Should you do a Roth conversion before the (possible) expiration of TCJA in 2026?

A shadowy Block Woman views a yellow ball labeled with red initials TCJA partially below the horizon of a blue and green sea.

As you might know, there’s a huge, all-encompassing change to tax law potentially coming up at the end of 2025. If it happens, you will almost certainly be big-time impacted.

What is that all-encompassing change to tax law? It’s the expiration of the Tax Cut and Jobs Act, which went into effect on January 1, 2018. All of the changes the TCJA ushered in will expire at the end of 2025—and tax rates and other rules therefore go back to the pre-2018 levels—unless Congress renews it.

It’s anybody’s guess whether Congress will renew it.

There are many provisions in the TCJA that really benefit our clients. If you, like our clients, are in tech, make good money and/or have good wealth, and have various forms of equity compensation, you probably benefit, too.

So, it behooves us to look at what tax rules are in effect now that potentially will disappear come 2026, and ask ourselves:

Should we take advantage of TCJA tax rules while they still definitely exist (because they might not exist come 2026)?

Consider these strategies this year and next.

Given the “maybe?” nature of all of this, you don’t want to do anything that you’ll regret if the tax laws stay the same. So, you’re looking for strategies that will serve you well—or at least not hurt you—regardless of what happens tax-wise.

This is, may I remind you, the nature of almost all of personal financial planning: You’re making decisions based on what you think or hope will happen in the future, not on what you know will happen in the future.

How do you still make good decisions in an environment of such irreducible uncertainty? For each choice available to you, you need to think about all the possible outcomes of making that choice. If any of those outcomes is simply unacceptable, then that choice isn’t right for you.

If some outcomes are better or worse than others, but none of them would be catastrophically bad for you (financially or emotionally), then it could be a reasonable choice to make.

For example, let’s say you work at a pre-IPO company. You have stock options. You could exercise them now, paying not only the exercise cost but also the associated tax bill. You can’t know what will happen to the company, and more specifically, the stock, in the future. Let’s say the stock does poorly and you lose all that money.

  • If that means you’d lose your emergency fund and throw your retirement plans off track, then that’s not a reasonable choice.
  • If that instead means you can’t take that One Vacation, but you’re more or less okay with missing it, then okay! Go forth and take that risk.

Below I discuss one strategy to consider before the TCJA expires (maybe): Roth conversions (and the corollary: contributing Roth instead of pre-tax). Later this month, I’ll publish another blog with the other strategies I think are worth considering:

  • Exercising ISOs
  • Delaying charitable contributions
  • All sorts of potentially very complicated stuff to reduce the size of your estate (for those of you who already have millions of dollars)

I’m covering only those strategies that I think are most likely to affect our clients (and therefore you, if you’re like our clients). The changes made by the TCJA are vast and beyond the scope of this blog post.

If you want to know more about the whole TCJA “thing,” you can find articles that are broader in scope from the likes of Schwab or Forbes or any number of financial advisory firms focused on other clientele.

Why talk about this now?

The changes may or may not happen, and making giant decisions based on a possibility is often a bad idea.

But we’re talking about it now for a few reasons:

  • There are some potentially powerful strategies you can use for 2024 and 2025 that will lose their power come 2026, if TCJA expires.
  • If you need to involve an estate planning attorney in any work, they’re gonna be slammed come the latter half of 2025. Best to reach out to them ASAP.
  • Even if it were entirely rational to wait for a while to discuss any of this stuff, you’re going to start seeing some “sky is falling” headlines, if you haven’t already. So, let’s discuss this in a useful manner before the headlines hijack your brain.

Roth conversions: Convert pre-tax IRA or 401(k) dollars to Roth

Why do we care about pre-tax and Roth?

Some background and edumuhcation about Pre-tax vs. Roth

Let me ask you a question: Would you rather save pre-tax when your tax rates are high or low?

The answer is High. If your tax rate is 39%, every dollar saved pre-tax saves you 39¢ in taxes. If your tax rate is 25%, every dollar saved pretax saves you 25¢. Saving 39¢ is better.

Now, would you rather save after-tax (i.e., to a Roth account) when tax rates are high or low?

The answer is Low. At a 39% tax rate, you pay 39¢ in taxes for every dollar you save to a Roth account. At a 25% tax rate, you pay 25¢ for every dollar you save to a Roth account. Paying 25¢ is better.

That’s a useful, but simplistic, way of thinking about the pre-tax vs. Roth/after-tax question. For a bit more nuance:

When you take money out of pre-tax accounts (typically IRAs or 401(k)s) in retirement:

  • You will need to pay income tax on all of that money.
  • That income can also increase other costs, like Medicare Parts B and D premium and the taxability of your Social Security retirement income.
  • All money in a pre-tax IRA or 401(k) is subject to Required Minimum Distributions, meaning that you must take money out of those accounts starting at what is now age 73.

Sounds kinda crappy. Why would we put money into a pre-tax account? Why, to save money on taxes now, of course.

By contrast, Roth accounts are tax-free, and any money in those accounts can stay in there for your whole life, you never have to take the money out, and if you do, it’s not subject to taxes and won’t raise your taxable income in a way that will impact Medicare premiums, etc. But you don’t get any tax breaks now for any contributions or conversions into Roth accounts.

[Note: The “Roth vs Pre-tax” discussion is a multi-layered one. Some considerations are technical (comparing current tax rates with expected future tax rates). Some are emotional (I, for example, would rather just bulk up tax-free assets while I’m young and have strong earning power). This TCJA-inspired consideration has to fit into the larger Roth vs. Pre-Tax discussion, which is, alas! outside the scope of this blog post.]

Why now is such a good time to consider Roth conversions

I wrote a whole blog post about Roth conversions a little while ago. (If you think you want to do a Roth conversion, I highly recommend you read the whole thing. Oh, and work with a CPA to model the tax impact.)

In that post, I pronounced that one good opportunity for doing Roth conversions is when “You bet the federal government will raise tax rates.” Well….?! That’s precisely what we’re talking about here!

If TCJA expires, here’s how tax rates and tax brackets would change. Observe that not only do tax rates go up, but higher tax rates apply to lower bands of income, meaning that your tax bill could go up double-whammy style.

Source: fpPathfinder®

We already consider Roth conversions for clients who are having an unusually low-income year, clients who are taking a sabbatical, going back to school, got laid off and can’t find a job, etc.

Because of this TCJA thing, even if this is a totally “normal” income year, you should still look at doing Roth conversions. These might end up being anomalously low tax rates anyways, simply because of federal tax policy.

Keep in mind that doing a Roth conversion means you are volunteering to pay taxes before you have to. You could just wait for another several decades to pay taxes on this money. But you’re making a bet that by paying taxes now, you’ll pay less (over your lifetime) than if you pay taxes later. (So much delayed gratification energy going on here, it hurts.)

It’s always possible you could convert the pre-tax money, and the tax rates don’t go up. Lord knows there have been bountiful predictions for decades now that tax rates will (“have to!”) go up…predictions that have yet to come true.

Consider doing this: Ask your CPA to model for you how much you can convert from pre-tax to Roth (in your IRA or 401(k)) and still stay within the same tax bracket, or even one tax bracket up, along with the tax bill you’d incur in both cases. If you want to convert, remember you have to do so by year’s end. You can even convert some this year and some again next year.

Remember, you want to have cash or taxable investments to pay the extra taxes. You do not want to withhold any money from the IRA in order to pay the taxes.

Contribute Roth instead of pre-tax

Many of our clients have $100ks or over $1M in pre-tax accounts (IRAs or 401(k)s). That is a lot of money to consider converting. (In reality, it probably makes sense to convert only some of it.)

By contrast, annual contribution limits to all these retirement accounts are way way lower: $23,000 for 401(k)s and $7k for IRAs (plus some catchup for people 50 years old and up). So, “pre-tax vs. Roth contribution” can be a much smaller-scale decision.

It’s still worthwhile considering, however! And maybe, behaviorally speaking, it’s a lot easier to contribute Roth (and not reduce your tax bill) than it is to convert to Roth (and intentionally increase your tax bill, possibly by a lot). Progress, not perfection, people!

Many of you likely have access to, and perhaps are even saving to, after-tax contributions to your 401(k) (aka, mega backdoor Roth). In that case, you’re already getting lots of after-tax/tax-free money into your retirement portfolio. Maybe that takes the pressure off shifting even more money into that tax-free status.

Consider doing this: Saving to your 401(k) Roth instead of pre-tax, for the rest of this year and in 2025. You could switch back to saving pre-tax if TCJA expires and tax rates jump up.

It’s hard to figure out how all this affects you!

I don’t know if you’ve noticed this, but our federal tax code is complicated. Like, really, really complicated. And getting more so every year. (Be sure to give your friendly local CPA a sympathetic glance, and maybe a cookie, next time you see them.)

The tax code is so intricate and interrelated that you can’t ever glibly proclaim that the change of <this one thing> will affect your taxes <in this specific way>. You need tax software because you need to effectively process your entire tax return in order to get a reliable answer about any single thing. It’s an unfortunate reality.

For example, if you live in California and have a mortgage and earn a lot of money, the higher tax rates will hurt you, but your ability to deduct more of your mortgage and more of your state income taxes (as illustrated below) will help you.

Source: fpPathfinder®

To make good decisions confidently, you need to work with a tax professional who has software that can model your entire tax situation under TCJA tax rules vs. your tax situation if TCJA expires.

Alright, friends and strangers. See you in the next blog, for more discussions of strategies you should start considering before the end of this tax year. Tootles.

Would you like to work with a thinking partner who can help you to discover and define your goals, and use that to help make your best financial decisions? Reach out and schedule a free consultation or send us an email.

Sign up for Flow’s twice-monthly blog email to stay on top of our blog posts and videos.

Disclaimer: This article is provided for educational, general information, and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. We encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Flow Financial Planning, LLC, and all rights are reserved. Read the full Disclaimer.

Look out for These Mistakes in Your Estate Plan.

Block Woman stands in front of a white sheet of paper with the title written in old script that says Last Will and Testimont. The letter i in misspelled Testimont is crossed through in red and a letter a is written above.

You have money? You need an estate plan.
You have children? You need an estate plan.
You have a body? You need an estate plan.

Many of our clients don’t have estate planning documents when they come to us. If a client has no estate plan—or an outdated one—we recommend they work with an estate planning attorney to create one. Then, after the attorney has drafted a set of documents and implementation advice for our clients, we review it all.

And sometimes (not often; turns out estate planning attorneys are generally pretty good at their jobs! how nice) we find either mistakes or “sub-optimal” bits.

This blog post is not advice on “what your estate plan should say.” That’s better written by an estate planning attorney. This blog post describes those mistakes and sub-optimal bits that we come across most often. I hope you can use our experience to help avoid making the same mistakes in your own estate plan.

The mistakes we see clients (unwittingly) make

I am not an estate planning attorney.

More importantly, our clients are not estate planning attorneys. Which means that they generally don’t know how to read, understand, or interpret a lot of the documentation that is written for them. (Certain lawyer clients notwithstanding…) They might understand the words, but not the implications for them or their family.

The estate planning attorney is, obviously, the expert on the law. But not usually on the client.

So, between the client, the attorney (the expert on the law), and me (the expert on the rest of the client’s life and finances), I think we ultimately do a pretty good job of getting the clients an estate plan that serves them and their family and their values really well.

Here are the mistakes we’ve helped clients correct over the years:

A plan exists…but it’s not yours.

You might think that if you don’t have estate planning documents or you haven’t set your beneficiaries on your life insurance policy or 401(k), you don’t have an estate plan.

Wrong.

You have a plan. But it’s the state’s plan for you. Not one of your own design. There are all sorts of state-level and federal-level laws that will dictate what happens to you and your stuff and your children in the event of your death or incapacity.

If you don’t draft estate planning documents and designate beneficiaries and fund your trust, etc. etc. etc., you are tacitly saying, “Okay, state, you make all the decisions on my behalf!”

You don’t have all the necessary documents.

This is kind of a subset of the above mistake. You have parts of your plan, but not all the parts.

In practice, we’ve never found this to be a problem with clients who engage an attorney directly to work with. We’ve found this only when clients use their workplace legal benefits or some other service here an attorney isn’t personally guiding the conversation.

We have one client who “got their estate planning documents done” via their workplace benefits…and it contained only a will. No powers of attorney. No living will. No healthcare proxy.

Do you have all the appropriate documents for your situation? The standard suite of documents is, well, pretty standard:

  • Will. If you are a parent, you absolutely need a will…to name the person who will take care of your child if you die. (Everyone else needs a will, too. It’s just that having a kid is the thing that finally persuades people to do the work.)
  • General durable power of attorney (for financial decisions)
  • Healthcare power of attorney (for healthcare decisions)
  • Living will/advance medical directive. What healthcare decisions should be made if you’re unable to make them?
  • HIPAA release. Who should have access to your healthcare information?
  • Maybe a trust
Your estate planning attorney should know what kind of documents are appropriate for your financial and family situation and in your specific state. For example, whether or not you should have a trust depends on your personal financial situation and the state you’re in. In Virginia, my husband and I had revocable living trusts. In Washington, we don’t.

All sorts of beneficiary “gotchas.”

Designating a beneficiary on an IRA, a 401(k), a life insurance policy, or a variety of other accounts is about the easiest way to make sure a certain person gets your money when you die. (On taxable accounts, it’s usually set up as a “Transfer on Death” designation, as opposed to a “beneficiary” per se.)

While they’re usually very easy to set up, there are a ton of ways that your beneficiary designations can go wrong.

If you don’t know how to correctly designate your beneficiaries, ask your attorney.

You don’t have a beneficiary set up on every account and policy.

The “easiest” way to go wrong when it comes to designating beneficiaries is simply that you haven’t designated a beneficiary for each account. And, if we’re going to gild the lily a bit, each account should also likely have a secondary or contingent beneficiary, just in case the first one dies before you do.

You’re married, but someone or something other than your spouse is the beneficiary, especially on retirement accounts.

Let’s say you have set beneficiaries on all your accounts. If you’re legally married, but your spouse isn’t listed as a beneficiary, that’s going to catch our eye.

Spouses get better treatment than anyone or anything else on many accounts: IRAs, 401(k)s, 403(b)s, and HSAs in particular. Life insurance benefits and taxable accounts can more reasonably be designated to go somewhere else, especially if you also have a trust (which could be the proper beneficiary).

If you check your beneficiaries and your spouse isn’t the beneficiary, just confirm with your attorney that this is in fact the right way to go, both in terms of “how do I minimize taxes?” and also “who do I want to end up with all my money?”

Your IRA/401(k) leaves some money to a charity and some money to a human.

The tax treatment of the money in your IRA/401(k) differs depending on who inherits it when you die: your spouse gets different rules than your child would, and both of those sets of rules differ from the rules governing a charitable beneficiary.

If you have both a human and charity as a beneficiary on an IRA, then the rules assigned to the charity might negatively impact how your human heir inherits the money, too.

The solution? It’s probably better to have two IRAs, one leaving money to the charity, and the other leaving money to your favorite humans. This way, the human gets the most tax-favorable distribution rules when they inherit your money.

Your minor children are designated as beneficiaries.

If your child is younger than 18 years old, designating them as a beneficiary can cause problems. They have to be adults to directly receive that money.

This isn’t necessarily a catastrophe. But you do want to consult first with your attorney to ensure that you want that money going as directly as possible to your child. (Maybe it’s better going into a trust managed on behalf of your child, for example?)

Then, assuming this is indeed the plan, you should consult with the custodian where you hold your account or policy (like Schwab or Transamerica) to ask how the beneficiary needs to be written so that someone you trust can serve as custodian of that money on behalf of your child until they’re 18.

Your Beneficiaries No Longer Make Sense.

Have you gotten divorced? Have you had a child? Have you drafted a trust? Have you gotten married? Have your children become adults?

All of these are reasons why your existing beneficiaries might no longer make sense. You will likely pick up on this yourself if you simply take the time to look at your beneficiaries.

Your will leaves money to a charity.

Why is this a problem? Well, maybe it’s not.

But if you have money in a traditional, pre-tax IRA/401(k) as well as money that passes through a will, it’s likely that leaving money to the charity from your IRA/401(k)—and leaving your other assets to human beneficiaries—is much more tax efficient.

Charities won’t have to pay taxes on the money in your pre-tax IRA/401(k). Human beneficiaries will. And taxable assets get a “step up” in basis upon your death, usually resulting in vastly lower tax bill for your human heir than they’d have to pay if they inherited the same amount of money through a pre-tax IRA/401(k).

You accidentally disinherit future children.

If your will, trust, or any beneficiary designations name your existing child by name and have no mention of the possibility for future children, then you risk disinheriting children you might have in the future.

Most documents I’ve ever seen say something like “My current child, Kim, and any future issue.” But sometimes documents simply say “My child, Kim.” Full stop. Be aware!

You name a contradictory hodgepodge of people for different roles in your estate plan.

Your estate plan might end up naming a lot of people for different roles: an executor for your will, an agent for your healthcare power of attorney, for your general durable power of attorney, a guardian for your kid, a trustee of your trust, etc. And all of these people should also have backups.

It can get confusing. So, make a list of all the different people and make sure they make sense together. Do you want the same person with general durable power of attorney and healthcare power of attorney and guardian for your kid? Or do you want to separate some of those powers?

Double check the names you’ve listed against your actual desires. Sometimes we just get confused and end up mistakenly listing the wrong person in the wrong place.

You will lose access to your child’s healthcare information when they turn 18.

One thing that many parents don’t think about is that, when their kids turn 18, the kids are no longer minors, and the parent no longer has a default legal right to their medical info. If you want to make sure you can get information about your child’s health while they’re, say, off at college, make sure you have a HIPAA release for your child.

You have a trust, but you haven’t “funded” it yet.

Many of our clients have revocable living trusts as part of their estate plan. The trust, basically, describes a set of rules that dictate how everything “inside” the trust will get handled. Trusts can be great in that they organize all your assets under a single set of rules, and they keep your estate information private upon your death. (Information about anything that passes through your will is publicly available.)

The catch is: You have to put stuff inside the trust in order for those rules to be useful. If there’s nothing inside the trust, the rules don’t apply to anything.

This is called “funding” your trust.

Your attorney most likely will give you a list of instructions for how to do that. We see these most commonly:

  • If you own a home, you can assign the deed for your house to your trust (from your name). Your attorney can help you do that.
  • If you own taxable investment accounts, you should be able to “retitle” the account so that it is owned by your trust, no longer by you. (Retirement accounts like IRAs and 401(k)s are owned individually by you. They don’t and cannot get retitled to the trust.)
  • Some accounts that are owned by you can’t be retitled. The institutions that host the accounts don’t allow it. We see this most often with bank accounts. Check with your attorney if this is okay, but the most common workaround is to simply designate the trust as a “Transfer Upon Death” or traditional beneficiary for the account. The trust won’t own it during your life, but as soon as you die, the money gets shoved into your trust and the rules apply.

You let your kids have unfettered access to all your money too young.

Many of our clients have minor children (many are just wee babies!). These same clients currently have or will likely have a lot of money over the ensuing years (especially if we consider life insurance death benefits).

Our clients’ wills or their trusts talk about what will happen to that money when they die. Usually, our clients want that money going to their kids. Very natural.

What we expect to see in the estate planning documents is language like this: After your death, the money will be kept in a trust. While the money is in the trust, the trustee of that trust will distribute money from the trust to pay normal expenses for the child. At the age of 25, the child can get access to one-third of the entire amount of the trust. At the age of 30, the child can get access to half of the entire amount of the trust at the age. And at the age of 35, the child can get access to all the money that remains in the trust.

(This isn’t how the trust document actually words it. It is a legal document after all. But that’s the meaning.)

Why do it this way? While the child is young, and obviously unable to manage their own money, the trustee manages everything on the child’s behalf. The child doesn’t get their first exposure to Big Money until age 25, by which age they’ve hopefully learned a bit about prudent money management. But if not, they can only “squander” one-third of the inheritance. They learn a little something through that process, and five years later, they get another lump sum of money. Hopefully by then they’re a little wiser. Rinse and repeat by age 35.

We’ve seen estate plans that (unwittingly!) give the child full, unfettered access to 100% of the money as soon as they turn 18. Yikes! I don’t know about you, but I’m fairly sure me coming into $4M at the age of 18 would not have been a good idea. And I don’t intend to leave money like that to my children if I die while they’re still relatively young.

So, think about how you’d want your child to inherit your money. All at once? In stages? At what age(s)? Make that clear to your attorney.

Prioritize doing your estate planning with a good human attorney over doing it cheaply.

Many of the mistakes, omissions, and oversights I mention above have come from clients who did their estate planning via a low-cost, tech-first, low-touch, online solution. It turns out, estate planning is complicated! Not necessarily because we’re using complicated solutions, but because the law changes over time and your values and emotions and lives are complicated.

So, for my clients (and for myself), I lean heavily in the direction of engaging an actual human attorney 1-on-1 to do your estate planning work with you. Maybe for particularly simple situations, the high-tech/low-touch tools make sense? But it seems penny wise, pound foolish to me. You’re not paying for an estate plan every year. Hopefully you can afford to do it thoroughly, because you only have to update it every few years.

Here are some thoughts from estate planning attorney, Alan D. Khalfin, Managing Partner at Vaksman Khalfin, PC, with whom I’ve had many illuminating conversations over the years.

While DIY estate planning might save a few bucks upfront, it often ends up costing families more in the long run due to administrative and tax issues. This is because DIY plans are not tailored to specific asset, tax, and family dynamics, nor do they contemplate the numerous contingencies that may arise. Each client’s situation is unique, with specific nuances that need to be addressed, even if not overly complex.

In my trust administration and probate practice, I’ve seen firsthand the dangers of DIY estate planning materialize. Significant issues and unnecessary complexities often arise from inadequately prepared documents, many of which require court involvement to resolve. This can be costly and time-consuming, far exceeding the initial savings from using an online platform. Working with an attorney from the beginning can help prevent these pitfalls and ensure a smoother process during a difficult time.

It’s simply impossible for online services to provide the counseling required for tailored estate planning that works as intended. Counseling is essential during all phases of the engagement, including design, drafting, execution, and funding. And as life and assets evolve after the estate plan is in place, it’s important to address questions and changes with an experienced firm that has a relationship with you and knows your situation. While some online services offer “attorney advice” for an additional fee, it’s typically from a different attorney each time who doesn’t know your situation or the estate plan already in place. And given the compensation these services offer their attorneys, the chances of getting quality advice are slim.

Another practical consideration: if things go awry and a mistake was made by an attorney, the heirs can pursue that attorney’s legal malpractice insurance to make them whole. This is not possible with an online service, which is not a law firm and does not carry legal malpractice insurance. And of course, with an online service, the heirs have nobody to turn for assistance when incapacity and death occur.

Frankly, the only situations where I can condone DIY estate planning are: 1) if the client simply can’t afford the fees an attorney charges and would otherwise have no estate plan; 2) a temporary will, POA, and healthcare directive needed immediately for health or travel reasons, with the intent of doing a full estate plan with an attorney when able; and 3) POA and healthcare directive for young adults with no assets who aren’t ready for a full estate plan.

Revisit your estate planning when…

When should you go back to your attorney and ask them to review or replace your estate plan? Simply put, when something big changes in your life:

  1. You get married (or divorced)
  2. You have a child (or your child turns 18)
  3. Your wealth grows by a lot (especially if it’s “overnight,” by way of inheritance or IPO)

The simple passage of time is a good reason to revisit your plan. Maybe nothing needs to change. But 10 years can create a lot of change, cumulatively, which you’re not particularly aware of. Kind of like someone losing weight, a few pounds a month. Nothing looks different day to day…but if you see that person for the first time after a couple years, whoa!

Not to mention that changes in the law can render estate plans or certain provisions in estate planning documents wrong or useless.

Do you want to work with a financial planner who will connect you with an estate planning attorney and help ensure that your estate plan serves your finances, your life, and your family? Reach out and schedule a free consultation or send us an email.

Sign up for Flow’s twice-monthly blog email to stay on top of our blog posts and videos.

Disclaimer: This article is provided for educational, general information, and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. We encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Flow Financial Planning, LLC, and all rights are reserved. Read the full Disclaimer.

Should You Participate in an Exchange Fund with Your Big Pile of Company Stock?

Block Woman peers over the edge of a clear blender, looking down on an ice cube and the stainless steel blender blade.

Do you have too much of your company stock? Today let’s talk about one specific solution to that “concentration risk”: the exchange fund. (Really, I talk, you listen. Juuuuust the way I like it.) 

Many people seem to think that exchange funds are another one of those “rich, sophisticated people who know how to work the system” tools. So much cool. So much smart. So much brag-worthy. In my opinion, however, in general, you’d be well served by staying away.

I recently went through this analysis with a client, who’d been invited to join an exchange fund and was wondering if she should. (Yes, you have to be invited to participate.) I hereby share the results of that analysis with you, in case you are tempted to join an exchange fund.

Much of what I know about exchange funds comes from my favorite book about equity compensation: Managing Concentrated Stock Wealth. The author, Tim Kochis, is kinda the godfather of equity-comp planning. The first time I ever heard him speak, I remember walking away with this single impression: Almost all the time, the best solution is to sell it, pay the taxes, and move on. So, be aware that that is the attitude I bring with me to all discussions about company stock. Any reason to vary from that approach is gonna have to be Pretty Damn Persuasive.

What is an Exchange Fund?

Let’s just consult Investopedia for its definition:

An exchange fund, also known as a swap fund, is an arrangement between concentrated shareholders of different companies that pools shares and allows an investor to exchange their large holding of a single stock for units in the entire pool’s portfolio. Exchange funds provide investors with an easy way to diversify their holdings while deferring taxes from capital gains.

After you keep your money in the exchange fund for at least seven years, you can sell your shares in the fund. At that point, you will pay long-term capital gains taxes on the gains, i.e., the value of the shares over your original cost basis. That’s what the above definition means by “deferring taxes.”

An example:

  1. Your investment portfolio is $3M. $2M (67%) of that is Airbnb stock. You acquired this stock by exercising ISOs way long ago, and so your cost basis in that stock is only $20k.
  2. You are invited to participate in an exchange fund and to reduce your concentration in Airbnb, you accept.
  3. You move all $2M (for simplicity’s sake) into the fund. This happens with no tax consequences. Now, instead of owning $2M of Airbnb, you have $2M of a mix of Airbnb, Meta, Datadog, Fastly, Amazon, Microsoft, Tesla, Nvidia, etc. (all the other stocks that were invited to join the fund). You have moved from ownership of a single stock to (indirect) ownership of many stocks, without incurring any tax bill.
  4. In seven years, your share of that fund is worth $3M.
  5. You sell your share and now you owe taxes: The taxable gain is $3M- $20k = $2.98M. You pay long-term capital gains tax on that $2.98M.

Why Would You Consider Using an Exchange Fund?

Because taxes suck.

I mean, I’m not one of those types who think taxation is theft. I very much like my paved roads and national parks and national defense and public schools and feeding the hungry. But I know as well as anyone that paying taxes is painful.

Having a lot of your money in a single stock creates a concentration risk. The opposite of concentration is diversification: having a little bit of your money in a lot of stocks (or, more broadly, in a lot of investments, including bonds and, for some people, real estate and commodities and precious metals, to name a few). You get easy diversification when you invest in something like a Total US Stock Market fund or a target-date fund.

If you sell your company stock in order to reduce your concentration and invest the proceeds in a diversified portfolio, you’re gonna have to pay taxes on the gains in the stock you sell. (Notice I said gains; you don’t have to pay taxes on the total value of the stock, only on the growth it has experienced since you acquired it.)

Exchange funds promise that diversification without the tax hit.

Ooooh, that sounds niiiice.

What’s the catch?

Cons of Exchange Funds

Oh, my friend, the catch is big. And multi-faceted. Let us count the ways this can bite you in the butt.

Your money is locked up for seven years.

I’ve already mentioned the seven-year holding requirement in order to get these tax benefits. You might be able to get your money out earlier (check the terms of the exchange fund), but if you do, you won’t get the tax-deferral benefits. The seven year holding period is actually a legal requirement.

Why is this lockup a potential problem?

Well, there’s the obvious “But what if I need the money?” problem. For my client who inspired this blog post, this wasn’t a problem: she has plenty of money outside this company stock and shouldn’t need the company stock money for many years.

Then there’s the not-so-obvious “If the performance of the fund starts to tank, I can’t do anything about it” problem. You gotta leave your money in, watching helplessly as your investment falls in value. And considering that exchange funds are often created after a huge run up in a particular industry’s stocks, it can easily happen that you put the stock into the fund at or near the top…and then watch the stock prices run down.

Some of your money is probably invested in crappy real estate.

Twenty percent of an exchange fund must be invested in “illiquid” investments. Usually, this means real estate. So when you participate in an exchange fund, yes, you own a portion of Airbnb, Meta, Datadog, Fastly, Amazon, Microsoft, Tesla, Nvidia, etc. You also own a portion of a real estate investment that the managers of the exchange fund pick.

Here to comment on said real estate investment, Mr. Kochis:

Excellent real estate opportunities can be packaged and sold on their own merits. Real estate used to meet a tax requirement for the packaging of some other main event is not likely to be the kind of with the very best investment characteristics.

In other words, you’re likely not getting the crème de la crème real estate in the fund. Probably not even the plain old crème. And yet 20% of your investment in the fund now depends on that real estate investment’s performance. Not ideal.

They’re expensive.

Historically it has been white-shoe firms like Goldman Sachs and Eaton Vance who have offered exchange funds. The fees have been hefty. It’s not surprising to find an annual cost of 2% of your share of the fund. Have $1M in the fund? You’re paying $20,000 each year.

That said, Cache, a much newer company, charges a much-lower fee: 0.50% – 0.95%.

Not-so-diversified diversification

Exchange fund managers try to get stock into the fund (by invitation) in order to recreate/track a diversified market index. That’s the whole point after all: Diversification! (without a tax bill)

Alas, this promise of diversification often doesn’t turn into actual, meaningful diversification.

Again, Kochis writes:

The opportunistic timing of the creation of exchange funds can diminish true diversification even more. These funds are especially likely to be brought to potential investors when a particular market sector has recently enjoyed exceptional growth. [Sound like the tech industry, anyone?] Such growth often leads to many newly wealthy investors looking for ways to manage their new problems—far too much of a single holding in proportion to the rest of their portfolio. They are often found in the same industry or market sector at the same time making for a rather dubious attempt to minimize the downside risks of market exposure for a closely correlated position. This is especially problematic since investors in exchange funds are precluded for 7 years from taking any other action on the stock they contribute.

Traditionally exchange funds have usually tried to track the S&P 500 (which as of earlier this year, was 40% in the tech industry). Cache tries to create a fund that tracks the Nasdaq 100 (when I looked, it was 62% in the tech industry).

So, yes, you diversify away from the risk of your one company. That is valuable! But you’re still wildly exposed to the vagaries of one industry: tech. You own little of US companies in other industries, and probably very little to no international stock, bonds, smaller companies, etc.

Some offerings are very new.

Call me a luddite (I prefer “realistic based on experience”), but at this point I instinctively distrust fintech offerings that haven’t been around for probably at least a decade. I have been burned by a sexy new fintech startup—and have seen many people be burned by others—as the companies “pivot” to find a business model that is actually sustainable. That pivot often completely undermines the value to the early adopters. I daren’t name names for fear of crossing some unknown-to-me legal line, but if you harken back over the last five years, I’m sure you can think of a fintech tool that ended up really damaging some people’s finances and lives.

As much as I instinctively turn up my nose at Goldman Sachs, at least they’ve been offering exchange funds for years and years. I don’t have personal (direct or indirect through my clients) experience working with Cache, but it was founded in early 2022, and frankly that alone is enough for me to be wary of them.

Exchange funds are hugely complicated tools and tech has a history of flouting either the letter of the law or the spirit of best practices (tidily summarized in the euphemistic phrase “disrupting the industry”). Occasionally, yes, the tech folk get punished for it. Much more often, however, the end consumer is the one who suffers.

Your taxes aren’t eliminated, just delayed.

This isn’t a con per se, but it can still hurt you if you think (incorrectly) that exchange funds allow you to avoid taxes. And I fear many people do.

Even if you use an exchange fund and get some level of diversification, when you sell (after at least seven years), you still owe taxes on the gains in the fund. There is value to tax-deferral, for sure! That’s why so many of you likely contribute to your 401(k) pre-tax. But the tax bill is still gonna be there, and, if the exchange fund hasn’t lost a lot of money, the bill is still gonna be big.

When Are Exchange Funds Most Likely to Be Useful for You?

After reading this far, you might wonder, as did my client, “Who, then, would actually benefit from using an exchange fund?”

As best I can tell, you’re most likely to benefit if you’re in the following situation:

  • You’re currently in a high-tax situation (because of your income and/or state), and it’s possible you’ll be in a much-lower tax situation in seven years (because it’s at that point that the taxes will be calculated).
  • Your stock has very low cost basis. That means your gain is large, and the tax bill upon sale will be large. By contrast, if your company stock is all from vested RSUs, it’s probable that your cost basis is actually pretty high (because you paid taxes on the RSU shares when they vested, setting the cost basis equal to the value of the stock on the day of vest), meaning the gain is small. In that case, just selling the stock would actually not create that big a tax bill.
  • You have lots of broadly diversified investments outside the concentrated stock so that the inability to access the money for seven years isn’t a big deal, and the continued lack of broad diversification in the fund isn’t that big a risk to your total portfolio. This is more “you can afford for the exchange fund to go poorly” and less “the exchange fund will actually help you.”

the snark

As I’ve already mentioned, you have to be invited to join an exchange fund. That makes sense, because the managers are trying to construct a fund that tracks a certain market index (ex., the S&P 500). They can’t just take all comers.

You also need to be an Accredited Investor or maybe even a Qualified Purchaser in order to participate. That means that you have to have a certain (high) minimum household income or household net worth.

As you might imagine, this creates a sense of exclusivity, of elitism that can be very tempting.

Kochis writes:

On rare occasions you may have a client who prefers the exclusivity of an exchange fund, despite all its limitations, or one who finds the seven-year lock-up helpful for reasons unrelated to investment optimization [ex., they want an excuse to not give money to family].

Heh. Well, the world takes all kinds. And there probably are some cases where these considerations are important enough. Though, if they are, I’d suggest you might benefit more from some personal or family therapy.

One of the basic rules of investing is: Don’t invest in anything you don’t understand.

As you now perhaps understand, exchange funds can be wildly difficult to understand (well). So, either avoid exchange funds, acquire the knowledge yourself to analyze the opportunity (but lord, why would you spend your one wild and precious life doing that??), or work with a financial professional who already has the knowledge (not only of exchange funds, but also the knowledge of you and your goals).

If you want help thinking through all the complicated “but maybe they’re good?” financial opportunities in your life, from someone who knows you and cares about you, reach out and schedule a free consultation or send us an email.

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Disclaimer: This article is provided for educational, general information, and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. We encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Flow Financial Planning, LLC, and all rights are reserved. Read the full Disclaimer.

Focus on these Few, Important Parts of Your Auto Insurance

Block Woman stands in focus in the background with two blurry red cars in the foreground that have crashed into each other.

My husband pointed me to this recent, kinda insane Twitter thread about auto insurance: 

It tells story after story of people doing or saying “dumb” things about auto insurance.

You get enough such stories strung together and you start to realize, “This isn’t the consumer’s fault. It might be their problem, but it’s (often) not their fault. They’re not doing these ‘dumb’ things because they’re dumb or subject to magical thinking. The system is simply too complicated to understand (alongside the umpteen other systems they need to understand…oh yeah and don’t forget their job and family obligations).”

That plus the fact that some clients have been goggle-eyed at the increase in their auto insurance premiums and, lo’, this blog post was born.

We are not insurance agents or brokers (originally typed as “borkers,” and let me tell you, that almost stayed) here at Flow. Such people have already written lots of articles across the internet that explain every aspect of auto insurance. I’m not interested in recreating that. (You should absolutely work with an auto insurance agent or broker in order to fully understand your coverage.)

I’m coming from a perspective of knowing enough about auto insurance and having worked with many a client to figure out the most appropriate coverage for their total financial picture. I have learned what to focus on…and what to safely ignore.

Auto insurance policies can provide a lot of different kinds of coverage. I don’t care about most of them. They’re nice-to-haves.

I want to discuss the short list of items in an auto insurance policy that we review on our clients’ policies—and that you therefore might focus your energies on. We believe they are the most likely to protect you against catastrophic (or even just really painful) financial damage, while keeping premiums as low as possible.

Liability Coverage

When I look at my auto insurance policy, this is formally called “Bodily injury and property damage Liability.” It covers your legal liability when your accident injures another person or damages someone’s property, i.e., when you’re sued by the person you hit.

Now, if you get an Umbrella Liability coverage—which we generally recommend to our clients—you’ll likely need to max out this coverage anyways. But even in the absence of that requirement, this is probably The Most Important Part of your auto insurance.

Why? Because it protects against the most catastrophic financial costs: being sued. While the cost of repairing or replacing your car is bounded (by the value of the car or a replacement car, more or less), people can sue you for any amount they want.

We generally recommend our clients max out their liability coverage.

Deductibles

Setting deductibles too low is probably the most common mistake we find amongst our clients. They’ve set their deductibles to, say, $250 when they could be much higher (usually $1000 is the highest available).

Why do I recommend they raise their deductibles? Because it will lower their premium.

What makes that an acceptable trade-off? The fact that they have plenty of cash to pay that extra $750 if they submit a claim. If you don’t have much cash lying around to pay the possible bill yourself, then yes, you should probably keep your deductible low. In my opinion, deductibles should be set in coordination with your cash emergency fund: the bigger your cash cushion, the higher you can afford to set your deductible.

This logic applies to both Comprehensive (covers the cost of repairing damage to your car by an event other than a car collision, such as theft or vandalism) and Collision (covers the cost of repairing damage if your car overturns or if it hits another car or object) deductibles.

Underinsured/Uninsured Motorist Coverage

That Twitter thread mentioned at the start features a “Plaintiff’s personal injury litigator” who says he recommends to all his friends and family that they get lots of underinsured/uninsured motorist coverage.

Anywhere from 5% to 25% of drivers are uninsured, depending on the state.

Which really really sucks when they hit you. Their lack of insurance, it turns out, ain’t payin’ any of your bills.

There are two parts of this coverage:

  • Underinsured Motorist Bodily Injury: This covers costs for damages you (and a few other related people…see your insurance policy for details) incur, including medical expenses and lost wages.
  • Underinsured Motorist Property Damage: This covers the cost of repairing your car. If your car is a beater 👋, then it’s not very worthwhile.

We generally recommend our clients pay for underinsured motorist coverage and tailor the “property” damage coverage to the value of their car.

So, take a look-see at your auto insurance and make sure that you at least have these three categories of your policy set appropriately for your situation, okay? 

And yes, your premiums have probably gone up and they’re probably high…and there’s probably nothing for it but to pay the bill.

That or trade in your vehicle for a 20-year old Toyota Sienna that’s worth about $13 and move out of California. See? Easy!

If you want to work with a financial planner who will take a look at all parts of your financial situation, reach out and schedule a free consultation or send us an email.

Sign up for Flow’s twice-monthly blog email to stay on top of our blog posts and videos.

Disclaimer: This article is provided for educational, general information, and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. We encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Flow Financial Planning, LLC, and all rights are reserved. Read the full Disclaimer.

How Much Can You Safely Spend from Your Investments?…for the Young and Financially Independent

Block Woman stands at the start of a blurry game board of Life.

You have millions of dollars. You’re 40ish years old. You’re financially independent. At least, you think you are. But that all depends on not taking too much money out of your investment portfolio. So, how much can you spend and still be “safe”?

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How I Created My Own Charitable Giving Plan: The Final Installation (Probably)

Block Woman reviews a hand-written list of potential charitable donations. There is a pile of cash underneath the list.

Two major iterations (and several years) later, my charitable plan is finally where I want it to be. That said, even my original plan was good enough as it was! After all, the charities were still getting our money, and that’s the whole point. So, please, if there’s one lesson you take away from my “journey,” let it be: Just Start Somewhere.

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What Are Estimated Taxes? How Do They Work? What Should You Do About Them?

A few weeks ago, I was talking with a client about his 2023 taxes. About the fact that he hadn’t paid estimated taxes in 2023. And that a probably big, but who-really-knew-how-big tax bill was looming before April 15. And that his CPA would give him some recommendations for paying estimated taxes in 2024. And that he should pay those estimated taxes so we’re not in this position again next year.

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