Understanding Tail Risk and how to protect your investments

What is Tail Risk?

Tail Risk is the possibility of suffering large investment losses due to sudden and unforeseen events. The name tail risk comes from the shape of the bell curve. Under normal circumstances, your most likely investment returns will gravitate in the middle of the curve. For long term investors, this will represent your average expected return. The more extreme returns have a lower probability of occurring and will taper away toward the end of the curve.

The tail on the far-left side represents the probability of unexpected losses. The far-right represents the most extreme outcomes of substantial investment gains. For long-term investors, the ideal portfolio strategy will seek to minimize left tail risk without restricting the right tail growth potential.

Why is tail risk important?

Intuitively, we all want to be on the ride side of the bell curve. We want to achieve above-average returns and occasionally “hit the jackpot” with sizeable gains.

In real life, abrupt economic, social, and geopolitical events appear a lot more frequently than a rational human mind would predict. Furthermore, significant market shocks have been occurring about every three to five years resulting in “fatter” tails.

Also known as “Black Swans, they are rare and unique. These “one-off” events impose adverse pressure on your investment portfolio and create risk for outsized losses. Tail risk events bring a massive amount of financial and economic uncertainty and often lead to extreme turbulence on the stock market.

The Covid outbreak, Brexit, the European credit crisis, the collapse of Lehman Brothers, the Enron scandal, the US housing market downfall, and the 9/11 terrorist attacks are examples of idiosyncratic stock market shocks. Very few experts could have predicted them. More notably, they caused dramatic changes to our society and our economy, our consumer habits, and the way we conduct business.

Assessing your tail risk exposure

Retirees and those close to retirement, people who need immediate liquidity, executives, and employees holding a large amount of corporate stock are more susceptible to tail risk events. If you fall into one of these categories, you need to review your level of risk tolerance.

Investing is risky. There are no truly risk-free investments. There are only investments with different levels of risk. It is impossible to avoid risk altogether. The challenge for you is to have a reasonably balanced approach to all the risks you face. Ignoring one risk to help you prevent another risk does not mean you are in the clear.

Winners and losers

It is important to remember that every shock to the system leads to winners and losers. For example, the covid outbreak disproportionately hurt leisure, travel, retail, energy, and entertainment businesses. But it also benefited many tech companies as it accelerated the digital transformation. As bad as it was, the global financial crisis damaged many big and small regional banks. But it also opened the door for many successful fintech companies such as Visa, Mastercard, PayPal, and Square and exchange-traded fund managers like BlackRock and Vanguard. The aftermath of 9/11 drove the stock market down, but it led to a boost in defense and cybersecurity stocks.

Know your investments

The first step in managing your tail risk is knowing your investments. That is especially important if you have concentrated positions in a specific industry, a cluster of companies, or a single stock. Black Swan events could impact different stocks, sectors, and countries differently. For instance, the Brexit decision mostly hurt the performance of the UK and European companies and had no long-term effect on the US economy.

Know your investment horizon

Investors with a long-term investment horizon are more likely to withstand sudden losses. The stock market is forward-looking. It will absorb the new information, take a hit, and move on.

I always give this as an example. If you invested $1,000 in the S&P 500 index on January 1, 2008, just before the financial crisis, you would have doubled your money in 10 years. Unfortunately, if you needed your investment in one or two years, you would have been in big trouble. It took more than three years to recover your losses entirely.

Diversify

Never put all your eggs in one basket. The most effective way to protect yourself from unexpected losses is diversification. Diversification is the only free lunch you will ever get in investing. It allows you to spread your risk between different companies, sectors, asset classes, and even countries will allow your investment portfolio to avoid choppy swings in various market conditions. One prominent downside of diversification is that while you protect yourself from the left tail risk, you also limit the right tail potential for outsized returns.

Hold cash

Keeping cash reserves is another way to protect yourself from tail risk. You need to have enough liquidity to meet your immediate and near-term spending needs. I regularly advise my clients to maintain an emergency fund equal to six to twelve months of your budget. Put it in a safe place, but make sure that you still earn some interest.

Remember what we said earlier. There is no risk-free investment – even cash. Cash is sensitive to inflation. For instance, $100,000 in 2000 is worth only $66,800 in 2020. So, having a boatload of cash will not guarantee your long-term financial security. You must make it earn a higher return than inflation.

Furthermore, cash has a huge opportunity cost tag. In other words, by holding a large amount of money, you face the risk of missing out on potential gain from choosing other alternatives.

US Treasuries

US Government bonds have historically been a safe haven for investors during turbulent times. We have seen the demand for treasuries spiking during periods of extreme uncertainty and volatility. And inversely, investors tend to drop them when they feel confident about the stock market. Depending on their maturity, US treasuries may give you a slightly higher interest than holding cash in a savings account.

While offering some return potential, treasuries are still exposed to high inflation and opportunity cost risk. Also, government bonds are very sensitive to changes in interest rates. If interest rates go up, the value of your bonds will go down. On the other hand, when interest rates go down, the value of your bonds will decrease.

Gold

Gold is another popular option for conservative investors. Similar to treasuries, the demand for gold tends to go up during uncertain times. The faith for gold stems from its historical role as a currency and store of value. It has been a part of our economic and social life in many cultures for thousands of years.

As we moved away from the Gold standard, the Gold’s role in the economy has diminished over time. Nowadays, the price of gold is purely based on price and demand. One notable fact is that gold tends to perform well during periods of high inflation and political uncertainty.

In his 2011 letter to shareholders of Berkshire Hathaway, Warren Buffet described gold as an “asset that will never produce anything, but that is purchased in the buyer’s hope that someone else … will pay more for them in the future…..If you own one ounce of gold for an eternity, you will still own one ounce at its end.”

Buying Put Options to hedge tail risk

Buying put options om major stock indices is an advanced strategy for tail risk hedging. In essence, an investor will enter into an option agreement for the right to sell a financial instrument at a specified price on a specific day in the future. Typically, this fixed price known as a strike price is lower than the current levels where the instrument is trading. For instance, the stock of XYZ is currently trading at $100. I can buy a put option to sell that stock at $80 three months from now. The option agreement will cost me $2. If the stock price of XYZ goes to $70, I can buy it at $70 and exercise my option to sell it at $80. By doing that, I will have an immediate gain of $10. This is just an illustration. In real life, things can get more complicated.

The real value of buying put options comes during times of extreme overvaluation in the stock market. For the average investor, purchasing put options to tail risk hedging can be expensive, time-consuming, and quite complicated. Most long-term investors will just weather the storm and reap benefits from being patient.

Final words

Managing your tail risk is not a one-size-fits-all strategy. Black Swam events are distinctive in nature, lengh, and magnitude. Because every investor has specific personal and financial circumstances, the left tail risk can affect them differently depending on a variety of factors. For most long-term investors, the left tail and right tail events will offset each other in the long run. However, specific groups of investors need to pay close attention to their unique risk exposure and try to mitigate it when possible.

December 2, 2020November 8, 2022

10 practical ways to pay off debt before retirement

Pay off debt before retirement is a top priority for many of you who are planning to retire in the near future. In my article Retirement Checklist, I discussed a 12-step roadmap to planning a successful and carefree retirement. One of the most important steps was paying off your debt. According to the Federal Reserve, US households owe $4 trillion in non-housing loans and $10 trillion in mortgage debt. In today’s world, it is easy and effortless to get credit. Loan and credit card offers are lurking on every corner.

Why is it essential to pay off debt before retirement?

Being debt-free is a significant milestone in becoming financially independent. Retirement opens a new chapter in new life. You can no longer rely on your working wage. Your retirement income will come from a combination of steady income sources such as social security, pension, retirement savings, and possibly annuities. Your income will drop, your healthcare cost will rise, and your debt payments will remain the same. Having a large amount of debt during retirement will reduce your disposable income and strain your financial strength.

For those of you who are committed to paying debt before retirement, I have created a multi-step guide that can help you navigate through the challenges of becoming debt-free

1. Set your goals

Setting your financial and retirement goals is an essential pathway in your life journey. Pay off debt before retirement starts with establishing up your goals. Having goals give you structure and will prepare you for the future. If you do not know where you are going, you can end up anywhere. Following your objectives will provide you with essential life milestones. Achieving your goals will give you a sense of accomplishment and boost your confidence.

2. Take control of your spending habits

If you are approaching retirement with considerable debt, you need to rein in spending habits. You can not be a big spender. Therefore, as long as you spend more than you earn, you will need to cut back. I know it is a painful task. It is not easy to make changes to your lifestyle. Still, think of it as a small and responsible sacrifice today so you can live a better tomorrow.

3. Create a budget

If you find yourself spending more than you make, you will need to set up a budget. Numerous websites and mobile apps can help you track your income and expenses by groups, categories, and periods. Regular budgeting can help you steer away from outsized spending and frivolous purchases.

4. Build an emergency fund

An emergency fund is the amount of cash you need to cover 6 to 12 months of essential expenses. Financially successful people maintain an emergency fund to cover high, unexpected costs. Your rainy-day stash can serve as a buffer if you lose your job or lose your ability to earn income. By maintaining an emergency fund, you could avoid taking debt and cover temporary gaps in your budget. Suppose you don’t have an emergency fund. Start with setting up a certain percentage of your wage that will automatically go to your savings account. Don’t get discouraged if it takes a long time to build your rainy-day fund. It is okay. Look forward and keep saving.

5. Track your loans

Did you notice that the first four steps of becoming debt-free did not involve debt at all? I hope you will agree that building long-lasting financial habits is the key to financial independence.

So, if you have reviewed my first four recommendations, it is time to look at your debt.

Make a list of all your loans – credit cards, auto, mortgage, student, home equity, personal loans. Sort them by amount and interest rate. Pay attention to due dates and monthly interest charges. Do not miss payments. Late or missed payments can trigger enormous late fees and penalty charges. Stay on top of your loans. Track them daily and monthly.

6. Pay off higher interest loans first

I strongly recommend that you pay off your highest interest loans first. Credit cards tend to have the highest interest rates and the most punishing late fees. If you have credit card debt, there is a high chance that you need to tackle it first. Remember, there are always exceptions to the rules, and every one case is different.

Another popular theory suggests that you pay off your smaller loans first and repay the bigger loans next. The reasoning behind this recommendation is that paying off even smaller loans awards you with the feeling of accomplishment. You can also focus on the big picture once you eliminate the smaller loans.

Mathematically, paying off your highest interest loans makes more sense. Emotionally, paying off the smaller debt first could be more effective. In the end, you can find a happy medium. Use the approach that works best for you and your specific situation.

7. Pay off or refinance your mortgage

I recommend that you pay off your mortgage by the time you retire. Owning your house without the burden of debt is the ultimate American dream and the secret to a happy retirement. In today’s world, there is nothing more liberating than owning your home. Your home is your fortress. It’s the place where you can be yourself. You can host your family and friends and enjoy your favorite hobby.

Now, if you are still making mortgage payments, you may want to look into refinancing options. With record-low interest rates, today offers an excellent opportunity to lower your monthly mortgage bill. It’s certainly will be easier to refinance your mortgage while still working and having regular income and paystubs. I highly recommend that you shop around for the best offer. Banks and mortgage brokers will offer you a wide range of interest rates, closing costs, and refinancing rules. Generally, stay away from bids with high closing costs. Evaluate your savings for each offer and choose the option that best suits your need.

8. Downsize and relocate

Another popular way to control your cost and pay off debt before retirement is downsizing and relocating. Sometimes you can do them both at the same time. Owning a big house requires high maintenance, bills, and possibly higher property taxes. Moving to a smaller home in a more affordable location can save you a lot of money in the long run. The USA offers a wide range of affordable locations in smaller states and communities. Choose a location that fits your budget, health insurance needs, and lifestyle.

9. Work longer

if you are approaching retirement age and holding debt, you may want to consider working longer. Working after retirement is no longer a stigma. Many retirees choose to work part-time, remain active, and earn an extra income. The additional money can help your pay off your remaining loans. You can use the extra cash to maintain your emergency fund or support your current lifestyle.

10. Do not touch your retirement savings

Your retirement savings are sacred. They are your ticket to financial freedom. It can be tempting to pay your debt before retirement by tapping into your 401k or IRA. However, this strategy rarely ends very well. Do not withdraw your 401k or IRA savings unless you are in dire need. Hold on to your retirement savings until you exhaust your other options. One, when drawing from your retirement plan, you will need to pay taxes. Furthermore, you may have to pay a penalty charge if you are younger than 59 ½. Second, paying off debt without controlling your expense will only have a short-term impact. You will be back where you started in just a couple of months or years. And lastly, tapping your retirement savings now will reduce your future income. How confident are you that you can replace your lost revenue in the future?

October 6, 2020July 31, 2023

Benefits and drawbacks to buying Indexed Universal Life Insurance

Today, I am going off the beaten path for me and will discuss the pros and cons of buying Indexed Universal Life Insurance. As a fee-only advisor, I do not sell any insurance or commission-based products. However, on numerous occasions, I have received requests from clients to review their existing insurance coverage. I certainly do not know every IUL product out there. And I might be missing some of the nuances and differences between them. My observation is that IUL is not suitable for the average person due to its complexity and high cost. And yet, the IUL might be the right product for you if you can take advantage of the benefits that it offers.

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What is an Indexed Universal Life Insurance (IUL)?

Indexed Universal Life is a popular insurance product that promises protection coverage with stock market-like performance and a zero-downside risk. Like other universal life insurance, IUL offers a death benefit and a cash value. Your cash value account can earn interest based on the performance of a specific stock market index such as the S&P 500, Dow Jones Industrial Average, the Nasdaq 100, and Russell 2000.

IUL Illustration rate

IUL policies use an illustration rate for advertising and hypothetically projecting the policy values in their sales materials. The Illustration rate is the fixed rate derived from historical performance. Usually, the illustration rate ranges between 5% and 10%.

Is IUL right for me?

On the surface, Indexed Universal Life Insurance sounds like a great deal. You receive a stock market upside with zero risks for losses. Nevertheless, IUL comes with some severe caveats.

Let’s break down the main benefits and drawbacks of IUL.

Benefits of Indexed Universal Life Insurance

Tax-Deferred Accumulation

Index Universal Life Insurance allows you to grow your policy cash value and death benefit on a tax-deferred basis. Typically, you will not owe income taxes on the interest credited to your cash value and death benefit.

Tax-Free Distribution

Life Insurance, in general, is a lucrative tool for legacy planning. With IUL, your policy beneficiaries will receive the death benefit tax-free. As long as you maintain your insurance premiums and don’t take outsized loans, you can pass tax-free wealth to the next generation.

Access to a cash value

You can always withdraw your policy basis (original premiums paid) tax-free. In most cases, you can also access your cash value through tax-favorable policy loans or withdrawals. In case of emergency, you may borrow from your indexed universal life insurance policy. You can access your cash value without any penalty regardless of your age.

Supplemental Retirement Income

You can use the cash value from your policy as a source of supplemental retirement income. You can also use it to cover future medical expenses.

Limited downside risk

IUL offers protection against stock market volatility. An IUL delivers stock market-linked gains without the risks of losing principal due to the stock market declines. With the IUL’s principal-protection guarantee, your annual gains are locked in. Your principal cash value remains the same, even if the stock market goes down.

A guaranteed minimum rate

Many IUL policies come with a guaranteed minimum annual interest rate. This rate is a floor of how much you can earn every year. The guaranteed allows you to receive a certain percentage regardless of how the market performs. This floor rate depends on the specific insurance, and it could vary between 0% and 2%.

Drawbacks of Indexed Universal Life Insurance

IUL is complex

IUL is an extremely complex insurance product. There are many moving parts in your UIL policy, making it confusing and hard to understand. Most sales illustration packages portray an ideal scenario with non-guaranteed average market performance figures. In reality, between your annual premiums, cap rates, floors, fees, market returns, cash value accumulation, riders, and so on, it is tough to predict the outcome of your insurance benefits.

Upfront Commissions

The people who sell IUL are highly trained sales professionals who may not be qualified to provide fiduciary financial advice. The IUL comes with a hefty upfront commission, which is often buried in the fine print and gets subtracted from your first premium payment.

IUL has high fees

The policy fees will shock you and eat your lunch literally. I have personally seen charges in the neighborhood of 11% to 13% annually. These fees will always reduce the benefits of your annual premium and earned interest.

Limited earnings potential

IUL policies will typically limit your stock market returns and will exclude all dividends. Most IULs offer some combination of participation rate and capped rate in comparison to the illustration rate used in their marketing materials.

Participation Rate is the percentage of positive index movement credited to the policy. For example, if the S&P 500 increased 10% and the IUL has an annual participation rate of 50%, your policy would receive 5% interest on the anniversary date.

Cap Rate is the maximum rate that you can earn annually. The cap rate can vary significantly from policy to policy and from insurance provider to the next.

Why capped upside is an issue?

The problem with cap rates and participation rates is they limit your gains during, especially good years. Historically, the stock market returns are not linear and sequential, as the policy illustration rates suggest. In the 40 years between 1980 and 2019, the stock market earned an average of 11.27% per year. During this period, there were only eight years when the stock market had negative returns or 20% of that period. There were only seven years when the stock market posted returns between 0% and 10%. And there were 25 years when the stock market earned more than 10% per year. In 17 of those 25 periods, the stock market investors gained more than 20% or 42% of the time.

In other words, historically, the odds of outsized gains have been a lot higher than the odds of losses.

However, as humans, the pain of losing money is a lot stronger than the joy of gaining.

In effect, long-term IUL policyholders will give up the potential of earning these outsized profits to reduce their anxiety and stress of losing money.

Surrender charges

IULs have hefty surrender charges. If you change your mind in a couple of years and decide to cancel your policy, you may not be able to receive the full cash value. Before you get into a contract, please find out the surrender charges and when they expire.

Expensive Riders

Indexed Universal Life Insurance typically offers riders. The policy riders are contract add-ons that provide particular benefits in exchange for an additional fee. These provisions can include long-term care services, disability waivers, enhanced performance, children’s’ term insurance, no-lapse guarantee, and many more. The extra fee for each rider will reduce your cash value, similar to the regular policy fees. You need to assess each rider individually as the cumulative cost may outweigh your benefit and vice versa,

Cash value withdrawals reduce your death benefit

In most cases, you might be able to make a tax-free withdrawal from the cash value of your IUL policy. These withdrawals are often treated as loans. However, legacy-minded policyholders need to remember that withdrawing your cash value reduces your beneficiaries’ death benefit when you pass away.

Potential taxable income

There is still a chance to pay taxes on your IUL policy. If you let your policy lapse or decide to surrender it, the money you have withdrawn previously could be taxable. Withdrawals are treated as taxable when they exceed your original cost basis or paid premiums.

January 7, 2021November 7, 2022

401k contribution limits 2021

401k contribution limits for 2021 are $19,500 per person. All 401k participants over the age of 50 can add a catch-up contribution of $6,500.

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What is 401k?

401k plan is a workplace retirement plan where both employees and employers can make retirement contributions. These retirement plans can be one of the easiest and most effective ways to save for retirement. As an employee, you can make automatic contributions to your 401k directly through your company payroll. You can choose the percentage of your salary that will go towards your retirement savings, Most 401k will provide you with multiple investment options in stocks and fixed income. Additionally, most companies offer a 401k match up to a certain percentage. In most cases, you need to participate in the plan in order to get the match.

There are two types of contributions – traditional 401k tax-deferred and tax-exempt Roth 401k contributions.

Tax-deferred 401k

Most employees, typically, choose to make tax-deferred 401k contributions. These payments are tax-deductible. They will lower your tax bill for the current tax year. Your investments will grow on a tax-deferred basis. Therefore, you will only owe federal and state taxes when you start withdrawing your savings.

Roth 401k

Roth 401k contributions are pretax. It means that you will pay all federal and state taxes before making your contributions. The advantage of Roth 401k is that your retirement savings will grow tax-free. As long as you keep your money until retirement, you will withdraw your gain tax-free. It’s a great alternative for young professionals and workers in a low tax bracket.

How much can I contribute to my 401k in 2021?

401k contribution limits change every year. IRS typically increases the maximum annual limit with the cost of living adjustment and inflation. These contribution limits apply to all employees who participate in 401(k), 403(b), most 457 plans, and the federal government’s Thrift Savings Plan. Additionally, the limits apply to both tax-deferred and Roth contributions combined.

Employees can contribute up to $19,500 to their 401(k) plan for 2021, the same amount as 2020.
Employees of age 50 or over are eligible for an additional catch-up contribution of $6,500 in 2021, the same amount as 2020
The employee compensation limit for calculating 401k contributions is $290,000, $5,000 more than 2020
Companies can make a matching contribution up to the combined limit of $58,000 or $64,500 with the catch-up contribution. If an employee makes the maximum allowed contribution, the company match cannot exceed $38,500 in 2021.

Solo 401k contribution limits 2021

A solo 401k plan is a type of 401k plan with one participant. Those are usually solo entrepreneurs, consultants, freelancers, and other small business owners. Self-employed individuals can take advantage of solo 401k plans and save for retirement.

The maximum contribution limit in 2021 for a solo 401k plan is $57,000 or $63,500 with catch-up contributions. Solo entrepreneurs can make contributions both as an employee and an employer.
The employee contribution cannot exceed $19,500 in the solo 401(k) plan for 2021.
Self-employed 401k participants, age 50 or over are eligible for an additional catch-up contribution of $6,500 in 2021.
The total self-employed compensation limit for calculating solo 401k contributions is $285,000.
Employer contribution cannot exceed 25% of the compensation
If you participate in more than one 401k plan at the same time, you are subject to the same annual limits for all plans.

Please note that if you are self-employed and decide to hire other employees, they will have to be included in the 401k plan if they meet the plan eligibility requirements.

January 7, 2021November 7, 2022

Roth IRA Contribution Limits 2021

The Roth IRA contribution limits for 2021 are $6,000 per person with an additional $1,000 catch-up contribution for people who are 50 or older.

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Roth IRA income limits for 2021

Roth IRA contribution limits for 2021 are based on your annual earnings. If you are single and earn $125,000 or less, you can contribute up to the full amount of $6,000 per year. If your aggregated gross income is between $125,000 and $140,000 you can still make contributions but with a lower value.

Married couples filing jointly can contribute up to $6,000 each if your combined income is less than $198,000. If your aggregated gross income is between $198,000 and $208,000 you can still make reduced contributions.

What is a Roth IRA?

Roth IRA is a tax-free retirement savings account that allows you to make after-tax contributions to save towards retirement. Your Roth investments grow tax-free. You will not owe taxes on dividends and capital gains. Once you reach retirement your withdrawals will be tax-free as well.

Roth vs Traditional IRA

Roth IRA allows you to make after-tax contributions towards retirement. In comparisons. Traditional IRA has the same annual contributions limits. The Traditional IRA contributions can be tax-deductible or after-tax depending on your income. Additionally, your Traditional IRA savings grow tax-deferred. Unlike Roth Roth, you will owe income taxes on your withdrawals.

Roth IRA Rules

The Roth IRA offers a lot of flexibility and few constraints. There are Roth IRA rules that can help you maximize the benefits of your tax-free savings account.

Easy and convenient

Opening a Roth IRA account is a great way to start planning for your financial future. The plan is an excellent saving opportunity for many young professionals with limited access to workplace retirement plans. Even those who have 401k plans with their employer can open a Roth IRA.

Flexibility

There is no age limit for contributions. Minors and retired investors can invest in Roth IRA as well as long as they earn income.

No investment restrictions

There is no restriction on the type of investments in the account. Investors can invest in any asset class that suits their risk tolerance and financial goals.

No taxes

There are no taxes on the distributions from this account once you reach 59 ½. Your investments will grow tax-free. You will never pay taxes on your capital gains and dividends either.

No penalties if you withdraw your original investment

While not always recommended, Roth IRA allows you to withdraw your original dollar contributions (but not the return from them) before reaching retirement, penalty and tax-free. Say, you invested $5,000 several years ago. And now the account has grown to $15,000. You can withdraw your initial contribution of $5,000 without penalties.

Diversify your future tax exposure

Roth IRA is ideal for investors who are in a lower tax bracket but expect higher taxes in retirement. Since most retirement savings sit in 401k and investment accounts, Roth IRA adds a very flexible tax-advantaged component to your investments. Nobody knows how the tax laws will change by the time you need to take out money from your retirement accounts. That is why I highly recommend diversifying your mix of investment accounts and take full advantage of your Roth IRA.

No minimum distributions

Unlike 401k and IRA, Roth IRA doesn’t have any minimum distributions requirements. Investors have the freedom to withdraw their savings at their wish or keep them intact indefinitely.

Earnings cap

You can’t contribute more than what you earned for the year. If you made $4,000, you could only invest $4,000.

January 9, 2022November 7, 2022

IRA Contribution Limits 2022

The IRA contribution limits for 2022 are $6,000 per person with an additional $1,000 catch-up contribution for people who are 50 or older. Contribution limits remain the same as 2021.

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What is an IRA?

IRA or Traditional IRA is a tax-deferred retirement savings account that allows you to make tax-deductible contributions to save towards retirement. Your savings grow tax-free. You do not owe taxes on dividends and capital gains. Once you reach retirement age, you can start taking money out of the account. All distributions from the IRA are taxable as ordinary income in the year of withdrawal.

IRA income limits for 2022

The tax-deductible IRA contribution limits for 2022 are based on your annual income. If you are single and earn $129,000 or less, you can contribute up to the full amount of $6,000 per year. If your aggregated gross income is between $129,000 and $144,000 you can still make contributions but with a smaller amount.

Married couples filing jointly can contribute up to $6,000 each if your combined income is less than $204,000. If your aggregated gross income is between $204,000 and $214,000 you can still make reduced contributions.

Spousal IRA

If you are married and not earning income, you can still make contributions. As long as your spouse earns income and you file a joint return, you may be able to contribute to an IRA even if you did not have taxable compensation. Keep in mind that, your combined contributions can’t be more than the taxable compensation reported on your joint return.

IRA vs 401k

IRA is an individual retirement account. 401k plan is a workplace retirement plan, which is established by your employer. You can contribute to a 401k plan if it’s offered by your company. In comparison, anyone who is earning income can open and contribute to a traditional IRA regardless of your age.

IRA vs Roth IRA

Traditional and Roth IRA have the same annual contribution limits. The Traditional IRA contributions can be tax-deductible or after-tax depending on your income. In comparison. Roth IRA allows you to make after-tax contributions towards retirement. Another difference, your Traditional IRA retirement savings grow tax-deferred, while Roth IRA earnings are tax-free.

January 14, 2021November 7, 2022

IRA Contribution Limits 2021

The IRA contribution limits for 2021 are $6,000 per person with an additional $1,000 catch-up contribution for people who are 50 or older.

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What is an IRA?

IRA income limits for 2021

The tax-deductible IRA contribution limits for 2021 are based on your annual income. If you are single and earn $125,000 or less, you can contribute up to the full amount of $6,000 per year. If your aggregated gross income is between $125,000 and $140,000 you can still make contributions but with a smaller amount.

Spousal IRA

IRA vs 401k

IRA vs Roth IRA

January 9, 2022November 8, 2022

TSP contribution limits 2022

TSP contribution limit for 2022 is 20,500 per person. Additionally, all federal employees over the age of 50 can contribute a catch-up of $6,500 per year.

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What is TSP?

Thrift Saving Plan is a Federal retirement plan where both federal employees and agencies can make retirement contributions. Moreover, this retirement plan is one of the easiest and most effective ways for you to save for retirement. As a federal employee, you can make automatic contributions to your TSP directly through your employer’s payroll. You can choose the percentage of your salary that will go towards your retirement savings. TSP provides you with multiple investment options in stocks, fixed income, and lifecycle funds. Additionally, most agencies offer a TSP match up to a certain percentage. In most cases, you need to participate in the plan in order to get the match. For more information about investment options in your TSP account, check my article – “Grow your retirement savings with the Thrift Savings Plan.”

Who is Eligible to Participate in the TSP?

Most employees of the United States Government are eligible to participate in the Thrift Savings Plan. You are eligible if you are:

Federal Employees’ Retirement System (FERS) employees (started on or after January 1, 1984)
Civil Service Retirement System (CSRS) employees (started before January 1, 1984, and did not convert to FERS)
Members of the uniformed services (active duty or Ready Reserve)
Civilians in certain other categories of Government service

How much can I contribute to my TSP in 2022?

TSP contribution limits for 2022 increased slightly from 2021. IRS typically increases the maximum annual limit with the cost of living adjustment and inflation. These contribution limits apply to all employees who participate in the federal government’s Thrift Savings Plan, 401(k), 403(b), and 457 plans. Additionally, the limits apply to both tax-deferred and Roth contributions combined.

Employees can contribute up to $19,500 to their TSP plan for 2022, a $1,000 increase from 2021.
Employees of age 50 or over are eligible for an additional catch-up contribution of $6,500 in 2022, the same amount as 2021.
Employee compensation limit for calculating TSP contributions is $305,000, $15,000 more than 2021
For participants who contribute to both a civilian and a uniformed services TSP account during the year, the elective deferral and catch-up contribution limits apply to the combined amounts of traditional (tax-deferred) and Roth contributions in both accounts.
Members of the uniformed services, receiving tax-exempt pay (i.e., pay that is subject to the combat zone tax exclusion), your contributions from that pay will also be tax-exempt. Your total contributions from all types of pay must not exceed the combined limit of $61,000 per year.

There are two types of contributions – tax-deferred traditional TSP and tax-exempt Roth TSP contributions.

Tax-deferred TSP

Most federal employees, typically, choose to make tax-deferred TSP contributions. These contributions are tax-deductible. They will lower your tax bill for the current tax year. Your investments will grow on a tax-deferred basis. Therefore, you will only owe federal and state taxes when you start withdrawing your savings.

Roth TSP

Roth TSP contributions are pretax. It means that you will pay all federal and state taxes before making your contributions. The advantage of Roth TSP is that your retirement savings will grow tax-free. As long as you keep your money until retirement, you will withdraw your gain tax-free. It’s a great alternative for young professionals and workers in a low tax bracket.

TSP Matching

Federal agencies can make a matching contribution up to the combined limit of $61,000 or $67,500 with the catch-up contribution. If you contribute the maximum allowed amount, your agency match cannot exceed $40,500 in 2022.

If you are an eligible FERS or BRS employee, you will receive matching contributions from your agency based on your regular employee contributions. Unlike most private companies, matching contributions are not subject to vesting requirements.

FERS or BRS participants receive matching contributions on the first 5% of your salary that you contribute each pay period. The first 3% of your contribution will receive a dollar-for-dollar match. The next 2% will be matched at 50 cents on the dollar. Contributions above 5% of your salary will not be matched.

Consider contributing at least 5% of your base salary to your TSP account so that you can receive the full amount of matching contributions.

Matching schedule

TSP Matching contribution — Source: tsp.gov

Opening your TSP account

FERS Employees

If you are a federal employee hired after July 31, 2010, your agency has automatically enrolled you in the TSP. By default, 3% of your base salary will be deducted from your paycheck each pay period and deposited in the traditional balance of your TSP account. If you decide, you have to make an election to change or stop your contributions.

If you are a FERS employee who started before August 1, 2010, you already have a TSP account with accruing 1% automatic contributions. In addition, you can make contributions to your account from your pay and receive additional matching contributions.

CSRS Employees

If you are a Federal civilian employee who started before January 1, 1984, your agency will establish your TSP account after you make a contribution election using your agency’s election system.

BRS Members of the Uniformed Services

Members of the uniformed services who began serving on or after January 1, 2018, will automatically enroll in the TSP once you serve 60 days. By default, 3% of your basic pay is deducted from your paycheck each pay period and deposited in the traditional balance of your TSP account. You have can always select to change or stop your contributions.

January 14, 2021November 8, 2022

TSP contribution limits 2021

TSP contribution limits for 2021 is 19,500 per person. Additionally, all federal employees over the age of 50 can contribute a catch-up of $6,500 per year.

Retirement Calculator

What is TSP?

Who is Eligible to Participate in the TSP?

Most employees of the United States Government are eligible to participate in the Thrift Savings Plan. You are eligible if you are:

Federal Employees’ Retirement System (FERS) employees (started on or after January 1, 1984)
Civil Service Retirement System (CSRS) employees (started before January 1, 1984, and did not convert to FERS)
Members of the uniformed services (active duty or Ready Reserve)
Civilians in certain other categories of Government service

How much can I contribute to my TSP in 2021?

TSP contribution limits for 2021 stayed the same as change every year. IRS typically increases the maximum annual limit with the cost of living adjustment and inflation. These contribution limits apply to all employees who participate in the federal government’s Thrift Savings Plan, 401(k), 403(b), and 457 plans. Additionally, the limits apply to both tax-deferred and Roth contributions combined.

Employees can contribute up to $19,500 to their TSP plan for 2021, the same amount as 2020.
Employees of age 50 or over are eligible for an additional catch-up contribution of $6,500 in 2021, the same amount as 2020.
Employee compensation limit for calculating TSP contributions is $290,000, $5,000 more than 2020
For participants who contribute to both a civilian and a uniformed services TSP account during the year, the elective deferral and catch-up contribution limits apply to the combined amounts of traditional (tax-deferred) and Roth contributions in both accounts.
Members of the uniformed services, receiving tax-exempt pay (i.e., pay that is subject to the combat zone tax exclusion), your contributions from that pay will also be tax-exempt. Your total contributions from all types of pay must not exceed the combined limit of $58,000 per year.

There are two types of contributions – tax-deferred traditional TSP and tax-exempt Roth TSP contributions.

Tax-deferred TSP

Roth TSP

TSP Matching

Federal agencies can make a matching contribution up to the combined limit of $58,000 or $64,500 with the catch-up contribution. If you contribute the maximum allowed amount, your agency match cannot exceed $38,500 in 2021.

Consider contributing at least 5% of your base salary to your TSP account so that you can receive the full amount of matching contributions.