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At the end of the year, most people in the United States are thinking about the holidays and the potential credit card bills for gifts and family visits. One good way to control this potentially stressful month is to take some time to breathe and get your own finances in order. There are several actions you should consider and complete before the year ends in order to start next year on the best foot possible.

A few weeks ago, the IRS announced that the 2017 individual contribution limit toward a 401(k) retirement account will remain unchanged from 2016. Anyone financially comfortable enough to maximize the contribution will be able to tuck away $18,000 this upcoming year (the same as they could this past year). Savers aged 50 or older qualify for an extra $6,000, in addition to the $18,000, for a total contribution limit of $24,000.

If you plan to maximize your contribution, and did so this past year, you don’t need to make any changes. However, if you didn’t reach the contribution limit this year but plan to do so in 2017, take some time now to plan.

Contact your benefits department via phone or website and change your deductions for the upcoming year. The changes could take a few weeks to go into effect. If you want the increased contributions to take effect at the beginning of the year, it’s best to start looking at the details now.

Calculate Based on Employer Match

Winter SnowIn many cases, employers offer some sort of matching contribution. For example, the company might match half of your contributions, up to the first 6% of your salary that you contribute. Or, perhaps they’ll match all of your contributions up to the first 3% of your salary.

Let’s take the first case. In order to maximize your tax benefit and matching benefit, you’ll need to deduct 6% of your paycheck every period, if 6% of your annual salary adds up to $17,000 or less ($22,500 or less if you’re 50+ years old). In the second case, you’ll only need to deduct 3% of each paycheck. If the optimal percentage would result in exceeding the government-mandated maximum, you’d have to determine the best percentage that prevents you from exceeding that threshold.

Special Provisions

I found out recently that some employers offer a benefit, sometimes called something like “spillover protection.” Let’s say you contribute more than the IRS maximum. Companies that offer this feature will allow you to continue deferring income to your 401(k); it would just be considered after-tax contributions. Most other employers would just automatically stop your contribution once you hit the limit. So why is this a nice benefit to have? Well, for those whose deferments automatically stop, and whose employer matches contributions on a per-paycheck basis, they’ll miss out on some matching contributions. Essentially, they’re giving up free money. With this spillover protection, their employer will continue contributing their match (the free money) up to the limit, versus leaving it on the table.

Employers may also have other contribution limits. It’s common for a corporation to say that the maximum contribution percentage is 50% of an annual salary. Be sure to check into your benefits and plan out the year’s contributions accordingly.

Not Maxing Out Contributions This Year?

Recalculating the 401(k) contribution at the end of the year is not a tactic just for those earning enough to maximize the tax benefit. Let’s say you received a raise or cost of living increase this year and haven’t adjusted your 401(k) deferment to match the extra cash flow. The end of the year is a good time to bump your contribution by one or two percentage points. Some 401(k) plans have options where the investor can initiate automatic investment increases each year. This is a good opportunity to turn this feature on or manually adjust your contribution.

This advice also isn’t just for people working for large corporations. Non-profit organizations often offer similar benefits called 403(b) plans, and if you’re self-employed, you may save for your retirement using an individual (or Solo) 401(k) plan.

Don’t wait. The process of changing your contribution can take a few weeks to take effect, so if you want to contribute a consistent percentage of your income throughout the new year, the sooner you make the change, the easier that will be.

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With the holidays approaching, many companies are preparing their bonus checks. However, some employees who are looking forward to their bonuses are also concerned about tax consequences.

I gave up this “extra” part of my corporate pay, in exchange for the benefit of working for myself, when I left my day job a few years ago. An annual bonus was certainly an appreciated part of my income, however. However, if this year’s holiday season is anything like years past, I know I can expect people around me to complain that they’d rather not receive a bonus. But why?

There is a widely-held belief that the extra income from a bonus — which is not really extra, just a variable aspect of compensation — supposedly bumps them into a higher tax bracket. This, they believe, is bad. They believe that they could potentially owe the government a higher tax rate on all of their income. This is incorrect and represents confusion about how marginal tax rates work.

These misconceptions and the resulting complaints are intensified when the bonus check arrives. Typically, they’ll see a net payment amount representing only a fraction of the gross income listed on their pay stub. This only fuels the anti-bonus fire.

What a Bonus Actually Does to Taxes

For most taxpayers, the IRS treats bonus income the same as regular income. All taxable W-2 income gets added together in one box when you file your federal tax return forms. The same tax rates apply to each dollar shown, whether it came from your 9-to-5, your side hustle, weekend babysitting, or a holiday bonus.

There is a catch, though, and is the reason this confusion runs rampant. While the IRS doesn’t discriminate between regular pay and bonus pay, employers often do.

How Employers Calculate Taxes

Employers can choose between two primary methods of withholding federal taxes from bonus or supplemental income. This applies when said “extra” income is given to the employee in a check or direct deposit separate from regular income.

Option 1: The employer may withhold a flat 25% for federal income taxes from the bonus payment. If the employee receives over $1 million in bonus payments in one year, the employer can withhold 25% of the first $1 million in addition to 35% from the amount over $1 million.

Option 2: The employer may add the bonus payment to the most recent regular income payment. They would then determine the standard withholding based on tax tables and the sum of the two payments. Then, subtract the amount already withheld from the most recent regular income payment, and withhold the rest from the bonus.

*Option 3: The employer may base withholding on the sum of the bonus and regular pay using the standard withholding tables. *This option is for employers who choose to combine bonus compensation with regular compensation in one payment, check or direct deposit, without any differentiation between the two types of income.

Regardless of the method the employer chooses, bonus income and regular income are grouped together when you file your taxes. The IRS will refund any overpayment and will collect any underpayment.

Outliers

One interesting exception to the rule of bonuses being taxed the same as all other income applies to hedge fund and other investment managers. This type of income is known as carried interest. Investment managers often take their bonuses from investment gains, and these can be taxed at the long-term capital gains rate of 15%. This rate is usually significantly lower than their marginal tax rates.

My Final Advice

Don’t be afraid of earning that bonus or more money in general. Your employer might withhold more of the check for taxes than you’re used to, but it will even out when you file your taxes.

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If you plan to retire early, you may be wondering whether it makes sense to invest in traditional retirement accounts, such as employer-sponsored 401(k)s/403(b)s and IRAs/Roth IRAs. The speculation comes into play because there’s an early withdrawal penalty when you take money out of these accounts before age 59 ½.

I argue that it’s still a good idea to invest in traditional retirement accounts if you plan to retire early. This is because there are tax benefits that come with these retirement plans. Money contributed to employer sponsored 401(k)s/403(b)s are pre-tax and reduce your taxable income for the year. Money contributed to Roth IRAs isn’t pre-tax but the money grows tax-free.

The best scenario is to have enough money outside of these retirement accounts so that you can live off other investments before age 59 ½ and then tap into your retirement accounts after turning 59 ½. Here are a few tips to aid you in your early retirement planning.

Avoid Early Withdrawal Penalties

Generally, the money withdrawn from a retirement plan before the age of 59 ½ is considered “early” or “premature.” When this happens, you must pay an additional 10% early withdrawal tax. For most, that 10% penalty is a big deal. It will likely result in enough money lost that you’ll want to avoid making early withdrawals.

One thing you can do to avoid early withdrawal penalties from retirement plans is to have other investments. We’ll get to that in a moment.

Another way to avoid early withdrawal penalties is via the IRS rule 72(t). This rule permits penalty-free withdrawals from an individual retirement account (IRA), provided that you take “substantially equal periodic payments (SEPPs)” for at least five years or until you reach 59 ½, whichever period of time is longer. The payment amount will depend on your life expectancy as calculated by IRS-approved methods.

The withdrawals will still be taxed at your normal income tax rate. You can roll over a portion of your 401(k) into an IRA to take advantage of this rule as well. A good guide for IRA conversion can be found here on Dough Roller.

The IRS rule 72(t) is a bit complicated. You may want to work with a financial advisor to make sure you are complying by the rule’s stipulations. If you stop payments too early, you’ll have to pay the early withdrawal penalty on the previously withdrawn amounts.

It’s good to know there’s a way to access your retirement plan funds without the early withdrawal penalty. But, that doesn’t have to be the only option if you plan to retire early. Another option is to have other investments that you can liquidate before you turn 59 ½.

Plan on Other Investments

The best thing you can do is not touch your retirement plan funds until you reach age 59 ½. It’s best to have other investments that you can use as income until you reach IRS retirement age. This means you’ll have to do even more saving during your early years. But it’s worth it for the sake of early retirement.

Here are some options for where to save the rest of your money:

  • Savings accounts and certificates of deposit (CDs) – These accounts offer lower interest rates but guaranteed returns. Your money is also FDIC insured up to at least $250,000.
  • Peer to peer lending – Companies like LendingClub and Prosper let you build an investment portfolio of personal loans. This gives you monthly cash flow.
  • Rental properties – This investment takes some time and skill. But it also offers monthly cash flow as long as you have tenants.
  • Dividend stocks – You’ll gain money in two ways. First, you’ll earn as the value of the stocks appreciate. Second, you’ll gain money from distributions paid out to shareholders by the dividend-paying companies.

You can use these investments to fund your lifestyle until you reach IRS retirement age. Depending on the age you plan to retire, you may not even need that much to sustain you until you reach 59 ½. It’s all about planning ahead of time.

Consider Phased Retirement

Most people work a long career and then jump right into retirement and stop working altogether. If you plan to retire early, though, that doesn’t necessarily have to be the path for you. Consider phased retirement as an alternative, in order to make early retirement work for you.

For example, if you work an office job now and want to retire at age 40, you can leave that day job and then start another career. You could start an online business that doesn’t require you to go into an office. Use the time between when you leave your first career and when you reach age 59 ½ to explore another one of your interests. Have you always wanted to write books? Do you have a passion for working with animals? The possibilities are endless.

Finding a new career to embark on during the first few years of early retirement will not only give you extra money to live on, but it’ll also keep you mobile and energized. Make sure it’s something you enjoy so you can still consider yourself “retired.”

Final Thoughts

Yes, you should invest in traditional retirement accounts if you plan to retire early. They have many tax benefits that make them good investments. What you want to avoid is early withdrawal penalties. You can avoid this by taking advantage of the IRS rule 72(t) as explained above. Or, you could have other investments that fund your lifestyle until you reach age 59 ½ and can withdraw money from your retirement plans penalty-free.

Another consideration to keep in mind is phased retirement. Although you retire from your day job at an early age, that doesn’t mean you don’t have to work at all. Consider starting a new career based on another one of your interests or passions. This way, you’ll keep some money coming in until you reach age 59 ½ — and can withdraw from the traditional accounts — but you’ll still enjoy your early retirement.

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It’s been a long time since banks offered savings accounts with decent returns. The Fed may raise interest this year, meaning rates could finally rise. In the meantime, what do you do?

If you’re looking for a quick way to create an investment vehicle that is FDIC insured, and promises greater returns than online savings, Fidelity Investments has an option for you. The new Model CD Ladder tool is Fidelity’s attempt at bringing easy CD Ladders to its account holders. Let’s look at what this tool offers and see if it’s a better option than an online savings account.

Finding a Safe and Steady Return on Cash Holdings

For a detailed explanation of CDs, go here. Basically, in a volatile financial environment, CDs offer investors an FDIC-insured means to safely earn a consistent return on their cash. The rates of return can’t match the stock market, but they are better than what you’ll find with savings accounts. If the Fed finally decides to raise interest rates, the yield on new CDs should rise with them.

CD Ladders Explained

CD Ladders are multiple CDs purchased together, each with varying time horizons. This “ladder” is designed to return the owner’s initial investment at intervals, with interest payments paid out during the life of each individual CD. Each CD is a different “rung” on the ladder. As each CD matures and you climb up the ladder, your yield rises and liquidity remains the same. The goal is to max out the ladder with the highest yielding, longest term CDs and continually renew them as each rung expires. Your waiting time for each rung to mature should be the same as the very first CD that matured.

Yield, Liquidity, and the World of CDs

I just mentioned yield and liquidity. I want to find an equilibrium between the two when I am building my CD Ladder.

Yield is the rate of return that I’ll receive on my premium. My premium is my initial investment in each CD, and in Fidelity’s case, $1,000 is the smallest CD they broker. I’ll address overall minimum investment amounts later.

Liquidity is how easily or quickly I can access my investment.

Liquidity and yield are inversely related in the world of CDs. As liquidity rises, yield falls. As yield rises, liquidity falls. This is true when you first purchase the CD. Rates are generally locked in upon purchase.

But I said that “your yield rises and liquidity remains the same” when you create a CD Ladder. This is true, and you’ll understand why by the end of this article.

Put another way, the longer your CD time horizon, the less liquid it will be. It will take me more time to access the money I’ve invested, usually measured in months and years. If I have a 5-year CD, I’ll have to wait 5 years from the date of purchase to access the principal. If I want to access it before the 5-year period is up, there will be a penalty fee associated with that action. There is, however, a bonus to having to wait so long to get my premium back. Because of the inverse relationship of yield and liquidity, though, your yield is going to be higher. Ideally it’s high enough to make it worth waiting 5 years!

Conversely, the short time horizon CDs – such as 3 to 12 month CDs – are more liquid and yield much less than a 2 to 5-year CD.

In my ladder, I would start out with low yielding, shorter term CDs. They will mature in the first two years, while the clock ticks away on longer term, less liquid CDs with a higher yield. By doing this I am balancing my need for liquidity and yield with a mix of short and long term CDs.

Once I make it past the initial CD, or rung, my average percentage yield (APY) climbs with each rung expiration. That is why the CD ladder is a great tool for holding cash.

Fidelity’s New CD Ladder Tool

Fidelity Investments new CD Ladder tool lets you quickly make a CD Ladder that meets your individual yield and liquidity goals. Divided into three easy steps, your Model CD Ladder can become a reality in just a few minutes.

When creating your CDs with the Model CD Ladder tool, you will pick between a 1, 2, or 5-year ladder. Let’s look at what it takes to create each one, and what kind of return you can expect.

Minimum Amounts and Yields

If I want to create a Fidelity CD Ladder, it will take $4,000 or more. The next minimum investment amount is $8,000 (you calculate by $4,000 increments). Also, the $4,000 minimum applies to the 1- and 2-year ladders, and a $5,000 minimum applies to the 5-year model.

If I’m going to create a 5-year CD Ladder, I’ll need the $5,000 minimum and increase that by $5,000 increments if I want to invest more.

The yield for each ladder varies day-to-day, but as of this writing you’re going to see the following:
cd
Time Horizons

I can choose between a 1-year, 2-year, and 5-year CD Ladder.

The 1 year option will consist of 4 CDs that mature at the 3, 6, 9, and 12-month maturity date. For example, if I buy a ladder on November 1, the first portion (3 months) of the ladder will mature on or around February 1. This specific CD will pay both the interest accrual and full principal upon maturity. At 3 months, the amount will be relatively small. The 6-month CD will mature on May 1, the 9-month on August 1, and the 12-month on November 1 of the following year. Here’s an example of a 1-year Model CD Ladder:
cd1
The 2-year ladder will hold 6, 12, 18, and 24-month maturity dates. The same example above will apply with the modified time horizons. I will receive the original principal as each rung expires, and interest payments for the life of each CD. Here’s an example:
cd2
The 5-year ladder will hold CDs with 1, 2, 3, 4, and 5-year maturity dates. Remember, I needed a $5,000 minimum investment to start this longer-term ladder. This means I’ll get 5 annual principal payments and interest payments throughout each year. Here’s the 5-year ladder example:

cd3
*Assumes that I reinvested each premium into the longest term, highest yielding CD after the first CD expired. For the 1-year CD Ladder, I’d purchase another 12-month, 0.80% yield CD. For the 2-year ladder, I’d buy the 24-month CD yielding 1.20%. The APY listed in each chart is the starting APY, and this climbs as you reinvest each rung.

Using the 5-year model as an example, I should re-invest the principal from the 1-year CD into the ladder when it matures. I’ll then buy a 5-year CD to add another rung and keep the ladder going. This will cause my average percentage yield to climb. Consider that I would add a 1.80% yielding CD – or higher if interest rates rise – and eliminate that short term low yielding CD by letting it mature. My 2-year CD is now only 1 year from maturity and yielding 1.25%, and so on. At the end of the 5-year period, I’d have a CD ladder with a 1.80% APY.

This is the power of the ladder. If I do nothing and take the principal out as each rung expires, I am losing out on future higher returns.

Author’s note: I used this CD Ladder calculator to do the calculations for these examples. This website has over 400 financial calculators for personal finance, business analysis, and more.

Ladder Strategies: Investment or Income

After choosing the time horizon for my ladder, I must decide between two strategies to achieve my goals. Do I want to just contribute an initial investment, or do I have a specific annual income that I’m after?

With either option, the job is easy. If I desire $100 in annual income from a CD ladder, I see I’ll need to invest $10,000 in a 5-year ladder. Fidelity automatically fills the ladder with the best CDs that match my strategy. This is true whether I’m using either strategy.

Overview and Estimated Interest

The overview tab lists out the key details for each rung of the ladder. The coupon rate (yield) and maturity date are available for the user to see immediately on each rung.

The estimated interest tab breaks down the payment schedule for the ladder. A key point to note here is that it does not illustrate the power of executing the ladder. The chart does not assume you reinvested the principal each time a rung expired.

Choosing CDs and Attributes

If I want the freedom to pick and choose CDs, I’ve got it. I can replace any rung in my ladder by choosing other CDs on the market.

All CDs will tell me if they have sinking fund protection, call protection, and FDIC insurance. I have yet to see one that didn’t have those three options.

If I click on the CD name, I’ll get the Overview and Price/Performance tabs where I can get the CUSIP, Issuer Information, and see how often the CD pays out interest.

Other Options – Custom Rungs

There is an option to select different bond types and ratings. Don’t mess with it. The Fidelity Model system operates on the same page as their bond ladder program. By selecting your model CD Ladder, you’ve already notified the system you want to see CDs and there are no additional settings you should adjust here.

There is a custom “number of rungs” option, and after experimenting with the tool I could modify the ladder to between 2 and 5 rungs.

No Fees and Renewal Options

Fidelity charges no fees for buying CDs using their ladder tool. There are no annual cost or commission fees.

Fidelity will not automatically renew your CDs for you, so it’s important to track when your CDs are maturing. Reinvest the principal of your maturing CD into the longest term, highest yielding CD available for your ladder.

A Word on Penalty Fees

If I create a CD Ladder, and an emergency – or opportunity – pops up that requires me to cancel one or all my CDs, what will happen? Many investors assume they will automatically face an early withdrawal penalty. This isn’t the case with Fidelity’s CDs.

Since I’m creating my ladder out of brokered CDs, there are no termination penalties brought on by Fidelity. If I do want to exit my CDs, I must find a buyer for each one to get my principal back. The CD will be sold on the open market to other individual or institutional investors, so I may not get the full-face value when I sell. This is a slightly better option than facing steep fees associated with canceling some types of non-brokered CDs.

This is a factor you’ll have to weigh when deciding whether to start CD Ladder. If you have extra money sitting around that is not “working” for you, I’d seriously consider a 2 or 5-year ladder.

But what about Online Savings Accounts? Don’t they provide a decent yield with great liquidity?

Well, sort of. There is no debate as to the liquidity of a savings account compared to a CD. But I’ll bet your online savings account won’t be able to beat the yield of a CD over longer time horizons.

The best online savings accounts will yield about 1 percent. That is better than most brick and mortar savings accounts. But I must consider how often and in what circumstances I’ll use the cash I have put away in my savings accounts. I will not use my emergency fund for anything other than an emergency, which statistically does not happen often in my life. My personal earnings are sufficient to cover most unexpected expenses with the help of a credit card, if necessary.

If I am going to hold large amounts of cash outside of what I need for my emergency fund, I should consider using a CD Ladder. That way, I can increase my returns and at least maintain pace with inflation.

Online savings accounts can be beat within one year of starting a Fidelity Model CD Ladder.

Right now, a 1-year ladder will never match the online savings account.

But, if I use the 2-year ladder, I will beat online savings accounts by the 12-month mark! Boom. Every 6 months, I’ll have $1,000 due to me that I can either use or reinvest back into the ladder and earn 1.25%. If interest rates rise during the life of this ladder, the longest I’ll have to wait is 6 months before I can purchase a new rung with a higher interest rate. Here’s how the math works out:

cd4

For a 5-year ladder, Fidelity beats the best online savings accounts immediately. The only disadvantage it has against the 2-year model is the liquidity. I’ll have to wait 12-months for each rung to mature, rather than 6-months with the 2-year model.
cd5

The Evidence Favors the Ladder

If you agree that you generally don’t access your cash stockpiles in your online savings accounts, the evidence favors using a CD Ladder. It doesn’t have to be from Fidelity, but this tool illustrates that you can quickly outpace the returns of the latest 1% online savings account. I wish my bank offered this tool and the great rates that come with it. Right now, I’m only seeing a CD for 1% at my home bank.

Fidelity CDs vs Ally Bank and Others

In the 5-year CD Ladder, Fidelity beats Ally Bank on a $5,000 investment by 10-20 basis points. Ally has a 3 and 4-year Ladder option that beats the Fidelity 2-year model. Fidelity also sells 3-year CDs that yield just 5 basis points lower than Ally’s 3-year term. You can use the model tool to insert a CD like this into your custom ladder.

Nationwide Bank offers more competitive interest rates than Fidelity. The 5-year yield is around 2.25%, which over the first 5 years of a ladder will earn you about $120 more than Fidelity’s model.

Discover Bank is about the same as Fidelity for anything 5 years or less. It’s the same with Alliant Credit Union.

Fidelity beats Capital One by half a percent on a 5-year CD, and beats all other time horizons.

What Works for You

Fidelity’s Model CD Ladder tool makes it fast, simple, and easy to start earning more on your cash. If you don’t have any fixed income vehicles in your asset allocation plan, this may be the perfect place to get started. Balance your liquidity and yield needs to come up with the perfect ladder, either by choosing a target annual income or initial lump sum investment. Online tools like this are perfect for experimenting – use it to find the right CD Ladder for your investment strategy.

Have you ever tried a CD ladder?

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