Category Archives: Investing

Money Battles and the pitfalls of financial infidelity

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Let’s face it, making important financial decisions can be stressful at the best of times. When life partners fail to see eye-to-eye on finances it can lead to discord if they don’t have a way of working through their differences. It’s no secret, when compared to other types of marital disagreements, arguments over finance are the strongest predictors of divorce.  Financial decisions get even harder to make as we grow older—the habits of the past increasingly difficult to break. Add a touch of procrastination to the mix and you’ve got the potential for real trouble. It’s no wonder then, how easily decisions affecting retirement can turn into a battle over money, when so much is at stake. The best way to avoid unpleasant (and generally unnecessary) confrontations over money is to have a process in place. Let me explain . . .

Ideally, couples will create a money decision-making process early enough in their relationship that it becomes almost second nature—ensuring financial discussions are honest, frank, frequent and cordial. Both partners must be kept up-to-date on the family’s financial dealings and how those dealings align with understood and accepted goals. From our experience, monthly or at least quarterly meetings to discuss/review finances are invaluable.

This isn’t to say, every penny must be accounted for. Each partner must feel that they have reasonable autonomy and freedom to act within an allotted budget, BUT both must be clear that there are boundaries. Some couples set a specific dollar amount above which they must check with their partner and/or reach out to their financial advisor when especially tough financial decisions arise. For example, couples are well advised to discuss in detail funding a child’s college education, their retirement budget, or when to cease working.

Fights over money can be avoided if both partners have a handle on household finances, and moreover, feel their voice is included in all financial decisions.

If one partner pays all the bills and takes care of all the investments, the other partner over the long-term will begin to feel they are not a full participant in the relationship (or at least, they ought to feel that way). To counter this possibility, some choose to exchange roles for part of the year. Others have a regular monthly meeting to be sure that both are indeed aware of the family’s finances. AT A MINIMUM, all couples should go over how to access the family’s financial information (bank accounts, retirement plans, insurance, and investment accounts, etc.) AT LEAST ONCE PER YEAR.

When one partner takes on the financial responsibility for the family the inequity can (unintendedly or not) lead to “financial infidelity.” Financial infidelity occurs when one partner hides their spending on things they feel strongly about despite a clear agreement to the contrary by the couple. As an example, one partner might secretly fund their child’s business venture. I’m aware of one case where this actually happened. The situation was not revealed until the death of the offending life partner. The surviving partner’s betrayal was made all the worse by the fact that their retirement assets were depleted without his/her knowledge. The child that benefited from the covert funding, moreover, was not in a position to repay the surviving parent.

To avoid or at least reduce the likelihood of conflict over money, here are a few helpful guidelines:

  1. Communicate on expenses early, frankly, openly and honestly
  2. Meet regularly to review finances
  3. Update goals and ensure all parties are on the same page

When speaking of goals, articulate them out loud (i.e., verbally or in writing) and be sure to include your goals for both the present and the future.

The decision-making process itself should be reviewed as part of your conversation. For example, how do you determine your life-style budget, your savings goals, and what happens when you encounter expenses that fall outside of your budget for some reason?

As large financial decisions approach (such as retirement funding), the reality will undoubtedly generate much needed discussion. This conversation can turn into conflict if one side of a partnership is not in touch with family finances and family goals. Those who opt to avoid financial conversations will invariably find themselves in “money battles” that can seriously erode trust and faith in the relationship.

Facing major financial decisions, such as when, how and where to retire, needn’t be a source of discomfort or conflict. Far from it. If there is a reasonable process in place, the experience can be part of a shared life experience, an opportunity for optimism and mutual support.

I should add, in closing, that being single and unattached, doesn’t make you less susceptible to the stress imposed by major financial decisions like those discussed above. In fact, the “internal conflict” may be worse without someone to bounce things off of. If you are on your own, the same guidelines apply, but your “partner” in this is your trusted financial advisor.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Should you be a landlord in retirement?

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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

Caregiving for a Parent or Elder Can be Rewarding

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As I read the latest survey which found Americans unprepared for the complex and unpredictable realities of longevity and caregiving, I thought about my own experience. In my case, planning with parents for their wishes has allowed for open and frank conversations that helped to develop trust and understanding. It provided a chance to resolve and express unspoken sentiments and a time to see parents/in-laws as peers. It was also a time for them to share life enriching experiences. In the process of helping them plan for their lifestyle choices and care, I learned something more about them, myself and my family. In my situation it allowed me to recognize how much value I place on having intellectual and meaningful activities.

It was interesting to read, in the survey of caregivers, (called C.A.R.E.—Costs, Accountabilities, Realities, and Expectations) that 60% said caring for two aging parents can be more demanding than caring for two children (ages 3-5). It also found that 66% said that the extra costs involved would have a large financial impact on them, and, perhaps more significantly, 38% said they had not planned for these costs. Most respondents believe the shortfall would be offset from cuts to discretionary living expenses, retirement savings, or from another source of income.

This survey is particularly worthwhile because it reveals a disconnect between the perception and the reality of caring for an elder. The perception is that caregiving is mostly about grocery shopping, cooking and laundry. Whereas, experienced caregivers know that although chores and emotional support play a large part, it is financial support and personal hygiene that are the most stressful and anxiety building aspects of caregiving. The lesson here is that you can best assist your parent or elder by pointing out this disconnect—help with chores is fine and may be necessary, but thinking through how caregiving will be financed and how their physical needs will be met is paramount to avoiding serious challenges.

As they plan their caregiving you should encourage them to agree on the signs that will be used to indicate it is time to seek further assistance with their finances and physical care. It is during these caring conversations about their wishes that you can volunteer ways in which you are willing and able to be of help (but only after you’ve examined your own retirement plan).

As the off-spring of a parent that raised a family, that may have managed a firm and made countless complicated decisions during their careers, it can be difficult to envision your mother or father sometime down the road when logging onto the Internet or even frying an egg seem onerous tasks. A key ingredient to helping them along is to examine honestly what lies ahead and plan accordingly. Encourage them to remain connected to family (they will benefit from increased meaningful contact with a loved one) and to build a fiduciary team for their physical, mental and financial wellbeing. With the right type of built-in support along the way, their retirement can truly be the “golden years,” an immensely satisfying and productive time.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Converting Sweat Equity to Personal Wealth

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

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

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

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

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

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

table

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

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

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

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

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

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

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Building Wealth: Your Real Estate Asset

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

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

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

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

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

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

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

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

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

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Financial Decisions: Taming unhealthy habits

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

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

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

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

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

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

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Wealth – a place for art and wine in your portfolio?

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Not long ago I was asked by a client about purchasing a valuable musical treasure. What did I think about taking money from her budget to make such a purchase? What role could it play, she wondered, in her investment portfolio? And just last week I was asked by another client how he could include his valuable wine inventory in his portfolio? Interesting questions, indeed, and not just because they have to do with investing, but because they are a reflection of the deep seated desire in all of us to find some way to make our passions work for us.

As an intelligent investor we must first create a base or foundation on which to build wealth before investing current cash flow into such possibilities. If you think of your wealth as forming three tiers, the first tier, or foundation, consists of good credit sources together with a robust combination of liquid assets and emergency funds. With this tier in place, an investor can withstand market volatility, support ongoing needs and endure any unforeseen emergencies for a period of time. The first tier provides the conditions necessary for building the second tier—a diversified equity and bond portfolio.

The purpose of the second tier is to extract as much growth as possible from the market, while providing a safety-net that respects your risk tolerance. The second tier is intended for your future financial security and must therefore not be exposed to excessive risk (at Aikapa, we believe that the best way to counter market risk is through a diversified global portfolio). Once your finances cover these two tiers, then, and only then, can we seriously consider a third (speculative) investment tier that could potentially offer higher returns in exchange for accepting higher risks. These speculative investments could include art,
musical instruments, wine, coins, jewelry, antique firearms or other collectibles for which you may have a passion and an expertise (though not pertinent to this article, this tier can also include other non-collectible investments).

The beauty of this third tier is that it often feeds your creativity and passion, and so should never be discouraged or dismissed, so long as it comes from a position of knowledge and experience. With time and talent it is possible to build a collection that can grow in value over the years. We have a client that has collected stamps since childhood and has therefore a very valuable asset. These investments can be very lucrative when the market is favorable, but a heavy burden when not.

The risk and expense of collectible investing goes beyond the volatility that we’ve seen with wine and the recent upsurge in artworks, with high-profile purchases like the Gaugin that sold for around $300 million.

Collectibles require storage, insurance and maintenance regardless of whether there is even a market to buy them (at times they can be highly illiquid). Accurate valuation is also a challenge, since you must actually attempt to sell any given item to determine its fair market value. The market for collectibles is fickle and historic value is no guarantee. What once sold for a good price, may no longer be in vogue.

If we’re to consider a collectible as part of a portfolio, it must be evaluated for
potential future return. What is often overlooked is the cost of bringing an item to market. In addition to the usual insurance, there can be maintenance costs, special storage facility fees to retain value, and fees associated with proving authenticity. There may also be costs for shipping, installations and appraisals. Selling a collectible often incurs a commission. For artworks, auction house fees can range from 10-25%. Finally, don’t forget that tax liability exists on any gain. For collectibles, the federal tax rate is 28%. There is also state tax and, potentially, a 3.8% net investment income tax for those in
higher tax brackets. We estimate that for most of our California clients they would pay 35-43% of their gain in taxes on collectibles, which often comes as a great shock to the uninitiated.

In a nutshell, speculative investments should never be depended upon to achieve critical goals, such as retirement. While many of our clients include collectibles as part of their wealth (and are generally very passionate and knowledgeable about them), it is only as a component of the third tier of their investment strategy. These collectibles, while often extremely valuable, are never an essential part of a core investment portfolio or retirement plan.

If you’re interested in developing a third tier for your investment portfolio let us know and we’ll work together to provide a financial perspective on your plan. We do not recommend developing this tier from a budget unless tier 1 and 2 are already fully funded.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Retirement Portfolio Distribution – vital considerations

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Not sure when and how to start dipping into your hard-earned retirement funds? It’s a BIG consideration with BIG implications. How might you withdraw your money without worry that you’ll outlive your portfolio?

You could use a generic retirement distribution model that targets a 4% withdrawal from your portfolio (if portfolio is allocated at 60/40 equities/bonds). This generic model focuses on not outliving your assets and often leaves much to be desired in terms of maximizing how you distribute your portfolio efficiently. This is where a retirement distribution plan is absolutely vital since it will outline the amount that you need to meet your specific needs each year, the impact on taxes and on your ability to not outlive your portfolio (particularly important 5-10 years to retirement).

Many studies demonstrate that creating a portfolio withdrawal plan that more closely fits your needs in early retirement while providing for your wishes later in retirement leads to a successful retirement. Of course, retirement planning first requires that you’ve accumulated enough assets to support your lifestyle for the length of your potential retirement. It should also allow for unexpected obstacles and other goals.

You may find after discussions that your retirement of choice might be much different than a standard generic model. In some cases, it is in your best interests to keep working even part-time into your “retirement.” This is becoming more and more the case (so don’t feel alone if it comes to that) even if you have enough assets to support full retirement.

A recent study by T. Rowe Price revealed that 22% of recent retirees have rejoined the workforce at least part-time and of these 18% are earning as much as they were earning prior to retirement. Of course others have chosen to adjust their budgets to extend the life of their portfolio and are living on 67% of pre-retirement incomes rather than returning to employment. The study found that retirees are covering their early retirement expenses from the following sources: 18% from pension plans, 42% from social security and 17% from tax-advantaged accounts.

The latest methods for funding retirement are much more specific to your individual situation than a flat 4% withdrawal. When working together (5-6 years to retirement) we’ll formulate your distribution plan through retirement. This would include how your portfolio will be allowed to recover from any potential market decline and how it provides for your wishes during the 30-40 years in retirement. As retirement approaches (or whenever you make the request) we will outline the latest successful approaches to asset distribution for your situation – we want to be sure that you don’t unnecessarily skimp through early retirement or outlive your portfolio later in life.

A formal retirement distribution plan should include a review of alternative income streams, a financial breakdown of at least the first 3 years of retirement, an overall budget for those years, including expected distribution and social security. This is when the value of having different cash flow streams becomes obvious. Taxable accounts, tax free, pension/social security, annuities, and tax-deferred are the usual assets considered in all retirement distribution plans.

By setting the finances for the first years in retirement, you can plan for the potential of a market downturn and also the possibility of allocating more during the first 10 years of retirement if you so wish. Most often, families want to spend their first 10 years traveling or hosting family events as a way of enjoying their most active phase of retirement.

The most obvious danger of ad-hoc or unplanned withdrawals from a portfolio is that the account balance dwindles faster than any return can support. By funding non-budget needs, the portfolio may no longer be able to fund the necessary budget items that are important in that client’s lifetime. To succeed, this requires open communication with our clients, their trust in our work, and their discipline to rein-in non-budget expenses.

Retirement can last 30-40 years and can exhaust any portfolio without a distribution plan. Outside of retirement, your other goals may or may not need a separate distribution plan (we do one for college plans and home purchase too). Speak to your advisor if you are in any way uncertain about how or when to tap into any of your portfolio savings.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Cost Basis: How not knowing can hurt you

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Knowing the cost basis on your house or your investment portfolio is critical to building your wealth in a tax efficient manner. Without managing the cost basis in your portfolio you may inadvertently increase your tax liability. These last six months we’ve encountered a large number of cost basis issues so I’d like to enhance your understanding of how cost basis can impact your wealth.

What is cost basis? When you look at your investment statements you’ll see a column that states the cost basis for that investment. Simply stated, cost basis is the cost you incurred for that security. In reality, cost basis is more than the original cost. In fact, many securities change their cost basis annually and in other specific situations.

First let’s make sure that we’re clear on the types of accounts that we’re talking about. If your investment portfolio only consists of tax-advantaged accounts (401K, pension or any IRA) you can safely ignore cost basis. In such accounts your tax liability is governed by Federal and State tax rules and not impacted by the cost basis rules discussed here. If, on the other hand, you have a taxable account (a trust, individual, or transfer on death (TOD)), every year your personal tax liability will be dependent on what is in that account and how it is managed.

Just about everyone knows that gain from the sales of a security is taxed (short-term rates if held less than 12 months and long-term rates if held longer). This taxable gain, as you can imagine, is the difference between the sale price and the cost basis. It is to our tax advantage to keep this difference low but it is a better investment when it grows far higher than the basis.

What you may not realize is that without buying/selling you may still incur 1099 dividend and capital gain distributions that are taxable. These are distributions that flow to the shareholders from funds when they earn and “realize” gain. For high earners these distributions can add an unreasonable annual tax burden because the current tax code not only taxes the gain but adds the gain to inflate the Adjusted Gross Income (AGI). After all, it is the level of the AGI that will determine the phase out deductions and if higher taxes apply. If possible high earners need to reduce funds that yield large distributions from their taxable portfolio.

Up until 2012 we were each responsible for tracking cost basis on our taxable accounts and reporting cost basis and gains for our investments. If you have no actual evidence of the cost basis then your basis is considered to be zero – maximizing your gain and therefore your taxes. Not something any tax payer would want. In 2012 funds were required to report basis relieving us of this task by creating what are known as “covered shares” (those purchased after 2012 and for which the brokerage firm has records) and non-covered shares (those for which the brokerage firm has no record or were purchased prior to 2012). We help you track, recreate and manage cost basis for portfolios under our management.

If you were diligent enough to read this far, I want to alert you to one very important role of cost basis. On the death of the original owner of a security current rules allow for the basis to be elevated to the market value on the day of death. This is called a step-up in basis. Why is this important? If those securities have appreciated in value, the advantage is substantial. The gain in the securities is wiped out so that inherited assets are received at current value without paying capital gain tax. This process of step-up must follow required steps and careful monitoring of cost basis information.

When managing a portfolio whose goal is to be inherited there is little advantage to reducing any gains to the portfolio, particularly if the current owner already is subject to high taxes. The opposite might be true if the owner has low taxable earnings and is still young since they would benefit from keeping the gain of the portfolio low and therefore available for near term purchases (with minimal tax implications in any one year).

Considering the effort in managing cost basis, why do I consider a taxable account essential to your portfolio? A taxable account has at least two practical advantages that other types of accounts can’t provide. One is that it is available for short-term goals (for withdrawals prior to age 59½). The other is that in a retirement portfolio it often provides a means to reduce taxes during retirement. For example, most retirees have social security and tax deferred accounts to fund retirement. Withdrawals from such tax-deferred accounts are treated as having a zero cost basis and taxed as regular income. Whereas assets withdrawn from a taxable account with the cost basis carefully managed should see a lower tax liability. A taxable account is a key part in planning how the portfolio will support your needs.

The real lesson here is that growth in a taxable account is a double edge sword. To avoid paying unnecessary taxes and take full advantage of the account, it needs to be managed and, moreover, requires that you provide your advisor with updates on your past taxes and current year tax plan. The key is to choose the right investments and to manage the cost basis based on your specific goals and tax situation.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Fostering Financial Peace of Mind

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According to a study (conducted by the Research Intelligence Group) we struggle with regret over financial decisions, argue over spending, feel pressure to keep up with friends or colleagues, and bend the truth to friends and family about our financial situation in order to save face. In many cases, the primary response of stress is denial. Unfortunately, putting off these financial conversations can affect mental and physical well-being and the quality of our lives. The longer we stay silent about challenging financial situations, the bigger the problem is likely to become. Often this leads to regret for not having created a financial plan (and good financial habits) early in our lives – but is it ever too late?

Without a financial plan in place it is difficult to know if you’re making the most of the resources you have. It is also difficult to establish financial habits that will support you regardless of what life throws your way. Moreover, it is difficult to annually monitor and adjust the various competing demands for your finances in a way that allows you to sleep well at night.

According to many studies women are significantly more likely than men to lose sleep over financial worries. Fifty percent of women admit losing sleep over financial worries and forty percent of men. It is these issues that bring out some of the differences in how women handle financial adversity. For women, financial planning is inclusive, focused on building and maintaining the family, community and even beyond, well into the future. For men (on average) it seems that the focus is less on the relationship and more on the short-term transaction. According to financial author Kelley Keehn, in the face of considerable stress, men release higher doses of adrenaline, activating a “flight or flight” response, while women produce higher levels of oxytocin, activating a “tend and befriend” response.

Keeping in mind how we tend to react to financial stress, a clear well-defined financial path and a trusted financial professional with whom you can maintain a sincere collaborative and communicative relationship can go a long way toward building confidence, and hence, peace of mind.

Here are a few things you can do to ensure that you’re not the one losing sleep over finances:

  1. Do your due diligence. Demand that those giving you advice have your best interest at heart and have the qualifications and experience to provide this advice (especially if you have very specific needs). Moreover, find out if your advisor has any real or potential conflicts of interest.
  2. Understand what fees you pay and what value they add to your ongoing and future financial needs.
  3. Be prepared when you meet with your advisor. Do your part, keeping track of your finances and letting your advisor know in advance of your meeting of any items that you would like clarified as part of the agenda.
  4. Get to know your financial and personal goals intimately and be sure that they are reflected in all your financial decisions.
  5. Seek opportunities to enhance your financial education. Keeping abreast of valuable (not hyped) financial news. Stay away from pundits and financial hype.
  6. Include your partner and your adviser in your process. Don’t try to “go it alone.”

At Aikapa, we choose our clients carefully to be sure that we have the greatest chance to add value to their financial lives and their portfolio. Our clients tend to be high achieving professionals/business owners with an interest in building solid financial habits that will lead them to a life they will enjoy.

Sleeping well is essential to good solid decisions and enjoying life. If you find yourself losing sleep over your finances or getting overly anxious, give us a call or drop us an email. It is our mission to educate and help you build a stress reduced financial life while maximizing your wealth. Let’s continue to remain in touch and let us know if we can help you with any financial issue.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com