Financial Strategies for Low Rates

Posted On August 6, 2020 By Scott Stratton, CFP(R), CFA In Financial Planning /

Opportunities for a Low Yield World, Part 3

Today’s low rates are challenging for investors and may require changes not just to your investment portfolio, but also your overall financial strategies. In Part 1 of this series, we looked at the potential of rising defaults in high yield bonds and why it’s problematic to buy high yield bonds. Then in Part 2, we looked at four concrete ways to increase your yield today without radically changing your risk profile.

For Part 3, we looking at the broader ramifications of low interest rates on financial planning. My goal is always to explain and educate, but most importantly, to offer tangible solutions. Even in a crisis, there are opportunities.

But before we get into specific financial planning strategies, let’s consider two important points. First, low interest rates penalize savers. But low rates help borrowers. So, this is a great time to be a borrower, especially if you can lock in a low rate for 15, 20, or 30 years. Hopefully the current crisis will be short-lived, but borrowing at these low rates could be beneficial for decades to come.

Second, we should consider inflation. Bonds may be earning only 1%, but if inflation is zero, you would still have a real return of 1%. Your purchasing power is growing by 1%. Now, if bonds were yielding 6% and inflation was 5%, your real return would be the same, just 1%. While real returns are indeed quite low today, inflation is also below the historic average. So, your real returns aren’t as bad as they might appear.

Now, here are nine specific financial strategies to use today’s low rates to improve your situation.

Borrow for Appreciation

1) Refinance Mortgage. This is a great time to refinance your mortgage and lock in a low rate. Try to avoid lengthening the term of your loan and instead use low rates to pay off your mortgage sooner. If you can save 1% or more and plan to be in your home for several years, it will probably make sense to refi. I would be careful, however, of using low rates to buy the most expensive home possible. A home is largely an expense, rather than a great investment. Even better: use low rates to buy new investment properties. If you can borrow money to buy a business, investment property, or other appreciating asset, money is the cheapest it has ever been. Think long-term today!

2) Pay down debt. As long as you have a good emergency fund and a stable job, how much additional cash do you need? If you have student loans, a mortgage, car loans, or especially credit card debt, maybe it makes more sense to pay down your high-interest debt. Especially, debt that is not tied to an appreciating asset. Paying down 5% loans with cash earning 0% will save you interest costs.

Portfolio Adjustments

3) Reallocate away from bonds. With the 10-Year Treasury yielding under 1%, a lot of investment grade bonds and funds are going to have piddling returns over the next decade. Unless you really need to be defensive (maybe you are 5 years from retirement), having 40-50% earning 1% will likely be a drag on your portfolio. I have no idea what the stock market will do over the next 12-24 months. But, I do believe that a 90% equity allocation will probably outperform a 50% equity allocation over the next 30 years. Not everyone should take on more risk, but young people should invest for growth. The historical returns of a 60/40 portfolio are pretty much out the window with today’s low rates.

4) Alternative assets start to look more attractive when bonds are yielding 1%. Perhaps a 50% equity/30% alternative/20% bond portfolio could provide more return with less risk than a 60% equity/40% bond portfolio.

Retirement under Low Rates

5) Delay Social Security for 8% gains. When you delay your Social Security starting date, you can increase your monthly benefit by 8% a year (from age 66 to 70). Where else can you get a guaranteed 8% return today? No where. It may be better to spend down your bonds earning 1% from 62 or 66 until age 70 for the increase in SS benefits. The lower the rate of return from your portfolio, the more valuable the 8% Social Security increase becomes.

6) Take a pension, not a lump sum. If you have a pension from your employer, should you take the monthly payments or a lump sum? The answer will depend, in part, on your rate of return if you invest the lump sum option. Pension benefits have stayed up, but interest rates have moved down, which means that the pension is on the hook for very expensive benefits now. Companies are sweating this. But for a participant, it is tougher today to assume that you can do better by taking the lump sum. If your goal is lifetime income for you and your spouse, let’s run the numbers before making this decision. (We will also want to consider the credit quality of your Pension, its funded status, and your health and longevity profile.)

7) Immediate annuity. You can try to fund your retirement with bond income, but that’s more difficult with low interest rates. Immediate annuity payouts have not declined as much. So today, they are relatively attractive compared to bonds and eliminate the risk of outliving your money. With bonds, you have only two options under low rates: decrease the payout to yourself or start eating into your principal.

Estate Planning for Wealth Transfer

8) Trust Planning and intra-family loans. The Applicable Federal Rate and the 7520 rate are the lowest they have ever been. These low rates create opportunities for advanced financial strategies in estates and trusts. Intra-family loans: if you want to loan money to children or grandchildren for a mortgage, to buy your business, or to buy life insurance on your life, the interest rate required by the IRS is presently only 1.15%, for loans over 9 years.

9) Grantor Retained Annuity Trust. This is an irrevocable trust, which will shift assets outside of your lifetime gift and estate exemption. As the grantor, you receive income from the GRAT, and the remainder goes to your heirs (outside of your estate). The GRAT assumes the current 7520 rate of 0.80%, which is a low hurdle to beat. If your GRAT can do better than 0.80%, the heirs benefit.

Why do this Estate Planning now? The 2020 Estate Tax exemption of $11.58 million is set to sunset and revert to $5.49 million in 2026. If you are above these amounts, now is a great time to plan ahead. Placing assets into a GRAT now would remove their future growth from your estate. So, if you have assets which you think are undervalued today or which you expect will have significant growth going forward, removing them from your estate today could save tremendous future estate taxes for your heirs.

Low interest rates are problematic for savers and for bond holders, but also an opportunity for different financial strategies. Would some of these nine strategies enable you to benefit from low interest rates? I’m here to help you uncover ideas you haven’t considered, examine if they might be useful for you, and implement them effectively. Let’s take a look at your liabilities, your portfolio, your retirement income, and your estate goals and create a comprehensive plan for you.

The 12% Roth Conversion

Posted On February 23, 2020 By Scott Stratton, CFP(R), CFA In Retirement Planning /

If you make less than $117,150, 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 $89,450 for 2023. That’s taxable income. With a standard deduction of $27,700, a couple could make up to $117,150 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 $70,000, you could convert up to $47,150 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 $47,150 Roth conversion would cost only $5,658 in additional taxes this year. And then you will have that $47,150 growing with no future tax liabilities.

Take Advantage of the 12% Rate

If you have a large IRA or 401(k), the 12% rate is highly valuable. The key to the 12% Roth Conversion is doing it repeatedly over a period of years. 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. Once you start Required Minimum Distributions, you really won’t have a choice about taking those taxable distributions. I have so many clients who don’t need their RMDs, but are forced to take out their money.

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

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.
One spouse has retired, the other is still working. If that gets you into the 12% bracket, make a conversion.
Retiring in your 60’s? Hold off on Social Security so you can make Roth Conversions. Once you are 73, you will have both RMDs and Social Security. It is amazing how many people in their seventies are getting taxed on over $117,150 a year once they have SS and RMDs! These folks wish they had done Conversions earlier, because after 73 they are now in the 22% or 24% bracket.

Retiring Soon?

Considering retirement? Let’s say you will receive a $50,000 pension at age 65. (You are lucky to have such a pension – most workers do not!) For a married couple, that’s only $22,300 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. Spend the cash or bonds and defer the Social Security.

Now you can convert $67,000 a year into your Roth from age 65 to 70. That will move $335,000 from your Traditional IRA to a Roth. Yes, that will be taxable at 12%. But at age 73, you will have a lower RMD – $12,641 less in just the first year.

When you do need the money after 73, 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 $89,451 to $190,750 taxable income (2023). 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.

Social Security Planning: Marriage, Divorce, and Survivors

Posted On April 29, 2017 By Scott Stratton, CFP(R), CFA In Retirement Planning /

The Social Security Statement you receive is often incomplete if you are married, were married, or are a widow or widower. Your statement shows your own earnings history and a projection of your individual benefits, but never shows your eligible benefits as a spouse, ex-spouse, or survivor.

In general, when someone is eligible for more than one type of Social Security benefit, they will receive the larger benefit, not both. But how are you supposed to know if the spousal benefit is the larger option? Social Security is helpful with applying for benefits, but they don’t exactly go out of their way to let you know in advance about what benefits you might receive or when you should file for these benefits.

The rules for claiming spousal benefits, divorced spouse benefits, and survivor benefits are poorly understood by the public. And unfortunately, many financial advisors don’t understand these rules either, even though Social Security is the cornerstone of retirement planning for most Americans. Today we are giving you the basics of what you need to know. With this information, you may want to delay or accelerate benefits. The timing of when you take Social Security is a big decision, one which has a major impact on the total lifetime benefits you will receive.

1) Spousal Benefits. If you are married, you are eligible for a benefit based on your spouse’s earnings, once your spouse has filed to receive those benefits. If you are at Full Retirement Age (FRA) of 66 or 67, your spousal benefit is equal to 50% of your spouse’s Primary Insurance Amount (PIA). If you start benefits before your FRA, the benefit is reduced. You could start as early as age 62, which would provide a benefit of 32.5% of your spouse’s PIA. Calculate your benefit reduction here.

If your own benefit is already more than 50% of your spouse’s benefit, you would not receive an additional the spousal benefit. When you file for Social Security benefits, the administration will automatically calculate your eligibility for a spousal benefit and pay you whichever amount is higher. A quick check is to compare both spouse’s Social Security statements; if one of your benefits is more than double the other person’s benefit, you are a potential candidate for spousal benefits.

If your spouse is receiving benefits and you have a qualifying child under age 16 or who receives Social Security disability benefits, your spousal benefit is not reduced from the 50% level regardless of age.

Please note that spousal benefits are based on PIA and do not receive increases for Deferred Retirement Credits (DRCs), which occur after FRA until age 70. While the higher-earning spouse will receive DRCs for delaying his or her benefits past FRA, the spousal benefit does not increase. Furthermore, the spousal benefit does not increase after the spouse’s FRA; it is never more than one-half of the PIA. If you are going to receive a spousal benefit, do not wait past your age 66, doing so will not increase your benefit!

2) Divorced Spouse Benefits. If you were married for at least 10 years, you are eligible for a spousal benefit based on your ex-spouse’s earnings. You are eligible for this benefit if you are age 62 or older, unmarried, and your own benefit is less than the spousal benefit. A lot of divorced women, who may have spent years out of the workforce raising a family, are unaware of this benefit.

Unlike regular spousal benefits, your ex-spouse does not have to start receiving Social Security benefits for you to be eligible for a benefit as an ex-spouse, as long as you have been divorced for at least two years.The ex-spouse benefit has no impact on the former spouse or on their subsequent spouses. See Social Security: If You Are Divorced.

If you remarry, you are no longer eligible for a benefit from your first marriage, unless your second marriage also ends by divorce, death, or annulment.

A couple of hypothetical scenarios, below. Please note that the gender in these examples is irrelevant. It could be reversed. The same rules also apply for same-sex marriages now.

a) A man is married four times. The first marriage lasted 11 years, the second lasted 10 years, the third lasted 8 years, and his current (fourth) marriage started three years ago. The current spouse is eligible for a spousal benefit. The first two spouses are eligible for an ex-spouse benefit, but the third is not because that marriage lasted less than 10 years. A person can have multiple ex-spouses, and all marriages which lasted 10+ years qualify for an ex-spouse benefit!

b) A woman was married for 27 years to a high-wage earner, and they divorced years ago. She did not work outside of the home and does not have an earnings record to qualify for her own benefit. She is 66 and unmarried, so she would qualify for a benefit based on her ex-spouse’s record.

However, if she were to marry her current partner, she would no longer be eligible for her ex-spousal benefits. If the new spouse was not receiving benefits, she could not claim spousal benefits until he or she filed for benefits. Additionally, if the new partner is not a high wage earner, her “old” benefit based on the ex-spouse may be higher! Some retirees today are actually not remarrying because of the complexity it adds to their retirement and estate planning. And in some cases, there is an actual reduction in benefits by remarrying.

3) Survivor Benefits. If a spouse has already started their Social Security benefits and then passes away, the surviving spouse may continue to receive that amount or their own, whichever is higher. The survivor’s benefit can never be more than what they would receive if the spouse was still alive.

If the deceased spouse had not yet started benefits, the widow or widower can start survivor benefits as early as age 60, but this amount is reduced based on their age (See Chart). Widows or widowers who remarry after they reach age 60 do not have their survivorship eligibility withdrawn or reduced.

One way to look at the survivorship benefit: which ever spouse has the higher earnings history, that benefit will apply for both spouse’s lifetimes. The higher benefit is essentially a joint benefit. For this reason, it may make sense for the higher earner to delay until age 70 to maximize their benefit. If their spouse is younger, is in terrific health, and has a family history of substantial longevity, it may be profitable to think of the benefit in terms of joint lifetimes.

Additionally, Social Security offers a one-time $255 death benefit and also has benefits for survivors who are disabled or have children under age 16 or who are disabled.

The challenge for planning is that none of these three benefits – spousal, ex-spouse, or survivor – are indicated on your Social Security statement. So it is very easy to make a mistake and not apply for a benefit. I like for my clients to send me a copy of their Social Security statements, and I have to say that more than half of the clients I have met don’t understand how these benefits work, even if they are aware that they are eligible.

Social Security Administration: it’s time to fix your statements. You can do better.

How to Maximize Your Social Security

Posted On July 14, 2014 By Admin In Retirement Planning /

When should I start my Social Security benefits? I am asked this question frequently and find that many otherwise rational individuals don’t actually look at any data or analysis when making this important decision. As a financial planner, I have the tools to help you take a closer look at all your options to make an informed choice, rather than relying on heuristic biases. The first step, though, is to understand what happens when you start at age 62, 66, or 70. And that’s what today’s post aims to accomplish.

74% of Americans start their Social Security benefits early, before the Full Retirement Age (FRA) of 66 (for individuals born between 1943-1954). Starting at age 62 will result in a reduction in benefits to 75% of your primary insurance amount (PIA). If you wait past age 66, you will receive Delayed Retirement Credits (DRCs), equal to 8% a year, or a 32% increase for individuals who wait until age 70. Many of the individuals who wait until age 70 do so because they are still working. However, even for individuals who retire at age 62, it may make sense to delay benefits to age 66 or 70 and live off other sources of income, in order to receive a higher future Social Security benefit.

Delaying from age 62 to 70 offers a 76% increase in benefits. For example, someone with a PIA of $1000 a month would receive this amount at age 66, but would receive $750 at 62 or $1320 at 70. While COLAs or additional earnings will increase your benefits regardless of when you start, a 2% COLA is obviously going to produce a higher dollar increase if your benefit amount is $1320 rather than $750. So in nominal dollars, the difference between 62 and 70 typically exceeds 76%.

For single individuals, the decision is relatively straightforward. Social Security was designed so that a person with average life expectancy will receive the same benefits regardless of whether they start at age 62, 66, or 70. On an individual level, if your life expectancy is above average, you will receive greater total lifetime payments by delaying benefits until age 70. And if your life expectancy is below average, you will not have enough years of higher benefits to make up for the lost years, so you should start benefits earlier. The breakeven for delaying from age 66 to age 70 is between age 83 and 84. Delaying from 62 to 70 creates a breakeven between age 80 and 81.

Since 74% of recipients start benefits early, the behavioral bias is that people are underestimating their life expectancy. It should be 50% – half of us will live shorter than average and half will live longer. Unfortunately, many of the 74% will live longer than average and their choice means they will receive lower lifetime benefits than if they had delayed to age 66 or 70.

In addition to life expectancy, the other consideration for a single individual is if they have other sources of income. If he or she can get by with withdrawals of 4% or less from their portfolio from age 62 or 66 to age 70, then I would encourage them to delay the Social Security benefits.

Delaying benefits will reduce the future withdrawals required from their portfolio and increase the likelihood that their portfolio will be able to provide lifetime income. When I run Monte Carlo analyses for clients, those who fund a larger percentage of their needs from guaranteed payments like Social Security (or a Pension) have a greater probability of success than retirees who are more dependent on portfolio withdrawals. A larger Social Security benefit reduces the impact from poor potential outcomes in the stock and bond markets, or from an initial drop in the market, called Sequence of Returns Risk.

For married couples, the decision to delay benefits becomes more complex. Neither your Social Security statements nor the calculators on the SSA.gov website help with coordinating spousal benefits. Often, it may make sense to delay for one spouse but not for the other.

A general rule for couples is that you should consider maximizing the higher earning spouse’s SS benefit amount by delaying to age 70. The larger benefit will become the survivor’s benefit, so in effect, the higher earner can consider his or her benefit to be a joint and survivor benefit. And if the spouse is younger or has a high life expectancy, than delaying to age 70 for the higher earner may be an even better idea, in terms of actuarial odds.

Social Security is a good hedge for portfolio performance and an 8% guaranteed increase for delaying one year is a valuable benefit. I looked at quotes this month for immediate single-life annuities and for a 66-yr old male versus a 67-yr old, the rate increase was only 2.2%. Delaying from 66 to age 70 increased the annuity benefit by 12.2%. That gives you an idea of how exceptionally valuable the 8% annual increase is (or 32% for waiting four years), given the low interest rate environment we face today.

Aside from the principle of delaying the higher earning spouse, it is difficult to make other generalizations about delaying to age 70 as the details of a couple’s specific situation typically determine the best course of action. I use financial planning software to analyze your options and suggest an approach to coordinate your benefits into your overall financial plan. There are two tools which married couples might consider to provide some often-missed benefits as one or both defer to age 70.

The first tool is the ability to file and suspend. At full retirement age (66), you can file for benefits but immediately suspend the payments. This enables your spouse to be eligible to receive a spousal benefit, while you can continue to receive deferred credits for delaying to age 70. This is typically used if the spouse does not have any SS benefit based on their own earnings, or if the spouse’s individual benefit is less than the spousal benefit amount (half of the first spouse’s PIA, if the second spouse is at FRA).

If a spousal benefit applies, it is important to know that DRCs are not added to a spousal benefit. While the primary spouse will receive the 8% increase after age 66, the spousal benefit does not increase. So, if the spouse is the same age or older than the higher earning spouse, it is important to not delay the spousal benefit once both are age 66.

The second tool is a restricted application. At FRA, a spouse may restrict their application to receive only their spousal benefit amount and still earn Deferred Retirement Credits on their own benefit. Then they can switch to their own benefit at age 70. However, to receive any spousal benefit, the other spouse must be currently receiving benefits. This works if you want to delay from age 66 to 70 and if your spouse is already receiving benefits (or has filed and suspended).

These two tools provide a benefit from age 66-70 which many people miss. Both techniques will allow one spouse to defer their individual benefit to age 70 to maximize their payment amount (and potentially, the survivor’s benefit amount), while receiving an additional benefit for those four years. If you might benefit from either of those tools, don’t expect the Social Security Administration to tell you. And if you miss those benefits, you’ll lose free money that you can’t get later.

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