Archives for July 2013

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Avoiding a Common Social Security Planning Mistake

When you look at your Social Security statement (if you receive it in the mail) or your online Social Security account, you will see three figures:

  • An estimated monthly retirement benefit if you claim at age 62,
  • An estimated monthly retirement benefit if you claim at your full retirement age (FRA), and
  • An estimated monthly retirement benefit if you claim at age 70.

One of the most common mistakes I see when it comes to Social Security planning is to use these numbers without understanding the assumptions that go into them.

To be more specific, what many people overlook about these figures is that each of them is calculated based on the assumption that you will continue working — at your current rate of earnings — right up until the date at which you claim benefits. In other words:

  • The at-62 figure assumes you will work until age 62, then claim benefits,
  • The at-FRA figure assumes you will work until FRA, then claim benefits, and
  • The at-70 figure assumes you will work until age 70, then claim benefits.

But these three scenarios might not be a match for the retirement scenarios you are considering.

For example, if you retire at age 60, but wait until age 70 to claim your retirement benefit, the actual amount you receive per month could be significantly lower than the age-70 benefit listed on the statement, because you would have 10 fewer years of earnings history than what is assumed in the at-70 figure on the statement.

In effect, the SSA statement bundles the when-to-claim-benefits decision together with the when-to-retire decision.

If you want to do an analysis solely of the when-to-claim decision, it typically makes sense to use the figure on the statement that assumes a retirement date closest to the age at which you actually plan to retire, then adjust that benefit upward or downward as needed to figure out the amount you would receive if you claimed at a different point in time. For example, if you plan to retire at 62 you would want to:

  • Look at the age-62 benefit provided on the statement to get the benefit you would receive if you claim at 62,
  • Multiply the age-62 benefit from the statement by 1.33 to get the benefit you would receive if you claim at 66 (assuming an FRA of 66), and
  • Multiply the age-62 benefit from the statement by 1.76 to get the benefit you would receive if you claim at 70 (again assuming an FRA of 66).

If you plan to retire at an age other than 62, full retirement age, or 70, you can use the SSA’s “Online Calculator” or “Retirement Estimator” to get the applicable benefit figures. (Both of these calculators assume, however, that you will claim benefits at the later of age 62 or the date at which you retire. So you will still have to do your own math to adjust the calculator’s output to find what your benefit would be if claimed at different ages.)

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Tax Planning for Affordable Care Act Subsidies

The Affordable Care Act creates a new tax credit for certain taxpayers purchasing health insurance via one of the new insurance exchanges. The idea of the credit is to subsidize the cost of health insurance for those who might not otherwise be able to afford it.

To be eligible for the credit, your “household income” must be between 100% and 400% of the federal poverty level. For example, in 2013, 400% of the federal poverty level would be $45,960 for a family of one, or $62,040 for a family of two.

For these purposes, “household income” means the adjusted gross income (plus any foreign earned income, tax-exempt interest income, and tax-exempt Social Security benefits) of everybody who is being counted in the household for the purposes of this credit (i.e., the taxpayer, his/her spouse, and dependents). Note that adjusted gross income (AGI) is not the same as “taxable income.” AGI is the bottom line on the first page of your Form 1040. That is, it’s the figure before backing out the standard deduction (or itemized deductions) and personal exemptions.

For somebody who has qualifying coverage for the entire year, the credit is calculated as:

  • The annual premium for the second lowest cost “silver” plan available in the exchange, minus
  • A specified percentage of the taxpayer’s household income (ranging from 2% for taxpayers with household income close to 100% of the federal poverty level, to 9.5% for taxpayers with household income closer to 400% of the federal poverty level).

The credit is, however, limited to the total amount spent on premiums for qualifying health plans — which could be relevant if you decide to purchase a plan that’s less expensive than the second lowest cost “silver” plan.

In other words, the effect of the credit is that qualifying taxpayers will not have to spend more than the applicable percentage of their income (2% to 9.5%, depending on income level) on health insurance premiums — unless they purchase coverage that’s more expensive than the “silver” plan used in the calculation of the credit.

Tax Planning Ramifications

If you buy insurance via one of the new exchanges and you have the ability to keep your household income below 400% of the federal poverty level, the new tax credit effectively results in you having a higher marginal tax rate than your ordinary income tax bracket — because additional income will not only cause additional income tax according to your tax bracket, it can also cause the amount of your Affordable Care Act subsidy/tax credit to go down.

As you might imagine, a change in your marginal tax rate has numerous tax planning ramifications. With regard to portfolio management, the two biggest categories of changes that come to mind are:

  1. Retirement account-related decisions, and
  2. Capital gain/loss management.

With regard to retirement account-related decisions (for people who qualify or almost qualify for the credit):

  • People who are still working will find tax-deferred contributions (as opposed to Roth contributions) more advantageous than they would otherwise be, because they could increase the amount of the credit.
  • People in retirement (specifically, early retirement, because this credit is only relevant before Medicare kicks in) will find that financing spending via distributions from tax-deferred accounts will be less advantageous than it would otherwise be, because such distributions could reduce the amount of the credit or make them ineligible for the credit.
  • And people (regardless of whether they’re retired or still working) will find Roth conversions to be less advantageous than they would otherwise be, because the conversion could reduce the amount of the credit or make them ineligible for the credit.

As far as capital gain/loss decisions go, I think the biggest impact will be that taxpayers who might otherwise benefit from tax-gain harvesting (to take advantage of the fact that long-term capital gains in the 10% and 15% tax brackets are not taxed at all) may want to avoid (or postpone) harvesting their gains, because the increase in household income could make them ineligible for the credit.

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The Case for Roth Conversions in Retirement

I recently finished reading Dana Anspach’s new book Control Your Retirement Destiny (highly recommended, by the way — you can see my review here) and found the author’s ideas on Roth conversions in retirement to be quite worthy of sharing.

As a bit of background, the big question when considering a Roth conversion is, “how does my marginal tax rate right now (i.e., the tax rate I would pay on the conversion) compare to the marginal tax rate I expect to have when I’m spending this money?”

If you’re over age 59.5, it usually makes sense to do the conversion if your current marginal tax rate is less than or equal to the marginal tax rate you expect to have when you spend the money. (Exception: If you expect the IRA to be left to your heirs, the relevant question becomes how you expect your current marginal tax rate to compare to the IRA beneficiary’s marginal tax rate at the time he/she will be taking the money out of the IRA.)

In her book, Anspach makes the case that, for a few reasons, your marginal tax rate later in retirement may be higher than you might expect.

Social Security Taxation

As we’ve discussed before, the unique way in which Social Security is taxed often leads to situations in which taxpayers have marginal tax rates that are far higher than just the tax bracket they’re in. For example, it’s possible for a Social Security recipient to be in the 15% tax bracket, yet have a federal marginal tax rate of 27.75%, because each additional $100 of income not only results in $15 of regular income tax, it also causes $85 of Social Security benefits to become taxable, thereby resulting in another $12.75 of income tax.

Because of this unique tax treatment for Social Security income, it’s very often true that if you have years of retirement prior to receiving Social Security, your marginal tax rate in those years is significantly lower than the marginal tax rate you will have after you start receiving Social Security. Conclusion: Roth conversions in these years are often advantageous.

Death of a Spouse

Anspach also bring up a point that I don’t think gets nearly enough attention (and, for the record, I’m as guilty as anyone, as I don’t believe I’ve covered it in an article before): A widow/widower’s marginal tax rate in retirement is often higher than the marginal tax rate that the couple had while they were both still alive.

The reason this often happens is that a single person’s 10% and 15% tax brackets, standard deduction, and personal exemption are each half as large as those for a married couple filing jointly, yet a surviving spouse’s income will often be well above 50% of the income that the couple had — because he/she will get to keep the larger of the two Social Security benefits and because portfolio-sourced income will stay the same.

As a result, Roth conversions during retirement can sometimes make sense for married couples as a way to best prepare for the period of widowhood/widowerhood.

Medicare Premiums

Premiums for Medicare Parts B and D are a function of your modified adjusted gross income. (For these purposes, MAGI includes tax-exempt interest income.) But rather than operating on a sliding scale, they ratchet upward in steps. For example, if your MAGI exceeds $85,000 ($170,000 if married filing jointly), your monthly premium will be $40 higher than it would be if your income was below that level.

While this isn’t technically a tax, it has the same effect from a financial planning standpoint. That is, the dollars of income that put your MAGI just barely above the applicable thresholds in effect have a very high marginal tax rate. As a result, Roth conversions can sometimes make sense for retirees who are not yet eligible for Medicare, if the conversions allow them to stay just under the threshold once they are eligible for Medicare.

Do The Math

While the three points above do result in advantageous Roth conversion circumstances for many retirees, the point Anspach really hammers home in her book (a point with which I fully agree) is that you have to actually do the math with your own figures. This is not the sort of thing where a rule of thumb works very well.

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."

Index Fund Portfolios vs. Active Fund Portfolios

Perhaps the most-referenced source in the “active vs. passive” debate is the ongoing series of Standard and Poor’s SPIVA scorecards. The SPIVA studies (updated twice each year) consistently show that most actively managed mutual funds fail to outperform their benchmark index. In other words, if you randomly picked a fund, you would have a less than 50% chance of outperforming an index that tracks the performance of the asset class in question.

While that’s interesting information (and it’s nice to have a consistently up-to-date source for figures), it’s worth noting that the question the studies answer has some limitations with regard to its real-life applicability.

First, the studies compare the performance of real-life actively managed funds to the performance of an index, yet an index is not something we can invest in. We can only invest in index funds, which (unlike the indexes themselves) have expenses

Second, most investors aren’t picking funds randomly. They’re doing better than that. For example, John Reckenthaler (Morningstar’s Vice President of Research) found last year that in most fund categories, the asset-weighted performance is better than the equal-weighted performance (meaning that investors are putting the majority of their assets into funds that perform better than the middle of the pack).

This shouldn’t be terribly surprising. Given the evidence that the poorest-performing group of funds tends to continue to perform poorly, all investors have to do is avoid choosing funds with terrible past performance in order to have a decent likelihood of a better-than-random selection.

Third, looking at the “active vs. passive” question on a fund-by-fund basis is probably less applicable than looking at things on a whole-portfolio basis.

A New Look at the Active vs. Passive Question

In a recent study, Rick Ferri (of Portfolio Solutions) and Alex Benke (of Betterment) looked at the likelihood of a portfolio of actively managed funds outperforming a portfolio of index funds. In other words, they took two big steps closer to reality by comparing actively managed mutual funds to actual, investable index funds and by looking at how an active fund portfolio is likely to compare to an index fund portfolio.

The specific figures vary depending on the period and asset allocation tested, but the general conclusion is that a portfolio of actively managed funds has a much less than 50% chance of outperforming an index fund portfolio. And that chance gets smaller as you look at longer periods of time. In addition, in scenarios in which the portfolio of active funds outperforms the portfolio of index funds, it tends to outperform by a smaller amount than the amount by which it underperforms in scenarios in which it loses.

Perhaps the most interesting part of the study was that Ferri and Benke also checked to see how the results change when you exclude actively managed funds with above-average costs from the active fund portfolios. (I think this is a useful test given that investors do tend to put the majority of their money into funds on the low-cost half of the spectrum.) The answer: Excluding high-cost funds meaningfully improves the results for the active portfolios, but the degree of improvement is still well below what would be necessary for an active fund portfolio to be a good bet.

I’d be interested to see what happens if the very same idea is carried further. For example, what if the active portfolios were constructed such that they only included funds in the bottom 25% in terms of expenses? What about the bottom 10%? Is there a point at which the cost difference is small enough for the actively manage funds to, on average, outperform (or roughly tie) the index fund portfolios?

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