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Name Successor Trustees (Plural!) for Your Trust

Today I want to share with you a brief “estate planning gone wrong” story. The story is real, but of course the names have been changed. If you are not up-to-speed on basic trust terminology, please read “What’s the Point of a Trust?” first.

Here’s the basic sequence of events:

  • Hank and Wanda (a married couple) had their attorney, Adam, create a trust for them.
  • Hank was named as trustee of the trust.
  • Adam was named as successor trustee.
  • Hank and Wanda were co-beneficiaries of the trust, with their adult children named as secondary beneficiaries.
  • Hank and Wanda moved essentially all of their assets into the trust. (Retirement accounts, which cannot go into the trust, made up only a very small portion of their assets.)
  • Adam died before Hank or Wanda. The trust was not modified to add a new successor trustee.
  • Hank died.

The result: the trust had no trustee — nobody who was authorized to make decisions about how to use the assets. Wanda was beneficiary of the trust, but because she was not the trustee, she had no control over the assets. This resulted in two problems:

  1. Wanda could not spend from the money that she naturally thought of as “her” money.
  2. There was nobody who could make any portfolio management decisions.

Wanda petitioned the applicable court to appoint a new trustee for the trust, and the court eventually did so. But the process took several months. And in the meantime, there was very little other than her monthly Social Security check that she had access to.

Fortunately, her adult children were able to step in and provide some needed funds. And, fortunately, the portfolio being left on autopilot did not result in any bad outcome. But you can easily imagine situations where either of those two problems could have resulted in very real damage to Wanda’s well-being.

Why wasn’t Wanda named as co-trustee along with Hank? Frankly, I don’t know. There are various cases in which it would make sense for only one of two spouses to be named as a trustee (e.g., the other spouse has a gambling problem or cannot be trusted to make sound financial decisions for some reason). I could not see any obvious reason in this case, but maybe the husband and the attorney really did have a good reason.

Regardless, this is an easily avoided situation. Make sure your trust has multiple successor trustees. Even if you like the idea of naming a family member or a trusted individual professional as the trustee, naming a business entity, such as a well-established law firm that’s likely to outlive any one person, as a final successor trustee can prevent the situation described here.

In addition, estate plans should be updated periodically. In the example above, the situation would have been avoided if the couple had reviewed their estate plan after the first attorney’s death, as they (or the attorney doing the review) would have realized that the trust no longer had a successor trustee.

Investing Blog Roundup: Monte Carlo-Based Retirement Spending Strategies

I’ve written before about how I consider retirement spending strategies to exist on a spectrum.

  • Strategies at one end of the spectrum (e.g., the classic “4% rule” approach) do not adjust spending based on portfolio performance. This makes spending predictable, but the tradeoff is that it results in both a higher probability of portfolio depletion as well as a higher probability of having a huge unspent sum at death. In other words, by not adjusting spending based on portfolio performance, you have a greater likelihood of ultimately overspending or underspending.
  • And at the other end of the spectrum is a strategy in which you spend a given percentage of the portfolio each year. By adjusting spending based on the portfolio’s performance (e.g., the portfolio fell by 30% last year, so this year’s spending will be 30% lower than last year’s spending), you dramatically reduce the risk of underspending or overspending. But for some people, the necessary changes to spending from one year to the next simply would not be plausible.

For most people, a strategy somewhere in the middle is going to make the most sense (i.e., adjust spending somewhat over time, but don’t necessarily increase/decrease spending by a full 30% in a given year if the portfolio grew/fell by 30% in the year before).

For people who use Monte Carlo simulations as a part of their retirement planning, Derek Tharp and Justin Fitzpatrick recently shared an approach that may be of interest:

Other Recommended Reading

Thanks for reading!

Digging Into Solo 401(k) Contribution Limit Math

Nearly every week I receive emails telling me that my solo 401(k) contribution limit calculator is wrong. Those emails are generally based on one of two misunderstandings.

  • The first category of email is something to the effect of, “I’m confident that the employer contribution limit is 25% of the business’s profit instead of 20%.”
  • And the second is something along the lines of “where on earth did you get the idea that the employer contribution is limited to half of the difference between your net earnings from self-employment and the employee contribution?”

Let’s dig into both of these.

The “25% of Compensation” Limit

The limit in question, which comes from IRC 404(a)(3), says that the employer contribution is limited to 25% of compensation. Note that this is the exact same limit that applies for employer contributions when the worker in question is an employee.

For an employee, “compensation” is a reasonably obvious amount. For a sole proprietor, compensation is defined as:

  • Profit, minus half of self-employment tax, minus the employer contribution.*

Note that we have circular math going on here. The employer contribution limit is 25% of compensation, and the definition of compensation includes a deduction for the employer contribution.

So we have to do a little algebra. We start with our rule from 404(a)(3):

  • Employer Contribution ≤ 25% of Compensation

And given our definition of compensation above, we can restate that as:

  • Employer Contribution ≤ 0.25 x (Profit – SETax/2 – Employer Contribution)

And then we do the following algebra:

  • Employer Contribution ≤ 0.25 x (Profit – SETax/2 – Employer Contribution)
  • 4x Employer Contribution ≤ Profit – SETax/2 – Employer Contribution
  • 5x Employer Contribution ≤ Profit – SETax/2
  • Employer Contribution ≤ 0.2 x (Profit – SETax/2)

Or said differently, the employer contribution is limited to 20% of net earnings from self-employment, when we define that as “profit minus half of self-employment tax.”

You can see the IRS doing this math in the “Rate Table for Self-Employed” in IRS Publication 560. It’s the reason that table exists (i.e., to convert from an employer contribution limit that’s defined as a percentage of compensation to a contribution limit that is defined as a percentage of net earnings from self-employment).

The “Half of the Difference…” Limit

The calculator also implements a limit in which the employer contribution is limited to half of the difference between your net earnings from self-employment and the employee contribution.

This limit comes from IRC 415(c), which in this case says that the whole contribution is limited to 100% of compensation.

But again, we have an issue of circular math, given that we’re trying to figure out the contribution limits, and they’re defined based on “compensation” which itself includes a deduction for the employer contribution.

So, again, time for some algebra. We start with the limit as stated in IRC 415(c):

  • Employer Contribution + Employee Contribution ≤ Compensation

And given our definition of compensation above, we can restate that as:

  • Employer Contribution + Employee Contribution ≤ Profit – SETax/2 – Employer Contribution

And then we do the following algebra:

  • Employer Contribution + Employee Contribution ≤ Profit – SETax/2 – Employer Contribution
  • 2x Employer Contribution + Employee Contribution ≤ Profit – SETax/2
  • 2x Employer Contribution + Employee Contribution ≤ Net Earnings From Self Employment (when we again define that as profit minus half of self-employment tax)
  • 2x Employer Contribution ≤ NEFSE – Employee Contribution
  • Employer Contribution ≤ (NEFSE – Employee Contribution) / 2

Or as stated on the calculator’s page, “the employer contribution is limited to half of the difference between your net earnings from self-employment and the employee contribution.”

You can see the IRS doing this math in step 11 and step 12 of the “Deduction Worksheet for Self-Employed” in Publication 560.

*This definition of compensation comes from IRC 415(c)(3)(B) and 404(a)(8), which both define compensation for self-employed individuals as the earned income of the individual as defined in 401(c)(2). 401(c)(2) uses the definition of net earnings from self-employment from 1402(a) but makes various modifications to that definition (including that we have to back out the employer contribution and the deduction for 1/2 of self-employment tax).

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Investing Blog Roundup: Financial “Pig Butchering” Scams

In my prior roundup article, I referenced a few different types of scams that you’re likely to encounter. In reply, multiple readers recommended the following recent episode of Last Week Tonight with John Oliver. It’s an excellent explanation of another common and clever type of scam that you and your loved ones should be aware of.

Other Recommended Reading

Thanks for reading!

Can You Give Investment Advice (Without Being a Registered Investment Adviser)?

One question that I am often asked is under what circumstances a person can give investment advice, without needing to be a registered investment adviser (RIA). I want to be clear that what follows is only a high level summary of that topic. If this is more than just a curiosity for you, I would encourage you to consult with an attorney with relevant expertise.

Where to Find the Rules

The actual relevant legislation consists primarily of:

And then there are of course various other relevant sources such as regulations, court cases, etc.

What’s an Investment Adviser (“ABCs Test”)

The Investment Advisers Act of 1940 defines an investment adviser as: “any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities.”

The Uniform Securities Act includes a definition that is nearly identical to the above.

People often use the mnemonic device “ABCs” to remember this test. That is, an investment adviser is somebody who is 1) in the business of 2) giving advice 3) about securities 4) for compensation. (Advice, Business, Compensation, Securities.)

And the idea is that you have to meet all of those requirements before you’d need to register as an investment adviser.

So, for example, if you’re a nurse and your daughter comes to you asking how she should invest in the 401(k) at her new job, you are perfectly allowed to give her advice. And there’s no need for a “this is not investment advice” disclaimer. It is advice about securities, but you’re not receiving any compensation, nor does your daughter have any reason to think that you’re “in the business” of providing investment advice for compensation. You don’t meet the ABCs test and thus don’t have to register as an investment adviser.

One important point here is that the SEC and state regulators tend to interpret the above tests as broadly as possible (i.e., to include as many people under the definition as possible). So, for example, any economic benefit received in exchange for the advice would be probably considered “compensation.”

Exclusions

The 1940 Act and Uniform Securities Act also provide exclusions. That is, there are certain people who do meet the above requirements (i.e., they satisfy the ABCs test) but who are nonetheless explicitly excluded from the definition of investment adviser — and thus don’t have to register as investment advisers.

Some of those exclusions include:

  • Any lawyer, accountant, engineer, or teacher whose performance of such services is solely incidental to the practice of his/her profession.
  • Any broker or dealer whose performance of such services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation for the investment advice.
  • The publisher of any bona fide newspaper, news magazine or business or financial publication of general and regular circulation.
  • A bank or savings institution.
  • Any person whose advice, analyses, or reports relate to no securities other than securities which are direct obligations of or obligations guaranteed as to principal or interest by the United States.

This is why, for example, somebody can write a blog that discusses all sorts of investment topics, without having to register as an investment adviser. It’s also why somebody can teach a personal finance class — and provide investment advice in that class — without having to register as an investment adviser.

I will note that, as somebody who is a practicing CPA, the exception for accountants is somewhat challenging to apply in real life.

Firstly, what specifically is meant by “the practice of my profession”? That is, what services are considered included in my profession as an accountant, so that we can then try to figure out what would be “incidental” to that profession? At least here in Missouri, public accounting is defined as “services involving the use of accounting or auditing skills, or one or more management advisory or consulting services, or the preparation of tax returns or the furnishing of advice on tax matters.” So basically, accounting includes tax preparation, tax advice, management advisory or consulting services, and “services involving the use of accounting skills” — a pretty circular definition.

And what would be “solely incidental” to that practice? That wording is clearly intended to be vague (i.e., determined on a case-by-case basis, depending on the facts and circumstances). So it’s no surprise that different accountants will draw the line in different places, as far as what degree of investment-related advice they feel comfortable giving.

So, in short, if you meet the “ABCs test” (i.e., you’re in the business of giving advice about securities, in exchange for compensation) when that test is interpreted as broadly as possible (i.e., to include as many people as possible), and you do not fall under one of the explicit exclusions, you probably need to register as an investment adviser. But again, if you’re even remotely unsure about whether something you’re doing (or considering doing) would require you to register as an investment adviser, I’d encourage you to consult with an attorney.

Investing Blog Roundup: Be Careful Out There

Hopefully by now, everybody is familiar with basic online safety measures (e.g., even if you have a Bank of America account, don’t click the link in the email from Bank of America — instead directly visit the website and navigate to what you need).

But the tools and techniques used by scammers keep improving, as we can see in the articles below:

Other Recommended Reading

Thanks for reading!

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