Jan 15

Divorce is Getting Even More Expensive

By Chris Chen CFP | Capital Markets

Divorce is Getting Even More Expensive

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.

 

Dec 12

US Tax Adjustments in 2023

By Pat Sanders | Tax Planning

US Tax Adjustments in 2023 and How They Could Affect You

Inflation is one of the United States’ most significant challenges. Currently, inflation pressures continue to weigh on the economy, with the core inflation rate up by 6.6% in just 12 months, the biggest gain since 1982. The increase in inflation has caused a large jump in food, energy, shelter, transportation, and medical care prices. The average American worker will continue to feel the effects of the rising costs in 2023, with their hourly earnings down by 3% from a year ago.

The Inflation Reduction Act, signed by President Joe Biden in August, is a landmark federal law that aims to curb inflation by reducing the government budget deficit and adjusting current tax laws. The reforms stipulated by the Act are designed to address climate change, healthcare, and corporate taxation. This is good news for American taxpayers as they ring in 2023. But before making any considerable changes to your finances, it’s vital that you understand how this new law will affect your tax bill.

Today, we’ll discuss the recent U.S. tax adjustments and how they can affect you in 2023:

Clean energy tax credits

The Act is part of the federal government’s body of policies aimed at addressing the climate crisis. It includes incentives designed to address climate change by providing tax credits for renewable energy:

For Homeowners
Until 2032, homeowners are provided with up to 30% tax incentives when they add solar or wind power systems, energy-efficient water heaters, heat pumps, and HVAC systems to their homes. Homeowners who make these purchases may qualify for tax rebates worth up to $14,000.

For Vehicle Owners
The tax credit for the purchase of electric vehicles is extended until December 2032. Qualified buyers of new electric cars will receive an immediate $7,500 credit, while buyers of used electric vehicles will get a $4,000 tax rebate. Married couples filing jointly with income less than $300,000 per year and single tax filers with income under $150,000 are eligible for the credits.

Healthcare tax subsidies

The Act also has subsidies targeted to address the growing cost of healthcare through tax adjustments:

Affordable Care Act premium subsidies
The Inflation Reduction Act has extended subsidies for health insurance under the Affordable Care Act (ACA) through 2025. This extension is expected to benefit 13 million Americans who purchase their insurance under the ACA.

Prescription drug prices for seniors
The new law allows Medicare to negotiate drug prices and institute payment caps for its beneficiaries. Beginning in 2023, the program will cover only 10 specific drugs on the list of the most commonly used medications. By 2025, the list will expand to 20. This is designed to lower the cost of medications for beneficiaries.

https://www.pexels.com/photo/tax-documents-on-the-table-6863175/

Corporate taxes

The Act has created changes in corporate taxation:

15% corporate minimum tax
Currently, most U.S. corporations with profits exceeding $1 billion are subject to a 21% corporate tax rate. However, many firms pay either little or no federal tax under the current law. Under this change, which applies to taxable income beginning January 1, 2023, a new minimum 15% tax would apply based on annual income posted in a corporation’s financial statement rather than taxable income.

Preparing for these tax adjustments

To keep up with the constantly changing laws, you must prepare for these tax adjustments. Here are two ways you can do so:

1. See a tax specialist
If you have questions about how to file your taxes or what information you might need to report on them, a tax specialist can help guide you through the process. These professionals understand the intricacies of tax rules and can provide strategic guidance on tax planning, monitoring, and compliance based on updated laws and regulations.

2. Review your financial records
Checking your financial records from the past year for accuracy and completeness is one way to implement a tax planning strategy for 2023. If any missing pieces of information could affect how much money you owe in taxes or how much of a refund you’ll receive based on the new laws, now is the time to find them.

Tax laws are constantly changing, and it can be challenging to stay abreast of them. Understanding how they work and knowing the new changes that could happen in 2023 and beyond can help you prepare for when you file your next tax return.

Nov 14

Investment Bucket Strategy for Retirement

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

retirement bucket strategy

Retirement Bucket Strategy 

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

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

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

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

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

What Are The Three Buckets of Investing?

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

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

The immediate bucket

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

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

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

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

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

The intermediate bucket

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

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

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

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

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

The long-term bucket

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

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

Graph 1: S&P 500 Performance 

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

How does it Work?

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

retirement bucket strategy

Graph 2: A Hypothetical Bucket Plan

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

retirement bucket strategy power of compounding

Graph 3: Power of Compounding

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

What are the benefits of a retirement bucket strategy?

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

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

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

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

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

What are the drawbacks of a retirement bucket strategy?

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

Other critics find the retirement bucket strategy challenging to maintain. 

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

Is the investing bucket strategy right for you? 

If you need a retirement plan that allows you to 

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

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

 

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

 

 

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

May 24

Should You Carry Your Mortgage Into Retirement?

By Chris Chen CFP | Financial Planning , Retirement Planning

retiring with a mortgage

Introduction

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

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

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

Could it make sense?

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

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

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

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

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

Can you retire with a mortgage

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

Are There Other Benefits?

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

Keep Your Debt Under Control

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

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

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

When is it Acceptable to Retire With Mortgage Debt?

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

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

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

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

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

Potential Benefit

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

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

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

Can you retire with a mortgage

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

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

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

Consider the Opportunity Cost of Paying off Your Mortgage

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

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

How to decide?

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

Don’t let Emotions Override Logic

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

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

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

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

 

Check out our blog post on Bucket Investing.

Mar 18

Ways to Divide Parent Loans in Divorce

By Saki Kurose | Divorce Planning , Financial Planning , Student Loan Planning

Introduction

Divorce is stressful and complicated and hurts on so many emotional and financial levels. It becomes even more complex when you throw in the additional financial stress of student loans. It can be hard to deal with even after you have decided that a student loan is a marital or separate debt.

Student loans are a complex liability because there are so many different and complex methods for repayment. They come with many acronyms such as PAYE, REPAYE, IDR, and PSLF.

The borrower’s circumstances can also play a huge factor in deciding how to deal with student loans properly. For example, you might not have to repay your student loans in total if you get student loan forgiveness for various reasons. The most common are taxable long-term forgiveness or Public Service Loan Forgiveness.

How student loans are handled in a divorce is not altogether easy to understand. Depending on the laws of the State in which the divorce occurs, if one of the parties incurred student debt before the marriage, it could be considered separate property. It is especially common if the borrower’s partner received no economic benefit from the student loans or if the parties come from certain states that have community property laws (1).

But what happens if you have Parent PLUS loans that you took out for your children? Let’s imagine a case in which a couple has been married for years, and one spouse has taken out $250,000 of Parent PLUS loans under her name to pay for their two children’s college education.

Unfortunately, this is a common situation. Arguably, because the Parent PLUS loans were taken out during the marriage for the benefit of their children, they ought to be considered marital debt (1).

$250,000 of Parent PLUS loans

Let’s take a closer look at the case of Jack and Jill. They are both 55. Jack makes $180,000 a year working for an accounting firm, and Jill makes $45,000 working for a 501(c)(3) non-profit organization.

Jill has $250,000 of federal Parent PLUS loans that charge a 6% interest rate. As a result, Jack and Jill expect to pay $2,776 a month or $33,312 a year. Even with a joint income approaching $200,000, it is a significant financial burden that impairs their ability to plan for retirement and other long-term goals.

Refinancing the Parent PLUS loans

If Jack and Jill refinance at 3%, it will reduce the monthly payments to $2,414 a month. Although the $362 monthly savings are welcome, they are not a significant improvement in their situation.

Divorce has a way of making money scarce and future projections challenging. In many divorces, the division of assets and debts approaches 50%, meaning that the burden of paying for her half of the loans would be significantly greater on Jill, who only makes $45,000 a year. Even with an asymmetric division to reduce Jill’s share, it will likely not be easy to sustain (2).

Other Factors to Consider in Divorce

Jack and Jill have agreed to sell the family home as part of the divorce. They expected to net about $250,000 after expenses and mortgage repayment to be divided equally. Jack wants to use the proceeds from the sale to pay off the entire parent loan balance. Jack had heard horror stories about other parents not being able to retire because of parent loan payments, so he wanted to get rid of the balance and not worry about monthly payments that could continue into his retirement.

So, he and Jill decide to split the loans down the middle. It means that Jack will pay Jill $125,000 from the sale of their shared home since the Parent PLUS loans are in Jill’s name. With that, Jack’s share of the parent loan debt is addressed, and he believes that Jill should use her share of the sale to pay her half of the debt.

Summary of Jill’s Parent Loan Repayment Options

Here’s the thing. With the $125,000 that she would receive from Jack and her $125,000 share from the home sale, she could pay off the debt and move on to other issues. Jill was all in on the idea of each side paying half of the loans until she spoke to a Student Loan Strategist and decided to take a different route with the $250,000 of Parent PLUS loans still in her name.

Jill has always been passionate about providing support for vulnerable children worldwide. She works full-time at a local charity, a 501(c)(3) non-profit organization, making $45,000 a year. She loves her work and has no plans to retire for at least ten years. In this case, Jill could qualify for Public Service Loan Forgiveness (PSLF). It means that she could get her loans forgiven tax-free after she makes 120 monthly payments in an Income-Driven Repayment plan (2).

Here is a summary of Jill’s parent loan repayment options:

  1. Make a lump-sum payment of $250,000 from the sale of their marital home ($125,000 from Jack + $125,000 of Jill’s share) to pay off the entire loan balance.
  2. Keep the $250,000 proceeds and pay off the loans with the federal Standard 10-year repayment plan or private refinancing.
  3. Enroll in an Income-Driven Repayment plan and pursue PSLF.

Let’s take a look at each option in detail.

  1. Make a lump-sum payment of $250,000 from the sale of their marital home ($125,000 from Jack + $125,000 of Jill’s share) to pay off the entire loan balance.

In this case, the total cost of the parent loan is $250,000. This way, Jill can get rid of the parent loans in her name. However, Jill still needs to figure out her post-divorce life, including how to pay for her new housing and how to invest the other assets she may receive from Jack from the asset division from their divorce.

  1. Keep the $250,000 proceeds and pay off the loans with the standard federal 10-year repayment plan or private refinancing

The cost of paying off $250,000 of federal loans with 6% under the default 10-year Standard repayment plan is $2,776/mon and $333,061 total over the ten years. However, if Jill could find a private refinancing deal at 3% interest for the same 10-year term, the cost is $2,414/mon and $289,682 total, which is $362/mon and $43,379 savings in total. It may make sense for Jill to do that if she needed to use the $250,000 home sale proceeds to buy a new house to live in, and she could afford the $2,000+ per month of payments for the student loans. However, this is not an attractive option for Jill since her monthly income is $3,750, and the loan payments would absorb so much of it. Even if her divorce agreement provided for alimony, it would still be difficult.

  1. Enroll in an Income-Driven Repayment plan and pursue PSLF

Typically, federal Parent PLUS loans are only eligible for one of the Income-Driven Repayment plans called the Income-Contingent Repayment (ICR) plan even after being consolidated into a Direct Consolidation Loan.

Still, in some cases, they can be “double consolidated” (read more about this loophole strategy here) and qualify for cheaper Income-Driven Repayment plans. For example, let’s say that Jill double consolidated her parent loans, enrolled in Pay As You Earn (PAYE), and pursued Public Service Loan Forgiveness for ten years. Then, filing taxes as Single every one of those years, working for the 501(c)(3) employer and making the same level of annual income ($45,000 adjusted annually for inflation), she pays $205 to $283 monthly and a total of $29,059 over ten years.

The remaining loan balance (which happens to be $430,633 under this scenario) is forgiven tax-free under current tax rules. In this case, assuming that Jill makes the $205~$283 monthly payments out of her cash flow, she gets to keep all $250,000 from the home sale proceeds and pay off the parent loans for just under $30,000. She can use the $250,000 to buy a new home for herself or invest it in retirement, whatever she and her wealth strategist thought would work best (3).

The burden is still on the Borrower spouse

Did we mention that student loan repayment options can be complicated? Jill should ensure that she has her ducks perfectly aligned before engaging in the double consolidation/PSLF strategy. In the worst case, she could have missed something and may remain liable for the entire loan and the full payment or end up with a very large tax bill. Hence Jill should get an experienced student loan strategist to counsel her on her strategy.

If she felt inclined, she could discuss this PSLF option prior to the divorce with Jack and divide the benefit between them. However, Jill should remember that the burden is still on her because under this strategy, she has to stay in the PSLF program for ten years. That obligation is not quantified but should be considered in the asset division.

Summary

Sometimes we can find a silver lining in the worst situations. In their divorce, Jack and Jill could take advantage of a quirk of student loans and could save up to hundreds of thousands of dollars. As a result, Jill could have an additional $220,234 to support her lifestyle.

Student loan repayment strategies can be very different depending on the situation. For example, it would be an entirely different situation if Jill’s income was higher, her employment did not qualify her for PSLF, or she retired earlier than expected. There are still pitfalls ahead for her.

Solutions to student loan problems tend to be very unique and difficult to generalize. If you have federal student loans, the short and long-term costs can significantly differ depending on your income situation and the repayment plan you choose. However, as a federal student loan borrower, remember that you do not always have to pay back the entire loan balance.

Everyone’s situation is different, especially in divorce, especially with student loans. If you are unsure what to do, reach out for help. It might pay off!

Notes:

  • Consult an attorney to figure out what applies to you
  • Consult a financial professional with a specialization in student loans
  • Consult a financial planner
  • Note: The projection in the PSLF option assumes that, among other factors such as Jill’s PSLF-qualifying employment status and family size staying the same, Jill’s income grows 3% annually, which increases her monthly payment amount each year. Individual circumstances can significantly change results.
Feb 14

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

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

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

Social Security

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

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

Retirement Accounts

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

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

Pensions

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

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

Roth Accounts

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

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

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

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

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

Municipal Bonds

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

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

Investments

When held for one year or longer, investments outside of retirement accounts are subject to long-term capital gains taxes. They can range from 0% to 23.8%, including potential Medicare surcharges.  In 2022, for a married couple filing jointly with taxable income up to $83,350, long-term capital gains are taxed at 0% federally ($41,675 for people filing as single).

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

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

Annuities

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

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

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

Life Insurance

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

Earned Income

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

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

The challenge is to plan our income situation strategically in order to minimize lifetime taxes. 

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

Jan 20

What Financial Specialists Do You Need?

By Chris Chen CFP | Divorce Planning , Financial Planning

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

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

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

Lawyers are important, but…

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

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

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

Three Questions You Need to Answer

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

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

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

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

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

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

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

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

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

Common Financial Specialists Used In a Divorce

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

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

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

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

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

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

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

Let’s Recap

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

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

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

 

Jan 09

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

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

Social Security and Divorce

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

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

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

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

A Short History

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

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

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

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

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

Benefits for Divorced People

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

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

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

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

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

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

Who Qualifies?

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

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

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

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

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

More Marriages and Divorces

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

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

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

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

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

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

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

When Your Ex dies

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

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

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

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

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

Pension Repercussions

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

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

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

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

What Does It All Mean?

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

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

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

Jack

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

Last Words

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

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

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

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

Note:

  1. The 4% rule is widely used as a rule of thumb to estimate retirement income from assets. It was initiated in a 1996 study by Bill Bengen published in the Journal of Financial Planning. More recent revisions of the study imply that the safe withdrawal rule could be less than 4%. Other methods to plan retirement income may be more appropriate depending on the case.
  2. I have a series of handy flowcharts that can help guide mediators and clients through the decision complexities. Please ask for it at info@insightfinancialstrategists.com
Nov 15

Public Service Loan Forgiveness: limited waiver opportunity

By Saki Kurose | Student Loan Planning

PSLF waiver

Public Service Loan Forgiveness (PSLF) is a loan forgiveness program offered by the government for borrowers who work for a U.S. federal, state, local, or tribal government or not-for-profit organization. Under PSLF, public service workers can get their federal student loan balance forgiven after making 120 qualifying payments while working for a qualifying employer.

The program has been plagued with issues. Many borrowers who should have qualified have not gotten their loans forgiven for reasons such as being on the wrong repayment plan, payments not being counted for unreasonable reasons, or borrowers provided with wrong information by their loan servicers.

Last month, the Department of Education announced a major change to the program that could fix some of these issues: it will “implement a Limited PSLF Waiver to count all prior payments made by student borrowers toward PSLF, regardless of loan program.”

Here’s a summary of what it means and what you have to do if you qualify.

What is the limited PSLF waiver?

For a limited time, between now and October 31, 2022, borrowers may be able to receive credit for past payments made on loans that would otherwise not qualify for PSLF. The employment requirements have not been changed. To qualify, borrowers must be employed full-time by the government, 501(c)(3) not-for-profit, or other not-for-profit organization that provides a qualifying service.

Who qualifies for the waiver?

  • borrowers with Direct Loans
  • those who have already consolidated into the Direct Loan program
  • those with other types of federal student loans who submit a Direct consolidation application while the waiver is in effect
  • students only (no parent borrowers)

Who benefits?

Students who made payments while working for qualifying employers but the loans were previously determined to be disqualified (ex: had FFEL loans instead of Direct Loans or was a wrong repayment plan like Extended Repayment instead of an IDR plan)

Who does NOT benefit?

Borrowers who:

  • already refinanced to a private loan
  • already paid loans off
  • Parent PLUS loan borrowers (will not become eligible even if consolidated before October 31, 2022)

Do this before October 31, 2022

October 31, 2022 is the deadline to qualify for the limited PSLF waiver.

Make sure to:

  • consolidate into the Direct Loan Program if you need to (borrowers with older FFEL loans from before 2010 should)
  • submit a PSLF form

What payments will count?

-payments made after October 1, 2007 (when the PSLF program was started) and on or before October 31, 2021

What to expect

Automatic adjustments will be made:

  • When/if you have consolidated your loans into the Direct Loan Program and submitted the PSLF form, you will see automatic adjustments in your account.

If you’ve already done all the above steps:

  • You don’t need to do anything until you receive an update/communication from Student Aid

If you have Direct Loans but haven’t applied for PSLF:

  • Submit a PSLF form to see if your current or past employers qualify for PSLF by October 31, 2022 (don’t wait- expect delays)

If you have FFEL loans or Perkins loans:

  • submit a consolidation application to get the loan into Direct Loan program
  • submit PSLF form by October 31, 2022

Don’t know what types of loans you have?

  • log into your studentaid.gov account, My Aid and see your Loan Breakdown section
  • ”FFEL” (Federal Family Education Loans) or “Perkins” must be consolidated (it becomes a Direct Consolidation loan afterwards) to qualify for this Waiver

As always, if you are not sure what to do, book a free introductory call with a student loan expert to make sure you don’t miss this opportunity!

Oct 26

Seven Year End Wealth Opportunities

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

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

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

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

1. Harvest your Tax Losses

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

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

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

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

2. Review your Investment Planning

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

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

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

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

3. Review your Retirement Planning

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

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

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

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

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

4. Roth Conversions

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

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

5. Choosing your Health Plan 

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

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

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

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

6. Plan your RMDs

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

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

7. Charitable Donations

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

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

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

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

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

 

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