Using the ACA to Retire Early

Posted On January 15, 2020 By Scott Stratton, CFP(R), CFA In Retirement Planning /

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). What’s the PTC? It’s a tax credit for buying an insurance plan on the health exchange, under the Affordable Care Act (“Obamacare”). The key is to know what the income levels are and what counts as income. Then, use other savings or income 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.

ACA Income Levels

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, 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). Unfortunately, MAGI 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.

Premium Tax Credit

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 month
Single 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/month
Married 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

Understand ACA Income

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. 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 investments with large capital gains, sell 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, 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 (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.

Minimum Income 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 PTC. Instead, you will 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).

Retire Early with the ACA

If you can delay your retirement income until after 65, you may be eligible for 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. We can 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. Create an estimate of what you might pay out-of-pocket as well as what your maximum out-of-pocket costs would be.

Good Life Wealth is here to be your guide and partner to make early retirement happen. We are a fiduciary planning firm, offering independent advice to help you achieve the Good Life. Email [email protected] to learn more.

Your Home Is Like A Bond

Posted On January 15, 2020 By Scott Stratton, CFP(R), CFA In Financial Planning /

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 pay off your mortgage. You could own your house free and clear and never have to worry about a mortgage again. You could 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.

Maximize Your Net Worth

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, what if your mortgage is 3% and you could be making 7%? Then, you would maximize your net worth by staying invested and not pre-paying your mortgage.

Most people would prefer to be debt free. However, if you can invest at a higher return than you borrow, 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 to bonds, or slightly less.

Home Versus Bonds

Looking at the Case-Shiller 20 City Home Price Index (which includes Dallas), the overall rate of return since 2000 was 4.02%. Let’s look at an actual bond fund, not just hypothetical indexes. An investor could have earned 5.15% a year in the Vanguard Intermediate Term Bond Index fund, since 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’re lucky, 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 (i.e. same as 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 it is important to consider the overall levels of risk and return of your portfolio, 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 1.25%, there’s not much return to be had in bonds.

Using Cash or Bonds to Pay Down Mortgage

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 would 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. This means increasing your equity percentage allocation. However, I wouldn’t sell stocks to pay down a long dated mortgage. Consider the math on that decision carefully.

Additional Considerations

There’s a lot to evaluate 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.

If your choices are to send in extra mortgage payments or do nothing, then yes, send in extra payments. That’s better than spending it!
Are you choosing between extra payments versus another investment? Then, consider the long-term expected rate of return of the investment versus the interest rate of the mortgage.
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. A fixed mortgage, however, will 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.
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 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.
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. You will feel wealthier because you improved your cash flow. But if you don’t invest that $1,500 a month going forward, you will likely just increase your discretionary spending. Be careful to not miss that opportunity to increase your saving.

On Home Values

Your home value 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: Inflation and Real Estate
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 don’t include 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, most people cannot deduct their property taxes and mortgage interest. This is especially true for married couples. So, forget about having a home as a great tax deduction; most taxpayers 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, you could reduce bond holdings to pay off a mortgage. Your home is significant part of your net worth statement. It’s often one of your biggest assets, liabilities, and expenses. Think carefully about how you manage those costs. Genuinely analyze how different decisions could impact your net worth over ten or more years. That’s the approach we want to use when asking, Should I pay off my mortgage?

2019 Year-End Tax Planning

Posted On November 17, 2019 By Scott Stratton, CFP(R), CFA In Tax Strategies /

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. Investing in a home security system can improve home safety and protect your home from break-ins and theft. 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

Posted On November 10, 2019 By Scott Stratton, CFP(R), CFA In Behavioral Finance /

“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 wealth building 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. When 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. Wealth building habits need to be easy, and it doesn’t get any easier than automatic.

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.

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 Get Professional Help?

You cannot be an expert in all fields. Successful people rely on professionals 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. An advisor can 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 wealth building 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

Posted On November 10, 2019 By Scott Stratton, CFP(R), CFA In Financial Planning /

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.

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.

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.

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.

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.

Long Bonds Beating Stocks in 2019

Posted On September 2, 2019 By Scott Stratton, CFP(R), CFA In Portfolio Management /

Through August 31, the S&P 500 Index is up 18.34%, including dividends. Would it surprise you to learn that bonds did even better? The Morningstar US Long Government Bond Index was up 18.40% in the same period. Even with this remarkable stock market performance, you would have done slightly better by buying a 30-year Treasury Bond in January!

How do bonds yielding under 3% give an 18% gain in eight months? Bond prices move inversely to yields, so as yields fall, prices rise. The longer the duration of the bond, the greater impact a change of interest rates has on its price. This year’s unexpected decrease in rates has sent the prices of long bonds soaring. While bonds have made a nice contribution to portfolios this year because of their price increases, today’s yields are not very attractive. And longer dated bonds – those which enjoyed the biggest price increases in 2019 – could eventually suffer equivalent losses if interest rates were to swing the other direction. We find bonds going up 18% to be scary and not something to try to chase.

Today’s low interest rates are a conundrum for investors. The yields on Treasury bonds, from the shortest T-Bills to 10-year bonds are all below 2%. CDs, Municipal bonds, and investment grade corporate bonds have all seen their yields plummet this year. In some countries, there are bonds with zero or even negative yields.

What can investors do? I am going to give you three considerations before you make any changes and then three ideas for investors who want to aim for higher returns.

1. Don’t bet on interest rates. Don’t try to guess which direction interest rates are going to go next. We prefer short (0-2 year) and intermediate (3-7 year) bonds to minimize the impact that interest rates will have on the price of bonds. With a flat or inverted yield curve today, you are not getting paid any additional yield to take on this interest rate risk. Instead, we take a laddered approach. If you own long bonds which have shot up this year, consider taking some of your profits off the table.

2. Bonds are for safety. The reason why we have a 60/40 portfolio is because a portfolio of 100% stocks would be too risky and volatile for many investors. Bonds provide a way to offset the risk of stocks and provide a smoother trajectory for the portfolio. If this is why you own bonds, then a decrease in yield from 3% to 2% isn’t important. The bonds are there to protect that portion of your money from the next time stocks go down 20 or 30 percent.

3. Real Yields. Many of my clients remember CDs yielding 10 percent or more. But if inflation is running 8%, your purchasing power is actually only growing at 2%. Similarly, if inflation is zero and you are getting a 2% yield, you have the same 2% real rate of return. While yields today are low on any measure, when we consider the impact of inflation, historical yields are a lot less volatile than they may appear.

Still want to aim for higher returns? We can help. Here are three ideas, depending on how aggressive you want to go.

1. Fixed Annuities. We have 5-year fixed annuities with yields over 3.5%. These are guaranteed for principal and interest. We suggest building a 5-year ladder. These will give you a higher return than Treasuries or CDs, although with a trade-off of limited or no liquidity. If you don’t need 100% of your bonds to be liquid, these can make a lot of sense. Some investors think annuity is a dirty word, and it’s not a magic bullet. But more investors should be using this tool; it is a very effective way to invest in fixed income today.
Read more: 5-year Annuity Ladder

2. High Yield is getting attractive. Back in 2017, we sold our position in high yield bonds as rising prices created very narrow spreads over investment grade bonds. Those spreads have widened this year and yields are over 5%. That’s not high by historical standards, but is attractive for today. Don’t trade all your high quality bonds for junk, but adding a small percentage of a diversified high-yield fund to a portfolio can increase yields with a relatively small increase in portfolio volatility.

3. Dividend stocks on sale. While the overall stock market is only down a couple of percent from its all time high in July, I am seeing some US and international blue chip stocks which are down 20 percent or more from their 2018 highs. Some of these companies are selling for a genuinely low price, when we consider profitability, book value, and future earnings potential. And many yield 3-5%, which is double the 1.5% you get on the US 10-year Treasury bond, as of Friday.

While we don’t have a crystal ball on what the stock market will do next, if I had to choose between owning a 10-year bond to maturity or a basket of companies with a long record of paying dividends, I’d pick the stocks. For investors who want a higher yield and can accept the additional volatility, they may want to shift some money from bonds into quality, dividend stocks. For example, a 60/40 portfolio could be moved to a 70/30 target, using 10% of the bonds to buy value stocks today.

When central banks cut rates, they want to make bonds unattractive so that investors will buy riskier assets and support those prices. When rates are really low, and being cut, don’t fight the Fed.

Long bonds have had a great performance in 2019 and I know the market is looking for an additional rate cut. But don’t buy long bonds looking for capital appreciation. Trying to bet on the direction of interest rates is an attempt at market timing and investors ability to profit from timing bonds is no better than stocks. If you are concerned how today’s low yields are going to negatively impact your portfolio going forward, then let’s talk through your options and see which might make the most sense for your goals.

Source of data: Morningstar.com on September 2, 2019.

Will There Be A Recession?

Posted On September 2, 2019 By Scott Stratton, CFP(R), CFA In Portfolio Management /

There has been a lot of talk recently about a recession, with concerns about slowing economic growth, the Federal Reserve cutting interest rates, an inverted yield curve, a trade war with China, and so on. A recession is two or more quarters of economic contraction, of negative growth of a country’s economy. Several European countries recently reported one quarter of negative growth and may well be on their way towards a recession this quarter.

So… will there be a recession in the US? Yes, there will. When? I have no idea.

Please excuse my glib answer. I could put a lot of thought and analysis into the question, but statistically, it’s not predictable with accuracy or certainty. Recessions are an inevitable part of the economic cycle, winter to the summer season of expansion. Unfortunately, unlike December 22, the first day of winter, it is not possible to determine when the first day of a recession will occur. Economists only calculate recessions in hindsight and it would be foolish, and likely even detrimental, for investors to try to change their investments based on today’s recession fears.

While the US Stock Market made new highs in July, August saw a pullback with increasing worries about a recession. A recession would be negative for investors in the short run, but I think it is very important for investors to stay focused on the long run. The temptation is to think that if we could go to cash before a recession that our returns would be better and we’d avoid losses. As appealing and rational as those thoughts may be, the reality is that attempting to time the market is exceedingly difficult. In my experience, investors who try to time the market rarely do better than those who remain invested and they often would have been better off making no changes.

Thankfully, I don’t think you need a crystal ball to be a successful investor. Let’s keep a healthy perspective on recessions. Here are some thoughts which may help you to stay invested.

1. If you’re a young investor, contributing monthly to your 401(k) or IRA, and have three or four decades before you retire, you should want a recession! That’s the stock market throwing you a fire sale. You get to buy shares when they are down maybe 20% or more! While Dollar Cost Averaging cannot guarantee a profit, I can tell you that the shares of mutual funds which your colleagues bought in 2008 or 2001 have probably been enormously profitable. If you bought an S&P 500 Index fund 10 years ago, you’d be up about 320% today.

Recessions have occurred every 5-10 years since 1900. If you are investing for many decades, I wouldn’t be worried about what happens in 2019 or 2020. If the market goes down, keep buying shares of a diversified asset allocation and be glad to buy shares with a very low cost basis.

Do, however, avoid betting heavily on an individual stock. While the overall stock market has recovered very nicely from previous recessions, there can always be individual companies like Lehman Brothers or Enron, which don’t survive. Those companies may be present in an Index Fund, but if your fund owns 500 or 1000 companies, the impact of one company blowing up is often inconsequential.

2. Think in percentages, not dollars, and study stock market history. A 20%+ drop in the market does occur from time to time, maybe even two or more times a decade. Knowing this, you should be prepared for a drop of this magnitude if you’re in an aggressive allocation. But let’s rephrase this in dollar terms: once you have a $500,000 portfolio, could you stomach a drop of $100,000? That sounds a lot worse than a 20% drop! Of course, when the market goes up 20%, like it did from December 2018 to the highs of July, that would also be a $100,000 gain.

Seeing performance in dollar terms may feel harsher than looking at performance as percentages which fluctuate greatly from year to year. When you have a big account, you are going to see big swings. This can be difficult to get used to and that’s why I want to look at percentages instead.

If you understand that a market cycle includes up and down years, you will understand that a drop is often only temporary until the market rebounds. If you sell when the market is down and go to cash, you are locking in that loss and eliminating the possibility of participating in a future up cycle. While there’s no guarantee this cycle will always occur in the future, it has been the historical pattern, and I think you have to embrace this tenet of investing if you are to be successful over time.

3. We build highly diversified portfolios and rebalance. If your target allocation is 60% stocks and 40% bonds (60/40) and the market drops, your weighting to stocks decreases. We will sell some bonds and buy stocks that are down. We have a built-in mechanism to respond to market fluctuations already. Just by maintaining a target allocation and rebalancing, we will be buying stocks when they are on sale and trimming stocks when they have run up. That won’t prevent a loss when the market does drop, but rebalancing can help to potentially smooth returns and maintain your target level of risk for your portfolio.

4. Investors who are getting closer to retirement undoubtedly feel the most pressure about near-term performance. In part, this is due to an oversimplification of the retirement planning process, by using something like the “4% rule”. Then, if your portfolio drops 20% in the year before retirement, it would appear to be devastating. If you were expecting $40,000 a year in income from a $1 million portfolio, a drop to $800,000 would reduce your 4% withdrawal rate to just $32,000 a year.

That’s why we should be careful about using a “rule of thumb” approach as being the ultimate guide in retirement planning. For someone who is 65 and healthy, we should be planning for a 20-30 year time horizon, not for the next 1-2 years. As retirements become longer, it is a reality that you are going to experience multiple recessions. Looking at a retirement date of 1-3 years away does not mean that you automatically have a short-term investment horizon. We need to think long-term and have a plan that isn’t going to be derailed by performance in the last year or two before retirement.

5. If you’re retired and taking 4% withdrawals, consider this: The dividends in our US stock market ETFs are around 2% and higher for our foreign ETFs, often in the 3% range. Even with today’s low interest rates, your bonds are overall yielding 2% or more. Regardless of your allocation, you’ve already covered at least half of your annual 4% withdrawals from stock dividends and bond interest. In terms of sales, you might be dipping into principal by only 2% a year or less. If the market is down for a year or two, you’re not going to run out of money. For my clients who are taking distributions, we set dividends and interest to pay out in cash and I generally only have to sell a small number of shares once a year.

I’m not looking forward to a recession or a Bear Market, but I’m not really all that worried either. Knowing that recessions are a natural part of the economic cycle doesn’t make them any less painful, but if you can step back and take a longer-term view, you will be more comfortable with accepting that being an investor requires patience, perseverance, and a positive attitude. We’ve built our portfolios for all environments, but that doesn’t mean that risk can be avoided or eliminated. Rather, we can choose how much risk we take and to avoid unnecessary risks of being overweight one stock, sector/country funds, or being undiversified. Whether you are a new investor or a retiree, I don’t want you to make knee-jerk reactions because of talk about a future recession. Recession talk may play well on cable news, but it’s not a useful input for long-term investment success.

7 Strategies If The Stretch IRA is Eliminated

Posted On July 26, 2019 By Scott Stratton, CFP(R), CFA In Retirement Planning /

On May 31, I sent a newsletter about US House of Representatives approving the SECURE Act and six changes it would create for retirement plans. To pay for the cost of new rules, like extending the RMD age from 70 1/2 to 72, the legislation proposes to eliminate the Stretch IRA starting in 2020. While the Senate has yet to finalize their own version of this legislation, odds are good that something is going to get passed. And if the Stretch IRA manages to survive this time, it will likely be back on the chopping block in the near future.

A Stretch IRA, also known as an Inherited IRA or Beneficiary IRA, allows the beneficiary of an IRA to continue to enjoy the tax-deferred growth of the IRA and only take relatively small Required Minimum Distributions over their lifetime. Congress has recognized that while they want to encourage people to contribute to IRAs to save for their retirement, they’re not as happy about the IRAs being used as an Estate Planning tool.

If you have a large IRA, one million or more, you might have more in assets than you will need to spend. If you leave it to your spouse, they can still roll it into their own IRA and treat it as their own. Once the Stretch IRA is eliminated, and you leave the IRA to someone other than a spouse, they will have to withdraw the entire IRA within 10 years. Those distributions will be treated as ordinary income and there could be substantial taxes on a seven-figure IRA.

Now is the time to start planning for the end of the Stretch IRA. There are ways that could potentially save many thousands in taxes on a million dollar IRA. But these methods may take years to work, so it pays to start early. Here are seven considerations:

1. Charitable Beneficiary. If you are planning to leave money to a charity (a church, arts organization, university, or other charity), make that bequest through your IRA rather than from your taxable estate. The charity will receive the full amount and as a tax-exempt organization, not owe any taxes on the distribution. It will be much more tax efficient to leave taxable assets to individual beneficiaries and IRA assets to charities than the reverse.

2. QCD. Better than waiting until you pass away, you can donate up to $100,000 a year in Qualified Charitable Distributions after age 70 1/2 that count towards your RMD. This reduces your IRA but preserves a tax benefit today, which is even better than leaving it as an inheritance. Plus you get to see the good your donation can make while you are still alive. (And you don’t have to itemize your tax return; the QCD is an above the line deduction.)

3. Start withdrawals at age 59 1/2. The traditional approach to IRAs was to avoid touching them until you hit 70 1/2 and had to start RMDs. With today’s lower tax brackets, if you have a very large IRA, it may be preferable to start distributions as early as 59 1/2 and save that money in a taxable account.

For a married couple, the 24% tax bracket goes all the way up to $321,450 (2019). Those rates are set to sunset after 2025. Additionally, while any future growth in an IRA will eventually be taxed as ordinary income, IRA money that is withdrawn and invested in ETFs now will become eligible for the preferential long-term capital gains rate of 15%. Your future growth is now at a lower tax rate outside the IRA.

4. If you’re going to take annual distributions and pay the tax gradually, an even better way is through Roth Conversions. Once in the Roth, you will pay no tax on future growth and you heirs can receive the Roth accounts income tax-free. Conversions don’t count as part of your RMD, so the best time to do this may be between 59 1/2 and 70 1/2. Look at gradually making partial conversions that keep you within a lower tax bracket.

5. A lot of owners of large IRAs want to leave their IRA to a Trust to make sure the funds are not squandered, mismanaged, or taken by a child’s spouse. Unfortunately, Trust taxes are very high. In fact, Trusts reach the top tax rate of 37% once they hit just $12,750 in taxable income. In the past, trust beneficiaries were able to still use the Stretch IRA rules even with a Trust. However, if the Stretch IRA is eliminated, most of these IRA Trusts are going to pay an egregious amount of taxes.

One alternative is to establish a Charitable Remainder Trust (CRT). This would allow for annual income to be provided to your beneficiaries just like from a Stretch IRA, but once that beneficiary passes away, the remainder is donated to a charity. This preserves significant tax benefits as the initial IRA distribution to the CRT is non-taxable. The downside is that there are no lump sum options and the payments will not continue past the one generation named as beneficiaries.

Still, if you have a Trust established as the beneficiary of your IRA, you will want to revisit this choice very carefully if the Stretch IRA is eliminated.

6. Life Insurance. I usually recommend Term Insurance, but there is a place for permanent life insurance in estate planning. If the Stretch IRA is repealed, it may be more efficient to use your IRA to pay for $1 million in life insurance than to try to pass on a $1 million IRA. Life insurance proceeds are received income tax-free by the beneficiary.

For example, a healthy 70 year old male could purchase a Guaranteed Universal Life Policy with a $1 million death benefit for as little as $24,820.40 a year. Take the RMD from your $1 million IRA and use that to pay the life insurance premiums. Now your heirs will receive a $1 million life insurance policy (tax-free) in addition to your $1 million IRA. This policy and rate are guaranteed through age 100. If you don’t need income from your IRA, this could greatly increase the after-tax money received by your heirs.

7. If you are an unmarried couple, you might want to consider if it would be beneficial to be married so that one spouse could inherit the other’s IRA and be able to treat it as their own.

The elimination of the Stretch IRA has been proposed repeatedly since 2012. In some ways, its repeal is a new inheritance tax. Billionaires typically have little or insignificant IRA assets compared to the rest of their wealth and have access to complex trust and legal structures. However, working professionals who have diligently created a net worth of $1 to 4 million, likely have a substantial amount of their wealth in their retirement accounts. And these are the families who will be impacted the most by the elimination of the Stretch IRA.

If you are planning on leaving a substantial retirement account to your beneficiaries, let’s talk about your specific situation and consider what course of action might be best for you.

6 Changes Congress Wants to Make to Your Retirement Plan

Posted On July 12, 2019 By Scott Stratton, CFP(R), CFA In Retirement Planning / 1 Comment

In a rare bipartisan vote of 417-3, the House of Representatives approved the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019. The Act now goes to the Senate, which may make modifications, but is likely to still pass and reconcile a version of this legislation.

The version passed by the House has provisions which will indeed enhance 401(k)s, IRAs, and other retirement plans for all Americans. Hopefully, this will get more people saving and starting their contributions at a younger age. There are also provisions which will help retirees and people over age 70.

Here’s a partial list of the changes in the legislation:

Pushing back the age for Required Minimum Distributions (RMDs) from 70 1/2 to 72.
Allowing workers over age 70 1/2 to continue to contribute to a Traditional IRA.
Allowing up to $5,000 in penalty-free withdrawals from IRAs to cover birth or adoption expenses for parents (taxes would still apply, but the 10% penalty would be waived).
Allowing up to $10,000 in withdrawals from 529 College Savings Plans to pay off student loans.
Requiring 401(k) statements to show participants how much monthly income their balance could provide.
Eliminating the “Stretch IRA”, also known as the Inherited or Beneficiary IRA. Currently, a beneficiary can take withdrawals over their lifetime. Instead, they will be required to withdraw all the money – and pay taxes – within 10 years.

The first two reflect the reality of how poorly prepared some Baby Boomers are for retirement and that more people are working well into their seventies today. Pushing back the RMD age will help people save for longer and reflects that life expectancy has gone up significantly since the original RMD rules were established decades ago.

10 Rules for Playing Defense in Investing

Posted On May 31, 2019 By Scott Stratton, CFP(R), CFA In Portfolio Management /

Stocks take the stairs up and the elevator down. When they rise, it is slow and steady, but when they go down it feels like a free-fall. Given the recent market tumult, I wanted to share my top ten rules for defensive investing.
Defense doesn’t mean that you won’t have losses on days when the market goes down. It means that you avoid unnecessary risks that could really blow up your portfolio, so you can have the confidence to stay with the plan.

1. Diversification is the only free lunch in investing. You should be diversified by company, as well as by sector and country. If your employer issues you stock options or has an Employee Stock Purchase Plan, take every opportunity to sell and diversify elsewhere. Most disaster stories I hear are from people who failed to diversify.

2. Index Funds are the antidote to performance chasing. When you pick a concentrated fund, such as a sector fund or single country fund because of its recent track record, you risk buying at the top and experiencing a painful (and much larger than necessary) drop when the winds change direction. While it’s so easy to find actively managed funds that beat the index over the past year, there is a better than 80% chance that those funds will lag the index over the next five or more years. The Index fund is also likely a fraction of the cost and is also more tax-efficient than an actively managed fund.

3. Asset Allocation is the most important decision you make. Start with a carefully measured recipe so you don’t end up with a random collection of funds and stocks you’ve acquired over the years. If you’ve decided that a 60/40 portfolio is the right mix for your needs, that should be for all market environments, not just while stocks are going up.

4. You are going to be tempted to adjust your Asset Allocation. It is very tough to get this right, because humans are wired to make terrible investing decisions. We want to sell a down market and we want to buy when the market is at all-time highs. Obviously, in hindsight, we should buy when things are really ugly and sell at the peaks. Invest with your brain and not your gut-feeling.

5. Rebalance. When you have a target asset allocation, then the process of rebalancing back to your target levels creates a built-in process of selling assets which have shot up in value and buying assets which have temporarily gone out of favor. This works great with Funds, but don’t try this will individual stocks.

6. We buy stocks for growth and bonds for income and safety. When you try to switch those objectives, things seldom go as planned or hoped. Buying stocks for their yield and safety can easily lead to long-term under performance. Many times you will be better off in a plain vanilla index fund than a basket of super-high dividend stocks or supposedly safe stocks. Many high-yielding stocks are very low quality companies with no growth. When they do eventually cut their dividends, the shares plummet.

Similarly, you can find bonds that as quoted, should yield stock-like returns. Stay away. These could be future bankruptcies.