Author Archives: Edi

Retirement Plans for the Self-Employed – An introduction to reducing taxes by increasing retirement savings

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The self-employed small business owner has at least three ways to save for retirement while saving on current taxes. The best known is the simplified employee pension plan (SEP). Not quite as well known, is the individual 401K-profit sharing plan (401K-PSP). And definitely least known is the Defined Benefit (DB) plan. Your choice should not be based on familiarity but on your retirement needs, current cash flow, and tax liability. Without planning the choices are limited to a SEP IRA or other IRAs. SEPIRAs can be created any time prior to tax filing but the contributions can only be as much as 20-25% of net earnings from self-employment (up to $52K).

A 401K-PSP, on the other hand, must be created in the same year (meaning that if it is used for 2014 contributions it must be created before Dec 31 of 2014). Ideally the contributions are made by December 31st for employee deferred compensation but employer contributions are made later, prior to tax filing. Employee deferral limits this year are $17.5K (plus an additional $5.5K after 50) or to the maximum earned, whichever is less. Profit sharing contributions can top up to $52K (plus an additional $5.5K after 50). Tax filings for the plan are required once the total assets exceed $250K. For most small business owners the 401K-PSP allows for higher annual contributions (than the SEP) and therefore lower tax liability.

DB plans are the least used by self-employed and yet the most powerful at reducing tax liability by allowing very high tax-deferred contributions. A business must have sufficient profit and cash flow to take full advantage of this type of plan. DB plans, like 401k, must be established in the same year and have specific requirements including annual tax filings. These types of plans are not limited by the fixed maximum contribution of $52K but instead on annually calculated contributions based on a future benefit. The maximum annual benefit is up to $210K this year. DB plans provide the highest contribution amounts particularly when combined with a 401K-PSP.

The best type of retirement savings plan for you, as a self-employed individual, is partially dependent on your business’s current and projected cash flow. Ideally you will match the features in all available plans with your retirement needs, selecting the plan that maximizes your retirement savings while reducing your current tax liability.

The key is to plan ahead with someone that knows the self-employed plan options and your personal and business finances. Working together you can provide for your future while reducing your tax liability today.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Business Entities: Business for profit, nonprofit or a bit of both?

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Thinking to start your own business? Or maybe your business is growing and some form of reorganization is necessary to manage it all? If you are engaged in the sale of a product or service commercial law pretty much governs your options for setting up and administering your business. These entities include corporations, cooperatives, partnerships, sole proprietors, limited liability companies and others.

So, which type of business structure is right for you? The answer depends on the type of business you run, how many owners it has, and the overarching financial situation. Some of the most important factors to consider, include:

  • the potential risks and liabilities of your business
  • the formalities and expenses involved in the various business
  • structures
  • the motivation behind the venture (profit, social, or charitable)
  • your income tax situation
  • your investment needs, and
  • the sources of revenue.

In large part, the best ownership structure for your business depends on the type of service or product it provides and the sources of revenue. Often the ownership structure is ruled only by tax and risk questions but there are many other reasons. I will highlight legal, tax and motivational reasons that are associated with specific business structures and in particular provide information on two new entities.

If your business engages in what most people would consider “risky activities” you ought to consider a business entity that provides some personal liability protection (such as a limited liability company, or LLC), which shields, to a certain degree, your personal assets from business debts. Note that I said it offers some personal liability protection.

Under a traditional corporate structure, corporate directors have a fiduciary duty to exercise business judgment with the goal of maximizing profits. In fact, corporate officers and directors can be held legally liable to shareholders if they do not maximize profits to the exclusion of other goals.

New to the mix are benefit corporations (sometimes informally called a “B Corp,” not to be confused with a certified “B Corp”). Benefit corporations don’t follow the traditional profits-only model. Instead, these have a dual purpose, to generate some type of public benefit while creating value for their stakeholders. For example, if the charter of a benefit corporation makes it clear that it is organized to build affordable housing, officers and directors are therefore held accountable to achieve both this objective and a profit. Legally this means benefit corporations are shielded from lawsuits by shareholders who argue that the corporation has diluted their stock by putting social objectives over profit.

Of course there is also the full non-profit corporation where the social mandate is the only mandate and large profits are not permitted. Most nonprofits are known by their 501 tax-exempt status. Owners of sole proprietorships, partnerships, and LLCs (LLC for tax purposes) all pay taxes on business profits in the same way. These three business types are “pass-through” tax entities, which means that all of the profits and losses pass through the business to the owners, who report profits (or deduct their share of losses) on their personal income tax returns. Therefore, sole proprietors, partners, and LLC owners can count on similar tax complexity, paperwork, and costs. Owners of these unincorporated businesses must pay income taxes on all net profits of the business, regardless of how much they actually take out of the business each year. That said, LLCs do have the option to file as a corporation for tax and benefit purposes.

In contrast, the owners of a corporation do not report their share of corporate profits on personal tax returns. Owners pay taxes only on profits they actually receive in the form of salaries, bonuses, and dividends. The corporation itself pays taxes, at special corporate tax rates on any profits that are left in the company from year-to-year (called “retained earnings”). Corporations also have to pay taxes on dividends paid out to shareholders, but this rarely affects small corporations, which seldom pay dividends. A double taxation occurs when the corporation pays taxes on its profits AND the owners pay taxes on the dividends. Subchapter corporations (S Corp) are popular with professional services businesses primarily for tax reasons.

Unlike other business forms, corporations can sell ownership shares in the company through stock offerings. This makes it easier to attract investment capital and to hire and retain key employees. But for businesses that don’t need to issue stock options and will never “go public,” forming a corporation may not warrant the added administration and expense. If it’s limited liability that you want, an LLC provides the same protection as a corporation. If it is ease of use, then sole proprietorship or partnership may be the most appropriate. Moreover, the simplicity and flexibility of LLCs and sole proprietorships can offer a clear advantage over corporations.

An L3C is a new variation on the LLC. What sets it apart from regular LLCs and other for-profit entities is its ability to pursue charitable, educational or socially beneficial objectives. Although the L3C can also pursue profit oriented objectives, they are secondary to its social goals. The L3C is a hybrid entity taking on the flexible characteristics of an LLC in combination with a low-profit socially beneficial objective. The verdict is still out on their usefulness and whether or not these business entities will endure, but they are currently an option in some states, including Hawaii and California. For social and community conscious business ventures to succeed, they need a flexible, lightly regulated business structure that allows access to investment capital.

The L3C format was designed to satisfy this need. Before you can decide how you want to structure your business, you’ll need to review your vision for the business against all the available structures. Here’s a brief rundown on the most common ways to organize a business:

  1. sole proprietorship
  2. partnership
  3. limited partnership
  4. limited liability company (LLC – profit mandate)
  5. low profit limited liability company (L3C- profit & social/community mandate)
  6. corporation — usually C or S Corp (for-profit mandate)
  7. benefit corporation (profit & social/community mandate)
  8. nonprofit corporation (not-for-profit or 501 firms), and
  9. co-operatives

If you are contemplating a new business or thinking to restructure an existing one, you should seek both legal and tax professional advice. Aikapa can help integrate this advice with your vision.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Insurance – “The Basics” on when and how to cover contingencies

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The purpose of insurance is to cover a specific contingency—risks to life, health, income, property—that insurance companies can pool and provide under an affordable monthly premium. Insurance is a contract and it must be read and understood completely. Properly understood and applied insurance is an invaluable part of your financial life and to building wealth. The wrong insurance, on the other hand, can drain your finances, not cover the contingencies you need. In effect it can derail your wealth building plan. Below are some basics to think about when considering your insurance needs but there are many more than can be discussed here. All insurance tools need to be reviewed from two perspectives: 1) identifying the tools you need throughout life’s ups and downs and 2) the level of coverage that you need (this can change from year to year).

Life Insurance – this tool is essential for anyone who has a dependent. It should always be purchased to cover the future needs of those who are dependent on the insurer’s income. Once you have a target amount you need to focus on obtaining a contract from a reputable company for the least cost over the period you’ll need it. If your cash flow is limited, there are no dependents and your assets are under $5M, then there is no need for life insurance. Similarly, if your cash flow is limited but you have many dependents then only consider term life insurance. This type of insurance is best purchased outside of employer plans and additional amounts can be supplemented from employer benefit plans (if needed for a short period of time).

Disability Insurance – this tool is intended to cover a percentage of your income for you and dependents if you’re disabled (mentally or physically). We highly recommend anyone under 65 consider purchasing long term disability insurance. It is least expensive if purchased within an employer plan but if you’re healthy may be reasonable as private insurance. Self employed or small business owners should purchase personal long term disability insurance while they have sufficient earnings and are healthy.

Long Term Care (LTC) Insurance – this tool covers the cost of care if you’re unable to perform the basic acts of living (dressing, washing, etc). Although you may need it before retirement most individuals purchase this insurance to cover LTC in retirement. The rates do increase with age and may not be available after you’ve developed health issues.

Liability Insurance – this tool protects your wealth from legal actions. Some liability insurance is part of your auto and house insurance but additional liability insurance is purchased as “Umbrella coverage”. This is a relatively inexpensive coverage and the amount changes as your wealth grows.

P&C Insurance (Property & Casualty) – these tools protect your property (auto and house). Your insurance broker/agent can review the latest options, the benefits, and premium available to you. We encourage you to be aware of your policy and get as much insurance as you’ll be willing to claim and as fits with your financial plan.

Of course there are other insurance tools and new ones being created every year. If you wish to discuss a specific insurance tool we’ll help you better understand it and determine if it is a tool that would be appropriate for you.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Retirement – Vocation, Vacation or A bit of both?

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You’ve heard it said: “idle hands make for idle minds.” The idea of an absolutely “work free” retirement may appeal to some, especially if you are passionate about a particular hobby or sport, but others may well find that an “endless vacation” loses its charm after some months or years. Don’t underestimate the benefits of continuing to work through your retirement. Continued employment keeps the mind engaged, provides a sense of personal identity, can aid in physical & mental fitness and, of course, can contribute positively to your finances.

Since I work primarily with self-employed individuals I hear first-hand just how many clients would actually prefer their retirement to include some form of meaningful part-time employment. For most, this work ought to be stimulating, engaging, productive and affirming with or without financial rewards.

What would you want in retirement? How do you determine what you prefer? What are some options?

Explore what would inspire you with colleagues, friends and family. This conversation can be with a group of similarly motivated and stimulating colleagues (or friends/friends) and help identify your ideal retirement. You might also examine your “motivators,” both existential and economic. Are you someone that thrives on intellectual stimulation, competition, growth and learning, is your identity tightly linked to the work you do? These are “motivators” for finding a vocation in retirement. On the other hand, do you work solely for economic reasons, are you primarily concerned with the rising cost of living, maintaining a given lifestyle, managing debt, or leaving more to your heirs? Vocation may be right for you if you are motivated by existential rather than economic reasons.

You can also use existing social entrepreneurship organizations (such as encore.org) that tap the altruistic resources of retired individuals. Even providing grants for mature adults to develop their ideas while connecting participants with others that share a similar calling.

You might consider that according to AARP nearly 90% of those over age 65 want to remain in their residence throughout retirement. Providing aging-in-place support to elderly in all facets, including bookkeeping, gardening, tutoring, transportation for outings and errands are all viable opportunities. Balance: This is your retirement. Find the combination that best suits you – be it as a vocation, a vacation or a bit of both.

There are unique considerations to working after your formal retirement. To make the most of your in-retirement earnings, you should work carefully with a financial advisor so that social security and taxes can be properly coordinated.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Guaranteed income at what price? – An introduction to annuities – a tool to provide guaranteed income but not to replace your portfolio

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Retirement planning entails finding ways to cover expenses for the rest of our lives when we ultimately cease or reduce our working income. The goal is to ensure that we don’t outlive our assets, regardless of our longevity. Although Social Security is our best guaranteed income another tool can also provide guaranteed income: Annuities.

 Annuities are a contract that you enter into with a company (an annuity carrier such as an insurance company). You provide the payment and they guarantee a certain amount of ‘income’ for a period of time or for life. This is not the same as purchasing a CD or buying a mutual fund since once the annuity is purchased the assets used for the purchase are no longer yours.

 It is clear that annuities can’t beat a well-diversified portfolio in projected performance but they do provide a guaranteed cash flow that a portfolio can’t provide. For example, when you decide to take a lifetime-income stream from an annuity, you are in essence betting against the annuity carrier that you will live longer than they think you will live. This transfer of risk is the true value proposition of any annuity that is based on guaranteeing a lifetime income. It is therefore most important that we use only the guaranteed aspects of an annuity when deciding its place in a retirement plan. It is equally important that we consider the importance of actual purchasing power for the annuity.

 Annuities come in many flavors but can be classified as either fixed or variable types. These types differ in many ways including how the assets in the annuity will grow and how the benefits will be calculated. Annuities can be purchased with a lump sum (immediate annuities) or with regular contributions (deferred annuities). The benefits are received within a year in the first case and at a much later time in the second. Immediate annuities can be useful to fill a specific role in the very near future that requires a guaranteed income stream. Whereas deferred annuities are used when we want to guarantee income at a later date, like retirement (we find this necessary when Social Security is lacking or missing).

 The tax nature of annuities can differ BUT most annuities today are funded with tax deferred dollars so the gain will be taxed at ordinary tax rates. When planning to receive benefits from an annuity prior to age 59 ½ make sure you let us review it to ensure that the 10% IRS penalty doesn’t apply.

 Although annuities can be a useful tool in certain scenarios, too often unpleasant surprises reveal themselves (to annuity owners) within the fine print. If you’re considering purchasing an annuity talk to us and let’s review the contract before making your purchase.

 There is NEVER a need to RUSH into buying an annuity. Take the time to determine what will be the best way to deploy your assets and use the best available tools before and after retirement. The goal is to meet your specific goals and have your assets last you through your entire retired life.

 

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Social Security – an under appreciated but invaluable part of your retirement plan

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Retirement planning entails finding ways to cover expenses when we ultimately cease or reduce our working income. The goal is to ensure that we don’t outlive our assets, regardless of our longevity.

To the surprise of many, one of the most valuable (yet under rated) tools to fund retirement is Social Security. Clients often ask about ways to bolster their retirement income; such as, maximizing their investments, reverse mortgages and annuities. They seldom consider how to maximize their Social Security benefits.

We pay for Social Security and Medicare through payroll taxes with the employer paying half of this expense and the employee, often grudgingly, paying the other half. In particular, I detect a sense of being “over taxed” by those who are self-employed and must therefore bear the full brunt of the Social Security tax. Some make it a goal to reduce their profit or earnings so that they can lower this tax, sometimes entirely avoiding paying any social security tax. And yet the very best inflation protected guaranteed income during retirement is Social Security. If you don’t pay the tax you don’t collect the retirement benefit.

I will outline a few interesting facts to help you understand aspects of Social Security that we consider when creating retirement projections.

Although you must have 10 years of Social Security taxed earnings to qualify for benefits the Social Security Administration actually uses the highest 35 years of earnings (any missing years are zeroed) to calculate your retirement benefit. To earn the maximum retirement benefit you would need to pay social security tax at the highest level allowed each year for 35 years. Each year the maximum social security taxable earnings changes. In 2014 it is $117K.

The earliest age you can begin to collect Social Security is 62 while the Full Retirement Age (FRA) is now between 66 and 67, dependent on your birth year. Unless in poor health, it is seldom advantageous to collect Social Security benefits before reaching FRA. Collecting Social Security prior to FRA will close the door on some options that can help maximize your Social Security income and should only be considered in unusual situations.

Many file for benefit at their FRA whereas others delay filing until sometime after FRA. Waiting until as late as age 70 to collect these benefits can significantly increase the Social Security payout for a lifetime.

One feature of Social Security that often surprises clients is the option to collect spousal benefits. Spousal benefits uses only your spouse’s work history to provide you with half of your spouse’s social security benefits. One way to use this option is (once you reach your FRA) to choose to delay filing for Social Security based on your own work history and instead claim half of your spouse’s benefits. Why would you do that? By collecting a reduced spousal benefit you can allow the benefit based on your own work history to continue to grow until up to age 70.

What are some considerations associated with receiving spousal benefits? The marriage must have lasted at least 10 years. You can claim based on your ex-spouse’s Social Security benefits so long as you’ve not remarried (or if you remarry after age 60). You can only claim a spousal benefit when you’ve both reached FRA. This feature works maximally for same age spouses since they can both claim spousal benefits on each other, therefore collecting Social Security while still allowing their own Social Security to grow until age 70.

One unpleasant feature of Social Security is called the Windfall Elimination Provision which can surprise workers who have worked for two employers where one was not subject to Social Security withholdings. The social security benefits are reduced even though the second earnings were subject to Social Security withholdings. We see the Windfall Elimination most often with teachers who also worked in other non-teaching positions.

So are Social Security benefits taxed? Yes. 85% of your Social Security earnings will be part of your retired taxable income. This can drop to 50% if the in-retirement AGI is low enough.

Your Social Security tax payment entitles you to guaranteed retirement income, an essential part of the retirement plan for most Americans. The important role Social Security plays in your retirement planning cannot be over stated. A sole conversation with Social Security Administration should not be enough. Considering that the Social Security handbook has over 2,700 rules in a thick manual called POMS (Program Operating Manual System) it should come as no surprise to you that the Social Security Administration can’t always provide the best information in relation to your own situation.

Take the time to determine what will be the best way to deploy your Social Security scenario since this retirement income will be both inflation protected and last you through your entire retired life.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Handling Finances When You’ve Lost a Loved One

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As you would expect, we each respond in our own way to the death of someone close to us. Some focus on getting things done while others find themselves unable to function. The range of reactions spans the full spectrum of emotions. During this time you will also need to know how to begin the process of taking care of the deceased’s finances. The following are a few important points to keep in mind.

First and foremost, before reporting the death to financial institutions you must ensure that you (or the executor) have access to legal/financial documents and to sufficient assets to pay for all expenses associated with this process. Be prepared that if the documents are stored in a safety deposit box it will be sealed when notice of the death is received and not available to anyone that doesn’t have their name on the box. Since some accounts will also be sealed it is also a good idea to determine the source of assets that will be used to cover ongoing expenses and to support dependents while the deceased’s estate is processed. If funds are in joint accounts be sure they will not be frozen once you submit the death certificate.

A surprising tidbit is that you’ll need 20-25 certified death certificates (one original per financial institution) from the County Registrar or Funeral Director or Health Department. Your instinct might have been to ask for one.

As early as possible, engage with your support team (CPA, estate attorney, financial advisor, executors and trustees), then keep the lines of communication open throughout the process of settling the estate. There may be time constraints associated with certain filings and activities related to settling the estate making it doubly important to work together.

A sampling of other financial considerations:

  • Identify all automatic deductions and regular subscriptions to determine which need to be changed or terminated
  • Debt should be handled with care since some will end with the deceased
  • In partnership with the executor, obtain a tax ID for the estate
  • File the necessary tax forms (e.g., Forms 1040 and 1041)
  • Take particular care when handling tax-advantaged accounts and when making decisions on insurance proceeds – check with your team
  • Take a close look at the fine print. Spouses, partners and children may be entitled to survivor benefits

This is only a partial catalog of considerations.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Tax Penalty/Bonus? – Single, Married, Domestic Partnerships

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After nearly thirty years of marriage, I would be the last person to suggest that
tax consequences are a reason for making a lifelong personal commitment. On
the other hand, I am often the first to point out that marriage is not always a
tax neutral activity. Some people work on the expectation that a “married
filing jointly” (or MFJ) tax filing will always result in a lower combined tax
liability and a marriage tax bonus (meaning taxes are reduced solely due to
filing as MFJ). They are surprised when this joint filing actually creates a
marriage tax penalty (meaning filing MFJ results in higher taxes).

So when should we expect a penalty or bonus? The literature describes that ‘in
general’ we see a tax bonus when two partners have disparate incomes and a
tax penalty when they have similar or equal income. Based on the literature I
expected that income splitting (as occurs in a domestic partnership tax filing)
could provide an additional tax bonus over MFJ since disparate incomes can
be split evenly between partners.

While exploring the new 2013 tax rules we examined some tax scenarios and
want to share some highlights with you. We found that starting at a combined
AGI (Adjusted Gross Income–the number at the very bottom of the 1040
form) of $230K filing as MFJ resulted in a tax bonus of about $2K IF the two
people had disparate incomes ($200K and $30K respectively) but a penalty of
$2K for those with similar incomes ($115K each). Therefore at this level of
AGI couples with disparate incomes do slightly better under MFJ and those
with similar AGI do slightly better filing as individuals.

With a joint AGI of $330K the single disparate earners ($300K and $30K)
receive a marriage tax bonus of about $3K. If the same joint income was
earned evenly ($165K each) they would pay $4K more filing as MFJ than as
two individuals (a $4K tax marriage penalty). Looking at these scenarios, it
became clear that those with similar incomes would annually save thousands
of dollars if they filed as individuals rather than MFJ (Note: this is not the
same as married filing separately but rather unmarried individuals). As a
corollary, those in a domestic partnership may want to verify that they will not
have a large tax increase if they marry and file as MFJ.

Finally we looked at a couple with a $530K AGI who will pay $143K in taxes if
they file as two individuals with disparate incomes ($500K and $30K) and
taxes will be about the same if they file under MFJ (there is about a $1K tax
bonus). We do see a large tax penalty if this income was earned evenly by two
individual filers ($265K each) and they file MFJ. As two individuals the tax
burden would drop by at least $15K.

Marriage does provide non-income tax related advantages for spouses and
the family which are not discussed here.

Once you consider tax consequences of marriage, domestic partnership or
single tax filings any decision you make will work as long as you make plans to
cover the marriage tax penalty or find ways to spend the marriage bonus.
The above analysis assumed that ‘itemized deductions’ were kept constant and
that there was no AMT. These were modeled tax estimates – please consult
your tax preparers for the specific tax impact in your situation.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Long Term Care – Should you self-fund or purchase insurance?

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Long term care (LTC) provides assistance for those who need help
performing functions essential to daily living. These include basic
functions like eating or dressing yourself.

Who needs it? This assistance is needed after physical or cognitive loss,
a disease, an accident, or loss that occurs naturally as we age. The
probability of needing this type of support increases with age.

Who Provides this care? If still living at home then the care is most
often provided by either family members or in-home care professionals.
At some point either by your choice or out of necessity you may have to
transition to an “assisted living community” and/or “a nursing home”.
Robotic tools are also able to provide some assistance for daily living
activities.

Who Pays for it? Costs for LTC are most often paid out of family or
personal assets. Medicare does not cover long term care. Medicaid
(Welfare) provides some limited coverage to low income families. In
your retirement plan we need to include how you’ll cover long term care
expenses. Most often out of your assets or through insurance coverage.
LTC insurance needs to be seriously considered by age 50 since it may
become prohibitively expensive by the time you’re ready to retire. LTC
insurance premiums may be tax-deductible.

How much does it cost? That will depend on how much care is needed,
whether it’s provided at home or in a dedicated community, and the cost
of living in your retirement area.

Your retirement plan should include how you’ll cover potential long
term care expenses – either out of assets or through insurance. We’ll
need to determine which method and amounts are right for you.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

SEC charges former CalPers CEO in Agent Fee Scheme

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SEC Charges Former CalPERS CEO and Friend With Falsifying Letters in $20 Million Placement Agent Fee Scheme

According to http://www.sec.gov/news/press/2012/2012-73.htm website Buenrostro (former CalPers CEO) directed placement agent fees to Villalobos through falsification of documents with CalPers logo.  The placement fees paid were at least $20 million dollars.

The letter was a new requirement by this fund company for fees paid to placement agents that assisted in raising funds.

There seems to be no end of leading executives who continue to cross ethical lines to enrich themselves and their friends.  Kudos to the SEC for identifying this action and hopefully, if found guilty, will apply a sufficient deterrence to discourage others from crossing over this very clear ethical line.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com