Inflation, portfolio allocation and long-term goals

The erosion of purchasing power through price increases is referred to as “inflation” (though it has a more detailed technical definition). A prosperous economy needs some inflation to sustain growth but excessive inflation can stall growth and derail a conservative portfolio. This year, we begin paying more attention to the inflation rate as it appears to tick above the Federal Reserve’s target rate (“green line”).

PCE Inflation - Bloomberg 2018 03 31

Source: Bloomberg; As of 3/31/18 US core PCE inflation

 

Inflation is a negative and important part of evaluating portfolio performance but, in the last years, we’ve been lulled into ignoring it (since it stayed below the Federal target rate). To help understand inflation’s impact on purchasing power, consider the following illustration of the effects of inflation over time.

DOC - Price comparison 1916-2017

Source for 1916 and 1966: Historical Statistics of the United States, Colonial Times to 1970/US Department of Commerce. Source for 2017: US Department of Labor, Bureau of Labor Statistics, Economic Statistics, Consumer Price Index—US City Average Price Data.

 

In 1916, nine cents would buy a quart of milk. Fifty years later, nine cents would only buy a small glass of milk. And in 2017, nine cents would only buy about seven tablespoons of milk. How do we protect your portfolio against this loss of purchasing power throughout our lives and particularly in retirement?

Investing and saving today for future spending

As purchasing power declines over time, investing in fixed income (bonds and annuities), in terms of inflation, increases the risk of outliving your assets. This is particularly exacerbated by fear of market volatility and the practice of increasing fixed income and reducing equity as we age. Although we agree that fixed income allocation is useful to reduce volatility we are not in agreement with tools such as Target Date funds which automatically increase fixed income based solely on age.

Investors know that over the long-haul stocks (equities) have historically outpaced inflation, but you may not know that there have been stretches where this has not been the case. For example, during the 17-year period from 1966–1982, the return of the S&P 500 Index was 6.8% before inflation, but after adjusting for inflation it was 0%. Additionally, if we look at the period from 2000–2009, the so-called “lost decade,” the return of the S&P 500 Index dropped from -0.9% before inflation to -3.4% after inflation. These are a reminder that S&P 500 equity return alone is not always able to protect purchasing power.

Despite these tough periods, one dollar invested in the S&P 500 in 1926, after accounting for inflation, would have grown to more than $500 at the end of 2017 and would have significantly outpaced inflation. On the other hand, the story for US Treasury bills (T-bills), however, is quite different. T-bills are often used as a proxy for a safe fixed income allocation. From 1926 to 2017, T-bills were unable to keep pace with inflation, and an investor would have experienced an erosion of purchasing power. As you can see in the chart below, one dollar invested in T-bills in 1926 grew to only $1.51 at the end of 2017. Yet a purchase for $1 in 1926 would cost you $14 in 2017! [caveat: other bonds/fixed income did better than T-bills.]

Growth of $1 from 1926–2017

Dow Jones Indices 1926-2017

S&P and Dow Jones data © 2018 Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Past performance is no guarantee of future results. Actual returns may be lower. Inflation is measured as changes in the US Consumer Price Index.

 

Your portfolio with AIKAPA has a fixed income component to protect against loses based on short-term unexpected equity downturn. Instead of increasing the fixed income component of a portfolio with age or as fear of loss grows, we prefer to educate clients on how the portfolio works to both create and protect wealth. We do not encourage reduction in equity exposure based solely on increased age. Even so, we evaluate individual allocation, risk of outliving assets, and risk tolerance annually and encourage clients to let us know if they are anxious about their quarterly portfolio returns. Our target is to provide enough equity for growth/inflation with just enough fixed income to protect and not create anxiety over portfolio changes.

We think that experience with a diversified global portfolio needs to start well before retirement. Combining this experience with ongoing education and open communication we believe is the best way to determine fixed income allocation.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Funding Retirement Cash Flow (and RMD)

The importance of a strategic and tax efficient portfolio withdrawal becomes very clear  to retirees or those funding their daily expenses from their portfolio (i.e., those who are financially independent).

Though we have all become pretty comfortable with deferring income to gain a tax advantage while working (through 401K, 403b, 457, Keogh, and IRAs), we delay learning about how we’ll deploy these accumulated assets until some later date. We usually include one possible distribution in retirement projections but we leave the actual details until closer to retirement. This includes ways to manage Required Minimum Distribution (or RMD).

Essentials of RMD:

Starting at age 70.5 and each year after you will be required to withdraw from your tax-deferred accounts a portion regardless of whether you need it to fund your expenses (this is the crux of RMD). This amount is fully taxable as if it were income (it is after all your prior deferred income). The required withdrawal amount is a portion that is dependent on your account balance and your age.

How is the amount of RMD determined?

Every year it is calculated on the total account balance, at prior year end, of all of your tax-deferred accounts divided by an annuity factor. This factor is based on your age and the age of your spouse (slightly different factor if the difference between you and your spouse’s age is greater than 10 years). As an example, I’m using factor 26.4 for a person age 71. If this person’s total tax-deferred portfolio on the prior December 31 had a balance of $500K then their RMD would be $18,939. If the same individual had a $3M portfolio they would have to withdraw at least $113,636.

Why not ignore this requirement and pay the penalty?

Required Minimum Distribution (RMD) has a 50% penalty. If the above RMD withdrawal is not made in the specified period, then the penalty for the $500K portfolio would be about $9.4K and $56.6K for the $3M portfolio – Yikes!

Keep in mind that RMD is the MINIMUM amount you MUST withdraw from your tax-deferred accounts each year but you can draw more if you wish. Everything you withdraw from your tax-deferred account (except for advisory fees) is fully taxable and impacts tax liability and cash flow.

When and why might RMD be a problem for retirees?

The basic problem is lack of control over timing of distributions. The strategic deployment of a portfolio is tax dependent, market dependent and most of all it is ‘needs dependent.’ If we have a choice, we only want taxable income to the level it is needed by you for that year. Sometimes we take more because we are planning for a future event.

Taking RMD can increase tax liability excessively in specific years, because you are temporarily in a higher tax bracket. This happens most often when a home or other large capital asset is sold (or may last longer if it is due to distribution from a company deferred compensation plan). In those years it would be best not to withdraw from a tax-deferred account since there is enough cash flow and tax liability from the sale. Adding RMD serves only to increase tax liability unnecessarily. It also impacts Medicare premiums (recall that Medicare is means tested – see the March 2016 Nibbles article (or online blog) for details on Medicare means testing).

An additional problem arises during years when market corrections take place or if portfolios are not fully diversified. During the 2000 and 2008 crises, equity markets were at their highest the prior year-end, but after the crisis they dropped significantly forcing a crisis for those who had not made their RMD withdrawals. We prefer not to add these potential risks to our client portfolios during retirement – we make RMD withdrawals early in the year and we ensure retirement portfolios are diversified and therefore less volatile.

What action may minimize the impact of excessive taxes caused by RMDs?

Currently there is only one solution after age 70 but several if you plan ahead.

In the years prior to age 70 you can take advantage of several strategies that effectively decrease the tax-deferred account balance and provide alternatives without RMDs. The objective is to even out the tax rates and reduce years of higher tax rates.

During retirement there is no way to avoid this increased tax liability from RMDs unless you don’t need the RMD for your personal retirement needs. If you don’t need the RMD, it can be donated to a qualified charity (there is a specific process that must be followed) and meet your RMD requirement without increasing your tax liability. Obviously this is a limited solution since to avoid the penalty and taxes you are giving away the RMD but hopefully it is going to a cause you care about.

How do we plan portfolio withdrawal given RMDs?

Like all questions regarding retirement or financial independence we need to always begin by knowing what you want to do and how much you need to spend (your burn rate). We’ve also found greater success when we have several funded pools of retirement assets with different tax natures. In planning distributions we consider cost basis, burn rate, tax brackets, social security, and RMDs, along with the current tax rules so as to create the most appropriate distribution from the portfolio. If we plan ahead, we find that spreading-out tax liability over several years (with a lower effective rate) often helps in this endeavor.

Financial plans create retirement scenarios that provide a high probability that the portfolio assets will support your planned retirement spending and provide you with confidence that your savings level today will support your chosen lifestyle in the future. It is during implementation of the retirement plan that rules and priorities (for example, how to handle RMD, taxes, cost basis) need to be applied as to further improve the probability that your portfolio will outlast you.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Tax Planning: Year-End Items to Consider

Tax planning consists of ensuring that tax liability is appropriate (given the tax code, family finances, and family goals) and that required actions are completed by the deadlines. At year-end, we identify relevant actions and relevant timeline.

Current Year actions …

  1. Estimate total earnings and total tax withholdings along with any tax-deferral that has or will be made for the current year. Use these and your deductions to estimate Federal and State tax liability.
  2. Ensure that expected tax liability has been paid either through payroll or through estimated tax payments. It is always best to pay taxes through payroll.
  3. For the self-employed, estimating taxes and ensuring that enough but not too much tax is paid throughout the year is part of tax planning. This is particularly important for businesses that have no payroll and pay their income tax and self-employment tax (i.e. Medicare and Social Security) simultaneously. Without tax planning, it is common for these businesses to underpay their Federal tax liability.
  4. Again, estimating profit from business entities (S Corp, C Corp, LLC, or sole proprietorship) allows business owners to adjust cash flow and meet tax deadlines. Business owners often create or contribute to various tax-deferral plans. The largest pre-tax contributions are for plans that have to be created prior to year-end.
  5. Any deductible contributions to H.S.A., Traditional IRAs or other accounts need to be made by their specific deadlines. These contributions might lower taxable income today (Traditional IRA, pension and 401K) or be tax free in the future (Roth) or both tax free now and in the future (H.S.A.).
  6. Year-end provides an opportunity to harvest investment accounts and therefore reduce or increase capital gain. Capital gain can be countered against capital losses to provide a net gain or loss which will either increase or decrease tax liability for any given year. We can reduce tax liability by adjusting what we buy/sell (i.e. the lot) at year-end depending on the overall tax burden. Keep in mind that tax rates differ based on taxable income. The federal tax rate for gain can be from zero to 23.8%.
  7. Estimating overall tax liability prior to year-end allows families to adjust deductions and employers to make needed capital purchases before year-end.

Actions based on next year’s rules …

Since we don’t yet know the tax rules that will apply in 2018, it will be especially difficult to fulfill the second part the year-end tax planning (where we either act or defer actions this year based on comparing the tax code in both the current and coming years).
Based on the two tax proposals (House and Senate versions) we consider acting prior to year-end if there is a high probability that a tax advantage will be lost in the new year and it plays a significant role in the person’s finances.

Though neither proposal appears to “simplify” taxes, both bills make significant changes to current tax rules and may, in fact, make it ideal to take some actions before the end of 2017 (taking advantage of current rules), while delaying those that benefit from the rules in the new year.

It will now be the job of the legislative committee to reconcile the differences without inserting any new provisions which will then need to go to the House and Senate for final approval. It is still too early to take action according to one or the other proposal but exploring the impact in light of individual tax circumstances makes sense.

  1. It may be worth considering accelerating itemized deductions into 2017 that are targeted for elimination. For example State income tax is scheduled to disappear in both proposals. Nevertheless, consideration must be given to unique situations, particularly regarding AMT (Alternative Minimum Tax).
  2. Consider recognizing tax losses prior to year-end (which is a normal annual year-end tax action) but the ability to select tax lots may disappear in 2018. The new rules may require that sales “first-in-first-out” (FIFO) which results in higher tax liability as it recognize higher gains on the sale of a security. We are hoping FIFO will not survive the reconciliation process but if it does we’ll have to act quickly before Dec 31.
  3. If you are planning to transfer very large assets between family members you would be well advised to wait until 2018 when there is an increased tax exemption. This doesn’t change the annual gifting which is currently at $14K in 2017 (and will be $15K in 2018).

Though we all want to contribute our share of taxes to sustain our communities and our way of life, it is always prudent to annually evaluate and implement the best way to handle tax liability considering current and future implications.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Aging gracefully―a blueprint for your future

If you could peek into the future and the final 10-20 years of your life, what would that look like? Do you see yourself traveling, healthy, energetic and excited about experiencing new challenges? Or do you have visions of illness, body pains, lethargy, disengagement and a lonely life?

What if you could manage that trajectory to a more positive future with fewer deficits and more joy? Research is churning out reports on how we can slow down the negative parts of aging and enhance the joyful aspects of our lives.

Throughout my life, I’ve met many people on both sides of aging. It is clear that our attitude drives this journey. It can turn us into victims or champions over our lives. Often it begins with our attitude each day―do we resign ourselves to a self-defeating diagnosis and settle for dissatisfaction? Or do we take daily challenges as an opportunity to remain engaged and positive? Experts in aging are in agreement that we will be much happier as we age if we are comfortable in our chosen lifestyle (that is to say, we are in the habit of doing things that give meaning and value to us) and that we don’t let our “illness” or age-related challenges define our daily lives.

As technology continues its exponential growth, the key to managing and thriving in this ever-faster moving era is our ability to adapt and remain true to ourselves. I believe equally important is to allow ourselves time to unwind and gain perspective. Unfortunately, most of us would likely skip ‘self-time’ (time for meditation or reflection) in pursuit of getting more accomplished.

Though it doesn’t take a financial windfall to have a healthy retirement, it does help tremendously not to have financial worries. Financial plans and conscious financial choices will help minimize financial anxiety and create an opportunity for a healthy retirement. Beyond this opportunity, it is up to us to build lifestyles (and needed financial resources) that give us joy today and throughout our later lives.

Research on aging recommends that we include the following:

  1. Though we are all different and choose different lifestyles, we all benefit from activities that provide us with at least a minimal level of social interactions. It is social engagement, according to these experts, that can add years and quality to our lives. In addition, volunteering has been shown to reduce pain as well as increase endorphins. Even when homebound, it is essential to be active and motivated.
  2. It is no surprise that a graceful happy retired life must also include regular and vigorous mental engagement. Your financial plan should be your guide to attain your goals, but it will be your consistent financial behaviors that will keep you mentally engaged with your money later in life. We are all aware that as we age we have a higher risk of memory loss, dementia and even Alzheimer’s. We can’t control inherited diseases (50% of those over 85 are affected with a dementia-like Alzheimer’s disease but that also means, 50% are not!) but we can rise to the challenge and keep our brains mentally active.
  3. Improving your quality of life includes addressing your physical health and diet. It is recommended that we exercise regularly, including at least 45 minutes of aerobic activity. A diet with reduced portions and elimination of processed foods appears to also be connected with healthier happier lives.
  4. Though sometimes difficult, it is essential that we be able to ‘let go’ of hate, resentment and regret that reinforces negative emotions. Though it’s never easy, experts say that ideally you’ll forgive or ‘walk away’ to attain a healthier life. I find that smiling every day makes me happier and has the added bonus that it makes others smile too.
  5. Finally, stay true to your lifestyle and decision process throughout your life. If you are comfortable in your core values and habits then even the worst challenges will be manageable.

In short, a successful blueprint for a long and rewarding life entails the intentional effort to remain active, engaged and positive.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Cost effective implementation of Long Term Care insurance

Long Term Care (LTC) decisions form a critical part of all retirement plans. That said, we can’t properly address individual LTC needs until a retirement plan is designed and participants are able to quantify the aspect of Long Term Care they will fund. If LTC insurance is part of their ideal LTC plan then we must identify the best policy and the most cost effective way to pay for it. This article is intended to review LTC and layout how a business can help pay for LTC insurance in a cost effective manner.

(1) Long Term Care – a review
Long-term care (https://longtermcare.acl.gov) is a range of services and supports needed to meet personal care which is not included in healthcare. About 2/3 of the population will need LTC after age 65 (and 1/3 before 65). Of those reaching age 65, 70% will need LTC or assistance with activities important to life. LTC includes everything from social services, physical and emotional support, finances, housing, a myriad of legal decisions, family interaction and social dynamics. LTC should include all assistance with tasks that will allow for productive, engaged and enthusiastic daily life. It should include assistance with routine tasks such as housework, money management, taking medication, shopping, traveling, caring for pets, responding to emergencies (these are known as Instrumental ADLs) and NOT just the “basic” Activities of Daily Living (ADLs, such as assistance with bathing or eating).

Currently, 80% of all LTC needs provided in the home are supported by unpaid family, friends or neighbors. The average support needed in the home is about 20 hours per week. Fortunately, as services develop, we find an increase in community support services. These include adult care services, transportation services, and home care that is round the clock or as needed.

If you require or prefer the use of LTC services provided by an institution or facility you will need to investigate Assisted Living, board and care homes, or Continuing Care retirement communities, not just nursing homes.

(2) What is LTC insurance?
LTC insurance is a contract to pay premiums every year for care you may need in the future. It will pay out an agreed daily amount for your care only if you are unable to do a certain number of Activities of Daily Living (ADLs). These are the basic ADLs (includes bathing, eating and dressing). LTC insurance is not usually available if there are pre-existing conditions. Benefits are provided for a set number of years of care based on a daily dollar amount dependent on local costs and total maximum benefits (these are usually capped at around $350K). But how many years of LTC will be needed is unique to the individual, though we have past indications that males need at least 2 and females 4 years. Three years is the standard, but we know that 20% of those over 65 years will need ADL assistance for longer than 5 years. For these reasons we recommend this insurance purchase be made based on your retirement plan.

Naturally, LTC insurance premiums are less expensive for the young (and healthy) but starting early will cost more over time and is not advisable if your personal cash flow can’t support this expense throughout your life.

(3) Best ways to pay for LTC insurance
How do we pay for LTC insurance if we think it fits within our retirement plan? It should be clear that healthcare or Medicare (except for very short periods of time and only in specific emergency situations) do not cover LTC costs. On the other hand, Medicaid does cover LTC but has very strict requirements to qualify. If you are fortunate to qualify, LTC coverage is provided by the Older American Act (OAA) and Department of Veteran Affairs.

The most common way to pay for basic LTC needs is through insurance or out of the personal or family budget. Other ways include a reverse mortgage, annuities, other assets, and income from a dedicated source (such as rental income).

LTC insurance premium costs are based on your age, your location, your wishes for level and amount of care. The premiums are not usually a burden on a yearly basis but they take a toll over time. These premiums must remain in effect for life. Additionally, policy premiums today can increase by more than inflation (over the last year we’ve seen 18% to 90%[!] increases in premiums for existing policies).

Long Term Care Purchasing Options

There are at least 2 ways to pay for a new LTC insurance policy – as an individual or as a business. The advantage of an individual LTC insurance policy is that it is based on your needs and can be tailored to you. The advantage of a business LTC insurance plan is that it can be paid by the business and therefore tax deductible. If you are the business owner it can also be tailored to your wishes (see the chart below assembled by Aikapa).

LTC insurance premiums are supposed to be deductible but we find that most of our clients with high AGI (Adjusted Gross Income) and low medical expenses are not able to deduct their premiums on their annual IRS tax filings (Schedule A has a 10% AGI floor). In addition, the deduction is also limited to age specific maximums (see table below) regardless of actual cost for the purchased LTC insurance policy. To help you understand the implications I’ll outline at LTC insurance for three separate age scenarios (ages 55, 61, and 71):

Currently a basic 3-year policy with $150 benefit per day would have an annual premium of around $2,100 at age 55, $2,900 at age 61, and $6,900 at age 71 (quotes may differ given different assumptions and are likely to be lower for males and couples but may be higher or not available based on health history).

Long Term Care Deductible Limits

To help understand how tax deductions actually work if buying this insurance individually, I’ll use the three LTC examples outlined above: To allow for this comparison, I’ve assumed that the cost of the above three policies are the only tax deductible medical expense. This is important because the deductibility is dependent on exceeding a 10% floor based on AGI. Anyone with an AGI (i.e. number at the bottom of the first page of your 1040 IRS filing) of more than $60K would not be able to deduct their LTC premium under any of these scenarios unless there were other deductible medical expenses. Most of our clients that purchase an individual policy are not able to deduct premiums. In retirement deductible medical expenses rise and then some of these premiums are tax-deductible.

On the other hand, the same insurance policy purchased by a business provides tax deduction of LTC insurance premiums up to age limits and may even cover the entire premium (see below for details).

Sole Proprietors, Partnerships, S Corporations, and LLCs can provide owners and spouses with LTC premium tax-deductions that are only limited by age specific maximums (see above table – which shows that at a business can pay up to $1,530 for an owner’s (aged 51-60) LTC premium tax-free). If we look at the same three examples AND purchase the policy using one of these firms the tax deduction in 2017 for the 55 year old would be $1,530 (less than the cost for a base policy of $2,100), the 61 year old would have their premium fully paid tax-free (since their premium of $2,900 is less than the maximum limit of $4,090 for her age group), and the 71 year-old would pay no tax on $5,110 (though premium total was $6,900).

C Corporation and non-profits may cover LTC insurance premiums  for owners or members tax-free (without age limits mentioned above).

Using the same three examples AND having the C Corporation or the nonprofit pay for the premiums, then the entire LTC insurance premium for all age groups would be tax-free.

In summary, Long Term Care planning involves much more than just buying a LTC insurance policy. It encompasses consideration of a myriad of integrated services and support that should be aligned with your wishes both early and later in life. LTC insurance is one way to cover basic ADLs. Before making a purchase of LTC insurance you must have calculated what you wish to cover yourself and what will be paid for by insurance benefits. It is more cost effective if LTC insurance is provided by an employer (with no cost to you) and even better if you are the employer. As the employer you can design a policy that best fits your plan and offers tax-free premiums.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Two common estate planning failures

(1) Failing to plan for incapacity:

Only 33% of Americans have executed a medical directive (as found by the American Bar Association). AARP (American Association for Retired Persons) reports that 45% of Americans over the age of 50 have a durable power of attorney.

Legal documents to plan for incapacity include a power of attorney, a medical directive and a trust. Even though it is a good first step, a comprehensive estate plan requires these documents and more.

Media mogul Sumner Redstone had an estate estimated to be over $42B, but late in his life a series of conflicts began over his competence and the control of his estate. According to the granddaughter, “the aunt and other family members succeeded in reversing decades of my grandfather’s careful estate planning and poised themselves to seize control of Viacom and CBS.”

Naturally, we all have some expectation of what our life’s work will amount to. The legal system has documents that can be used to support our wishes if we are unable to make decisions, but who decides when we are not able to make them? As difficult and challenging as it is, we might want to consider what indicators we wish to use to trigger assistance. Otherwise, you could find yourself making a good many mistakes before anyone deploys these legal estate documents.

In one case, the California Court of Appeals ruled: “Appellant produced evidence of forgetfulness, erratic, unstable and emotional behavior, and of suspicion, probably delusional at times, on the part of the testatrix. This is of no avail unless it were shown, as it was not, that it had direct influence on the testamentary act.” In essence, the court is saying that the individual displaying these disturbing signs is still capable of making their own financial decisions. After all, we are all entitled to make poor decisions.

In a perfect world we would never have to deal with diminishing faculties or the thought that, at some point, someone else will have to make decisions for us. The truth is, most of us struggle with the timing and triggers that have to do with relinquishing our ability to self-direct or make our own decisions.

Estate planning begins with the basic documents, but effectively planning for incapacity entails much more.

(2) Dying without a will:

Dying without a will doesn’t impact the deceased, but signing a will does make it easier on those left behind. And yet, people who ought to know a whole lot better continue to die intestate (without a will). Famous examples include Abraham Lincoln. Lincoln was a successful and skilled attorney and yet he left an estate of $110,297 without a will. In more recent times, the entertainer, Prince, died without a will, leaving an estate of $300M. Though Prince’s sister and five half-siblings appear now to be the instate heirs, this would have turned out differently if not for DNA testing. Carlin Q claimed to be the “love child” of Prince and would have inherited the entire estate (!) had DNA testing not proven that he was not a biological offspring of Prince.

It is shocking that over 64% of Americans do not have a will. Yet a will is simple to create. Dying without a will means the estate will be handled by attorneys in front of a probate court. Dying intestate results in delays, higher fees and possible litigation. It surprises many that intestacy can create other messy dispositions based upon the order of death or age of those inheriting assets.

In many states, each child and the surviving spouse will inherit an equal percentage. If a trust is not established, a minor child may be entitled to receive inherited assets by age 18. Ex-spouses may have control of the inheritance until the child reaches adulthood.
In some states, if a married couple with no descendants (children) and no wills are injured in the same accident and one spouse dies prior to the other even by a few minutes the outcome will be that only one spouse’s descendants will inherit the couple’s joint estate and the other spouse’s family will receive no assets. In California, Alaska, Kentucky, Texas, and Wisconsin the state requires that the spouse must outlive the other by more than 120 hours, not just a few minutes, for the assets to pass to the ‘surviving spouse’ and skip the first-to-die family.

Some famous examples include musician, songwriter and poet,  Kurt Cobain, who left a detailed suicide note but didn’t sign a will. As it happened, his wife and daughter were his only heirs and the estate was split in half. Martin Luther King Jr. died without a will leaving his children in a long fight over the estate.

So how does the state decide who manages the assets for under-age children when there is no will? Current state statutes set an order of appointment with the surviving spouse normally being the first person, followed by the closest BLOOD family members. This is determined by relationship, not competence. Think about it. Do you really want anyone to manage the estate for your loved ones just because they are your closest blood relative?

Prince’s estate is an example of how much of his legacy will be wasted as six different heirs without knowledge or competence in the music field are now fighting over how to handle his vast music empire and unreleased songs. Of course, he is gone so at least he doesn’t have to worry about it, BUT his fans will be affected.

Finally, the wishes of the deceased may not be respected without a will. NFL player Steve McNair purchased a million dollar home for his mother to live in, but he retained title to the home. On his death, his wife demanded that the mother pay rent and when she couldn’t, she had to move out! It would have been so simple for McNair to provide a written will stating that his mother could keep the home when he was gone.

Estate planning is a significant part of your overall financial picture. We’ve reserved the month of June to review beneficiaries on your accounts and to encourage you to review your wishes for your estate plan. Our priority in estate planning is to ensure that you are comfortable with the basic estate planning documents (DPOA, will and trust) that will protect you and your family to a very large degree in the event of your incapacity or death.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

‘Burn rate’ should be key to retirement savings

People often talk about “saving for retirement.” Few question the need to put aside adequate savings to ensure the successful funding of their retirement plan. The operative word though is “adequate.” How much in the way of savings is “adequate”? Of course, it differs from individual to individual, but you will most likely find that spending is the common variable that shapes the limits of what constitutes adequate savings. With few exceptions, our spending needs in retirement will exceed the amount provided by our inflation adjusted social security benefit. Everything else being equal, the success or failure of any effort to fund retirement is above all dependent on lifestyle and spending habits or ‘burn rate’.

To help you visualize “the power of spending” and its impact on a retirement portfolio, I’ve created four basic retirement funding scenarios. These scenarios assume the same retirement period (beginning 2017 and ending 28 years later), an annual social security benefit of $40K (adjusted for inflation), and a $1M diversified portfolio with a rate of return of 5.5%. The only varying parameter between scenarios is the amount of spending each year with associated tax liability. Each scenario was created using 500 cycles of Monte Carlo probability simulations that modify every parameter except length of retirement to address a range of economic variables and unexpected expenses. The charts include only four (out of 500) projection lines from “best case” to “worst case”.

For the first scenario, our hypothetical client spends $50K/year (before tax), having accumulated $1M at the point that she is ready to retire in 2017. As the chart demonstrates, for the best possible outcome the $50K annual spending client actually grows her nest egg to $1.4M over 28 years (this is the blue line or highest line at year 2045) ― leaving, I should add, a sizable chunk of change for a life beyond 28 years, long term care needs, or for her legacy (be it a favorite charity or her grandchildren). If all economic variables are worse than expected and things don’t quite pan out, she can still expect $250K in assets (see the gray line or lowest line at 2045) after enjoying 28 years in retirement. Not too shabby!

But what if our hypothetical client was in the habit of spending about $75K/year (before tax) instead of $50K? (again, assuming she starts her retirement in 2017 with a $1M portfolio). In this situation, assuming everything goes better than expected the Monte Carlo simulations show a surplus of over $1M after 28 years, BUT in a worst-case scenario the portfolio is depleted after 20 years (around 2037) ― enough to make a financial planner seek ways to protect against the worst-case scenario.

Approaching the Bay Area experience is a hypothetical client who spends $100K/year (before tax). What then? The $1M portfolio would not last her beyond 21 years (2038) even in the best scenario. Unfortunately, there is a higher probability that it will be gone after 15 years (2031). While the worst-case simulation shows that the portfolio could be depleted in as little as 10 or 11 years (2028).

Though there are many other possible spending targets (and also more parameters to consider than those in these scenarios), our final hypothetical client spends $150K/year (before tax) to maintain her lifestyle. In which case, the $1M portfolio would last 9 years tops (2026) and could well be depleted within 5 years (2022).

The story told by the 4 charts is very clear. Saving and spending levels must be aligned for a successful retirement strategy. Clearly, accumulated assets alone are not in and of themselves indicative of success over the long-haul. On the other hand, spending habits and your ability to adhere to a budget are very useful indicators. They can provide a realistic view of your retirement “burn rate” and better align your savings today with future need.

Think of it this way, your approach to spending and your connection to buying are formed throughout your life. It becomes an unshakable habit. For this reason, spending seldom decreases in retirement except with a great deal of stress, anxiety, and depression. To avoid this unhappy outcome, the smartest and healthiest action is to establish a realistic budget for the lifestyle that you seek, then plan your savings around the cost to sustain that lifestyle. The goal of your retirement savings would be to build enough wealth to support your lifestyle.

Though planning for retirement includes more than your burn rate and savings rate they are critical beginnings. What I like best is that these are aspects of retirement planning that we can control.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Death and sepulcher – facing the inevitable

Benjamin Franklin famously wrote, “in this world nothing can be said to be certain, except death and taxes.” In all the years that I’ve worked with clients to create a financial path for their long-term wishes in life and after they are gone, I’ve covered a huge spectrum of topics. Until now, I’ve never asked clients about their “right of sepulcher” (the right of sepulcher means the right to choose and control the burial, cremation, or other final disposition of a deceased person). I recognize that, for some, this topic may seem a tad morbid. The cautionary tales of contentious and messy celebrity funerals that follow (suggested by Amy F. Altman, an associate at Meltzer, Lippe, Goldstein and Breitstone) may provide you with some perspective and may help you consider how you and your loved ones feel about your right of sepulcher.

  • Litigation surrounding the 2007 death of actor, model and TV personality Anna Nicole Smith made headline news for weeks as her mother and the guardian of her infant daughter battled for the right of sepulcher. Ultimately, the daughter’s guardian prevailed and Anna was buried in the Bahamas next to her late (and recently deceased) son.
  • Boston Red Sox Hall of Famer Ted Williams’ death in 2002 resulted in a spectacular rift between his children over the disposition of his remains. His eldest daughter argued that Williams’ will clearly stipulated cremation, BUT his son had been given power of attorney and his father’s health proxy and he wanted his father cryogenically preserved. Eventually, the son won out, largely because the daughter could not afford the cost of litigation.
  • Legendary actor Mickey Rooney died in 2014. His estranged wife wanted him buried in a shared plot purchased before they had separated. Rooney’s conservator (court appointed guardian) had other ideas and a costly tug-of-war ensued. In the end, his wife capitulated, recognizing that burial in a Hollywood cemetery befitting Rooney’s status was appropriate.

These cases, regardless of age, underscore the importance and value of discussing with loved ones your preferences for disposition. The laws regarding rights of sepulcher vary widely by state. If permitted under state law, completing a “disposition of remains form” together with advanced directives seems an appropriate start. This will create clarity with respect to the sensitive issues surrounding burial.

As with all legal documents you need to first understand what it is that you really want, which can take a long time to fully grasp and may require delicate discussions with loved ones and personal introspection. Leaving aside what I consider the more important question regarding life support for now, you can first deal with the question, do you want to be cremated, or perhaps cryogenically preserved? Do you want to be an organ donor? Would you like your funeral to take place at home or at a funeral parlor? Do you want a formal service or commemorative event? Though you’ll be gone, these are all options that may well prove to be important (and costly if mishandled) to those you leave behind.

At times, I think that there is so much to do while we are alive that taking time to consider what will happen after we’re gone seems inconsequential and entirely unimportant, but this may not be the case for loved ones. Let me offer an example.

Recently, a client shared that over the course of a dinner conversation with his parents they casually revealed their preference to be cremated. This came as an enormous shock. “Never in a million years,” he said, “would I have predicted that this was my parents actual wish.” This is a man who has made every effort to ensure he is in touch with the real wishes of his aging parents. “I would have got it wrong,” he said, adding “a split second’s worth of conversation set me straight.” He felt like a huge weight was lifted from his shoulders.

The person to whom you give the right of sepulcher may gain much by having even a short conversation about your wishes, regardless of your age.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Your Credit History – wealth and identity

Our recorded credit history is tracked by the three national credit bureaus (Equifax, TransUnion, and Experian) and each calculates a credit score. Though the credit score is a required component for loans it is NOT based on our entire financial history and it may not represent us correctly. It is up to us to ensure that it does. Why is this important? For your wealth and your identity.

Each credit bureau uses an algorithm (model) to generate a number (FICO score) based on your recorded credit history that is, imperfectly, a measure of the risk the system associates to someone with your recorded history. Lenders who depend on credit bureau reports for assessing whether or not to lend, use this score as one measure of your “credit worthiness”. Those with no financial history or less than sterling repayment records are likely to face higher cost loans IF they are able to obtain a loan at all. It is true that loans are available for those with lower credit scores but additional requirements will be imposed, including a low debt-to-income ratio. Even then, the loan will be at a higher rate.

Couples can sometimes be surprised when one partner lowers the expected family credit score. These couples may be effectively managing their financial life and yet obtain a low combined credit score that will raise their cost of borrowing. In most cases, the partner with the higher credit score applies for the loan singly to obtain the best rates (‘excellent’ rates are generally available with a FICO of 780 or higher), while the other partner must rebuild their history.

As time goes on, more and more of our interactions are managed electronically. Hand-in-glove with electronic transactions come ways for us to be identified and verified electronically. It is now more common for our financial identity to be confirmed by using facts found in one of our three credit bureau history records. It is crucial that you know and can recognize all information in each of these reports.

Once you have checked your history thoroughly, you’ll find an annual check-up to be quick and sufficient. Obtaining your credit history and checking it for errors can be completed on your own or with our assistance. If you need to make corrections, let us know or contact the specific credit bureau directly.

Finally, when you are getting ready to take out a loan for a large purchase be sure to first check your credit history (more than three months ahead) – you don’t want surprises.

So how might you be able to improve or maintain your credit score? Here are a few essentials to keep in mind:

  • don’t miss payment due dates – set up automatic minimum payments even if you pay your accounts in full (this will protect against the unexpected)
  • monitor your cash flow – don’t over extend yourself – try not to use more than 30% (better at less than 10%) of available credit (credit used compared to total credit available is called the ‘utilization rate’)
  • don’t apply for a lot of credit from different sources all at once – it can set off major alarm bells and may impede new financial loans for several months
  • if consolidation is indicated, try to keep your total credit the same and never close your oldest credit card
  • installment loans (i.e. car, mortgage) can have a positive impact on your score – be sure your lender actually reports to at least one bureau (some don’t)
  • your credit history can include a lot more than just a car loan or credit card – utility, cable, rent, and cell phone payment history can all be tracked and used either to boost the score or knock it down
  • if retirement is on the horizon, make extra effort while you are still earning to maximize all aspects of your credit history and bolster your credit score
  • if retired, disabled or unemployed restrain your credit card purchases and instead find ways to reduce expenses – it is more difficult to recover from credit card debt when income is limited
  • verify your credit history on a regular basis and correct errors promptly

Credit history is not a statement about you personally but a less than perfect measure to determine ‘credit worthiness’. It is best to capitalize on the rules to obtain the best score possible. Moreover, since credit history is now used to verify identity, it is incumbent on us to ensure the records have captured our information accurately.

Feel free to give us a call if you need help with the process.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

A business owner quandary: cash or accrual?

Financial statements are one of the most powerful and least utilized business tools. Small business owners need to master financial statements if they hope to work not just in their business, but on their business. And yet, I see all too often just how little time business owners spend exploring them. In my experience the bookkeeping burden doesn’t excite us into spending time on financials beyond tax preparation. In this discussion, basic features of cash and accrual financial accounting are presented with the goal of demystifying them and providing an opportunity for exploration.

One of the first decisions when starting a business is to determine the most appropriate accounting method for the business and for tax filings (the two most common are cash and accrual).

The cash method accounts for revenue when the money is received and for expenses when the money is paid out. It is useful for tracking monthly cash flow since it works just like a checkbook and the balance sheet appears like a checkbook register. Unfortunately, it can convey the wrong message regarding the long-term well-being of a company.

The accrual method of accounting provides a better picture of company profits during an accounting period by recording revenues when they are earned and expenses when incurred but it is not intuitive since the financials do not represent day-to-day accounts. Accrual accounting instead provides a view on long-term financial well-being.

So, what does the IRS require?

The IRS in 2001 relaxed prior requirements that forced many small businesses to use accrual accounting. To reduce the accounting burden on small businesses the current rules allow firms with under $5M in revenue to use cash basis accounting, unless they are an inventory based business.

For tax purposes, the accounting method is locked-in with the first business tax filing. After the initial year, a business uses the same accounting method unless it receives prior approval from the IRS.

It has been my experience that cash and accrual accounting are often misunderstood. It is important that small business owners address with their accountant, bookkeeper, and tax preparer how these two accounting methods will be implemented. The key is to be consistent in applying the rules.

What are some of the problems that may surprise you?

To cite an unusual example, a client sent you a check (on December 30, 2016) for interior decorating services you provided to her and you received the check on January 2, 2017.  Small businesses using cash accounting might be surprised that the IRS expects you to apply this check as income received in 2016. Strictly speaking, the rules require you to observe ‘constructive receipt’. Meaning, the money is available to you and under your control, whether or not you have taken actual possession of it. The fact that you haven’t deposited the check is strictly speaking a moot point as far as the IRS is concerned. Adhering to this ideal is a burden on small businesses. It’s our observation that accountants for small businesses operating on a cash basis consequently define constructive receipt as earnings and expenses in the register by December 31.

Constructive receipt argues against some commonly employed practices, such as delaying the deposit of income or the acceleration of expenses for the sole purpose of avoiding taxes. On the other hand, delaying invoicing does seem to be a more acceptable practice. It is generally more common for cash basis businesses to delay invoicing rather than delay cashing a check received so as not to run “afoul” of the constructive receipt rule.

To be clear, there is a large difference between the unintended receipt of a delayed payment (typically due to a tardy customer payment or a receivable that is in the mail) and deliberate manipulation. Here’s an example of a practice that is clearly not allowed. A small business owner is entitled to receive $20,000 on a contract completed in 2016. The owner contacts the client requesting that the payment not be made until January 2017. That’s not acceptable per published IRS rules.

On the other hand, IRS rules can sometimes be too onerous for a small business. For example, if you pay $2,000 in 2016 for an insurance policy effective for one year beginning July 1, you should deduct $1,000 in 2016 and $1,000 in 2017. It is my experience that this is seldom the practice for small business owners who without intending to avoid payment of tax, will register payment in the year paid without an evaluation of when the benefit will be derived.

Though few use the accrual method of accounting, its purpose is to match income and expenses in the same year. It is therefore critical to choose the year well – when there is any doubt on which year to choose, the decision is made on when ‘economic benefit’ was attained. This can be burdensome to small business owners since the assessment of ‘economic benefit’ is sometimes quite difficult to ascertain.

Under an accrual method, you generally include an amount in your gross income for the tax year in which all events that fix your right to receive the income have occurred and you can determine the amount with reasonable accuracy. As an example, you sold a computer on December 28, 2016 and billed the customer the first week of January 2017, but did not receive payment until February 2017. Using the accrual method, you must include the amount received for the computer with your 2016 income because ‘economic benefit’ was obtained when the computer was sold. Obviously, tracking and attribution requires a lot more work on the part of the small business owner using the accrual accounting method.

As part of learning to work on your business, not just in your business, it is important that you first develop confidence that your financial statements (Profit & Loss, Balance Sheet, and Cash Flow statements) accurately represent your financial activity. It can take time to develop a reliable and consistent system. Once you have confidence in your financial statements you should address deriving more from them than just how to handle business tax liability.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com