All Posts by Chris Chen CFP

Year End Tax Planning Opportunities

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

The Tax Cut and Jobs Act of 2017 (TCJA) was the most consequential tax reform package in this generation. It changed many of the ways that we think about reducing taxes.

According to the Tax Policy Center, we know that about 80% of taxpayers pay less income tax in 2018 than before the TCJA , about 5% pay more, and the balance of taxpayers pay about the same amount. On balance, the TCJA seems to have delivered on its promises.

A key item of the TCJA is that it increased the standard deduction, reducing the impact of the elimination of State and Local Taxes (SALT) under $10,000 and the elimination of personal deductions. As a result, about 84% of taxpayers claim the standard deduction and do not itemize. By comparison, about 56% of taxpayers itemized before the enactment of the TCJA. The vast majority of taxpayers are no longer subject to the Alternative Minimum Tax (AMT), since two of its key drivers, the deductibility of state and local taxes and personal deductions, are no longer a practical issue for most people. And in 2018, only 1,700 estates were subject to the federal estate and gift tax. So for most people, the TCJA has made taxes simpler to deal with. What’s there not to like about a simpler tax return ?

Source: Congressional Budget Office

Impact of the TCJA on the Federal Deficit

As predicted, the TCJA worsened the federal deficit bringing it to nearly a trillion dollars in fiscal year 2019. That was in spite of an increase in tax revenue due to the continuing improvement in the economic climate. Of course, the federal deficit continues to be driven by federal spending on the sacred cows of modern US politics: Defense, Social Security, and Medicare. Interest on the federal debt is also a major budget item that needs to be paid. While our continuing regime of low interest rates is helping control the interest on the debt, it is clear that the future may change that.

What will happen to tax rates?

Tax rates are lower now than they have been since the 1970s and 80s. Hence, industry insiders tend to think that tax rates have nowhere to go but up.  That is also what’s is predicted by the TCJA, which is largely designed to sunset in 2025. Should the American people turn on Republicans at the 2020 election, it’s possible that the TCJA will see a premature end. However, it seems that the possibility that the American people might elect a progressive in 2020 is largely discounted when it comes to tax rate forecasting: most people assume that tax rates will increase.

Year-End Planning

Political forecasting aside, there are still things that we can do to lower our taxes . It should be noted that many of the techniques in this article are not limited to the year-end. Furthermore, we all have different situations that may or may not be appropriate for these techniques. 

Tax Loss Harvesting

Even though we have had a pretty good year overall, many of us may still have positions in which we have paper losses. Tax-loss harvesting consists of selling these positions to realize the losses. This becomes valuable when you sell the equivalent amount of shares in which you have gains. So if you sell some shares with $10,000 in losses, and some with $10,000 in gains, you have effectively canceled out the taxes on the gains.

You then have to reinvest the shares sold into another investment. Be careful not to buy back the exact same shares that you sold. That would disallow the tax loss harvesting!

At the same time, it makes sense to review your portfolio and see if there are other changes that you would like to make. We are not fans of frequent changes for its own sake. However, periodically our needs change, the markets change, and we need to adapt.

Income Tax Planning

While tax loss harvesting is mostly about managing Capital Gains taxes, it is also important to keep an eye on income tax planning . This is a good time of year to estimate your income and your taxes for the year. When comparing your estimated Adjusted Gross Income with the tax tables, you will see if you might be creeping up into the next tax bracket. For instance, if you are single and your estimated AGI is $169,501 (and you have no other complexity), you are right at the 32% tax bracket (after you remove the $12,000 standard deduction).  In this example, that means that for every dollar above that amount you would owe 32 cents in federal income tax, and a little bit more for state income tax, if that applies to you.

If your income is from a business, you may possibly defer some of that income to next year. If your income comes from wages, another way to manage this is to plan an additional contribution to a retirement account. In the best of cases your $1,000 contribution would reduce your taxes by $320, and a little bit more for state taxes.

In some cases, you might have a significant dip in income. Perhaps if you have a business, you reported some large purchases, or you booked a loss or just had a bad year for income. It may make sense at this point to take advantage of your temporarily low tax rate to do a Roth conversion. Check with your wealth manager or tax preparer.

If your income does not straddle two tax brackets, the decision to invest in a Traditional IRA or a Roth IRA is still worth considering.

Charitable Contributions

By increasing standard deductions, the TCJA has made it more difficult for people to deduct charitable contributions . As a result, charitable contributions bring few if any tax benefits for most people.

One way around that situation is to bundle or lump charitable gifts. Instead of giving every year, you can give 2, 3 or more years worth of donations at one time. That would allow your charity to receive the contribution, and, potentially, for you to take a tax deduction. 

Pushing the bundling concept further, you could give even more to a Donor Advised Fund (DAF). With that option, you could take a tax deduction, and give every year from the DAF. That allows you to control your donations, reduce your income in the year that you donate, and potentially reduce income taxes and Medicare premiums. Consult your wealth strategist to ensure that taxes, income, and donations are optimized.

Retirement Accounts

First, it is important to review Required Minimum Distribution (RMDs). Anyone who is 70 ½ years of age or older is subject to RMDs. Please make sure to connect with your financial advisor to make sure that the RMD is properly withdrawn before the year-end.

The RMD is a perennial subject of irritation for people . Obviously, if your retirement income plan includes the use of RMDs, it’s not so much of an issue. However, if it is not required, it can be irritating. That is because RMD distributions are subject to income taxes that may even push you into the next tax bracket or increase your Medicare premium. There are, however, some ways that you can deal with that.  

For instance, if you take a Qualified Charitable Distribution (QCD) from your IRA and have the distribution given directly to a charity, the distribution will not be income to you. Hence you won’t pay income taxes on that distribution, and it will not be counted toward the income used to calculate your Medicare premium. However, it will fulfill your RMD, thus taking care of that pesky issue.

Generally, we advocate planning for lifetime taxes rather than for any one given year. Lifetime financial planning has the potential to result in even more benefits. It should be noted that many of the possibilities outlined in this article can be used throughout the year, not just at year-end. We encourage you to have that conversation with your wealth management team to plan for the long term!

Is A Health Savings Account Right For You?

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

It is health insurance plan signup season . Whether you subscribe to your employer’s health care insurance plan or you buy your own directly, it is the time of the year when you have to sign up all over again. Unless you have specific circumstances such as a change of employer, a divorce, or new baby, this is the one time in the year when you get to change your health care insurance plan.

If you have been keeping abreast of the popular financial media, you may have come across the Health Savings Account (HSA).  According to AHIP (America’s Health Insurance Plans), 22 million people had HSA accounts in 2018.  Financial Planners love HSA. It is potentially the most tax advantageous vehicle that exists.  Contributions to HSAs are pre-tax, the money is invested tax-free, and distributions are tax-free if used for health purposes. Triple tax-free. HSAs are even better than Roth retirement accounts !

The reality is that we all have health care expenses, and they can be substantial . Having the ability to pay with tax-free money is a critical advantage. If you have to pay a $100 hospital invoice, you might have to earn $150 or more first, pay Federal income taxes, Social security taxes, state income taxes, before you can have $100 to pay your bill. With an HSA, there is no income tax, you pay with $100 of your earnings. 

A Health Savings Account is effectively an alternative to the Flexible Spending Account (FSA) , the more traditional way to pay for health care expenses that are not covered by insurance. The FSA allows employees to save pre-tax from earnings, and then to spend it on health care expenses without paying taxes on the earnings.  Money in FSAs, however, is not invested, and it must be spent by year-end or be forfeited. It has to be spent, or it will be lost. HSA funds, on the other hand, can be invested, and funds from HSA accounts can be carried over into the future. Thus, HSAs can be spent in a way that is similar to other retirement savings accounts such as the IRA or the Roth IRA.

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

1. If used as intended for retirement, education or health expenses respectively

What’s in it for the employer?

In order to contribute to an HSA, you must have chosen a High Deductible Health Plan with your employer. 

According to the IRS, for 2019, a high deductible is defined as $1,350  ($1,400 in 2020) for an individual or $2,700 for a family ($2,800 in 2020.) On top of this high deductible, annual out of pocket expenses (including deductibles, copayments, and coinsurance) cannot exceed $6,750 for an individual or $13,500 for a family. Those numbers increase in 2020 to $6,900 for an individual and $13,800 for a family. 

For employers, offering high deductible health insurance plans is more cost effective than other plans. Therefore, they will prefer that their employees sign up for high deductible plans. Many employers will contribute directly to HSA accounts to encourage their workforce to choose a high deductible health insurance plan.

Theoretically, if employees have to pay out of pocket or out of their HSA for their health care expenses, they will be more careful about their choices.  While the funds in the HSA remain available to be used for health care expenses immediately if needed, the designers of the HSA believe that the ability to carry over HSA balances to future years will motivate employees to be better health care shoppers when choosing treatments or, indeed, when choosing to be treated in the first place. The net result is that high deductible health plans help employers contain health care expenses, and shift the burden on their employees. 

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

Financial Benefit 

And how do you maximize the value of the HSA? By contributing to the maximum, and investing it. A dollar contributed may be worth many times its value in the future when invested.

The Internal Revenue Service allows individuals in 2020 to contribute up to $3,550 to their HSAs. Families may contribute up to $7,100.  Both individuals and families can benefit from a catch-up provision of $1,100 if they are over 55.

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

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

If you are choosing the high deductible plan to save money, but you are not able to contribute to your HSA, you are putting yourself at risk if you have an unforeseen health event. Not having enough saved to cover the cost of the health care you need means that you may have to go into debt until you have met your plan’s deductible. 

So, if you have a tight budget, please think twice before trying to save money with a high deductible plan. It may just backfire on you.

Unintended Consequences

A question that is often minimized at enrollment time is what happens to the HSA if you have miscalculated, and you happen to have a significant health care expense in the year that you are contributing? 

First, if it is a major event, you may consider using funds in your HSA account. However the health care insurance will eventually kick in and cover most of the cost. So as a subscriber to a high deductible plan, you are still protected from the catastrophic consequences of an unexpected health issue. While you may not harvest all the benefits of the HSA, and you will likely lose the cost savings of choosing a high deductible plan, you are protected from financial disaster.

What if it is not a really major event, just a somewhat major event like, say, a trip to the emergency room for a temporary issue that you will easily recover from?

In that case, you also have the option to use your funds in the HSA to pay for those expenses. Your contributions will have been pre-tax as with an FSA. You will not have enjoyed much investment growth. Your distribution will still be tax-free. You are giving up the future benefits of the HSA, but you are dealing with your more immediate issues. Basically, your HSA will have functioned like an FSA. You will also lose the savings benefits of choosing a lower cost high deductible plan over a higher cost low deductible plan.

What if instead, you decide to pay for your trip to the emergency room out of pocket with post-tax savings and save your HSA for the future, as your wealth manager told you that you should? The real cost of your $5,000 trip depends on your income and tax bracket. If you happen to be in the 32% Federal tax bracket and you live in Massachusetts, the cost of the $5,000 emergency room trip will be around 58% higher.  

HSAs provide some tremendous benefits that should be considered by everyone who is looking to enhance their health care and their retirement situation. However, the decision to choose a Health Savings Account should be based on more than just taxes and the cost of your health care insurance. It is important to consider the very real costs of unforeseen events and to be realistic about your health insurance needs. 

McKenzie Bezos: 4 Wealth Strategy Concerns

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

McKenzie Bezos: 4 Wealth Strategy Concerns

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

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.

Seven Year End Wealth Strategies

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

As we approach the end of the year, 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. So 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 22, the Dow Jones is up 16.57%, and the S&P500 is up just 21% for the year. Unfortunately, there are still stocks and mutual funds that are down for the year. Therefore you are likely to have some 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 lemonade out of these lemons by harvesting your losses for tax purposes. However, 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, suppose you were to sell some losers and hypothetically accumulate $10,000 in losses. In that case, you could then also sell some winners. Then, if the gains in your winners sold 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, you have to wait 30 days before buying back the positions 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. However, as an important side benefit, it allows you to focus on more fundamental issues. So 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. Therefore, 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 your asset allocation matches your risk target. Then, reach out to your Wealth Strategist about that.

3) Check on your Retirement Planning

It is not too late to top out your retirement account! In 2021, you may contribute a maximum of $19,500 from your salary, including employer match to a 401(k), TSP, 403(b), or 457 retirement plan, subject to the terms of your plan. In addition, those who are age 50 or over may contribute an additional $6,500 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 2021, reduce your 2021 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 pretax 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 on a pretax 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. And, of course, it is possible that Congress will vote for tax rates to go up before the end of the year.
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 with a “low” deductible or 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 pretax and to pay for qualified healthcare expenses tax-free. In addition, 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 roll over unspent amounts to future years.

6) If you are past 70, plan your RMDs

If you are past 70, make sure to 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? Instead, 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. 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 reduce taxable income and provide financial planning benefits. However, due to 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 are $12,550 for individuals and $25,100 for joint filers. So, practically, what that means is that you need to accumulate $12,550 or $25,100 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. Or, within certain limits, to give directly from your IRA.
For instance, if you plan to give in 2021 and also in 2022, consider bundling your donations and giving just in 2021. 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 Strategist 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.  

Market Perspectives – October 2018

By Chris Chen CFP | Capital Markets

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.

Divorce is Getting Even More Expensive

By Chris Chen CFP | Capital Markets

Ten months later we are still finding out what the Tax Cuts and Jobs Act (TCJA) passed with great fanfare in December 2017 really does for us. If you think that you might join the ranks of divorced people this year or in the future, there are provisions of the TCJA that you may want to pay attention to.  

Some of these provisions include eliminating exemptions and most deductions, lowering federal tax rates,  and raising the limit for the Alternative Minimum Tax (AMT).

However, there are two main areas where the TCJA affects divorcing couples specifically: child support and alimony.

Exemptions and Child Support

The TCJA eliminates the value of the personal and dependent exemptions that were so familiar in years past. It also increases standard deductions from their 2017 values of $6,350 to $12,000 for single filers, $9,350 to $18,000 for Head of Household filers and, $12,700 to $24,000 for Married Filing Jointly filers.

As a result, claiming a Head of Household (HOH) status can make a measurable difference for a newly single parent. To claim it, the taxpayer needs to be unmarried, pay for more than 50% of the household expenses and have a dependent who has lived in the household for more than 50% of the time. If there is one child, only one parent can claim to be HOH for this family.

One child For divorcing couples, the incremental savings for being Head of Household instead of Single mean that this is likely to be a significant point of discussion in divorce negotiations.

The parent who is Head of Household can also claim the expanded $2,000 Child Tax Credit for each qualifying child, including $1,400 that are reimbursable (i.e., you need to earn income to get it). Tax credits are much more valuable than exemptions. Whereas exemptions reduce taxable income, tax credits directly reduce the amount of tax itself.

In the past, parents could alternate taking children as exemptions using IRS form 8332. Of course, children exemptions helped reduce taxable income. As a result, exemptions have been an important clause in separation agreements. However, under the new tax law, exemptions no longer result in a reduction in taxable income.

With TCJA, it is not clear that the Child Tax Credit will be tradeable. Effectively, it would require the IRS to publish a regulation that allows trading of the Child Tax Credit between parents and a form that makes it possible. So far, the IRS has not released that regulation. This is sure to frustrate some parents, as they try to arrange their finances for their post-divorce reality.  Their best bet is to negotiate as if the Child Tax Credit will not be tradeable, but write in the agreement that it may be traded if allowed by laws and regulations. Parents could then work on dividing the economic benefits of the credit instead.

The Child Tax Credit and the HOH status provide a measurable boost to the after-tax income of the beneficiary. Thus, they will become an essential consideration of any divorce negotiation involving children.

Alimony

Starting with agreements that will be signed on January 1, 2019, or later, alimony will no longer be deductible from taxable income by the payor or taxable as income to the recipient.  The TCJA ends a longstanding practice that allowed divorcing couples to liberate tax money from the federal government to enhance their post-divorce joint income. Because typically the payor of alimony has a higher income and is usually in a higher tax bracket than the recipient, taxpayers were able to arbitrage the two tax rates and enjoy additional cash flow that would not have been available otherwise. For many, deducting alimony from taxable income was a welcome sweetener to the bitterness of having to pay it.

Abolishing the deductibility of alimony ripples through its other provisions: no longer do divorcing couples have to worry about structuring their alimony to make it comply with tax law. From 2019 on alimony will be considered a simple property transfer pursuant to divorce with no income tax consequences.

The change in the law effectively makes alimony more burdensome to payors.  With deductibility, alimony reduced a payor’s income taxes. Thus the net impact to the payor’s cash flow was the alimony paid minus the taxes saved. Now that deductibility is eliminated, the impact on cash flow is just alimony.

Conversely, recipients will no longer have to pay income taxes on their alimony, theoretically resulting in higher cash flow. However, it is the view of this writer that as a result of this change, alimony awards will trend down to take into consideration the cash flow impact on the payor. In all likelihood, recipients will end up paying the price.

This clawback of tax revenue was projected to raise $8B over ten years, a trifle compared to the $1.5 trillion cost of TCJA.

While this change in alimony treatment comes in 2019, separation agreements concluded in 2018 and before will abide by the old rules unless the divorce agreement specifies otherwise. Speak with your mediator or your lawyer: there may still be time to complete a separation agreement before the end of the year.

A Last Word

Much of the TCJA sunsets in 2025, reverting in 2026 to the rules that were in force until 2017, with one notable exception: alimony which, under the current law, will continue to be non-deductible in 2026 and later. As a result, separation agreements should take into account that they may be subject to one set of tax rules until 2025, and then may have to revert to another one in 2026.

Can we count on Congress to extend the TCJA beyond 2025, as it did with the Bush tax cuts in 2013? Perhaps. Lawmakers are loath to vote for anything that could appear as a tax increase. However, it would not be prudent to count on Congress’ good heart! Thus, separation agreements should maintain sufficient flexibility to take future changes in the tax environment into account.

Overall the TCJA will likely be a net cost to divorcing couples, especially those with child support or alimony obligations. However, knowing the rules can still improve a divorcing situation. Checking with a Divorce Financial Planner is likely to pay dividends.

A previous version of this post was published in Kiplinger on October 5, 2018

 

Check out other interesting articles:

In Divorce, Can We Share a CDFA?

Pension Division in Divorce

Post-Divorce Investments 

 

Note: A previous version of this post was published in Kiplinger on October 5, 2018

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 a course of action that may be appropriate for you, consult with your attorney, financial planner or tax advisor before implementing any plan.. Tax laws and regulations are complex and subject to change, which can materially impact investment results.

 

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

By Chris Chen CFP | Financial Planning , Retirement Planning

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.

2. 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.

3. 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.

4. 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.

5. 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

4 Risks of Pension Plans in Divorce

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

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?

 

 

Doing the Solo 401k or SEP IRA dance

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

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)

The 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.

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!