What Is Direct Indexing? Can it Help Me?

By Chris Chen CFP | Investment Planning , Portfolio Construction

Direct indexing is an exciting investment method that will likely get much more attention in the near future. This is because direct indexing offers unique advantages not available through traditional ETFs or mutual fund structures – particularly around tax management and investment personalization.

According to a Cerulli report, direct indexing will continue to outpace mutual fund and ETF growth over the coming years due to its advantages. Following is what you should be aware of about the benefits of direct indexing.

What is Index Investing?

Investors, most likely including you, now commonly use index mutual funds or index Exchange Traded Funds (ETFs). Index funds replicate an index such as the S&P500 by investing in each of its components. In the case of the S&P500, it means buying 500 stocks with the same structure as the index itself.

Because an index fund mimics the index exactly, it allows an investor to match the performance of the index closely . Index funds are different from active funds that try to beat the index. Although we all prefer to beat the index, evidence shows that professional stock fund managers are usually unable to do so consistently on a risk-adjusted basis.

What is Direct Indexing?

With direct indexing, investors own each of the individual stocks that make up an Index rather than owning an index mutual fund or index ETF .

The goal with direct indexing is similar to the goal of an index ETF: achieve performance tracking the index. However, direct indexing also allows investors to personalize their investments and receive greater tax advantages from holding individual securities within their accounts .

Direct indexing has long been a staple of high-net-worth clients’ strategies. It makes sense, considering its numerous advantages – particularly regarding taxation. However, historically, the strategy was cumbersome because of the number of required trades and the associated trading costs. As a result, it was only cost-effective with very large accounts.

However, modern investment industry developments that reduce costs, such as no-commission trading, fractional share trading, and the availability of large-scale computing, are making it possible to offer direct indexing to a larger public.

Reduce Tax Bills

Direct indexing portfolios offer greater flexibility for tax loss and tax gain harvesting . That involves selling low-performing securities at a loss to offset capital gains in other securities. We are already familiar with market downturns that can create wide losses across a portfolio. In this unfortunate circumstance, loss harvesting is just a way to make lemonade from lemons.

Many people don’t realize that even in a rising market, many individual stocks inside an index will post negative returns . One of the reasons we use index investing is because it is challenging to identify beforehand which stocks will go up and which will go down.

Direct indexing tax loss harvesting allows investors to take advantage of the fact that many positions are going down even in a rising market . Harvesting these losses and a comparable gain makes a rising portfolio more tax efficient by reducing taxable profits.

According to Vanguard’s recent research, this could translate into significant after-tax returns of 1% or more. Other studies have estimated that the benefit could be up to 3%.

An academic study from Professor Lo et al. at the Massachusetts Institute of Technology examined historical returns over the past century. It concluded that from 1926 to 2018, direct indexing could have increased after-tax returns from 0.51% to 2.13%, with an average of 1.08% annually. So, is direct indexing worth it? When you consider the power of compounding, this makes it an enormous advantage for long term investors.

One percent may not sound like a lot. The results will vary for everyone depending on their investments, tax situation and other factors. It should be noted that direct indexing providers will implement differently, leading to different results .

Better Asset Allocation

With a mutual fund or ETF, the investor indirectly owns all of the index’s components, thus overlooking the issue of overexposure to other securities .

For example, an investor may already have a large position in a component of the index such as the S&P 500, for example, TSLA or AMZN or any of the 500 stocks that make up the index. Or the investor could have RSUs or stock options from their employer. A financial planner might tell them they are already overexposed to these individual securities, thus exposing them to greater risk.

With the flexibility allowed by direct indexing, the investor’s portfolio can build around these securities and exclude them from the indexed portfolio. That allows better asset diversification and reduces the risk of being overexposed to specific securities.

Pinpoint Personalization

With direct indexing, investors have the freedom to customize their portfolios by holding securities instead of an index fund, which is not customizable .

For example, portfolios can be tailored to ESG factors or exclude securities that don’t match investor values while keeping a more fully diversified portfolio than is practical with simply buying individual stocks.

We should note that personalization can cause a portfolio’s performance to diverge from its index. The original reason to invest in an index was to benefit from diversification. Therefore, personalizing a portfolio will necessarily result in performance divergence . Investors need to reflect on their own risk tolerance and expectations and how they may or may not match with a personalization strategy.

Direct Indexing – Is it Right For Me?

Direct indexing can offer the benefit of harvesting capital gains and losses, potentially resulting in a meaningful increase in performance . Because the IRS limits the amount of capital losses that we can claim for tax purposes, the full benefit of harvesting capital losses comes with harvesting capital gains to offset the losses.

For example, you have no net gains or losses if you sell security A at a loss of $2,000 and security B at a gain of $2,000. Balancing the two effectively reduces taxable capital income and, therefore, capital gains taxes.

Direct indexing also presents more complications than a portfolio using funds since individual securities can be held and traded for tax loss harvesting – creating additional transactions to consider.

According to various studies, direct indexing can result in a better Return On Investment, primarily through tax advantages . So whether saving for retirement, recovering from divorce, or simply accumulating wealth outside of retirement accounts, direct indexing performance advantages are bound to intrigue investors.

Tax harvesting is not a new concept. What is new is the ability to use investment software to do it systematically and at scale. Other recent innovations that facilitate direct indexing also include fractional share trading and no-cost trading. The first allows rebalancing to match the index instead of approximating it. The latter enables implementation of the strategy without concern for trading costs dragging performance.

These advances in technology make direct indexing accessible to retail investors.

Can you use better performance in your portfolio?

If not, that’s fine.

But if you do, reach out! Visit Insight Financial Strategists,  or schedule a complimentary call, 

What Is The Impact of Social Security on Divorced Retirement Income

By Chris Chen CFP | Financial Planning , Investment Planning , Portfolio Construction , Retirement Planning , Risk Management

When mediating a divorce settlement, a 50-50 split of assets isn’t always equitable when Social Security benefits are taken into account . Let’s explore some examples.

The complexities of Social Security retirement benefits make it a difficult topic for divorce settlement negotiations. It is an exceedingly important source of income for retirees, especially divorced and even affluent retirees. Therefore, Social Security’s place in a person’s retirement income plan is a critical item for mediators, divorce financial planners, lawyers and their clients to understand to achieve the elusive goal of a fair and equitable settlement.

The maximum benefit in 2023 is $54,660 a year. Of course, most people don’t get the maximum. Still, as the benefit decreases, I find that it constitutes a greater percentage of income. And, because state courts do not have jurisdiction over SS allocation, its impact tends to be overlooked in settlement negotiations .

How does it work in practice? Take Jack and Jill, who are retired and are both 66. Each has a house of equal value (to simplify), $1.7 million in their IRAs and $300,000 in other liquid assets for a total of $2 million. For Jack and Jill, a 50-50 division leaving each party with $1 million should be a fair division, right?

Maybe. But let’s first go over some Social Security background.

A Short History

The Social Security Act, passed in 1935, included benefits for workers but not their spouses . At the time, women who did not work outside of the home could not qualify for Social Security retirement benefits. A sweeping series of amendments enacted in 1939 extended Social Security to spouses and minor children. Wives who had not earned a Social Security retirement benefit or whose retirement benefit was less than 50% of their husband’s qualified for the first time.

Catching up with a changing society, another reform extended Social Security retirement benefits to divorced wives in cases when the divorce happened after a marriage of longer than 20 years. The word “spouse” replaced the word “wife” in the 1970s, allowing husbands to collect retirement benefits on their ex-wives’ records .

Later, the length of marriage required to qualify for benefits after a divorce was reduced to 10 years. When SCOTUS legalized same-sex marriage in 2015, survivor and divorce benefits extended to same-sex couples .

This short history of Social Security shows how it has evolved. Ex-wives and ex-husbands can now all receive retirement benefits based on an ex’s work record .

However, qualifying conditions must be met. The rules can be confusing and challenging to keep track of, especially for those who have had more than one marriage and divorce or those whose ex-spouse has died.

Benefits for Divorced People

When a divorced spouse claims their benefit at full retirement age or later, they will qualify to receive 50% of their ex-spouse’s primary insurance amount (PIA), so long as they have not remarried before 60 years of age and their own benefit is less than 50% of their ex-spouse’s.

In Jack’s and Jill’s case, Jack’s PIA is $3,000 per month, and Jill does not qualify for a retirement benefit on her own record. She can file for her divorced-spouse benefit at her full retirement age of 66. She will qualify for 50% of Jack’s PIA, $1,500.

However, divorced people who claim on their ex-spouse’s record will not get more if they delay their benefits past full retirement age, 66 to 67, depending on the birth year .

Note that if Jill had her own Social Security retirement benefit and it was more than 50% of Jack’s, she would receive only her own benefit. She would not also receive her divorced benefit!

Sometimes people wonder how the age difference with their ex-spouse can affect their benefits. The good news is that the ex-spouse’s age when they claim it is irrelevant. As long as Jill claims at full retirement age, she will receive her maximum divorce benefit independently of the timing of Jack’s claim.

Who Qualifies?

A person who claims benefits based on a former spouse’s record must be single at the time . So unfair, you say? If Jill has remarried, generally, she could get 50% of her new husband’s benefit, or her own, if her own is greater than 50% of her new husband’s. So let’s continue with a single Jill.

Jack may be married or unmarried. It makes no difference. If Jack is (re)married, Jill and the current wife could both qualify for the 50% benefit from Jack’s record.

Suppose Jill, who receives the 50% benefit, remarries. In that case, her 50% benefit from Jack’s record stops unless Jill’s new spouse also gets a divorced-spouse benefit. That’s except if the remarriage occurs after age 60.

Jill’s marriage must have lasted 10 years or longer to claim Social Security retirement benefits on Jack’s record . Because of that requirement, sometimes people who think of divorce will delay until 10 years of marriage are achieved. For example, if you’ve been married for 9.5 years, it may be worth waiting another six months. And with the slow speed of divorce proceedings, that is entirely possible without trying too hard!

Sometimes people are not sure when they got divorced. People often mark their court appearance date as the divorce date. In most states, however, the actual divorce date is later than the court appearance . For example, in Massachusetts, it is 90 or 120 days after the court appearance depending on the filing type.

More Marriages and Divorces

People sometimes ask: What if you had two or more 10-year marriages?

Then it can become complicated. Those who have divorced more than once after marriages of 10 years or longer get the higher of the two divorced-spouse benefits, so long as they are currently unmarried .

For example, suppose that Sheryl was married to Patrick for 20 years and then to John for 12 years. Sheryl has now divorced for the second time and has remained single for more than two years since her last divorce, from John.

Patrick’s PIA is $3,200, and John’s PIA is $2,800. So let’s suppose that Sheryl’s retirement benefit, based on her own record, is $1,200. However, she is at full retirement age (66 or 67, depending on her birth year).

When Sheryl files, she can receive $1,600, half of Patrick’s PIA, because it is higher than John’s $1,400 and her own benefit of $1,200. And, no, she cannot get both Patrick’s and John’s retirement benefits!

If Sheryl divorced less than two years before, she must wait until her last ex, John  in this case, has filed for his benefit. In addition, the worker on whose record the retirement benefit is claimed, Patrick, must have reached 62 years of age.

Patrick’s filing status is irrelevant to Sheryl’s claim if they divorced more than two years before. So unless Sheryl tells him, Patrick will never know if his ex-spouse has claimed. In either Patrick’s or John’s case, their own benefits will not decrease based on Sheryl’s claim.

It should be clear by now that Social Security rules can be complex. Next, I will be covering issues that can occur when your ex passes away and when the retiree also gets a pension benefit. Finally, I will be bringing it together by looking at an example where the application of the rules results in Jill getting 35% less retirement income than Jack, even though their assets are divided 50-50.

When Your Ex dies

Mike and Marie are 66 and have been married for more than 10 years and divorced for more than two. Because Marie is single and not remarried, she qualifies for a divorced-spouse retirement benefit based on Mike’s record, whether or not Mike has filed.

If Mike has passed away, Marie receives a divorced-spouse survivor benefit based on Mike’s record if she is currently unmarried or if she remarried after age 60. In addition, Marie’s benefit will be 100% of Mike’s PIA, the amount that Mike would have received at full retirement age. In the case of Mike dying, Marie’s retirement benefits are capped to full retirement age.

What if the same two people have married, divorced, remarried each other and divorced again? In that case, the length of the two marriages can be added together (including the time in between) to reach the qualifying minimum of 10 years. That is, if the remarriage happens before the end of the calendar year following the divorce!

Say Mike and Marie were married for seven years, from May 2002 to August 2009. They remarried in December 2010 and divorced again in November 2013 for three years. The total for the two marriages is 10 years. Mike and Marie meet the 10-year requirement because their second marriage happened before the end of the calendar year after the first divorce.

If, instead, Mike and Marie had remarried in January 2011, the 10-year clock would have been reset to zero.

Pension Repercussions

In my previous article, Jill and Jack divorced, and she had no Social Security record of her own and met the requirements to receive half of Jack’s PIA of $3,000. But let’s consider what would happen if Jill had a record of her own.

When Jill applies for her divorced spouse’s retirement benefit, what if she also worked for an employer not participating in the Social Security system? For example, many state and municipal government employees are exempt from paying into the Social Security system . For instance, if Jill was a teacher for her town’s school system, in many states (but not all) she could qualify for a state pension. But then her divorced-spouse Social Security benefit would be reduced by two-thirds of the amount of her pension because of the Government Pension Offset (GPO) rule . As a result, Jill’s Social Security benefit may be zero, depending on the size of her pension.

How would that work? Jill currently receives a $3,000 monthly teacher pension in Texas. She has divorced Jack after more than 10 years of marriage. Jack’s PIA is $3,000. Jill’s divorced-spouse benefit of $1,500 would be reduced by $2,000 (two-thirds of $3,000), which reduces the benefit amount to zero. She doesn’t get any Social Security.

If Jack dies, Jill becomes eligible for a divorced-spouse survivor benefit. After the GPO reduction, she will receive $800 ($3,000 – $2,000 = $800).

Suppose the spouse with the benefit also qualifies for a pension from an entity that doesn’t pay into Social Security. In that case, the Windfall Elimination Program (WEP) kicks in . That reduces the spouse’s benefit payments, and the ex-spouse’s benefit adjusts downward as well.

Note that if Jill benefits from a pension but always paid into Social Security, she would not be subject to the GPO and WEP rules. She may have other challenges that require the help of a professional to sort out, but she would benefit fully from both her Social Security and her pension.

What Does It All Mean?

As a reminder, Jack and Jill are retired and decided to divide their assets 50-50. Jack also benefits from a $3,000 Social Security PIA retirement benefit, and Jill has a divorced-spouse benefit of $1,500. Jack opts to delay his Social Security until 70 when his benefit would increase to $4,081. Jill has no such option.

A common (but potentially dangerous) rule of thumb in retirement planning is that if a retiree begins retirement by taking a 4% distribution from assets and increases it annually with inflation, the retiree will not run out of assets in their lifetime. (1)

As detailed in the table below, Jack and Jill’s 50-50 division of assets may look fair. However, Jill’s income will be 35% less than Jack’s.

For couples that have fewer assets to divide, the difference is larger. For example, if Jack and Jill had $500,000 each and the other assumptions were the same, the difference would be 45%.

On the other hand, couples that have more assets have a smaller difference. For example, if Jack and Jill had $5,000,000 each and all the other assumptions remained the same, the difference in income would be $12%.

Last Words

In the example, the difference between Jill’s and Jack’s total incomes comes to slightly more than $2,500 a month. Over a 20-year lifetime, it can easily add up to more than $600,000. When you add Social Security cost-of-living adjustments (COLA), the difference could be more than $875,000.

The difference in Social Security income is not a challenge that can be dealt with directly in litigation, because the courts have no jurisdiction over Social Security . However, a couple mediating could potentially address the issue to achieve a more balanced retirement income for both and a more equitable settlement. Most likely, that would require the assistance of a divorce financial planner.

The example of Jack and Jill is simplified from cases we might run across. There may be other assets, such as a pension, a vacation home and rental real estate. There may be child support and alimony. Maybe Jill qualifies for her own Social Security benefit. There may be an inheritance looming. Jack and Jill may be further away from retirement. Their investment styles may differ.

Diverse circumstances will complicate the analysis, often beyond what can be easily handled by a lawyer or a mediator. However, it is crucial for a couple and their mediator and lawyers to understand the consequences of their decisions. That is so especially for women because they will need to stretch their assets to meet their longer statistical life expectancy .

I have a series of handy flow charts that can help guide mediators and clients through the decision complexities. Please ask for it at info@insightfinancialstrategists.com.

Note:(1) The 4% rule is widely used as a rule of thumb to estimate retirement income from assets . It was initiated in a 1994 study by Bill Bengen published in the Journal of Financial Planning. More recent revisions of the study imply that the safe withdrawal rule could be less than 4%. Other methods to plan retirement income may be more appropriate depending on the case.

Secure 2.0

By Chris Chen CFP | Financial Planning , Investment Planning , Portfolio Construction , Retirement Planning , Risk Management

Congress passed SECURE 2.0 on December 23, 2022, and it was signed into law by President Biden on December 29, 2022, leading us to several significant changes in retirement planning . As the numeral indicates, SECURE 2.0 follows SECURE 1.0, which passed in 2021. SECURE 2.0 was long rumored but took a long time to become law. SECURE 2.0 was first proposed in Congress in May 2021. The following describes some of the major provisions of the law. If you are looking at retirement, there may well be something in there for you.

Required Minimum Distributions (RMDs):

One of the most consequential items for people approaching retirement is the postponement of RMDs from the current 72 years of age to 75, depending on the birth year.

SECURE 2.0 resets RMDs to:

• 73 if you turn 72 from 2022‐2027 
• 74 if you turn 72 in 2028‐2029 
• 75 if you turn 72 in 2030 or later

This will allow retirees to alter their retirement plan by continuing their Roth conversions for a few years past the former limit of 72 or even to have some for those who have to start late.

The key benefit, of course, is that a Roth conversion allows a retiree with a relatively low tax bracket to make the conversions at a relatively cheap cost . Unfortunately, when we have to take the RMDs, our tax brackets typically jump up, and Roth conversions can become uneconomical . 

Why would a retiree want to do a Roth conversion? For one, a Roth conversion can allow retirees to manage their taxes better . They may need to take more money out of their IRA in future years and thus pay a larger tax. If they have a Roth, they could take a distribution if they qualify, thus avoiding jumping tax brackets. The Roth conversion could allow them to arbitrage their taxes and reduce their lifetime tax bill. 

Another intriguing opportunity is legacy planning. An inherited IRA must be fully disbursed within ten years of inheritance . That can be quite inconvenient for heirs as they will be responsible for paying income taxes they would incur upon distributions. Depending on the age and situation of the heir, the inheritance could come in their peak earning years and thus end up being smaller after taxes than anticipated. More time for the parents to work with Roth distributions can help alleviate the issue. 

These are just a few possibilities that a later RMD requirement can allow. Check-in with me to see how it may affect your situation. 

IRA RMD penalties

Previously, there was no statute of limitations to IRA penalties. Even though IRS penalties and interests on most tax issues have a 3-year statute of limitation, there is no such thing for IRA penalties . The IRS could assess penalties and interest for missed RMD years after the event.

Unfortunately, missing an RMD is common. However, most people do that as a mistake.

It seems unfair to apply penalties and interest forever. Our government has decided to agree: SECURE 2.0 fixes that issue by applying the same statute of limitation to the IRA RMDs as it does to other tax issues .

Secure 2.0 Checklist

Catch-up contributions

SECURE 2.0 finally indexes IRA catch-up contributions for inflation . 

Before this year, IRA contributions, including plan salary deferral, plan catch-up contribution, and plan overall limits, were indexed for inflation. However, until the end of 2022, the IRA catch-up contribution limit was not. It had to be increased by legislation, which only happened once… in 2006!

The law also creates new plan catch-up contribution limits in years a participant turns 62, 63, and 64.

Such participants (62- to 64-year-old) have the following catch-up contribution limits beginning in 2023:

• 401(k)s and similar plans: $10k ($6.5k today)
• SIMPLE: $5k ($3k today)

At first glance, this is nice, but I can’t help but notice that Congress seems very interested in helping 62- to 64-year-olds save for retirement, but not 65, 66, and 67-year-olds. They go out of their way to ensure you that at 65 or later, you are out of luck. It would seem logical to increase the limit up to 67, especially since Full Retirement Age for Social Security can go that late. 

Catch-up contributions to Roth

One of the peculiar points of the new law is that it requires savers to make all catch-up contributions to Roth accounts! 

It’s interesting because not all plans, such as the SEP and SIMPLE IRAs, have Roth options. Many regulations will have to change to accommodate that new legal provision!

The only reason I can think of for that provision is that it allows the IRS to collect taxes now and not let them defer. However, people love their Roth accounts, so it’s all good, even though it is likely to increase taxes during working years for some.

SEP and SIMPLE Roth accounts

Continuing on this Roth trend, the law allows the creation of SEP and SIMPLE Roth accounts. For some reason, SEP and SIMPLE have not had a Roth option until now. 

Further, individual employees will be able to direct the employer matching contributions to the Roth side.  

This is great news for employees of smaller companies as it gives them more planning flexibility.

QCD rules

The Qualified Charitable Distribution (QCD) allows taxpayers to make charitable contributions directly from an IRA to a non-profit . This allows the taxpayer to decrease their balances and their RMDs and associated income taxes. It’s a convenient provision that presents interesting planning opportunities for charitably and tax-minded individuals.

Currently, the QCD is limited to $100,000 a year. SECURE 2.0 indexes that amount to inflation . 

The law also allows a one-time QCD, up to $50,000, to a split-interest entity such as a Charitable Remainder Trust (CRUT), a Charitable Remainder Annuity Trust (CRAT), or a charitable gift annuity. However, it’s not clear that it is cost-effective to establish a CRUT or a CRAT for this relatively small amount.

RMD penalties

Many know there is a 50% penalty for missing an RMD. The new law reduces it to 25% . The penalty is further reduced to 10% for timely and appropriately corrected errors within the “correction window,” which could be as long as three years. Sounds great, but right now, if you realize you missed an RMD but take corrective action and properly request relief, you’ll likely get a waiver of the 50% penalty.

It is still a 10% or 25% penalty, and you will be just as annoyed if you have to pay it, so plan accordingly.

Qualified student loan payments

Student loan borrowers who make payments towards their loan can have a “matching contribution” to their 401(k), 403(b), or SIMPLE IRA . 

This is great for borrowers who can now better pay their loans and save for retirement. It is also great for employers who can now provide an additional benefit for employees they want to retain.

529 Rollovers

Beginning in 2024, 529 beneficiaries will be able to roll over their account directly to a Roth IRA with no tax and no penalty ! This is great for people who have overfunded their 529 accounts.

There are a number of limitations, including the amount and the length of time that the account must have been held. It is one of the more complicated benefits of SECURE 2.0, so consult with your Certified Financial Planner.

In a scenario by industry pundit Michael Kitces, a child with an overfunded 529 could rollover over time the maximum of $35,000 to a Roth account and could end up with more than $1M at retirement. The power of compounding still amazes me!

These significant features of SECURE 2.0 change the retirement landscape significantly for many in pre-retirement or retirement. However, there are many more obscure and technical provisions of that new law. It will pay to consult with a specialist. What is obscure and technical to me could be quite interesting to you!  

To learn more about how this can impact your financial outlook, visit Insight Financial Strategists,  or schedule a complimentary call, 

 

(1): I should note that it is impossible to guarantee future returns.  

Investment Bucket Strategy for Retirement

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

Retirement Bucket Strategy 

What is the retirement bucket strategy? How does it work, and is this strategy right for you?

A key question for people retiring even with a healthy amount of assets is: is that going to last all the way?

So many elements go into answering that question. Still, on top of most people’s minds, one usually keeps them up at night: their investments.

And it makes sense: you can control your spending, social security is more or less a given, and Medicare and Medigap take care of most healthcare expenses. The biggest unknowns of our retirement are our lifespan and whether our investments will last all the way .

An effective retirement investment strategy is using the bucket investment strategy.

What Are The Three Buckets of Investing?

With the the retirement bucket strategy, retirees segment their spending needs into “buckets” depending on the time horizon of their spending . Of course, retirees can use as many buckets as they would like. However, for this discussion, let’s assume a 3 bucket investment strategy where the buckets can be arranged according to time horizon: near-term, medium-term, and long-term.

Retirees can use the immediate bucket to cover current living expenses and fund their lifestyle. Then they can use the intermediate bucket to refill the immediate bucket and the long-term bucket to refill the intermediate bucket. With a bucket retirement plan, each bucket pours into the next, creating multiple buckets or lines of defense between a retiree and adverse market events . 

The immediate bucket

The near-term or immediate bucket covers near-term living and lifestyle expenses. That could be defined as 1-5 years. In the case of Insight Financial Strategists, we tend to use five years.

To cover current living and lifestyle effectively, the risk of investments in the immediate bucket needs to be kept low. Hence the immediate bucket is invested in low-risk instruments, even cash, to ensure that market events such as a sudden drop in values don’t affect the investment and the spending they are associated with.

In market downturns, a low-risk immediate bucket allows the investor to leave their other buckets invested and not have to sell their investments at a loss.

Every year that passes reduces the money in the immediate bucket. With a five-year immediate bucket, there are only four years of expenses left after one year has passed. At that time, the immediate bucket is replenished from the intermediate bucket.

The long-term bucket is invested in assets that are expected to bring higher returns

The intermediate bucket

The role of the intermediate bucket is to get a better balance between risks and returns. While the immediate bucket is useful to tamp down short-term risk, too much in the immediate bucket would leave the retiree open to other risks, such as inflation, if the intermediate and long-term buckets did not complement it.

The amount budgeted in the intermediate bucket reflects spending and lifestyle needs after year 5 to another milestone. Our firm’s intermediate bucket covers expenses between the sixth and tenth year.

In addition to the time horizon, the risk embedded in the intermediate bucket reflects the investor’s risk tolerance. Typically this would result in a mix of stocks and bonds.

The allocation provides more growth potential than the low-risk immediate bucket and lower volatility than the long-term bucket. Because of that latter point, the intermediate bucket is expected to recover faster from a market downturn than the long-term bucket. 

Assets from this intermediate bucket are typically used to replenish the immediate bucket as it dwindles. 

The long-term bucket

Lastly, the long-term bucket aims to provide the portfolio with growth for assets expected to be used ten years or more in the future. In a retirement horizon of 20 years, 30 years, or longer, that is necessary to fight inflation and ensure that there will be enough in a retiree’s later years. 

In a retirement bucket strategy, the long-term bucket is invested in assets such as stocks that are expected to bring higher returns , although with higher volatility. The volatility is acceptable in this bucket because the immediate bucket covers short-term needs, and long-term bucket funds are not needed for another 10+ years. Downturns caused by the increased volatility have historically recovered (1). 

Graph 1: S&P 500 Performance 

Graph 1 represents the performance of the S&P500 from 2005 to 2021. Clearly, downturns occur, notably from the end of 2007 to the beginning of 2009. However, in the long term, the market is positively biased (1). 

How does it Work?

In years when the market is up, rebalancing happens normally. We replenish the immediate bucket from the intermediate bucket and the intermediate bucket from the long-term bucket. So if the market is up substantially, we might harvest more of the gains in case future years are less giving. 

Graph 2: A Hypothetical Bucket Plan

Exact bucket sizing will depend on the retirees’ needs and lifestyles. Most retirees will have a steady source of income, such as Social Security. In 2023, the maximum Social Security benefit is $4,459 per month, equivalent to $53,508 per year. If that is the retiree’s only steady income source, we expect the immediate bucket to cover expenses above that amount. For example, the retiree’s immediate bucket in Graph 2 represents spending for the plan’s first five years including potential mortgage payments. When netting steady income, such as Social Security, the plan generates an income need that investments can cover.

Graph 3: Power of Compounding

A key reason to remain invested in the intermediate and long-term buckets is the power of compounding . This property allows money invested over a more extended period of time to grow substantially. For example, Graph 3 shows the difference in the value changes between a hypothetical investment and cash. 

What are the benefits of a retirement bucket strategy?

There are a few distinct benefits of the retirement bucket strategy.

First, the financial planning needed to size retirement buckets properly can give retirees a great visual of how they can ride through retiremen t, living the life they prefer, yet without running out of funds. If the plan shows that it will be difficult, retirees can adjust their spending accordingly. Most people are surprised how even small changes in the parameters of a plan can result in outsized long-term effects.

Second, the bucket approach to investing can give retirees the peace of mind of knowing that their short-term needs will be taken care of regardless of market events . It will not stop people from worrying about what happens in the long-term bucket. After all, that’s where a lot of their resources are. 

Third, financial planning gives the investor a stronger ability to plan taxes optimally. It allows a deliberate use of various accounts such as brokerage, Traditional retirement, and Roth accounts.  

Fourth, it allows retirees to plan their legacy better. With the retirement bucket strategy, planning expenses and the resources needed to fund them enable the retiree to identify a legacy surplus if any. The excess funds can become an additional bucket focused on legacy planning. That allows the retiree to better think through how to help their children or their favorite causes. It enables them to plan the distribution of a legacy in a way that helps the children when they need it, which may be before the retirees’ death. 

What are the drawbacks of a retirement bucket strategy?

Some critics claim that the retirement bucket strategy results in an investment strategy that is too conservative and overweighted in bonds. However, as we size the buckets according to a retiree’s spending needs, there is no overweighting or underweighting, just right-sizing. That perhaps is the best feature of the retirement bucket strategy: removing the uncertainty of arbitrary allocation and distribution strategies.

Other critics find the retirement bucket strategy challenging to maintain. 

Working optimally, the retirement bucket strategy requires retirees to update their financial plans periodically . It also requires regular adjustments in investments. All of that can be complicated. However, the right software and skills help simplify the process.

Is the investing bucket strategy right for you? 

If you need a retirement plan that allows you to 

1. Balance your short-term and long-term needs
2. visualize your income and expenses, and visualize whether you will have enough for your lifetime. 
3. If you need to plan for a legacy without guessing how much you can spend, the bucket investing approach should be an option.  

To learn more about the retirement bucket strategy, visit Insight Financial Strategists,  or schedule a complimentary call, 

 

Check out our blog post on Carrying a Mortgage in Retirement!

 

 

(1): I should note that it is impossible to guarantee future returns.  

Should You Carry Your Mortgage Into Retirement?

By Chris Chen CFP | Financial Planning , Retirement Planning

Introduction

Transitioning to retirement while holding a mortgage isn’t ideal, yet it happens more often than most people think. An analysis from Lending Tree reported in Forbes stated that 19% of seniors in the top 50 metropolitan areas had a mortgage. And according to the Congressional Research Service, the amount of mortgage debt held by senior households has increased more than 500% over the past three decades.  So, if you are asking how many retirees have a mortgage, it is not uncommon. 

Should you carry a mortgage into retirement? Most financial planners offer the standard advice that it is not financially prudent to consider retiring with a mortgage or any other debt for that matter. That makes sense, of course. Debt creates an additional expense burden that must be satisfied and a liability that may eventually claim an asset to be liquidated.

However,  the data above shows that it is becoming increasingly difficult to retire without carrying a mortgage into retirement. And there are situations where it makes sense. Debt provides leverage and options to achieve goals that might be difficult to reach otherwise. 

Could it make sense?

It may sound obvious, but it bears reminding that getting a loan means that you can preserve other assets for other purposes. And many times, that makes sense.

For example, if your assets are tied in an illiquid investment, you may need the cash to buy that vacation house on Martha’s Vineyard. We don’t have to think exotic to find illiquid investments in our portfolios. Most retirement accounts, including 401(k)s and IRAs, have a form of limited liquidity. Because they are taxed at distribution, there are limits to the size of the distribution that is advisable to take in any given year. With a larger distribution, the tax bracket may be higher as well. Taking too much may result in more taxes than you are comfortable with. A mortgage on your primary residence may be a solution in this kind of scenario.  

Some also have their wealth tied in other illiquid investments such as real estate or private placements. Carrying a mortgage into retirement may allow you the flexibility to enjoy life without liquidating assets.   

there are situations in which it is acceptable to carry a mortgage during retirement

It also depends on the age of the mortgage. A key motivation to pay off a mortgage is to save mortgage interest payments. That is especially true at the beginning of the life of a mortgage. Then, most of the payments go to interest instead of principal. However, because mortgages amortize over time, most of the interest in the later life of a mortgage goes to the principal, with a decreasing percentage going to interest. 

This doesn’t mean that you cannot save interest payments by paying early; it just means that the amount that can be saved decreases with every payment. There comes a time when it may be less expensive to continue mortgage payments than paying early, depending on the financial situation.

Are There Other Benefits?

In most cases, mortgage interest is fixed. If you obtained your mortgage before the rate increases of the recent past, it is low interest. If your income is projected to increase, then the percentage that goes to mortgage payments will decrease. Over time, mortgage payments become a smaller part of your budget. 

Keep Your Debt Under Control

However, there are criteria to observe. The first is that the debt payments should fit within your budget. If you have such debt, you should be able to pay it comfortably from your retirement income. 

That can be confusing because people with retirement income continue to take from their retirement savings, such as Required Minimum Distributions. The key is to make sure with your Certified Financial Planner that it fits within the plan. 

Home equity loans (HELOC) usually work differently. First, there is often no amortization schedule, so the HELOC will not get paid off unless you make a concerted effort.

When is it Acceptable to Retire With Mortgage Debt?

Few people plan to take a mortgage into retirement. However, it happens. 

Parents may refinance a mortgage to fund college for their teenager. Unfortunately, with the rising cost of college and parents’ sense of responsibility, many Moms and Dads end up in that situation. 

People often move before retirement, buy a new house and end up with a mortgage. That could be due to downsizing or a move to a sunnier state. In this circumstance, people often have a plan for their accumulated equity. Some of that could go to pay other debt, such as student loans or PARENT PLUS loans. Or it could go to investment, maybe even a real estate investment such as a rental or vacation home. 

In some cases, some of the equity of the house that was just sold goes to helping to fund retirement at a faster clip, i.e., spending. There are so many things that we can do with money!

As a result, there are situations in which it is perfectly acceptable to carry a mortgage during retirement. The key consideration is to make sure that it fits within your overall financial plan. 

Potential Benefit

There may be a long-term benefit: with a fixed interest rate, your mortgage payments will remain fixed while inflation pushes your income and the value of your home upward.  

And in today’s inflationary environment, with inflation higher than mortgage interest rates, sometimes substantially, the value of a monthly mortgage payment decreases over time simply because money devalues due to inflation. 

In plain terms, this means it gradually becomes less expensive to pay a mortgage throughout retirement as long as that debt is locked in at a fixed rate and income rises.

What Not to do in the Context of Retiring With Mortgage Debt

If you feel it is prudent to pay off your mortgage as you transition to retirement, take some time to review the pros and cons. 

If you pay off the mortgage early in its life, you could be saving a lot of interest payments. Although, as noted previously, carrying a low mortgage interest rate in a high inflation environment may well pay for itself. 

Consider the Opportunity Cost of Paying off Your Mortgage

There can be a significant opportunity cost to paying off a mortgage early. It is even greater when paying off a mortgage that has aged for years or decades. For example, suppose you are collecting Social Security, pension payments, or other income adjusted for inflation, and there are no or few liquid post-tax assets. In that case, it might not make financial sense to pay off the entirety of the mortgage in one fell swoop. 

Doing so could leave you without an emergency fund or liquidity.  

How to decide?

When in doubt, run the numbers. Meet with a Certified Financial Planner to estimate the potential returns from investments or the cost to liquidate. Then, compare those anticipated returns with the interest that accumulates from holding your mortgage during retirement, paying the monthly minimum as you have for years or decades. If your investment returns are likely to outpace the money lost from the mortgage interest accumulation, it may be in your financial interest to use your financial nest egg to invest rather than pay off the balance of your mortgage, keeping in mind, of course, that there are no guarantees in investment.

Don’t let Emotions Override Logic

Like most homeowners, you are yearning to own your home outright and fire the bank as a co-owner. And if you are like most retirees, carrying a mortgage into retirement will make you uncomfortable.

You may also be tired of paying hundreds or thousands of dollars each month simply to have a roof over your head that you can call your own. 

However, it is a mistake to let mortgage debt, or any other money issue for that matter, become an overly emotional issue. But, unfortunately, it is also hard not to. 

Instead of paying a potentially steep financial price to eliminate your mortgage while retirement planning or soon after retiring, take the logical approach by meeting with your Certified Financial Planner. Your financial planner will delve into the nuances of your unique financial situation and then detail the advantages and disadvantages of holding the mortgage until its term ends or paying it off as you segue into retirement.

 

Check out our blog post on Bucket Investing.

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?

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Many people 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 for single filers, 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 Massachusetts 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, many people continue to 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 2022, for a married couple filing jointly with taxable income up to $83,350, long-term capital gains are taxed at 0% federally ($41,675 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 as a return of capital. 

Therefore, the taxation of annuity income falls somewhat below that of 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, like 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 so dominate the sales discussion that they obscure the other costs of cash value life insurance. The loan from the policy is tax-free, but that in and 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 minimizing taxes difficult for a retiree.

The challenge is to plan our income situation strategically 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!

What Financial Specialists Do You Need?

By Chris Chen CFP | Divorce Planning , Financial Planning

Should you get a financial specialist to help with your divorce? Most people start their divorces looking for a mediator or a lawyer, not a financial planner so that can be a startling question.

Yet divorce is likely to be the largest financial transaction in a person’s life. Larger than buying a house. Larger than paying for graduate school. Larger than raising a child. While marriage may have been about love, now that the flame has been extinguished, divorce is about securing the future and rebuilding a financially successful life. That is why it is crucial to make sure that the division of assets and income is fair, meets your needs and that of your children, and allows you to thrive after the divorce.  

Divorce can be complicated to navigate, and for that, you most likely need a lawyer. They are trained to help you through this complicated legal process. However, divorce contains many intricate details that can have long-term consequences on your finances and are beyond the education and horizon of lawyers.

Lawyers are important, but…

There is no question that you need a lawyer’s professional experience and skills in navigating the choppy waters of what is essentially a legal process. There are many intricacies in the way that divorce gets handled across issues such as child support, asset division, alimony, inheritances, and trusts that need the steady hand of a skilled lawyer.

Lawyers bring you to the finish line; that’s what you pay them to do. However, people divorcing have other needs to help them move on afterward. They need to make sure that the division of assets and income allows them to pursue their goals and lead fulfilling lives. And because modern life has made professional work so intricate and specialized, you have to ensure that you get the right professional for the right job.

Divorce lawyers do try to protect their client’s interests. Nevertheless, few lawyers are financial experts. It’s not part of the curriculum in law school, and financial planning is not part of the practice of the average divorce lawyer.

Three Questions You Need to Answer

Dealing with the immediate, potential, and future financial consequences of a divorce is where a qualified financial analyst can best help. A financial expert can help your divorce by helping you answer three critical questions:

The first question is, where are you today financially? What are your assets and your liabilities? What is the joint marital income, and what are the ongoing expenses?

Surprisingly, many people can’t answer those questions precisely. As long as the bills are paid, and the checking account balance is over the minimum, many are too busy dealing with the other issues of life to pay attention.

Diane Pappas, a veteran Certified Divorce Financial Analyst in Gloucester, MA, observes: “A lot of times when I’m working with a couple…they won’t know what they have in retirement accounts, what kind of assets they have. Sometimes they don’t even know what kind of money they’re making. So they literally have to go look at their paycheck to know what they’re getting paid.”

It’s difficult enough to go through the planning process that is required in a divorce without knowing that basic information. If you don’t even know where you are today, how will you be able to cope with all the financial changes that will occur during the upcoming split? If you don’t know where you are today, how will you figure out where you are going and how to get there?

The second question is, where will you be the day after the divorce? After answering the first question, it’s essential to navigate your negotiations to a settlement that can help you move forward. A quick example is a decision about the marital home. Should you keep it? Should you sell it? Should you sell it LATER after the children graduate? Can you afford it? Similar questions can be asked about most other financial issues. Of course, that also applies to liabilities or the debt owed on credit cards, student loans, or the remaining mortgage balance. Then there is the potential challenge of making ends meet on less income.

The third question is, where will you be 5, 10, or even 15 years down the road after the divorce? That is the measure of a successful divorce negotiation and successful post-divorce financial planning. Ignoring this question is easy because of the immediacy and stress of more immediate issues. It’s easier just to let the process move forward, however slowly, and hope for the best outcome. But without a solid answer to this question, you will not be able to provide informed consent for this largest transaction in your lifetime.

In fact, the inability to answer this question may prevent you from closing an agreement because you may not have the confidence to move forward.

Deferral or procrastination during emotional stress is human nature, especially when you are unsure what questions to ask and how to analyze the data. That is where borrowing the expertise of a knowledgeable professional can pay off. Getting the best divorce-related financial advice early in the process will pay dividends down that long road beyond the day that the divorce becomes final.

Common Financial Specialists Used In a Divorce

Bringing a financial expert into the divorce process can make the difference between making an informed decision that gives you a path forward or having to pick up the pieces later. Financial experts and advisors can play a useful role in divorce financial planning. However, it can be challenging to determine which financial specialist to pick, as they come with many different stripes and colors. Some of the major categories include:

Certified Public Accountants (CPAs) often focus on taxes. Because one of the significant challenges of a divorce is to figure out the tax consequences, it is essential to have that expertise on board. In addition, CPAs will sometimes also work on forensic accounting to help find hidden assets.

Business valuators get involved when the divorce case includes the ownership of a business. Regardless of the involvement of each spouse, the business is likely to be one of the most valuable assets of the marriage, one that is exceedingly difficult to divide. Using a business valuator will allow the parties to put a number to the business and facilitate the negotiation.

Certified Financial Planners: CFPs focus on bringing the client from the present to the future, beyond the effective date of your divorce. In a divorce situation, they do so by helping to optimize a settlement offer to take care of the now and position for the future. Some of the focus areas can include retirement planning, risk management, and investments. CFPs can bridge the gap between the attorneys’ focus on getting you to the divorce finish line, and your need for solid post-divorce planning that will lead you to financial independence. It is a skill set that is frequently overlooked or missing during divorce negotiations.

Certified Value Builders (CVBs) are a less common specialty. They help business owners increase the value of their business, often a top priority for business owners fresh out of a divorce. When the business owner and the Certified Value Builder are successful, the business owner can shore up the rest of their finances.

Certified Divorce Financial Analysts: CDFAs are financial professionals who help couples, and their lawyers arrive at a fair divorce settlement. CDFAs straddle the expertise of the tax professional with that of the Certified Financial Planner. They use their knowledge of tax law, short- and long-term financial planning, and distribution of assets to help clients reach an optimal settlement.

CDFAs often have other qualifications. Actually, CPAs and lawyers sometimes have the CDFA. But most often, it is paired with the CFP designation. This combination of CFP and CDFA can help clients ensure that their future is well analyzed.

Let’s Recap

You most likely could use a financial specialist for your divorce. The stakes are too high not to. Disentangling and splitting assets requires far more expertise than what a lawyer is trained in. Anyone involved in a divorce really should be able to answer the three basic questions of divorce: where are you financially now? Where will you be the day after the divorce? And where will you be 15 years after the divorce?

Being able to answer these questions, especially the last one, is often beyond the scope of what lawyers do. Yet the answers are critical to making sure that you know what you are getting to and how you will be financially successful after the divorce.

There are many kinds of financial experts running the gamut from tax accountants to business valuators. Many may be needed for some aspects of your divorce. But the most valuable divorce financial professionals may be the CFP/CDFA combination. They have the training and orientation to bring you to the next level: financial success after divorce.

 

Is a 30% Difference in Retirement Income Fair and Equitable? The Potential Impact of Social Security on Divorced Retirement Income

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

Social Security and Divorce

The complexities of Social Security retirement benefits make it a difficult topic to mediate. It is an exceedingly important source of income for retirees, especially divorced and even affluent retirees. However, Social Security and its place in a person’s retirement income plan are critical items for mediators to understand to achieve the elusive goal of fairness and equity. 

The maximum benefit in 2023 is $54,660 a year. Of course, most people don’t get the maximum. Still, as the benefit decreases, I find that it constitutes a greater percentage of income. And, Social Security retirement benefits are challenging to address in divorce settlement negotiations because State courts do not have jurisdiction over its allocation . 

For example, if Jack and Jill are retired, are both 66, each have a house of equal value (to simplify), $1.7M in their IRAs, and $300,000 in other liquid assets for a total of $2M, a 50-50 division leaving each party with $1M should be a fair division, right?

Maybe. But let’s first go over some Social Security background.

A Short History

The Social Security Act passed in 1935 included benefits for workers but not their spouses. At the time, women who did not work outside of the home could not qualify for Social Security retirement benefits. A sweeping series of amendments enacted in 1939 extended Social Security to spouses and minor children. Wives who had not earned a social security retirement benefit or whose retirement benefit was less than 50% of their husbands qualified for the first time.

Catching up with a changing society, another reform extended Social Security retirement benefits to divorced wives in cases when the divorce happened after a marriage longer than 20 years. Social Security replaced the word “wife” with the “word” in the 1970s, allowing husbands to collect retirement benefits on their ex-wives’ records .

Later, the length of marriage required to qualify for benefits after a divorce was reduced to 10 years. When SCOTUS legalized same-sex marriage in 2015, survivor and divorce benefits extended to same-sex couples .

This short history of Social Security shows how it has evolved. Ex-wives and ex-husbands can now all receive retirement benefits based on an ex’s work record. 

However, qualifying conditions must be met. The rules can be confusing and challenging to keep track of, especially for those who have had more than one marriage and divorce or those whose ex-spouse has died.

Benefits for Divorced People

When a divorced spouse claims their benefit at full retirement age or later, they will qualify to receive 50% of their ex-spouse’s Primary Insurance Amount (PIA), so long as they have not remarried before 60 years of age and their own benefit is less than 50% of their ex-spouse’s.

In Jack’s and Jill’s case, Jack’s PIA is $3,000 per month, and Jill does not qualify for a retirement benefit on her own record. She can file for her divorced-spouse benefit at her full retirement age of 66. She will qualify for 50% of Jack’s Primary Insurance Amount, $1,500, as her divorced-spouse benefit.

The earlier Jill claims her benefits, the less she will get, consistent with other Social Security retirement benefits. Conversely, Jill will receive more if she waits to claim. To maximize Social Security retirement benefits, you will typically need to delay them until 70 .

However, divorced people who claim on their ex-spouse’s record will not get more if they delay their benefits past full retirement age, 66 to 67 depending on the birth year.

Note that should Jill’s own benefit be more than 50% of Jack’s, she will receive her own Social Security retirement benefit. She will not also receive her divorced benefit!

Sometimes people wonder how the age difference with their ex-spouse can affect their benefits. The good news is that the ex-spouse’s age when they claim it is irrelevant. As long as Jill claims at Full Retirement Age, she will receive her maximum divorce benefit independently of the timing of Jack’s claim.

Who Qualifies?

A person who claims benefits based on a former spouse’s record must be single at the time . So unfair, you say? If Jill has remarried, generally, she could get 50% of her new husband’s benefits, or her own, if her own is greater than 50% of her new husband’s. So let’s continue with a single Jill.

Jack may be married or unmarried. It makes no difference. If Jack is (re)married, Jill and the current wife could both qualify for the 50% benefit from Jack’s record. 

Suppose Jill, who receives the 50% benefit, remarries. In that case, her 50% benefit from Jack’s record stops unless Jill’s new spouse also gets a divorced spouse benefit. That’s except if the remarriage occurs after age 60.

Jill’s marriage must have lasted ten years or longer to claim Social Security retirement benefits on Jack’s record. Because of that requirement, sometimes people who think of divorce will delay until ten years of marriage are achieved. For example, if you’ve been married for 9.5 years, it may be worth waiting another six months. And with the slow speed of divorce proceedings, that is entirely possible without trying too hard! 

Sometimes people are not sure when they got divorced. People often mark their court appearance date as the divorce date. In most states, however, the actual divorce date is later than the court appearance . For example, in Massachusetts it is 90 or 120 days after the court appearance depending on the filing type.

More Marriages and Divorces

People sometimes ask: what if you had two or more ten-year marriages?

Then, it can become complicated. Those who have divorced more than once from marriages of ten years or longer get the higher of the two divorced-spouse benefits, so long as they are currently unmarried.

For example, suppose that Sheryl was married to Patrick for 20 years and to John for 12 years. Sheryl has now divorced for the second time and has remained single for more than two years since her last divorce from John.

Patrick’s PIA is $3,200, and John’s PIA is $2,800. So let’s suppose that Sheryl’s retirement benefit, based on her own record, is $1,200. However, she is at Full Retirement Age (66 or 67, depending on the birth year).

When Sheryl files, she can receive $1,600, half of Patrick’s PIA, because it is higher than John’s $1,400. And, no, she cannot get both Patrick’s and John’s retirement benefits!

If Sheryl divorced less than two years before, she must wait until her last ex, Patrick, in this case, has filed for his benefit. In addition, the worker on whose record the retirement benefit is claimed, Patrick, must have reached 62 years of age.

Patrick’s filing status is irrelevant to Sheryl’s claim if they divorced more than two years before. So unless Sheryl tells him, Patrick will never know if his ex-spouse has claimed.

When Your Ex dies

Mike and Marie are 66 and have been married for more than ten years and divorced for more than two. Because Marie is single and not remarried, she qualifies for a divorced-spouse retirement benefit based on Mike’s record, whether or not Mike has filed. 

If Mike has passed away, Marie receives a divorced-spouse survivor benefit based on Mike’s record if she is currently unmarried or if she remarried after age 60. In addition, Marie’s benefit will be 100% of Mike’s Primary Insurance Amount (PIA), the amount that Mike would have received at Full Retirement Age. In the case of Mike dying, Marie’s retirement benefits are capped to full retirement age.

What if the same two people have married, divorced, remarried with each other, and divorced again? In that case, the length of the two marriages can be added together (including the time in between) to reach the ten years qualifying minimum. That is, if the remarriage happens before the end of the calendar year following the divorce!!

Say Mike and Marie were married for seven years, from May 2002 to August 2009. They remarried in December 2010 and re-divorced in November 2013 for three years. The total for the two marriages is ten years. Mike and Marie meet the 10-year requirement because their second marriage happened before the end of the calendar year after the first divorce. 

If, instead, Mike and Marie had remarried in January 2011, the ten-year clock would have been reset to zero. 

Pension Repercussions

When Jill applies for her divorced spouse’s retirement benefit, what if she also worked for an employer not participating in the Social Security system? For example, many state and municipal government employees are exempt from paying into the Social Security system . For instance, if Jill was a teacher for her town’s school system, she could qualify for a State pension. But, then, her divorced spouse’s Social Security benefit would be reduced by 2/3 of the amount of her pension because of the Government Pension Offset rule. As a result, Jill’s Social Security benefit may be zero, depending on the size of her pension.

How would that work? Jill currently receives a $3,000 monthly pension from a police department in Texas. She has divorced Jack after more than ten years of marriage. Jack’s PIA is $3,200. Jill’s divorced-spouse benefit of $1,600 would be reduced by $2,000 (2/3 of $3,000), which reduces the benefit amount to zero. She doesn’t get any Social Security.

If Jack dies, Jill becomes eligible for a divorced-spouse survivor benefit. After the GPO reduction she will receive $800 ($3,200 – $2,000 equals $1,200).

Suppose the spouse with the benefit also qualifies for a pension from an entity that doesn’t pay into social security. In that case, the Windfall Elimination Program kicks in. That reduces the spouse’s benefit payments, and the ex-spouse’s benefit adjusts downward as well.

What Does It All Mean?

As a reminder, Jack and Jill are retired and decided to divide their assets 50-50. Jack also benefits from a $3,000 Social Security PIA retirement benefit, and Jill has a divorced spouse benefit of $1,500. Jack opts to delay his Social Security until 70 when his benefit would increase to $4,081. Jill has no such option.

A common (but potentially dangerous) rule of thumb in retirement planning is that if a retiree begins retirement by taking a 4% distribution from assets and increases it annually with inflation, the retiree will not run out of assets in their lifetime (1).

As detailed in the table below, Jack and Jill may have divided their assets 50-50, which may look fair. However, Jill’s income will be 35% less than Jack’s.

	Jack	Jill	Difference
Assets	$1,000,000	$1,000,000	0%
4% Income	$40,000	$40,000	0%
Social Security	$48,972	$18,000	-63%
Total Income	$88,972	$58,000	-35%

Last Words

In the example, the difference between Jill’s and Jack’s total incomes comes to slightly more than $2,500 a month. Over a 20-year lifetime, it can easily add to more than $600,000. When you add COLA increases, the difference will be more than $875,000.

This is not a challenge that can be dealt with directly in litigation because the courts have no jurisdiction over Social Security. However, a couple mediating could potentially address the issue to achieve a more balanced retirement income for both and a more equitable settlement.

The example of Jack and Jill is simplified from cases we might run across. There may be other assets, such as a pension, a vacation home, and rental real estate. There may be child support and alimony. Maybe Jill qualifies for her own benefit. There may be an inheritance looming. Jack and Jill  may be further away from retirement. Their investment style may differ. 

Diverse circumstances will complicate the analysis. However, it is crucial for a couple and their mediator to understand the consequences of their decisions. That is so especially for women because they will need to stretch their assets to meet their longer statistical life expectancy .

Note:

1. The 4% rule is widely used as a rule of thumb to estimate retirement income from assets. It was initiated in a 1996 study by Bill Bengen published in the Journal of Financial Planning. More recent revisions of the study imply that the safe withdrawal rule could be less than 4%. Other methods to plan retirement income may be more appropriate depending on the case.
2. I have a series of handy flowcharts that can help guide mediators and clients through the decision complexities. Please ask for it at info@insightfinancialstrategists.com

Seven Year End Wealth Opportunities

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

As we come close to the end of the year, you still have time to make a few smart financial moves.

Maybe because of the year-end deadline, many year-end planning opportunities seem to be tax-related. However, tax moves should be made within the context of your overall long-term financial and investment plan. Hence, make sure to check in with your financial and tax advisors.

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

1. Harvest your Tax Losses

As of October 22, the S&P500 is up 21%, and the Dow Jones is up 16% for the year. Unfortunately, some stocks and mutual funds are still posting a loss for the year. Therefore, it is likely that some items in your portfolio show up in red when you check the “unrealized gains and losses” column in your brokerage statement.

You could still make lemonade out of these lemons by harvesting your losses for tax purposes. It is worth remembering that the IRS individual deduction for capital losses is limited to $3,000 for 2021. In other words, if you don’t offset your losers with your winners, you may end up with a tax loss carryforward that could only be used in future years. This is not an ideal scenario!

You can also offset your losses against your gains. For example, suppose you sell some losers and accumulate $10,000 in losses. You could then also sell some winners. Then, if the gains in your winners add up to $10,000, you would have offset your gains with your losses, and you will not owe capital gain taxes on that combined trade!

Bear in mind that Wealth Strategy is not all about taxes! Tax-loss harvesting could be a great opportunity to help you rebalance your portfolio with a reduced tax impact. Beware though of the wash sale rule: if you buy back your sold positions within 30 days, you will have negated the benefit. 

2. Review your Investment Planning

Tax-loss harvesting can be used effectively for short-term advantage. However, it also provides the opportunity to focus on more fundamental issues. So, in the first place, why did you buy these securities that you just sold? At one time, they probably played an important role in your investment strategy. And now, with the cash from the sale, it’s important to be mindful when reinvesting.

You may be tempted to wait for a while to see how the market evolves. We may have been spoiled into complacency with the bull run we experienced since the Great Recession. However, we should not forget that volatility does happen.

It’s almost impossible to predict accurately when the next bear market will start if it hasn’t already. And after more than eighteen months of strong gains, it is time to reassess if you and your portfolio are positioned for a potential downturn. 

You will want to ensure that your portfolio risk is aligned with your goals and that your asset allocation is aligned with your risk target. Reach out to your Wealth Strategist to review.

3. Review your Retirement Planning

There is still time to top out your retirement account! In 2021, you can contribute up to $19,500 from your salary, including employer match, to a standard defined contribution plan such as 401(k), TSP, 403(b), or 457, subject to the terms and conditions of your plan. And if you happen to be 50 years old or older, you can contribute an additional $6,500 for this year.

If you have under contributed to your plan, there may still be time! You have until December 31 to boost your retirement planning by topping off your 2021 contributions. This will also have the benefit of reducing your 2021 taxable income if you contribute to a Traditional plan.

As an alternative, you could contribute to a Roth account if your employer offers that plan option. 

Many employers offer a Roth in their employee retirement plans. If yours does not, schedule a chat with your HR department!

Many people think of the Roth account as tax-free. However, you should bear in mind that although Roth accounts are popularly designated as “tax-free,” they are merely taxed differently since you would be contributing after-tax funds. Double-check with a Certified Financial Planner professional to determine whether choosing to defer some of your salaries on a pretax basis or post-tax to a Roth account better fits your situation.

4. Roth Conversions

Our current tax environment is especially favorable to Roth conversions. With the current TCJA law, income tax rates will be going back up in 2026. Therefore, Roth conversions could cost less in current taxes until then. Of course, Congress could vote for tax rates to go up before the end of the year. There is even the possibility that Congress will remove the ability to do a Roth conversion after 2021.

To do a Roth conversion, you withdraw money from a Traditional tax-deferred retirement account, pay income taxes on the distribution, and move the assets into a Roth account. Then the assets can grow and be distributed tax-free, provided certain other requirements are met. If you think that your tax bracket will be higher in the future than it is now, you could benefit from a Roth conversion.

5. Choosing your Health Plan 

With health insurance re-enrollment season, the annual ritual of choosing a health insurance plan is with us. With health insurance getting ever more expensive, this could be one of your more important short-term financial decisions. 

Your first decision is to decide whether to subscribe to a high deductible option or stick with a traditional plan with a “low” deductible. The high deductible option will have a cheaper premium. However, if you have a lot of health issues, it may end up costing you more. High deductible plans allow access to Health Savings Accounts (HSA).

The HSA is a special instrument. With it, you can contribute money before taxes to pay for qualified healthcare expenses tax-free. Balances in HSAs can be carried forward to future years. They can also be invested to allow for potential earnings growth. This last feature is exciting to wealth managers because, in the right situation, clients could end up saving a lot of money.

If you choose a high deductible plan, you should plan to fund your HSA to the maximum. Many employers will contribute as well to encourage their employees to pick that option. If you choose a low deductible plan instead, make sure to fund your Flexible Spending Account. FSAs are used to pay for medical expenses on a pretax basis. The unspent amount cannot be rolled over to future years, unlike HSAs.

6. Plan your RMDs

Don’t forget to take your Required Minimum Distributions (RMDs) if you are past 70. The penalty for not taking your RMD is a steep 50%. Your first minimum distribution must be withdrawn by April 1 of the year following the year in which you turn 70 ½, and by December 31 for each year after.

Perhaps you don’t need the RMD? Then you may want to redirect the money to another cause. For example, you could fund a grandchild’s 529 tax-advantaged educational account. Contributions are post-tax, but growth and distributions are tax-free so long as they are used to pay for education.

7. Charitable Donations

You could also plan for a Qualified Charitable Distribution from the IRA. That distribution must go directly from the IRA to a charity. Unlike a normal RMD, it is excluded from taxable income and may count towards your RMD under certain conditions

Charitable donations can also help reduce taxable income and provide financial planning benefits. However, the Tax Cut and Jobs Act of 2017 (TCJA) has made it more complicated. A significant result of the TCJA is that standard deductions for 2021 are $12,550 for individuals and $25,100 for joint filers. In practice, it means that the first $12,550 or $25,100 of deductible items have no tax benefits. 

For example, if a married couple filing jointly (MFJ) pays $8,000 in real estate taxes and $5,000 in state income taxes for a total of $13,000 of deductions, they are better off taking the standard $25,100 deduction. The first $12,100 that they donate to charity would not yield a tax benefit. One way to go around this new situation is to bundle your donations in a given year. Another possibility, within certain limits, is to give directly from an IRA.

As an example, if you plan to give in 2021 as well as 2022, bundling your donations and giving just in 2021 could result in a deduction and the accompanying reduced tax. 

If your thinking wheels are turning after reading this article, check in with your Wealth Strategist or financial planner: there may be other techniques that you could or should do before the end of the year!

 

Should Your Spouse Join You in a Divorce Workshop?

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

Should Your Spouse Join You in a Divorce Workshop?

As a Financial Planner, I participate in many different types of workshops, including divorce. Pandemic obliging, these days they are usually webinars.   Divorce is no exception. Should you suggest to your spouse that they should join you in a divorce workshop? Or do you want to keep the information that you got in a divorce workshop to yourself?

As a Certified Financial Planner, I often answer complicated questions with “it depends.” However, for this question, I will just say, “Heck, yes, bring him or her along”! I recently recommended to a divorce workshop attendee that she come back to other workshops and bring her husband along. As it happens,  they are still talking, and my workshops are still Zooming. So, she might be able to get him there. The primary benefit of bringing your spouse to a divorce workshop is that you will start to get him on the same level of understanding about divorce issues.

The first step is understanding that divorce is emotionally difficult to negotiate for both sides. It is even more challenging if the two sides start from different vantage points. Just remember how you felt the last time you dealt with someone with a completely different perspective.  For example, think of the last time you tried to persuade your toddler to eat his or her vegetables. You and your spouse cannot have all your questions answered in one workshop or a dozen. Divorce is way too complex for that. But you will both learn something. And most importantly, you will both hear the same information and may learn the same thing. And that can form the basis for a productive negotiation and path forward.

If you and your spouse do go to the same divorce workshop, take it a step further and ask the questions on the points you disagree about. At the workshop, you will get a neutral expert opinion that may be helpful. Is it about planning for retirement with a lot fewer assets? Or whether you should keep your inheritance as separate property? The challenge of introducing the “D” word to the kids? The difficulties of comparing pensions to other assets? The potential for a creative solution? It doesn’t matter what the areas of disagreement are. You will both hear the same answer and have a starting point to move forward.

In war, you want to keep to yourself all the advantages that you can. Divorce may be war, but it is different in at least one respect: it pays to make sure that your spouse is as informed as you are because that reduces your legal bills and gets you closer to the finish line. Heck, it is also worth it to find out that your position might be wrong. That too can form the basis for moving on. You should note that what you hear in a divorce workshop can be great information, but it is not “advice.” Because every situation is unique, you will have to go back to a professional for objective advice. However, all journeys start with one step forward. Getting on the same page can be that important first step.