Archives for April 2014

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Protective File and Suspend Social Security Strategy

A few weeks ago, we discussed the fact that a claim for Social Security benefits can be backdated by up to 6 months (but no earlier than full retirement age), thereby resulting in a) a lump-sum payment for 6 months of benefits and b) a lower ongoing monthly benefit, as if you had originally filed at that earlier date.

This can be helpful as a way to effectively change your mind (e.g., in the case of an unmarried person who originally chooses to delay benefits, but who later finds out that his/her life expectancy is shorter than originally believed, thereby making an earlier application for benefits more appealing).

In the case of retirement benefits though, there’s an even more powerful “change your mind” strategy available — one that isn’t limited to just 6 months.

How the Strategy Works

If a person has filed for retirement benefits and has asked for those benefits to be suspended, he/she can later unsuspend and ask to have all or some of the benefits from the date of suspension onward paid as a lump sum. And this person’s ongoing monthly benefit would then be reduced as if he/she had originally started receiving benefits on that earlier date.

In other words, this is a way to retroactively “change your mind,” all the way back to full retirement age if you filed and suspended right away at full retirement age. (Note, however, that the date on which you change your mind must be before age 70, otherwise you will have already asked to unsuspend payments.)

Because of this ability, filing and suspending as a sort of protective action can make sense for some people. For example, an unmarried person who plans to wait until age 70 to take retirement benefits should probably go ahead and file and suspend at full retirement age, just to preserve the opportunity to change his/her mind later. (Ditto for a spouse in a married couple who does not plan to take retirement or spousal benefits prior to age 70.)

To be clear though, some people should definitely not be doing this. Specifically, for a spouse in a married couple who plans to file a restricted application at full retirement age (i.e., an application for spousal benefits only), it’s important to not file for your own retirement benefit until you actually want to start receiving it.

Technical note: For anybody interested in the applicable Program Operations Manual System (POMS) reference, it’s here (under “B. PROCEDURE — CLAIMANT REQUESTS RESUMPTION PRIOR TO AGE 70”). The key point is that the effective month of reinstatement of benefits can be any month during the suspension period. This topic is not covered in the actual Code of Federal Regulations, as far as I can tell.

Want to Learn More about Social Security? Pick Up a Copy of My Book:

Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less
Topics Covered in the Book:
  • How retirement benefits, spousal benefits, and widow(er) benefits are calculated,
  • How to decide the best age to claim your benefit,
  • How Social Security benefits are taxed and how that affects tax planning,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"An excellent review of various facts and decision-making components associated with the Social Security benefits. The book provides a lot of very useful information within small space."

Cookie Cutter Portfolios Are (Usually) Just Fine

A reader writes in, asking:

“I don’t get it. From reading Harry Sit’s series on Vanguard financial plans, why would I want to pay for a financial plan if all that’s included in the portfolio is the same four funds that are included in a target retirement fund anyway? That seems like a cookie cutter portfolio.”

Yes, they are cookie cutter portfolios. And, in my opinion, that’s a good thing.

That is, if Vanguard thought that the average investor should have some other allocation (e.g., overweighting REITs or using only TIPS for the bond portion of the portfolio), then wouldn’t they build the Target Retirement (and LifeStrategy) funds that way as well?

Ideally, you should only get a different recommended allocation if there’s something about you that makes you unusual. And, the truth is, for most investors, there isn’t.

Investing is much like nutrition in this regard. Some people do need a specialized diet — whether that means low-protein, gluten-free, or something else. But, for most people at most points in their lives, a run-0f-the-mill healthy diet will do just fine.

Similarly, some people do need specialized portfolios in some way. But most investors’ needs are not terribly different from the needs of most other investors. That is, while your risk tolerance is personal, how to implement a portfolio appropriate for that level of risk tolerance is generally not a very personalized sort of thing. (In most cases, different risk tolerances can be satisfied by simply bumping a cookie cutter portfolio’s stock allocation upward or downward.)

For you to need a very different portfolio from somebody else, there must be a specific, identifiable difference between the two of you. For example, if you have significant assets in taxable accounts, your portfolio should probably look different than the portfolio of somebody who has all of his/her assets in tax-sheltered retirement accounts. (For example, you may want to consider holding muni bond funds, and you probably don’t want to use all-in-one funds due to their tax-inefficiency.)

Please note that I’m not saying here that Vanguard’s specific 4-fund cookie cutter portfolio is distinctly superior to other cookie cutter portfolios. Rather, my points are simply that:

  1. Uniqueness is overrated when it comes to investing, and
  2. When evaluating an advisor, it’s a good sign if the advisor recommends portfolios that are generally very similar from client to client. (Not identical, but similar.)

When Should I Contribute to a Roth IRA as Opposed to Traditional IRA?

In reply to a recent Vanguard blog post indicating that investors contribute significantly more to Roth IRAs than to traditional IRAs, a reader asked for an explanation of when it makes sense to use a Roth IRA as opposed to traditional IRA.

For most people, the question of whether to make tax-deferred (i.e., “traditional”) retirement account contributions as opposed to Roth contributions is a function of marginal tax rates. (At any given time, your marginal tax rate is the rate of tax you would have to pay on an additional dollar of income.)

A simplified example illustrates how this works:

  • Let’s say you’re a 60-year-old taxpayer in the 25% tax bracket. You contribute $1,000 to a traditional IRA. You leave the money there for one year, during which it earns a 10% return (growing to $1,100). Then you take it out, while still in the 25% tax bracket, leaving you with $825 (i.e., $1,100 x 0.75) available to spend.
  • Alternatively, you could contribute to a Roth IRA. In this case, however, you can only afford to contribute $750, because you’ll no longer be getting the $250 of tax savings that you would have gotten in Year 1 via the $1,000 traditional IRA contribution. The $750 grows by 10%, to $825. When you take it out, you get to keep all $825 because the distribution is nontaxable.**

The key observation here is that if your marginal tax rate in the period of the contribution is the same as your marginal tax rate in the period of the distribution, then you’re left with exactly the same amount of money whether you use a Roth IRA or traditional IRA.

This is just the commutative property of multiplication at work. That is, at some point, the sum of money involved has to be multiplied by 0.75 to account for the 25% tax bite. It doesn’t matter whether we do that multiplication at the beginning (as is the case with a Roth IRA, where you have to pay tax on the income before being able to contribute it) or at the end (as is the case with a traditional IRA, in which you can contribute pre-tax money, but you have to pay taxes on distributions).

If, however, your marginal tax rate changes from the time of the contribution to the time of the distribution, one type of retirement account will come out ahead. Specifically:

  • If your marginal tax rate is greater in the year of the contribution, the traditional IRA will come out ahead, and
  • If your marginal tax rate is greater in the year of the distribution, the Roth IRA will come out ahead.

Guessing Tax Rates

In terms of guessing whether you’ll have a higher or lower marginal tax rate during retirement than during your working years, there are several factors at work.

One big factor in favor of traditional contributions is the fact that most taxpayers have lower levels of taxable income in retirement, because they’re no longer working. And, generally speaking, a lower level of taxable income leads to a lower marginal tax rate.

On the other hand, it’s likely that your marginal tax rate in many years of retirement will be higher than just your retirement tax bracket (e.g., you could be in the 15% tax bracket, yet have a marginal tax rate of 27%). For example:

  • In some cases, with the unique way in which Social Security benefits are taxed, a dollar of income in retirement not only causes the normal amount of income tax (e.g., 15 cents if you’re in the 15% tax bracket), it can also cause an additional 50 or 85 cents of your Social Security benefits to become taxable, which results in even more income tax.
  • If you retire prior to Medicare eligibility (and you do not have health insurance coverage through your former employer or your spouse’s employer), additional income can not only cause the normal amount of income tax, it can also shrink the amount of Affordable Care Act health insurance subsidies for which you’re eligible.

Both of those factors are points in favor of making Roth contributions during working years.

Frankly, I think that for investors who are many years away from retirement, trying to guess their marginal tax rate so far in the future is an exercise in futility, and the best approach is to simply do some of both (i.e., “tax diversify” by having some money in tax-deferred accounts and some money in Roth accounts).

Other Roth IRA Advantages

Finally, it’s important to note that regardless of this marginal tax rate guessing game, Roth IRAs do have three advantages over traditional IRAs:

  • There are no required minimum distributions (RMDs) during the original owner’s lifetime,
  • You can take contributions back out of the account tax-free and penalty-free at any time, and
  • They effectively allow you to tax-shelter more money (though this is irrelevant for anybody who does not have sufficient cash flow to max out their retirement accounts).

**We’re assuming here that you have satisfied the 5-year rule via prior Roth IRA contributions.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions, exemptions, and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

The Social Security Lump Sum Strategy: Don’t Bother

Reminder: Today at 3pm EST, I’ll be participating in a WSJ webcast about creating an action plan for tapping investments and Social Security in retirement. Questions from viewers are very welcome, so please join us. (For anybody who is interested but who cannot make it at the scheduled time, a recorded version of the webcast will be available at the same URL afterward.)

A reader recently asked me about an article in ThinkAdvisor in which the authors suggest that advisors recommend a “lump-sum” Social Security strategy to their clients. The article states:

“For those nearing retirement age, this seldom-discussed strategy can be just the Hail Mary play needed to ensure longevity protection throughout a long retirement. By delaying retirement for a few months, your clients can access the chunk of cash that can be fundamental to purchasing a product to protect them from the unexpected at a time when the client’s retirement needs have finally become a reality.”

As a bit of background: When you file for benefits (whether retirement benefits, spousal benefits, or widow/widower benefits), you can essentially backdate your application by up to 6 months. That is, you can request that the SSA pay you up to 6 months of benefits as a lump sum and treat you going forward as if you had filed 6 months earlier than you really did. (The backdating cannot, however, be applied to any month prior to full retirement age.)

The “lump-sum strategy” discussed in the article consists of:

  • Waiting at least 6 months beyond full retirement age to claim benefits, then
  • Filing a claim that includes a request for retroactive benefits paid as a lump sum, then
  • Using the lump-sum to purchase some sort of longevity insurance (e.g., a deferred lifetime annuity).

So for example, a person with an FRA of 66 following the strategy could wait until age 66 and 6 months to file for retirement benefits. Then he would file for his retirement benefit and request a lump sum payment for the months between his FRA and his current age. And he would then be treated as if he had originally filed at his FRA.

In other words, the strategy consists of holding off on receiving 6 months of benefits, only to receive the exact same amount later as a lump-sum. The only effect on you as an investor (relative to just claiming at full retirement age) is that you lose out on a few months of interest that you could have earned if you’d just taken the money earlier in the first place.

So what’s the point of the strategy? It gives you a lump-sum of cash, with which you can purchase a product from the advisor.

Summary: It’s not really a Social Security strategy. It’s a sales strategy.

Addendum: There can be cases in which it makes perfect sense to backdate a Social Security claim — if you’re filing because you just learned about a medical condition that gives you a significantly shorter life expectancy than you had previously thought, for instance. But planning ahead of time to backdate a claim would not usually make sense. It’s generally better to just claim earlier in the first place.

Want to Learn More about Social Security? Pick Up a Copy of My Book:

Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less
Topics Covered in the Book:
  • How retirement benefits, spousal benefits, and widow(er) benefits are calculated,
  • How to decide the best age to claim your benefit,
  • How Social Security benefits are taxed and how that affects tax planning,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"An excellent review of various facts and decision-making components associated with the Social Security benefits. The book provides a lot of very useful information within small space."

Investing Blog Roundup: Social Security and Retirement Webcast

On Monday (April 7) at 3pm Eastern, I’ll be participating in a WSJ webcast about creating an action plan for tapping investments and Social Security in retirement. Questions from viewers are very welcome, so please join us. (For anybody who is interested but who cannot make it at the scheduled time, a recorded version of the webcast will be available at the same URL afterward.)

Investing Articles

Other Money-Related Articles

Thanks for reading!

The Difference Between Exemptions, Deductions, and Credits

The following is an excerpt from my book Taxes Made Simple: Income Taxes Explained in 100 Pages or Less.

In short, the difference between deductions, exemptions, and credits is that deductions and exemptions both reduce your taxable income, while credits reduce your tax.

Exemptions

For 2014, you are entitled to an exemption of $3,950 for yourself, one for your spouse, and one for each of your dependents.

[Note: These exemptions are reduced if your total income, minus your above the line deductions (which we’ll discuss shortly) exceeds a certain threshold—for 2014, $254,200, or $305,050 if married filing jointly.]

EXAMPLE: Kevin and Jennifer are married, with a combined income of $80,000. They have four children, whom they claim as dependents. They will be allowed six exemptions of $3,950 each. As a result, their taxable income will be reduced by $23,700.

Deductions

Deductions generally arise from your expenses. For example, a deduction is allowed for interest paid on student loans.

EXAMPLE: Carlos is in the 25% tax bracket. Over the course of the year, he paid $1,600 in student loan interest. This $1,600 decrease in his taxable income will save him $400 in taxes ($1,600 x 25%).

Itemized Deductions or Standard Deduction?

Several deductions (such as charitable contributions or the interest on your home mortgage) fall into the category known as “itemized” deductions. Sometimes, these are known (as we’ll discuss momentarily) as “below the line” deductions. Every year, you have the choice to use either:

  1. The sum of all of your itemized deductions, or
  2. The standard deduction ($6,200 for a single taxpayer in 2013, or $12,400 for a married couple filing jointly).

For the most part, this decision is pretty easy. Simply add up all of your itemized deductions, and compare the total to the standard deduction you would be allowed. Then simply take whichever option allows you a larger deduction.

Above the Line vs. Below the Line Deductions

If a deduction does not fall into the category of itemized, or “below the line,” it must be what is known as an “above the line” deduction. Above the line deductions are helpful because you can claim them regardless of whether you choose to use the standard deduction or your itemized deductions.

Some common above the line deductions include contributions to a traditional IRA, interest paid on student loans, or contributions to a Health Savings Account (HSA).

In contrast to above the line deductions, which are always useful, below the line/itemized deductions are only valuable if and to the extent that they (in total) exceed your standard deduction amount. Here’s how it looks mathematically:

Total income (sum of all your income)
Above the line deductions
=  Adjusted gross income ← “The Line”
— Standard deduction or itemized deductions
Exemptions
=  Taxable income

EXAMPLE: Eddie is a single taxpayer. During the year he contributes $3,000 to a traditional IRA, and he makes a charitable contribution of $1,000 to the Red Cross. He has no other deductions, and his income (before deductions) is $50,000.

The IRA contribution is an above the line deduction, and the charitable donation is a below the line (a.k.a. itemized) deduction.

Using our equation from above, we get this:
$50,000 Gross Income
$3,000 Above the line deductions
= $47,000 Adjusted Gross Income ← “the line”
— $3,950 Exemption
$6,200 Standard deduction
= $36,850 Taxable Income

Important observations:

  1. Eddie’s itemized deductions ($1,000) are less in total than his standard deduction ($6,200). As such, Eddie’s charitable contribution doesn’t provide him with any tax benefit, because he’ll elect to use his standard deduction instead of his itemized deductions.
  2. Eddie’s above the line deduction provides a tax benefit even though he’s using the standard deduction.

Again, itemized/below the line deductions only help when they add up to an amount greater than your standard deduction. Above the line deductions, on the other hand, are always beneficial.

Credits

Unlike deductions and exemptions, credits reduce your taxes directly, dollar for dollar. After determining the total amount of tax you owe, you then subtract the dollar value of the credits for which you are eligible. This makes credits particularly valuable.

Credits arise from a number of things. Most often, they are the result of the taxpayer doing something that Congress has decided is beneficial for the community. For example, you are allowed a credit of up to $2,500 for paying “qualified education expenses” for one of your dependents. If you meet the requirements to claim the maximum credit, your tax (not taxable income) will be reduced by $2,500.

“Pre-Tax Money”

You’ll often hear the term “pre-tax money,” generally used in a context along the lines of, “You can pay for [something] with pre-tax money.” This means one of two things:

  1. The item is deductible, or
  2. The item can be paid for automatically in the form of a payroll deduction.

The reason these situations are sometimes referred to as “pre-tax” is that you get to spend this money before the government takes its cut. This makes it more cost-effective for you.

You will, from time to time, run across people who seem to be under the impression that something is free simply because it’s deductible or because they were allowed to spend pre-tax money on it. This is a severe misunderstanding. Being able to spend pre-tax money on something is more akin to getting a discount on it than it is to getting the item for free.

Simple Summary

  • You are entitled to one exemption for yourself, one for your spouse, and one for each of your dependents. In 2014, each exemption reduces your taxable income by $3,950.
  • Deductions arise from your expenses, and they reduce your taxable income.
  • Each year, you can use either your standard deduction or the sum of all your itemized (below the line) deductions.
  • Above the line deductions are particularly valuable because you can use them regardless of whether you use your standard deduction or itemized deductions.
  • Credits, unlike deductions and exemptions, reduce your tax directly (as opposed to reducing your taxable income). Therefore, a credit is more valuable than a deduction of the same amount.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions, exemptions, and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"
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