $250k married filing jointly) or Social Security income tax. This is a huge and very often overlooked benefit of ROTH IRAs. Not even tax-free municipal bonds provide this benefit.
  10. Any tax deferred retirement account (IRA, 401K, SEP, Simple, some other deferred comp plans) can be converted to a ROTH IRA. To convert an employer sponsored plan, the client must first be separated from the employer that sponsored the plan, then do a tax-free direct rollover to a traditional IRA. Any amounts transferred from a previous employer into a current employer-sponsored plan are eligible to be transferred out to a direct rollover IRA. Once the funds are in a rollover IRA, they can be converted and transferred to a ROTH account. Consolidating old employer-sponsored plans to a single IRA gives the investor more control and generally creates an opportunity to reduce costs from internal management fees. This intermediate step is not always required. It depends on the policies of the sending and receiving institutions. Once this is accomplished it’s generally better to convert the big IRA to a ROTH a little every year so as not to push the client to a higher tax bracket.

Illustration: A disciplined 45-year-old couple earning household income of $85,000 a year rolls a total of $200,000 in employer-deferred comp plans (401k) into two IRA accounts, then converts them to ROTH accounts over a five year period to minimize the tax consequences. This increased their effective tax rate from 8% to 14% for federal and state taxes for the five year conversion period.  Their effective tax rate is relatively low because they have significant mortgage interest and four dependent children. The total difference in tax liability experienced during the five year conversion period is $53,500. They paid $53,500 more in taxes during that time than they would have if they left the money in the traditional IRA.

  1. $85,000 x .08 = $6,800
  2. $125,000 x .14 = $17,500
  3. 5(17,500 – 6800) = $53,500

They paid the taxes due at conversion every year from funds outside the IRAs to avoid the 10% penalty for removing those funds before age 59 ½ and to leave more money inside the tax-free vehicle to compound over time. Neither of the clients have pensions, so they are depending exclusively on Social Security and distributions from retirement accounts to fund retirement. The couple decides to continue working and postpone filing for Social Security benefits until full retirement at age 66. The compound annualized growth rate (CAGR) for the S&P 500  over the past fifty years, adjusted for inflation, is 6.04%. Over the last ten years it has been 5.58%.

If we apply an inflation adjusted CAGR of 5% to the starting balance of $200,000, over the next 25 years they will have $677,271 when they begin retirement, assuming they make no further contributions. If they contribute $5000 each to their ROTH accounts every year until retirement, they will accumulate a total of $1,178,405. Keep in mind that these are inflation adjusted dollars. For the purpose of the illustration we will assume that the couple’s real earnings (adjusted for inflation) peak at $170,000 in household income at age 66 and base their Social Security income in retirement on that figure. Because we are using inflation adjusted dollars for everything else, we can use current estimates for household Social Security income in retirement. Estimated monthly household Social Security benefit in retirement is $2148 x 2 = $4296/month.

So…. let’s take a breath and see where we are. We know the following about our clients at age 66 and they are about to retire.

  1. They have a tax free retirement nest egg of $1,178,405.
  2. They have paid off their mortgage and no longer have kids to support or claim as dependents (fewer tax deductions).
  3. Medical expenses may be higher but are now subsidized by Medicare.
  4. Immediately before retirement, our couple has become accustomed to living on $170,000 annually net of federal, state, FICA taxes. FICA is 6.2%, effective combined fed and state is 22%. Total annual tax liability is 28.25%. Annual net is $121,975.
  5. Our couple is willing to make minor lifestyle adjustments to ensure that they don’t outlast their money and to leave a tax free legacy for their grandchildren. They decide they will find a way to live on $115,000 per year or $9,583/month.
  6. Our couple will be getting $4296 in social security benefits, so they will need to take $5287/month from their ROTH accounts. $9583 – $4296 = $5287.
  7. For simplicity, we will allow our couple a long and happy retirement. Simplified average life expectancy for men is age 83, for women is age 86. They both die in their sleep at age 85, enjoying 19 years doing all the things they dreamed of. . . . all tax-free.

Since ROTH distributions are tax free, they don’t count as income for Medicare surtax or federal income tax on Social Security income. Additionally, SS benefits are exempt from state income tax in Alabama.

If our couple had taken distributions from a traditional IRA or 401k, their effective tax rate on distributions would be 19.45% (higher than the 14% during conversion period) and 85% of Social Security income would be taxable at 14.45%. This would have created an annual tax liability of $19,557 or $379,183 over the entire 19 years of retirement. Our couple incurred a $53,500 tax expense during the IRA conversion period in order to save $379,183 in taxes during retirement.

Now, after 19 years of tax free retirement, our couple left a $988,171 tax free inheritance to two children and three grandchildren that did not count as part of the estate for gift tax exemption. While the beneficiaries will have to take RMDs (required minimum distributions) based on their life expectancy, it will be significantly less than the anticipated compounded annual growth rate of the accounts, particularly for the grandchildren.

This is only one illustration of the potential benefit of a ROTH IRA as a tool in retirement and estate planning. But of course, there are several obvious caveats:

  1. The clients must understand and adhere to the plan.
  2. There may be other strategies that are more appropriate in a given real case.
  3. We don’t know exactly what our Social Security or tax system will look like in 40 years, therefore any strategy must be adaptable to change.
  4. For simplicity, we didn’t include a comparison of after tax vs tax deferred annual contributions to ROTH vs traditional IRA accounts.

So here are the important takeaways:

Many of us and our clients will be responsible for funding our own retirement. Pensions are disappearing.

Many clients are likely to have a higher effective tax rate in retirement than while working, particularly early on in work life.

Most notable and often overlooked advantages of a ROTH are Social Security and estate tax exemption in retirement distribution and wealth transfer described above.


Not mentioned above, but clients with substantial carryover business or capital losses are exceptionally good candidates for ROTH conversion regardless of age.

All retirement accounts (including Roth, Traditional IRAs, SEP, Simple IRA, 401k, etc.) are simply containers for investments, not investments themselves. Mutual funds, annuities, and alternative investments can be held inside IRA accounts, but generally have fees, expenses, and lack of transparency that can significantly impact your return and the effectiveness of any strategy you use. Individual stocks, bonds, and other exchange traded securities, when properly deployed, provide the lowest cost and most effective investment vehicles.