12% Roth Conversion

The 12% Roth Conversion

If you make less than $105,050, you’ve got to look into the 12% Roth Conversion. For a married couple, the 12% Federal Income tax rate goes all the way up to $80,250 for 2020. That’s taxable income. With a standard deduction of $24,800, a couple could make up to $105,050 and remain in the 12% bracket. Above those amounts, the tax rate jumps to 22%.

For those who are in the 12% bracket, consider converting part of your Traditional IRA to a Roth IRA each year. Convert only the amount which will keep you under the 12% limits. For example, if you have joint income of $60,000, you could convert up to $45,050 this year.

This will require paying some taxes today. But paying 12% now is a great deal. Once in the Roth, your money will be growing tax-free. There will be no Required Minimum Distributions on a Roth and your heirs can even inherit the Roth tax-free. Don’t forget that today’s tax rates are going to sunset after 2025 and the old rates will return. At 12%, a $45,050 Roth conversion would cost only $5,406 in additional taxes this year.

Take Advantage of the 12% Rate

If you have a large IRA or 401(k), the 12% rate is highly valuable. Use every year you can do a 12% Roth Conversion. Otherwise, you are going to have no control of your taxes once you begin RMDs. If you have eight years where you can convert $40,000 a year, that’s going to move $320,000 into a tax-free account. I have so many clients who don’t need their RMDs, but are forced to take those taxable distributions.

Here are some scenarios to consider where you might be in the 12% bracket:

  1. One spouse is laid off temporarily, on sabbatical, or taking care of young children. Use those lower income years to make a Roth Conversion. This could be at any age.
  2. One spouse has retired, the other is still working. If that gets you into the 12% bracket, make a conversion.
  3. Retiring in your 60’s? Hold off on Social Security so you can make Roth Conversions. Once you are 72, you will have both RMDs and Social Security. It is amazing how many people in their seventies are getting taxed on over $105,050 a year once they have SS and RMDs! These folks wish they had done Conversions earlier, because after 72 they are now in the 22% or 24% bracket.

Retiring Soon?

Considering retirement? Let’s say you will receive a $48,000 pension at age 65. (You are lucky to have such a pension – most workers do not!) For a married couple, that’s only $23,200 in taxable income after the standard deduction. Hold off on your Social Security and access your cash and bond holdings in a taxable account. Your Social Security benefit will grow by 8% each year. The 10 year Treasury is yielding 1.6% today. Spend the bonds and defer the Social Security.

Now you can convert $57,050 a year into your Roth from age 65 to 70. That will move $285,250 from your Traditional IRA to a Roth. Yes, that will be taxable at 12%. But at age 72, you will have a lower RMD – $11,142 less in just the first year.

When you do need the money after 72, you will be able to access your Roth tax-free. And at that age, with Social Security and RMDs, it’s possible you will now be in the 22% tax bracket. I have some clients in their seventies who are “making” over $250,000 a year and are now subject to the Medicare Surtax. Don’t think taxes go away when you stop working!

How to Convert

The key is to know when you are in the 12% bracket and calculate how much to convert to a Roth each year. The 12% bracket is a gift. Your taxes will never be lower than that, in my opinion. If you agree with that statement, you should be doing partial conversions each year. Whether that is $5,000 or $50,000, convert as much as you can in the 12% zone. You will need to be able to pay the taxes each year. You may want to increase your withholding at work or make quarterly estimated payments to avoid an underpayment penalty.

What if you accidentally convert too much and exceed the 12% limit? Don’t worry. It will have no impact on the taxes you pay up to the limit. If you exceed the bracket by $1,000, only that last $1,000 will be taxed at the higher 22% rate. Conversions are permanent. It used to be you could undo a conversion with a “recharacterization”, but that has been eliminated by the IRS.

While I’ve focused on folks in the 12% bracket, a Conversion can also be beneficial for those in the 22% bracket. The 22% bracket for a married couple is from $80,250 to $171,050 taxable income (2020). If you are going to be in the same bracket (or higher) in your seventies, then pre-paying the taxes today may still be a good idea. This will allow additional flexibility later by having lower RMDs. Plus, a 22% tax rate today might become 25% or higher after 2025! Better to pay 22% now on a lower amount than 25% later on an account which has grown.

A Roth Conversion is taxable in the year it occurs. In other words, you have to do it before December 31. A lot of tax professionals are not discussing Roth Conversions if they focus solely on minimizing your taxes paid in the previous year. But what if you want to minimize your taxes over the rest of your life? Consider each year you are eligible for a 12% Roth Conversion. Also, if you are working and in the 12% bracket, maybe you should be looking at the Roth 401(k) rather than the Traditional option.

Where to start? Contact me and we will go over your tax return, wage stubs, and your investment statements. From there, we can help you with your personalized Roth Conversion strategy.

Preferred Stocks Belong in Your Portfolio

Why do we own Preferred Stocks? US Stocks are expensive today. Bond yields are very low. Neither are terribly attractive. With any allocation, the expected return of the portfolio going forward is lower than historical returns. Risks, however, remain in the market. That’s not a dire prediction, just a statement of fact. We hope 2020 is another great year, like 2019.

The challenge for a portfolio manager like myself, is to diversify and find the sweet spot of risk and return. Because of today’s high prices of stocks and bonds, we include a 10% allocation to alternative investments. We’re looking for things which might offer a higher yield than bonds, but with less risk than stocks. And ideally, with a low correlation to stocks or bonds.

What is a Preferred Stock?

A Preferred Stock is a hybrid security. It has characteristics of both a common stock and a bond. It trades like a stock and pays a quarterly dividend. Like a bond, it has a fixed rate of return and a par value. With a Par value of $25, a company issues a Preferred stock at $25 and can redeem it at $25. 

(How well do you understand bonds? Read: A Bond Primer.)

Historically, Preferred Stocks were “perpetual”, meaning that they had no ending date. More commonly today, Preferred Stocks are callable. Companies can buy back their Preferreds at $25 after a specific date in the future, most often five years after issue. Other Preferreds have a specific redemption date, when the company will buy back all of the shares.

Dividends of a Perpetual Preferred are typically qualified dividends. They qualify for the 15% tax rate on dividends. Other Preferreds, with redemption dates, may treat dividends as ordinary income, like bonds. As a result, we prefer to buy Preferreds in an IRA. 

The Investment Rationale

We are interested in Preferreds which are callable or have a redemption date of less than 10 years. The reason is that, unlike perpetual Preferreds, these ones are trading for close to $25 a share. The ones we own have coupons of 4.75% to 7.25% or higher. We are generally paying a little above $25 today, but plan to hold until the shares are redeemed or called. (We can also sell them any day if desired, as they are liquid.)  

You buy Preferreds for the dividend. They do not offer any growth. But that also means we have more stability. They tend to trade right around $25. And for those with a redemption date, we know the company will buy them for $25. So, any price volatility is likely a temporary fluctuation.

I am featured in this article “Are Preferred Stocks Preferable?” at US News & World Report from the summer of 2016. Since then, the relative attractiveness of Preferreds versus common stocks has improved significantly. Today, I think they have a place in our portfolios.

How to Invest in Preferred Stocks

Because Preferred Stocks carry the credit risk of the company, we prefer to purchase a basket rather than just one. Typically, we have a 5-6% allocation to Preferreds per household, and will buy at least five different issuers. That gives us some diversification of risks. Like any stock or bond, if the company goes bankrupt, you lose money. That’s why we diversify with a basket of small positions.

There are also funds and ETFs for Preferreds which offer a bigger basket. But, I prefer to pick the duration and companies I want. Also, we can save clients the expense ratio of a fund, often 0.50% to 1% a year. That would take a big bite out of your yield.

Preferreds are a niche investment and not a part of our core holdings. Given today’s market, we think they offer a nice complement to our traditional stock and bond holdings. Most advisors have never purchased a Preferred Stock, but I have been analyzing and trading the sector for over 15 years. We generally buy on the open market, but this month we have also participated in IPOs of Preferreds from Wells Fargo, AT&T, and Capital One. People want these yields. They’re no magic bullet, but Preferred Stocks are an interesting tool and we think a good fit for what our clients want.

If you’re looking for more than just a generic robo portfolio or a target date fund, let’s talk. Our Premiere Wealth Management Portfolios are for investors with at least $250,000 to invest.

Investment carries risk of loss of principal. Preferred Stocks are not guaranteed. 

Tax Planning

Tax Planning – What are the Benefits?

Taxes are your biggest expense. Tax Planning can help. A typical middle class tax payer may be in the 22% or 24% tax bracket, but Federal Income Taxes are only one piece of their total tax burden. They also pay 7.65% in Social Security and Medicare Taxes. If they’re self-employed, double that to 15.3%. Most of my clients here in Dallas pay $6,000 to $20,000 a year in property taxes, more if they also have a vacation home. After getting to pay taxes on their earnings, they are taxed another 8.25% when they spend money, through sales tax. 

High earners may pay a Federal rate of 35% or 37%, plus a Medicare surtax of 0.9% on earned income and 3.8% on investment income. There’s also capital gains tax of 15% or 20%. Business owners get to pay Franchise Tax and Unemployment Insurance to the state. Add it all up and your total tax bill is probably a third or more of your gross income.

I’m happy to pay my fair share. But I’m not looking to leave Uncle Sam a tip on top of what I owe, so I want make sure I don’t overpay. I help people with their investments, prepare to retire someday, and to make sure they don’t get killed on taxes. It’s vitally important.

The tax code is complex and changes frequently. We have talked about how the Tax Cuts and Jobs Act changes how you should approach tax deductions. This past month, I’ve been talking and writing about the new SECURE Act passed in December.

It’s February and people are receiving their W-2s and 1099s and starting to put together their 2019 tax returns. I like to look at my client tax returns. We can often find ways to help you reduce your tax burden and keep more of your hard-earned money, completely legally.

Two sets of eyes are better than one.

I’m not a tax preparer, and I don’t mean to suggest that your tax preparer is making mistakes. While I have, of course, seen a couple of errors over the years, they are rare. However, I think there is a benefit to having a second set of eyes on your tax return. I may look at things from a different perspective than your CPA or accountant. As a Certified Financial Planner professional and Chartered Financial Analyst, I have extensive training on Tax Planning and have been doing this for over 15 years.

Tax preparers are great at looking at the previous year and calculating what you owe. What I sometimes find is that they don’t always share proactive advice to help you reduce taxes going forward. 

For example, this month, I met with an individual and looked over his 2018 tax return. He would have qualified for the Savers Tax Credit but did not contribute to an IRA. I told him “your CPA probably mentioned this, but last year, if you had contributed $2,000 to a Roth IRA, you would have received a $1,000 Federal Tax Credit”. Nope, he had never heard about this from his long-time preparer, and let’s just say he was displeased. While his tax return was “correct”, it could have been better.

When you become a client of Good Life Wealth Management, I will review your tax return and look for strategies which could potentially save you a significant amount of money. Such as?

5 Areas of Tax Planning

1. Charitable Giving Strategies. It has become more difficult to itemize your deductions and get a tax savings for your charitable giving. We identify the most effective approach for your situation. For example, donating appreciated securities or bunching deductions into one year. If you’re 70 1/2, you could make QCDs from an IRA. Or we could front-load a Donor Advised Fund to take a deduction while you are in a higher tax bracket before retirement. If you are planning to make significant donations, I can help your money go father and have a bigger impact.

2. Tax-advantaged accounts: which accounts are you eligible for and will enable the greatest contribution? No one can tell without looking at your tax return. Let’s maximize your pre-tax contributions to company retirement plans, IRAs, Health Savings Accounts, and FSAs. Often someone thinks they are doing everything possible and we find an additional savings avenue for them or their spouse.

3. Investment Tax Optimization. Do you have a lot of interest income reported on Schedule B? Why are those bonds not in your IRA or retirement account?  Are your investments creating short-term gains in a taxable account? Do you have REITs which don’t qualify for the qualified dividend rate? You could benefit from Asset Location Optimization. 

Showing a lot of Capital Gains Distributions on Schedule D? Many Mutual Funds had huge distributions in 2019. Let’s look at Exchange Traded Funds which have little or no tax distributions until you sell. There may be more tax-efficient investments for your taxable accounts. Are you systematically harvesting losses annually?

4. If you make too much for a Roth IRA, are you a good candidate for a Backdoor Roth IRA?

5. Tax-Efficient Retirement Income. What is the most effective way to structure your withdrawals from retirement accounts and taxable accounts? When should you start pensions or Social Security? How can you minimize taxes in retirement?

I could go on about tax-exempt municipal bonds, tax-free 529 college savings plans, the Medicare surtax, or reducing taxes to your heirs. It’s a long list because almost every aspect of financial planning has a tax component to it. 

Most Advisors Aren’t Doing Tax Planning

Even though taxes are your biggest expense, a lot of financial advisors aren’t offering genuine tax planning. For some, it’s just not in their skill set, they only do investments. For a lot of national firms, management prohibits their advisors from offering tax advice for compliance reasons. Other “advisors” specialize in tax schemes which are designed primarily to sell you an insurance product for a commission. I’m in favor of the right tool for the job, but if you only sell hammers, every problem looks like a nail. 

Tax Planning is making sure that all the parts of your financial life are as tax-efficient as possible. If you’d like a review of your 2018 return before you complete your 2019 taxes, give me a call. I get a better understanding of a client’s situation by reviewing their taxes and I really enjoy digging into a tax return. 

While I can’t guarantee that we can save you a bunch of money on your taxes, we do often have ideas or suggestions to discuss with your tax preparer. That way you can participate more than just dropping off a pile of receipts. If you do your taxes yourself, as many do today, you can ask me “Are there any additional ways to reduce my taxes?” Let’s find out.

SECURE Act Retirement Bill

Tax Savings under the SECURE Act

A few weeks ago, we gave an overview of key changes under the SECURE Act Retirement Bill. Today we are going to dive into a few questions that investors have been asking about the Act. Here’s how the SECURE Act can help you reduce your tax bill.

RMDs and QCDs

1. Required Minimum Distributions are pushed to age 72 from 70 1/2. If you turned 70 1/2 in 2019, even though you won’t reach 72 in 2020, you will still be responsible for taking RMDs. You will not get to skip a year. 

2. Although RMDs have been pushed to 72, the age for Qualified Charitable Distributions (QCDs) was unchanged at age 70 1/2. I’ve read some articles suggesting people under 72 not do QCDs now. Sure you could wait until after 72 to count a QCD towards your RMD. However, most donors I know want to support their favorite charities annually. So if you are 70 1/2 and want to make a $5,000 charitable donation this year, consider three scenarios:

  • You could make a cash donation. To be able to deduct your charitable donations, you have to have more than $12,400 (single) or $24,800 (married) in itemized deductions for 2020  It’s likely that a $5,000 donation nets you no tax benefit.
  • Or you could donate appreciated securities. If you had a $5,000 position with a $2,500 cost basis, donating those shares would save you $375 in long-term capital gains. (Most tax payers are in the 15% LT rate.)
  • With a QCD, it wouldn’t save you any taxes this year. But it would remove $5,000 from your IRA, saving you in future taxes. If you are in the 24% tax bracket, that would save $1,200 in future income taxes. That’s still the best choice of these three options.

529 Plans Can Pay Student Loans

3. Beneficiaries of a 529 College Savings Plan can now use their account to pay up to $10,000 in student loans. This will help those who have finished and have leftover funds. But also, there could be an advantage to deliberately taking $10,000 in Stafford Loans in the first or second year of college to receive deferment on the loan until after you’ve graduated. Then the funds can grow for four or so years while the student receives a loan which has no payments or interest accruing. Upon the end of the deferment period, you could use the 529 to pay off the loan in full. Additionally, owners of a 529 plan can also use the funds to pay $10,000 towards a sibling’s student loans, should the original beneficiary not need the funds.

Stretch IRA Eliminated in 2020

4. With the elimination of the Stretch IRA, we previously shared tax saving strategies for owners of larger IRAs. Here’s one additional approach for a married couple who both have IRAs and plan to leave them to their children. Assuming both spouses have more funds than they will need in their lifetime, consider making your children the primary beneficiaries of your IRAs. Otherwise, the traditional approach of leaving each IRA to the spouse will ultimately double up the tax burden on the children as well as increasing RMDs for the surviving spouse. Since all inherited IRAs must be distributed in 10 years or less, it may be more tax efficient for the children to receive two distributions spread out, rather than one combined inheritance from the second-to-pass parent. Contact me for an examination of your specific situation. 

Annuity for Retirement Income?

5. 401(k) plans can now offer annuities for retirees to create a guaranteed income stream. This sounds like a big deal, but you have always been able to do this once you roll over your 401(k) into an IRA. And it still might be better to buy an annuity in an IRA for a couple of reasons:

  • You could shop for the best annuity product for you. Otherwise, you are stuck with whatever the plan sponsors have decided to offer. It could be that another insurance company offers higher payout rates. Contact me for quotes if this is something you are considering.
  • Your State Insurance Guaranty Association probably only protects $250,000 in losses should an Insurance Company go bankrupt. Some of the biggest ones, including AIG, almost failed back in 2009. If I had $400,000 or $600,000 to invest in annuities, you bet I’m going to divide that between two or three companies to stay under the covered limits. (Read more on the Texas Guaranty Association.)

Changes in law are common and an important reason for having an on-going financial plan with a professional who is staying informed. If you have questions about how the SECURE Act Retirement Bill could be beneficial or detrimental to your situation, please contact me. Our first meeting is always free.

SECURE Act Abolishes Stretch IRA

The SECURE Act passed in December and will take effect for 2020. I’m glad the government is helping Americans better face the challenge of retirement readiness. As a nation, we are falling behind and need to plan better for our retirement income. 

It’s highly likely that the SECURE Act will directly impact you and your family. Six of the changes are positive, but there’s one big problem: the elimination of the Stretch IRA. We’re going to briefly share the six beneficial new rules, then consider the impact of eliminating the Stretch IRA.

Changes to RMDs and IRAs

1. RMDs pushed to age 72. Currently, you have to begin Required Minimum Distributions from your IRA or 401(k) in the year in which you turn 70 1/2. Starting in 2020, RMDs will begin at 72. This is going to be helpful for people who have other sources of income or don’t need to take money from their retirement accounts. People are living longer and working for longer, so this is a welcome change.

2. You can contribute to a Traditional IRA after age 70 1/2. Previously, you could no longer make a Traditional IRA contribution once you turned 70 1/2. Now there are no age limits to IRAs. Good news for people who continue to work into their seventies!

3. Stipends, fellowships, and home healthcare payments will be considered eligible income for an IRA. This will allow more people to fund their retirement accounts, even if they don’t have a traditional job.

529 and 401(k) Enhancements

4. 529 College Savings Plans. You can now take $10,000 in qualified distributions to pay student loans or for registered apprenticeship programs.

5. 401(k) plans will cover more employees. Small companies can join together to form multi-employer plans and part-time employees can be included

6. 401(k) plans can offer Income Annuities. Retiring participants can create a guaranteed monthly payout from their 401(k). 

No More Stretch IRAs

7. The elimination of the Stretch IRA. This is a problem for a lot of families who have done a good job building their retirement accounts. As a spouse, you will still be allowed to roll over an inherited IRA into your own account. However, a non-spousal beneficiary (daughter, son, etc.) will be required to pay taxes on the entire IRA within 10 years.

Existing Beneficiary IRAs (also known as Inherited IRAs or Stretch IRAs) will be grandfathered under the old rules. For anyone who passes away in 2020 going forward, their IRA beneficiaries will not be eligible for a Stretch.

If you have a $1 million IRA, your beneficiaries will have to withdraw the full amount within 10 years. And those IRA distributions will be taxed as ordinary income. If you do inherit a large IRA, try to spread out the distributions over many years to stay in a lower income tax bracket. 

For current IRA owners, there are a number of strategies to reduce this future tax liability on your heirs.
Read more: 7 Strategies If The Stretch IRA Is Eliminated

If you established a trust as the beneficiary of your IRA, the SECURE Act might negate the value and efficacy of your plan. See your attorney and financial planner immediately.

IRA Owners Need to Plan Ahead

The elimination of the Stretch IRA is how Congress is going to pay for the other benefits of the SECURE Act. I understand there is not a lot of sympathy for people who inherit a $1 million IRA. Still, this is a big tax increase for upper-middle class families. It won’t impact Billionaires at all. For the average millionaire next door, their retirement account is often their largest asset, and it’s a huge change. 

If you want to reduce this future tax liability on your beneficiaries, it will require a gradual, multi-year strategy. It may be possible to save your family hundreds of thousands of dollars in income taxes. To create an efficient pre and post-inheritance distribution plan, you need to start now.

Otherwise, Uncle Sam will be happy to take 37% of your IRA (plus possible state income taxes, too!). Also, that top tax rate is set to go back to 39.6% after 2025. That’s why the elimination of the Stretch IRA is so significant. Many middle class beneficiaries will be taxed at the top rate with the elimination of the Stretch IRA. 

From a behavioral perspective, most Stretch IRA beneficiaries limit their withdrawals to just their RMD. As a result, their inheritance can last them for decades. I’m afraid that by forcing beneficiaries to withdraw the funds quickly, many will squander the money. There will be a lot of consequences from the SECURE Act. We are here to help you unpack these changes and move forward with an informed plan.

Using the ACA to Retire Early

A lot of people want to retire early. Maybe you’re one of them. The biggest obstacle for many is the skyrocketing cost of health insurance. It’s such a huge expense that some assume they have no choice but to keep working until age 65 when they become eligible for Medicare.

However, if you can carefully plan out your retirement income, you may be eligible for a Premium Tax Credit (PTC) when you purchase an insurance plan on the health exchange, under the Affordable Care Act (“Obamacare”). The key is to know what the income levels are, what counts as income, and then to have other sources of savings or income to cover you until after the year in which you reach age 65 and enroll in Medicare. If we can bridge those years, maybe you can retire early by having the PTC cover a significant portion of your insurance premiums.

You are eligible for a PTC if your income is between 100% and 400% of the Federal Poverty levels. For a single person, those income amounts are between $12,140 and $48,560 for 2019. For a married couple, your income would need to be between $16,460 and $65,840. The lower your income, the larger your tax credit. Please note that if you are married filing separately, you are not eligible for the PTC. You must file a joint return.

The PTC will be based on your estimate of your 2020 income. If your actual income ends up being higher, when you file your 2020 tax return in April 2021, then you have to repay the difference. So it is very important that you understand how “income” is calculated for the PTC.

Under the ACA, income is your “Modified Adjusted Gross Income” (MAGI), which unfortunately is not a line on your tax return. MAGI takes your Adjusted Gross Income and adds back items, such as 100% of your Social Security benefits (which might have been 50% or 85% taxable), Capital Gains, and even tax-free municipal bond interest.

Read more: What to Include as Income

Here are some examples of the Premium Tax Credit, based on Dallas County, Texas, for non-tobacco users:

  • Single Male, age 63 with $45,000 income would be eligible for a PTC of $580 a monthSingle Male, age 63 with $25,000 income, PTC increases to $811 a month.
  • Married couple (MF) age 63, with $60,000 income would have a PTC of $1,404/monthMarried couple (MF) age 63, with $40,000 income would have a PTC of $1,633/month

(Same sex couples are eligible for a PTC under the same rules: they must be legally married and file a joint tax return.)

For this last example of a 63 year old couple making $40,000, the average cost of a plan after the Premium Tax Credit would be $332 (Bronze), $428 (Silver), or $495 (Gold) a month, for Dallas County. That’s very reasonable compared to a regular individual plan off the exchange, or COBRA. 

Check your own rates and PTC estimate on Healthcare.gov

Here’s how you can minimize your income to maximize your ACA tax credit and retire before 65:

  • Don’t start Social Security or a Pension until at least the year after you turn 65. Consider that if you start taking $2,000 a month in income, it means you could lose a $1,400 monthly tax credit.
  • Don’t take withdrawals from your Traditional IRA or 401(k). Those distributions count as ordinary income.
  • You can however take distributions from your Roth IRA and that won’t count as income for the PTC. Just make sure you are age 59 1/2 and have had a Roth open for at least five years. 
  • Build up your savings so you can pay your living expenses for these bridge years until age 65. 
  • If you have stocks or funds with large capital gains, consider selling a year before you sign up for the ACA health plan. Although you might pay 15% long-term capital gains tax, you can avoid having those sales count as MAGI in the year you want a PTC.
  • In your taxable account, you can sell funds or bonds with low taxable gains in the years you need the PTC. That can be a source of liquidity. Rebalance in your IRA to avoid creating additional gains.  
  • You can pay or reimburse yourself from a Health Savings Account (HSA) for your qualified medical expenses. Those are tax-free distributions.
  • If you still have earned income when “retired”, a Traditional IRA contribution (if deductible) or a 401(k) contribution will reduce MAGI. 
  • If you sell your home (your primary residence), and have lived there at least two of the past five years, then the capital gain (of up to $250,000 single or $500,000 married) is not counted towards MAGI for the ACA.  

An important point: your goal is not to reduce your income to zero. If you do not have income of at least 100% of the poverty level, you are ineligible for the premium tax credit and will instead be covered by Medicaid. That’s not necessarily bad, but to get a large tax credit and use a plan from the exchange, you need to have income of at least $12,140 (single) or $16,460 (married).

If you can delay your retirement income and have other assets available to cover your expenses until after 65, you may be able to take advantage of the Premium Tax Credit. This planning could add years to your retirement and avoid having to wait any longer. If you want to retire before 65, let’s look at your expenses and accounts, and create a budget and plan to make it happen using the Premium Tax Credit.

Consider, too, that the plans on the exchange may have different deductibles and co-pays than your current employer coverage. Check if your existing doctors and medications will be covered in-network and create an estimate of what you might pay out-of-pocket as well as what your maximum out-of-pocket costs would be. 

Your Home Is Like A Bond

You’re doing well: you’ve got your emergency fund, you’re maxing out your 401(k), and you don’t have any credit card debt. At this point, a common question is: Should I send extra payments to my mortgage? And with markets near their highs, maybe you’re even wondering, Should I pay off my mortgage?

There are a lot of emotional reasons to do this: to own your house free and clear, to never have to worry about a mortgage again, or to reduce your bills in retirement. Investments carry uncertainty, whereas paying down a debt is a sure thing. Those are typical thoughts, but that’s not necessarily a rational answer.

In financial planning, our goal is to determine the solution which maximizes utility. Will I have a higher net worth if I pay off my mortgage or invest the money?

The answer, then, is it depends. It depends on the rate of return on your investments compared to the rate you are paying on your mortgage. If your mortgage is 3% but your cash is earning 0.5%, you would be better off paying down the mortgage (assuming you still kept sufficient liquidity for emergencies). On the other hand, if your mortgage is 3% and you could be making 7%, you would maximize your net worth by staying invested and just paying your mortgage at the expected rate.

While most people would prefer to be debt free, the fact is that if you can borrow at a low cost and invest at a higher return, you will grow your net worth faster. I don’t think of a home as being a great investment. Houses generally keep up with inflation, but have returns similar or less than bonds.

Looking at the Case-Shiller 20 City Home Price Index (which includes Dallas), the overall rate of return since 2000 was 4.02%. Looking at actual bond funds, not just hypothetical indexes, I see that an investor could have earned 5.15% a year in the Vanguard Intermediate Term Bond Index fund, since the fund inception in 2001. 

The money you put into your house, will likely behave like a bond, although possibly with more volatility. Over a long period, it should keep up with inflation, or if you are lucky, do a little better than inflation. (See below for my concerns about home prices, or thinking of a home as an investment.)
I do believe it is realistic, based both on historical returns and projected returns, to anticipate a return of 5-8% from a diversified portfolio containing 60% or more in stocks. That’s not guaranteed, but if your time horizon is twenty or thirty years for a mortgage, it’s a reasonable assumption. And the longer the time period we consider, the greater likelihood of a positive outcome from stocks.

While I think it is important to consider your portfolio as a whole entity, with total levels of risk and return, a portfolio is made up of specific segments. Today, the yields on high quality bonds are very low. With the 10-year treasury yielding only 1.7%, there’s not much return to be had in bonds.

Let’s consider an example, using round numbers for simplicity. Let’s say you have a $1 million portfolio in a 60/40 portfolio: $600,000 in stocks and $400,000 in bonds. You also have a $200,000 mortgage at 3.5%. The expected returns (hypothetical) for stocks is 7% and for bonds 2.5% today. That would give the overall portfolio an expected return of 5.2%, which is higher than your mortgage rate.

On the bonds, though, the expected return of 2.5% is less than your mortgage cost of 3.5%. If you believe that today’s low yield environment is likely to persist for a long time, it might make sense to take $200,000 from your bonds to pay off the mortgage. That would leave you with a portfolio containing $600,000 of equities and $200,000 in bonds, a 75/25 portfolio. 

The new portfolio would be more volatile than the original 60/40 portfolio, but the dollar value of your stock holdings will remain the same. And your net worth will grow faster, since we paid off debt at 3.5% with bonds that would have yielded only 2.5%.

Provided you are comfortable with having a more volatile portfolio, you might maximize your net worth by withdrawing from bonds but not from your equities, and therefore increasing your equity percentage allocation. However, if you are considering selling stocks to pay down a long dated mortgage, I think we should go through the math on that decision more carefully.

There’s a lot to consider here, so it is important we discuss your individual situation and not try to simplify this to some type of universal advice or rule of thumb.

Here are some additional considerations:

  1. If your choices are to send in extra mortgage payments or do nothing (spend that money), then yes, send in extra payments.
  2. If you are choosing between extra payments versus another investment, consider the long-term expected rate of return of the investment versus the cost of the mortgage.
  3. While bond yields are low today, it is possible they could rise in the future. If you have short-term bonds you might gradually reset your yields to higher levels. If you have a fixed mortgage, however, it’s guaranteed to stay at the same rate for the full term of 15 to 30 years. Now is a great time to borrow very cheaply. If we have higher inflation in the future, it will benefit borrowers and penalize savers.
  4. You can invest outside of a retirement account. In fact, if your goal is to retire early, become a millionaire, or create a family trust, you need to do a lot more than just a 401(k). Some people stop after funding a 401(k) and think they don’t need to make any additional investments. Paying down a mortgage is not your only option; consider a taxable account.
  5. A mortgage is a form of forced savings. If you have a monthly mortgage of $1,500, maybe $500 of that is interest and the remaining $1,000 is building equity in your home. If you pay off your mortgage from investments, you will save $1,500 a month, and you will feel wealthier because you improved your cash flow. But if you don’t create an automatic savings plan to invest that $1,500 a month, you will likely just increase your discretionary spending. Be careful to not miss that opportunity to increase your saving.

On house values:

  • Your home price will increase the same whether you have a mortgage or own it free and clear.
  • There are significant expenses in being a home owner which make it a poor investment, including property taxes, insurance, utilities, and repairs or improvements. These costs are not included in a home price index. Read more: Tracking Your Home Improvements.
  • Selling costs can also be significant, such as a 6% realtor commission. I bought a house for $375,000 in 2006 and sold it in 2017. After paying closing expenses, I received $376,000. That’s not a good return, and those amounts do not even include any of the improvements I made to the house. 
  • If your primary goal is to grow your net worth, consider your home an expense and not an investment. If you aren’t going to stay for at least five years, rent.
  • After the Tax Cuts and Jobs Act, you are less likely to be able to deduct your property taxes and mortgage interest, especially for married couples. So, forget about having a home as a great tax deduction; most people will take the standard deduction.

At best, you might consider home equity to be a substitute for a bond investment. Given today’s very low yields, if you want to reduce bond holdings to pay off a mortgage, that may be something to consider. Certainly, your home is significant part of your net worth statement, and it is often one of your biggest assets, liabilities, and expenses. It’s worth thinking carefully about how you manage those costs, looking to genuinely analyze how different decisions could impact your net worth over ten or more years. 

2019 Year-End Tax Planning

As 2019 draws to a close, we review our client files to consider if there are any steps we should take before December 31. Here are some important year end strategies we consider.

1. Tax Loss Harvesting

If an ETF, mutual fund, or stock is down, we can harvest that loss to offset any other gains we have realized during the year. Some mutual funds will distribute year end capital gains, so it is often helpful to have losses to offset those gains. If your losses exceed gains for the year, you can use $3,000 in losses to offset ordinary income. This is a great benefit because your ordinary income tax rate is often much higher than the typical (long-term) capital gains rate of 15%. Any additional losses are carried forward into future tax years.

We can immediately replace a sold position with another investment to maintain our target allocation. For example, if we sell a Vanguard Emerging Markets ETF, we could replace it with an iShares Emerging Markets ETF. This way we can realize a tax benefit while staying invested.

2019 has been a terrific year in the market, so there will be very few tax loss trades this year. That’s a good thing. Tax loss harvesting applies only to taxable accounts, and not to IRAs or retirement accounts. Conversely, when we rebalance portfolios and trim positions which have had the largest gains, we aim to realize those gains in IRAs, whenever possible.   

2. Income Tax withholding under the Tax Cuts and Jobs Act (TCJA)

For 2018, the TCJA lowered the withholding schedules for your federal income tax. Although many people paid lower total taxes for 2018, some were surprised to owe quite a bit in April 2019 when they completed their tax returns. Since your employer doesn’t estimate how much your spouse makes, or what deductions you may have, it is very easy to under-withhold for income taxes.

If you did end up owing taxes for 2018, the situation will likely be the same for 2019 if you have a similar amount of income. For W-2 employees, contact your payroll department to reduce your dependents. If you are already are at zero dependents, and are married, ask them to withhold at the single rate, or to add a set dollar amount to your payroll withholding.
If you are self-employed, you should do quarterly estimated payments. For more information on how to do this, as well as how to avoid underpayment penalties, see my article: What Are Quarterly Tax Payments? 

3. Bunch Itemized Deductions

After the TCJA, the number of tax payers who itemized their deductions fell from around 35% to 10%. If you anticipate having itemized deductions for 2019 (over $12,200 single, $24,400 married), you might want to accelerate any state/local taxes (subject to the $10,000 limit) or charitable contributions to be paid before December 31. Bunch your deductions into one year when possible to make that number as high as possible, and then take the standard deduction in alternate years.
Read more: 9 Ways to Reduce Taxes Without Itemizing

4. IRAs and the Required Minimum Distribution

If you are over age 70 1/2, you have to take a Required Minimum Distribution from your IRAs by December 31. Additionally, if you have an inherited IRA (also called Beneficiary IRA or Stretch IRA), you may also be required to take an RMD before the end of the year. When you have multiple retirement accounts, each RMD will be calculated separately, but it doesn’t matter which account you use for the distribution. As long as the total distribution for the year meets the total RMD amount, you can use any account for the withdrawal.

If you have not met your RMD and are planning charitable contributions before the end of the year, look into making a Qualified Charitable Distribution from your IRA. This offers a tax benefit without having to itemize your return, and the QCD can count towards your RMD.Read more: Qualified Charitable Distributions from Your IRA

Five Wealth Building Habits

“We are what we repeatedly do. Excellence, then, is not an act, but a habit.” – Aristotle

Accumulating wealth and developing financial independence does not happen overnight, but it’s not nearly as complicated as most people think. Good habits create results when consistently applied over time. Today, we are going to talk about how to get on track and create new habits.

Frankly, most of my clients are already doing these things. That’s why they have money to invest with me. So, I’m not really writing this for them. I meet a lot of people who have a similar level of income, who are intelligent and successful in their own field, but unfortunately, their habits are never going to lead them to become wealthy.   

This past week, I gave four presentations at different companies around Dallas about personal financial planning and estate planning. One of the most common questions was about saving money and creating wealth. I think there are a lot of myths about building wealth that are holding people back from success. We need to dispel those myths and replace old habits with a new habits that create wealth.

Myth 1: You don’t make enough money to become wealthy.

I’ve seen families who become millionaires with incomes under $100,000, and I’ve seen people go bankrupt who make over $300,000. Stop thinking that the problem is that you don’t have enough income. Until you have a savings plan, you are probably going to end up spending everything you earn. Without a savings plan, a raise will only stimulate additional spending.

To be a better saver, look at your biggest expenses. If you make smart choices about your home and car choices, everything else in your budget will fall into place nicely. If you have reached a bit too high for your budget, there is no magic way to save money when your fixed expenses consume all of your income. If you are in over your head with these costs, you need to find a way out. Don’t focus on how much you make, focus on how much you can save.

Habit 1: Wealth Builders are frugal about their two biggest expenses: their house (or rent) and their cars. They view these as expenses, not as investments or as “lifestyle” choices they deserve.
Read more: Rethink Your Car Expenses

Myth 2: You can’t save right now.
You’ve got student loans. You’ve got young children. You need to save for a down payment. You need to pay down your mortgage first. You’ve got a kid about to start college.

There’s always an excuse why people aren’t saving and investing today. But there’s never going to be a “green light” where you will feel that it is easy to invest.

Habit 2: Wealth Builders put their investing on autopilot.

First: establish an emergency fund with at least three months of living expenses. Pay off your credit cards so you do not carry a balance or pay any interest expenses. Then establish automatic monthly deposits into an account for each of your financial goals: 

  • a 401(k) or IRA for Retirement
  • a bank account for your next car purchase
  • a 529 Plan for your child’s college education

It doesn’t matter if you start small. If all you can afford today is $50 or $100 a month, just get started and don’t wait. When the money comes out automatically, you won’t miss it. As you are able, increase your monthly contributions. Your eventual goal is to save at least 15% of your income. Can you get there in a year or two? Calculate how much this is and get started. If you have to adjust later, that’s okay. Don’t wait another day, because that day could turn into years.

Read more: Don’t Budget, Focus on Saving

Myth 3: Things will take care of themselves.
You’re not worried. Time is on your side. You’ve got other things to deal with. It can wait.

Yikes. Get your head out of the sand. You can do this. Educate yourself about investing. 

While I encounter an attitude of denial sometimes with younger investors, it is not just Millennials who think this way. In fact, I think a lot of Millennials are proving to be much smarter than previous generations about materialism, credit card usage, and their life goals. 

What scares me more are older entrepreneurs who tell me that their business is their retirement plan and that their company is the best investment. Great, how many times have you built and sold a company for over a million dollars? Never done that? What is your exit strategy? 
It’s not a good idea to put all your eggs in one basket, and the successful entrepreneurs I know build a positive cash flow business which creates personal wealth in addition to their ownership value of the company.

Habit 3: Wealth builders educate themselves about their finances, are organized, and track their net worth. 

Read more: buy this book, it’s the best investment primer I have read.

The Cost of Waiting from 25 to 35

Myth 4: You have to become an expert in the stock market to be successful.
Day trading. Penny stocks. Cryptocurrency. Stock options. Commodity futures. Hedge funds.

You don’t need any of these things to become wealthy. You don’t have to read the Wall Street Journal everyday, watch CNBC for hours, or spend your weekends pouring over spreadsheets or stock reports. In fact, trying to beat the stock market is not only exceedingly difficult and unlikely to achieve, it often creates unnecessary risk in the process. The antidote is simple: 

Habit 4: Wealth Builders buy Index Funds. 

Buying the whole market gives you diversification, low cost, and tax efficiency. Evidence consistently shows the benefits of using an index approach. And you don’t have to be an expert, or become a stock trader, to use Index Funds.

Read more: Manager Risk: Avoidable and Unnecessary

Myth 5: Your best bet is to do it yourself.

We can all agree that no one cares more about your money than yourself. Unfortunately, there are reasons to distrust the financial services industry and to question whether they are putting their own interests ahead of yours. And it costs money to get professional advice. Those are the three main reasons why people want to manage their finances on their own.

Over the past 15 years, working at three different firms, I’ve had the pleasure to serve some incredibly successful people. There was a retired surgeon who served as a chairman of a major University. The president of an S&P 500 company. The co-founder of an oil and gas company who sold his company for $300 million. A Harvard educated software engineer. An engineering PhD who speaks five languages. 

These people are way smarter and more successful than I am. They could do it themselves if they wanted. But they all decided to hire a financial advisor, develop that relationship, and out-source their financial planning. Why?

  • You cannot be an expert in all fields. Successful people want to have team members who have specialized training, knowledge, and experience, including accountants, lawyers, and financial planners.
  • Time. They have more valuable uses of their time, not just for work, but also to spend with their family, hobbies, or other interests.
  • You don’t know what you don’t know. A qualified professional might help you avoid costly mistakes as well as to identify any behavioral biases or blindspots you might not be thinking about. Laws and regulations change all the time.
  • Accountability. An advisor will help you set goals, coach you to make good decisions, and proactively keep you on track even when you are busy thinking about other things.
  • Family: knowing they have planned for their family if something should happen to them and that the professional management of their financial affairs would continue.

If the most successful people you know have a financial advisor, maybe it’s time you stop trying to do it on your own.   

Habit 5: Wealth Builders value and seek professional help.

New habits take time to establish. In an age of instant gratification, recognizing that today’s steps might take years to pay off takes particular maturity. It won’t happen overnight, but I can assure you, you don’t have to be a rocket scientist to build wealth – just keep good habits. Apply your habits consistently, with patience and perseverance, and you won’t be surprised when someday you open an account statement and see a seven-figure number.  

Or you could keep doing what you are doing, and you will stay right where you are. Everyone believes that they are rational and logical, but in reality, we all naturally resist change even if that change is in our own best interest. We have to look in the mirror and be honest with ourselves if our actions are truly in line with our goals. That can be painful to acknowledge, but the reward of radical honesty could be the realization that you need to create new, better habits.

Unless you receive an inheritance or win the lottery, wealth is not an event, but a habit. Thankfully, even small changes in your habits can pay big rewards over time.

Giving Strategies, Now and Later

If you have a significant estate and are thinking about how to give money to charity or individual beneficiaries, you might want to consider if it would be possible to make some of those gifts during your lifetime. Today, we are going to look at the tax benefits or implications of different large gift strategies.

A gift to charity from your estate will reduce your your taxable estate. However, with the estate tax threshold presently at $11.4 million per person, most people will never pay any estate taxes. This was not the case 15 years ago when the estate tax threshold was just $1.5 million. For married couples, the threshold is doubled to $22.8 million. So if your past estate plan was based on estate tax avoidance, it may be time to update your plans and revisit your charitable strategies.

Charitable donations remain eligible as an itemized deduction, although many tax payers will not have enough deductions to exceed the 2019 $12,200 standard deduction ($24,400 married). However, if you are contemplating a large charitable donation, you can deduct up to 60% of your Adjusted Gross Income (AGI) when making a cash donation to a public charity. (This was increased from 50% under the 2017 Tax Cuts and Jobs Act.) If making a donation of non-cash property, such as appreciated shares of stock, the limit is 30% of AGI. In both cases, you can carry forward any excess donation for five years.

Here are seven principles for giving to charities and to individuals, such as your children or grandchildren:

1. If you have stocks or funds with a large gain, you can give those shares to charity, get the full tax deduction and avoid capital gains tax. The charity will not pay any taxes on the shares they receive and sell.

2. If you leave an IRA to a charity, that is name a charity as a beneficiary of your IRA rather than a person, they will pay no tax on receiving your IRA.

3. For individual beneficiaries of your estate, they will have to pay income tax on inheriting your IRA. Presently, there is a Bill which has passed the House which will eliminate the Stretch IRA. However, beneficiaries will receive a step-up in cost basis on inherited taxable accounts. The most tax efficient split is to leave your Traditional IRA to charity and your taxable assets and Roth IRAs, to your heirs. Then neither will pay income taxes on the assets they receive.

Read More: 7 Strategies If the Stretch IRA is Eliminated

4. If you are over age 70 1/2, you can make up to $100,000 a year in gifts from your IRA as Qualified Charitable Distributions, which count towards your RMD. You do not have to itemize to use the QCD.

 Read More: Qualified Charitable Distributions From Your IRA

5. You can give $15,000 a year to any individual; this is called the annual gift tax exclusion. A couple could give $30,000 to an individual. This includes your adult children. Additionally, you can directly pay medical or educational expenses for any individual without this limit. 

Where many people are confused: exceeding the gift tax exclusion does not automatically require you to pay a gift tax. It simply requires filing a gift tax return, which will reduce your lifetime Gift/Estate tax limit, which again is $11.4 million per person (2019). For example, if you give someone $17,000 this year, the $2,000 over the $15,000 limit will be subtracted from your $11.4 million estate tax exemption when you die.

6. If you want to create college funds for your grandchildren or other relatives, you can fund up to five years upfront into a 529 Plan without exceeding the gift tax exemption. That is $75,000 per beneficiary, or up to $150,000 if coming from both Grandma and Grandpa. You can retain control of the funds, even change the beneficiary if desired, and the money grows tax-free for qualified higher education expenses. 

Read More: 8 Questions Grandparents Ask About 529 Plans

7. You can make a large donation to a Donor Advised Fund to receive an upfront tax deduction and then make small donations in the years ahead. For example, it would be more tax efficient to make a $100,000 donation into a DAF and make $10,000 a year in charitable distributions for 10 years from the DAF, than to make regular $10,000 donations each year for 10 years. 

Read More: Charitable Giving Under The New Tax Law

Even if you know all of this information, I think many potential donors are still looking for more flexibility in their giving plans. What if you need money later? How much should you keep for your own expenses and needs? Creating a comprehensive retirement analysis is an essential first step, and then we can help you consider other more advanced giving strategies.

There are many ways of structuring charitable trusts which can split assets and income between the creator of the trust, a charity, and/or beneficiaries. Generally, the donor is able to receive an upfront tax deduction for the present value of a gift, based on their expected lifetime or duration of the trust. The present value is calculated using your age and a specific discount rate, known as the Section 7520 rate, which is published monthly by the IRS. It is based on intermediate treasury bonds and is currently 2.2% for trusts created in September 2019. This rate is down from 3.4% from last August. 

With a very low interest rate being used for the discount rate today, it is quite unappealing to establish a Charitable Remainder Trust (CRT). The low rate means that the tax deduction is very small compared to trusts that were established when the rate was higher. That’s unfortunate, because a CRT is an ideal structure: the creator receives income from the trust for life (or a set period of years) and then the remainder is donated to the charity when you pass away (or at the end of the term). 

A more effective structure for a low interest rate environment is a Charitable Lead Trust (CLT). In this type of trust, a charity receives income for a period of years (say 10 years) and then any remaining principal is distributed to your beneficiaries, free from gift or estate taxes. This might hold some appeal for tax payers who would be subject to the estate tax and who do not need or want income from some portion of their assets. But it doesn’t offer much appeal to donors who want income or flexibility from their trusts. 

If you are thinking about charitable giving or where your money might eventually go, let’s talk about which strategies might make the most sense for you.