Category Archives: Cash Flow/Budget

Your Portfolio Allocation and Emotional Reactions: The Coronavirus and Portfolio Discipline

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Here we go again – we’ve been down a similar road before, so none of this is news to those who have been with us through prior overreactions by market participants.

Volatility is part and parcel of participating in the market. When fear grips the market, selloffs by those who react to that fear provide portfolio opportunities for those who understand and adhere to a strategy. It is AIKAPA’s strategy to maintain your risk allocation and either ride out the volatile times or rebalance into them. Meaning that if you don’t need cash in the short-term, we buy when everyone else is selling.

As news of the Coronavirus (or other events outside of our control) stokes fear and uncertainty on a variety of fronts, it is only natural to wonder if we should make adjustments to your portfolio. If you are reacting to fear, then the answer is a resounding NO. On the other hand, if you are applying our strategy in combination with an understanding of the impact on business, then the answer is likely YES. When an adjustment is indicated we look for value and BUY while selling positions that are relatively over-valued. If the market continues to respond fearfully (without a change in value) then we will likely continue to buy equities and may sell bonds to fund those purchases. The only caveats to this strategy are that we must know that you don’t have short-term cash flow needs, that we stay within your risk tolerance, and that we are buying based on current value (keep in mind that value is based on facts not fear).

If you feel compelled to do something, then consider the following:

  1. Contact your mortgage broker and see if it makes sense to refinance (likely rates will drop soon after a significant market decline).
  2. Seriously examine the impact this has on your life today and let’s talk about changing your allocation once markets recover.
  3. Review the money you’ve set aside for emergencies and prepare for potential disruptions if these are likely.
  4. Business owners should consider the impact (if any) on their business, vendors and employees. Particularly important will be to maintain communication with all stake holders and retain a good cash flow to sustain the business if there is a possibility of disruptions.
  5. Regarding your portfolio, if you have cash/savings that you want to invest, this is a good time to transfer it to your account and have us buy into the market decline.

Market changes are a normal part of investing. Risk and return are linked. To earn the higher returns offered by investing in stocks, it is necessary to accept investment risk, which manifests itself through stock price volatility. Large downturns are a common feature of the stock market. Despite these downturns the stock market does tend to trend upwards over the long-term, driven by economics, inflation, and corporate profit growth. To earn the attractive long-term returns offered by stock market investing, one must stay invested for the long-term and resist the urge to jump in and out of the market. It has been proven many times that we can’t time stock market behavior consistently and must instead maintain portfolio discipline (if you want a historical overview of markets, see the “Market Uncertainty and You” video on our website www.aikapa.com/education.htm).

It is your long-term goals and risk tolerance that provide us with our guide to rebalancing and adjusting your portfolio, not short-term political, economic or market emotional reactions. In your globally diversified portfolio, we will take every opportunity to rebalance and capture value during portfolio gyrations. This IS the benefit of diversification and working with AIKAPA.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Funding Retirement Cash Flow (and RMD)

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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

‘Burn rate’ should be key to retirement savings

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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

A business owner quandary: cash or accrual?

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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

 

Understanding Longevity Risk and Your Retirement

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The oldest person alive today is Emma Morano of Vercelli, Italy who turned 117 this November. She was born in 1899! Queen Victoria was still on the throne of England and William McKinley was president of the United States. If you’d asked Emma in 1917 if she could imagine living long enough to see 2017, would she have imagined such a long life? Most Americans do not live as long as Emma, but in general we are living longer and healthier lives. The number of centenarians is on the rise. Longevity – long life – can have obvious perks, but also poses a conundrum in terms of finances. To help us plan for longevity we use “longevity risk” to measure the likelihood that you’ll run out of wealth before you’ll run out of life. In our planning we like to ensure that we mindfully set longevity at the right level for each person.

Few, if any of us, have advance knowledge of precisely when our time will come, so questions like this often boil down to statistics. You’ll sometimes hear that the average life expectancy for females is age 83 and age 81 for males, BUT are these appropriate target-end dates for your retirement plan? The truly important challenge is coming up with the best end-dates for retirement that will allow you to enjoy your wealth early while leaving enough assets to comfortably support you later in life.

In retirement planning, the variation in life expectancy can range quite dramatically and yet we find that client expectations generally fall into two categories, (1) those who want to make absolutely sure they don’t outlive their wealth, and (2) those who have a definite expiration date in mind, say 80 years of age, and believe that planning for life beyond that age is simply not relevant or realistic. The latter are often operating on some assumption based on, for example, both parents dying in their late 70s or not long after retirement.

At the risk of sounding morbid, but with the goal of having your retirement plan more fully represent your expected end of life target date, I want you to consider three facts that most often cause people to underestimate their longevity (in turn, this may help you understand why we sometimes encourage you to increase your target-end date):

Life expectancies that are often quoted may not be relevant since they are often calculated at birth. Life expectancy on reaching age 60 or 65 should be much higher than those quoted at birth since some will die before they reach this age. In fact, life expectancy for a 65-year-old, non-smoker is much higher. As an example, a 65-year-old female of average health has a 50% chance of reaching age 88 (see the table below) but once she reaches age 88 she has a much higher chance of reaching age 95.

longetvity_table

  1. Life expectancy is often calculated using mortality rates from a fixed year instead of projected to future expected mortality rates. Social Security Administration (SSA)’s period life tables are based on real mortalities in any given year. Though valuable, since they are real, they underestimate the observed trend for increased survival. As mentioned above, we perceive our survival based on our own anecdotal experiences. The question to ask ourselves, is this correct or is this an underestimation?
  2. Finally, we find that the population on which longevity risk calculations are based may not be appropriate. If we work with an aggregate US population life expectancy (as does the SSA period life tables) we must include a correction for socioeconomic and other factors that are known to impact mortality rates and could underestimate our lifespans. To-date there is evidence to indicate a positive link between income, education, long-term planning, and health. Yes, someone who plans and prepares appears (statistically) to live longer.

In case it is still not clear – let me explain. When planning retirement projections, the length of retirement greatly impacts planning choices (planning for 20 versus 45 years may require different strategies given the same wealth). Considering your specific longevity risk necessitates that we prepare for the contingencies that apply to you. There may be good reasons to target a lower longevity, but for most we will likely need to include, at the very least, a reasonable adjustment for expected increased longevity. This often means distribution of existing assets and thinking about end-of-life questions (a topic most prefer not to address too closely). If you are expecting a longer life, consider accumulating a pool of longevity assets (like some are doing to cover for potential Long-Term Care contingency) or purchasing a longevity annuity (this asset would only be used if you live past a certain age and, therefore, accumulate what are called mortality credits that can provide a good income late in life, but would be lost if you wind up passing sooner).

Obviously, estimations are just that, estimations. Still, a thoughtful scientific approach ought to be the foundation for retirement projections, never speculation or conjecture. Like Emma, some of us will be blessed with a long life, even inadvertently. One way or the other, I want all of us to feel that we’ve had a life well spent, and that will depend largely on how well we’ve planned for possible contingencies in your life.

This educational piece was drawn from my work with clients, www.longevityillustrator.org, the Social Security Administration period life tables, and a recent academic publication by Wade D. Pfau, Ph.D., published in The Journal of Financial Planning, November 2016, vol 29, issue 11, pp 40.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Converting Sweat Equity to Personal Wealth

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If you are a small business owner, you’re probably familiar with the term “sweat equity.” Essentially, sweat equity is a measure of the added interest or increased value that you’ve created in your business through plain hard work (that is to say, through physical labor and intellectual effort). Typically, business owners just starting out don’t have the necessary capital or don’t want to hire a large staff to run the business or to purchase high-tech, so they put in untold extra hours, do much of the work themselves and try to “think smart” in terms of marketing or production. They often use this opportunity to develop a clientele and a business process they enjoy. If well designed it can be profitable, but at some point the owner must put in place strategies that can convert business profit into personal wealth.

In other words, to be considered a truly viable business, at least two things must happen (there are others, but for the purposes of this article we’ll just focus on two). One, you must evolve the business to the point where it is sustainable with only the amount of personal labor you want to dedicate and in a way that allows you to maximally build Owner Wealth while covering business cash flow needs. Moreover, the goal is a process that gives you a sense of accomplishment and satisfaction. This is what we call a “life-style” business. Or two, you must organize and prepare the business to a degree or footing that it can be sold for a profit, at least enough and in a manner that will allow you to retain the profit as personal or “Owner Wealth.”

I should note, for those who are not self-employed, that employees can also generate sweat equity for their firm by creating additional ways to increase the bottom line. For startups, you may defer your vacation and even put off earnings. All these things add value to the company, but employees will expect to receive some form of compensation either in the form of existing benefits (bonus, parental leave, or nonqualified plans) or in shares of company value.
As a business owner, the first question you must ask yourself is “What do I want my life to look like while I’m creating this equity, and what do I want to accomplish in the long term?” Once you answer this question, and only then, can we come up with a proper plan to support your direction.

It is our experience that business owners without such a plan likely encounter challenges that can undermine their ability to convert their equity to personal wealth. These challenges come either in terms of selling the business or ensuring that the life-style business is sustainable. For instance, there is a good chance that instead of generating wealth to your maximum potential, you’ll be funding Uncle Sam (and the California Franchise Tax Board) and coping with cash flow problems.

Presupposing your business is already generating profits, a well-tailored plan can (at least potentially) make a big difference in terms of retaining or accumulating Owner Wealth. Aside from using earnings to support current lifestyle, your business can create benefits that permit the owner to retain earnings for future use and reduce current tax liability, particularly important in California, where the tax liability on business owners with profitable business can exceed 50% of their business profit.

For example, a business owner with sweat equity from their start-up or life-style business that yields around $500K per year (after business expenses) might have a tax liability of $110K (IRS only) or $155K in California (see table below). Using available benefit tools/strategy an owner can (in this scenario) build wealth annually of about $230K. Much of their wealth is built from deferring taxable income and lowering their tax liability to $45K (or $70K within California).

table

Allowed to grow over 5, 10, or 20 years this strategy could (at a conservative 5% annual return) yield wealth of $1.3M, $2.9M and $7M respectively for the business owner. On its own, tax and benefit planning can yield a high conversion of sweat equity to Owner Wealth.

When starting a business, the last thing we ever think about is how we’ll exit from it and collect on all the hard-earned sweat equity we’ve invested. We’re usually focused on creating value and determining how we can generate sufficient earnings. Yet for some businesses it is only from a well-designed and planned sale that the owner will realize any personal wealth from their risk and hard work. For the owner of a life-style business, selling your firm may seem akin to selling off your first-born, but there comes a time in all our lives when such decisions are unavoidable, even advantageous. At the very least, it may be worth considering selling part interest in the business as a way of reducing workload and simultaneously augmenting Owner Wealth.

As an owner ready to sell you will want to be confident that you are choosing the right time, securing the best price, and structuring the transaction wisely. You’d be well advised to seek expertise in selling your business (particularly new entrepreneurs), and give plenty of thought to how it will impact Owner Wealth, which is all too often overlooked.

When considering how to exit from their business, entrepreneurs need to at least follow these 7 steps to maximize Owner Wealth.

  1. Plan your exit well in advance since the best fit team and solution may take time to identify and develop.
  2. Understand and acknowledge your emotional connection to the business. It can be deeply personal and leave you unsatisfied if not fully addressed – regardless of profit.
  3. Prepare the business for the sale so that it is financially attractive to the financial advisors of potential buyers.
  4. Choose experienced individuals in your specific type of business to guide you through the process of selling your business BUT include your personal advisor to ensure that the best exit also meets with your personal financial goals. Again, building a team that is right for you.
  5. Think clearly about family succession – don’t make assumptions on how your family or key employees feel about the business.
  6. Gauge the interest for a friendly buyer from co-owners, family, employees, vendors, and even customers.
  7. Develop a thorough wealth strategy plan. The wealth strategy plan should NOT be just about the business but should address how your efforts will be used to build your personal wealth and meet your personal goals.

Take the time to know yourself, know your goals and make absolutely sure your financial advisor has a clear picture of your objectives. Together, your plan will convert all that valuable sweat equity into wealth to fuel your dreams.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Building Wealth: Your Real Estate Asset

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Real estate is often purchased as a lifestyle asset (to live in) or as a commercial investment (to generate rental income). It’s also quite common for people to think of their home as both lifestyle and an investment. Certainly, the most common near-term goal for families is home ownership – many think it amounts to a “no brainer” investment (meaning they think their home is a great investment) when it actually costs them much more than they realize.

In our examination of annual return rates on residential and commercial real estate we find that real estate is by no means a no brainer investment. Real estate assets can indeed contribute to wealth creation if the purchaser buys for value, carefully manages maintenance/renovation costs, and the sale is handled with an eye to minimizing taxes on gain from the sale.

Your residence has the potential to be a large part of your wealth, particularly in the Bay Area, but it can also be your largest liability.

Lending institutions have different requirements when lending for an owner occupied residence than for commercial real estate. A primary residence can often be purchased with lower down payments and lower mortgage rates than non-owner occupied real estate. In addition, on the sale of the owner occupied residence the gain will often fall under the capital gain exclusion rules which allow couples to exclude $500K from their income, tax free. This is one of the few opportunities to realize gain completely tax free. Couples who want their residence to be an investment rather than a lifestyle asset should consider selling their home once the gain (market value above basis) in their home approaches the $500K cap gain exclusion. This doesn’t mean you have to buy bigger or smaller or move away from your neighborhood but it does mean that you must sell a property to capture this tax free gain.

If a couple bought a home for $600K, made no renovations and 5-10 years later it is worth $1M they could choose to sell their home and retain the $400K gain tax free. They could repeat this process several times in a couple’s lives and each time a sale is completed the gain can be retained tax free. At the end of 3 rounds (there are residence requirements for each exclusion to be allowed) this couple could have managed to clear (net) well over $1M tax free. Despite this unparalleled opportunity to build tax free wealth, most home owners will buy one home and live in it until retirement. A well purchased property will still yield gain but much of it will be taxed. A home purchased at $600K that sells for $1.8M in retirement will have $500K of the gain tax free but $700K will be taxed at capital gain rates federally and at regular income rates by the state.

A residence can turn into a large liability when the debt burden is too high, when the home renovations do not yield increased value for resale, when the home requires a lot of maintenance, and when the location is no longer appealing (loss of home value appreciation).

Unlike residential home purchases, real estate purchased for investment is first valued on its ability to generate sufficient income and not as much on its appreciation. Before buying an investment property the property is thoroughly analyzed from various perspectives. An APOD (Annual Property Operating Data) is the principal tool to understand the cash flow, return rate, and profitability that can be expected from a prospective property. Once a property passes the APOD test (primarily for risk assessment) then the tax shelter provided by such an investment and the impact of the time value can be used to determine if this is an appropriate investment. Not surprisingly, much of the success of these investments stem from proper usage of tax rules. The value of the annual depreciation (using Schedule E) is well known. An equally important tax tool is a 1031 exchange. In a 1031 exchange the value of the investment property you own can be used to buy a second investment property of the same or greater market value while deferring tax payments on the gain.

In short, both residential and non-owner occupied real estate can be part of your investment plan. Unlike market investments it is more difficult to identify and protect against unexpected events and the illiquid nature of ‘real’ assets. Managing real estate to attain investment value requires thoughtful deliberate actions that may not always be aligned with your personal wishes (far from being a “no brainer”). Investing in real estate can reap big rewards, but entails doing a lot of meticulous research, taking only risks that are necessary, covering for contingencies, working with an experienced team, and then allowing time to do the work.

If you need help deciding whether a real estate purchase fits with your long term goals, give Aikapa a call.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Financial Decisions: Taming unhealthy habits

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I’ve always been fascinated by how and why we continue with habits (behaviors) we know to be intrinsically out of line with what we want. There’s plenty of literature to explain the biology, particularly related to marketing and Artificial Intelligence (AI), that illustrate how our brains make decisions. I wrote an article some years ago on the science behind financial decision making (“Taming Our Irrational Brain,” Association for Women in Science Magazine, Summer 2009, Vol 39, No 3). If you’re interested in the science you may find it a good place to start. In summary, I think understanding how to change our decision making process begins with a deeper understanding of ourselves.

Choosing among competing options is a fundamental part of life. Historically cognitive processes or reflexive stimulus-driven automatic reactions. To deal with the massive and complex number of choices we face on an ongoing basis, individuals use multiple “systems” that offer tradeoffs in terms of speed and accuracy, but can optimize behavior and decisions under different situations. We shift quickly from “use your head” to “go with your gut” making daily decisions heart wrenching. This clutters the brain and adds uncertainty to decisions – making decisions stress-filled.

Ideally we would have automatic behaviors that keep us aligned with our planned (cognitive) objectives. I believe that sustainable change has to be linked to a simple consistent and believable process that can support you during stress-filled times. Though there are different approaches to creating these behaviors I will focus on Charles Duhigg’s three-step process for changing habits (he refers to them as CUE-REWARD-ROUTINE) and add my own thoughts as we go along. Obviously, my focus is on developing healthy financial habits.

  1. First, we need to acknowledge what it is that we want to change and what it is that we wish to attain. What financial behavior are we interested in changing? We need to visualize what we’d like to see instead of our current behavior.
  2. We must then identify the triggers for this behavior (or “CUEs”). Duhigg suggests that we ask ourselves what we were doing right at the time, who were we with, where we were, and, what we were doing just before the behavior. One of his best examples is when you get up to get a snack in the middle of your work – what were you doing just before you got up? What was your trigger? Some people have similar triggers for spending beyond their budget and, yes, even for making buy/sell decisions on their portfolio.
  3. Next, we must understand what “reward” we obtain from this particular behavior (habit). This step is essential because we need to find something equally rewarding to successfully implement a change in our reaction when we next experience the same trigger. The new reward must be one that is both doable and strong enough to replace the current reward but also in line with our plan. Was the reward for getting a snack really to satisfy hunger, or were we bored, or in need of social interaction or just anxious? For example, consider the person who checks their portfolio every time they feel the trigger. Their reward may be to talk to people about it (social interaction) or it may be boredom (interacting with a different software) or it may be something else. This individual will first need to identify the trigger that prompts them to check their portfolio often and determine what reward they receive for doing this action.To change a reaction to a particular trigger, the goal is always to identify a substitute reward that is aligned with your well-being and your plan. For example, going for a walk alone or with friends, taking up a mental or physical activity that is positive–anything that will actually yield the change you are hoping to make.
  4. Then lock it in, so to speak, by establishing a “routine” around both the triggers and reactions that will make the new habit permanent. If the reward is strong enough, over time it will seem less and less routine, even enjoyable. In our fast moving world more and more decisions are made quickly, even without thought. It doesn’t help that marketers are out to manipulate our choices at every turn even if it means deviating us from our personal wishes (after all that is their job). This imposes a degree of stress if not countered by healthy habits. Ultimately, a well-lived life is all about making daily choices that enhance our chances of achieving the goals we set for ourselves.

It is evident that establishing any new behavior (habit) needs a belief system and a support system that you can reach out to during stressful times to ensure that you don’t revert to the original behavior. I find that for some clients Aikapa has become this support system as they strive to adjust financial habits and align them with their financial plan. It’s our job to help clients remember the reason(s) why these behaviors are important and to help them visualize their financial rewards on an annual basis. We do this through client meetings and by examining savings, investment portfolio and retirement plans.

In short, attaining financial wealth and peace of mind are indeed possible when you can develop habits that work for you. It is our mission to educate and help you build a stress reduced financial life while maximizing your wealth. If you are working on building a new financial habit to support your dreams, don’t forget to include Aikapa as part of your support team.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

IRS Audit rates for the wealthy

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The Internal Revenue Service in 2011 (2010 tax year filings) overall audit rate stayed constant for individual taxpayers at 1.1%. For those earning between $200-500K it is at 2.66%. Of note since 2009 has been the significant increase in audits for the following groups:

–> an increase in audits of 29.9% for taxpayers with $10 million in income (in 2010 it was 18.3% and 10.6% in 2009).This is a group that consists of 0.01 percent of taxpayers. In addition, the IRS has implemented a more a more intense IRS task force audit that is more time consuming and costly.

–> an increase of 20.75% (from 11.55%) for those with Adjusted Gross Incomes (AGI) of $5-10 million.

Interestingly many tax prepares claim that the IRS is quicker to audit individual returns than in the past, sometimes contacting people within months of their return being filed. In some cases, “correspondence audits” are the norm, where the IRS will send a letter asking a taxpayer to verify a specific item on the return such as charitable deductions.

This change started in 2009 when the IRS created a special unit to examine the tax returns of high-wealth individuals. “We will take a unified look at the entire web of business entities controlled by a high-wealth individual, which will enable us to better assess the risk such arrangements pose to tax compliance and the integrity of our tax system,” IRS Commissioner Douglas Shulman said in a December 2009 speech. “We want to better understand the entire economic picture of the enterprise controlled by the wealthy individual and to assess the tax compliance of that overall enterprise.”

=============== March 23, 2012 – Credit: Bloomberg News online

Self Employed Individual 401K Plan Loans

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Who said you can’t have your cake and eat it too?

Self employed small business owners have an opportunity to not only save maximally through retirement plans but also build a safety-net through their ability to borrow from their individual 401K accounts.  Properly structured they can borrow from their retirement plan when the need arises without incurring the usual 10% penalty for early withdrawal.

In addition, 401k Loans for the Self employed business owners provides a loan, while allowing them to pay back interest to their own 401K rather than a financial institution.

An Individual 401k loan is permitted using the accumulated balance of the Individual 401k as collateral for the loan. Individual 401k loans are permitted up to 1/2 of the total balance of the 401k (but not exceed $50,000). A loan from an Individual 401k is received tax free and penalty free. There are no penalties or taxes if loan payments are paid on time.

Individual 401K Loans

  1. Can be used for any purpose.
  2. There are no income or credit qualifications to receive the loan.
  3. The monthly loan payments of principal and interest are repaid back into your own Individual 401k – you borrow and grow your retirement at the same time.

In addition, the assets can be from prior employer or IRA accounts that are rolled over to your individual 401K account.

Individual 401k are available to self employed individuals and small business owners with no full time employees other than a spouse. Your business can be a Sole proprietorships, LLC, S and C corporations,

The terms are set by the employer (yourself) but the 401k usually has a 5 year maximum repayment term for most loans, except it can be longer, for home purchase. There are no income or credit qualifications although you must charge yourself a competitive interest rate.

Although simple and fast to execute you  should remember that you are borrowing on your retirement nest egg.  It is only a valid action when you know you will have the ability to pay it back – default results in a withdrawal that can carry a 10% penalty.  The loan facilitates borrowing when it might be too difficult or too expensive to go through banks and lending institutions.

As good as it sounds consider that unlike a mortgage or a home-equity loan, if you use a 401(k) loan to buy or improve your home, you won’t get a tax deduction on the interest you pay. You may have to pay a one-time fee to the plan administrator for the cost of originating a loan; the fee is usually $50-100. Your retirement plan will also miss future targets if you don’t continue making annual contributions while you have this outstanding loan.  Though most self-employed who borrow from their 401K often pay their loans early it is important not to misuse your hard-earned retirement assets.

As can be seen the 401K Loan, like all tools, has advantages in disadvantages.  The advantages for the self employed should  encourage anyone who is or is planning to have their own business to begin saving in a tax deferred manner maximally.  By using an individual 401K account you can have your tax deferred savings and simultaneously build a safety net.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com