Tag Archives for " social security "

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!

Jun 15

4 Risks of Pension Plans in Divorce

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

4 Risks of Pension Plans in Divorce

Although the number of pension plans has significantly declined over the years there are still many of them out there, and many divorcing couples have to figure out how to deal with them. The prime benefit that a pension plan provides is a fixed lifetime income.  A stream of income in retirement could well be a pension synonym. It used to be that fixed income was considered a negative. However, nowadays it is the lucky retiree who benefits from a pension plan!

In case of divorce, issues surrounding who is entitled to the pension present a challenge especially in the case of grey divorces (usually defined as people over 50).  Divorce and pension plans can sometimes generate conflict as the owner of the asset will often feel more proprietary about it than with other assets. Employees are often emotionally vested in their pension. They feel, more than with other assets, that they have really earned it. And that their spouse has not.  They often will have stayed in a job that they may not have liked for the privilege of qualifying for a higher paying pension. Couples look forward to getting that income when they retire. And so spouses will want to make sure that they get their share of it as part of the divorce.

Pension rights after divorce are determined as part of the overall divorce process. In a negotiated divorce, the parties can decide, within limits, how to divide their assets. In the worst case, the courts will make the decision.

What is a pension plan and how does it work?

The value of a pension benefit can be difficult to determine. Unlike other accounts, pensions don’t come with a statement that makes them easily comparable to other assets; they come with the promise of a benefit (the monthly payment that someone might get at retirement). So the number one priority when a pension is involved in a divorce is to get a valuation. The financial consequences of divorce are serious, and not getting a valuation may lead to struggling financially after divorce

Risk of Valuation

Even when valued, the number provided on a report may lead to a false sense of security. Unlike other retirement statements, the value of a pension is estimated using the parameters of the beneficiary and of the pension. In most cases the divorce pension payout is calculated with a predetermined formula based on the employee’s length of employment and income.  In some cases, the benefit may vary depending on a few other factors.

The next step is to estimate how long the benefit might be paid. That is done using actuarial tables. Based on periodic demographic studies, actuarial tables predict our life expectancy. Some actuarial tables include those produced by the Society of Actuaries, the Internal Revenue Service, and the Pension Benefit Guaranty Corporation (PBGC). A pension valuation will normally use the estimates from the actuarial tables representing  an average life expectancy of a cohort of people born in the same year. The estimates are usually accurate within their parameters, as individual variability is smoothed out  for large populations. However, individual longevity is harder to predict as it may fall within a wider range.

With the amount of the payment and the length of time that the payments will be made, how much is all of that worth?   Pension valuators use a “discount rate” to approximate the value of a future payment. The principle is that the value of a dollar paid next year will be less than the value of a dollar paid today. Hence you should be willing to accept less than a dollar for the promise of a payment next year, and even less for the promise of payment the year after.  

Financial analysts will use the concept of the prudent rate of return, the rate that a prudent person would invest at in order to receive that dollar next year or beyond. That of course could be subject to interpretation. Often the standard that is used is the government bond rate for the duration of the payment.  US government bonds are often considered to be risk free by economists and the public, although that too is subject to debate (Currently US government debt is rated at AA+ (below AAA) by Standard & Poor’s, the leading debt rating agency). Nonetheless that rate is often used for individual pension valuations.

The PBGC, on the other hand, has developed its own rates. The PBGC uses different rates before retirement, and rates during retirement. The former are significantly higher than the latter and assumes a rate of return that is in excess of the risk free rate.  That may be a better model for actual human behavior, as people will normally be tempted to take more risk for a better return, rationalizing, of course, that the incremental risk is not significant. On the other hand, for rates during retirement the PBGC uses rates that are well below the norm, reflecting the reality that retirees are even more risk averse than the average population.

Financial analysts will determine the value of the pension by taking a present value of the pension payments over the expected longevity of the individual at the determined discount rate(s). The number that comes out is usually a single number assuming a date of retirement.  

Understanding that we are working with an estimate, people usually ignore the fact that the magic number does not take into account the likely variability of  the inputs, in particular longevity.

If you will be the alternate payee (ie, if you are the spouse aiming to get a share of the other’s pension), it is important to pay attention to the fact that the real value of your share of the pension will fall within a range. It will not be a single number Hence when you trade that pension for another asset that has a fixed value, you want to make sure that you are not short changing yourself.

On the other hand if you are the beneficiary of the pension, it is painful enough to give up a share of it.  You don’t want to give up part of that asset if it will not be fully used. If it is the alternate payee that passes away early, his or her stream of payments stops, and, in most cases, does not revert back to you, the initial beneficiary.  If that were to happen you will have wasted a potentially substantial asset.

In summary it is important for divorcing couples to fully understand the value of their pensions for themselves and for their spouse.  Divorce already destroys enough wealth. There is no need to destroy more.

Risk of Default

Pensions have a risk of default or reduced benefits in the future. According to the Society for Human Resources Management  114 pension funds are expected to fail in the next 20 years. That is true even for pensions that do not look like they are in trouble currently. Some people may think that this is farfetched. Yet you only have to look at the Pensions Right website to convince yourself that benefit reductions do happen. When you consider that retirement can last 20, 30 or 40 years, you will want to evaluate if your pension plan is robust enough to last that long, and continue making payments for that long.

The risk of benefit reductions or outright default may apply mostly to the private sector. Yet public sector plans may be at risk also. For instance, Social Security has a trust fund that, together with payroll deductions, funds its retirement benefits (social security retirement benefits are effectively a pension). According to the 2009 Social Security Trustees Report, the Social Security trust fund will run out in 2037. When that happens, the Trustees project that retirement benefits will be cut by 24%.  

It should be noted that Social Security benefits are not divisible in divorce  The beneficiary keeps his or her benefits. The ex-spouse can get 50% of the beneficiary’s benefits (if married 10 years or longer) or 100% of his or her own, whichever is higher, but not both. That happens without prejudice to the prime beneficiary.

However, in 2037, both parties can expect a Social Security retirement benefit cut of 24%, unless Congress remedies the situation beforehand.

Personal Risk

People also underestimate personal risk. If you receive a pension as an alternate payee (ie the spouse who is getting a share of the pension from the former employee), you will want to consider the risks that your payments may be interrupted due to issues with your ex-spouse. Many pensions stop spousal payments when the beneficiary passes. When that happens, the alternate payee will have to find an alternate source of income to compensate.

It is worth remembering that our life expectancies are random within a range. The expected longevity of women reaching 65 years of age is to 85 years of age.  We often anchor on this or other numbers forgetting that few women pass away at 85. Most will pass away either before 85 or after 85. According to a paper by Dr. Ryan Edwards for the National Bureau of Economic Research, the standard deviation for longevity is 15 years. That means that most women will live to 85, +/- 15 years. From 70 to 100 with an average of 85. That is a wide range! What if the beneficiary of the pension passes away 10 years before his her life expectancy, and the alternate payee lives 10 years longer than life expectancy? That means that the alternate payee may have to do without his or her share of the pension for 20 years or longer (if the two ex spouses have the same expected longevity).

And what about inflation risk?

Most pensions do not have a Cost of Living Adjustment (COLA). That does not apply to all of them. For instance, the Federal Employee Retirement Systems (FERS) has a limited COLA. Effectively, when there is no inflation adjustment, the value of a pension payment is reduced every year by the amount of inflation. How bad can that be, you ask? Assuming a 3% inflation rate the value of a fixed payment will decrease by almost 50% over 20 years.  . What is the likelihood that expenses will have reduced by 50%?

A Last word

Pensions are a very emotional subjects in divorce. Perhaps because we are naturally risk averse, and perhaps because our risk aversion is exasperated by divorce related anxiety, we like to cling to what we perceive as solid. People will often want to keep the marital home, even if they cannot afford it, or take a chunk of a pension even when it may make better sense to trade it for another asset. Worse yet they will want to know whether to keep the house or pension in divorce.

What other asset you may ask? You could trade the pension for a tax- deferred retirement asset, such as an IRA or a 401k.  Or any other asset that you and your spouse own. The right decision will end up being different for everyone.

As a Divorce Financial Planner, it is my task to make sure that each side understands exactly what is at stake, and to help prepare them for rebuilding financially after divorce. In many cases it makes sense for both parties to get a share of the pension. In others it does not.  How to keep your pension in a divorce is a vital question. Even more important is to understand the true value of the pension, and its ambiguities.  It is a difficult task in a process that is already filled with anxieties and uncertainties to focus effectively on yet one more ambiguity. Yet for successfully managing finances after divorce it must be done.

 

Other posts that you may find interesting:

Pension Division in Divorce

Post-Divorce Investments 

In Divorce, Can We Share a CDFA?

 

 

Mar 03

How should I use the 529A Account?

By Chris Chen CFP | Financial Planning

How should Iuse the 529 Account?

author: Julia Wolf thru wikimedia commons; http://creativecommons.org/licenses/by-sa/2.0/deed.en; no changesThe first part of this post described 10 key features of the new 529A Account created by the ABLE Act that was passed by Congress in December 2014.  Let us know if we can send you a copy or a link to the entire article.  This second and final part discusses implications for disabled loved ones.

The 529A comes with built-in advantages such as relatively low costs (expected), tax advantages, and the ability to have up to $100,000 in assets without jeopardizing access to public support programs.

The new plan should be very attractive to many middle class families. Similar to the intent of the the 529 college plan for college bound students, the 529A allows families to set aside money for their disabled loved one, and use it as needed, while limiting the impact of unforeseen expenses on their lifestyle.

However, the 529A has restrictions for annual contributions and maximum balance which may make an account delicate to manage. It is not a vehicle for disabled people to accumulate more than $100,000. In fact due to the relatively low balance limit, the vagaries of market fluctuations that it may be subjected to, and the inevitable withdrawals that will occur, many people will want, if they can afford it, to supplement a 529A with a Special Needs Trust.

Due to the contribution limit, the accumulation phase of the 529A could last up to 7 years, making accumulation a medium term investment horizon. Perhaps one way to manage accumulation would be to contribute $14,000 for three or four or five years and then let the investment grow (hopefully to $100,000) over time. The distribution phase starts as the balance approaches $100,000. While it appears that according to the rules the beneficiary’s Supplemental Security Income will suspend when the balance goes over $100,000, it is not clear yet how this suspension would be implemented. Will “any” peak above $100,000 trigger the suspension? Or will it be the balance as of an arbitrary date, say at the end of the month? Rules and regulations are still being written, so we don’t have that answer yet.

Nonetheless, the key is that the balance will have to be managed, and drawn down as necessary so as not to exceed the magic $100,000 balance limit. Given the general upward bias of financial markets, it would imply that it may be best to 1) manage the balance to a level of safety below $100,000 like, say, $90,000; and 2) plan a periodic monthly withdrawal to cover ongoing expenses.

Using the 529A as a checking account cum investment account is not necessarily optimal. Most of us dissociate our checking accounts from our investment accounts for good reasons. And yet, the 529A seems to be designed to be used as both, primarily because 529A investment earnings are expected to be tax free (checking accounts are effectively tax free since they have no earnings to tax). Hence the only way to earn a windfall from the 529A is to invest.

Many readers will be familiar with the sequence of return problems that can come with a retirement account: when a new retiree takes initial withdrawals in the same period that the financial markets experience a downturn, the risk of running out of money before end of life increases tremendously. The same will be true for the 529A, especially since the time horizon can be so much longer than for retirement. While a 30 year retirement is common, it is likely that many 529A beneficiaries will need their account for up to 60 years or longer. In the absence of a party willing and able to replenish the account, for instance, by another relative after the parents pass away, 529A accounts may still need to be supplemented by Special Needs Trusts. Actually, 529 accounts fit well as a stop-gap before Special Needs Trusts are funded, as many Special Needs Trusts remain unfunded until life insurance pays up after the death of the parents.

Since 529A accounts are not offered yet as of the time of this writing, we don’t know what kind of investment options will be available. As mentioned, the accumulation phase could be for as little as 7 years, which makes it a medium term investment horizon, followed by a very long distribution phase (up to 60 years or longer) during which the main investment need will be for income, and the need to manage the balance to under $100,000. That is very different from 529 College plans which have up to 18 years accumulation and then distribute over a 4 to 5 years period.

States which will offer 529A Plans will be well advised to propose different investment offerings than those offered for their college plans. For instance, the standard age based investment options currently offered by most college plans will probably not be appropriate. In addition, because participants will sometimes draw from the 529A account in declining markets, they will likely demand solutions that are relatively insensitive to downward market fluctuations. The temptation will be to leave it in cash or near-cash, thus giving up on a critical feature, the ability to grow investments tax-free.

The 529A is not a perfect vehicle. However, it is a great new tool to help disabled people. It will allow more families to plan support for their disabled family members with an easy-to-use framework that should be relatively low cost and may provide additional funding in the form of tax free earnings. In addition, 529A Accounts supplement rather than replace Special Needs Trusts by filling a gap for the period before Special Needs Trusts are funded

Let us know if you would like a copy of  Part 1 and Part 2 of this article on the new 529A, or if you have further questions.

(A previous version of this article originally appeared in nerdwallet.com)

Feb 13

10 Things to know about the 529A

By Chris Chen CFP | Financial Planning

Ten things to know about the 529A Account

529AIn the week leading up to Christmas 2014, the US Congress passed the Achieving a Better Life Experience Act (the ABLE Act) , creating the 529A account to provide tax advantaged benefits for disabled individuals. It is a significant change to the financial planning landscape for special needs beneficiaries, with the potential for helping many families with disabled members.

The 529A plan is modeled after the Section 529 College Savings Plans, which are widely used for college planning. The 529A account is meant to allow tax advantaged accumulations and distributions for a wide range of expenses for the disabled beneficiary. The following lists some of the specifics, similarities, and differences that the 529A Account features:

1. The 529A Account uses the Social Security definition of disability. In addition it can benefit only people who have been diagnosed with a qualifying disability prior to age 26.

2. Like the 529 College Plans, the 529A plans will be set up on the state level. Presumably, the same state agencies that oversee the 529 College Plans will be responsible for the 529A, although that may differ from state to state.

3. There can be only one 529A account per beneficiary, normally in his or her state of residence. That is different from the 529 college plans, for which there is no limitation on which state plan is used, and where the distributions are made.

4. Spending for a beneficiary can occur only in his or her state of residence. This will allow simplified compliance verification for federal and state agencies.

5. Contributions in the 529A are with after tax money and are limited to $14,000 a year (in 2015) for each beneficiary from all sources. Individual states may choose to provide additional tax benefits.

6. Investment growth in the 529A is tax-free.

7. Distributions are tax-free so long as they are used for qualified expenses. Otherwise, earnings on distributions are taxed at ordinary income rates with a 10% penalty added. Qualified expenses include housing, transportation, health and wellness, education and more.

8. Having a 529A does not disqualify the disabled individual from Federal and State aid, such as Supplemental Security Income or Medicaid, so long as the amount held in the 529A does not exceed $100,000. Effectively that caps the 529A Account to $100,000.

9. Should the 529A account balance exceed $100,000, Supplemental Security Income would be suspended, but not terminated. Once the balance falls below $100,000, benefits would be resumed.

10. The limitations on contributions and on balance levels suggest that the 529A could be used as a hybrid between an investment account and a checking account.

In the next post we will discuss some of the subtleties and implications of the 529A for planning for disabled love ones.  Let me know if you would like me to email you a link to the next post!

(a previous version of this post appeared on Nerdwallet.com)
Jun 26

Overturning DOMA

By Chris Chen CFP | Divorce Planning , Financial Planning

Some financial impact from overturning DOMA for same-sex couples 

Overturning DOMAToday, the Supreme Court struck down the Defense of Marriage Act (DOMA), the 1996 federal law prohibiting married same-sex couples from receiving federal benefits.   According to Justice Kennedy who wrote the majority opinion “DOMA is unconstitutional as a deprivation of the equal liberty of persons that is protected by the Fifth Amendment.”

For states such as Massachusetts where same-sex marriage is legal, federal benefits that were previously unavailable can now be accessed by married same-sex couples.  Many of  the benefits are financial or have a financial impact.  For instance, with DOMA overturned, same-sex couples will now have the ability to file taxes jointly, or to qualify for social security benefits. In addition, same-sex couples can now simplify their legacy planning, since they will be subject to the same rules as opposite-sex couples.

Same-sex couples who divorce  will now be able to get the same benefits as opposite-sex couples.  For example, same-sex divorced couples can now divide property without incurring gift taxes.  When alimony is paid, the payor may now deduct the payments from taxable income.

Divorced same-sex couples may need to revisit their separation agreements.  For those people who have an alimony arrangement, as the alimony amount can now be deducted from the payor, it will also become  taxable to the payee.  Hence the amounts may need to be recalculated to take that new fact into account.   People who have had to pay gift taxes as a result of a property division pursuant to divorce may be able to reclaim those taxes.

These are exciting times for same-sex couples.  Life without DOMA will be easy to settle day to day.  For financial issues, such as financial planning and tax planning it may take a little more adjustment.  Make sure to contact your CFP and CPA for more details.

 

Simon Abrams on Unsplash.com
Jun 13

Working into Retirement

By Chris Chen CFP | Financial Planning , Retirement Planning

Working into Retirement

The Great Recession has many older Americans considering the prospects of going back to work after retirement or staying in the workforce past their normal retirement age. But working after retirement age is not a new necessity. According to the Social Security Administration, more than 30% of individuals between the ages of 70 and 74 reported income from earnings in 2010, the latest year data are available. Among a younger age group, those between 65 and 69, nearly 49% had income from a job.

Some remain employed for personal reasons, such as a desire for stimulation and social contact; others still want a regular paycheck. Whatever the reason, the decision to continue working into your senior years could potentially have a positive impact on your financial future.

Working later in life may permit you to continue adding to your retirement savings and delay making withdrawals. For example, if you earn enough to forgo Social Security benefits until after your full retirement age, your eventual benefit will increase by between 5.5% and 8% per year for each year that you wait, depending on the year of your birth. Although you can continue working after age 70, you cannot delay social security benefits past age 70. You can determine your full retirement age at the Social Security Web site (www.ssa.gov) or by calling the Social Security Administration at 1-800-772-1213.

Adding to Your Nest Egg

Depending on the circumstances of your career, working could also enable you to continue adding to your retirement nest egg. If you have access to an employer-sponsored retirement plan, you may be able to make contributions and continue building retirement assets. If not, consider whether you can fund an IRA. Just remember that after age 70 1/2, you will be required to make withdrawals, known as required minimum distributions (RMDs), from traditional 401(k)s and traditional IRAs. RMDs are not required from Roth IRAs and Roth 401(k)s.

Even if you do not have access to a retirement account, continuing to earn income may help you to delay tapping your personal assets for living expenses, which could help your portfolio last longer in the years to come. Whatever your decision, be sure to apply for Medicare at age 65. In certain circumstances, medical insurance might cost more if you delay your application.

Work doesn’t have to be a chore. You may find opportunities to work part time, on a seasonal basis, or capitalize on a personal interest that you didn’t have time to pursue earlier in life.

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