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Your Financial To-Do List for October

Year-end is right around the corner; here’s what to focus on this month.

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. We've entered the fourth quarter of 2021, and year-end will be here before we know it. Joining me to share what should be on your financial to-do list this October is Christine Benz. She's Morningstar's director of personal finance and retirement planning. 

Hi, Christine. Thanks for being here.

Christine Benz: Hi, Susan. It's great to see you.

Dziubinski: You're saying that it's a good idea around now for investors to stay a little bit plugged in to some of those potential tax changes that they're talking about in Washington right now. Can you sum them up for us, and what really should be on our radar?

Benz: Right. It's a really wide-ranging tax-reform proposal. One of the big line items involves higher income and capital gains rates for high-income individuals: $400,000 is the income threshold for a lot of these changes. If you're in excess of that, you would be subject to the higher rates. $450,000 for married filing jointly.

Then there are also some proposals that relate to retirement savings, specifically clamping down on higher-income individual's ability to take advantage of some of these tax-sheltered mechanisms for retirement savings. One of the big ones that we've been keeping an eye on relates to this idea of what's been called the backdoor Roth IRA, and there's also a separate maneuver called the mega backdoor Roth IRA. This is basically a technique that people are currently using whereby they're putting aftertax contributions into their IRAs--or in the case of the mega backdoor Roth IRA, they're putting an aftertax contribution into a 401(k)--and then they're converting those dollars to Roth.

And if this is executed properly, this is typically not going to result in a big tax bill and will let higher-income folks enlarge their balances in Roth IRAs and Roth 401(k)s. Well, Congress needs to find ways to raise revenue, so this is obviously a loophole that people have been taking advantage of for the past 10 years since the income limits on IRA conversions were lifted.

It looks likely that there will be a change here, where going forward, starting in 2022 if this passes through Congress, people will no longer be able to convert those aftertax dollars to Roth. So that would mean the end to the backdoor Roth IRA and the mega backdoor Roth IRA. You can still do it for 2021, but keep an eye on this space because we might see some activity here.

Dziubinski: So then, say this does pass, and this is no longer going to be an option for investors starting in 2022, what are some other options for high-income people?

Benz: It's a good question. They can still take advantage of 401(k) contributions. So I would start there. Health savings accounts would be very attractive to higher-income folks, especially those who can use their health savings account to be a tax-sheltered, additional savings receptacle. Many high-income folks may say, "Well, given the contribution limits on HSAs, that's kind of a drop in the bucket."

I think the next step from there will be to look at taxable accounts and just look at how you might invest tax-efficiently within the taxable account. You'll still be able to contribute aftertax dollars to a traditional IRA. There aren't any income limits there. The question is why you would--because when you pull the money out in retirement, the investment earnings component would be subject to ordinary income tax. If you invest in a taxable brokerage account, you can take advantage of the lower capital gains tax rates.

So my bias would be to focus your energy there on a taxable brokerage account. And the good news is that you can use ETFs. You can use traditional index funds. You can use municipal bonds. All of which can help keep those ongoing tax bills way down on taxable brokerage accounts. So I expect that we'll see more interest there, even more interest there than usual from higher-income savers.

Dziubinski: Now, another to-do that you're giving us for October, for some of us, at least in October, is to take a look at college savings. And you're saying that, of course, this is obviously for people with kids, but it also might be for grandparents or aunts and uncles or other people who have young people in their lives who they might want to contribute some college savings dollars to. What should be on their radar?

Benz: I think that you want to check out the tax-sheltered savings options for college. 529s have emerged as really the best option in that the tax advantages are the greatest; you can get the most in this account type. And you can receive a state tax break, assuming that you invest in your home state's plan. Some states actually give a tax break even if you invest out of state. So just investigate your home state's plan and what the rules are around it. Start with the 529. Start with your home state's 529, but do your due diligence.

And I know that our manager research team has been hard at work for several years now researching 529s. It's a pretty opaque space. There's not a lot of clarity for consumers, but we do have ratings on 529 plans. And the good news is that 529 plan quality has lifted quite a bit. I think in part because of some of the work that team here has been doing, shining a light on some of those 529s that did have high expenses or were otherwise subpar. So, start with a 529 plan.

Some people may want to use UGMA, UTMA accounts, but I think you really need to keep in mind the interplay between financial aid considerations and those types of accounts. They tend to be treated more punitively from the standpoint of financial aid. 529s also may affect financial aid eligibility as well. Perhaps get some advice here if you are looking to save a lot in a 529. I would say a 529 would be probably the first choice if you're looking to set aside significant sums for college savings.

Dziubinski: And if you are considering college savings, how should you be thinking about asset allocation for that pot of money?

Benz: Great question, Susan. This is a place where I think the age-based options are a godsend in terms of taking the guesswork out of how to allocate those college savings funds. So you simply match your child's college savings with wherever he or she is in terms of age. And you should be in an age-appropriate mix. If, for whatever reason, you're doing this on your own and you're calibrating your own asset allocation for college, the key message I would impart, especially given what a long-running equity rally we've had, is that it strikes me as a great time to de-risk if you have children who are in high school. And certainly if they're getting within a few years of college, I would absolutely think about taking risk off the table.

You've had a good run in equities, presumably, but I think the last thing that you'd want to have happen is to be hanging out there with an overly risky 529 portfolio as college draws close. You really need to rein in the risks, get into bonds and other short-term assets. It's about really just preserving your purchasing power as college draws very close.

Dziubinski: Well, Christine, thank you for your time today and for giving us some financial to-dos to think about for the month of October. We appreciate it.

Benz: Thank you so much, Susan.

Dziubinski: I'm Susan Dziubinski. Thanks for tuning in.