Financial planners often work with averages. But the reality is that each bear market will be different from the norm. At the time that I write this, the depth of this particular drawdown does not even rank with the worst in history. Sure, it may still get worse, but that’s where we are today.
We may not want to hear about how things will get better, because the situation with the Covid-19 pandemic and its resulting prescription of social isolation and market downdrafts is scary. But, eventually, things will get better.
Keep in mind that things may get worse before they get better. The count of people with the virus will almost certainly increase. If you don’t have a source yet, you can keep up with it over here. But eventually, the Coronavirus epidemic will run out of steam. We will get back to our places of work. Kids will go back to school. Financial markets will right themselves out. We will revert to standard toilet paper buying habits. We will start going out to eat again. Life will become normal again.
Financially, the question is not just how bad will things get, but how long it will take for our nest eggs to rebuild, so we can put our lives back on tr
Hence, it could take us a while before we make it back to the previous market peak. However, we may want to look at the data differently. This graph shows that, historically, we have needed to achieve a return of 46.9% to recover from a bear market . According to Franklin Templeton calculations, these numbers can look daunting. However, they have been achieved and exceeded after every past downturn. While there is no guarantee, these numbers suggest that there will be strong returns once we have reached the bottom of the market. I like to think of this as an opportunity.
With the time that it takes for investments to grow and get your money back, there is time to take advantage of higher expected returns. For those who have resources available, this means that there is time to deploy your money at lower prices than has been possible in recent months.
Those of us who have diversified portfolios and are not in a position to make new investments, the opportunity is to rebalance to benefit from a faster upswing.
We know from history that every US stock market downturn was followed by new peaks at some point following.
Could this time be different?
Of course, that too is possible.
I like to think that the future will be better. We will still wake up in the morning looking to improve ourselves, make our lives better, and achieve our goals. We are still going to invent new technologies, fight global warming, and struggle for a more equitable society.
We are living through difficult times right now. Losses in our brokerage and retirement accounts are not helping. But we will get through this. Please reach out to me if you have specific questions or concerns.
Roth IRA accounts are well known for providing tax-free growth and retirement income within specific parameters. The catch is that contributions must be made with earned income that has been taxed already. In other words, Roth accounts aren’t exactly tax-free, they are merely taxed differently.
On the other hand, Traditional IRA retirement accounts are funded with pretax dollars, thereby reducing taxable income in the year of contribution. Then, distributions from Traditional IRA retirement accounts are taxed as income.
The Roth IRA is not tax-free, it is merely taxed differently
However, the tax benefit remains the most prominent factor in the Roth vs. Traditional IRA decision. To make the decision that helps you pay fewer lifetime taxes requires an analysis of current vs. future taxes. That will usually require you to enlist professional help. After all, you would not want to choose to contribute to a Roth to pay fewer taxes and end up paying more taxes instead!
As everyone’s circumstances will be different, it would be beneficial to check with a Certified Financial Planner® or a tax professional to plan a strategy that will minimize lifetime taxes, taking into account future income and projected taxes.
Check out our other posts on Retirement Accounts issues:
The SECURE Act makes several changes to the Internal Revenue Code (IRC) as well as the Employee Retirement Income Security Act (ERISA) that are intended to expand retirement plan coverage for workers and increase savings opportunities. The SECURE Act also radically changes several techniques used for retirement and tax planning.
Some of the key provisions affecting employer retirement plans, individual retirement accounts (IRAs), and Section 529 Plans included in the SECURE Act are as follows.
This RMD provision is part of the good news in the SECURE Act. It will allow retirees more time to reach their retirement income goals. For many, it will enable better lifetime tax planning as well.
End of the “Stretch” IRA
Prior to the SECURE Act, the distributions on an inherited IRA could be “stretched” over the expected lifetime of the inheritor. That was a staple tool of estate and tax planning.
No more. With a few exceptions, such as for the spouse, the “stretch” is now effectively crunched into ten years. Accounts inherited as of 12/31/2019 are now expected to be distributed over ten years, without a specific annual requirement.
The new law allows a penalty-free distribution of up to $5,000 from an IRA or employer plan for a “Qualified Birth or Adoption Distribution.” For a qualified distribution, the owner of the account must take the distribution for a one-year period starting on (1) the date of birth of the child or (2) the date when the adoption becomes final (individual must be under age 18). The law permits the IRA owner who took the distribution to pay it back to the plan or IRA at a later date. However, these distributions remain subject to income taxes.
Generally speaking, we at Insight Financial Strategists think that people in this situation should avoid availing themselves of this new wrinkle in the law. In our experience, a distribution from retirement accounts before retirement can have profound impacts on retirement income security.
It may sound off-topic, but it is not. The SECURE Act also addresses 529 plans. For students and their parents, the SECURE ACT allows tax-free 529 plans to pay for apprenticeship programs if they are registered and certified by the Department of Labor.
This provision will be helpful for those people who have children headed to vocational track programs.
Given how students and parents scramble to meet the challenge of the cost of higher education, I do not forecast that most 529 plans have much left over to pay off loans!
Business Retirement Plans
(Part-Time) Employee Eligibility for 401(k) Plans – In most 401(k) plans, participation by part-time employees is limited. The SECURE Act enables long-time part-time workers to participate in 401(k) plans if they have worked for at least 500 hours in each of three consecutive 12-month periods. Long-term part-time employees who become eligible under this provision may still be excluded from eligibility for contributions by employers.
Delayed Adoption of Employer Funded Qualified Retirement Plan– Beginning in 2020, a new plan would be treated as effective for the prior tax year if it is established later than the due date of the previous year’s tax return. Notably, this provision would only apply to plans that are entirely employer-funded (i.e., profit-sharing, pension, and stock bonus plans).
403(b) Custodial Accounts under Terminated Plans are allowed to be Distributed in Kind – Subject to US Treasury Department guidance, the SECURE Act allows an individual 403(b) custodial account in a terminating plan to be distributed “in-kind” to the participant. The account distributed in this way would retain its tax-deferred status as a 403(b).
Establish Open Multiple Employer Plans (MEPs) – Employers may now join together to create an “open” MEPs, referred to in the legislation as “Pooled Plans.” This will allow small employers to join together and share the costs of retirement planning for their employees, such as through a local Chamber of Commerce or other organization, to start a retirement plan for their employees.
Increased Tax Credits – The tax credit for small employers who start a new retirement planwill increase from $500 to $5,000. In addition, small employers that add automatic enrollment to their plans also may qualify for an additional $500 annual tax credit for up to three years.
There are many more provisions in the SECURE Act. While some of them are useful for taxpayers, it is worth noting the observation by Ed Slott, a tax expert and sometimes wag: “whatever Congress names a tax law, it does the opposite .” This is worth keeping in mind as you mull the implications of this law. With the SECURE Act now the law, it may be time to check in with your fiduciary financial planner and revise your retirement income and estate plans.
A key item of the TCJA is that it increased the standard deduction, reducing the impact of the elimination of State and Local Taxes (SALT) under $10,000 and the elimination of personal deductions. As a result, about 84% of taxpayers claim the standard deduction and do not itemize. By comparison, about 56% of taxpayers itemized before the enactment of the TCJA. The vast majority of taxpayers are no longer subject to the Alternative Minimum Tax (AMT), since two of its key drivers, the deductibility of state and local taxes and personal deductions, are no longer a practical issue for most people. And in 2018, only 1,700 estates were subject to the federal estate and gift tax. So for most people, the TCJA has made taxes simpler to deal with. What’s there not to like about a simpler tax return ?
Source: Congressional Budget Office
Impact of the TCJA on the Federal Deficit
As predicted, the TCJA worsened the federal deficit bringing it to nearly a trillion dollars in fiscal year 2019. That was in spite of an increase in tax revenue due to the continuing improvement in the economic climate. Of course, the federal deficit continues to be driven by federal spending on the sacred cows of modern US politics: Defense, Social Security, and Medicare. Interest on the federal debt is also a major budget item that needs to be paid. While our continuing regime of low interest rates is helping control the interest on the debt, it is clear that the future may change that.
What will happen to tax rates?
Tax rates are lower now than they have been since the 1970s and 80s. Hence, industry insiders tend to think that tax rates have nowhere to go but up. That is also what’s is predicted by the TCJA, which is largely designed to sunset in 2025. Should the American people turn on Republicans at the 2020 election, it’s possible that the TCJA will see a premature end. However, it seems that the possibility that the American people might elect a progressive in 2020 is largely discounted when it comes to tax rate forecasting: most people assume that tax rates will increase.
Political forecasting aside, there are still things that we can do to lower our taxes . It should be noted that many of the techniques in this article are not limited to the year-end. Furthermore, we all have different situations that may or may not be appropriate for these techniques.
Tax Loss Harvesting
Even though we have had a pretty good year overall, many of us may still have positions in which we have paper losses. Tax-loss harvesting consists of selling these positions to realize the losses. This becomes valuable when you sell the equivalent amount of shares in which you have gains. So if you sell some shares with $10,000 in losses, and some with $10,000 in gains, you have effectively canceled out the taxes on the gains.
You then have to reinvest the shares sold into another investment. Be careful not to buy back the exact same shares that you sold. That would disallow the tax loss harvesting!
At the same time, it makes sense to review your portfolio and see if there are other changes that you would like to make. We are not fans of frequent changes for its own sake. However, periodically our needs change, the markets change, and we need to adapt.
Income Tax Planning
While tax loss harvesting is mostly about managing Capital Gains taxes, it is also important to keep an eye on income tax planning . This is a good time of year to estimate your income and your taxes for the year. When comparing your estimated Adjusted Gross Income with the tax tables, you will see if you might be creeping up into the next tax bracket. For instance, if you are single and your estimated AGI is $169,501 (and you have no other complexity), you are right at the 32% tax bracket (after you remove the $12,000 standard deduction). In this example, that means that for every dollar above that amount you would owe 32 cents in federal income tax, and a little bit more for state income tax, if that applies to you.
If your income is from a business, you may possibly defer some of that income to next year. If your income comes from wages, another way to manage this is to plan an additional contribution to a retirement account. In the best of cases your $1,000 contribution would reduce your taxes by $320, and a little bit more for state taxes.
In some cases, you might have a significant dip in income. Perhaps if you have a business, you reported some large purchases, or you booked a loss or just had a bad year for income. It may make sense at this point to take advantage of your temporarily low tax rate to do a Roth conversion. Check with your wealth manager or tax preparer.
One way around that situation is to bundle or lump charitable gifts. Instead of giving every year, you can give 2, 3 or more years worth of donations at one time. That would allow your charity to receive the contribution, and, potentially, for you to take a tax deduction.
Pushing the bundling concept further, you could give even more to a Donor Advised Fund (DAF). With that option, you could take a tax deduction, and give every year from the DAF. That allows you to control your donations, reduce your income in the year that you donate, and potentially reduce income taxes and Medicare premiums. Consult your wealth strategist to ensure that taxes, income, and donations are optimized.
First, it is important to review Required Minimum Distribution (RMDs). Anyone who is 70 ½ years of age or older is subject to RMDs. Please make sure to connect with your financial advisor to make sure that the RMD is properly withdrawn before the year-end.
The RMD is a perennial subject of irritation for people . Obviously, if your retirement income plan includes the use of RMDs, it’s not so much of an issue. However, if it is not required, it can be irritating. That is because RMD distributions are subject to income taxes that may even push you into the next tax bracket or increase your Medicare premium. There are, however, some ways that you can deal with that.
For instance, if you take a Qualified Charitable Distribution (QCD) from your IRA and have the distribution given directly to a charity, the distribution will not be income to you. Hence you won’t pay income taxes on that distribution, and it will not be counted toward the income used to calculate your Medicare premium. However, it will fulfill your RMD, thus taking care of that pesky issue.
Generally, we advocate planning for lifetime taxes rather than for any one given year. Lifetime financial planning has the potential to result in even more benefits. It should be noted that many of the possibilities outlined in this article can be used throughout the year, not just at year-end. We encourage you to have that conversation with your wealth management team to plan for the long term!
It is health insurance plan signup season . Whether you subscribe to your employer’s health care insurance plan or you buy your own directly, it is the time of the year when you have to sign up all over again. Unless you have specific circumstances such as a change of employer, a divorce, or new baby, this is the one time in the year when you get to change your health care insurance plan.
If you have been keeping abreast of the popular financial media, you may have come across the Health Savings Account (HSA). According to AHIP (America’s Health Insurance Plans), 22 million people had HSA accounts in 2018. Financial Planners love HSA. It is potentially the most tax advantageous vehicle that exists. Contributions to HSAs are pre-tax, the money is invested tax-free, and distributions are tax-free if used for health purposes. Triple tax-free. HSAs are even better than Roth retirement accounts !
The reality is that we all have health care expenses, and they can be substantial . Having the ability to pay with tax-free money is a critical advantage. If you have to pay a $100 hospital invoice, you might have to earn $150 or more first, pay Federal income taxes, Social security taxes, state income taxes, before you can have $100 to pay your bill. With an HSA, there is no income tax, you pay with $100 of your earnings.
A Health Savings Account is effectively an alternative to the Flexible Spending Account (FSA) , the more traditional way to pay for health care expenses that are not covered by insurance. The FSA allows employees to save pre-tax from earnings, and then to spend it on health care expenses without paying taxes on the earnings. Money in FSAs, however, is not invested, and it must be spent by year-end or be forfeited. It has to be spent, or it will be lost. HSA funds, on the other hand, can be invested, and funds from HSA accounts can be carried over into the future. Thus, HSAs can be spent in a way that is similar to other retirement savings accounts such as the IRA or the Roth IRA.
Contributions are pre-tax
Funds are invested tax-free
Distributions are tax-free (1)
Distributions can be taken in the future
If used as intended for retirement, education or health expenses respectively
What’s in it for the employer?
In order to contribute to an HSA, you must have chosen a High Deductible Health Plan with your employer.
According to the IRS, for 2019, a high deductible is defined as $1,350 ($1,400 in 2020) for an individual or $2,700 for a family ($2,800 in 2020.) On top of this high deductible, annual out of pocket expenses (including deductibles, copayments, and coinsurance) cannot exceed $6,750 for an individual or $13,500 for a family. Those numbers increase in 2020 to $6,900 for an individual and $13,800 for a family.
For employers, offering high deductible health insurance plans is more cost effective than other plans. Therefore, they will prefer that their employees sign up for high deductible plans. Many employers will contribute directly to HSA accounts to encourage their workforce to choose a high deductible health insurance plan.
Theoretically, if employees have to pay out of pocket or out of their HSA for their health care expenses, they will be more careful about their choices. While the funds in the HSA remain available to be used for health care expenses immediately if needed, the designers of the HSA believe that the ability to carry over HSA balances to future years will motivate employees to be better health care shoppers when choosing treatments or, indeed, when choosing to be treated in the first place. The net result is that high deductible health plans help employers contain health care expenses, and shift the burden on their employees.
And how do you maximize the value of the HSA? By contributing to the maximum, and investing it. A dollar contributed may be worth many times its value in the future when invested.
The Internal Revenue Service allows individuals in 2020 to contribute up to $3,550 to their HSAs. Families may contribute up to $7,100. Both individuals and families can benefit from a catch-up provision of $1,100 if they are over 55.
If you are choosing the high deductible plan to save money, but you are not able to contribute to your HSA, you are putting yourself at risk if you have an unforeseen health event. Not having enough saved to cover the cost of the health care you need means that you may have to go into debt until you have met your plan’s deductible.
So, if you have a tight budget, please think twice before trying to save money with a high deductible plan. It may just backfire on you.
A question that is often minimized at enrollment time is what happens to the HSA if you have miscalculated, and you happen to have a significant health care expense in the year that you are contributing?
First, if it is a major event, you may consider using funds in your HSA account. However the health care insurance will eventually kick in and cover most of the cost. So as a subscriber to a high deductible plan, you are still protected from the catastrophic consequences of an unexpected health issue. While you may not harvest all the benefits of the HSA, and you will likely lose the cost savings of choosing a high deductible plan, you are protected from financial disaster.
What if it is not a reallymajor event, just a somewhat major event like, say, a trip to the emergency room for a temporary issue that you will easily recover from?
In that case, you also have the option to use your funds in the HSA to pay for those expenses. Your contributions will have been pre-tax as with an FSA. You will not have enjoyed much investment growth. Your distribution will still be tax-free. You are giving up the future benefits of the HSA, but you are dealing with your more immediate issues. Basically, your HSA will have functioned like an FSA. You will also lose the savings benefits of choosing a lower cost high deductible plan over a higher cost low deductible plan.
What if instead, you decide to pay for your trip to the emergency room out of pocket with post-tax savings and save your HSA for the future, as your wealth manager told you that you should? The real cost of your $5,000 trip depends on your income and tax bracket. If you happen to be in the 32% Federal tax bracket and you live in Massachusetts, the cost of the $5,000 emergency room trip will be around 58% higher.
HSAs provide some tremendous benefits that should be considered by everyone who is looking to enhance their health care and their retirement situation. However, the decision to choose a Health Savings Account should be based on more than just taxes and the cost of your health care insurance. It is important to consider the very real costs of unforeseen events and to be realistic about your health insurance needs.
Long Term Care (LTC) can be a stressful subject to discuss, especially when costs are addressed. The reality is that Long Term Care is expensive. According to Genworth, a prominent provider of Long Term Care insurance, the median national cost of a stay at an assisted living facility is $48,000 annually in 2018. The total cost, over someone’s lifetime, ends up being much larger depending on where and how long a person will be needing it.
For example, the median cost of assisted living in New Jersey in 2018 was $72,780, according to Genworth. If someone were to stay at an assisted living facility for three years, the cost would be in excess of $200,000. Nursing home care could be even more expensive.
Even insurance companies have difficulty ascertaining the cost. Large insurance providers such as John Hancock have left the field and no longer offer LTC policies to the general public. Others, including Genworth and Mass Mutual, have been struggling with State Insurance Commissions to increase premiums. Recently, Genworth was approved to increase premiums by 58% in 22 States.
According to the Federal Government, Long Term Care is the range of services and support you will need to meet health and personal care needs over a long period of time when you are unable to provide it for yourself. LTC is not medical care, but rather assistance with the basic personal tasks of everyday life.
We have plenty of statistics on how LTC affects us as a whole, but very few on how it will affect us individually. Are we going to be part of the 70%, or can we avoid it and be part of the 30%. We just don’t have a very good way to predict how much long term care we will need, when we will need it, and how much it will cost. This is precisely why long term care planning is necessary as part of normal financial or retirement planning.
Who Pays for Long Term Care?
People often assume that Medicare or Medigap (the supplemental coverage for Medicare), or even regular health insurance will cover the cost of their Long Term Care expense.
Unfortunately, that is incorrect. Medicare is set up to cover only direct medical expenses, such as doctor and hospital visits, tests, and medicine. When it comes to issues of old age care, Medicare is not involved.
In general, most people without a plan who need Long Term Care will pay for it out of their own assets. Once there is no money left, Medicaid will usually take over. This approach works best for people who have enough assets to cover the other foreseeable circumstances in their future.
However, planning for Medicaid to take over is a backup plan at best. However, it is good to know that it is there, should we need it.
How do I protect my assets from nursing homes?
A close alternative to spending your own money and then letting Medicaid take over is actually to plan for Medicaid to take over. That involves creating a trust in which to put your assets so they can be protected in the event that long term care is needed. When that happens, the assets remain safely in the trust, and Medicaid pays for your long term care. You should keep in mind that Medicaid is taxpayer-funded, and as with other government programs, it is periodically under stress for funding. In other words, it is not easy to predict with certainty that such a plan would work, especially if it is much in the future.
Long Term Care Insurance
For others, purchasing a long term care insurance policy may be a better alternative. In exchange for the premiums, the insurance company commits to pay the amount contracted for. Effectively, the policy covers a significant percentage of the uncertainty generated by long term care. That amount can vary to take into account your own circumstances.
From a tax viewpoint, it is worth noting that some of the premiums for most standard LTC policies available today may be deductible from taxable income within the limits specified by the IRS, especially for business owners. Also, up to certain limits, benefits are not taxed as income. Take this favorable tax treatment as a sign that Uncle Sam would like to encourage you to be covered (and not use Medicaid)!
The challenge with LTC insurance is that insurance companies have miscalculated the premiums required to cover their costs. As a result, premium increases, including the one mentioned earlier from Genworth, have shocked pre-retirees and retirees alike, resulting in a considerable debate about whether to drop LTC insurance policies altogether.
The financial impact of premium increases is real. It is a painful hit on a sore subject. And as with any price increase like that, the impulse is just to cancel.
However, canceling would be a mistake for many people. The cost of LTC must be covered somehow, and if not through insurance, it is usually through your own assets. However, it does provide an opportunity to reconsider the issue with your financial planner. Most people affected by price increases bought their policy many years ago. It would be beneficial to re-analyze the LTC need and the benefits of the policy. You may find out that you are over-insured, or underinsured. And then you can figure out a way forward on how to right-size your coverage.
Long Term Care insurance helps pay for long term care expenses, helps preserve your assets and your legacy. Also, a portion of the premium is potentially tax-deductible. So why are so many people resistant to traditional Long Term Care insurance?
First, as we mentioned before, it is expensive. Although, it is worth noting that the cumulative cost of LTC insurance premiums usually is less than the cost of Long Term Care itself! Second, the possibility that the insurance policy may not be used, as in the case of death happening suddenly, is enough to stop many people from acquiring Long Term Care insurance. In this paradigm, the thought of paying premiums for years, and not collecting a benefit would make the insurance a waste.
Don’t Waste the Premiums
To counter this objection, the insurance industry has created products that allow you to “not waste the premiums.” These products allow you to purchase an annuity or a life insurance policy with a special “rider” that allows their conversion to an LTC policy should the need arise.
These products allow you to get Long Term Care coverage if needed, and allow repurposing the funds in case the Long Term Care benefit is not used. The details of these products are beyond the scope of this post. Suffice it to say, that these alternatives can provide a lot of flexibility, at a cost, in a financial plan. For people who have significant assets that are not needed for their retirement plan, these alternatives may be worth considering.
The answer is different for everyone. Being a financial planner and number geek, I believe that the answer for many resides in comparing the costs and the benefits. For most people that will result in keeping your insurance. If you are not sure, schedule a call, and we can review.
LTC can be a significant expense. As such, it needs to be factored into your overall retirement plan. The four approaches discussed (pay out of assets, Medicaid planning, traditional long term care insurance, and “not waste the premium” alternatives) all offer different benefits and should be matched to the right circumstance and individual preference.
For those filing as single with income below $25,000, or married filing jointly with income below $32,000, social security income is income tax-free. However, single filer retirees with income up to $34,000 or $44,000 for married filing jointly will find that 50% of their social security becomes taxable. When income increases over $34,000, or $44,000 for married filing jointly then 85% becomes taxable.
Retirement accounts such as 401(k), 403(b), and IRAs are an important source of income for retirees. Income from these accounts is taxed as ordinary income, as if it was being earned in a job, with tax rates ranging from 10% to 37% at the federal level. That is because the initial contribution to those accounts helped to reduce taxable income at the time. That means that the money in these retirement accounts was never taxed.
To complicate the matter, distributions from some accounts may be exempt from State taxes. For instance, 403(b) accounts earned in New Jersey are exempt from New Jersey State income taxes at distribution. Similarly, IRA distributions from accounts that were established by Massachusetts taxpayers are exempt from State income taxes. These peculiarities vary from State to State. It’s important to verify how they may apply in your State rather than making an assumption.
Many retirees still receive pension income. Some of the more common ones include state, federal and military pensions. Although private pensions have been in decline for several decades now, there continue to be many people who receive payments from these pensions.
Income from Roth accounts is not taxed in retirement. That is because the initial contribution came from after-tax money. In other words, the income used to make the contribution was taxed on the full amount before the contribution was made. I like to say that “Roth accounts are not tax-free, they are just taxed differently“.
A key benefit of Roth accounts is that their distributions do not count toward high-income surcharges for Medicare Part B and Part D premiums.
Income received from municipal bonds is federal tax-free. Like a Roth contribution, an investment in municipal bonds is made with after-tax money. If you own municipal bonds from the state of your residence, the interest is also state tax-free. However, if you own municipal bonds from states other than your residence, their interest is usually taxable at the state level.
People also wonder what happens when they sell their municipal bonds. When that happens, the price of the bond can be higher or lower than the face value, known as a premium or a discount. When the price is at a premium, the difference between the premium and the face value can be taxed. That can often be an impediment to a sale as people don’t want to be taxed.
When held for one year or longer, investments outside of retirement accounts are subject to long term capital gains taxes. They can range from 0% to 23.8%, including potential Medicare surcharges. In 2019, for a married couple filing jointly with taxable income up to $78,750, long term capital gains are taxed at 0% federally ($39,375 for people filing as single).
Therefore investments can potentially be taxed less than other sources of income such as retirement accounts. Balancing distributions from investments in conjunction with Traditional retirement and Roth accounts can be a valuable tax optimization tool.
Any income from annuities held inside qualified retirement accounts such as an IRA will be taxable as ordinary income in its entirety.
Income from annuities that are not held in qualified retirement accounts is partially taxable as ordinary income. The amount of the distribution that represents your original investment is considered tax-free.
Therefore, the taxation of annuity income falls somewhat below that the taxation of income from retirement accounts.
Loans from the cash value of an insurance policy are considered tax free. That is because, as any loans, they are not considered income. That is a critical point made at the time that an insurance sale occurs. It should be noted, however, that life insurance is an instance when the tax issues are so prevalent in the discussion that they obscure the other costs of cash value life insurance. The loan from the policy is tax-free, but that in an of itself does not necessarily make life insurance cost-effective or appropriate for your needs.
Income earned in retirement is taxed as any other earned income before retirement. Some retirees continue to earn work income, from part-time jobs or from consulting gigs for example. That income is taxed as earned income as if they were not retired, including Social Security and Medicare. Unfortunately, there is no tax break for working in retirement!
The reality for most of us is that we will owe taxes in retirement. The multiplication of tax situations can make planning difficult for a retiree.
The challenge is to plan our income situation strategically, manipulate it if you will, in order to minimize lifetime taxes.
Fortunately, wealth planning done properly is a very feasible endeavor that may help you keep more of what you earned in your pockets!
On April 4th, it was announced that McKenzie Bezos would be receiving 36 billion dollars worth of assets from her divorce from Jeff.
First of all, congratulations to Jeff and McKenzie for keeping this divorce process short, out of the media as much as possible, and out of the courts. We are not going to know the details of the Bezos’ agreement. However, some information has been disclosed in the press.
As reported by CNN, McKenzie is keeping 4% of their Amazon stock, worth approximately 36 billion dollars. Jeff retains voting power for her shares as well as ownership of the Washington Post and Blue Origin, their space exploration venture. According to The Economist, this makes the Bezos divorce the most expensive in history by a long shot.
Unsurprisingly, McKenzie’s wealth is concentrated in AMZN stock. That has worked out well for the Bezos’ for the past several years. It is likely to continue to be a great source of wealth for both of them in the future. As it stands, McKenzie is now the third richest woman in the world. Who knows, if she holds onto AMZN stock, she could become the richest woman in the world one day! McKenzie’s concerns with budgeting, taxes, and wealth strategy will soon be in a class of their own.
There are, however, some lingering considerations for McKenzie, particularly when it comes to capital gains taxes, portfolio management, philanthropy and wealth transfer.
A benefit of keeping the stock until her death is that her estate will benefit from a step up in cost basis. This would mean that the IRS would consider the cost of the stock to be equal to the value at her death. This favorable tax treatment would wipe out her capital gains tax liability.
Nevertheless, the standard advice that wealth strategists give clients with ordinary wealth applies to Ms. Bezos as well: it would be in McKenzie’s best financial interest to diversify her holdings. Diversifying would help her reduce the risk of having her wealth concentrated into a single stock. It is a problem that McKenzie (and Jeff) share with many employees of technology and biotech startups.
An advantage of having more money than you need is that you have the option to use the excess to have a measurable impact on the world through philanthropy. In 2018, Jeff and McKenzie created a $2B fund, the Bezos Day One Fund, to help fight homelessness. Given that the home page of the fund now only features Jeff’s signature, this may mean that Jeff is keeping this also. McKenzie will likely organize her own charity. What will her cause be?
McKenzie’s net worth is far in excess of the current limits of federal and state estate taxes. Unless she previously planned for it during her marriage, she will have to revise her estate plan. Even though she would benefit from a step up in basis on her AMZN stock if she chooses not to diversify, she would still be subject to estate taxes, potentially in the billions of dollars.
Of course, no matter how much estate tax McKenzie ends up paying, it is likely that she will have plenty to leave to her heirs.
Annuities are a popular retirement planning device. According to Investment News, sales broke a record in 2018. Yet, they continue to be misunderstood. There are several types of annuities, with fixed, fixed indexed, and variable being some of the most common. Unfortunately, annuities are so complex, that salespeople often have difficulty communicating their values and shortcomings to clients. It is sometimes said, humorously, that the greatest value of an annuity is the steak dinner that it comes with.
Joking aside, the point is that annuities are complex and most of their benefits are intangible, except for the steak. As a client, you will eventually have to decide that if you are not going to become an expert with annuities, you will have to trust a salesperson.
Annuities have value. However, their value must be balanced with costs and lost opportunity considerations. In addition to the direct costs of the annuity, like “mortality and expense”, the expense ratio of the investments or the costs of the “riders”, and indirect opportunity costs what are the value of the benefits you might be giving up to get an annuity?.
First, what does an annuity get you?
The most commonly advertised benefit of an annuity is fixed income. The insurance company that sells and manages the annuity will be paying you periodically, usually monthly, for the rest of your life (usually). That payment is presented as fixed: it will never decrease. Obviously, that is appealing to a lot of people: finally a financial instrument with some safety built in.
Rarely does the salesperson point out the obvious: the periodic payment amount will never increase either.
Why does it matter yo have your payment increase? In an age where people ought to be planning for retirement for 20 or 30 years or more, a periodic payment that does not increase is basically a payment that continuously loses value to inflation. While you may not notice it from one year to the next, inflation is pernicious: it will slowly eat away your purchasing power.
For instance, the table below shows that with inflation of 3%, the value in today’s dollars of a $5,000 annuity payment that you might receive today goes down to $2,803 in 20 years. In other words, you would be losing almost $2,200 of purchasing power automatically. Needless to say, this is something that you would want to know before buying the annuity.
Source: Insight Financial Strategists LLC
Also, annuities are Tax-advantaged. Americans love tax-advantaged investments, almost as much as they like tax-free investments. That is a key point to note: the money that you contribute to an annuity is not taxable when it distributes in retirement because, presumably, you have already paid taxes on it. Therefore, when the annuities distribute in retirement, part of the distribution is your own money that comes back to you tax-free. The gains, however, come back to you taxable as ordinary income.
Now, how does the tax treatment of annuities compare to other methods of investing, like for example investing in equities and fixed income outside of an annuity? As with annuities, contributions to your investment are not taxed again when they are distributed. However, your gains will usually be taxable as capital gains. This is important because for many people capital gains tax rates are lower than ordinary income tax rates. In other words, you may very well be paying more taxes by putting your money in an annuity than if you had invested outside of it if the right circumstances are met.
Another attractive benefit of annuities is that the payment amounts are Guaranteed. Financial Planners are not usually able to say that anything is guaranteed, because we do not know the future. However, financial salespeople can say that about annuities, because the benefits are guaranteed by the insurance company. Obviously, that is a very powerful statement, especially in the absence of comparable guarantees for traditional investment products.
The bottom line is that traditional investments are not guaranteed. We know from watching the market or hearing about it on TV that anything can happen. In particular, the stock market can drop.
Hence if we could protect ourselves from the risk of the stock market going down, it would obviously be a good thing. We know that in any given year the market could go down. In fact, according to Logan Kane, on any random day, we have a 47 percent chance of stocks falling and a 53% chance of stocks rising. In any given year, we have a 75% chance of stocks rising.
We also know that on average the stock market goes up. In fact, even when it goes down, we know that in any rolling five year period it will also go up as demonstrated with the S&P500 on the following graph.
Therefore, when we protect ourselves against the downsides of the stock market with annuities we give up a lot of upside opportunity cost in return.
Annuity companies tend to be shy about disclosing how your contributions are invested, except for variable annuities where the regulatory disclosure requirements are well developed. Variable annuities are invested in a mix of stock and bond funds. You can get a thorough description in their disclosure document.
Otherwise, insurance companies will rather have a root canal than tell you how their fixed annuities are invested. Perhaps it does not matter since the insurance company guarantees the payments. Maybe we don’t need to know.
Fixed index annuities are another matter. These instruments allow for the potential for growth. Mind you, in the typical words of a self-described “industry-leading financial organization”, ” your money is not actually invested in or exposed to the market”.
They can get away with this statement because it is, most likely, technically true. However, in order to make the returns that they claim that their annuities can make, the insurance companies have to invest in something more than cash. Fixed index annuities put their money, your money, in derivatives: stock options and futures. Technically, it saves you stock market volatility by being outside of it. Instead, you get derivatives market volatility which is even greater.
This has to be one of the most misleading sales pitches that financial salespeople make about fixed index annuities. Still, if the insurance company guarantees the returns, maybe it’s okay anyway?
Lastly, what about the costs??
Insurance companies tend to be less than forthcoming about the costs of their annuities, except when regulations force them to disclose them. For instance, variable annuities typically disclose a lot of information. When you read the prospectus you will find that it discloses various kinds of fees: administration, mortality and expense, mutual fund subaccount, turnover ratio, and death benefit being some of the most common. According to the Motley Fool, you might find that the total ongoing cost of your variable annuity can be anywhere from 2.46% to 5.94% a year.
Disclosure requirements for fixed and fixed index annuities are much less developed, which may be why insurance companies don’t typically disclose them. However, disclosure notwithstanding, there is definitely a cost that goes to paying your salesperson’s commission or the complicated options and futures strategies on your fixed index.
The primary value of annuity products is not in the income or guarantee or tax benefit that they provide. The primary value of annuities is that they absorb risks that you as an investor are not willing to take in the market. Annuities give you a guaranteed fixed income. In exchange, they limit the possibility of growth in your capital or your income.
They do that by balancing your risks with other people like you. As we suspect, most of us will not have an average life expectancy. We are either above average or below average. As Bill Sharpe, a Nobel prize winner in economics reminds us, buying an annuity allows us to share those risks, and for those of us who are above average, an annuity may well be a great bargain.
As the organizer of the annuity party, the insurance company absorbs some of the risks as well. When we buy an annuity, we are transferring the risk of investing on our own to the insurance company. If the insurance fails in its investments, it commits to paying us anyway. That is valuable, but does the benefit need to cost that much? Could it be overpriced?
Annuities can provide incredible value. However, the simplicity of providing guaranteed monthly income is well overtaken by the complexity, direct costs and the opportunity cost. It is important to understand what you are getting and what you are giving up with an annuity, You can make sure that it meets your needs first by getting advice that is in your best interest by a fee-only financial planner. You can find one at NAPFA or XYPN. Both are organizations of Certified Financial Planners that are committed to giving you advice that is in your best interest.
1) Harvest your Tax Losses in Your Taxable Accounts
As of[ October 26, the Dow Jones is up 1.65%, and the S&P500 is up just 0.98% ]for the year. Unfortunately, many stocks and mutual funds are down for the year. Therefore you are likely to have a number of items in your portfolio that show up in red when you check the “unrealized gains and losses” column on your brokerage statement.
However, you can also offset your losses against gains. For example, if you were to sell some losers and hypothetically accumulate $10,000 in losses, you could then also sell some winners. If the gains in your winners add to $10,000, you have offset your gains with losses, and you will not owe capital gain taxes on that joint trade!
This could be a great tool to help you rebalance your portfolio with a low tax impact. Beware though that you have to wait 30 days before buying back the positions that you have sold to stay clear of the wash sale rule.
2) Reassess your Investment Planning
Tax loss harvesting is a great tactic to use for short-term advantage. As an important side benefit, it allows you to focus on more fundamental issues. Why did you buy these securities that you just sold? Presumably, they played an important role in your investing strategy. And now that you have accumulated cash, it’s important to re-invest mindfully.
You may be tempted to stay on the sideline for a while and see how the market shakes out. Although we may have been spoiled into complacency after the Great Recession, the last month has reminded us that volatility happens.
Take the opportunity to review your goals, ensure that your portfolio risk matches your goals and that your asset allocation matches your risk target..
3) Check on your Retirement Planning
It is not too late to top out your retirement account! In 2018, you may contribute a maximum of $18,500 from your salary, including employer match to a 401(k), TSP, 403(b), or 457 retirement plan, subject to the terms of your plan. Those who are age 50 or over may contribute an additional $6,000 for the year.
If you have contributed less than the limit to your plan, there may still be time! You have until December 31 to maximize contributions for 2018, reduce your 2018 taxable income (if you contribute to a Traditional plan), and give a boost to your retirement planning.
Alternatively to deferring a portion of your salary to your employer’s Traditional plan on a pre-tax basis, you may be able to contribute to a Roth account if that is a plan option for your employer. As with a Roth IRA, contributions to the Roth 401(k) are made after tax, while distributions in retirement are tax-free.
Many employers have added the Roth feature to their employee retirement plans. If yours has not, have a chat with your HR department!
Although the media has popularized the Roth account as tax-free, bear in mind that it is not. Roth accounts are merely taxed differently . Check in with your Certified Financial Planner practitioner to determine whether electing to defer a portion of your salary to on a pre-tax basis or to a Roth account on a post-tax basis would suit your situation better.
It is health insurance re-enrollment season! The annual ritual of picking a health insurance plan is on to us. This could be one of your more significant financial decisions for the short term. Not only is health insurance expensive, it is only getting more so.
First, you need to decide whether to subscribe to a traditional plan that has a “low” deductible or to a high deductible option. The tradeoff is that the high deductible option has a less expensive premium. However, should you have a lot of health issues you might end up spending more. High deductible plans are paired with Health Savings Accounts (HSA).
The HSA is a unique instrument. It allows you to save money pre-tax and to pay for qualified healthcare expenses tax-free. Unlike Flexible Spending Accounts (FSAs), balances in HSAs may be carried over to future years and invested to allow for potential earnings growth. This last feature is really exciting to wealth managers: in the right situation clients could end up saving a lot of money.
If you pick a high deductible plan, make sure to fund your HSA to the maximum. Employers will often contribute also to encourage you to choose that option. If you select a low deductible plan, make sure to put the appropriate amount in your Flexible Spending Account. FSAs are used to pay for medical expenses on a pretax basis. Unlike with an HSA, you cannot rollover unspent amounts to future years.
6) If you are past 70, plan your RMDs
If you are past 70, make sure that you take your Required Minimum Distributions (RMDs) each year. The 50% penalty for not taking the RMD is steep. You must withdraw your first minimum distribution by April 1 of the year following the year in which you turn 70 ½, and then by December 31 for each year after.
Perhaps you don’t need the RMD? You may want to redirect the money to another cause. For instance, you may want to fund a grandchild’s 529 educational account. 529 accounts are tax-advantaged accounts for education. Although contributions are post-tax, growth and distributions are tax-free if they are used for educational purposes.
Or, you may want to plan for a Qualified Charitable Distribution from the IRA and take a tax deduction. The distribution must be directly from the IRA to the charity. It is excluded from taxable income and can count towards your RMD under certain conditions.
7) Plan your charitable donations
Speaking of charitable donations, they can also be used to reduce taxable income and provide financial planning benefits. However, as a result of the Tax Cut and Jobs Act of 2017 (TCJA), it may be more complicated than in previous years. One significant difference of the TCJA is that standard deductions went up to $12,000 for individuals and $24,000 for married filing jointly. Practically what that means is that you need to accumulate $12,000 or $24,000 of deductible items before you can feel the tax savings benefit.
In other words, if a married couple filing jointly has $8,000 in real estate taxes and $5,000 of state income taxes for a total of $13,000 of deductions, they are better off taking the standard $24,000 deduction. They would have to donate $7,000 before they could start to feel the tax benefit of their donation. One way to deal with that is to bundle your gifts in a given year instead of spreading them over many years.
For instance, if you plan to give in 2018 and also in 2019, consider bundling your donations and giving just in 2019. In this way, you are more likely to be able to exceed the standard deduction limit.
If your thinking wheels are running after reading this article, you may want to check in with your wealth manager or financial planner: there may be other things that you could or should do before the end of the year!
Note: The information herein is general and educational in nature and should not be construed as legal, tax, or investment advice. We make no representation as to the accuracy or completeness of the information presented. To determine investments that may be appropriate for you, consult with your financial planner before investing. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions.We make no representation as to the completeness or accuracy of information provided at the websites linked in this newsletter. When you access one of these websites, you assume total responsibility and risk for your use of the websites to which you are linking. We are not liable for any direct or indirect technical or system issues or any consequences arising out of your access to or your use of third-party technologies, websites, information, and programs made available through this website.