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Investing Blog Roundup: Affordable Care Act Open Enrollment

It’s Affordable Care Act open enrollment season (through December 15), so here are a few resources that may be helpful.

First, a thorough FAQ from the Kaiser Family Foundation about buying insurance through the marketplace. Next, a good overall open enrollment walkthrough from Tara Siegel Bernard. And finally, from Harry Sit, one specific tip that may be useful for some families.

Other Recommended Reading

Thanks for reading!

How Much Does a Business Have to Earn Before S-Corp Taxation Makes Sense?

A reader writes in, asking:

“In your opinion as a CPA – is there a minimum annual revenue threshold where looking at S-Corp tax treatment for a single member LLC makes sense given all the reporting requirements?”

Unfortunately there’s no way to make a useful rule of thumb here.

The tax savings from S-corp taxation (relative to sole proprietor taxation) come from the fact that profit from the business is not subject to self-employment tax (i.e., Social Security and Medicare taxes). But before there can be any profit, the business is required to pay the owner a “reasonable” amount of compensation, which will be subject to Social Security and Medicare taxes.

And there are several downsides to S-corp taxation as well. For example:

  • The business will have to pay unemployment insurance tax to your state based on the wages the business pays to you,
  • You will likely have a lower contribution limit to your retirement plans (because it will be based on your wages, rather than being based on what would have been the full profit from the business if it were a sole proprietorship),
  • You will likely have a smaller Social Security benefit in the future (again, because it will be based on your wages, rather than being based on what would have been the profit from the business if it were a sole proprietorship),
  • You will have to file Form 1120S (for the business) and Schedule E (for yourself) rather than just Schedule C,
  • Your business will have to register with your state and with the federal government as an employer (if it has not done so already) and must satisfy all the related periodic reporting and tax-payment requirements. (A payroll service provider is super helpful here.)

So S-corp taxation doesn’t really become advantageous until the business can pay you a “reasonable” amount of compensation and then still have enough profit left over for the tax savings on that profit to outweigh all of the negatives mentioned above.

But the tricky point is that what constitutes “reasonable” varies dramatically from one situation to another. For example, a freelance writer would usually be able to get away with a much lower level of compensation than a cardiologist. Even within a given line of work it can vary significantly. For example, a business owner who spends very little time actually working for the business (e.g., because they have another full-time job) will generally be able to get away with a lower level of compensation than somebody who works full-time for their business.

The following are a list of factors that the IRS (or applicable court) will consider, in addition to any other factors that may be relevant to the situation:

  • Your qualifications;
  • The nature, extent, and scope of your duties;
  • Your background and experience;
  • Your knowledge of the business;
  • The size and complexity of the business;
  • The amount of time you devote to the business;
  • The economic conditions generally and locally;
  • The character and amount of your responsibility in the business;
  • Whether or not the compensation is pre-determined based on activities to be performed or not determined until the end of the tax year;
  • Amounts paid to you in prior years;
  • The salary policy of the business with regard to other employees; and
  • The amounts paid by similarly sized businesses in the same area to equally qualified employees for similar services.

Also, state laws play a significant role in the decision as well. In some states the cost of unemployment insurance tax is very minor because the tax rate is low, the wage base is low, or both. In some states it will have a larger impact. And some states (e.g., Illinois) impose an income tax on the S-corporation itself.

In short, there are simply too many moving pieces for a dollar-amount rule of thumb to be useful. The decision of whether or not to elect S-corporation taxation for a business really must be done on a case-by-case basis.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less

Topics Covered in the Book:
  • The basics of sole proprietorship, partnership, LLC, S-Corp, and C-Corp taxation,
  • How to protect your personal assets from lawsuits against your business,
  • Which business structures could reduce your Federal income tax or Self-Employment tax,
  • Click here to see the full list.

Investing Blog Roundup: Maybe This Time Is Different

Stock market declines have always been temporary — at least in this country. So when the market is going down, you can generally take some comfort in the near certainty that the market will, at some point, go back up and eventually surpass its prior high.

As Christine Benz notes though, maybe this decline is different.

Other Recommended Reading

Thanks for reading!

Lifetime Annuity: Avoid the Period Certain

A reader writes in, asking:

“Can you please write an article about SPIAs with guarantees of a minimum payout period?”

For those who are unfamiliar, a single premium immediate lifetime annuity (sometimes referred to as a SPIA) is an insurance product where you give the insurance company a lump sum of money (which you cannot get back) and in exchange the insurance company promises to pay you a certain amount of money every month for the rest of your life. In short, it’s a pension that you purchase from an insurance company.

Such annuities are useful because they protect against longevity risk (i.e., the financial risk that comes from living very long and therefore having to pay for a very long retirement).

One thing that stops many people from buying such annuities, however, is the fear that they’ll die soon after purchasing the annuity. For example, if you spend $100,000 on a SPIA that pays you $6,000 per year for the rest of your life, but the rest of your life only turns out to be a couple of years, you will have had a net loss of $88,000.

And that’s why insurance companies offer the option to purchase a “period certain,” whereby the insurance company promises to pay out for at least a given period of time. For example, for a lifetime annuity with a 10-year period certain, the insurance company promises to pay out for the rest of your life but no less than 10 years. (So if you died after two years, the insurance company would continue to make payments for another 8 years to your named beneficiary.)

Of course, because of this guarantee, a lifetime annuity with a period certain will cost more (i.e., will require a higher premium) for a given level of income than you would have to pay for a lifetime annuity without a period certain.

Why a Period Certain Is a Bad Deal

The whole point of insurance is risk pooling. For example, consider 1,000 people who purchase homeowners insurance from a given insurance company. Most of those people will not have their homes destroyed by a fire or a tornado. And that fact — the fact that the insurance company is going to collect money from all of those people without ultimately having to make a huge payout to them — is how the insurance company can afford to make a huge payout to the person whose home is destroyed by a fire.

A key point, however, is that for every dollar that an insurance company receives in premiums, they keep some part of it to cover their administrative costs and to provide profit to shareholders. So only some of the money spent on premiums ultimately goes to pay for claims to people purchasing the insurance product in question. So in general it is unwise to purchase an insurance product unless:

  1. There is risk pooling going on (i.e., many people are going to ultimately get a bad deal so that some people can get a very good deal), and
  2. You need such risk pooling (i.e., you cannot reasonably afford to cover this risk out of pocket on your own).

With a lifetime annuity, risk pooling occurs because some annuitants will die prior to reaching their life expectancy (i.e., the insurance company will pay less than the “expected” amount to those people — which is how it can afford to pay more than the “expected” amount to the people who live beyond their life expectancy).

But if the insurance company is providing a period certain, it knows it must pay out for that entire period. In other words, the annuity then offers no risk pooling for that period. Instead, what’s occurring for that period is just the insurance company gradually paying your money back to you — after taking a piece off the top for profit and expenses — without any actual net insurance effect.

In most cases you would be better off investing the money yourself for the period certain, then buying the annuity at the end of that period. (Of note: if you would be considering a 10-year period certain, don’t buy 10-year bonds. Instead buy longer-term bonds to offset the interest rate risk that you face with the annuity purchase. See this prior article and this Bogleheads discussion for a more thorough explanation.)

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

Investing Blog Roundup: Types of Employer Stock

The biggest news in the tax world since the last roundup is the New York Times’ Trump tax investigation. Political implications aside, I thought the authors did a commendable job of discussing complex tax topics in such a way as to make them understandable.

Other Recommended Reading

I also recently encountered a neat ongoing series from financial planner Sophia Bera about the various types of employer stock that an employee might own:

Thanks for reading!

61: The Magic Retirement Age?

David Blanchett of Morningstar recently released a piece of research discussing the uncertainty of retirement age: The Retirement Mirage (pdf). I linked to it in the most recent roundup, but I wanted to highlight its findings, as I know that any single article in a roundup can be easy to miss.

Blanchett looked at 12 years of data from the University of Michigan’s Health and Retirement Study (HRS). The HRS is interesting because it tracks a large group of people (approximately 20,000) over a period of time, so you can see how people’s circumstances and views change over time.

Blanchett learned two interesting things from the HRS data.

First, he found that you’re likely to retire closer to age 61 than you think. In Blanchett’s words:

“According to the Health and Retirement Study data, planned and actual retirement ages align at 61, with those planning to retire earlier than that tending to retire later than expected, and those planning to retire after 61 tending to retire earlier than expected. In other words, actual retirement ages pull toward 61, with each retirement year planned before or after age 61 resulting in a half-year’s difference in actual retirement age. For example, someone who plans to retire at age 69 will likely retire at age 65 (69 – 61 = 8 × 0.5 = 4; 69 – 4 = 65)”

Of those planning an early retirement, many are ultimately unable to retire as early as planned.

And of those planning on working well into their 60s, many are unable to do so for one reason or another. (Alternatively, some people are probably retiring earlier than anticipated because they’re finding that they do not need to work as far into their 60s as planned.)

So, what might help us to predict who will be in the “retiring earlier than planned” or “retiring later than planned” groups? That leads us to Blanchett’s second noteworthy finding:

“The rich HRS data set allowed us to test more than a dozen factors, including general personal characteristics such as gender, marital status, and education, along with factors that might be expected to lead to retiring early, such as job stress level, how physical a job is, and whether health problems limit someone’s work. However, these factors had little or no predictive power on retiring early. The only factor that appeared to tell us much about when someone might retire was their planned retirement age and its distance from the previously noted ‘magic’ retirement age of 61. […] Not only do many people retire earlier than expected, but it’s nearly impossible to predict who will be part of this group.”

This obviously presents some challenges as far as retirement planning. But it also suggests a few financial/life strategies that are likely to be worthwhile.

If you’re planning an early retirement, keep your professional skills sharp, as there’s a good chance you’ll be working longer than you anticipate. Also, if you’re currently in the position of “grinding it out” at a job that you hate, with the hope of being happy once you achieve an early retirement, you may want to consider a different approach. “Just 2 more years” could well turn out to be 3, 4, or 5 more years. Focusing instead on making changes that allow you to be happy while still working is likely to be a good idea.

At the other end of the spectrum, if for example you are currently age 60 and planning to work until 68, socking away that last chunk of necessary retirement savings may be more urgent than you think. Retirement may ultimately be something that happens to you, rather than a decision you make.

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."
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