How does a tax-deferred IRA differ from a Roth?

Tax-deferred savings (to an IRA or employer pre-tax retirement plan) reduce your tax liability today BUT are fully taxable (including gains) on withdrawal. The tax-deferral accounts are an excellent way to minimize your current taxable income. The goal is to use what would have been tax dollars as part of your savings. The main rules to keep in mind are that withdrawals shouldn’t be expected before age 59.5 AND that you MUST take mandated distributions (called RMD) when you reach age 72 (according to the new tax rules). Unfortunately, these accounts are now also not inherited in the same beneficial manner as in the past (these now follow the new Secure Act of 2019 rules).

A Roth on the other hand, doesn’t provide tax deferral when saved but it does provide tax-free dollars, on withdrawal. Contributions to a Roth are limited in amounts each year and not easily available for high earners. Whereas Roth conversions require income tax payment on converting pre-tax IRA dollars, not everyone is permitted to make Roth conversions. Fortunately, Roth IRAs are not impacted by the Secure Act of 2019 and remain free of RMD. They are also still inherited tax-free to individual or trust beneficiaries and are likely to be favored for those considering leaving a legacy.

As income tax rises (likely, given our debt load), Roth accounts will become even more powerful tools in retirement for those in the higher tax brackets. Currently they help us regulate your taxable income and keep taxes and Medicare costs reasonable during retirement.

We’d like to consider Roth conversions for you in years when you expect a lower tax rate. It is particularly useful when tax-deferred accounts are undervalued and when you have accumulated large tax-deferred accounts.

The basic takeaway is that a tax-deferred account should be maximized during years with high earnings (to reduce taxes) and high tax rates. When you expect a low earning year then a Roth conversion may provide you with an ideal situation BUT ONLY IF your retirement tax rate is expected to be high enough to trigger additional taxes or Medicare costs.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

New tax rules (Secure Act of 2019)

As you know, we believe strongly that managing tax liability is essential to building wealth. The Secure Act of 2019 has made significant changes which we will use to create and action strategies best suited for each of you.
Everyone, near retirement, is aware that there was an extension to the Required Minimum Distribution (i.e., RMD) from age 70.5 to age 72. This is good for many since it gives you more control over your tax liability early in retirement, but it also has made the Roth accounts an even more powerful tool for some.

Sadly, the Secure Act of 2019 has made inherited IRAs a big tax burden for beneficiaries, particularly trust beneficiaries. Because of this, IRA accounts that use a trust as a beneficiary may need to be re-examined to ensure that the language allows beneficiaries to minimize their tax liability.
Let me know if these topics are of interest and we’ll include them at our next financial planning meeting.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

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

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

Cyber-crime, Phishing, Robocalls, and Wanting to do Good

Almost every day there is an article in the news about financial fraud. Much of it impacts seniors, like the telephone scam now doing the rounds that has fraudsters posing as Social Security representatives. However, we are all at risk, especially if we believe we are too young, too smart and too vigilant to fall for a scam. Sadly, scam artists are very sophisticated, intelligent, and focused so that they’ve become experts at separating people from their money. Only last month, “Shark Tank” magnate, Barbara Corcoran, was tricked out of nearly $400,000 through an email phishing scam in which fraudsters convincingly posed as her assistant.

A lot of financial fraud targets seniors or those in high pressure situations because cognitive agility decreases as we age or when we are stressed. Furthermore, seniors who live alone are particularly vulnerable.

Here are several things you can do to protect yourself and loved ones from financial fraud:

  1. Simplify your financial life. One of the best things you can do to reduce the chances you’ll be taken advantage of is to reduce the number of accounts you have and the number of financial institutions you work with. Fraudsters are experts at catching people off guard, posing as others and making their prying questions sound both reasonable and plausible. Make it a habit not to respond to phone calls regarding finances unless you know the person at the other end and never trust emails involving finances without first verifying the source.
  2. Limit access to and block large transactions. The first step in preventing fraud is to limit the money that can be easily accessed by not keeping large sums in checking accounts. Keep large accounts with a separate institution so that it takes a day or two to make a transfer. Next, if your bank allows it, set alerts for large transactions or block transactions over a certain size. Always use a credit card for online purchases since they give you the ability to reject a charge, while your debit card will automatically pay from your account.
  3. Always use maximum security on email accounts that you use for financial communications. We’ve seen most cyber fraud through yahoo.com and gmail.com accounts prior to the additional security currently available.
  4. For large transfers, particularly during hectic times, involve a trusted financial partner and NEVER accept changes to the receiving account and contact over email (or a call from someone you don’t know). It is better to halt the process entirely or at least confirm with a known financial entity than to change course midstream during a cash transfer. Most of the successful fraudulent transfers have been during escrow for a new house purchase or sale. The methods used are creative and ever improving.
  5. Families should plan their spending ahead and NOT respond to charitable requests on the fly. It is not unusual for seniors to receive many robocalls and mail requests from real charitable organizations because they know that seniors want to do good. It is not unusual for seniors to spend more on charitable donations made ad hoc than was planned. Make a point never to donate based on a phone call or last-minute request at a checkout unless that is part of your charitable plan for the year. I recommend families sit together and come up with an annual plan for charitable donations. When charitable opportunities present themselves defer them for review at your next family charitable giving gathering.
  6. For seniors or those facing high stress situations, you may want a backup notification sent to your spouse, financial caretaker, or a trusted person for high value transfers. If your bank does not provide for such alerts, then make it a standard practice never to make high value transfers without extensive planning and verification.
  7. For seniors, it’s important to have a potential financial surrogate in place long in advance of cognitive decline. Identify a trusted family member or friend or trusted professional to be your financial caretaker and start conversations long before you feel you need to turn over your finances. Consider providing view-only access to a trusted person so that they can help you monitor your account activity and be notified of large transactions and suspicious activity. It is a good idea to involve them with your tax preparation and filings as well.
  8. Due to the number of data breaches in recent years (that have exposed thousands of people’s Social Security numbers and other sensitive data), it has become increasingly possible for fraudsters to open accounts in another person’s name. On a regular basis, personally monitor your credit history with all three major credit agencies for new activity that you didn’t initiate.
  9. I’m personally uncomfortable with ongoing Credit Freezes unless you can monitor and implement them yourself at minimal cost and without involving a third party. Using a credit monitoring service is not recommended since you are involving an unregulated third party and, in any case, will only alert you after you’ve been victimized. The recommended approach when this happens is to freeze your credit at all 3 major credit agencies. Keep in mind that though this is often recommended by cybersecurity experts it can become a major hassle for you. Freezing your credit can be an issue for you if a company needs to legitimately verify a transaction with your credit history (this is the case for some insurance and bank transactions). Unfortunately, freezing your credit is sometimes the only way to prevent attempts to open a new account in your name, and maybe the preferred or only option for seniors.

Financial fraud is rampant. However, with a bit of preparation, a support system, and communication, you can significantly reduce the odds that it happens to you and your love ones.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Business Owners: Hiring family

One of the most common reasons individuals become business owners is to have more control over their time and financial decisions—to create and be able to drive their own vision in an environment that they choose, and hopefully enjoy.

Those decisions include, among others, what types of solutions the business will offer, how clients will be serviced, which vendors the business will use, and who the business will hire and fire.

Moreover, the IRS’s website states, “One of the advantages of operating your own business is hiring family members.” The IRS is very clear that businesses can and should hire family members. They know that at times family members are the glue that keeps small businesses functioning and often provides owners with the time needed to lead and grow their companies. Small businesses are an essential part of the US economy. The most common family members hired by small companies are spouses since the success of a small business owner is often entwined with the support they receive from their life partner. This is so common that even 401K plans for single-owned businesses include spouses. Though more common, hiring family members can go beyond the spouse and includes anyone that is related, a sibling, a parent AND even a child. [see more details on the IRS perspective on hiring family https://www.irs.gov/businesses/small-businesses-self-employed/family-help].

When hiring family members (either as employees or as 1099 consultants) a business owner must adhere to the same rules as for nonfamily members. From a strictly operational point of view, one clear advantage of hiring family is that a family member can provide support or services that the owner, for whatever reason, is uncomfortable having performed by a nonfamily member. This may be particularly true when the business wishes to keep its financial reports “for family eyes only” or if the business relies on sensitive proprietary information or compliance rules that could be jeopardized by employee turnover. Similarly, a family member can provide cohesion and ensure the retention of corporate knowledge when employees leave the firm – this is invaluable to many small businesses. On the other hand, owners might hire a parent or a child solely to provide them with a taxable income while they engage in work that benefits the business owner’s vision.

The business owner does have the responsibility of deciding on a fair level of compensation for all employees. To avoid potential conflicts within the firm, compensation ought to be similar to that of any regular employee performing the same function. Another more flexible option, is to hire family members as 1099 consultants. Consultants have more flexibility on the tasks they can perform and the compensation they are awarded.

Hiring family can be a straightforward way to reward family members who contribute to the success of the business. Providing spouses, siblings, children and even parents with taxable earnings while serving in roles that provide benefit to the business owner and the running of the business.

For business owners in high tax brackets, hiring family (who are in lower tax brackets) can garner meaningful tax relief. If hiring children, it also provides for “good parenting” opportunities and leadership development. The key to hiring your child is to strictly abide by standards of bona fide age-appropriate work, ensure a reasonable wage, and follow federal and state regulations relating to labor standards. Getting a handle on all of this, can feel overwhelming but it is actually fairly straight forward.

When hiring a minor (family or not) the Fair Labor Standard Act (FLSA) must be followed which has restrictive language on the type of employment for those under the age of 14. FLSA actually states the specific jobs that are permitted which include delivering papers, casual babysitting, or modeling/acting. Starting at age 14 the regulations only limit the amount of time (not the type of job) but also that the work doesn’t expose the minor to dangerous environments such as radioactive areas and working in demolitions (among others).

Hiring family as employees (rather than consultants) is a constant balancing act that requires careful consideration but can deliver financial benefits. It may be prudent, at least initially, to place hired family under the direct supervision of a trusted nonfamily employee that will have full authority over mentoring. This works well for minors but not so well with adults. The potential for unhealthy rivalries and vying for attention amongst siblings and hired staff can sour what is often an exceptional opportunity. Open communication and clear accountability is the key to success when hiring family as employees. Everyone involved must have a clear picture of where they stand, eliminating time wasted on misunderstandings and second guessing one another’s motives and intentions.

The process is a bit easier and the rules a bit more advantageous if family members have their own business (1099 reporting business) and are hired as consultants to support the business owner. In addition, as a 1099 consultant, they have the flexibility to also work outside the family business. Often their total earnings will be taxable at much lower tax brackets than they would be if it was earned by the higher earning business owner. They will also qualify for tax-deferral and social security on their net business earnings.

We encourage you to consider hiring family members particularly if you are a business owner with high earnings and high tax liability. We strongly recommend hiring family members when we discover that family already provide unpaid assistance to the business owner and are in need of financial support or need to increase their social security income.
Let us know if you are considering including a family member (parents, spouse or children are the most common) in your business. We’ll provide a summary of the benefits to you, your family and your specific business.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

The TCJA Tax Act Several Months In

I’ll quickly summarize the impact of the TCJA (Tax Cuts and Jobs Act) that we’ve observed on personal taxes and then I’ll switch to the impact on small business owners by covering QBI (the Qualified Business Income) and changes to deductions.

The tax bracket has dropped significantly for personal federal taxes since the top rate is now 37% AND the higher tax brackets begin at much larger taxable income. Though this sounded like a great opportunity to reduce the family tax liability it was combined with drastic changes to the estimated tax deductions and elimination of exemptions. The net result for residents of high-income tax rate states (such as California) and who used Schedule A itemized deductions is that their taxes actually increased. Most others found no change or a small reduction in their tax liability in 2018 from the new rules EXCEPT for small business owners. We expect the same in 2019.

Small business owners have a unique new tool in the TCJA – the QBI deduction. This tool provides a real opportunity to reduce taxable income and therefore tax liability. The QBI deduction is available from 2018-2025 and is only for pass-through entities (businesses that are not C Corporations). This deduction is available without income restrictions for businesses that are deemed a ‘Qualified Business”.

The chart above specifies that to qualify for this deduction you must be a Qualified Business. To be a Qualified Business it can’t be a service business or be a trade or business that involves the performance by the employer of services as an employee. The following are NOT a Qualified Business: doctors, lawyers, accountants, performers, athletes, health care professionals, financial and broker service providers, partnership interests. Only two service providing businesses are considered a Qualified Business: engineering and architectural firms. Though unclear in the code as to how gray areas would be decided the key catchall is that you can’t be a ‘Qualified Business’ if the business’ principal asset is the reputation or skill of one of the owners. Most of our clients own excluded (non-qualified) businesses.

As an excluded business owner (such as attorneys, consultants, etc.) you MAY STILL qualify for this QBI deduction IF your personal taxable income falls below the limits of $315K and $157.5K (married filing jointly and single filer respectively).

The QBI rule allows a Qualified Business (or excluded businesses that qualify under the taxable income limits) to reduce their taxable income by 20% of their QBI (QBI is business profit, not W2 income). An IMPORTANT CAVEAT is that the 20% deduction is the lesser of QBI or taxable income.

For example, if your business profit is $200K and your taxable income is $100K the actual deduction is $20K not the $40K that you might have expected. Regardless this new tool does provide for a way to reduce taxes.

When I initially reviewed the code, I was very excited for the Qualified Businesses owned by our clients since they were to benefit regardless of income. It was not until the last few months that a complicated wrinkle has limited this excitement. We’ve found that even Qualified Businesses have hurdles if the taxable income exceeds these same limits ($315K/$157.5K for married filing jointly and single filer respectively). If the business owner’s taxable income exceeds these income limits, then two additional rules are used rather than just receiving a deduction of 20% of QBI. For Qualified Businesses in excess of these limits there is a two-pronged test to measure the lesser of 20% of QBI (profit) OR the greater of either 50% of all W2 wages or W2 wages plus 2.5% of your qualified equipment/land costs. Yes, after jumping all of these hoops we found that some QB businesses didn’t qualify for 20% of QBI because the W2 weren’t high enough. Even so, the business owner did obtain a deduction though not as high as was initially estimated.

Added to the QBI deduction the TCJA rules also include these changes:

1. Entertaining clients is no longer a business expense that is deductible federally (it used to be 50% deductible). Office parties are still 100% deductible.

2. Businesses supported by debt financing can only deduct 30% of the owner’s adjustable taxable income BUT don’t despair since it will only apply to small businesses that have gross receipts of $25M for each of the last three years.

3. NOL deduction (Net Operating Loss) which is often carried back two tax years or future 20 years will now be only allowed for years going forward AND limited to 80% of income in that year.

I’m providing this education article to give perspective on how you benefit from the TCJA tax rules. Our ultimate goal is to have you knowledgeable enough to understand the critical role of taxes in your planning. If you have additional questions feel free to ask us or your tax preparer.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

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