Too many people make these common errors.
Many affluent professionals and business owners put estate planning on hold. Only the courts and lawyers stand to benefit from their procrastination. While inaction is the biggest estate planning error, several other major mistakes can occur. The following blunders can lead to major problems.
Failing to revise an estate plan after a spouse or child dies. This is truly a devastating event, and the grief that follows may be so deep and prolonged that attention may not be paid to this. A death in the family commonly requires a change in the terms of how family assets will be distributed. Without an update, questions (and squabbles) may emerge later.
Going years without updating beneficiaries. Beneficiary designations on qualified retirement plans and life insurance policies usually override bequests made in wills or trusts. Many people never review beneficiary designations over time, and the estate planning consequences of this inattention can be serious. For example, a woman can leave an IRA to her granddaughter in a will, but if her ex-husband is listed as the primary beneficiary of that IRA, those IRA assets will go to him per the beneficiary form. Beneficiary designations have an advantage – they allow assets to transfer to heirs without going through probate. If beneficiary designations are outdated, that advantage matters little.1,2
Thinking of a will as a shield against probate. Having a will in place does not automatically prevent assets from being probated. A living trust is designed to provide that kind of protection for assets; a will is not. An individual can clearly express “who gets what” in a will, yet end up having the courts determine the distribution of his or her assets.2
Supposing minor heirs will handle money well when they become young adults. There are multi-millionaires who go no further than a will when it comes to estate planning. When a will is the only estate planning tool directing the transfer of assets at death, assets can transfer to heirs aged 18 or older in many states without prohibitions. Imagine an 18-year-old inheriting several million dollars in liquid or illiquid assets. How many 18-year-olds (or 25-year-olds, for that matter) have the skill set to manage that kind of inheritance? If a trust exists and a trustee can control the distribution of assets to heirs, then situations such as these may be averted. A well-written trust may also help to prevent arguments among young heirs about who was meant to receive this or that asset.3
Too many people do too little estate planning. Avoid joining their ranks, and plan thoroughly to avoid these all-too-frequent mistakes.
This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note - investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.
Citations.1 - thebalance.com/why-beneficiary-designations-override-your-will-2388824 [10/8/16]2 - fool.com/retirement/2017/03/03/3-ways-to-keep-your-estate-out-of-probate.aspx [3/3/17]3 - info.legalzoom.com/legal-age-inherit-21002.html [3/16/17]
Where do things proceed from that point?
Every day, people die intestate. In legalese, that means without a will. This opens the door for the courts to decide what happens with their estates.
When no valid will exists, state intestacy laws dictate how assets are distributed. These laws divide an estate evenly (or equitably) among heirs. Any assets held in joint tenancy go to the joint owner. Assets held in a trust transfer to the trust beneficiaries (with spouses getting a share of those assets in some states). Community property goes to a spouse or partner in community property states.1
Simple, right? Unfortunately, the way assets transfer under these laws may not correspond to the wishes of the deceased person. Did the decedent want some of his or her estate to go to a charity or a person close to them? These laws will not allow that. State law will also decide who the executor of the estate is, since the decedent never named one.2
If the deceased person designated beneficiaries for his or her retirement accounts and life insurance policy, those retirement accounts and insurance proceeds should transfer to those beneficiaries without dispute, even when no will exists. When life insurance policies and retirement accounts lack designated beneficiaries, then those assets are lumped into the decedent’s estate and subject to intestacy laws.2
Most people have specific ideas about who should inherit what from their estates. To articulate those ideas, they should write a will – or better yet, they should draft one with the help of an attorney. Anyone who cares about the destiny of his or her wealth should take this basic estate planning step.
For a last will & testament to be valid, it must meet three important tests. It must be created by a person of sound mind. It must express that person’s free will – that is, it cannot be written or drafted under coercion or duress. Lastly, it must be signed and dated in the presence of two or more unrelated people who stand to inherit nothing from that person’s estate.1
Many wills are signed in the presence of notaries; although, a will does not have to be notarized to be legally valid. Some wills are self-proving – they have an attached, notarized affidavit, which acknowledges that all three tests noted in the preceding paragraph have been met. When this affidavit accompanies a will, there is no need to track down the parties who witnessed the signing and dating of the document years before.1
A last will and testament should be formatted and printed using a computer and printer; at the very least, it should be typed. Handwritten wills may not pass muster in some probate courts.1
When an individual dies intestate, the future of his or her estate is largely up to the courts. A basic, valid will stating his or her wishes may prevent that fate.
Citations.1 - legalzoom.com/knowledge/last-will/topic/wills-intestate [3/20/17]2 - money.cnn.com/2016/04/28/pf/dying-without-a-will-prince/ [4/28/16
What do each of these terms really mean?
Investment management can be active or passive. Sometimes, that simple, fundamental choice can make a difference in portfolio performance.
During a particular market climate, one of these two methods may be widely praised, while the other is derided and dismissed. In truth, both approaches have merit, and all investors should understand their principles.
How does passive asset management work? A passive asset management strategy employs investment vehicles mirroring market benchmarks. In their composition, these funds match an index – such as the S&P 500 or the Russell 2000 – component for component.
As a result, the return from a passively managed fund precisely matches the return of the index it replicates. The glass-half-full aspect of this is that the investment will never underperform that benchmark. The glass-half-empty aspect is that it will never outperform it, either.
When you hold a passively managed investment, you always know what you own. In a slumping or sideways market, however, what you happen to own may not be what you would like to own.
Buy-and-hold investing goes hand-in-hand with passive investment management. A lengthy bull market makes a buy-and-hold investor (and a passive asset management approach) look good. With patience, an investor (or asset manager) rides the bull and enjoys the gains.
But, just as there is a potential downside to buy-and-hold investing (you can hold an asset too long), there is also a potential downside to passive investment management (you can be so passive that you fail to react to potential opportunities and changing market climates). That brings us to the respective alternatives to these approaches – market timing and active asset management (which is sometimes called dynamic asset allocation).
Please note that just as buy-and-hold investing does not equal passive asset management, market timing does not equal active asset management. Buy-and-hold investing and market timing are behaviors; passive asset management and active asset management are disciplines. (A portfolio left alone for 10 or 15 years is not one being passively managed.)
Active investment management attempts to beat the benchmarks. It seeks to take advantage of economic trends affecting certain sectors of the market. By overweighting a portfolio in sectors that are performing well and underweighting it in sectors that are performing poorly, the portfolio can theoretically benefit from greater exposure to the “hot” sectors and achieve a better overall return.
Active investment management does involve market timing. You have probably read articles discouraging market timing, but the warnings within those articles are almost always aimed at individual investors – stock pickers, day traders. Investment professionals practicing dynamic asset allocation are not merely picking stocks and making impulsive trades. They rely on highly sophisticated analytics to adjust investment allocations in a portfolio, responding to price movements and seeking to determine macroeconomic and sector-specific trends.
The dilemma with active investment management is that a manager (and portfolio) may have as many subpar years as excellent ones. In 2013, more than 80% of active investment managers outperformed passive investments indexing the S&P 500 (which rose 29.60% that year). In 2011, less than 15% did (the S&P was flat for the year).1,2
The two approaches are not mutually exclusive. In fact, many investment professionals help their clients use passive and active strategies at once. Some types of investments may be better suited to active management than passive management or vice versa. Similarly, when a bull market shifts into a bear market (or vice versa), one approach may suddenly prove more useful than the other, while both approaches are kept in mind for the long run.
Citations.1 - forbes.com/sites/investor/2015/03/30/active-versus-passive-management-which-is-better/ [3/30/15]2 - macrotrends.net/2526/sp-500-historical-annual-returns [2/2/17]
A plan for sustaining the business you have built after your death.
Business owners are builders. They spend their lives building firms to provide goods and services to their clients, and those firms provide them with a living. But nothing can tear down that lifetime of work faster than the death of a business owner, or the death of a business partner. Often, much of the value of a business dies with the owner.
Small business owners face two major succession questions. First, can the business heirs keep the company afloat when the owner dies, or at least avoid surrendering it at a “fire sale” price?
The executor of a deceased business owner’s estate can elect to continue the company, but must find someone willing to run it. That may not be easy. Some heirs or business partners may want to keep things going; others may want to cash out. This discord can potentially sink a firm, because if the business continues, any partners wanting out will want to be fairly compensated. If sufficient cash isn’t on hand to do that, liquidation may be the only option.
Selling the business means finding a buyer. Any potential buyer will be negotiating with an advantage, for the business will become less valuable with each passing day following the owner’s death.
Now to the second major succession question: how can an owner keep employees confident that the business, and their jobs, will continue after he or she is gone?
Surviving business partners may need to be reassured as well. If one partner dies, the remaining partners may find themselves in business with the deceased partner's heirs, who may have different goals for the company. If the heirs want to sell their inherited ownership interest, is there enough cash on hand to buy it?
These questions can throw the value & continuation of a business into doubt. If left unanswered, they could make creditors more likely to call in loans, and make retaining key employees harder.
Cross-purchase buy-sell agreements are designed to answer these questions. Often funded by life insurance, these agreements are essentially deals struck between owners, partners, or key employees of a business, permitting the sale of their ownership share to another person.1
How do they work? In the classic cross-purchase buyout agreement, each business partner takes out a life insurance policy on the other partners within the company, naming himself or herself as the beneficiary of those policies. If one partner passes away, then one or more beneficiaries can use the life insurance proceeds to buy the deceased partner’s ownership interest. This way, partners or key persons can continue to work and operate the business seamlessly, and the deceased partner’s heirs receive a fair, agreed-upon price for the ownership interest.1
Thanks to the buy-sell agreement, both heirs and partners know that the business is positioned to continue. In addition, greater productivity and loyalty may be seen from any key employees made part of the agreement, who see ownership in their future.
The sale can happen rather quickly; estate issues can be settled more expediently. Heirs will get a fair, pre-determined price for the ownership interest, and won't be selling under duress.
These agreements do have some disadvantages. Participants have to trust and verify that each partner keeps his or her insurance policy in force. This isn't as simple as making sure premiums are paid. Usually the policies are owned personally, not by the firm. If a partner suffers a bankruptcy, federal or state exemptions may not protect all of its cash value from creditors. Sometimes a participant will mistakenly buy an insurance policy on her or his own life and make the other participants beneficiaries; under those conditions, the insurance payout resulting from his or her death will likely be taxed.2,3
As the number of partners involved in a buy-sell agreement increases, the number of policies grows exponentially – as does the cost of the agreement. Two partners? Two policies. Three partners? Six policies. (When three partners are involved in a cross-purchase buyout agreement, Partner A needs to buy coverage for Partner B and Partner C, etc.) Speaking of cost, an older or less healthy partner will pay much more for the agreement than a younger, healthier partner, as life insurance is a necessary component.2,3
Before you make a decision about how you’ll protect the future of your business, it may be wise to speak to a qualified professional who can help you research this option as well as others.
1 - nerdwallet.com/blog/insurance/life-insurance-small-business-partners/ [1/20/16]
2 - insure.com/life-insurance/bankruptcy.html [11/13/15]
3 - insurancenewsnet.com/innarticle/how-to-keep-a-buy-sell-agreement-from-derailing [5/21/15]
How can you plan to do it? What kind of financial commitment will it take?
How many of us will retire with $1 million or more in savings? More of us ought to – in fact, more of us may need to, given inflation and the rising cost of health care.
Sadly, few pre-retirees have accumulated that much. A 2015 Government Accountability Office analysis found that the average American aged 55-64 had just $104,000 in retirement money. A 2016 GoBankingRates survey determined that only 13% of Americans had retirement savings of $300,000 or more.1,2
A $100,000 or $300,000 retirement fund might be acceptable if our retirements lasted less than a decade, as was the case for some of our parents. As many of us may live into our eighties and nineties, we may need $1 million or more in savings to avoid financial despair in our old age.
The earlier you begin saving, the more you can take advantage of compound interest. A 25-year-old who directs $405 a month into a tax-advantaged retirement account yielding an average of 7% annually will wind up with $1 million at age 65. Perhaps $405 a month sounds like a lot to devote to this objective, but it only gets harder if you wait. At the same rate of return, a 30-year-old would need to contribute $585 per month to the same retirement account to generate $1 million by age 65.3
The Census Bureau says that the median household income in this country is $53,657. A 45-year-old couple earning that much annually would need to hoard every cent they made for 19 years (and pay no income tax) to end up with $1 million at age 64, absent of investments. So, investing may come to be an important part of your retirement plan.4
What if you are over 40, what then? You still have a chance to retire with $1 million or more, but you must make a bigger present-day financial commitment to that goal than someone younger.
At age 45, you will need to save around $1,317 per month in a tax-advantaged retirement account yielding 10% annually to have $1 million in 20 years. If the account returns just 6% annually, then you would need to direct approximately $2,164 a month into it.4
What if you start trying to build that $1 million retirement fund at age 50? If your retirement account earns a solid 10% per year, you would still need to put around $2,413 a month into it; at a 6% yearly return, the target contribution becomes about $3,439 a month.4
This math may be startling, but it is also hard to argue with. If you are between age 55-65 and have about $100,000 in retirement savings, you may be hard-pressed to adequately finance your future. There are three basic ways to respond to this dilemma. You can choose to live on Social Security, plus the principal and yield from your retirement fund, and risk running out of money within several years (or sooner). Alternately, you can cut your expenses way down – share housing, share or forgo a car, etc., which could preserve more of your money. Or, you could try to work longer, giving your invested retirement savings a chance for additional growth, and explore ways to create new income streams.
How long will a million-dollar retirement fund last? If it is completely uninvested, you could draw down about $35,000 a year from it for 28 years. The upside here is that your invested retirement assets could grow and compound notably during your “second act” to help offset the ongoing withdrawals. The downside is that you will have to contend with inflation and, potentially, major healthcare expenses, which could reduce your savings faster than you anticipate.
So, while $1 million may sound like a huge amount of money to amass for retirement, it really is not – certainly not for a retirement beginning twenty or thirty years from now. Having $2 million or $3 million on hand would be preferable.
1 - investopedia.com/articles/personal-finance/011216/average-retirement-savings-age-2016.asp [12/8/16]
2 - time.com/money/4258451/retirement-savings-survey/ [3/14/16]
3 - interest.com/retirement-planning/news/how-to-save-1-million-for-retirement/ [12/12/16]
4 - reviewjournal.com/business/money/how-realistically-save-1-million-retirement [5/20/16]
Emotion often drives our financial decisions, even when logic should.
When we go to the grocery store, we seldom shop on logic alone. We may not even buy on price. We buy one type of yogurt over another because of brand loyalty, or because one brand has more appealing packaging than another. We buy five bananas because they are on sale for 29 cents this week – the bargain is right there; why not seize the opportunity? We pick up that gourmet ice cream that everyone gets – if everyone buys it, it must be a winner.
As casual and arbitrary as these decisions may be, they are remarkably like the decisions many investors make in the financial markets.
A degree of emotion also factors into many of our financial choices. There is even a discipline devoted to how our emotions affect our financial decisions: behavioral finance. Examples of emotionally driven financial behaviors are all around us, especially in the investment markets.
Behavior #1: Believing future performance relates to past performance. In truth, there is no relation. If an investment yields 8-10% for six consecutive years, that does not mean it will yield 8-10% next year. Still, we may be lulled into expecting such performance – how can you go wrong with such a “rock solid” investment? In behavioral finance, this is called recency bias. Bullish investors tend to harbor it, and it may lead to irrational exuberance.1
Similarly, investors adjust risk tolerance in light of past performance. If their portfolio returned spectacularly last year, they may be tempted to accept more risk this year. If they took major losses in the equity markets last year, they may become very risk-averse and get out of equities. Both behaviors assume the future will be like the past, when the future is really unknown.1
Behavior #2: Investing on familiarity. Familiarity bias encourages you to make investment or consumer choices that are “friendly” and comfortable to you, even when they may be illogical. You go with what you know, without investigating what you don’t know or looking at other options. Another example of familiarity bias is when you invest in a company or a sector largely because you are attracted to or familiar with its “story” – its history, its reputation.2
Behavior #3: Ignoring negative trends. This is known as the ostrich effect. We can ignore the reality of a correction or a bear market; we can ignore the fact that our credit card debt is increasing. Studies suggest that investors check in on their portfolios with less frequency during market slumps – they would rather not know the degree of damage.3
Behavior #4: Wanting decisions to pay off now. Patience tends to be a virtue in both equity investing and real estate investing, but we may suffer from hyperbolic discounting – a bias in which we want a quick payoff today rather than an even larger one that might result someday if we buy and hold.3
Behavior #5: Falling for a decoy. When given a third consumer choice, instead of two consumer choices, we may choose a different product than we originally would, and perhaps make a choice we would not have otherwise considered. Once, an ad in The Economist offered three kinds of subscriptions: $59 for online only, $159 for print only, and $159 for online + print. The $159 print-only option was an illustration of the decoy effect – the choice existed seemingly just to make the $159 online + print option look like a better deal.3
Behavior #6: Seeing patterns where none exist. This is called the clustering illusion. You see it in casinos where a slot machine pays out twice an hour, and people line up to play that “lucky” machine, which has, in fact, just paid out randomly. Some investors fall prey to it in the markets.3
Behavior #7: Following the herd. The more consumers or investors that subscribe to a particular belief, the greater the chance of other consumers or investors to join the herd, or “jump on the bandwagon,” for good or bad. This is the bandwagon effect.3
Behavior #8: Buying the amount of something that we are marketed. In our minds, we believe that there is an optimal amount of something per purchase. This is called unit bias, and when marketing suggests the ideal amount should be larger, we buy more of that product or service.3
There are dozens of biases we may harbor, temporarily or regularly, all subjects of study in the discipline of behavioral finance. Recognizing them may help us to become a better consumer, and even a better investor.
Citations.1 - marketwatch.com/story/a-financial-plan-to-help-you-simplify-and-succeed-2016-09-23 [9/23/16]2 - abcnews.go.com/Business/stock-stories-fairy-tales/story?id=42529959 [10/3/16]3 - businessinsider.com/cognitive-biases-2015-10 [10/29/15]
Key lessons for retirement savers.
You learn lessons as you invest in pursuit of long-run goals. Some of these lessons are conveyed and reinforced when you begin saving for retirement, and others you glean along the way.
First & foremost, you learn to shut out much of the “noise.” News outlets take the temperature of global markets five days a week (and even on the weekends), and fundamental indicators serve as barometers of the economy each month. The longer you invest, the more you learn to ride through the turbulence caused by all the breaking news alerts and short-term statistical variations. While the day trader sells or buys in reaction to immediate economic or market news, the buy-and-hold investor waits for selloffs, corrections and bear markets to pass.
You learn how much volatility you can stomach. Volatility (also known as market risk) is measured in shorthand as the standard deviation for the S&P 500. Across 1926-2014, the yearly total return for the S&P averaged 10.2%. If you want to be very casual about it, you could simply say that stocks go up about 10% a year – but that discounts some pronounced volatility. The S&P had a standard deviation of 20.2 from its mean total return in this time frame, which means that if you add or subtract 20.2 from 10.2, you get the range of the index’s yearly total return that could be expected 67% of the time. So in any given year from 1926-2014, there was a 67% chance that the yearly total return of the S&P might vary from +30.4% to -10.0%. Some investors dislike putting up with that kind of volatility, others more or less embrace it.1
You learn why liquidity matters. The older you get, the more you appreciate being able to quickly access your money. A family emergency might require you to tap into your investment accounts. An early retirement might prompt you to withdraw from retirement funds sooner than you anticipate. If you have a fair amount of your savings in illiquid investments, you have a problem – those dollars are “locked up” and you cannot access those assets without paying penalties. In a similar vein, there are some investments that are harder to sell than others.
Should you misgauge your need for liquidity, you can end up selling at the wrong time as a consequence. It hurts to let go of an investment when the expected gain is high and the P/E ratio is low.
You learn the merits of rebalancing your portfolio. To the neophyte investor, rebalancing when the market is hot may seem illogical. If your portfolio is disproportionately weighted in equities, is that a problem? It could be.
Across a sustained bull market, it is common to see your level of risk rise parallel to your return. When equities return more than other asset classes, they end up representing an increasingly large percentage of your portfolio’s total assets. Correspondingly, your cash allocation shrinks as well.
The closer you get to retirement, the less risk you will likely want to assume. Even if you are strongly committed to growth investing, approaching retirement while taking on more risk than you feel comfortable with is problematic, as is approaching retirement with an inadequate cash position. Rebalancing a portfolio restores the original asset allocation, realigning it with your long-term risk tolerance and investment strategy. It may seem counterproductive to sell “winners” and buy “losers” as an effect of rebalancing, but as you do so, remember that you are also saying goodbye to some assets that may have peaked while saying hello to others that you may be buying at the right time.
You learn not to get too attached to certain types of investments. Sometimes an investor will succumb to familiarity bias, which is the rejection of diversification for familiar investments. Why does he or she have 13% of the portfolio invested in just two Dow components? The investor just likes what those firms stand for, or has worked for them. The inherent problem is that the performance of those companies exerts a measurable influence on the overall portfolio performance.
Sometimes you see people invest heavily in sectors that include their own industry or career field. An investor works for an oil company, so he or she gets heavily into the energy sector. When energy companies go through a rough patch, that investor’s portfolio may be in for a rough ride. Correspondingly, that investor has less capacity to tolerate stock market risk than a faculty surgeon at a university hospital, a federal prosecutor, or someone else whose career field or industry will be less buffeted by the winds of economic change.
You learn to be patient. Even if you prefer a tactical asset allocation strategy over the standard buy-and-hold approach, time teaches you how quickly the markets rebound from downturns and why you should stay invested even through systemic shocks. The pursuit of your long-term financial objectives should not falter – your future and your quality of life may depend on realizing them.
Citations.1 - fc.standardandpoors.com/sites/client/generic/axa/axa4/Article.vm?topic=5991&siteContent=8088 [6/4/15]
When should you review it? What should you review?
An estate plan has three objectives. The first goal is to preserve your accumulated wealth. The second goal is to express who will receive your assets after your death. The third goal is to state who will make medical and financial decisions on your behalf if you cannot.
Over time, your feelings about these objectives may change. You may want to name a new executor or health care agent. You may rethink how you want your wealth distributed.
This is why it is so vital to review your estate plan. Over ten or twenty years, your health, wealth, and outlook on life may change profoundly. The key is to recognize the life events that may call for an update.
Have you just married or divorced? If so, your estate plan will absolutely need revision. For that matter, some, or all, of your will may now be legally invalid. (Some state laws strike down existing wills when a person is married or divorced.) If your children or grandchildren marry or divorce, that also calls for an estate plan review.1
Has there been a loss or serious illness within your family? If so, your named executor or health care agent may have to be changed. If one family member has now become physically or financially dependent on you, that too may be an occasion for a second look at the plan.
Has your net worth risen or declined substantially since the plan was first implemented? If you have become much wealthier in the past five or ten years (or much less wealthy), that circumstance may have altered your vision of how you want your assets distributed at your death. Maybe you want to give more (or less) to charity or your heirs. A large inheritance can also prompt you to rethink your wealth protection and wealth transfer strategy.
Have you changed your mind about what your wealth should accomplish? Today, you may view your wealth differently than you did when you were younger. New purposes may have emerged for it – new roles that it can play. Following through on those thoughts may lead you to reconsider aspects of your estate plan.
Have your executors or trustees changed their mind about their roles? If they are no longer interested in shouldering those responsibilities, no longer alive, or no longer of sound mind or reputable character, it is revision time.
Have you retired, moved to another state, or bought or sold real estate? All of these events call for an estate plan check-up.
The first step in revising an estate plan is to update essential documents. Not just your will or your trust, but also your financial power of attorney and health care proxy. Review all the names: your executor; your trustee; your health care agent. Changes in your personal (and even your business) relationships may call for alterations to those choices.
The second step is to review your risk management. Does language in your will need revision? Does a trust created years ago need to be modified or replaced? Do new estate planning vehicles need to enter the picture in order to help you adequately transfer wealth, counter estate taxes, or endow charities?
What about your life insurance? Do beneficiary forms of life insurance policies need updating? Is corporate-owned life insurance coverage you once counted on now absent? Will policy payouts be sufficient enough to help your loved ones address financial issues after your death?
The third step is to make sure your assets are in sync with your plan. For example, if you have a revocable trust, have you transferred ownership of all the assets that are supposed to go into it? Have you acquired new assets that need to be “poured in?”
If you are married and it appears certain that your estate will be taxed, you may want to own some assets and have your spouse own others. Yes, the federal estate tax exemption is portable, so any unused estate tax and gift tax exemption is allowed to pass to a surviving spouse. At the state level, though, there are different rules. So if all assets are in your spouse’s name and your home state levies an estate tax, that scenario may mean higher estate taxes for your heirs than if those assets were alternately owned by either you or your spouse.2
Even if nothing major happens in your life, review your plan every five years or so. While your life may be uneventful over five years, tax law, the financial markets, and business climates may change significantly. Those kinds of shifts can impact your estate planning strategy.
1 - 360financialliteracy.org/Topics/Retirement-Planning/Estate-Planning-Basics/How-often-do-I-need-to-review-my-estate-plan [8/4/16]
2 - time.com/money/4187332/estate-planning-checkup-items-review/ [1/20/16]
The answer depends on your income.
Your Social Security income could be taxed. That may seem unfair, or unfathomable. Regardless of how you feel about it, it is a possibility.
Seniors have had to contend with this possibility since 1984. Social Security benefits became taxable above certain yearly income thresholds in that year. Frustratingly for retirees, these income thresholds have been left at the same levels for 32 years.1
Those frozen income limits have exposed many more people to the tax over time. In 1984, just 8% of Social Security recipients had total incomes high enough to trigger the tax. In contrast, the Social Security Administration estimates that 52% of households receiving benefits in 2015 had to claim some of those benefits as taxable income.1
Only part of your Social Security income may be taxable, not all of it. Two factors come into play here: your filing status and your combined income.
Social Security defines your combined income as the sum of your adjusted gross income, any non-taxable interest earned, and 50% of your Social Security benefit income. (Your combined income is actually a form of modified adjusted gross income, or MAGI.)2
Single filers with a combined income from $25,000-$34,000 and joint filers with combined incomes from $32,000-$44,000 may have up to 50% of their Social Security benefits taxed.2
Single filers whose combined income tops $34,000 and joint filers with combined incomes above $44,000 may see up to 85% of their Social Security benefits taxed.2
What if you are married and file separately? No income threshold applies. Your benefits will likely be taxed no matter how much you earn or how much Social Security you receive.2
You may be able to estimate these taxes in advance. You can use an online calculator (a Google search will lead you to a few such tools), or the worksheet in IRS Publication 915.2
You can even have these taxes withheld from your Social Security income. You can choose either 7%, 10%, 15%, or 25% withholding per payment. Another alternative is to make estimated tax payments per quarter, like a business owner does.2
Did you know that 13 states also tax Social Security payments?North Dakota, Minnesota, West Virginia, and Vermont use the exact same formula as the federal government to calculate the degree to which your Social Security benefits may be taxable. Nine other states use more lenient formulas: Colorado, Connecticut, Kansas, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, and Utah.2
What can you do if it appears your benefits will be taxed? You could explore a few options to try and lessen or avoid the tax hit, but keep in mind that if your combined income is far greater than the $34,000 single filer and $44,000 joint filer thresholds, your chances of averting tax on Social Security income are slim.If your combined income is reasonably near the respective upper threshold, though, some moves might help.
If you have a number of income-generating investments, you could opt to try and revise your portfolio, so that less income and tax-exempt interest are produced annually.
A charitable IRA gift may be a good idea. You can make one if you are 70½ or older in the year of the donation. You can endow a qualified charity with as much as $100,000 in a single year this way. The amount of the gift may be used to fully or partly satisfy your Required Minimum Distribution (RMD), and the amount will not be counted in your adjusted gross income.3
You could withdraw more retirement income from Roth accounts. Distributions from Roth IRAs and Roth workplace retirement plan accounts are tax-exempt as long as you are age 59½ or older and have held the account for at least five tax years.4
Will the income limits linked to taxation of Social Security benefits ever be raised? Retirees can only hope so, but with more baby boomers becoming eligible for Social Security, the IRS and the Treasury stand to receive greater tax revenue with the current limits in place.
1 - ssa.gov/policy/docs/issuepapers/ip2015-02.html [12/15]
2 - fool.com/retirement/general/2016/04/30/is-social-security-taxable.aspx [4/30/16]
3 - kiplinger.com/article/retirement/T051-C001-S003-how-to-limit-taxes-on-social-security-benefits.html [7/16]
4 - irs.gov/retirement-plans/retirement-plans-faqs-on-designated-roth-accounts [1/26/16]
These spending and investing precepts may encourage its longevity.
All retirees want their money to last a lifetime. There is no guarantee it will, but, in pursuit of that goal, households may want to adopt a couple of spending and investing precepts.
One precept: observing the 4% rule. This classic retirement planning principle works as follows: a retiree household withdraws 4% of its amassed retirement savings in year one of retirement, and withdraws 4% plus a little more every year thereafter – that is, the annual withdrawals are gradually adjusted upward from the base 4% amount in response to inflation.
The 4% rule was first formulated back in the 1990s by an influential financial planner named William Bengen. He was trying to figure out the “safest” withdrawal rate for a retiree; one that could theoretically allow his or her savings to hold up for 30 years given certain conditions (more about those conditions in a moment). Bengen ran various 30-year scenarios using different withdrawal rates in relation to historical market returns, and concluded that a 4% withdrawal rate (adjusted incrementally for inflation) made the most sense.1
For the 4% rule to “work,” two fundamental conditions must be met. One, the retiree has to invest in a way that will allow his or her retirement savings to grow along with inflation. Two, there must not be a sideways or bear market occurring.1
As sideways and bear markets have not been the historical norm, following the 4% rule could be wise indeed in a favorable market climate. Michael Kitces, another influential financial planner, has noted that, historically, a retiree strictly observing the 4% rule would have doubled his or her starting principal at the end of 30 years more than two-thirds of the time.1
In today’s low-yield environment, the 4% rule has its critics. They argue that a 3% withdrawal rate gives a retiree a better prospect for sustaining invested assets over 30 years. In addition, retiree households are not always able to strictly follow a 3% or 4% withdrawal rate. Dividends and Required Minimum Distributions may effectively increase the yearly withdrawal. Retirees should review their income sources and income prospects with the help of a financial professional to determine what withdrawal percentage is appropriate given their particular income needs and their need for long-term financial stability.
Another precept: adopting a “bucketing” approach. In this strategy, a retiree household assigns one-third of its savings to equities, one-third of its savings to fixed-income investments, and another third of its savings to cash. Each of these “buckets” has a different function.
The cash bucket is simply an emergency fund stocked with money that represents the equivalent of 2-3 years of income the household does not receive as a result of pensions or similarly scheduled payouts. In other words, if a couple gets $35,000 a year from Social Security and needs $55,000 a year to live comfortably, the cash bucket should hold $40,000-60,000.
The household replenishes the cash bucket over time with investment returns from the equities and fixed-income buckets. Overall, the household should invest with the priority of growing its money; though the investment approach could tilt conservative if the individual or couple has little tolerance for risk.
Since growth investing is an objective of the bucket approach, equity investments are bought and held. Examining history, that is not a bad idea: the S&P 500 has never returned negative over a 15-year period. In fact, it would have returned 6.5% for a hypothetical buy-and-hold investor across its worst 15-year stretch in recent memory – the 15 years ending in March 2009, when it bottomed out in the last bear market.2
Assets in the fixed-income bucket may be invested as conservatively as the household wishes. Some fixed-income investments are more conservative than others – which is to say, some are less affected by fluctuations in interest rates and Wall Street turbulence than others. While the most conservative, fixed-income investments are currently yielding very little, they may yield more in the future as interest rates presumably continue to rise.
There has been great concern over what rising interest rates will do to this investment class, but, if history is any guide, short-term pain may be alleviated by ultimately greater yields. Last December, Vanguard Group projected that, if the Federal Reserve gradually raised the benchmark interest rate to 2.0% across the three-and-a-half years ending in July 2019, a typical investment fund containing intermediate-term fixed-income securities would suffer a -0.15% total return for 2016, but return positively in the following years.3
Avoid overspending and invest with growth in mind. That is the basic message from all this, and, while following that simple instruction is not guaranteed to make your retirement savings last a lifetime, it may help you to sustain those savings for the long run.
Citations.1 - money.cnn.com/2016/04/20/retirement/retirement-4-rule/ [4/20/16]2 - time.com/money/4161045/retirement-income/ [5/22/16]3 - tinyurl.com/hjfggnp [12/2/15]