Low yields from both stocks and bonds have led some income-seeking investors in search of cash-flow-friendly alternatives. TIPS (or Treasury Inflation Protected Securities), which are issued by the federal government, have been popular with income investors since their introduction in 1997 for this very reason. Plus, they offer a safe buffer from the threat of rising prices.
Additionally, some big name corporations are tapping the demand for inflation-protected securities by issuing bonds that are pegged to the consumer price index. These corporate inflation-indexed notes are also proving to be popular with investors. Plus they offer monthly payments that are adjusted immediately to reflect changing prices.
Corporate inflation-indexed notes are suitable for investors looking for immediate cash flow, whereas TIPS are generally suited for people seeking protection from rising prices down the road. That’s because TIPS primarily adjust for inflation by increasing the principal value of the bond. For corporate inflation-indexed notes, however, changes in inflation are applied to the bond’s monthly coupon rate. Therefore, corporate inflation-indexed notes often adjust more quickly to changes in interest rates, which can possibly provide more income over time.
Taxes can be a tricky issue with corporate inflation-indexed notes. Income from these corporate-issued bonds is subject to Federal, state, and local taxes, while income from TIPS are exempt from state and local taxation. Because of this difference, effective after-tax yields for corporate inflation-indexed notes could be lower than those for TIPS (depending upon the investor’s income tax bracket).
On the other hand, corporate inflation-indexed notes avoid a tax trap that often catches TIPS investors. When the TIPS’ principal value is adjusted for inflation, the IRS considers this taxable income. The TIPS holder must pay income taxes on this income when it is realized – in the year that the bond’s value is increased – even though the investor does not actually receive the income until the bond is sold or matures. Because the inflation adjustment for the corporate notes is made on the bond’s coupon rate and the bondholder immediately receives all income that is realized, the “phantom tax” that affects TIPS does not have an impact on holders of the corporate inflation-index notes.
It is important to keep in mind that consumer prices do not always rise but can decrease, as was the case in the United States during the 1930’s and Japan during the 1990’s. Falling prices or “deflation” over a prolonged period would decrease the interest payments received by TIP owners; additionally a TIP investor could experience a loss of principal if the TIP is sold prior to maturity.
Aside from the tax-consequences, keep in mind that corporate notes are subject to higher credit risk than TIPS since they are based on the credit-worthiness of the company issuing the bonds. In contrast, TIPS are backed by the full, faith, and credit of the federal government.
Monday, January 30, 2006
Spending Down Assets
How would you pay for nursing home care or other types of long-term medical care? Many people believe that Medicare will cover the bills. But the fact is Medicare only pays a portion of your long-term care expenses – and that’s only for short-term skilled care and for the first 100 days.[1] With the average nursing home stay lasting 2½[2] years, it is no wonder that many people start out paying for much of their long-term care expenses out of their own pocket.
How will decisions about planning and paying for long-term medical care impact you? Let’s consider some of the issues you could potentially face by looking at a hypothetical couple:
John and Mary are both in their 60’s, happy and healthy, with two grown children. They have sufficient funds to maintain their current standard of living throughout retirement, and intend to leave some of this wealth to their children after John and Mary pass away.
Mary’s parents are still alive, are in their 80’s, and have lived in a nursing home for the past year. All of the money that they had put away is going toward their nursing home expenses. Eventually, they will have spent their entire life savings on long-term health care, and will have to fall back on Medicaid or their own children to pay these bills.
Mary sees what has happened to her parents and doesn’t want the same circumstances to affect her and John’s independence. She realizes that long-term costs for two individuals would possibly jeopardize the wealth they have accumulated, as well as their retirement goals. What options do John and Mary have?
Medicare might cover a small part of their expenses, but John and Mary would bear the responsibility for the remainder. And they might not qualify for Medicaid until they have spent down their assets to the level required by law.[3] This could leave them with little to live on if they no longer needed the special care. Plus it could reduce or eliminate any hope of helping their children.
For John and Mary, long-term care insurance could provide a suitable solution. A long-term care policy can possibly be written to address many specific medical concerns they may have, such as a family history of Alzheimer’s or other congenital diseases. Plus, they can review different plans to find a premium that would fit into their retirement budget. Long-term care insurance can be an effective means of remaining independent, preserving your wealth, and avoiding the potential need to spend down your assets under the Medicaid rules.
[1] MyMedicare.gov (2005)
[2] Long Term Care Study, Michigan State (2004)
[3] Centers for Medicare & Medicaid Services (2005)
How will decisions about planning and paying for long-term medical care impact you? Let’s consider some of the issues you could potentially face by looking at a hypothetical couple:
John and Mary are both in their 60’s, happy and healthy, with two grown children. They have sufficient funds to maintain their current standard of living throughout retirement, and intend to leave some of this wealth to their children after John and Mary pass away.
Mary’s parents are still alive, are in their 80’s, and have lived in a nursing home for the past year. All of the money that they had put away is going toward their nursing home expenses. Eventually, they will have spent their entire life savings on long-term health care, and will have to fall back on Medicaid or their own children to pay these bills.
Mary sees what has happened to her parents and doesn’t want the same circumstances to affect her and John’s independence. She realizes that long-term costs for two individuals would possibly jeopardize the wealth they have accumulated, as well as their retirement goals. What options do John and Mary have?
Medicare might cover a small part of their expenses, but John and Mary would bear the responsibility for the remainder. And they might not qualify for Medicaid until they have spent down their assets to the level required by law.[3] This could leave them with little to live on if they no longer needed the special care. Plus it could reduce or eliminate any hope of helping their children.
For John and Mary, long-term care insurance could provide a suitable solution. A long-term care policy can possibly be written to address many specific medical concerns they may have, such as a family history of Alzheimer’s or other congenital diseases. Plus, they can review different plans to find a premium that would fit into their retirement budget. Long-term care insurance can be an effective means of remaining independent, preserving your wealth, and avoiding the potential need to spend down your assets under the Medicaid rules.
[1] MyMedicare.gov (2005)
[2] Long Term Care Study, Michigan State (2004)
[3] Centers for Medicare & Medicaid Services (2005)
Don't be so Quick to Sell that Life Insurance Policy
Do you own a life insurance policy that you no longer can afford or want? Perhaps you’re tempted to sell it to an investor who has offered you a way to get money from this relatively illiquid asset. However, before you take the cash, be sure to get all the facts. You just might be better off keeping the life insurance or surrendering it.
Life settlements are frequently directed towards people over age 65 who own life insurance policies with at least a $100,000 face value, have some health problems, and have a life expectancy of 2 to 15 years. When you sell a life insurance policy to a third party, you will no longer be responsible for the premiums. The investor will make all future payments to the insurance company and collect the death benefit after you die.
This concept could be attractive if you think you don’t need the coverage, your beneficiaries have died, or you want the money for other things, such as long-term care insurance. But what is the cost?
These transactions can possibly have high commissions and tax implications to sellers. A study by Deloitte Consulting and the University of Connecticut found that life-settlement companies, on average, paid only 20% of the face value of the policies to the sellers. Whereas the estimated future returns to investors were 64% of the face amount. Therefore, if you want to pass on the maximum amount to your heirs or a charity, you might be better off keeping the policy.
But suppose you need the money? Instead of selling the policy, a better choice could possibly be selling other assets, such as securities. Or you could take a loan from the policy. Another idea is to have your beneficiaries assume the premium payments—after all they’re the ones who will eventually benefit the most.
So how can you determine if a life settlement company is offering a fair price?
Compare it to your other options, such as the policy’s surrender value. Think about this: You most likely bought the life insurance policy when you were healthy. And the insurance company based the future surrender values on your health at that time. These values do not change, regardless of declining health status. Conversely, the life settlement company will use your present medical condition to come up with their offer. Therefore, as the level of your impairment increases, so should the amount of the offer.
Of course don’t forget about the income-tax free death benefit your beneficiaries won’t receive if you get rid of the policy. And in case you’re still not sure what to do, remember that a seasoned, institutional investor wants to buy your policy. Consequently, it must have a significant value. I always advise clients to consult with their own qualified tax and financial advisor prior to making any investment decisions.
Life settlements are frequently directed towards people over age 65 who own life insurance policies with at least a $100,000 face value, have some health problems, and have a life expectancy of 2 to 15 years. When you sell a life insurance policy to a third party, you will no longer be responsible for the premiums. The investor will make all future payments to the insurance company and collect the death benefit after you die.
This concept could be attractive if you think you don’t need the coverage, your beneficiaries have died, or you want the money for other things, such as long-term care insurance. But what is the cost?
These transactions can possibly have high commissions and tax implications to sellers. A study by Deloitte Consulting and the University of Connecticut found that life-settlement companies, on average, paid only 20% of the face value of the policies to the sellers. Whereas the estimated future returns to investors were 64% of the face amount. Therefore, if you want to pass on the maximum amount to your heirs or a charity, you might be better off keeping the policy.
But suppose you need the money? Instead of selling the policy, a better choice could possibly be selling other assets, such as securities. Or you could take a loan from the policy. Another idea is to have your beneficiaries assume the premium payments—after all they’re the ones who will eventually benefit the most.
So how can you determine if a life settlement company is offering a fair price?
Compare it to your other options, such as the policy’s surrender value. Think about this: You most likely bought the life insurance policy when you were healthy. And the insurance company based the future surrender values on your health at that time. These values do not change, regardless of declining health status. Conversely, the life settlement company will use your present medical condition to come up with their offer. Therefore, as the level of your impairment increases, so should the amount of the offer.
Of course don’t forget about the income-tax free death benefit your beneficiaries won’t receive if you get rid of the policy. And in case you’re still not sure what to do, remember that a seasoned, institutional investor wants to buy your policy. Consequently, it must have a significant value. I always advise clients to consult with their own qualified tax and financial advisor prior to making any investment decisions.
Get More from your Assets
Do you own an asset that you wished paid more income, yet you don’t want to sell because you’ll face a hefty capital gains tax? For example, maybe you have a piece of raw land or stocks that don’t pay the dividends you are looking for. In such a case, you might be able to convert them into another investment that provides more income while avoiding the capital gains tax. This could be accomplished through a Charitable Remainder Trust (CRT).
Through a CRT, highly appreciated and/or low-income producing assets are transferred to a trust that will pay you an ongoing income for your life or for a specified time period. Here is a basic summary of how it works:
Your attorney draws up the trust;
You transfer assets that have appreciated significantly to the trust but are producing an income that is lower than your current expectations or needs;
The trust sells the asset and pays no capital gains tax;
The trust then reinvests the proceeds in investments that could possibly pay a higher income (e.g., bonds or preferred stock) Please note that investments in preferred stocks and bonds involve risks, including the possible loss of principal invested.
Some people overlook this technique because they believe that they must leave the trust’s entire principal to the charity. That, however, is not always the case. As a practical matter, the present value of the remainder interest to the charity must equal at least 10% of value of the donor’s income interest. This calculation is largely based upon the age of the income beneficiaries, trust duration, value of the contributed assets and the Applicable Federal Rate (AFR) published by the Treasury Department. Although the trust must be irrevocable, the donor can serve as the trustee of the trust, which can allow you some discretion over the trust investments.
Furthermore, the trust can be designed, in some cases, to provide children and grandchildren with some benefits. In some cases, these trusts have been drafted to provide children, grandchildren, and other relatives with the benefits associated with the income interest. In other cases, the income from these trusts has also been used to fund the premiums of a life insurance policy to support the younger relatives at the donor’s death.
In addition to the potentially higher income payments, the donor is usually entitled to an income tax deduction, which is tied to the value of the charities’ remainder interest. Also, when the trust is properly created, the assets remaining in the trust at the end of the donor’s life (or predetermined term of years) can pass to the charity free of federal estate taxes. Of course, certain income limitations and deduction restrictions will often apply to the amount and timing of the income-tax deduction. For this reason, careful planning is required to determine the extent of the donor’s income and estate tax benefits. As these benefits are subject to several federal tax rules, professional assistance from an established estate-planning attorney is highly recommended.
Through a CRT, highly appreciated and/or low-income producing assets are transferred to a trust that will pay you an ongoing income for your life or for a specified time period. Here is a basic summary of how it works:
Your attorney draws up the trust;
You transfer assets that have appreciated significantly to the trust but are producing an income that is lower than your current expectations or needs;
The trust sells the asset and pays no capital gains tax;
The trust then reinvests the proceeds in investments that could possibly pay a higher income (e.g., bonds or preferred stock) Please note that investments in preferred stocks and bonds involve risks, including the possible loss of principal invested.
Some people overlook this technique because they believe that they must leave the trust’s entire principal to the charity. That, however, is not always the case. As a practical matter, the present value of the remainder interest to the charity must equal at least 10% of value of the donor’s income interest. This calculation is largely based upon the age of the income beneficiaries, trust duration, value of the contributed assets and the Applicable Federal Rate (AFR) published by the Treasury Department. Although the trust must be irrevocable, the donor can serve as the trustee of the trust, which can allow you some discretion over the trust investments.
Furthermore, the trust can be designed, in some cases, to provide children and grandchildren with some benefits. In some cases, these trusts have been drafted to provide children, grandchildren, and other relatives with the benefits associated with the income interest. In other cases, the income from these trusts has also been used to fund the premiums of a life insurance policy to support the younger relatives at the donor’s death.
In addition to the potentially higher income payments, the donor is usually entitled to an income tax deduction, which is tied to the value of the charities’ remainder interest. Also, when the trust is properly created, the assets remaining in the trust at the end of the donor’s life (or predetermined term of years) can pass to the charity free of federal estate taxes. Of course, certain income limitations and deduction restrictions will often apply to the amount and timing of the income-tax deduction. For this reason, careful planning is required to determine the extent of the donor’s income and estate tax benefits. As these benefits are subject to several federal tax rules, professional assistance from an established estate-planning attorney is highly recommended.
Creditors will have a Tougher Time Getting to Your IRAs
No one likes to think about bankruptcy. But it can happen to the best of people. In fact, the Administrative Office of the U.S. Courts reported that for the 12-month period ending March 31, 2005, there were almost 1.6 million bankruptcy filings.[1]
A study by Harvard University showed that medical problems caused half of these individuals to seek protection from creditors.[2] And according to the Congressional Record, seniors (65 and older) are now the fastest growing age group filing for bankruptcy protection.[3] If circumstances force you into bankruptcy, you can take comfort in knowing that some of your assets might now be better protected.
On April 20, 2005, the President signed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. The purpose of this new legislation was to revise existing laws to help make credit more affordable for Americans.[4] Part of the regulations expanded the language regarding retirement plans.
All money that you have in qualified retirement plans, such as 401(k)s and profit sharing plans; and 403(b)s are now exempt from bankruptcy. And your IRAs and Roth IRAs will have a $1 million limitation that is adjusted for inflation. Now you may think that this isn’t a particularly large amount since many investors get big rollovers when they retire. The government took care of you there. The $1 million limitation applies only to your contributions and the associated appreciation. It does not include funds rolled into your IRAs from qualified plans, which have unlimited protection.
For example, suppose that over the last 30 years you had faithfully contributed the maximum into your IRA. Now that account is worth $400,000. What if you still have $800,000 sitting in your former employer’s 401(k) and were afraid to roll it into your IRA because your state had poor bankruptcy protection laws? The new federal law has changed all of that.
For even though the IRA will be worth $1.2 million after the rollover, only the original $400,000 will apply to the $1 million limit. The balance falls into the unlimited protection category. However, this only applies to bankruptcy. Not to judgments awarded in other courts where state creditor protection laws could possibility prevail.
Thanks to the new provisions, your IRAs will have more creditor protection and be there when you need the money. Therefore, you can have greater peace of mind when you roll your qualified plan funds into an IRA. Plus you’ll have the flexibility that an IRA can offer, such as more investment options, less restrictive rules, and tax-savings provisions for your beneficiaries. I strongly recommend all investors consult with their own qualified tax and financial advisors prior to making any investment decisions.
[1] http://www.uscourts.gov/Press_Releases/news61005.html
[2] http://www.hms.harvard.edu/news/releases/2_2Himmelstein.html
[3] http://www.senate.gov/~feingold/statements/05/03/2005415658.html
[4] http://www.whitehouse.gov/news/releases/2005/04/20050420-5.html
A study by Harvard University showed that medical problems caused half of these individuals to seek protection from creditors.[2] And according to the Congressional Record, seniors (65 and older) are now the fastest growing age group filing for bankruptcy protection.[3] If circumstances force you into bankruptcy, you can take comfort in knowing that some of your assets might now be better protected.
On April 20, 2005, the President signed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. The purpose of this new legislation was to revise existing laws to help make credit more affordable for Americans.[4] Part of the regulations expanded the language regarding retirement plans.
All money that you have in qualified retirement plans, such as 401(k)s and profit sharing plans; and 403(b)s are now exempt from bankruptcy. And your IRAs and Roth IRAs will have a $1 million limitation that is adjusted for inflation. Now you may think that this isn’t a particularly large amount since many investors get big rollovers when they retire. The government took care of you there. The $1 million limitation applies only to your contributions and the associated appreciation. It does not include funds rolled into your IRAs from qualified plans, which have unlimited protection.
For example, suppose that over the last 30 years you had faithfully contributed the maximum into your IRA. Now that account is worth $400,000. What if you still have $800,000 sitting in your former employer’s 401(k) and were afraid to roll it into your IRA because your state had poor bankruptcy protection laws? The new federal law has changed all of that.
For even though the IRA will be worth $1.2 million after the rollover, only the original $400,000 will apply to the $1 million limit. The balance falls into the unlimited protection category. However, this only applies to bankruptcy. Not to judgments awarded in other courts where state creditor protection laws could possibility prevail.
Thanks to the new provisions, your IRAs will have more creditor protection and be there when you need the money. Therefore, you can have greater peace of mind when you roll your qualified plan funds into an IRA. Plus you’ll have the flexibility that an IRA can offer, such as more investment options, less restrictive rules, and tax-savings provisions for your beneficiaries. I strongly recommend all investors consult with their own qualified tax and financial advisors prior to making any investment decisions.
[1] http://www.uscourts.gov/Press_Releases/news61005.html
[2] http://www.hms.harvard.edu/news/releases/2_2Himmelstein.html
[3] http://www.senate.gov/~feingold/statements/05/03/2005415658.html
[4] http://www.whitehouse.gov/news/releases/2005/04/20050420-5.html
Convert to Roth after Retirement?
Should you convert a traditional IRA to a Roth IRA after retirement? With retirees enjoying longer lives these days, a post-retirement conversion to a Roth IRA could have advantages for certain investors.
A Roth IRA can be a good savings vehicle for those still working, thanks to the tax-free treatment of qualified earnings. A Roth IRA conversion can also benefit a retired investor. Because there are no minimum distribution requirements, Roth IRA assets can be invested for a longer period and thus have more time to work for you. For a recent retiree, that could mean your assets could potentially have 10 or 20 years to grow on a tax-free basis.
However, you must weigh the benefit of tax-free treatment against the costs of the conversion (in terms of the federal income taxes paid on the converted amount). Furthermore, a Roth IRA conversion generally works best when an investor has a longer investment time horizon.
Generally, you should only consider a post-retirement Roth conversion when you have assets outside your traditional IRA to pay the taxes on the converted amount. Also, if you would end up paying more taxes on the conversion than you would if you leave the assets in your traditional IRA for withdrawals later in life, then a Roth IRA conversion might not be in your best interest.
Some rules to consider: You are only eligible to convert a traditional IRA to a Roth if your modified adjusted gross income ("MAGI") is below $100,000 and you file a joint return with your spouse or you are single.[1] The good news is that the amount of traditional IRA converted is no longer included in your MAGI to determine your eligibility for a Roth conversion.
Another rule you should be aware of: If you convert to a Roth IRA after age 70½, you must take one last required minimum distribution from your traditional IRA for the year in which you make the conversion. The remaining assets in your IRA are then available for conversion to a Roth.
Although distributions from a Roth IRA typically come out tax-free upon retirement, you must satisfy a five-year holding period requirement to achieve this benefit. Please also note that early distributions prior to age 59 ½ can be subject to ordinary income taxes and a 10% income tax penalty.
[1] IRS Publication 590 (2005)
A Roth IRA can be a good savings vehicle for those still working, thanks to the tax-free treatment of qualified earnings. A Roth IRA conversion can also benefit a retired investor. Because there are no minimum distribution requirements, Roth IRA assets can be invested for a longer period and thus have more time to work for you. For a recent retiree, that could mean your assets could potentially have 10 or 20 years to grow on a tax-free basis.
However, you must weigh the benefit of tax-free treatment against the costs of the conversion (in terms of the federal income taxes paid on the converted amount). Furthermore, a Roth IRA conversion generally works best when an investor has a longer investment time horizon.
Generally, you should only consider a post-retirement Roth conversion when you have assets outside your traditional IRA to pay the taxes on the converted amount. Also, if you would end up paying more taxes on the conversion than you would if you leave the assets in your traditional IRA for withdrawals later in life, then a Roth IRA conversion might not be in your best interest.
Some rules to consider: You are only eligible to convert a traditional IRA to a Roth if your modified adjusted gross income ("MAGI") is below $100,000 and you file a joint return with your spouse or you are single.[1] The good news is that the amount of traditional IRA converted is no longer included in your MAGI to determine your eligibility for a Roth conversion.
Another rule you should be aware of: If you convert to a Roth IRA after age 70½, you must take one last required minimum distribution from your traditional IRA for the year in which you make the conversion. The remaining assets in your IRA are then available for conversion to a Roth.
Although distributions from a Roth IRA typically come out tax-free upon retirement, you must satisfy a five-year holding period requirement to achieve this benefit. Please also note that early distributions prior to age 59 ½ can be subject to ordinary income taxes and a 10% income tax penalty.
[1] IRS Publication 590 (2005)
Probate is the legal process of wrapping up a person's affairs, paying their bills, and distributing their assets. And it is not uncommon for this to take several months to go through the court system. The expenses involved can potentially include property appraisal, executor fees, court costs, plus legal and accounting fees. The amount varies depending on your state and the local practice in your community.
To avoid this burden on their loved ones, seniors frequently transfer assets into joint-tenancy ownership with their intended beneficiaries. Although this strategy can reduce settlement costs by eliminating probate, it could open up another set of problems.
Assets held in joint-tenancy automatically go to the surviving owner when you die. However, while you are alive, the joint owner can legally withdraw part or all of the money in the account without your permission. In addition, if he or she gets into financial or legal trouble, the property could be at risk to creditor claims.
Rather than making a beneficiary a joint owner of your property to simply avoid probate, you might consider another idea.
An individual can own certain assets and list a beneficiary. At the owner’s death, the assets pass to the named beneficiary and avoid probate. While you are alive, your beneficiary does not have access to your account. You can change beneficiaries at anytime, and you might even be allowed to name a contingent beneficiary.
A Payable on Death (P.O.D.) registration applies to bank, savings and loan, and credit union accounts, as well as United States savings bonds. On the other hand, a Transfer on Death (T.O.D.) registration is used for securities such as stocks, bonds, and mutual funds (but only if the securities firm allows it). With both of the above, the beneficiary receives the funds by offering proof of identity and a copy of your death certificate, regardless of the provisions in your will. Please note that the assets will still be included in your estate when you pass away. Estates that exceed $2 million are subject to federal estate taxes.
To avoid this burden on their loved ones, seniors frequently transfer assets into joint-tenancy ownership with their intended beneficiaries. Although this strategy can reduce settlement costs by eliminating probate, it could open up another set of problems.
Assets held in joint-tenancy automatically go to the surviving owner when you die. However, while you are alive, the joint owner can legally withdraw part or all of the money in the account without your permission. In addition, if he or she gets into financial or legal trouble, the property could be at risk to creditor claims.
Rather than making a beneficiary a joint owner of your property to simply avoid probate, you might consider another idea.
An individual can own certain assets and list a beneficiary. At the owner’s death, the assets pass to the named beneficiary and avoid probate. While you are alive, your beneficiary does not have access to your account. You can change beneficiaries at anytime, and you might even be allowed to name a contingent beneficiary.
A Payable on Death (P.O.D.) registration applies to bank, savings and loan, and credit union accounts, as well as United States savings bonds. On the other hand, a Transfer on Death (T.O.D.) registration is used for securities such as stocks, bonds, and mutual funds (but only if the securities firm allows it). With both of the above, the beneficiary receives the funds by offering proof of identity and a copy of your death certificate, regardless of the provisions in your will. Please note that the assets will still be included in your estate when you pass away. Estates that exceed $2 million are subject to federal estate taxes.
Which Account Should Your Draw from First
This is a common dilemma for seniors who are retired and have investments in taxable accounts as well as tax-deferred ones, like IRAs. Generally, you would want to take money from your taxable accounts first so as to preserve the tax deferral of the other funds. There may, however, be circumstances where investors should consider alternatives.
When you withdraw funds from a taxable account, your income tax liability is limited to amounts exceeding your cost basis that has not been previously taxed. Whereas all money you take from your IRA is usually taxable. Yet if you let the IRA grow, you’ll pass that tax burden to your beneficiaries.
On the other hand, if you use the IRA funds first, you’ll have the income tax to pay. But then a greater amount of the taxable accounts can remain intact to transfer income tax free to your heirs.
It can be a tough choice to make and everyone’s situation is different. Here are two other solutions that you may want to consider:
Convert to a Roth IRA
You could roll your traditional IRA to a Roth. You’ll have to pay income tax on the amount transferred. But once the funds are rolled over, withdrawals and bequests are income tax free.
Wealth Replacement Trust
Compare your income tax liability of taking money from the taxable account vs. the IRA.
Also how big of a tax bill will your beneficiaries face? You could buy a life insurance policy to pay the income tax for them. And possibly you might finance it each year with the taxes saved by withdrawing funds from your taxable accounts rather than the IRA.
When you withdraw funds from a taxable account, your income tax liability is limited to amounts exceeding your cost basis that has not been previously taxed. Whereas all money you take from your IRA is usually taxable. Yet if you let the IRA grow, you’ll pass that tax burden to your beneficiaries.
On the other hand, if you use the IRA funds first, you’ll have the income tax to pay. But then a greater amount of the taxable accounts can remain intact to transfer income tax free to your heirs.
It can be a tough choice to make and everyone’s situation is different. Here are two other solutions that you may want to consider:
Convert to a Roth IRA
You could roll your traditional IRA to a Roth. You’ll have to pay income tax on the amount transferred. But once the funds are rolled over, withdrawals and bequests are income tax free.
Wealth Replacement Trust
Compare your income tax liability of taking money from the taxable account vs. the IRA.
Also how big of a tax bill will your beneficiaries face? You could buy a life insurance policy to pay the income tax for them. And possibly you might finance it each year with the taxes saved by withdrawing funds from your taxable accounts rather than the IRA.
What's the Real Return on a Fixed Annuity
Annuity interest rates can often change in tandem with the rates paid on other fixed interest investments. However, whenever rates drop, the real return on annuities could potentially be higher than other interest-paying assets.
First of all, fixed deferred annuities typically promise a minimum rate of return for the term of the contract. For example, if you select an annuity that locks in current rates for five years, you will earn a competitive rate for the first five contract years. After that, you will receive no less than the minimum rate, regardless of how low market rates might possibly go.
Second, annuities are tax-deferred investments. That means the earnings on your annuity’s principal will compound without you owing current taxes. Other fixed income investments, such as CDs, are taxed as interest is credited (of course, CDs are FDIC insured for up to $100,000 per account). Even if you reinvest the interest, you have to pay income tax. This reduces the effective rate of return on your taxable fixed interest investments.
Please note, however, that annuities are designed for long-term investing and ordinary federal income taxes and a 10% tax penalty could apply to withdrawals taken prior to age 59 ½.
Third, many annuities pay bonuses for the first year. This extra return could boost the yield over the term of the contract. However, early withdrawals from annuities could result in surrender charges that reduce the benefits of these bonuses. Please note that annuities that pay bonuses may have higher fees and charges and longer surrender periods than other annuities that do not offer a bonus.
In some cases, you can also put off taking money out of an annuity and therefore delay paying income taxes. This could allow you to arrange your payments to coincide with time periods when you are in a lower tax bracket. Furthermore, you can sometimes postpone receiving payments from annuities for your lifetime and structure a plan to create additional funds for your heirs. In this case, your heirs will pay income taxes at their respective tax rates. You can’t do that with CDs (of course, annuities and CDs are both subject to estate taxes if the owner’s taxable estate exceeds $2 million). As previously mentioned, annuity benefits and guarantees are based upon the claims-paying ability and financial strength of the underlying insurance company and are not government insured. Additionally, one should remember that annuity surrender charges are often based upon the time the insured has been invested in the annuity and surrender schedules vary from company to company.
First of all, fixed deferred annuities typically promise a minimum rate of return for the term of the contract. For example, if you select an annuity that locks in current rates for five years, you will earn a competitive rate for the first five contract years. After that, you will receive no less than the minimum rate, regardless of how low market rates might possibly go.
Second, annuities are tax-deferred investments. That means the earnings on your annuity’s principal will compound without you owing current taxes. Other fixed income investments, such as CDs, are taxed as interest is credited (of course, CDs are FDIC insured for up to $100,000 per account). Even if you reinvest the interest, you have to pay income tax. This reduces the effective rate of return on your taxable fixed interest investments.
Please note, however, that annuities are designed for long-term investing and ordinary federal income taxes and a 10% tax penalty could apply to withdrawals taken prior to age 59 ½.
Third, many annuities pay bonuses for the first year. This extra return could boost the yield over the term of the contract. However, early withdrawals from annuities could result in surrender charges that reduce the benefits of these bonuses. Please note that annuities that pay bonuses may have higher fees and charges and longer surrender periods than other annuities that do not offer a bonus.
In some cases, you can also put off taking money out of an annuity and therefore delay paying income taxes. This could allow you to arrange your payments to coincide with time periods when you are in a lower tax bracket. Furthermore, you can sometimes postpone receiving payments from annuities for your lifetime and structure a plan to create additional funds for your heirs. In this case, your heirs will pay income taxes at their respective tax rates. You can’t do that with CDs (of course, annuities and CDs are both subject to estate taxes if the owner’s taxable estate exceeds $2 million). As previously mentioned, annuity benefits and guarantees are based upon the claims-paying ability and financial strength of the underlying insurance company and are not government insured. Additionally, one should remember that annuity surrender charges are often based upon the time the insured has been invested in the annuity and surrender schedules vary from company to company.
Tax Strategies for Retirees
Now that you are either retired or close to retired, preserving your principal while taking a steady income from your investments could be more important than ever. But if you are in a high income tax bracket, the federal government could be waiting to take up to 35% of the income you receive from your investments.[1]
With respect to your IRA money, you could also be at the age (over 70½) where you are required to take minimum distributions (RMD). But each year, do you find yourself sticking the money into a checking account or CD. Although there is something to be said about safety and the FDIC insurance afforded to these investments, it is important to also consider the effects of income taxes and cost of living. In years where inflation is on the rise, you could find that your “after-tax” return is not keeping up with the cost of living.[2]
As a practical matter, municipal bonds could offer an alternative and some tax relief, since the interest is generally received free of federal, state and local income taxes. This could provide more income to help meet retirement needs. Of course, there are exceptions to the favorable income tax treatment for taxpayers that are subject to the Alternative Minimum Tax (ATM) or who have invested in bonds outside of their state of residence. You should remember that these bonds are backed by the credit of the issuing local government, and the principal and yield on these bonds can fluctuate with market conditions.
On another note, if your beneficiaries receive your IRA money, they will have to pay income taxes on their distributions. Assuming that your IRA grows, this means that the potential income tax liability to your love ones will also increase. On the other hand, beneficiaries who receive assets that are owned “outside” the IRA will receive them at the fair market value on your date of death. In other words, you beneficiaries receive a “stepped-up” cost basis on the inherited asset.
To illustrate this principal, you could have mutual fund shares in your IRA that are worth $100,000. When the funds are held inside an IRA or other qualified retirement plan, your beneficiaries will eventually pay income tax on the entire value of the shares at their respective tax rate. However, if you own the shares outside an IRA, your heirs could receive and sell the shares without owing any federal income taxes (although federal estate taxes could apply if the decedent’s estate exceeded $2 million). This is something to consider if you are concerned about the end-result of your estate plan.
[1] 2005 Federal Income Tax Rates
[2] Society of Certified Senior Advisors, Working With Seniors, p. 351 (December 2003)
With respect to your IRA money, you could also be at the age (over 70½) where you are required to take minimum distributions (RMD). But each year, do you find yourself sticking the money into a checking account or CD. Although there is something to be said about safety and the FDIC insurance afforded to these investments, it is important to also consider the effects of income taxes and cost of living. In years where inflation is on the rise, you could find that your “after-tax” return is not keeping up with the cost of living.[2]
As a practical matter, municipal bonds could offer an alternative and some tax relief, since the interest is generally received free of federal, state and local income taxes. This could provide more income to help meet retirement needs. Of course, there are exceptions to the favorable income tax treatment for taxpayers that are subject to the Alternative Minimum Tax (ATM) or who have invested in bonds outside of their state of residence. You should remember that these bonds are backed by the credit of the issuing local government, and the principal and yield on these bonds can fluctuate with market conditions.
On another note, if your beneficiaries receive your IRA money, they will have to pay income taxes on their distributions. Assuming that your IRA grows, this means that the potential income tax liability to your love ones will also increase. On the other hand, beneficiaries who receive assets that are owned “outside” the IRA will receive them at the fair market value on your date of death. In other words, you beneficiaries receive a “stepped-up” cost basis on the inherited asset.
To illustrate this principal, you could have mutual fund shares in your IRA that are worth $100,000. When the funds are held inside an IRA or other qualified retirement plan, your beneficiaries will eventually pay income tax on the entire value of the shares at their respective tax rate. However, if you own the shares outside an IRA, your heirs could receive and sell the shares without owing any federal income taxes (although federal estate taxes could apply if the decedent’s estate exceeded $2 million). This is something to consider if you are concerned about the end-result of your estate plan.
[1] 2005 Federal Income Tax Rates
[2] Society of Certified Senior Advisors, Working With Seniors, p. 351 (December 2003)
Sunday, December 25, 2005
Narrow Minded People Debate the Pros and Cons of Variable Annuities
Some conversations about investing make no sense like the argument that variable annuities are great (made by those who sell them) or terrible (made by those that hate any product with fees, e.g. the Wall Street Journal). A variable annuity, like a corporation, is a type of entity. You would never argue that corporations are “good” or “bad” and you cannot argue that VAs are good or bad. They are however appropriate and inappropriate in various situations. And they have too often been sold inappropriately by someone who did not know better (many people with traditional life insurance backgrounds have poor investment understanding) or simply sold the product to gain a commission. Let’s pull back the covers.
Typically, the proponents of the product argue the benefits
? Tax deferral
? The death benefit
? Riders such as guaranteed income benefits
Opponents argue that
? Mutual funds are betters because withdrawals from VAs are taxed as ordinary income
? The death benefit is of little value (how many people make an investment with the intention to die?)
? The guaranteed income riders may not be worth it
As to the issue comparing VAs to mutual funds, the “winner” will be a function of the
? investor’s age,
? his current and future tax bracket,
? the type of fund and sub-account being compared,
? the investments fees in each and
? the amount of switching among funds done by the investor
For example, if one were to hold aggressive growth funds which typically have turnover rates exceeding 100%, much of the gains will be short-term and taxed as ordinary income—no better than the tax on VA withdrawals. So the argument that the taxation of VAs is worse than funds is not always true. And the taxation is only one of the five variables that need to be considered.
Age is another issue and this is where VAs likely get a bad reputation. In any tax deferred vehicle, the tax deferral has the greatest benefit the longer the tax deferral period. Therefore, older people cannot benefit much from the tax deferral and the sale of VAs to seniors is questionable. Of course, there’s always the exceptional grandpa who says “I want to leave this $100,000 to my grandchildren. Let’s put it in a VA in the most aggressive fund. If it doubles, then great, my grandkids win. If it tanks, then they still get the $100,000 death benefit.” In general however, VAs are more suitable for younger, not older investors, as younger investors get more benefit from longer deferral.
Start with $100,000
Taxable at 5% Tax Deferred at 5%
Year 5 $117,910 $127,628
Year 10 $139,029 $162,889
Year 15 $163,930 $207,893
Year 20 $193,290 $265,330
This table shows that the difference between a tax deferred and taxable balance grows with the deferral period making any tax deferred investment most appropriate for younger people.
The death benefit is of highly questionable value. On a mathematical basis, we could show in most cases that the amount charged for the death benefit is not worth it. While the death benefit is clearly comforting to many people, it isn't worth anywhere near the price most insurance companies charge their customers for it, according to a study by Moshe Arye Milevsky of Canada's York University and Steven Posner of Goldman Sachs. They found that consumers are being charged as much as 5 to 10 times the economic value of the guarantee for a basic return-of-premium variable annuity. Indeed, once the steep variable-annuity fees are taken into account, most long-term investors would do much better putting their money into a low-fee equity index mutual fund or a tax-managed mutual fund. Their bottom line: Most insurance companies are charging their customers too high a price.
Similarly, new riders that provide minimum lifetime income payments or a guaranteed return may not be of economic value. Basically, if you are young, the payment for these rider guarantees is a raw deal. But they do have economic value if you are older and make more aggressive investment selections. In the case of both the death benefit and minimum income benefits, the big question is how the individual buyer values these. Since people do not make logical or rationale decisions, the economic value of these guarantees appear to be far less important than how important the feature “feels.” That’s the difference between a financial advisor and an economist. Good fincnial advisors attempt to give good technical advice and good emotional advice. They actually talk to and care for the people they serve and realize that they buy emotionally.
This issue of serving investors emotional needs cannot be overlooked and because it is, often causes a fruitless conversation about VA pros and cons. The accountant argues that the tax benefits of VAs are poor and the advisor, rather than to argue this point, would do well to agree with the assertion. But the advisor need further explain that his clients would sit with their money in a 2% money market had it not been for the comfort provided by the VA minimum income guarantee that was not available in another instrument (some VAs now provide a rider offering a 5% minimum return if held for 10 years). In other words, as advisors, the task is to improve the client’s situation even if the client won’t do what’s optimal. Accountants, economists and academics often seem to take the position that of the solution is not the best solution, it’s bad.
In general, VAs will be most suitable for growth oriented younger investors. Advisors would do well to offer those with low fees to the investor and sacrifice commission. (Many options with super low cost structures are available now, typically offered by fee-based planners). The only significant objection that a young buyer would have is the penalty for withdrawal prior to age 59 ½. Consequently, VAs should be sold as a long term retirement saving tool that may eventually provide a lifetime income and contribute to a sustainable retirement. It’s only when VAs are mis-sold for the wrong reasons, to the wrong buyers and sellers attempt to defend indefensible features (e.g. the economic value of guarantees), that VAs and their sellers get egg on their face.
Saturday, December 24, 2005
This site looks very good
Retirement Investing
For retirees or people rapidly approaching retirement.
Learn to construct your portfolio in retirement for comfortable golden years.
How to allocate your resources between investment classes.
Investing for growth in retirement,
mutual funds,
stocks,
separately managed accounts,
real estate,
Investing for income,
Bonds,
Bond Funds,
Preferred Shares,
Mortgages,
Structured Products,
Investing for liquidity,
Bank products,
Other alternatives
Retirement Investing
For retirees or people rapidly approaching retirement.
Learn to construct your portfolio in retirement for comfortable golden years.
How to allocate your resources between investment classes.
Investing for growth in retirement,
mutual funds,
stocks,
separately managed accounts,
real estate,
Investing for income,
Bonds,
Bond Funds,
Preferred Shares,
Mortgages,
Structured Products,
Investing for liquidity,
Bank products,
Other alternatives
Reverse Mortgages for more Income in Retirement
Seniors who are in a cash flow bind because of increasing expenses or a drop in their investment income may want to look into tapping one of their most valuable assets: their homestead.
There are several ways to get equity out of your home. You could sell it, but you would have to move. Or you could take out a loan against it, which would leave you with payments to make each month. The third choice is a reverse mortgage.
A reverse mortgage is a loan that lets homeowners over 62 years old convert the equity in their house into cash, yet allows them to still live there. The lender will give the payout all at once, as a fixed monthly income (up to lifetime), as a line of credit to use when you choose, or as a combination of these. The money will have to be paid back with interest when you die, sell the home, or permanently move out. But you or your heirs have the option to pay off the reverse mortgage at any time and keep the house. And the amount that must be repaid can never exceed the value of the home. Furthermore, if the sales price exceeds the amount owed, the excess will go to you or your estate.
There is no income or medical requirement to qualify for a reverse mortgage. And you can use the money any way you wish, for example, to pay daily living costs, medical bills, or travel expenses.
The size of the reverse mortgage you could obtain will depend on several factors, including your age, the value of your home, and current interest rates. The money you receive will be tax-free and will not affect your Social Security or Medicare benefits.
Take for example, Bill and Marge, ages 65 and 63 respectively. They own their home, which is valued at $250,000. Bill had to close his part-time consulting business because of health problems, and the loss of this income forced them to cancel a once-in-a-lifetime cruise that they had been planning for the past year. A reverse mortgage offered Bill and Marge the following options (from http://www.rmaarp.com/estimates.htm):
Single lump sum or line of credit - $140,285
Lifetime monthly income - $784
They chose the line of credit, took out enough to pay for their cruise, and will keep the balance available for another vacation, for an emergency, or to supplement their income in the future.
More information and a list of reverse mortgage lenders in your state are available from the National Reverse Mortgage Lenders Association. Or, you can get assistance from a local Certified retirement Financial Advisor. See directory at http://www.retirement-financial-advisor.com.
In Search of Retirement Income—International Bond Funds
Some foreign governments may offer a higher interest rate on their bonds than the US government does. Additionally, some foreign corporations might offer a higher interest rate than the US companies. For investors, this could be an opportunity to diversify in an area that offers potentially higher returns.
Also, international bond funds can provide diversification and potentially higher returns. International bond funds invest primarily in bonds issued by foreign governments and corporations. There are different types of international bond funds—single country, single region, global (which includes US bonds), and foreign (no US bonds included). There are also industry and sector funds—utilities, government, telecommunications, and so forth.
What are some other reasons to consider international bond investments? Interest rates can move in different directions throughout other parts of the world. For instance, when US rates are low, rates in other stable countries may be higher. The same could happen to movements in the stock markets. Of course, the opposite could also come about.
When you buy international bonds or bond fund shares you are opting for the potential of higher returns in exchange for accepting some additional risks. For example, foreign markets are often more volatile than the U.S. markets. These investments involve other special risks, including currency exchange, political and economic uncertainties as well. Professional managers can sometimes help to mitigate these risks by monitoring international market developments and by adopting strategies to hedge against currency exchange rates. However, the additional time involved in managing these risks will usually result in higher management fees.
There are also international bond funds that invest in the area of emerging market bonds. Investing in emerging markets involves greater risk and potential reward than investing in more established markets. These markets tend to help when trade barriers are reduced (as is the case with NAFTA), or when privatization occurs in formerly communist or socialist countries. However, the risks associated with emerging markets include the risks relating to the relatively smaller size and lesser liquidity of these markets, high inflation rates, and also adverse political developments.
Investing a small percentage of your assets in international bond funds could potentially increase your income by giving you the opportunity to profit from growth in other economies. However, you should have a complete understanding of the associated risks of these investments. For more information on this and other retirement income strategies, you can get assistance for a Certified retirement Financial Advisor. See directory at http://www.retirement-financial-advisor.com.
A Way to Generate a Guaranteed Income Flow for Life –
And Accomplish Other Financial Goals in Retirement
And Accomplish Other Financial Goals in Retirement
One of the greatest fears many retirees face is the fear of outliving their retirement savings. To relieve this fear, some retirees turn to fixed annuities with lifetime payout options, which can provide a regular stream of income that is guaranteed for life.
Some retirees choose to purchase a fixed annuity with a lump-sum distribution from a retirement plan. But you should not overlook the alternative of funding these retirement income vehicles with periodic premium payments. In fact, if you have other financial goal, such as leaving a monetary legacy to your heirs, regular payments into these types of annuities could help you to satisfy your financial needs.
Here’s how it could work: a married couple who has just reached retirement age wants to draw enough income from their retirement savings to supplement their Social Security income. They also wish to leave a substantial portion of their assets to their children and grandchildren upon their death. They could choose to live off of investment income and periodic withdrawals from their savings for a number of years, then purchase a fixed immediate annuity with lifetime payout option at the last possible moment. This strategy could provide suffient income for the rest of their lives. However, the couple might not have as much assets as they would like to pass along to their heirs.
Instead of that, the couple could choose to invest regularly into a fixed deferred annuity that will make lifetime payments. Their retirement income needs could potentially be met with two reliable sources – the annuity and Social Security. Meanwhile, other assets the couple owns can be invested for long-term growth, to help build enough wealth to pass along to their children and grandchildren. Or, the remaining assets can be used for other financial needs, such as purchasing life or long-term care insurance policies.
In general, fixed annuities can provide the annuity owner with a predictable stream of cash flow to meet daily living expenses during retirement. These payments can last for a period of years or, as previously mentioned, can be paid out over a lifetime or even the joint-lifetimes of a husband and wife. With fixed annuities, most companies also offer interest rate guarantees, which vary from company to company. The initial guaranteed rate will typically vary according to the company involved and the duration of the contract. Some companies offer increases in the interest rate for premium payments above a certain amount.
The payments of a fixed annuity can begin immediately, or can be deferred until a certain date in the future. An annuity that provides payments at a date in the future is known as a deferred annuity. With an immediate annuity, however, payments begin immediately after the premium payment is made. Cash flow payments from an immediate annuity can be higher than what is offered through a deferred annuity. However, the sacrifice is that the unpaid account balace is typically forfieted in the event of a premature death. Your decision to purchase a deferred or immediate annuity will depend, upon your investment time horizon, your anticipated income needs during retirement, and your liquidity needs.
Fixed annuities are long-term investments designed for retirement purposes. Withdrawals of taxable amounts are subject to income tax and, if taken prior to age 59½, a 10% federal tax penalty may apply. Early withdrawals may be subject to surrender charges. Annuity guarantees are backed by the claims-paying ability of the issuer.
While fixed annuities may not be for everyone, they are worth a look if you are looking for a reliable source of cash flow that could last throughout your retirement. Please call my office to schedule an appointment for a retirement income analysis or to learn more about these products. For more information on this and other retirement income strategies, you can get assistance for a Certified retirement Financial Advisor. See directory at http://www.retirement-financial-advisor.com.
Friday, December 16, 2005
One of the significant sources of income for retirees yet complex areas is income from retirement plan distributions. One of the better sites is at IRA Distribution. Issues covered are
early retirement and different ways to use rule 72t
the stretch IRA and why it's likely to fail
information about trusts as beneficiaries
common beneficiary mistakes
and often overlooked items by IRA owners.
If you feel you may get value from individual advice, there are advisors that have studied this area listed at Retirement Planner.
early retirement and different ways to use rule 72t
the stretch IRA and why it's likely to fail
information about trusts as beneficiaries
common beneficiary mistakes
and often overlooked items by IRA owners.
If you feel you may get value from individual advice, there are advisors that have studied this area listed at Retirement Planner.
Sunday, December 11, 2005
I have created a number of web sites that are hopefully of great information to seniors on retirement planning, retirement investing, etc.
They are all linked together so the resources available can be had by starting at http://www.retirement-income.net
They are all linked together so the resources available can be had by starting at http://www.retirement-income.net
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