Tag Archives: Taxes

Changes in tax law create problems for trusts

The Federal Estate Tax was created in 1916 to help pay for World War 1.  The tax is levied on everything you own or have interests in at your death.  At first, it did not apply to many people but inflation and prosperity began taking its toll.  From 1987 to 1997 the government tax on estates over $600,000 was 55%.

By then, many people who owned a nice home and had savings and investments became worried that a lot of their money want going to go to the government rather than their heirs.  Each person has his or her own exemption.  A married couple has two exemptions.  However, if one died, leaving everything to the spouse, the surviving spouse only had one exemption left.

The legal profession came up with an answer: the A/B Trust otherwise known as the “spousal” and the”family” trust.  Under current law, you can leave an unlimited amount of money to your spouse free of tax.  But you can leave up to $600,000 to a trust that your spouse can use for his or her benefit but is not legally their property.  This is known as the “family trust.”  The rest goes directly to the spouse or to a “spousal trust.”

Then when the surviving spouse dies, the heirs inherit both the “family trust” assets ($600,000) and the surviving spouse (or “spousal trust”) assets up to the $600,000 limit – for a total of $1,200,000 free of federal estate tax.

At a tax rate of 55%, that saves the heirs a whopping $330,000 in taxes.  Everyone thought that was a great idea.  Many estate plans and trust documents were prepared with these issues in mind.  There were some drawbacks with these plans but the estate tax savings overwhelmed all other considerations.

Beginning in 1988 the amount of the exemption that could be passed on to non-spousal heirs was gradually increased.  In 2000 it went to $1,000,000 and for one year – 2010 – there was no estate tax at all.  In 2012 the law was changed and the limit was raised to $5 million and indexed for inflation.  In 2016 the estate tax exemption is $5.45 million and the estate tax rate is 40%.

This means that a lot fewer people will be subject to the estate tax and now are faced with the negative aspects of this approach to estate planning. These include

  • Inconvenience
  • Administrative costs
  • Capital gains taxes

We will address these issues in our next essay.

Questions?  Call us.

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Avoiding Tax Scams

Financial Advisor magazine ran an excellent article about a scam that is being run by people pretending to be IRS agents. One of these scams defrauded more than 5,000 people out of more than $25 million.  Here’s how one scam works:

Victims are told they owe money to the IRS and it must be paid promptly through a pre-loaded debit card or wire transfer. If the victim refuses to cooperate, they are then threatened with arrest, deportation or suspension of a business or driver’s license. In many cases, the caller becomes hostile and insulting.

Here’s what you must know: the IRS never solicits payments by phone or e-mail.  If they need information they will always write a letter first.  Do not respond to e-mails that appear to be from the IRS or an organization closely linked to the IRS, such as the Electronic Federal Tax Payment System.

There are a number of other frauds that involve taxes.  A thief may steal your identity and fraudulently file a tax return and claim a refund.  There are several ways to avoid this happening to you.  First, protect your identity by shredding all documents that contain personal information.  Second file early and electronically; electronic filing eliminates paper documents with sensitive information will not get stolen in the mail.

Beware of tax preparer fraud.  It is important to choose carefully when hiring an individual or firm to prepare your return. This year, the IRS wants to remind all taxpayers that they should use only preparers who sign the returns they prepare and enter their IRS Preparer Tax Identification Numbers (PTINs).

Beware of “Free Money” from the IRS or scams involving social security.

Flyers and advertisements for free money from the IRS, suggesting that the taxpayer can file a tax return with little or no documentation, have been appearing in community churches around the country. These schemes promise refunds to people who have little or no income and normally don’t have a tax filing requirement – and are also often spread by word of mouth as unsuspecting and well-intentioned people tell their friends and relatives.

 

We protect your identity and work hard to safeguard sensitive financial information.  It’s why we provide you with a password protected Lock Box when we send information such as performance reports to you electronically.

For more information, please contact us.

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Getting a bigger tax deduction for long term care insurance in 2016

The IRS is increasing the amount that can be deducted from tax returns in 2016 for Long Term Care insurance premiums.

Medical expenses for seniors keep rising and the cost of a long-term-care facility can reach $10,000 per month. At that rate a lifetime of savings can be depleted rapidly. As a result, many seniors have bought long term care policies.

For people between 50 and 60 years of age the deductible limit is $1,460.

For those older than 60 but under 70 the limit is $3,900.

For younger individuals the limits are lower:
• Under 40 years old it’s $390.
• From 40 to 50 it’s $730.

Keep in mind that the deductibles are classified as unreimbursed medical expenses and can only be deducted if they exceed 10% of your adjusted gross income. Premiums above the new limits are not considered a medical expense.

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Avoid These Common Retirement Account Rollover Mistakes

If you are one of the people who are uncertain of the basic financial steps to take when you retire, you are not alone. Author and public speaker Ed Slott recently recounted how little most people really know about what to do with their 401(k)s, IRAs and other retirement assets when it comes time to leave work.

Most people do not know what to do with their retirement plans (commonly referred to with obscure names like 401(k), 403(b), 457, and TSP) once they retire. Many people simply leave the plan with their former employer because they don’t know what else to do. But that could end up being a mistake. Others know they can roll their plan into a Rollover IRA, but are not aware that if they don’t do it exactly right, they could be faced with a big tax bill.

Handling IRAs is often fraught with danger. There is a big difference between a rollover and a direct transfer. Rollovers are distributions from a retirement plan. Sometimes they are paid directly to you via check. You then have 60 days to move the assets into a new IRA or you will be taxed. If the rollover is paid directly to you, it is customary to have 20% automatically withheld for taxes. Counter-intuitively, you have to replace the 20% withholding when you fund the new IRA or that amount will be considered a taxable distribution and you will owe tax on the amount withheld. You can only make one rollover per 12 month period. If you make more than one rollover per year, you will be taxed.

A direct transfer is one where your IRA assets are moved from one custodian to another without passing through your hands. Under current law you can make as many direct transfers per year without triggering a tax penalty and there is no withholding.

When you are retired and reach the age of 70 ½, you will encounter Required Minimum Distributions. If these are not handled correctly, they can trigger huge tax consequences. If an individual fails to take out the Required Minimum Distribution (RMD) from a retirement plan, there is a 50 percent penalty tax on the shortfall.

Even many people in the investment industry do not understand the rules well. Slott notes that many financial companies do not provide advice on these topics because they are so focused on accumulating assets that they do not train their advisors on “decumulation.” Decumulation is a term that applies to retirees once they begin to take money from their retirement plans to supplement their other income sources.

“Every time the IRA or 401(k) money is touched, it’s like an eggshell; you break it and it’s over…. You mess up with a rollover and you can lose an IRA.”

Retirement is a time when people want to relax and pursue their leisure activities. Unfortunately, the rules actually get even more complicated. Make sure that you take time to learn the rules, or find a professional that does, before you move money from a retirement account.

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A Client Asks: What’s the Benefit of Inflation?

One of our retired clients sent us a question recently.

“I can’t understand the FED condoning and promoting any inflation rate. To me inflation means that the value of money is simply depreciating at the inflation rate. Further, any investment paying less than the inflation rate is losing money. A quick review of CD rates and government bonds show it is a rare one that even approaches the promoted 2% rate. It seems to me to be a de-facto admission of wanting to screw conservative investors and forcing them into riskier investments… Where is there any benefit to the financial well-being of the ordinary citizens?”

I suspect that there are a lot of people who feel the same way. It’s a good question. Who wants ever rising prices?

Here’s how I addressed his question.

Let me answer your inflation question first. My personal opinion is that 0% inflation is ideal, and I suspect that you agree. However, lots of people see “modest” rates of inflation (say 2%) as healthy because is indicated a growing economy. Here’s a quote from an article you may want to read:

Rising prices reflect a growing economy. Prices typically rise for one of two reasons: Either there’s a sudden shortage of supply, or demand goes up. Supply shocks—like a disruption in the flow of oil from Libya—are usually bad news, because prices rise with no corresponding increase in economic activity. That’s like a tax that takes money out of people’s pockets without providing any benefit in return. But when prices rise because demand increases, that means consumers are spending more money, economic activity is picking up, and hiring is likely to increase.

A case can be made that in a dynamic economy you can never get perfect stability (e.g. perfectly stable prices) so it’s better for there to be more demand than supply – driving prices up – rather than less demand than supply – causing prices to fall (deflation). Of course we have to realize that “prices” here includes the price of labor as well as goods and services. That’s why people can command raises in a growing economy – because employers have to bid for a limited supply of labor. On the other hand wages are stagnant or even decline when there are more people than jobs.

But for retirees on a fixed income inflation is mostly a negative. Your pension is fixed. Social Security is indexed for inflation but those official inflation numbers don’t take food and fuel costs into consideration and those have been going up faster than the “official” rate. The stock market also benefits from modest inflation.

Which gets us to the Federal Reserve which has kept interest rates near zero for quite a while. It’s doing this to encourage business borrowing which is supposed to lead to economic expansion but the actual effect has been muted. That’s because other government policies have not been helpful to private enterprise. In effect you have seen the results of two government policies in conflict. It’s really a testimony to the resilience of private industry that the economy is doing as well as it is.

The effect on conservative investors (the ones who prefer CDs or government bonds to stocks) has been bad. It’s absolutely true that after inflation and taxes the saver is losing purchasing power in today’s interest rate environment. The FED is not doing this to hurt conservative investors but that’s been the effect. The artificially low rates will not last forever and the Fed has indicated they want to raise rates. They key question is when, and by how much.

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The Real vs. the Ideal (Sometimes Life Happens)

The latest issue of Investment News reminded me of an article I saw recently about Marco Rubio, a Senator seeking the Republican Presidential nomination. It seems that he cashed in a 401k to buy a refrigerator, an air conditioner, pay some college costs for his children and cover some campaign expenses.

Financial planners always tell their clients that they need to put money aside for retirement and to never, ever take money out of retirement plans before age 59 ½ because the taxes and penalties can take nearly half of the money that you withdraw.

The article goes on to say that:

“Unfortunately, many middle-class Americans aren’t saving enough for retirement and some, like Mr. Rubio, even pull money out of their retirement plans prematurely.”

Our advice regarding the timing of withdrawals from retirement accounts is, of course, exactly right. And it will be followed if you are rich enough. Unfortunately, as John Lennon once said, “life is what happens when you’re making other plans.”

Most people have finite resources. Not everyone has the money to fully fund their IRA, 401k, 529 college savings plan, health savings account, life insurance and long-term care insurance policies. Life is about making choices between have-to-have and nice-to-have.

We realize that, and provide our clients with the trade-offs they often need to make. Some goals are achievable and others may not be. And sometimes it’s worthwhile cashing in a 401k if it means that later on you can become President.

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Paying a million dollars in taxes?

It’s time to pay our taxes and for many people it’s a painful chore. Whether you’re getting a refund or sending the US Treasury a check, the amount of money the government takes from our hard-earned income is never pleasant.

But I have told people that one year I would like to actually have to pay the government $1 million in taxes. Why? Because it means that I probably earned in the neighborhood of $2 million and that’s a nice neighborhood.

I have had a number of conversations this year with clients who have to write big checks to the government. The question always comes up “is there a way to pay less?” The answer is “yes” but the trade-off is not always to their advantage.

Tax free bonds (“munis”) have been a traditional way of avoiding taxes. Unfortunately the Federal Reserve’s zero interest rate policy has reduced the yield on munis to the very low single digit range. A triple A rated Virginia muni maturing in 10 years yields a touch over 1.5%. Unless you are very taxaphobic the idea of tying your money up for a decade at a rate below inflation is not very attractive.

Exchange Traded Funds (ETFs) have been touted for their tax efficiency. That’s true, but unless you buy and hold them forever, at some point you will have to sell them to get money for living expenses.  That’s when the tax comes due. And the tax rate could actually be higher.

The same argument goes for buying individual growth stocks. At some point, you will want to turn them into cash that you can spend for, say, a new car, travel, or all the other things you need money for and that’s when the tax man wants his share. Keep in mind that today’s growth stock can be tomorrow’s bankruptcy. Trees don’t grow to the sky and at some point even Apple may find that there’s a worm in the core. Individual stocks are fine, but lack of diversification is one of the biggest risks to wealth.

The US tax rate reached 94% during WW II in 1944. In the years that followed the rate never dropped below 70% until 1981. Investments were offered whose primary goal was to shelter income from taxes. These were often extremely poor investments. One shelter I recall was an investment in an aircraft leasing company that owned used aircraft. When the price of fuel rose, these planes were sidelined for more efficient models.  Some of the used planes were sold for parts.  Most investors eventually broke even … after a decade or so. The lesson here is that you should not let tax avoidance drive your investment decisions.

Top federal tax rates
These “tax shelters” mostly dried up during the Reagan era when top tax rates dropped to 28% in 1988.

They have been rising gradually since then.

Regular garden variety mutual funds have been getting a bad press because their capital gains distributions are not predictable. However, they have two advantages: (1) they focus on the primary objective of growth of capital rather than secondary issues, and (2) they allow you to pay your taxes as you go. The benefit of that is that when you want to turn your mutual funds into cash to pay for groceries – or whatever is you need money for – most of your tax may already have been paid and the tax man will take a smaller bite.

The desire to avoid taxes is natural, but the best way to manage money is to focus on avoiding major losses and getting a fair return. If taxes bother you, vote for the candidate who you think will lower the tax rate. That’s the smart way to manage your taxes.

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Estate taxes and you.

Have you reviewed your estate plans recently? If not, you may want to do so now. The reason is that there have been some big changes in the amount of money you can leave to your heirs free of estate taxes.

For the 2014 tax year, the estate tax exclusion amount is $5.34 million. It increases to $5.43 million for 2015.

That’s good news, right?  Maybe not.

There may be a problem if your estate plan was drafted in 2001 when the exemption was $675,000. Since then, the exemption has fluctuated wildly from 2001 though 2011. During this time, many people had wills and trusts drafted that would double the exemption by creating “family” trusts.

It’s possible that the formula for determining how much of the couple’s assets will go to the “family” trust will now cause all of the assets go into the trust rather than to the surviving spouse. This may not be the result that most people want.

For added information about estate planning, get a copy of our book “Before I Go” and the accompanying workbook.

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Financial tips for corporate executives

The December 2014 issue of Financial Planning magazine had an article about “Strategies for Wealthy Execs.” It begins:

Just because your clients are successful executives doesn’t mean they understand their own finances.

And that’s true. Successful executives are good at running businesses or giant corporations. But that does not make them experts in personal finance.

One of the ways executives are compensated is with stock options. But options must be exercised or they will expire. Yet 11% of in-the-money stock options are allowed to expire each year. That’s usually because they don’t pay attention to their stock option statements.

Executives usually end up with concentrated positions in their company’s stock. Prudence requires that everyone, especially including corporate executives, have to be properly diversified. Their shares may be restricted and can only be sold under the SEC’s Rule 144. To prevent charges of insider trading, many executives sell their company stock under Rule 10b5-1.

An additional consideration for executives is charitable giving. Higher income and capital gains tax rates make it beneficial for richer executives to set up donor-advised funds, charitable lead trusts, charitable remainder trusts, or family foundations.

For more information on these strategies, consult a knowledgeable financial planner.

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Living on a fixed income has gotten a lot harder

At one time, living on a fixed income meant you were retired, received a pension and social security, and got some extra income from your savings. For our parents and grandparents, certificates of deposit, otherwise known as “CDs” were a guaranteed source of no-risk income. Back in 1981 you could put your savings in the bank and get nearly 18%. That was a period of high inflation when prices were also going up. But CDs and bonds paid investors high enough rates so that retirees were comfortable with putting their money into CDs or bonds.

But interest rates have been on a downward path since then. CD rates have dropped from about 11% in 1984 to 1% or less today.

CD rates history

 

Today, CDs and bonds, once the go-to choice of the thrifty retiree, pay a small fraction of what they once did, and provide very little income to supplement their other retirement income sources.
The Federal Reserve has been keeping rates close to zero for years to try to jump-start the economy, with limited success. But while it’s been good for businesses and home buyers who have have been able to borrow money at rates that we have not seen since the 1950s, the traditional saver has seen their income dry up, collateral damage of Federal Reserve policy.

Charles Schwab, in an article published in the Wall Street Journal states that:

U.S. households lost billions in interest income during the Fed’s near-zero interest rate experiment. Because they are often reliant on income from savings, seniors were hit the hardest. Households headed by seniors 65-74 years old lost on average $1,900 in annual income over the past six years, according to a November 2013 McKinsey Global Institute report. For households headed by seniors 75 and older, the loss was $2,700 annually.
With a median income for senior households in the U.S. of roughly $25,000, these are significant losses. In total, according to my company’s calculations, approximately $58 billion in annual income has been lost by America’s seniors since 2008.
Retirees depend on income from their savings for basic living expenses. Without that income, many seniors have taken on greater risk to increase the potential yield on their savings, or simply spent down their nest eggs. After decades of playing by the rules, putting off spending and socking away money, seniors have taken it on the chin. This strikes a blow at the core American principles of self-reliance, individual responsibility and fairness.

What’s a retiree to do? Let’s look at some of the alternatives that people on fixed incomes are being offered and what to watch out for. All of them involve risk that may not be readily apparent. There are traps for the unwary.

Continue reading

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