Archives for February 2015

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What Is Estate Planning, and Do I Need to Worry About It?

When I recently asked for suggestions of specific estate-planning-related topics to write about, one thing that immediately became clear is that many people aren’t entirely sure what estate planning is — and whether it’s something they should be thinking about.

To put it bluntly, estate planning is planning for your incapacitation or death — choosing, for example, what will happen to your financial assets, your minor children, and your health care in such situations. As you can imagine, that’s a pretty broad field, and almost everybody has at least some degree of estate planning that they should be doing.

At the simplest level, estate planning would include making sure that the beneficiary designations on your retirement accounts and insurance policies are up-to-date. (Remember, it’s the beneficiary designation that controls where the money goes, regardless of what you say in your will.)

A very basic level of estate planning would also include making sure that you have a will that accurately reflects your wishes for any other assets (i.e., assets that do not pass directly to a named beneficiary outside of the will).

At a more advanced level of estate planning, some people will benefit from creating a trust to serve any of several different purposes. In short, a trust is a legal entity to which you would give some of your assets. Those assets are then managed by a person or entity whom you name (the “trustee”), for the benefit of some other person(s) or entity.

A trust can be helpful, for example, if there is somebody to whom you wish to leave assets, yet who you do not think should be put in charge of managing those assets (e.g., because of a disability or because of a well-established history of poor financial decisions).

Alternatively, trusts can be helpful for people on their second marriage. For example, imagine that you want to leave your assets to your new spouse, but you want to be sure that any assets remaining after that spouse dies go to your children from your first marriage (rather than to that spouse’s children from his/her first marriage). In such a case, you could put the assets in a trust, naming your spouse as a beneficiary to receive income from those assets for the duration of his/her life, and naming your children as beneficiaries who will receive those assets after your spouse’s death.

For some people, estate planning involves engaging in various activities to minimize the effect of estate taxes. This is, however, not a concern for most people these days, given the size of the federal estate tax exemption: $5.43 million in 2015, twice that for married couples.

Estate planning also includes several topics that are not strictly of a financial nature, such as choosing a guardian who will care for your children in the event of your death, or granting a medical power of attorney to a trusted family member or friend, so that he/she can make health care decisions on your behalf if you become incapacitated.

Don’t Change Tax Plans Based on Presidential Budgets

A reader writes in, asking:

“I heard on the radio recently that Obama will be changing IRA rules so that Roth IRAs will require RMDs and so there will be a limit on IRA account size. Do you think this has a big effect on the decision of which type of account to contribute to?”

To be clear, these are proposed changes that were included in the Obama Administration’s budget for the 2016 fiscal year. Every year, the President is required to submit a budget to Congress. And every year, the budget includes a list of tax changes — the nature of which naturally varies depending upon whether a Democrat or Republican is in office.

A key point, however, is that the President does not actually have the power to implement such changes to existing law.** For such a change to take effect, somebody would have to introduce a bill in the House of Representatives, where it would ultimately have to be passed. And the Senate would have to pass it as well. Then the President comes into play by signing the bill into law (or, in some cases, refusing to do so).

So, what ultimately ends up happening with most tax-related proposals in presidential budgets? Nothing. Most never even get introduced as bills. And, of those that do, many never get anywhere near becoming law. This is especially true in situations such as we have today in which the President is of one party and both houses of Congress are controlled by the other party. In fact, some ideas (the limit on retirement account sizes, for instance) have been proposed repeatedly without ever going anywhere.

From a civic duty perspective, it may be worth following such proposals so that you can contact your elected representatives to let them know whether (and why) you do or do not support various tax changes.

But from a financial planning perspective, if nobody has even introduced a bill yet, it’s far too early to start making any changes to your tax planning.

That said, you don’t want to bet everything on the idea that nothing will change. Tax law does change over time, which is why “tax diversification” — having some money in tax-deferred accounts and some money in Roth accounts — is generally considered to be a good idea.

**The executive branch does have some power with regard to how existing law is applied. That is, in cases in which a particular provision in the tax law is ambiguous, the Treasury Department has some leeway in choosing how to administer the law. And then if taxpayers oppose the way in which the Treasury Department applies the law, the judicial branch (i.e., the courts) will ultimately get involved as well.

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How Do Child’s Benefits Affect Social Security Claiming Strategies?

A reader writes in, asking:

“If I have a young child, how does that affect the age at which I should be filing for my Social Security?”

Before getting into how claiming strategies are different for people with qualifying children than for people without qualifying children, we must first discuss who is a qualifying child.

How Does Somebody Qualify for Child’s Benefits?

While you’re still alive, in order for your child to qualify for a Social Security benefit based on your work record, your child must be:

  • Under 18,
  • 18 or older and disabled (with the disability having begun before age 22), or
  • 18 or older and a full-time student in grade 12 or below.

In addition:

  • Your child must be “dependent” on you (though in the case of a natural child, that requirement is automatically considered to be met unless the child has been legally adopted by somebody else), and
  • You must have filed for your retirement benefit.

How Do Child’s Benefits Affect Claiming Strategies?

There are three key points to understand about the interaction of child’s benefits and Social Security claiming strategies.

First: Waiting to claim your retirement benefit does not increase your child’s benefit amount. While you are alive, your child’s benefit amount is simply 50% of your primary insurance amount — your PIA being the monthly retirement benefit you would receive if you claimed that benefit at your full retirement age. (After you die, your child’s benefit is 75% of your PIA.)

Second: Because you must have filed for your retirement benefit in order for your child to be able to qualify for a child’s benefit, the cost of each year that you wait to file is greater than it would be for a person without a qualifying child (because you’re giving up a year of child’s benefits as well as a year of retirement benefits).

Third: If you have a qualifying child, your spouse may be able to qualify for spousal benefits based on your work record, even if your spouse has not yet reached the normal qualifying age of 62.

As a result of these three facts, having a qualifying child is a point in favor of claiming early. It isn’t necessarily a conclusive reason that you should file early, but it’s certainly a point weighing in that direction.

For example, for an unmarried person, currently age 62, who is considering:

  1. Starting retirement benefits now at 62, as opposed to
  2. Starting at 70 (after filing and suspending at 66, in order to allow the child to start receiving benefits)

…having a qualifying child pushes the break-even point from age 80.5 to age 84.** That is, rather than having to live beyond age 80.5 in order for waiting to be advantageous, you’d have to live beyond age 84 (which is, of course, less likely).

For a married couple, there’s no way to give a generalized break-even point, because it depends on the difference in the spouses’ ages, as well as the difference in primary insurance amounts.

Possible Claiming Strategies

With the additional moving piece that comes into play when child’s benefits are involved, the complexity of assessing one strategy against another goes through the roof. As a result, while using a Social Security claiming calculator is likely a good idea for anybody, it’s even more likely to be beneficial for people who have a qualifying child. Unfortunately, to the best of my knowledge, only one of the online calculators (MaximizeMySocialSecurity.com) includes child’s benefits in the analysis.

Having said that, the following two strategies may serve as a (very rough) starting point for analysis.

Strategy one:

The low-PIA spouse claims retirement benefits as early as possible, thereby allowing the child to start taking benefits based on that spouse’s work record. Then, upon reaching FRA, the high-PIA spouse files a restricted application (thereby receiving spousal benefits based on the low-PIA spouse’s work record). Then, at 70, the high-PIA spouse files for his/her own retirement benefit, and the child begins receiving benefits based on the high-PIA spouse’s work record.

Strategy two (which may be preferable when the difference between the two spouses’ PIAs is quite large):

The low-PIA spouse still files for retirement benefits at 62, allowing the child to start receiving benefits. Then, at his/her FRA, the high-PIA spouse files and suspends, thereby allowing the low-PIA spouse to start receiving a spousal benefit, and thereby allowing the child to start receiving a higher child’s benefit. Then, at his/her age 70, the high-PIA spouse actually starts receiving retirement benefits by asking to have them unsuspended.

**We’re keeping things simple in this analysis by ignoring investment returns. If we assume that early-taken benefits are invested and outpace inflation, that would push the break-even point back even further.

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Roth IRA Withdrawal Rules

The whole point of an IRA (Roth or otherwise) is to save for retirement. Unfortunately, things don’t always go as planned, and you may find yourself needing to withdraw money from your Roth IRA before age 59½.

The most important thing to know is this: Contributions (that is, the money that you put into your Roth) can come out at any time, free of taxes and penalties.

Distributions of Earnings

When it comes to distributions of earnings, however, things get a bit more complicated. That’s why I prepared this handy flowchart (and the following explanations) to help you determine whether or not distributions of earnings will be subject to income taxes and/or penalties. 🙂

Please note, this flowchart only applies to earnings when your Roth does not include any amounts converted from a traditional IRA or other retirement plan. If your Roth does include such amounts, please see “Distributions After a Roth Conversion” below.

RothIRADistributions

Qualifying Reasons for Distributions

The following are the “qualifying reasons for distributions” referenced in the first step of the flowchart:

  • You have reached age 59½.
  • The distribution was made to your beneficiary after your death.
  • You are disabled.
  • You use the distribution to pay certain qualified first-time homebuyer amounts.

5-Year Rule

Any earnings distribution prior to the first day of the fifth year after your first Roth was established will be taxed as ordinary income, at whatever your tax rate is at the time.

Example: You open a Roth IRA on May 18, 2009. The 5-Year Rule is satisfied as of January 1, 2014.

Other Exceptions to 10% Penalty

Even if your distribution is not for a “qualifying reason,” you may be able to escape the 10% penalty (but not ordinary income taxes) if any of the following situations apply:

  • You have unreimbursed medical expenses that exceed 10% of your adjusted gross income.
  • You are paying medical insurance premiums after losing your job.
  • The distributions are not more than your qualified higher education expenses.
  • The distribution is due to an IRS levy of the qualified plan.
  • The distribution is a qualified reservist distribution.
  • The distribution is a qualified disaster recovery assistance distribution.
  • The distribution is a qualified recovery assistance distribution.

All Roth IRAs Are Viewed as One

When applying each of the above rules, the IRS views all of your Roth IRAs together as one big Roth IRA. For example, once you’ve met the 5-Year Rule for one of your Roth IRAs, you’ve met it for all of them. Also, distributions from a Roth will not count as distributions of earnings until you’ve withdrawn an amount greater than the total of all of your contributions to all of your Roth IRAs.

Example: In 2013, you contribute $2,000 to a Roth. In 2014, you open a Roth with a different brokerage firm, and contribute $3,000 to it. By 2015, each Roth has grown to $5,000. You could withdraw $5,000 from either (but not both) of the two Roth IRAs without having to pay taxes or penalties because your total contributions were $5,000 and because the IRS considers them to be one Roth IRA.

Distributions After a Roth Conversion

If, you’ve converted money from a traditional IRA to a Roth IRA, things get slightly trickier.

Any distributions of converted amounts (assuming they were taxable at the date of the conversion) will be subject to the 10% penalty (though they’ll be free from ordinary income taxes) if the distribution occurs less than 5 years after the first day of the year in which the conversion occurred. If, however, the distribution was for a “qualifying reason” or you meet one of the “other exceptions” above, the distribution will be free from penalty.

If the conversion included amounts that were not taxable (because they came from a nondeductible IRA), those amounts will not be subject to the 10% penalty even if they are withdrawn from the Roth prior to the first day of the fifth year after the date of the conversion.

Order of Distributions

According to IRS Publication 590B, distributions are assumed to occur in the following order:

  1. Regular contributions.
  2. Conversion and rollover contributions, on a first-in-first-out basis (generally, total conversions and rollovers from the earliest year first). Take these conversion and rollover contributions into account as follows:
    • Taxable portion (the amount required to be included in gross income because of the conversion or rollover) first, and then the
    • Nontaxable portion.
  3. Earnings on contributions.

Example: During 2013, you contribute $5,000 to a Roth IRA. You also convert $20,000 from a traditional IRA into your Roth IRA. Of that $20,000, $13,000 was taxable upon the conversion, and $7,000 was not because it came from nondeductible IRA contributions.

In 2014, you withdraw $8,000 from your Roth. The first $5,000 is free from tax and penalty because it’s a return of your contributions. The next $3,000 is assumed to come from the taxable portion of your converted amount. As a result, it will be free from income tax, but it will be subject to the 10% penalty because the distribution occurred prior to the first day of the fifth year after the date of the conversion.

In 2015, you withdraw another $15,000 from your Roth. The first $10,000 will be the remainder of the taxable portion of the conversion (and will again be free from income tax but subject to the 10% penalty). The remaining $5,000 will be considered to have come from the nontaxable portion of the conversion, and it will be free from both tax and penalty.

Phew!

Admittedly, things can get a bit tricky. Hopefully this helped to clear things up. 🙂

Should Financial Advisors Be Fiduciaries?

A reader writes, asking:

“Do you think that a financial advisor should be a fiduciary? I’ve seen that discussed elsewhere, but never on your blog.”

Well, that depends on exactly what you mean.

If you’re in the market for a financial advisor, and you’re wondering whether you should use one who is a fiduciary (i.e., one who has a legal duty to put his/her client’s interests first) or one who is not, my answer would be, “Yes, use an advisory who has a fiduciary duty to you.”

This is a bit of an oversimplification, but in general:

  • Registered investment advisers (RIAs) and representatives thereof do owe a fiduciary duty to clients.
  • Insurance agents and stockbrokers do not owe a fiduciary duty to clients.

In the case of insurance agents and stockbrokers, they earn their pay by selling you specific products, which tends to result in biased advice. (This is not to say that RIAs are without their biases. Even fee-only RIAs have conflicts of interest, but I think they are at least somewhat less significant than the conflicts of interest faced by brokers and insurance agents.)

On the other hand, if you’re asking whether I think all financial advisors should be fiduciaries — a question which has been the subject of a great deal of debate within the industry over the last several years — I don’t have any strong opinions. I think it’s probably a good idea. (After all, why shouldn’t somebody who calls himself/herself a financial advisor be legally required to put clients’ interests first?) But, frankly, I’m not optimistic that such a change would have a large positive impact on the industry.

As it is, there are countless RIAs (who do have a fiduciary duty) who do all sorts of things that, in my opinion, clearly show they’re putting their own interests ahead of their clients’ interests. Yet, regulators don’t seem to have any problem with it.

For instance, many RIAs charge in excess of 1% per year to do nothing but passive portfolio management. At the same time, at Vanguard, you can get similar portfolio management, plus a basic financial plan, plus access to a CFP for 0.3% per year. The idea that the advisor charging more than three times as much for a lower level of service is somehow putting his/her clients’ interest first is laughable, given that there is such an obviously-better option for the investor. And yet, industry regulators have no problem with this — it is apparently not considered a breach of fiduciary duty.

And that’s not even remotely the worst of it. There are RIAs who charge high annual fees while also using expensive actively managed funds. There are RIAs who charge high annual fees while rapidly trading concentrated portfolios of individual stocks — or engaging in any number of other poorly-researched investment strategies. And, in the overwhelming majority of cases, such activities are not considered to be a breach of fiduciary duty.

In other words, if you’re going to use an advisor, yes, you should probably use one who has a fiduciary duty to you. But the sole fact that an advisor has a fiduciary duty does not ensure that he/she will always do what’s best for clients.

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