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

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

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

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

A business owner quandary: cash or accrual?

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

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

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

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

So, what does the IRS require?

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

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

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

What are some of the problems that may surprise you?

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

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

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

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

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

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

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

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

 

Retirement Income Planning – Spend early or make it last?

During our working years we plan for retirement or financial independence in part by saving maximally and investing in assets that are likely to appreciate.  While we are working and saving for retirement we are in the accumulation phase. As we approach retirement (within about 5 years) we continue accumulating assets and begin the process of distributing those assets to sustain our chosen lifestyle throughout retirement. When we use an income stream from our assets we have entered the distribution phase.

During the accumulation phase we all focus on portfolio returns and tolerate some volatility. We can weather market fluctuations and lack of liquidity since we are not dependent on the portfolio and have our earnings to support our lifestyle. The main objective is to pay required taxes, support our lifestyle, save, and establish a life that encourages us to flourish.

As we approach the time when our assets alone will be used to support our lives, it becomes essential that we address the nuances of how the assets will be deployed – this is termed Retirement Income Planning.

Retirement Income Planning addresses in a pro-active manner how to create a stream of income for our remaining days (using accumulated assets) once our income from work no longer fully supports our lifestyle. Since the retirement time horizon is unknown, we must marry wishes for early retirement or plans for having larger income distributions with having assets last through an unknowable lifespan.

Running out of money is never an option in retirement but leaving money behind is also not acceptable, if it limits your lifestyle. This balance becomes a challenge as lifespans extend and health preservation becomes more successful and expensive. The latest survey shows that couples aged 65 have more than half probability (56%) of at least one spouse living to age 92. Despite these findings many feel they will not live past 80 and yet, if healthy and productive, they might feel very differently once they reach 90. Planning effectively for longevity is essential and must be weighed against the benefits of early spending.

For Retirement Income Planning, we also need to manage tax liability since we want to be sure that assets last as long as possible, particularly tax-deferred assets that are taxed at ordinary tax rates on withdrawal.

A market downturn can more greatly impact a portfolio early in retirement or just before the distribution phase. In retirement, unlike in the accumulation phase, it is much more difficult for the portfolio to recover from a market downturn. A robust retirement income plan must include ways to deliver the needed income regardless of market behavior.

The new reverse mortgages are income distribution tools that retirees can use to access home equity as part of a retirement income plan. For some, they provide at least three advantages early in retirement: reduced tax liability, longer investment time for the portfolio, and enjoyment of their home until retirees are ready to downsize.

For all retirees preserving their purchasing power (not just preserving the dollar amount) is an essential part of an income plan. Failure to include inflation protection is evident when retirees hold little to no significant equity portfolio and the consequences are dire. Though annuity and pensions are useful income distribution tools they fail unless combined with a strategy that protects against inflation. Sustaining purchasing power is even more significant when considering healthcare expenses. Keep in mind that healthcare costs grow due to inflation and also as a percent of annual spending as we age.

Scenarios that use all available tools to address how to best deploy retirement income will provide each retiring person with confidence to spend early and throughout retirement without fear of outlasting their assets.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Should you be a landlord in retirement?

As you would expect, we often think about ways to supplement client retirement income and diversify a client’s finances beyond their market portfolio.

Owning one or more rental properties (commercial real estate) can provide a steady source of income and cash flow during retirement, with the added advantage of building owner equity (owner wealth). Once established, rental properties can also be a great resource to meet both planned and unexpected life events. And since they can be depreciated on your income tax, rental properties can provide a significant tax advantage while the asset actually gains in value. All this said, owning a rental property, let alone more than one, is not for the faint of heart. Without regular attention and constant re-appraisal, they can become a major headache and a huge liability.

The path to becoming a commercial real estate investor (a fancy way of saying “landlord”) often begins, innocently enough, with owning a single family home and then, for whatever reason, deciding to convert it to a rental. In this case, the property may need to be adapted in some fashion to accommodate renters. Others will approach a real estate agent with the deliberate intention of purchasing a rental property, in which case the property may be “turn key,” requiring little, if any, alteration. Whichever way you start out, the following are just some of the things you need to take into account before you commit to becoming a landlord in your golden years.

Commercial real estate requires at least 20%-30% down payment and an ongoing source of cash flow to fund expected and unexpected expenses. This means your equity will be locked in your property and only available through the available cash flow stream.

Real estate can be a great addition to an investment strategy, but rarely prudent as a sole investment. Unlike your portfolio, which will have fixed expenses, be liquid and globally diversified, your real estate will be impacted by local conditions with unexpected expenses and periods of poor liquidity. Expenses that are predictable include mortgage, taxes, landlord-specific insurance policies (both property and liability). Less predictable expenses are maintenance and repair costs as well as tenant related expenses. For those in control of their family cash flow, it is this difference that makes rentals a good consideration as a secondary investment and as part of their financial plan.

Like all investments it takes time and due diligence to generate a stable positive cash flow from rental properties – luck alone will not suffice. The price you set for rent is all important as are the expenses you incur. You need to be sure to cover your operating expenses which can include mortgage, property tax, insurance, maintenance, bookkeeping and accounting fees, utilities and if you use a management company you must also include their fee. In addition, the rent must provide you with a reasonable return based on cash flow, not just property appreciation, since you can’t sell the property to pay for ongoing expenses. The property must remain competitive with the local rental market and your cash flow able to cover expenses that may not be deductible in the year they are spent (a roof is an example of an expense that is depreciated and not deductible).

In addition to the financial considerations cited above, you will have legal obligations that are based on local laws and regulations pertaining to rental housing. A broken water pipe, furnace or refrigerator? Round-the-clock availability for emergencies is your responsibility. You can, of course, assign or pay for someone to take care of such things, but the legal responsibility will still be yours (always have sufficient liability and property replacement insurance). You are likely to be held liable for tenant or visitor injuries if due to unsafe conditions, especially in the common areas. Safety and habitability is paramount. On a regular basis, you must make sure structural elements are safe, the electrical, potable and wastewater infrastructure is sound, that trash containers are provided, that any known or potential toxins (such as mold or asbestos) are properly managed, that rodents or other vermin are kept clear off the premises.

However you come by your rental property, you will have to choose whether you should be your own property manager (directly overseeing and paying for maintenance yourself) or to take a more arms-length approach by contracting with a property management firm. Some clients hand these tasks to a family member who wishes to work part-time while others hand it over to a professional. A property manager can help those who wish to limit their day-to-day responsibilities, especially if you aren’t the handy sort or aren’t physically up to the task, but then you will have to cover the additional expense. Property managers, in simple terms, are hired to find tenants, maintain the property, create budgets, and collect rents. You will want to hire someone who knows about advertising, marketing, tenant relationships, collecting rent, maintenance, plus local and state laws in the location that you have the property. As the property owner, you can be held liable for the acts of your manager. It’s prudent, therefore, to hold the rental property in an entity that can provide some legal protection. Costs for contracting a property manager will usually run about 8% of rental income for management and about the same for engaging new tenants—this can eliminate your profit but if properly priced will provide you with a sustainable model well into retirement.

Finding reliable tenants is always a challenge, even if you employ a property manager. Tenants need to be able to pay their monthly rent, keep the property in good condition, and follow policies in the lease or rental agreement. You’ll find it easier to find good tenants if you select a property in an area experiencing low vacancies and high demand. Unfortunately, this means the property will also cost you more.

You should be prepared to have to deal with (or have someone deal with) evictions, wear and tear on your investment, unauthorized sub-lets, termination without proper notice, smoking, illicit drugs, pet odor and damage, parking and waste management issues, advertising, noise (including sometimes difficult neighbor relations), and other eventualities. Or, you can get lucky and find perfect long-term tenants! Realistically, as you age these tasks may become too stressful, eventually requiring you to hire a property management company or engage a (younger) interested and motivated loved one to take on this role. Either way, you must put this in writing as part of your purchase plan—including when you want this to happen, who this person should be, and finally, when the property should be sold.

During retirement some will love the ability to work part-time at managing their properties (even if only in a limited manner) whereas others will find it too complicated for their ideal retirement life. Invariably a well-managed property can generate ongoing income and create owner equity that will be a godsend in retirement or as an alternative to your market portfolio. Unfortunately for some, the process can become too complicated and stressful. So much so, that they avoid the tough decisions and derail their entire retirement plan. Being a landlord is very much an individual decision.

The bottom line is that rental property cash flow can generate a stable income during retirement, and can provide needed equity to fund contingency plans (such as disability, long-term care, health care needs, legacy) but profiting requires planning and annual review. It is a business that needs your ongoing attention or it will become a major liability. Even with the help of a property management firm, you may wonder in what way you can really consider yourself “retired” owning and managing rental properties.

Like any other financial investment, do your homework, and moreover, make sure it fits with your long-term financial goals and vision for a rewarding life.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

The skateboard champion and other stories

As a way to put money away and save on taxes we often think of retirement accounts for the self-employed that include a simplified employee pension plan (SEP), an individual 401K-profit sharing plan (401K-PSP), or Defined Benefit (DB) plan. DB plans are the least used and yet the most powerful at reducing tax liability and quickly increasing your tax-deferred savings. To illustrate how DB plans can be used, I want to share with you how creative individuals were able to leverage their DB plan to save maximally and retire early.

  • The Skateboard Champion – A 30-year-old skateboarder plans ahead and saves $130K per year from winnings and endorsements. He will have saved $2.6M by the time he turns 50 (without considering any market growth).
  • The Lobster Fisherman – A 61-year-old fisherman from Maine pays himself $35K in payroll from his C Corporation and saves $60K per year for the last five years before retiring. His reward: an estimated $300K in accumulated additional savings for his retirement.
  • The Clothing Store Sales Rep – At 57 years of age the rep contributes $150K per year for herself and $12K for her young assistant until retirement at age 65. She accumulates another $1.2M not including growth.
  • The Lobbyist from Virginia – Beginning at age 48, the lobbyist contributes $145K/year for 7 years saving just over $1M by age 55.
  • The University Professor & Guest Speaker – Starting at age 54, the Prof contributes $42K per year from guest speaking engagements. He does this for 12 years and adds $502K in savings (excluding growth) to his already substantial university benefit plans.

DB plans provide the highest contribution amounts particularly when combined with a 401K. To take full advantage of this type of plan, a business must have sufficient profit and cash flow. DB plans, like a 401k, must be established in the same year and have specific requirements including annual tax filings. DB plans are not limited by the fixed maximum contribution found in SEP or 401K plans but instead are based on age, payroll and future benefit. This year, the maximum annual future benefit is up to $210K (this can amount to substantially more than a $210K contribution in any one year).

If you have a side business or are starting your own full time business consider the DB plan. Even though these are powerful, the best type of retirement savings plan for you is dependent on your business’ current and projected cash flow. As you can tell from the stories above, a well-designed DB Plan is not just for those over 50 or those with large earnings. It can be a very smart way to defer taxes today and provide for your lifestyle in the future.

Defined Benefit plans are not appropriate for everyone but I’ve seen them work for so many different people in unexpected situations that I thought I’d share some success stories with you.

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