Oct 28

Is A Health Savings Account Right For You?

By Chris Chen CFP | Divorce Planning , Financial Planning , Investment Planning , Tax Planning

Is A Health Savings Account Right For You?

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.

IRA Roth IRA 529 FSA HSA
Contributions are pre-tax Yes No No Yes Yes
Funds are invested tax-free Yes Yes Yes N/A Yes
Distributions are tax-free (1) No Yes Yes Yes Yes
Distributions can be taken in the future Yes Yes Yes No Yes
  1. 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. 

From an employee’s point of view, high deductible plans can make a lot of sense . If you don’t believe that you will need (much) health care in the coming year, you can benefit from a lower cost plan, and from the savings and investment opportunity.  

Financial Benefit 

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.

According to Debbie Taylor, a CPA and tax expert, many people make the mistake of not investing their HSA contributions and keeping them in money market. Because one of the key benefits of HSAs is that the contributions can grow tax-free , not investing them is a grievous and expensive mistake. 

However, it’s worth noting that an HSA may need to be invested differently from your retirement accounts , especially if you plan to use your HSA at different times than you might use your retirement accounts. Consult your wealth manager for more insight.

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.

Unintended Consequences

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 really major 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. 

Sep 19

Should you cancel your LTC insurance?

By Chris Chen CFP | Financial Planning , Retirement Planning , Risk Management

Photo by rawpixel.com from Pexels

Should you cancel your LTC insurance?

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.

Aside from overall unpleasantness, a key issue with planning for LTC is the uncertainty. 70% of Americans will need it. But how much, and for how long? LTC is often the most unpredictable expense of retirement, and the least planned for.

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.

The fact is that most of us will require some form of long term care usually toward the latter part of our lives . Given the high probability, and the high level of expense, it is something that needs to be addressed in our financial and retirement plans.

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.

Who needs Long Term Care Insurance?

Long Term Care Insurance can help to preserve assets for other goals, including for legacy . It can also help you determine the level of care that you would like when you have a need for long term care.

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.

According to Tara Bernard at the New York Times analyzing your LTC coverage can even lead to a renegotiation of the policy, especially if you are reducing the benefits.

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.

Should I cancel my LTC insurance?

Because of the increases in premiums that are sweeping the LTC insurance industry, many people are wondering if they should cancel their policies . There is no easy answer to that question. The increased cost can be burdensome. But the other side to this question is if you cancel your insurance because of the premium increase, how are you going to pay for your Long Term Care expenses when they occur?

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.

In my experience, most people find it liberating to include LTC in a retirement plan formally, and know what is planned and how much is planned for. It then leaves greater flexibility to focus on the fun aspects of life!

If you need to figure out which option works best for you, schedule a conversation with me today!

Aug 06

What to Expect Financially When Expecting

By Jason Berube | Financial Planning

What to Expect Financially When Expecting

Recently two of my closest friends and their wives became expecting parents. Of the two couples, one is expecting for the very first time. This very happy news inspired me to write this post to share my experiences as both a parent and a financial planner.  I would like to share my insights with becoming a parent for the very first time and getting a chance to understand and become competent at the financial aspects of parenting. 

Going down the path to parenthood, a thrilling moment in a relationship is quickly followed by the sobering realization of the costs involved in raising a child.

Many people receive help from family, friends and baby showers in accumulating the initial items needed such as furniture, baby equipment, and newborn clothes. This assistance may ease some of the immediate financial burdens but the ongoing cost of diapers, food, toys, and childcare can be a staggering expense.

What is less apparent at first is that non-child related expenses may be reduced. Many parents stay home more to take care of the baby, which means they have less time to go out and spend money on restaurants, bars, entertainment, and travel!

I am often asked what is the biggest financial expense that new parents should anticipate. I have found from my own experience is that most parents’ budgets will adapt to accommodate the new needs and replace old ways of spending. 

If you are a new or expecting parent, here are some suggestions on how you can take action now to prepare your financial life for your new way of life.

Set Up An Online Automatic Savings Account

The best way to prepare for increased expenses is to start making monthly contributions, before the baby arrives, to a savings account dedicated to baby-related costs. When goal-setting, it is often a good idea to establish different savings accounts for each goal like a vacation, buying a new house or, in this instance, saving for the ongoing cost of providing for a child. Having separate accounts can be a great way to keep track of how you organize your money. For example, if you have two different checking accounts, they can each have a different name, such as “Baby’s Expenses” and “Mom’s Mad Money” – or whatever you want! Putting aside money each month will benefit you in two ways. It gives you a chance to get use to the bigger cash outflows from your checking account and it also provides you with a nice cash cushion for baby-related expenses that you may have overlooked.

Create A Budget

Once you have children, finances have a way of becoming more complex.  That can be compounded by the fact that there is less time to keep track of everything.

New parents should consider creating a budget to keep their finances on track. One way is to create a “reverse budget”. It simply helps you to figure out how much you need to save, makes those savings automatic and then allows you to spend the remaining amount of money as you please. This process emphasizes using a regular and ongoing savings method instead of manual expense tracking, (a big plus when unexpected baby expenses arise). Once a reverse budget is set up, the entire thing is automated. 

From a financial planning perspective, a reverse budget forces you to write out your short- and long-term goals, which may be different now that a little one is on the way. And, you can use the same tool for other goals such as vacation or retirement.

Get Basic Estate Documents

Estate planning is a frequently overlooked task. Nonetheless, it remains very important for new parents to complete. There are five estate planning documents you should consider regardless of your age, health and wealth:

    1. Will
    2. Durable power of attorney
    3. Advanced medical directives
    4. Letter of instruction (LOI)
    5. Living trust (or revocable trust)

Creating a will is the most important step in an estate plan because it distributes your property and assets as you wish after death. Even more importantly, a will names legal guardians for your children in case both parents pass away while the children are still minors. 

Without a will that names a guardian for your children, the state you reside in will determine it for you.  That may not align with your wishes and creates needless anxiety.

Although, the other items in the list above are beyond the scope of this post, expecting parents should pay attention and review them, with a professional if you need to.

Figure Out Childcare Now

Whether you want to send your kids to daycare, hire a nanny, get help from grandparents or stay at home yourself, you need to get a plan in place soon.

The average cost of center-based daycare in the United States is $11,666 per year ($972 a month), but prices range from $3,582 to $18,773 a year ($300 to $1,564 monthly), according to the National Association of Child Care Resource & Referral Agencies (NACCRRA).

Most daycare centers require a non-refundable deposit. If you’re planning on using daycare, you should make a deposit at your daycare of choice as soon as possible!!!

Daycare slots will fill up quickly, so even registering for daycare just a few months before your due date can still leave you on a waiting list.

Hiring a nanny is not easy either. Finding someone you can trust, afford and fit in your schedule can be tricky. It is a little more difficult to secure a nanny as far in advance as a daycare center, but it is never too soon to begin looking so you can familiarize yourself with the important qualities and nuances of these relationships.

Long Term

It’s easy to remain focused on the joy (and anxieties) of the present. However, don’t forget the long term: although you may be overwhelmed by the excitement of a new addition to the family, you still have to steer your growing family into financial security for the long term.  

A new baby on the way is a great opportunity to check your long term financial plan. A bit like checking the air in your tires before a long trip. What to do for college savings.  How to prioritize retirement savings and investment. Dealing with the mortgage and other debt. And many other questions.

Consider Hiring A Financial Planner

If you’re feeling concerned about all the financial details involved in raising a child, just know that you’re going to do great! You’re planning ahead and getting prepared now, which will go a long way once your baby arrives.

But if you’re still worried, now may be the time to hire a financial planner, preferably a fee-only fiduciary. Hiring a professional frees up your time to do the other things you love most in life – including focusing on your growing family.

It can also help alleviate any stress your finances may cause because a really good financial planner will work with you to get your entire financial house in order and help you keep it that way forever.

Jul 16

Do You Have To Pay Taxes in Retirement?

By Chris Chen CFP | Financial Planning , Retirement Planning , Tax Planning

Do You Have To Pay Taxes in Retirement?

Many people mistakenly look forward to not having to pay income taxes in retirement. It is understandable that after a lifetime of paying taxes, retirees would feel that they deserve a break. 

Unfortunately, that is not generally how income taxes work! In this article, I categorize nine sources of income and their corresponding level of taxes. 

It may seem at times that taxes are hitting us from all directions.  However, a variety of tax rules can also give retirees, or ideally pre-retirees, opportunities to plan such that they can optimize their lifetime taxes, and avoid paying more than their fair share .

Social Security

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. 

So while it is correct that a portion of their social security income will be income tax-free, many retirees find that they will pay some taxes on their social security income

Retirement Accounts

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.  

Pensions

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.

Retirees are often surprised to find that their pension income is taxable as ordinary income at the federal level, just as other retirement account income. As with other retirement income sources, there may be exceptions for state taxes that vary from state to state and pension to pension.

Roth Accounts

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. 

Retirees find that Roth accounts can be tremendously useful to optimize taxes in retirement by strategically combining income from Roth accounts with income from taxable accounts .

As a result, effective retirement planning should include considering saving in Traditional vs Roth accounts and strategically converting Traditional to Roth accounts, when appropriate.

Before jumping into making a Roth conversion, it is important to understand that the point of a Roth account contribution should not be to avoid taxes in retirement per se.  Instead, it should be to reduce lifetime taxes . It is possible that a badly timed Roth contribution would increase lifetime taxes, while also reducing retirement income taxes. A strategic plan is important to think through and implement. 

Municipal Bonds

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.  

Investments

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.

For people preparing to retire, it may make sense to divert investments from retirement accounts to brokerage accounts . Since taxes cannot be entirely avoided, it is about creating a strategy that optimizes investment vehicles to reduce lifetime taxes.

Annuities

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. 

Life Insurance

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.

Earned Income

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!

Apr 15

McKenzie Bezos: 4 Wealth Strategy Concerns

By Chris Chen CFP | Divorce Planning , Financial Planning , Tax Planning

McKenzie Bezos: 4 Wealth Strategy Concerns

source: pexels

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.

As a post-divorce financial planner, I feel a little silly thinking of what I would tell McKenzie to do with her money now. The magnitude of her portfolio is well beyond run of the mill high net worth divorces with assets only in the millions or tens of millions of dollars. McKenzie can buy $100M or $200M houses and condos wherever she wants. She can have her own jets and her own yachts. She could buy an island or two.

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.

Capital Gains Taxes

McKenzie probably has an enormous tax liability built into her AMZN holdings. While I am not privy to her cost basis, it is not unreasonable to assume that it is close to zero since the Bezos’ have owned Amazon stock since the company’s inception. Should McKenzie sell her AMZN stock, the entire amount would likely be subject to capital gains taxes. As such McKenzie may not be worth quite $36 Billion after taxes are accounted for .

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.

Portfolio Management

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.

McKenzie might not want to sell all of her AMZN stock or even most of it. Although we have not read their separation agreement, she has probably agreed with Jeff that she would retain the bulk of her holding. She may also believe enough in AMZN and Jeff’s leadership to sincerely want to keep it. Regardless, McKenzie should still diversify her portfolio to protect herself against AMZN specific risks.

Philanthropy

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?

Philanthropy can be an effective tax and estate management tool , primarily because, within limits, the IRS allows you to deduct your donations against your income thus helping you manage current and future taxes. For McKenzie, it is about deciding what to do with the money, instead of letting Congress decide.

Wealth Transfer

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.

Financially, McKenzie Bezos has what wealth strategists would consider as ‘good financial problems’ . She has the financial freedom to focus on the important aspects of life: family, relationships and making a difference.

 

A version of this post appeared in Kiplinger on April 12, 2019

Mar 20

Should You Buy An Annuity?

By Chris Chen CFP | Capital Markets

Should You Buy An Annuity?

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?

Fixed Income

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

Tax Advantage

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.

Guarantee

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.

Source: bespokepremium.com

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.  

Investments

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?

Costs

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.

Value

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.

Nov 18

Seven Year End Wealth Management Strategies

By Chris Chen CFP | Financial Planning , Investment Planning , Retirement Planning , Tax Planning

Photo by rawpixel on Unsplash

As we approach the end of a lackluster year in the financial markets, there is still time to improve your financial position with a few well placed year-end moves .

Maybe because we are working against a deadline, many year-end planning opportunities seem to be tax related .  Tax moves, however, should be made with your overall long-term financial and investment planning context in mind. Make sure to check in with your financial and tax advisors.

Here are seven important moves to focus your efforts on that will help you make the best of the rest of your financial year .

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.

You can still make an omelet out of these cracked eggs by harvesting your losses for tax purposes . The IRS individual deduction for capital losses is limited to a maximum of $3,000 for 2018.  So, if you only dispose of your losers, you could end up with a tax loss carryforward, i.e., tax losses you would have to use in future years. This is not an ideal scenario!

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.

No one knows when the next bear market will happen , if it has not started already. It is high time to ask yourself whether you and your portfolio are ready for a significant potential downturn.

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.

4) Roth Conversions

The current tax environment is especially favorable to Roth conversions . Under the current law, income tax rates are scheduled to go back up in 2026; hence Roth conversions could be suitable for more people until then.

With a Roth conversion, you withdraw money from a Traditional retirement account where assets grow tax-deferred, pay income taxes on the withdrawal, and roll the assets into a Roth account. Once in a Roth account, the assets can grow and be withdrawn tax-free, provided certain requirements are met. If you believe that your tax bracket will be higher in the future than it is now, you could be a good candidate for a Roth conversion .

Read more about the new tax law and Roth conversions

5) Pick your Health Plan Carefully

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.

 

Gozha net on Unsplash

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!

 

Check these other wealth management posts:

Is the TCJA an opportunity for Roth conversions?

New Year Resolution

How to Implement a New Year Resolution

Tax Season Dilemna: Invest ina Traditional IRA or a Roth IRA 

 

 

 

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.  

Nov 18

Market Perspectives – October 2018

By Chris Chen CFP | Capital Markets

Market Perspectives

Third Quarter 2018

Should we panic yet?

September 2018 marked the 10 year anniversary of the Lehman Brothers bankruptcy in 2008, that ushered several months of extreme activity in the financial markets. The market slide from December 2007 to March 2009 was one of the steepest and scariest that we remember.

Yet, ten years later, the S&P 500 has enjoyed the longest bull market in US history, having lasted 3,453 days from March 9, 2009, until the end of September 2018. (footnote: Dow Jones Indices and Washington Post) As has been the case throughout its history US markets have recovered and more than made up the losses of the last downturn. According to Morningstar, the S&P 500 returned an annual 12% from October 1, 2008, to September 30, 2018. On a cumulative basis, the S&P 500 has returned by 210%.

This rally has been largely fueled by the easy monetary policy of the Federal Reserve, which moved short-term interest rates effectively to zero in the wake of the 2008-2009 bear market, promoting risky behaviors, especially with corporate borrowing, which have helped drive the U.S. stock market upwards since then.

We all want to know when the next market downturn will occur. Some may think that it has started already with the October 2018 volatility. Since we cannot predict the future with any accuracy, we’ll stipulate that it may well have. However, we believe that the October market reflects a reversal to the greater volatility that the financial markets have historically displayed instead of the placid pace that we have been accustomed to since the Great Recession. We should get used to more of the same in the future.

We are likely to be in the late innings of the current economic expansion. However, there are reasons for a cautiously positive outlook for the short term. Either for the short or long run, it continues to be important to match the risks of your investments with the need you will have for the funds.  (If you are not sure what I am talking about here, drop me a line). If your needs for your money is in the short term, invest appropriately.

With proper matching of asset risk and liability timing, you can be well prepared for the downturns that will inevitably come.

A New Round of Tariffs

In late September, the U.S. placed an additional round of tariffs on $200B of Chinese goods. They are expected to affect a wide range of products, from computer electronics to forestry and fishing.

In response, China accused the Trump administration of bullying and applied their own tariffs on $60B worth of goods. If the Chinese response looks weak, it is only because China imports a lot less from the US than we do from them!  That should not be reassuring as China has many other tools to retaliate with besides imposing tariffs on American goods.

According to Fitch, the rating agency, these trade escalations will have a negative impact on global growth. As a result, they lowered their economic growth forecasts slightly from 3.2% to 3.1%.

In its simplest form, a tariff is a tax imposed on imported goods. Eventually, it gets paid by consumers. There are already anecdotes of the effects of the tariffs on the price and availability of some products. Coupled with the tariffs imposed by China, we expect that they will work themselves in the numbers in quarters to come.

Consumer Confidence Near All-time High

American consumers continue to be oblivious to the effects of trade and tariff risks. The Conference Board’s Consumer Confidence Index hit an 18-year high and sits very close to an all-time high, due in part to a strong outlook on economic growth and low unemployment.

Speaking of unemployment: it fell to 3.7% in September 2018, well below the 50- year average of 6.2%. Normally, we expect low unemployment to be associated with wage inflation. Fortunately for employers, although not for workers, wage growth has remained stagnant well below historical averages.

The Era of Easy Money is Coming to an End

In each of the last four quarters, the Federal Reserve increased the Fed Funds rate 25 basis points (bps). It now stands at a level of 2.00% – 2.25%. We have had three increases already in 2018 and 8 since 2015. It is possible that the volatility that we experienced in October 2o18 may delay the projected December 2018 increases. However, at this time, owing to the otherwise strong economy, we expect that the increase will come through, and will be followed by two more increases in 2019.

Inflation Is Stable

The Core PCE (Personal Consumption Expenditures), a measure of inflation, is running right around the Fed target of 2%. From the Federal Reserve perspective, that is good news, as inflation has persisted below this mark for the last several years. Inflation is one of the key economic measures that the Fed watches very closely. When interest rates climb faster than anticipated, it may signal an overheating economy and inflation. The Fed may then increase interest rates more quickly.  

U.S. Equity

Reversing last quarter when small-cap stocks outperformed large-cap stocks, this quarter saw large-cap stocks outperform their small-cap counterparts as trade and tariff talk dissipated. In addition, large-cap stocks are still benefiting from the effects of the tax cut. Even so, on a year-to-date basis, small-cap stocks have still outpaced large-cap stocks 11.5% to 10.5% as of the end of September.

From a style perspective, the last quarter continued to increase the gap between growth and value stocks. On a year-to-date basis, large-cap growth stocks, as represented by the Russell 1000 Growth, have outperformed large value stocks, as represented by the Russell 1000 Value by 13.2% (17.1% vs. 3.9%).

Non-U.S. Equity

International equities have continued to lag their U.S. counterparts in 3Q2018. In fact, the MSCI EAFE was the only major international equity index we follow that earned a positive return during the quarter (1.4%). Additionally, each of the four major international equity indexes we follow have fallen on a YTD basis.

During 3Q, much of the conversation in emerging markets surrounded Turkey and Argentina. Turkey’s direct impact on the overall return of the MSCI Emerging Markets index was minimal as it comprises only 0.6% of the MSCI Emerging Markets Index. However, because Argentina comprises almost 16% of the MSCI Frontier Markets Index, its troubles certainly had a greater impact on returns. We expect that MSCI will reclassify Argentina into the MSCI Emerging Markets Index in mid-2019.

Emerging markets continue to have strong growth and attractive fundamentals. Specifically, they are considerably less expensive from a P/E ratio perspective and pay higher dividends.

However, the Fed rate increases have hurt, as US rate hikes have a tendency to increase the value of the dollar, and decrease the attractiveness of emerging market investments. Also, while the U.S. comprises 55% of global market capitalization, 45% continues to come from outside our borders.

Therefore, despite occasional challenges, we believe that it is important for investors to be diversified in markets outside the U.S. Investors should keep in mind that investing domestically vs. internationally should not be an all-or-nothing endeavor. We continue to believe that global diversification is important.

Fixed Income

Fixed income investments continue to be challenged in a rising rate environment. Specifically, Treasury investments have yielded negative returns over the last 12 months. The picture worsens with longer maturities and most other fixed-income categories.

We continue to keep an eye on the shape of the yield curve. When the 2 year and 10 year Treasuries (the yield curve) come to close together, it is often a precursor of recession. That happens when investors no longer believe that they are being adequately compensated for holding longer maturities. This year the gap between the two has continued to narrow and therefore has fueled speculation. As of now, the curve has not inverted (ie short-term rates are still lower than long-term rates). Therefore, the best we can say is that this indicator is inconclusive at this time.

In anticipation of continued fixed income market turmoil due to rising rates and other factors, our fixed income portfolio is weighted toward shorter maturities and floating rate instruments. We believe that this provides an adequate return at an acceptable risk.

 

Check our blog post on the Seven Year End Wealth Management Strategies

 

Note: The information herein is general and educational in nature and should not be construed as legal, tax, or investment advice. Views expressed are the opinions of Insight Financial Strategists LLC 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 accuracy or completeness of the information presented. This communication should not be construed as a solicitation or recommendation to buy or sell any securities or investments. To determine investments that may be appropriate for you, consult with your financial planner before investing. Market conditions, tax laws, and regulations are complex and subject to change, which can materially impact investment results. Index performance information, financial conditions, inflationary and future risk and return information is provided for illustrative purposes only. One cannot invest directly in an index. Past performance is no guarantee of future results. Individual investor performance may vary depending on asset allocation, the timing of investment, fees, rebalancing, and other circumstances. All investments are subject to risk, including the loss of principal.

Insight Financial Strategists LLC is a Massachusetts Registered Investment Adviser.

Oct 15

Financial Planner or Estate Planner: Which Do You Need?

By Anna Byrne | Financial Planning , Retirement Planning , Tax Planning

Financial Planner or Estate Planner: Which Do You Need?

Financial Planners and Estate Planners are two different professions that are often confused. There is some overlap between professionals in these fields, but their roles are rather distinct. When you are striving to make a long-term plan for a strong financial future, both financial planners and estate planners play a crucial role.

In fact, when you consider some of the most recent personal finance statistics, it becomes very clear that many Americans could really benefit from retaining the services of both a financial planner AND an estate planner. For instance, 33% of Americans have no money saved for retirement, 60% lack any form of an estate plan, and only 46% have money saved for emergencies. Better planning starts with understanding what both types of planners do.

What is a Financial Planner?

A financial planner is a professional who offers a wide range of services that can assist both individuals and businesses to accomplish their long-term financial goals and accumulate wealth. They fall into two categories:

  • Registered Investment Advisor
  • Certified Financial Planner

Certified Financial Planners (CFP) are required to comply with the Certified Financial Planner Board of Standards, which means they have a basic level of expertise backed by a larger organization. Ethically they have to work in your best interest.

Services provided by both financial advisors and CFPs include:

What is an Estate Planner?

The goal of a financial planner is to assist with wealth accumulation. On the other hand, an estate planner can help you to make financial plans associated with your passing, which includes protecting the wealth that you have accumulated .

While you might believe only wealthy individuals need to work with an estate planner, you should consider the fact that everything you have accumulated in your life comprises your estate. Accumulated assets such as vehicles, furniture, bank accounts, life insurance, your home, and other personal possessions are all included in your estate.

Your assets become the property of the state if you die without a will or an estate plan in place , and your family members will not be able to claim them without paying legal fees and taxes. They will also have to face the stress of potential disagreements with other family members over how your property should be divided.

Besides planning for your passing, estate planning also involves creating a clear plan for your care if you become disabled , and it also covers naming guardians for underage children. Estate planning is a way to protect your family and your assets while reducing taxes and legal fees .

Which Do You Need?

The roles of financial planners and estate planners are unique, and for this reason, you will benefit from working with both . While your financial planner helps you accumulate wealth, he or she can also prepare you for a meeting with an estate planner as part of your long-term strategy. This includes providing the estate planner with lists of beneficiaries, tax return documentation, lists of investments and a breakdown of income and expenses.

When you work with both a financial planner and an estate planner, they will keep you accountable by periodically reviewing your documentation and beneficiaries and making sure everything is updated and reviewed as necessary. By taking the time to work with both these professionals, no important decisions will be overlooked, and you will take control of your financial future.

 

Note: This article was authored by Kristin Dzialo, a partner at Eckert Byrne LLC, a Cambridge, MA law firm that provides tailored estate planning. Eckert Byrne LLC and Insight Financial Strategists LLC are separate and unaffiliated companies. This article is provided for educational and informational purposes only. While Insight Financial Strategists LLC believes the sources to be reliable, it makes no representations or warranties as to this or other third party content it makes available on its website and/or newsletter,  nor does it explicitly or implicitly endorse or approve the information provided.  

Sep 18

3 Simple Ways to Avoid Ruining Your Retirement

By Eric Weigel | Investment Planning , Retirement Planning , Sustainable Investing

3 Simple Ways to Avoid Ruining Your Retirement

 

Photo by Melvin Thambi on Unsplash

 

What’s your “Probability of Ruin”?

Many people considering retirement or in the early phases of this new stage in life worry about outliving their assets.  

These individuals no longer have the luxury of a steady paycheck, and unless they are one of the lucky ones with a defined benefit plan and/or a large portfolio of liquid investments, they will have to dip into their 401k’s and savings to fund their lifestyle.

Somebody in the de-accumulation phase will naturally worry about how long their money will last and whether they can maintain their lifestyles.

People are living longer these days and it is not unheard of for a newly minted retiree to live another 30 years.  

Let’s look at the data. According to the Social Security Actuarial Life Table (2014) estimates, life expectancy for a 65 male is 17.81 years and for a female 20.36 years.  Somebody in above average health may live even longer – these are just median numbers. If you want to conduct your own calculations, you can refer to How Long Will You Live?

David Blanchett of Morningstar uses the 2012 Society of Actuaries annuity table to estimate the likelihood of living to a certain age using the methodology outlined in his 2013 FPA journal article. This cohort of individuals comes from a higher than average socio-economic group and tends to live longer than average.

Table 1 highlights the calculations from the perspective of a 65-year-old. There is a 50% chance that a male lives to age 89 with a female living to age 91.

Table 1

 Life Expectancy

Source: David Blanchett, Morningstar

The point of these projections is that most people should plan for a long period in retirement. The good news is that we are living longer today but the bad news is that we need to make our retirement savings last longer if we are to maintain a certain lifestyle.

Some people retire with very healthy nest eggs that, barring a cataclysmic event, will provide plenty of cash to fund their lifestyles.  They need not worry much as long as assets vastly outstrip expenses.  They have a high margin of safety.

For most retirees, however, the margin of safety provided by their financial assets in relation to their expenses is slimmer.  They do need to worry about how much they are spending, how their investments are performing and how long they may need their portfolio assets to last.  They may have other sources of income such as Social Security but still need to make their investment portfolios work hard to bridge the gap between lifestyle expenses and sources of income.

Most people in retirement face a balancing act

They can control their expenses to some extent (putting off non-essential expenses).  They can plan and make sure that their investment portfolios are structured in accordance with their appetite and need for risk-taking (maybe requiring the help of a financial professional). But what they can’t control are capital market returns and how long they need to tap into their retirement accounts (how long they will live).

One way to identify the various trade-offs required to ensure the sustainability of an investment portfolio is to come up with a CHRIS, a Comprehensive Holistic Retirement Investment Strategy with the help of a financial professional.  A good plan should clearly outline what actions you need to take and what type of minimum portfolio return you will need to achieve to ensure that the probability of running out of money before you or your partner/spouse die is within your comfort zone.

Another alternative is to forego a formal financial plan and utilize some sort of rule of thumb such as William Bengen’s 4% rule. According to this highly popular rule published in 1994, you can safely withdraw 4% of your capital every year in retirement.  The research contains a number of key assumptions (such as a 50/50 stock/bond allocation) often ignored in the popular press, but the Bengen rule is not only well known but popular among many retirees.

Should one just jump ahead in and rely on the Bengen 4% rule? Our view is that before you do so, you really should understand the probability of running out of money.

Milevsky and Robinson provide a simple approach in their highly touted article A Sustainable Spending Rate without Simulation to calculating what they call the “probability of ruin.”

Milevsky and Robinson identify three important factors: your rate of consumption, the risk/reward structure of your portfolio, and how long you live. Visually, these concepts can be illustrated in a Retirement Finances Triangle as depicted in Figure 1.

Without going into the mathematics of the Milevsky and Robinson approach for calculating a “probability of ruin” lets us think a bit more deeply about what makes retirement planning complicated in the first place.

 Figure 1

The first aspect that makes retirement planning difficult is the uncertainty surrounding how long you and your spouse/partner are going to live. People are living longer, on average, than in previous generations. But an average does not necessarily help you.  Your physical and mental health could be dramatically different from the “average” individual.

The other variable that is highly uncertain and makes retirement planning more difficult relates to the variability of investment outcomes on your retirement portfolio.  While history is a guide as to what to reasonably expect in terms of key asset class returns and risks over the long-term, in any given year returns could fall within a wide range.

As most people already know, stock returns exhibit more variability in outcomes than bonds.  The “probability of ruin” calculation using the Milevsky and Robinson formula incorporates the ability of individuals to evaluate the implications of various forms of asset allocation with varying levels of expected risk and return.

As you have probably figured out by now, calculating the “probability of ruin” is extremely important in planning your retirement.

The Setting:

To make the situation more realistic let’s look through the eyes of George and Mandy, both aged 65 and about to retire from their corporate jobs.  They have saved diligently over the years and now have a portfolio worth $1,000,000 that they will tap to fund their lifestyle in retirement.

The Problem:

George and Mandy estimate that they will need $90,000 a year to maintain their lifestyle.  Their Certified Financial Planner has also told them that their Social Security income will be $50,000 a year.  They face an annual gap of $40,000. They expect to tap into their retirement portfolio to fund this gap.

They are in reasonably good health and based on discussions with their financial planner they assume that they will live to age 90. To be safe, they assume a retirement horizon of 30 years.

Their starting portfolio value is $1,000,000 and they wish to withdraw $40,000 a year to fund their living expenses.

Capital Market Assumptions:

We assume that inflation will run 3% per year, on average.  Currently, inflation is running a bit lower than 3% in the US but the historical average is only slightly north of 3%.

What sort of investment risk and return assumptions should people use to calculate the probability of running out of money under this scenario?

Past returns are often a poor guide in forecasting returns and George and Mandy decide as a starting point to use the current Insight Financial Strategists long-term capital market assumed risk and return numbers as outlined in Table 2. These numbers are derived from expected long-term growth, profitability and starting valuation relationships.  They should be viewed as purely hypothetical and subject to great variation.

For illustrative purposes only, Insight Financial Strategists has aggregated all the asset class risk and return numbers into six multi-asset class strategy portfolios according to investment risk – Conservative, Moderate Conservative, Moderate, Moderate Aggressive, Aggressive and the industry convention of a 60/40 balanced strategy.

Table 2

Source: Insight Financial Strategists

Let’s start out gently – the Case of No Uncertainty:

It always helps to start off with a hypothetical scenario where all decision elements are known with certainty up front. We assume that George and Mandy own a 60/40 portfolio returning 4.9% per year and an annual inflation rate of 3%.

If they were to withdraw the equivalent of $40,000 a year in inflation-adjusted terms what would the required distribution look like over their retirement years?

Figure 1

Source: Insight Financial Strategists

The red line in Figure 1 depicts what would happen to their expenses in retirement if inflation were to rise every year by 3%.

What started off as a withdrawal of $40,000 turns into a much larger number over time. For example, after ten years they would need to withdraw $52,000 each year to fund their lifestyle (assuming that their Social Security checks are adjusted annually for inflation as is the current practice).

After 20 years they would need to withdraw $70,000 from their portfolio each year and after 30 years (their last year in their calculations) the number would increase to $94,000 annually. Inflation can sure take a bite!

In terms of George and Mandy’s portfolio, the assumption is that it will yield 4.9% per year or in inflation-adjusted terms, 1.9% per year. After withdrawals are taken out of the portfolio by George and Mandy to fund their lifestyle net of portfolio returns (the assumed 4.9% nominal return per year) the assumed value of the portfolio is depicted in Figure 2.

 Figure 2

Source: Insight Financial Strategists

At the end of the 30th year, the portfolio is expected to be worth $277K.  As long as George and Mandy only live 30 years in retirement and the assumed inflation and portfolio returns prove spot on (accurate) then things should be ok.  They will glide through retirement and even have some assets left over.

The problem occurs if either George and/or Mandy live past age 95. According to the actuarial data in Table 1, there is a 25% chance that George will live to age 99 and Mandy will live to age 101.

Now what? Their current $1,000,000 portfolio is now insufficient to fund their retirement expenses past the age of 97.  They will run out of money and not be able to rely on portfolio income anymore.

What could they do to prevent such an unpleasant outcome?

For starters, they could spend less. For example, they could cut back their annual spending to $30,000.

They could also shoot for higher portfolio returns by taking on a bit more investment risk.  George and Mandy understand that higher portfolio returns are not generated out of thin air.  Higher prospective returns are tied to higher risks.

But does the real world work like this?

Is it just a matter of pulling some levers here and there and voila you have wished for the perfect outcome?

Unfortunately, referring to the Retirement Finances Triangle depicted in Figure 1 although there are some things that George and Mandy can control such as their expenses but when it comes to how long they will live and how their portfolio will actually perform over their retirement years there are lots of unknowns.

Let’s deal with the real world – Introducing Uncertainty:

What if George and/or Mandy live longer than the assumed 30-year lifespan? This is what professionals refer to as longevity risk.  Living a high quality, long life is a very noble and common goal. Outliving your assets is a real fear.

What if portfolio returns do not measure up to our assumed returns? This is referred to as investment risk. What happens if investment returns are significantly below expectations and portfolio income proves insufficient to maintain your desired lifestyle?  Most retirees seek some margin of safety in their investments for this exact reason.

The Milevsky and Robinson formula is designed to take these uncertainties into account by modeling the likely distribution of portfolio returns and longevity.  The end output is a probability of running out of money at some point in time over the retirement horizon.  They refer to this number as the “probability of ruin”.

Let’s start by looking at the implications of the various portfolios strategies presented in Table 1. The Conservative strategy is the least risky approach but also has the lowest prospective returns. This strategy is exclusively composed of bonds.

The Aggressive strategy is exclusively composed of equities and is expected to have the highest returns as well as the highest risk of all of our strategies.

The 60/40 strategy falls along the middle in terms of prospective portfolio returns and risk.

What do the different risk and return profiles of the strategies imply in terms of the probability of ruin of George and Mandy’s portfolio?

Figure 3 depicts graphically the output from the Milevsky and Robinson formula.

Figure 3

Source: Insight Financial Strategists

What immediately jumps out from the bar charts is that the probability of ruin for the various portfolios is quite high. No longer assuming that everything is perfect creates, not surprisingly, more difficult likely outcomes.

For example, if George and Mandy were to employ the Conservative strategy yielding an assumed 2.3% annual return there is an 80% probability of them running out of money at some point in retirement.  Being conservative has its drawbacks!

What if they had the internal fortitude to employ the all-equity Aggressive strategy yielding a prospective return of 6.8% with a volatility of 17%? Their probability of ruin would drop to 37%.

Even if they employed the conventional 60/40 strategy, their probability of ruin would still exceed 45%.

What if the probability of running out of money is too high? 

Well, for starters they could reduce their rate of consumption, i.e. spend less. Maybe not what they wanted to hear but possible.

Let’s assume that instead of taking out $40,000 a year from their investment accounts they withdraw only $30,000? Let’s also assume that they invest in the traditional 60/40 portfolio. The only thing that has changed from the previous scenario is that now George and Mandy are spending only 3% of their initial portfolio to fund their lifestyle.

By spending less and thus depleting their investment assets at a slower rate, they lower their probability of running out of money at some point over their remaining lives to 30%. George and Mandy start thinking that maybe searching for a more inexpensive vacation option makes sense and allow them to worry less about outliving their assets.

 Figure 4

Source: Insight Financial Strategists

 

What else can they do to shift the odds in their favor?

Besides spending less, another option is to work a bit longer and postpone their retirement date. Let’s say they both work five years longer than originally planned.   What would happen assuming that they still intend to withdraw $40,000 in portfolio income and they invest in the 60/40 strategy?

Figure 5

Source: Insight Financial Strategists

By delaying retirement for five years George and Mandy lower the probability of running out of money to below 38%. Not bad but maybe not quite to their satisfaction.

Could George and Mandy restructure their investment portfolio to improve their odds?

Yes, that is certainly a feasible approach as we already outlined in Figure 3.  Higher return strategies carry higher risk but when held over the long-term tend to lower the probability of running out of money.

But not everybody is equally comfortable taking investment risk even if it is likely to result in higher ending portfolio values over the long-term.

Is there another approach to design a more suitable retirement portfolio?

While risk and return are inextricably intertwined, recent financial research has identified the “low volatility” anomaly where lower volatility stocks outperform their higher volatility cohorts on a risk-adjusted basis.  See this note for an introduction to the low volatility anomaly.

Let’s say that instead of assuming a 10.4% volatility for the 60/40 portfolio we are able to utilize a mixture of similar investment vehicles designed to exhibit lower levels of volatility but equivalent returns. Say the volatility of this strategy is now 8.4% and uses a range of lower volatility fixed income and equity approaches plus possibly an allocation to a guaranteed annuity.

Figure 6 illustrates the implications of using the lower volatility investment strategy.  The probability of ruin goes down marginally to below 42%.  Good but not great in the eyes of George and Mandy.

Figure 6

Source: Insight Financial Strategists

What else can George and Mandy do? 

After all, they have evaluated the impact of lowering their expenses, deferring their retirement date and structuring a more suitable investment portfolio and they still are uncomfortable with a probability of ruin in the 30% range.

The short answer as in many areas of life is to do a bunch of small things.  They could elect to just lower their spending from 4% to 3% and the probability of running out of money would drop to about 30%.

But George and Mandy realize that they could do even better by doing all three things:

  • Spending less
  • Working a bit longer
  • Structuring a more suitable investment portfolio

Figure 7 highlights the various alternative courses of action that they could take to increase the odds of not running out of money in retirement.

Figure 7

Source: Insight Financial Strategists

There are no guarantees in life, but spending less, delaying retirement and designing a more suitable portfolio lowers the probability of running out of money to about 20%.

While we all strive for control, George and Mandy are comfortable with this approach and the sacrifices required. To them leading a fulfilling life in retirement is more than just about money and sacrificing a bit in order to gain peace of mind is a worthwhile trade-off.

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What does calculating the probability of running out of money in retirement teach us?

Is the trade-off that George and Mandy are making appropriate for you? Maybe, but maybe not. At the very least, understanding your own circumstances and your own probability of running out of money may lead to vastly different choices.

Your retirement could extend for 30+ years. Having enough resources to fund your retirement is important to maintain your lifestyle and achieve peace of mind.

While much of life is beyond our control, everybody can still exert some influence over their retirement planning.  In this article we highlighted three general strategies:

  • Adjusting your spending
  • Delaying when you tap your retirement resources
  • Designing an investment portfolio that suitably balances risk and reward

As people enter retirement, they can’t eliminate either longevity or investment risk. What they can do is manage the risks and remain open to adapting their plan should things change.

At Insight Financial Strategists we don’t believe in shortcuts. A CHRIS, a Comprehensive Holistic Retirement Income Strategy, gives you the best chance of full understanding your circumstances and what needs to happen to fund your lifestyle in retirement.

Barring a full financial plan, at a minimum people should evaluate the likelihood of running out of money. Applying the Milevsky and Robinson formula represents a starting point for an in-depth conversation about your needs, goals and especially your attitude toward risk and capacity to absorb losses.

Interested in having the professionals at Insight Financial Strategists guide you? Please request a complimentary strategy session here.

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Disclaimer:

Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. 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. References to specific investment themes are for illustrative purposes only and should not be construed as recommendations or investment advice. Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation.

This piece may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Stock and bond markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Investing involves risk, including the risk of loss.

 

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