All Posts by Chris Chen CFP

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Chris Chen CFP CDFA is the CEO and a Wealth Strategist with Insight Financial Strategists LLC in the Boston area. He specializes in retirement planning and divorce financial planning

Sep 19

Should you cancel your LTC insurance?

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

Photo by rawpixel.com from Pexels

Should you cancel your LTC insurance?

Long Term Care (LTC) can be a stressful subject to discuss, especially when costs are addressed. The reality is that Long Term Care is expensive. According to Genworth, a prominent provider of Long Term Care insurance, the median national cost of a stay at an assisted living facility is $48,000 annually in 2018. The total cost, over someone’s lifetime, ends up being much larger depending on where and how long a person will be needing it.

For example, the median cost of assisted living in New Jersey in 2018 was $72,780, according to Genworth. If someone were to stay at an assisted living facility for three years, the cost would be in excess of $200,000. Nursing home care could be even more expensive.

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

Even insurance companies have difficulty ascertaining the cost. Large insurance providers such as John Hancock have left the field and no longer offer LTC policies to the general public. Others, including Genworth and Mass Mutual, have been struggling with State Insurance Commissions to increase premiums. Recently, Genworth was approved to increase premiums by 58% in 22 States.

According to the Federal Government, Long Term Care is the range of services and support you will need to meet health and personal care needs over a long period of time when you are unable to provide it for yourself. LTC is not medical care, but rather assistance with the basic personal tasks of everyday life.

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

We have plenty of statistics on how LTC affects us as a whole, but very few on how it will affect us individually. Are we going to be part of the 70%, or can we avoid it and be part of the 30%. We just don’t have a very good way to predict how much long term care we will need, when we will need it, and how much it will cost. This is precisely why long term care planning is necessary as part of normal financial or retirement planning.

Who Pays for Long Term Care?

People often assume that Medicare or Medigap (the supplemental coverage for Medicare), or even regular health insurance will cover the cost of their Long Term Care expense.

Unfortunately, that is incorrect. Medicare is set up to cover only direct medical expenses, such as doctor and hospital visits, tests, and medicine. When it comes to issues of old age care, Medicare is not involved.

In general, most people without a plan who need Long Term Care will pay for it out of their own assets. Once there is no money left, Medicaid will usually take over. This approach works best for people who have enough assets to cover the other foreseeable circumstances in their future.

However, planning for Medicaid to take over is a backup plan at best. However, it is good to know that it is there, should we need it.

How do I protect my assets from nursing homes?

A close alternative to spending your own money and then letting Medicaid take over is actually to plan for Medicaid to take over. That involves creating a trust in which to put your assets so they can be protected in the event that long term care is needed. When that happens, the assets remain safely in the trust, and Medicaid pays for your long term care. You should keep in mind that Medicaid is taxpayer-funded, and as with other government programs, it is periodically under stress for funding. In other words, it is not easy to predict with certainty that such a plan would work, especially if it is much in the future.

Long Term Care Insurance

For others, purchasing a long term care insurance policy may be a better alternative. In exchange for the premiums, the insurance company commits to pay the amount contracted for. Effectively, the policy covers a significant percentage of the uncertainty generated by long term care. That amount can vary to take into account your own circumstances.

Who needs Long Term Care Insurance?

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

From a tax viewpoint, it is worth noting that some of the premiums for most standard LTC policies available today may be deductible from taxable income within the limits specified by the IRS, especially for business owners. Also, up to certain limits, benefits are not taxed as income. Take this favorable tax treatment as a sign that Uncle Sam would like to encourage you to be covered (and not use Medicaid)!

The challenge with LTC insurance is that insurance companies have miscalculated the premiums required to cover their costs. As a result, premium increases, including the one mentioned earlier from Genworth, have shocked pre-retirees and retirees alike, resulting in a considerable debate about whether to drop LTC insurance policies altogether.

The financial impact of premium increases is real. It is a painful hit on a sore subject. And as with any price increase like that, the impulse is just to cancel.

However, canceling would be a mistake for many people. The cost of LTC must be covered somehow, and if not through insurance, it is usually through your own assets. However, it does provide an opportunity to reconsider the issue with your financial planner. Most people affected by price increases bought their policy many years ago. It would be beneficial to re-analyze the LTC need and the benefits of the policy. You may find out that you are over-insured, or underinsured. And then you can figure out a way forward on how to right-size your coverage.

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

Long Term Care insurance helps pay for long term care expenses, helps preserve your assets and your legacy. Also, a portion of the premium is potentially tax-deductible. So why are so many people resistant to traditional Long Term Care insurance?

First, as we mentioned before, it is expensive. Although, it is worth noting that the cumulative cost of LTC insurance premiums usually is less than the cost of Long Term Care itself!
Second, the possibility that the insurance policy may not be used, as in the case of death happening suddenly, is enough to stop many people from acquiring Long Term Care insurance. In this paradigm, the thought of paying premiums for years, and not collecting a benefit would make the insurance a waste.

Don’t Waste the Premiums

To counter this objection, the insurance industry has created products that allow you to “not waste the premiums.” These products allow you to purchase an annuity or a life insurance policy with a special “rider” that allows their conversion to an LTC policy should the need arise.

These products allow you to get Long Term Care coverage if needed, and allow repurposing the funds in case the Long Term Care benefit is not used. The details of these products are beyond the scope of this post. Suffice it to say, that these alternatives can provide a lot of flexibility, at a cost, in a financial plan. For people who have significant assets that are not needed for their retirement plan, these alternatives may be worth considering.

Should I cancel my LTC insurance?

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

The answer is different for everyone. Being a financial planner and number geek, I believe that the answer for many resides in comparing the costs and the benefits. For most people that will result in keeping your insurance. If you are not sure, schedule a call, and we can review.

LTC can be a significant expense. As such, it needs to be factored into your overall retirement plan. The four approaches discussed (pay out of assets, Medicaid planning, traditional long term care insurance, and “not waste the premium” alternatives) all offer different benefits and should be matched to the right circumstance and individual preference.

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

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

Jul 16

Do You Have To Pay Taxes in Retirement?

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

Do You Have To Pay Taxes in Retirement?

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

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

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

Social Security

For those filing as single with income below $25,000, or married filing jointly with income below $32,000, social security income is income tax-free. However, single filer retirees with income up to $34,000 or $44,000 for married filing jointly will find that 50% of their social security becomes taxable.  When income increases over $34,000, or $44,000 for married filing jointly then 85% becomes taxable. 

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

Retirement Accounts

Retirement accounts such as 401(k), 403(b), and IRAs are an important source of income for retirees.  Income from these accounts is taxed as ordinary income, as if it was being earned in a job, with tax rates ranging from 10% to 37% at the federal level. That is because the initial contribution to those accounts helped to reduce taxable income at the time.  That means that the money in these retirement accounts was never taxed. 

To complicate the matter, distributions from some accounts may be exempt from State taxes. For instance, 403(b) accounts earned in New Jersey are exempt from New Jersey State income taxes at distribution. Similarly, IRA distributions from accounts that were established by Massachusetts taxpayers are exempt from State income taxes. These peculiarities vary from State to State. It’s important to verify how they may apply in your State rather than making an assumption.  

Pensions

Many retirees still receive pension income. Some of the more common ones include state, federal and military pensions. Although private pensions have been in decline for several decades now, there continue to be many people who receive payments from these pensions.

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

Roth Accounts

Income from Roth accounts is not taxed in retirement.  That is because the initial contribution came from after-tax money. In other words, the income used to make the contribution was taxed on the full amount before the contribution was made. I like to say that “Roth accounts are not tax-free, they are just taxed differently“.

A key benefit of Roth accounts is that their distributions do not count toward high-income surcharges for Medicare Part B and Part D premiums. 

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

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

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

Municipal Bonds

Income received from municipal bonds is federal tax-free.  Like a Roth contribution, an investment in municipal bonds is made with after-tax money. If you own municipal bonds from the state of your residence, the interest is also state tax-free. However, if you own municipal bonds from states other than your residence, their interest is usually taxable at the state level.

People also wonder what happens when they sell their municipal bonds.  When that happens, the price of the bond can be higher or lower than the face value, known as a premium or a discount. When the price is at a premium, the difference between the premium and the face value can be taxed. That can often be an impediment to a sale as people don’t want to be taxed.  

Investments

When held for one year or longer, investments outside of retirement accounts are subject to long term capital gains taxes. They can range from 0% to 23.8%, including potential Medicare surcharges.  In 2019, for a married couple filing jointly with taxable income up to $78,750, long term capital gains are taxed at 0% federally ($39,375 for people filing as single).

Therefore investments can potentially be taxed less than other sources of income such as retirement accounts. Balancing distributions from investments in conjunction with Traditional retirement and Roth accounts can be a valuable tax optimization tool.

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

Annuities

Any income from annuities held inside qualified retirement accounts such as an IRA will be taxable as ordinary income in its entirety.

Income from annuities that are not held in qualified retirement accounts is partially taxable as ordinary income. The amount of the distribution that represents your original investment is considered tax-free. 

Therefore, the taxation of annuity income falls somewhat below that the taxation of income from retirement accounts. 

Life Insurance

Loans from the cash value of an insurance policy are considered tax free. That is because, as any loans, they are not considered income. That is a critical point made at the time that an insurance sale occurs.  It should be noted, however, that life insurance is an instance when the tax issues are so prevalent in the discussion that they obscure the other costs of cash value life insurance. The loan from the policy is tax-free, but that in an of itself does not necessarily make life insurance cost-effective or appropriate for your needs.

Earned Income

Income earned in retirement is taxed as any other earned income before retirement. Some retirees continue to earn work income, from part-time jobs or from consulting gigs for example. That income is taxed as earned income as if they were not retired, including Social Security and Medicare. Unfortunately, there is no tax break for working in retirement!

The reality for most of us is that we will owe taxes in retirement. The multiplication of tax situations can make planning difficult for a retiree.

The challenge is to plan our income situation strategically, manipulate it if you will, in order to minimize lifetime taxes. 

Fortunately, wealth planning done properly is a very feasible endeavor that  may help you keep more of what you earned in your pockets!

Apr 15

McKenzie Bezos: 4 Wealth Strategy Concerns

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

McKenzie Bezos: 4 Wealth Strategy Concerns

source: pexels

On April 4th, it was announced that McKenzie Bezos would be receiving 36 billion dollars worth of assets from her divorce from Jeff.  

First of all, congratulations to Jeff and McKenzie for keeping this divorce process short, out of the media as much as possible, and out of the courts. We are not going to know the details of the Bezos’ agreement. However, some information has been disclosed in the press.

As reported by CNN, McKenzie is keeping 4% of their Amazon stock, worth approximately 36 billion dollars. Jeff retains voting power for her shares as well as ownership of the Washington Post and Blue Origin, their space exploration venture. According to The Economist, this makes the Bezos divorce the most expensive in history by a long shot.

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

Unsurprisingly, McKenzie’s wealth is concentrated in AMZN stock. That has worked out well for the Bezos’ for the past several years. It is likely to continue to be a great source of wealth for both of them in the future. As it stands, McKenzie is now the third richest woman in the world. Who knows, if she holds onto AMZN stock, she could become the richest woman in the world one day! McKenzie’s concerns with budgeting, taxes, and wealth strategy will soon be in a class of their own.

There are, however, some lingering considerations for McKenzie, particularly when it comes to capital gains taxes, portfolio management, philanthropy and wealth transfer.

Capital Gains Taxes

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

A benefit of keeping the stock until her death is that her estate will benefit from a step up in cost basis. This would mean that the IRS would consider the cost of the stock to be equal to the value at her death. This favorable tax treatment would wipe out her capital gains tax liability.

Portfolio Management

Nevertheless, the standard advice that wealth strategists give clients with ordinary wealth applies to Ms. Bezos as well: it would be in McKenzie’s best financial interest to diversify her holdings. Diversifying would help her reduce the risk of having her wealth concentrated into a single stock. It is a problem that McKenzie (and Jeff) share with many employees of technology and biotech startups.

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

Philanthropy

An advantage of having more money than you need is that you have the option to use the excess to have a measurable impact on the world through philanthropy. In 2018, Jeff and McKenzie created a $2B fund, the Bezos Day One Fund, to help fight homelessness. Given that the home page of the fund now only features Jeff’s signature, this may mean that Jeff is keeping this also. McKenzie will likely organize her own charity. What will her cause be?

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

Wealth Transfer

McKenzie’s net worth is far in excess of the current limits of federal and state estate taxes. Unless she previously planned for it during her marriage, she will have to revise her estate plan.  Even though she would benefit from a step up in basis on her AMZN stock if she chooses not to diversify, she would still be subject to estate taxes, potentially in the billions of dollars.

Of course, no matter how much estate tax McKenzie ends up paying, it is likely that she will have plenty to leave to her heirs.

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

 

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

Mar 20

Should You Buy An Annuity?

By Chris Chen CFP | Capital Markets

Should You Buy An Annuity?

Annuities are a popular retirement planning device. According to Investment News, sales broke a record in 2018. Yet, they continue to be misunderstood. There are several types of annuities, with fixed, fixed indexed, and variable being some of the most common. Unfortunately, annuities are so complex, that salespeople often have difficulty communicating their values and shortcomings to clients. It is sometimes said, humorously, that the greatest value of an annuity is the steak dinner that it comes with.

 

Joking aside, the point is that annuities are complex and most of their benefits are intangible, except for the steak. As a client, you will eventually have to decide that if you are not going to become an expert with annuities, you will have to trust a salesperson.

Annuities have value. However, their value must be balanced with costs and lost opportunity considerations. In addition to the direct costs of the annuity, like “mortality and expense”, the expense ratio of the investments or the costs of the “riders”, and indirect opportunity costs what are the value of the benefits you might be giving up to get an annuity?.

First, what does an annuity get you?

Fixed Income

The most commonly advertised benefit of an annuity is fixed income. The insurance company that sells and manages the annuity will be paying you periodically, usually monthly, for the rest of your life (usually).  That payment is presented as fixed: it will never decrease. Obviously, that is appealing to a lot of people: finally a financial instrument with some safety built in.

Rarely does the salesperson point out the obvious: the periodic payment amount will never increase either.

Why does it matter yo have your payment increase? In an age where people ought to be planning for retirement for 20 or 30 years or more, a periodic payment that does not increase is basically a payment that continuously loses value to inflation. While you may not notice it from one year to the next,  inflation is pernicious: it will slowly eat away your purchasing power.

For instance, the table below shows that with inflation of 3%, the value in today’s dollars of a $5,000 annuity payment that you might receive today goes down to $2,803 in 20 years. In other words, you would be losing almost $2,200 of purchasing power automatically. Needless to say, this is something that you would want to know before buying the annuity.

Source: Insight Financial Strategists LLC

Tax Advantage

Also, annuities are Tax-advantaged. Americans love tax-advantaged investments, almost as much as they like tax-free investments. That is a key point to note: the money that you contribute to an annuity is not taxable when it distributes in retirement because, presumably, you have already paid taxes on it. Therefore, when the annuities distribute in retirement, part of the distribution is your own money that comes back to you tax-free. The gains, however, come back to you taxable as ordinary income.  

Now, how does the tax treatment of annuities compare to other methods of investing, like for example investing in equities and fixed income outside of an annuity?  As with annuities, contributions to your investment are not taxed again when they are distributed. However, your gains will usually be taxable as capital gains. This is important because for many people capital gains tax rates are lower than ordinary income tax rates. In other words, you may very well be paying more taxes by putting your money in an annuity than if you had invested outside of it if the right circumstances are met.

Guarantee

Another attractive benefit of annuities is that the payment amounts are Guaranteed.  Financial Planners are not usually able to say that anything is guaranteed, because we do not know the future.  However, financial salespeople can say that about annuities, because the benefits are guaranteed by the insurance company. Obviously, that is a very powerful statement, especially in the absence of comparable guarantees for traditional investment products.

The bottom line is that traditional investments are not guaranteed. We know from watching the market or hearing about it on TV that anything can happen. In particular, the stock market can drop.

Hence if we could protect ourselves from the risk of the stock market going down, it would obviously be a good thing. We know that in any given year the market could go down. In fact, according to Logan Kane, on any random day, we have a 47 percent chance of stocks falling and a 53% chance of stocks rising. In any given year, we have a 75% chance of stocks rising.

We also know that on average the stock market goes up. In fact, even when it goes down, we know that in any rolling five year period it will also go up as demonstrated with the S&P500 on the following graph.

Source: bespokepremium.com

Therefore, when we protect ourselves against the downsides of the stock market with annuities we give up a lot of upside opportunity cost in return.  

Investments

Annuity companies tend to be shy about disclosing how your contributions are invested, except for variable annuities where the regulatory disclosure requirements are well developed. Variable annuities are invested in a mix of stock and bond funds. You can get a thorough description in their disclosure document.

Otherwise, insurance companies will rather have a root canal than tell you how their fixed annuities are invested. Perhaps it does not matter since the insurance company guarantees the payments. Maybe we don’t need to know.

Fixed index annuities are another matter.  These instruments allow for the potential for growth.  Mind you, in the typical words of a self-described “industry-leading financial organization”, ” your money is not actually invested in or exposed to the market”.

They can get away with this statement because it is, most likely, technically true. However, in order to make the returns that they claim that their annuities can make, the insurance companies have to invest in something more than cash. Fixed index annuities put their money, your money, in derivatives: stock options and futures. Technically, it saves you stock market volatility by being outside of it. Instead, you get derivatives market volatility which is even greater.

This has to be one of the most misleading sales pitches that financial salespeople make about fixed index annuities. Still, if the insurance company guarantees the returns, maybe it’s okay anyway?

Costs

Lastly, what about the costs??

Insurance companies tend to be less than forthcoming about the costs of their annuities, except when regulations force them to disclose them. For instance, variable annuities typically disclose a lot of information. When you read the prospectus you will find that it discloses various kinds of fees: administration, mortality and expense, mutual fund subaccount, turnover ratio, and death benefit being some of the most common. According to the Motley Fool, you might find that the total ongoing cost of your variable annuity can be anywhere from 2.46% to 5.94% a year.  

Disclosure requirements for fixed and fixed index annuities are much less developed, which may be why insurance companies don’t typically disclose them.  However, disclosure notwithstanding, there is definitely a cost that goes to paying your salesperson’s commission or the complicated options and futures strategies on your fixed index.

Value

The primary value of annuity products is not in the income or guarantee or tax benefit that they provide. The primary value of annuities is that they absorb risks that you as an investor are not willing to take in the market. Annuities give you a guaranteed fixed income. In exchange, they limit the possibility of growth in your capital or your income.

They do that by balancing your risks with other people like you. As we suspect, most of us will not have an average life expectancy. We are either above average or below average. As Bill Sharpe, a Nobel prize winner in economics reminds us, buying an annuity allows us to share those risks, and for those of us who are above average, an annuity may well be a great bargain.

As the organizer of the annuity party, the insurance company absorbs some of the risks as well. When we buy an annuity, we are transferring the risk of investing on our own to the insurance company. If the insurance fails in its investments, it commits to paying us anyway. That is valuable, but does the benefit need to cost that much? Could it be overpriced?

Annuities can provide incredible value. However, the simplicity of providing guaranteed monthly income is well overtaken by the complexity, direct costs and the opportunity cost. It is important to understand what you are getting and what you are giving up with an annuity, You can make sure that it meets your needs first by getting advice that is in your best interest by a fee-only financial planner.  You can find one at NAPFA or XYPN. Both are organizations of Certified Financial Planners that are committed to giving you advice that is in your best interest.

Nov 18

Seven Year End Wealth Management Strategies

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

Photo by rawpixel on Unsplash

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

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

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

1) Harvest your Tax Losses in Your Taxable Accounts

As of[ October 26, the Dow Jones is up 1.65%, and the S&P500 is up just 0.98% ]for the year. Unfortunately, many stocks and mutual funds are down for the year. Therefore you are likely to have a number of items in your portfolio that show up in red when you check the “unrealized gains and losses” column on your brokerage statement.

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

However, you can also offset your losses against gains. For example, if you were to sell some losers and hypothetically accumulate $10,000 in losses, you could then also sell some winners. If the gains in your winners add to $10,000, you have offset your gains with losses, and you will not owe capital gain taxes on that joint trade!

This could be a great tool to help you rebalance your portfolio with a low tax impact. Beware though that you have to wait 30 days before buying back the positions that you have sold to stay clear of the wash sale rule.

2) Reassess your Investment Planning

Tax loss harvesting is a great tactic to use for short-term advantage. As an important side benefit, it allows you to focus on more fundamental issues. Why did you buy these securities that you just sold? Presumably, they played an important role in your investing strategy. And now that you have accumulated cash, it’s important to re-invest mindfully.

You may be tempted to stay on the sideline for a while and see how the market shakes out.  Although we may have been spoiled into complacency after the Great Recession, the last month has reminded us that volatility happens.

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

Take the opportunity to review your goals, ensure that your portfolio risk matches your goals and that your asset allocation matches your risk target..

3) Check on your Retirement Planning

It is not too late to top out your retirement account!  In 2018, you may contribute a maximum of $18,500 from your salary, including employer match to a 401(k), TSP, 403(b), or 457 retirement plan, subject to the terms of your plan. Those who are age 50 or over may contribute an additional $6,000 for the year.

If you have contributed less than the limit to your plan, there may still be time! You have until December 31 to maximize contributions for 2018, reduce your 2018 taxable income (if you contribute to a Traditional plan), and give a boost to your retirement planning.

Alternatively to deferring a portion of your salary to your employer’s Traditional plan on a pre-tax basis, you may be able to contribute to a Roth account if that is a plan option for your employer. As with a Roth IRA, contributions to the Roth 401(k) are made after tax, while distributions in retirement are tax-free.

Many employers have added the Roth feature to their employee retirement plans. If yours has not, have a chat with your HR department!

Although the media has popularized the Roth account as tax-free, bear in mind that it is not. Roth accounts are merely taxed differently . Check in with your Certified Financial Planner practitioner to determine whether electing to defer a portion of your salary to on a pre-tax basis or to a Roth account on a post-tax basis would suit your situation better.

4) Roth Conversions

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

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

Read more about the new tax law and Roth conversions

5) Pick your Health Plan Carefully

It is health insurance re-enrollment season! The annual ritual of picking a health insurance plan is on to us. This could be one of your more significant financial decisions for the short term. Not only is health insurance expensive, it is only getting more so.

First, you need to decide whether to subscribe to a traditional plan that has a “low” deductible or to a high deductible option.  The tradeoff is that the high deductible option has a less expensive premium. However, should you have a lot of health issues you might end up spending more.  High deductible plans are paired with Health Savings Accounts (HSA).

The HSA is a unique instrument. It allows you to save money pre-tax and to pay for qualified healthcare expenses tax-free. Unlike Flexible Spending Accounts (FSAs), balances in HSAs may be carried over to future years and invested to allow for potential earnings growth. This last feature is really exciting to wealth managers: in the right situation clients could end up saving a lot of money.

If you pick a high deductible plan, make sure to fund your HSA to the maximum. Employers will often contribute also to encourage you to choose that option.  If you select a low deductible plan, make sure to put the appropriate amount in your Flexible Spending Account. FSAs are used to pay for medical expenses on a pretax basis. Unlike with an HSA, you cannot rollover unspent amounts to future years.

 

Gozha net on Unsplash

6) If you are past 70, plan your RMDs

If you are past 70, make sure that you take your Required Minimum Distributions (RMDs) each year. The 50% penalty for not taking the RMD is steep. You must withdraw your first minimum distribution by April 1 of the year following the year in which you turn 70 ½, and then by December 31 for each year after.

Perhaps you don’t need the RMD? You may want to redirect the money to another cause. For instance, you may want to fund a grandchild’s 529 educational account. 529 accounts are tax-advantaged accounts for education. Although contributions are post-tax, growth and distributions are tax-free if they are used for educational purposes.

Or, you may want to plan for a Qualified Charitable Distribution from the IRA and take a tax deduction. The distribution must be directly from the IRA to the charity. It is excluded from taxable income and can count towards your RMD under certain conditions.

7) Plan your charitable donations

Speaking of charitable donations, they can also be used to reduce taxable income and provide financial planning benefits. However, as a result of the Tax Cut and Jobs Act of 2017 (TCJA), it may be more complicated than in previous years. One significant difference of the TCJA is that standard deductions went up to $12,000 for individuals and $24,000 for married filing jointly. Practically what that means is that you need to accumulate $12,000 or $24,000 of deductible items before you can feel the tax savings benefit.

In other words, if a married couple filing jointly has $8,000 in real estate taxes and $5,000 of state income taxes for a total of $13,000 of deductions, they are better off taking the standard $24,000 deduction. They would have to donate $7,000 before they could start to feel the tax benefit of their donation.  One way to deal with that is to bundle your gifts in a given year instead of spreading them over many years.

For instance, if you plan to give in 2018 and also in 2019, consider bundling your donations and giving just in 2019. In this way, you are more likely to be able to exceed the standard deduction limit.

If your thinking wheels are running after reading this article, you may want to check in with your wealth manager or financial planner: there may be other things that you could or should do before the end of the year!

 

Check these other wealth management posts:

Is the TCJA an opportunity for Roth conversions?

New Year Resolution

How to Implement a New Year Resolution

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

 

 

 

Note: The information herein is general and educational in nature and should not be construed as legal, tax, or investment advice. We make no representation as to the accuracy or completeness of the information presented.  To determine investments that may be appropriate for you, consult with your financial planner before investing. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions.We make no representation as to the completeness or accuracy of information provided at the websites linked in this newsletter. When you access one of these websites, you assume total responsibility and risk for your use of the websites to which you are linking. We are not liable for any direct or indirect technical or system issues or any consequences arising out of your access to or your use of third-party technologies, websites, information, and programs made available through this website.  

Nov 18

Market Perspectives – October 2018

By Chris Chen CFP | Capital Markets

Market Perspectives

Third Quarter 2018

Should we panic yet?

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

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

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

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

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

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

A New Round of Tariffs

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

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

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

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

Consumer Confidence Near All-time High

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

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

The Era of Easy Money is Coming to an End

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

Inflation Is Stable

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

U.S. Equity

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

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

Non-U.S. Equity

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

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

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

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

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

Fixed Income

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

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

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

 

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

 

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

Insight Financial Strategists LLC is a Massachusetts Registered Investment Adviser.

Aug 09

Top 5 Financial Mistakes Made by Foreign Nationals Living In the US

By Chris Chen CFP | Financial Planning , Retirement Planning

Top 5 Financial Mistakes

Made by Foreign Nationals Living in  America

Approximately 1.5 million foreign nationals move to the US every year to study, work and live. Many come on green card visas, and others on working and other temporary visas.  They come from all walks of life. They are engineers, scientists, physicians, academics.

Anyone who has moved to another country can testify that it is a daunting task. Everything is new. A lot of what was known must be relearned. What number to call for emergencies? How much to tip at restaurants if at all? And how to deal with investment and other financial matters?  

Engineers, scientists, physicians, academics, and business people moving to the US often continue to hold assets in checking,  investment accounts and in real estate in other countries. Some may even inherit assets in other countries while living in the US.  Eventually many move back to their home country or a third country.

All newly arrived people in the US  face the common dilemma of how to efficiently reinvent their financial lives.  In many ways the US financial system may seem odd. Many of the differences relative to their former home base can be found relatively easily.

However, there are financial pitfalls specific to foreign nationals living in the US to be aware of. Here are five of them.  

  1. Failure to understand US reporting requirements

Unless they have been in a monastic retreat, US citizens will know that their government cares about their foreign income and assets. Ugly acronyms such as FATCA and FBAR have been designed to ensure tax compliance from all Americans.  What is often overlooked is that the reporting requirements of foreign income and assets also apply to all residents of the US, including foreigners living in the US.

Foreign nationals in the US routinely underestimate the impact of necessary reporting requirements.  They do so at their own peril. Whether they are citizens or not, residents of the US are subject to taxation on their worldwide income. In many cases, taxes paid overseas can be offset by credits to US taxes, thus limiting the monetary impact. The real challenge is the obligation to report. Laws, including the aforementioned FATCA and FBAR, obligates all US residents to report foreign income and assets.  

In a routine instance, a foreign national may own a checking account, a brokerage account, or even real estate in their home country. When moving to the US and focusing on the excitement and challenge of a new life, it is easy to forget about these assets or believe that they do not fall under the jurisdiction of the IRS.Such an assumption would be wrong.

All these assets are subject to reporting to US government authorities. Under the Foreign Account Tax Compliance Act of 2010 (FATCA) the US government set up a global reporting infrastructure to mandate foreign banks and governments to report foreign-held assets owned by US residents to the US government. To ensure compliance, foreign institutions are subject to stiff penalties when they fail to report assets owned by US residents.  In other words, if you own a foreign asset, it is unlikely to be a secret to the US government.

Reporting requirements don’t stop with banks and governments. Taxpayers are also responsible for reporting their own information through FBAR and IRS form 8938 filings. Information in those forms is then compared with the bank and government reports. Discrepancies and failures to report can be considered tax evasion and fraud. They are subject to penalties that can be punitive. Ignoring this issue is not a sustainable strategy, because eventually, the government will catch up. If in doubt check with a professional.

  1. Get overwhelmed by US tax complexity

Foreign nationals who come to America are often overwhelmed by the complexity of the U.S. tax system.  As a result, they often become paralyzed by the complexity and end up missing out on taking care of their financial needs. On average, foreign nationals in the US have the advantage of being stronger savers than Americans. However, to gain a sustainable advantage you need to invest your savings to allow the laws of compound growth work for you and fructify your savings. For every problem, there is a solution.

Although it looks daunting, US tax complexity can also be overcome. Because software solutions are not typically designed to handle the complexities of foreign assets and income, it is advisable to hire professionals who have experience with international matters.

  1. Not being aware of tax treaties

The US maintains tax treaties with some 68 foreign countries that determine rules and exceptions for the treatment of various taxable events. The treaties provide a framework to avoid or minimize double taxation on a variety of active and passive income. Failure to be aware of the tax treaties, their provisions, and their implementation can result in unnecessary withholdings and taxes.

Tax treaties can also provide benefits. If you have worked in the US for a while, you will have accumulated social security credits, potentially qualifying you for social security retirement benefits. Through “totalization” agreements with 26 countries, those credits can be transferred to a number of social security peer systems in those countries, thus improving retirement benefits in those countries.  The reverse is also true. If you have social security equivalent credits in those 26 countries and retire in the US, they could be counted towards your US social security benefits. In the case where there is no totalization agreement and the foreign national has contributed to US social security for 10 years or longer (technically 40 quarters), the foreign national is usually eligible for a US social security retirement benefit.

  1. Cashing out retirement accounts upon leaving the U.S.

Foreign nationals often accumulate substantial U.S. retirement account balances during their American career. Most companies offer a 401(k) retirement plan; foreign national employees are also eligible to participate.  It is often an easy decision: 401(k) plans provide an easy saving mechanism and an immediate tax reduction. It allows a maximum annual saving for people under 50 of $18,500 a year including the company match, if applicable.

When they look to return to their home country, people are often conflicted about how to handle those accounts. Broadly speaking the choices are to leave the accounts unperturbed or to cash out and go home. Often the decision is to cash out.

Cashing out of a deferred tax retirement account such as a 401k or an IRA before age 59 ½ results in punitive taxation.  The distribution is taxed as income. Usually, it propels the account owner to a higher tax rate resulting in additional costs. For instance, a taxpayer that was in the 24% tax bracket could find himself or herself in the 32% bracket as a result of a retirement account distribution.  

To add insult to injury, the distribution is also subject to a 10% penalty for those who take when they are younger than 59 1/2.  It is easy to see that cashing out is an expensive proposition that robs you of the benefits of saving and tax-deferred growth.

The other possibility is to leave the account in the US or roll it over to an IRA if it is in a 401k or other company sponsored plan.  The immediate advantage is that there is no immediate income tax or penalty. In addition, the investment options are usually much stronger and less expensive than in other countries. The downside is that the assets may be subject to estate taxes if the foreign national dies owning the asset.  And, as with Americans, distributions in retirement are subject to income taxes. For those who choose to leave the retirement accounts in the US, a plan can be built to optimize income and estate taxes to ensure that you can benefit from the fruits of your savings.

  1. Not recognizing the advantages of keeping U.S. investment accounts when leaving.

The US investment environment is more favorable to individual investors than most others.  Mutual fund and ETF expense ratios are lower, transaction costs are lower, and management fees are lower.  Market liquidity is usually higher even for many investments that are focused on specific foreign markets. And the range of investment options available to individuals is wider. For instance, there are 80 ETFs listed in Singapore and 134 listed in Hong Kong, compared with 1,707 in the US (August 2018).

It should be noted that although financial assets held by foreigners are not `subject to US capital gains taxes, dividends and interest are subject to withholding taxes of 10% to 30%, depending on whether there is a tax treaty.  Often tax treaties can help mitigate the impact of income and estate taxes, including the withholding tax. Again this is an area where financial professional familiar with the intricacies of cross-border families can really help.

On balance, when they leave the US, foreign nationals can continue to enjoy the generally stronger US investment climate.

Last Word

Moving to the US to continue a thriving career is often a dream of many foreign nationals. A new lifestyle, upward progress and a taste of American culture. What is there not to like about such an adventure? But that dream may not turn out to be that great in real life if you don’t properly address the complexities and uniqueness of the US tax system. However, the five mistakes outlined in this note can be easily addressed with the help of the right professional. Do so, and you will reap the rewards

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?

 

 

May 16

Doing the Solo 401k or SEP IRA dance

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

Doing the Solo 401(k) or SEP IRA Dance

Doing the Solo 401(k) or SEP IRA dance

If you are self-employed, one of your many tasks is to plan for your own retirement. While most Americans can rely on their employer’s 401(k) for retirement savings, this is not the case for self-employed people.

In some respects, that is an advantage: most employees barely pay any attention to their 401(k). It is an opportunity for the self-employed to make the best choices possible for their business and personal situation.

The most obvious benefit of saving for retirement is that you will have to retire anyway, one day, and you will need a source of income then. With a retirement account, most people appreciate that it is specifically meant to save for retirement. People also appreciate the tax benefits of the SEP IRA and Solo 401(k).

The more immediate benefit is that retirement savings in tax-deferred accounts help reduce current taxes, possibly one of the greatest source of costs for small businesses. Of course, the tax saved with your contribution will have to be paid eventually when you take retirement distributions from the SEP-IRA.

When it comes to tax-deferred retirement savings vehicles for the self-employed and owner and spouse businesses, two of them stand out due to their high contribution limits and flexible annual contributions: the SEP IRA and the Solo 401(k). These two vehicles provide a combination of convenience, flexibility, and efficiency for the task.

SEP IRA

The SEP IRA is better known by its initials than its full name (Simplified Employee Plan IRA). For 2018 the SEP IRA contribution limits are the lesser of 25% of compensation up to $275,000, or $55,000 whichever is less. You may note that this is significantly higher than the limit for most 401(k)s plans, except those that have a profit sharing option. SEP IRA rules generally allow contributions to be deductible from the business’ income, subject to certain SEP IRA IRS rules.

One of the wrinkles of SEP IRA eligibility is that it applies to employees: you have to make a contribution of the same percentage of compensation as you are contributing for yourself. So if you have employees, another plan such as a Solo 401(k) might be a better choice.

And for fans of the Roth option, unfortunately, the SEP IRA doesn’t have one. When comparing the SEP IRA vs Roth IRA, the two clearly address different needs.

Solo 401(k)

credit: InvestmentZenThe Solo 401(k) also known as the individual 401(k) brings large company features to the self-employed. It generally makes sense for businesses with no common law employees. One of the Solo 401k benefits is that just owners and their spouses, if involved in the business, are eligible. Employees are not. So, if you are interested in just your own retirement plan (and your spouse’s), a Solo 401(k) may work better for you than a SEP IRA. If your business expands to include employees and you want to offer an employer-sponsored retirement plan as a benefit to them, then you should consider a traditional company 401(k) option.

The Traditional Solo 401k rules work in the same way as the SEP IRA: it defers income taxes to retirement. It makes sense if you believe that you will be in an equal or lower tax bracket in retirement. Those who think that they may be in a higher tax bracket in retirement should consider a Roth option for their Solo 401(k): it will allow you to contribute now on an after-tax basis, and you will benefit from tax-free distributions from the account after retirement. A Roth 401k calculator may be required to compare the benefits. Again, the Roth option is not available in SEP accounts.

Solo 401k contribution limits permit you to contribute the same amount as you might in its corporate cousins: up to 100% of compensation, up to $18,500 a year when you are younger than 50 years old, with an additional $6,000 annual catch-up contribution for those over 50 years of age.

In addition, profit sharing can be contributed to the Solo 401(k). The Solo 401k limits for contributions are up to 25% of compensation (based on maximum compensation of $275,000) for a maximum from all contributions of $55,000 for those under 50 years of age and $61,000 for those over 50 years of age.

Another difference with the SEP IRA is that the Solo 401(k) can be set up to allow loans. In that way, you are able to access your savings if needed without suffering a tax penalty.

So Which Plan Is Best for You?

The SEP IRA is simpler to set up and administer. However, the Solo 401(k) provides more flexibility, especially for contribution amounts. Given that the amount saved is one of the key factors for retirement success, that should be a consideration.

Comparing the Solo 401k with the traditional employer 401k, you may no longer have to ask how to open a Roth 401k.  You will have control of that. On the other hand you will be entirely responsible for figuring out your Roth 401k employer match.

As could be expected, administration of the Solo 401(k) is slightly more onerous than that of the SEP IRA.

SEP IRA vs 401k chart

Solo 401(k) and SEP IRA

A Last Word

If you don’t have a plan get one. It is easy. It reduces current taxes. And it will help you plan for a successful retirement. The SEP IRA and the Solo 401(k) were designed specifically for small businesses and the self-employed. Although we have reviewed some of the features of the plan here, there are more details that you should be aware of. Beware of the complexities!

Once you decide on the type of plan, it will be time to choose a provider that offers the features that you need, the investment choices that you need, and the guidance to help you maximize your hard earned savings.

At Insight Financial Strategists we help figure out what works for you and your retirement plansand show you how to set up a Solo 401k or a SEP IRA!

Apr 13

7 IRA Rules That Could Save You Time and Money

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

7 IRA Rules That Could Save You Time and Money

People often end up with several different retirement accounts that are spread between one or more 401(k)s, 403(b)s, IRAs and other retirement accounts.

Treating these various retirement accounts as one, known as “aggregating”, will often make sense.  IRA aggregation can allow more efficient planning for distributions and more efficient investment strategy management . Note that aggregation means treating several accounts as one, not necessarily actually combining them. Nonetheless, there are situations where aggregating IRAs is not permitted and can cause negative tax consequences and could result in penalties .

In general, when IRA aggregation is permissible for distribution purposes, all the Traditional IRAs, SEP IRAs, and SIMPLE IRAs of an individual are treated as one traditional IRA. Similarly, all of an individual’s Roth IRAs are treated as a single Roth IRA.

The following are seven key aggregation rules for IRAs that could save you time and money . The key learning is that it takes strong recordkeeping and awareness of the rules to avoid the pitfalls of aggregation. You should be aware of the requirements, observe them or get help from your Wealth Manager.

  1. IRA Aggregation does not apply to the return of excess IRA contributions

The IRA contribution limit for individuals is based on earned income. Individuals under 50 years of age can contribute up to $5,500 a year of earned income. Those older than 50 years of age are allowed an additional catch up contribution of $1,000. The contribution limit is a joint limit that applies to the combination of Traditional and Roth IRAs.

When the IRA contribution happens to be in excess of the $5,500 or the $6,500 limit (for people over 50), the excess contributions, including net attributable income (NIA), ie the growth generated by the excess contribution, must be returned before the IRA owner’s tax filing due date, or extended tax filing due date. Those who file their returns before the due date receive an automatic six-month extension to correct the excess contributions.

  1. Mandatory aggregation applies to the application of bases for Traditional IRAs

Contributions to Traditional IRAs are usually pre-tax. Thus, distributions from IRAs are taxable as income.  In addition, distributions prior to 59.5 years of age are also subject to a 10% penalty.

However, individuals may also contribute to a Traditional IRA on a non-deductible basis , ie with after-tax income. Similarly, contributions to an employer-sponsored retirement plan can also be made on an after-tax basis (where allowed by the retirement plan) , and potentially rolled over to an IRA where they would retain their non-deductible character.

After-tax contributions to an IRA, but not the earnings thereof, may be distributed prior to 59 ½ years of age without the customary 10% penalty. Distributions from an IRA that contains after-tax contributions are usually prorated to include a proportionate amount of after-tax basis (amount contributed) and pre-tax balance (pro rata rule).

Some IRA owners will choose to keep non-deductible IRA contributions in a separate IRA which simplifies tracking and administration. However, that has no impact on distributions, because, when applying the pro-rata rule, all of an individual’s Traditional IRAs, SEP IRAs, and SIMPLE IRAs are aggregated and treated as one.

Suppose that Janice has contributed $700 to a non-deductible Traditional IRA, and it has grown to $1,400.  If Janice takes a distribution of $500, one half of the distribution is returnable on a non-taxable basis, and the other half is taxable and subject to the 10% penalty if Janice happens to be under 59½ years of age. You can see why Janice would want to keep accurate records of her transaction in order to document the taxable and non-taxable portions of her IRA.

  1. Limited aggregation applies for inherited Traditional IRAs

Inherited IRAs should be kept separate from non-inherited IRAs . The basis in the latter cannot be aggregated with the basis of an inherited IRA.

In practice, it means that if Johnny inherited two IRAs from his Mom and another from his Dad, Johnny must take the Required Minimum Distributions for his Mom’s two IRAs separately from his Dad’s, and also separately from his own IRAs.

Furthermore, IRAs inherited from different people must also be kept separate from one another. They can only be aggregated if they are inherited from the same person.  In addition, inheriting an IRA with basis must be reported to the IRS for each person.

  1. Mandatory aggregation applies to qualified Roth IRA distributions

Qualified distributions from Roth IRAs are tax-free. In addition, the 10% early distribution penalty does not apply to qualified distributions from Roth IRAs.  

Roth IRA distributions are qualified if:

– they are taken at least five years after the individual’s first Roth IRA is funded;

– no more than $10,000 is taken for a qualified first time home purchase;

– the IRA owner is disabled at the time of distribution;

– the distribution is made from an inherited Roth IRA; or

– the IRA owner is 59½ or older at the time of the distribution.

If Dawn has two Roth IRAs, she must consider both of them when she takes a distribution.  For instance, if Dawn takes a distribution for a first time home purchase, she can only take a total $10,000 from her two Roth IRAs

  1. Optional aggregation applies to required minimum distributions

Owners of Traditional IRAs must start taking required minimum distributions (RMD) every year starting with the year in which they reach age 70½ . The RMD is calculated by dividing the IRA’s preceding year-end value by the IRA owner’s distribution period for the RMD year.

An individual’s Traditional, SEP and SIMPLE IRAs can be aggregated for RMD purposes .

The RMD for each IRA must be calculated separately; however, the owner can choose whether to take the aggregate distribution from one or more of his Traditional, SEP or SIMPLE IRAs.

So, if Mike has a Traditional, a SIMPLE and a SEP IRA, he would calculate the RMD for each of the accounts separately.  He could then take the RMD from one, two or three accounts in the proportions that make sense for him.

As a reminder, Roth IRA owners are not subject to RMDs.

  1. Limited aggregation applies to Inherited IRAs

Beneficiaries must take RMDs from the Traditional and Roth IRAs that they inherit with the exception of spouse beneficiaries that elect to treat an inherited IRA as their own.

With this latter exception, RMD rules apply as if the spouse was the original owner of the IRA.

When a beneficiary inherits multiple Traditional IRAs from one person, he or she can choose to aggregate the RMD for those inherited IRAs and take it from one or more of the inherited Traditional IRAs. The same aggregation rule applies to Roth IRAs that are inherited from the same person.

Suppose again that Johnny has inherited two IRAs from his Mom and one from his Dad. Johnny can calculate the RMDs for the two IRAs inherited from his Mom, and take it from just one.  Johnny must calculate the RMD from the IRA inherited from his Dad separately, and take it from that IRA.

If in addition, Johnny has inherited an IRA from his wife, he may aggregate that IRA with his own.

It is important to note that RMDs for inherited IRAs cannot be aggregated with RMDs for non-inherited IRAs , and RMDs inherited from different people cannot be aggregated together.

  1. One per year limit on IRA to IRA rollovers

If an IRA distribution is rolled over to the same type of IRA from which the distribution was made within 60 days, that distribution is excluded from income.

Such a rollover can be done only once during a 12-month period.

In this kind of situation, all IRAs regardless of types (Roth and non-Roth) must be aggregated. For instance, if an individual rolls over a Traditional IRA to another Traditional IRA, no other IRA to IRA (Roth or non-Roth) rollover is permitted for the next 12 months.

Conclusion: What you should keep in mind

These are some of the more common IRA aggregation rules.  There are others including rules for substantially equal periodic payments programs (an exception to the 10% early distribution penalty), and those that apply to Roth IRAs when the owner is not eligible for a qualified distribution.

Although IRAs are familiar to most of us, many of the rules surrounding are not . It is still helpful to check with a professional when dealing with them.

Lastly, many of the potential problems that people may face with IRA aggregation can be avoided with proper documentation. Recordkeeping is essential. Individuals can do it themselves or they can rely on their Wealth Managers. In the case where you have to change financial professionals, make sure that you have documented the history of your IRAs.   

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