Family Office Millennial Educational Series: Financial Literacy Basics

Family Office Millennial Educational Series: Financial Literacy Basics

 

LUTZ BUSINESS INSIGHTS

 

Family Office Millennial Educational Series – Financial Literacy Basics: Beginner’s Guide

Nick Hall and Josh Jenkins of Lutz Financial cover savings plans, insurance basics, and credit & debt, along with a Q&A session.

 

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Being Mindful of the Social Security Tax Torpedo & Medicare Surcharges

Being Mindful of the Social Security Tax Torpedo & Medicare Surcharges

 

LUTZ BUSINESS INSIGHTS

 

being mindful of the social security tax torpedo & medicare surcharges

nick hall, investment adviser

 

Social Security and Medicare are programs often at the forefront of retirees’ minds. The claiming strategies and rules can be very confusing for the average person. To complicate matters, timing decisions on claiming Social Security retirement benefits coupled with the withdrawal strategy decisions from an investment portfolio impact the amount of Social Security benefits that are taxed. In a related manner, higher income households need to be mindful of Medicare surcharges on Part B and Part D when going about determining withdrawal strategies in retirement.

Taxation of Social Security Benefits

The Social Security system is such a generous program that they tax people twice– pay/benefits are taxed on the way in (wages) and taxed upon receipt later in life. Jokes aside, under current law as little as 0% of retirees’ benefits are taxable but as much as 85% of retiree benefits are taxable for higher income households. However, a large portion of people fall somewhere in between in which some of their Social Security benefits are taxed but not the entire 85%. There is a calculation called provisional income which is used to calculate the amount or percentage of Social Security benefits that are taxable. Other income sources such as interest, dividends from investments, capital gains, rental income, pensions, IRA distributions, etc. affect this provisional income number.

It is in this range where William Reichenstein and William Meyer, head of research and CEO of Social Security Solutions, respectively, say people need to have an awareness of the self-coined phrase “tax torpedo”. The “tax torpedo” refers to the sharp rise and fall in marginal tax rates caused by taxation of Social Security benefits. I will highlight the “tax torpedo” in action in a hypothetical example below:

Sam and Sally Smith: Born in 1953 (Turn 66 this year), $50,000 of combined Social Security benefits, $15,000 of dividends from taxable investments, Sally $5,000 of pension income, and $30,000 of capital gains.

With the additional 50,000 of income and using the provisional income calculation, only $21,500 or 43% of Sam and Sally’s $50,000 annual Social Security retirement benefits are taxable. Assuming they filed the standard deduction, they would have an approximate taxable income of only $45,000 which places them in the middle of the 12% marginal Federal tax bracket. Even though they had $100,000 of income from Social Security and other sources, less than half of Social Security benefits would be subject to Uncle Sam. In fact, Sam and Sally could have up to $92,000 of other income (assuming the same $50,000 of annual Social Security) before the full 85% of Social Security benefits are taxable.

The Tax Torpedo in Action

People can get into trouble with respect to the “tax torpedo” when it comes to their withdrawal strategy from the investment portfolio during the distribution phase in retirement. In the above example, Sam and Sally might think it is a good idea to leak some money out of their traditional rollover IRA that came from an old employer’s 401(k) plan. On the surface, it appears they can take another $30,000+ out of the IRA each year and stay in the 12% Federal income tax bracket. However, what people fail to realize is that adding additional income from other sources inadvertently causes more of Social Security benefits to be taxable and increases the marginal tax rate of the transaction.

In Sam and Sally’s example, an extra $30,000 IRA distribution would cause $15,000 more of Social Security benefit taxation or a total of $36,500 to be taxable in that year. Sam and Sally’s new taxable income would be virtually doubled at approximately $90,000. More importantly, this creates about $12,500 in income that is now taxed at the 22% Federal bracket versus the much lower 12% Federal bracket. Assuming Sam and Sally are Nebraska residents and using a 6% Nebraska state tax, they added roughly $9,350 of additional income tax by innocently trying to leak out $30,000 from their pre-tax IRA while they were in a low tax bracket. Further, the tax torpedo doesn’t additionally adversely affect those whose high income already places them in a situation in which the maximum 85% of Social Security benefits are taxable.

Medicare Surcharges

For higher-income households in retirement, the acceptance of the full 85% of Social Security benefits being subject to tax is simply the reality. Another important concern begins to creep in for people who are over 65 and on Medicare. This concern relates to the income limits associated with Medicare Part B and Part D. A majority of the population will pay $135.50 per month for Medicare Part B premiums. However, high income households with modified adjusted gross income (MAGI) of over $170,000 for married filers ($85,000 for single filers) must begin paying an Income Related Monthly Adjustment Amount (IRMAA) or Medicare premium monthly surcharge. For Medicare purposes, income from two years prior affects the current years’ Medicare Part B premiums. The chart below details the Medicare Part B premiums based on income:

 

If your yearly income in 2017 (for what you pay in 2019) was You pay each month (in 2019)
File individual tax return File joint tax return File married & separate tax return
$85,000 or less $170,000 or less $85,000 or less $135.50
above $85,000 up to $107,000 above $170,000 up to $214,000 Not applicable $189.60
above $107,000 up to $133,500 above $214,000 up to $267,000 Not applicable $270.90
above $133,500 up to $160,000 above $267,000 up to $320,000 Not applicable $352.20
above $160,000 and less than $500,000 above $320,000 and less than $750,000 above $85,000 and less than $415,000 $433.40
$500,000 or above $750,000 and above $415,000 and above $460.50

Source: https://www.medicare.gov/your-medicare-costs/part-b-costs

 

As you can see, the highest income households end up paying $325/month more per individual for Medicare premiums. This equals $7,800 annually per married couple. Even the first jump represents a $1,296 increase in Medicare Part B premiums for a married couple. Unlike Social Security, Medicare surcharges are a cliff and the surcharges will be charged even if you exceed the MAGI threshold by $1. In addition to Medicare Part B, Medicare Part D (or Prescription Drug Coverage) includes a monthly surcharge as seen in the chart below:

 

If your filing status and yearly income in 2017 was
File individual tax return File joint tax return File married & separate tax return You pay each month (in 2019)
$85,000 or less $170,000 or less $85,000 or less your plan premium
above $85,000 up to $107,000 above $170,000 up to $214,000 not applicable $12.40 + your plan premium
above $107,000 up to $133,500 above $214,000 up to $267,000 not applicable $31.90 + your plan premium
above $133,500 up to $160,000 above $267,000 up to $320,000 not applicable $51.40 + your plan premium
above $160,000 and less than $500,000 above $320,000 and less than $750,000 above $85,000 and less than $415,000 $70.90 + your plan premium
$500,000 or above $750,000 and above $415,000 and above $77.40 + your plan premium

Source: https://www.medicare.gov/drug-coverage-part-d/costs-for-medicare-drug-coverage/monthly-premium-for-drug-plans

Two-Year Lookback and Request for Reconsideration of IRMAA Charges

The two-year lookback with respect to income can cause many people to pay high Medicare surcharges when initially going onto Medicare or certain times during retirement. However, the Social Security Administration is surprisingly forgiving when it comes to appealing these higher rates if there has been a significant life event that happened to give cause to an income spike or a reduction of income going forward like a sale of a business, inheritance, employer stock grants or deferred compensation, retirement, death of a spouse, etc. If you have had one of these major life events and now have a much lower income, it is most likely worth filing a request for reconsideration.

Planning for Tax Torpedo and Medicare Surcharges

An important tax planning strategy that we recommend to clients is Roth IRA conversions, the act of purposely moving money from Traditional IRAs to Roth IRAs. A great opportunity to do this is when people are in the first few years of retirement or what I call the “retirement income gap”, the time period before taking Social Security benefits or being required to take minimum distributions from pre-tax IRAs. The effectiveness of this strategy depends on delaying Social Security benefits and before RMDs happen at age 70 ½ to maximize lower tax brackets while not having to worry about the tax torpedo.

Because the Medicare surcharges are implemented on a cliff schedule, it becomes critically important to plan around this when possible during the distribution phase or determining a portfolio withdrawal strategy. Those with large pre-tax IRAs and big RMDs at age 70 ½, very large taxable accounts, pensions, rental income, or other higher ordinary income can be pushed into Medicare surcharge areas. Utilizing Roth IRA conversions and other tax strategies to accelerate income while people are in low tax brackets is a great solution to lower future income and manage Medicare surcharge cliffs. This can not only protect them against future tax rate increases but it can help minimize taxes at age 70 ½ and lower RMDs which kick off income that may adversely affect tax rates or Medicare premium surcharges.

The presence of the tax torpedo of Social Security benefits and Medicare premium surcharges add an extra layer of complexity for people in retirement. Developing a disciplined retirement withdrawal strategy and advanced planning can lower overall taxes during retirement by lessening the impact of the tax torpedo or helping avoid Medicare premium surcharges. As always, please consult with your CPA about any complex tax related question regarding these topics.

ABOUT THE AUTHOR

402.827.2300

nhall@lutz.us

LINKEDIN

NICK HALL, CFP® + INVESTMENT ADVISER

Nick Hall is an Investment Adviser at Lutz Financial with over eight years of industry experience. He specializes in comprehensive financial planning and investment advisory management services.

AREAS OF FOCUS
  • Financial Planning
  • Investment Advisory Services
  • Retirement Planning
  • Income Tax Planning
  • Social Security and Medicare Planning
  • Education Planning
  • Investment Product Research
  • Small Business Owners
  • High Net Worth Families in Transition
AFFILIATIONS AND CREDENTIALS
  • Financial Planning Association of Nebraska, Member
  • Certified Financial Planner
EDUCATIONAL BACKGROUND
  • BSBA in Finance and Business Management, Eller College of Management - University of Arizona, Tuscon, AZ
COMMUNITY SERVICE
  • Mount Michael Benedictine, Alumni Board President-Elect
  • Lutz Gives Back, Committee member
  • United Way, Volunteer
  • Salvation Army, Volunteer
  • Omaha Home For Boys, Volunteer
  • Susan G. Koman Race for the Cure, Volunteer

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P: 402.462.4154

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Is the Traditional Bypass Trust Outdated?

Is the Traditional Bypass Trust Outdated?

 

LUTZ BUSINESS INSIGHTS

 

Is the traditional bypass trust outdated?

justin vossen, investment adviser, principal

 

Many early-retirement Boomers feel comfortable that their estate plan is in order, having put their estate plan in place when they had younger children. With adult children, and the increase in the estate and gift tax exemption amounts, many feel that there is little planning to be done. However, upon review, we see plans that may need adjusting due to the recent changes in tax laws. Specifically, those plans with the AB Trust/Bypass trust structure.

How the AB trust/Bypass Trust Structure Works

With the traditional bypass trust, when the first spouse dies, the bypass trust is funded with an amount equal to the applicable exclusion amount in order to minimize federal and state estate taxes. Any remaining marital assets would transfer to the surviving spouse via a separate marital trust, typically. 

Today, that amount is $11,400,000; meaning that all assets would be moved into the bypass trust if the estate is less than $11.4 million. Anything over that $11.4 million would go to the surviving spouse via the marital trust. Most folks do not have $11.4 million of assets in their name; so generally, most assets will flow to the bypass trust when trusts contain inflexible formulas for funding at death.

Assets owned by the deceased spouse receive a basis adjustment at death. However, assets placed in the bypass trust will NOT receive a second basis step at the surviving spouse’s death. This is a key worry in today’s estate planning environment. Any assets passed outright to the spouse or placed in a marital trust, WOULD receive a second step at the surviving spouse’s later death. However, the bypass trust would allow for the growth of those assets to occur outside the surviving spouse’s estate. This structure is written to use the client’s maximum estate exclusion at the first passing to primarily avoid estate tax.

 

Why Does/Did This Structure Make Sense?

Attorneys and planners used this bypass trust structure because estate tax avoidance was a primary concern when individuals passed away a handful of years ago. For example in 2001, the estate and gift tax exclusion was $675,000; and if you did not use that exclusion on the first death, it died with you. If you owed estate tax for amounts of assets higher than $675,000, you would have had to pay a tax of 55% on that amount. The estate tax used to be extremely punitive. Therefore, good estate planners would make sure to use the full $675,000 exemption amount at the first passing via the bypass trust. This shielded those assets and any growth from future estate taxes on the second passing. 

Advantages of the Bypass Structure:

Creditor protection: This varies from state to state, so consult an attorney to understand your particular situation.

Spendthrift protection: A couple can predetermine how the surviving spouse benefits from the trust and protects the money for future generations. This also provides control of the assets for the benefit of the future generation. Also, this could shield the assets from a future spouse in case of divorce or from a comingling of assets in a mixed family situation. This could avoid the children being accidentally disinherited.

Probate: The assets in the bypass trust would avoid probate when the surviving spouse dies.

 

Disadvantages of the Bypass Structure:

New Laws: Today, two major things have happened, the first being the $11.4 million exclusion amount and the second was the advent of portability in 2011. Portability allows for the surviving spouse to actually “port” the amount that is unused by the first spouse which is then added to their own exclusion amount. Thus, the surviving spouse could have a $22.8 million estate and gift exclusion, as well as essentially two steps in basis if both spouses’ steps are used. The estate and gift tax percentage has also dropped to 40%, still punitive but lower than before. So, the bypass structure may no longer be needed in many cases.

Expense: Over a lifetime, the bypass trust structure is costly to create and perhaps a costly burden to administer as it requires its own tax return and administration.  

Taxes: The bypass trust has a compressed (high) tax structure so careful considerations to allocations and income distribution need to be considered.

Today – What Could I Be Doing?

You need to consult your estate attorney on what is most appropriate to use in your particular situation.  However, a few things should be considered:

Portability: If your assets are substantially less than the $11.4 million exemption, the portability provision has given rise to a simplified approach. This provision allows individuals to leave all of their assets to the surviving spouse and transfer their exemption to them. This allows the couple to protect $22.8 million from estate taxes without using the bypass trust planning. While this does NOT protect it from creditors or future spouses, it is a simple way to avoid the estate tax. However, keep in mind that these increased exemption amounts are due to sunset in 2026 to their pre-2018 levels.

Disclaimer Provisions: Many attorneys are drafting flexibility into plans by the use of disclaimers or “Clayton” disclaimers for federal tax planning. With this trust planning, when the first spouse dies, the surviving spouse receives the assets of the deceased spouse. At that time, the surviving spouse then has the OPPORTUNITY to make a disclaimer election. This disclaimer election would allow the assets to pass directly into a bypass or martial trust. This allows for the surviving spouse to use all or a portion of the deceased spouse’s estate exclusion amount. 

Why would you want to leave the surviving spouse with a decision to make at an emotional time? The reasons to do this type of disclaimer would be to provide flexibility as the laws change over time. As mentioned, the current estate and gift exemption is scheduled to sunset at the end of 2025. Given the political climate, it may make sense to provide flexibility in the plan to do what is best at the time of the first passing.

 

What Should I Do?

There is not a one-size-fits-all solution for anyone with estate planning. Family dynamics, balance sheets, asset structure, and legislation continue to change as people’s lives evolve. You may not be able to achieve all of your objectives and goals with one solution, but you can get pretty close. Ultimately, creating the optimal wealth transfer plan requires an evolving strategy refined by you and your trusted advisors over time.

 

 

IMPORTANT DISCLOSURE INFORMATION

PLEASE REMEMBER THAT PAST PERFORMANCE MAY NOT BE INDICATIVE OF FUTURE RESULTS.  DIFFERENT TYPES OF INVESTMENTS INVOLVE VARYING DEGREES OF RISK, AND THERE CAN BE NO ASSURANCE THAT THE FUTURE PERFORMANCE OF ANY SPECIFIC INVESTMENT, INVESTMENT STRATEGY, OR PRODUCT (INCLUDING THE INVESTMENTS AND/OR INVESTMENT STRATEGIES RECOMMENDED OR UNDERTAKEN BY LUTZ FINANCIAL), OR ANY NON-INVESTMENT RELATED CONTENT, MADE REFERENCE TO DIRECTLY OR INDIRECTLY IN THIS NEWSLETTER WILL BE PROFITABLE, EQUAL ANY CORRESPONDING INDICATED HISTORICAL PERFORMANCE LEVEL(S), BE SUITABLE FOR YOUR PORTFOLIO OR INDIVIDUAL SITUATION, OR PROVE SUCCESSFUL.  DUE TO VARIOUS FACTORS, INCLUDING CHANGING MARKET CONDITIONS AND/OR APPLICABLE LAWS, THE CONTENT MAY NO LONGER BE REFLECTIVE OF CURRENT OPINIONS OR POSITIONS.  MOREOVER, YOU SHOULD NOT ASSUME THAT ANY DISCUSSION OR INFORMATION CONTAINED IN THIS NEWSLETTER SERVES AS THE RECEIPT OF, OR AS A SUBSTITUTE FOR, PERSONALIZED INVESTMENT ADVICE FROM LUTZ FINANCIAL.  TO THE EXTENT THAT A READER HAS ANY QUESTIONS REGARDING THE APPLICABILITY OF ANY SPECIFIC ISSUE DISCUSSED ABOVE TO HIS/HER INDIVIDUAL SITUATION, HE/SHE IS ENCOURAGED TO CONSULT WITH THE PROFESSIONAL ADVISOR OF HIS/HER CHOOSING.  LUTZ FINANCIAL IS NEITHER A LAW FIRM NOR A CERTIFIED PUBLIC ACCOUNTING FIRM AND NO PORTION OF THE NEWSLETTER CONTENT SHOULD BE CONSTRUED AS LEGAL OR ACCOUNTING ADVICE.  A COPY OF LUTZ FINANCIAL’S CURRENT WRITTEN DISCLOSURE STATEMENT DISCUSSING OUR ADVISORY SERVICES AND FEES IS AVAILABLE UPON REQUEST.

ABOUT THE AUTHOR

402.827.2300

jvossen@lutzfinancial.com

LINKEDIN

JUSTIN VOSSEN, CFP® + INVESTMENT ADVISER, PRINCIPAL

Justin Vossen is an Investment Adviser and Principal at Lutz Financial with over 20 years of relevant experience. He specializes in wealth management and financial planning.

AREAS OF FOCUS
  • Financial Planning
  • Wealth Management
AFFILIATIONS AND CREDENTIALS
  • Certified Financial Planner™
  • Financial Planning Association, Member
EDUCATIONAL BACKGROUND
  • BSBA in Economics and Finance, Creighton University, Omaha, NE
COMMUNITY SERVICE
  • St. Augustine Indian Mission, Board Member
  • Nebraska Elementary and Secondary School Finance Authority, Board Member
  • St. Patrick's Church, Trustee
  • March of Dimes Nebraska, Past Board Member

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747 N Burlington Avenue, Suite 401

Hastings, NE 68901

P: 402.462.4154

OMAHA

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Omaha, NE 68154

P: 402.496.8800

Toll-Free: 866.577.0780  |  Privacy Policy

All content © Lutz & Company, PC

 

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P: 531.500.2000

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Grand Island, NE 68803

P: 308.382.7850

Will I Outlive My Assets?

Will I Outlive My Assets?

 

LUTZ BUSINESS INSIGHTS

 

Will I Outlive My Assets?

JOE HEFFLINGER, DIRECTOR & INVESTMENT ADVISER

 

Running out of money is often cited as the biggest fear of retirees. Most investment and financial advice has traditionally been focused on the accumulation phase (growing assets before retirement). But, with the elimination of traditional pension plans and increased life expectancies, retirees are now finding that the distribution phase (spending down assets in retirement) is far more complex and requires a skill-set that they may not possess. This blog will provide a couple brief pointers on how to review your financial situation and investment allocation so that you don’t spend your retirement worrying about outliving your assets.

 

How much can I spend each year in retirement?

The best way to answer this is to perform a comprehensive retirement cash flow analysis. By modeling out detailed projections, you can analyze how your income and expenses will affect your retirement nest egg over time. This will include a review of your balance sheet, sources of annual income, tax features and how much you plan on spending each year. It is important to work with an experienced advisor who uses a high-quality planning software that can model out different scenarios so that you can see how modifying various assumptions can impact your financial picture.

Keep the following points in mind to ensure an accurate review of your financial situation:

  • Understand the timing and length of your retirement (estimate of retirement date and how long you will live) – longevity is one of the biggest stresses on retirement funds
  • Prepare an estimated budget of your annual expenses (don’t just wing this, if this is way off it can materially impact the analysis)
  • Quantify your sources of income (Social Security, rental income, farm income, pension, part-time employment, required minimum distribution (RMD) income, etc.)
  • Get a good estimate of what your healthcare and potential long-term care expenses will be[i]
  • Have a conservative assumption for taxes and inflation
  • Set a realistic growth rate for your investments based on your overall asset allocation (more on this to come below)

The cash flow analysis will help you find out if a level of annual spend is sustainable based on your balance sheet and the underlying assumptions (the key is to be realistic but conservative). It’s important to update this analysis periodically as you progress through retirement to account for any changes in your situation and to confirm your plan remains on track.

 

How do I determine my investment allocation in retirement?

As mentioned above, it’s important to use a reasonable investment growth rate when modeling out your retirement cash flow. What’s “reasonable” depends in part on what your investment allocation will be in retirement (i.e., your ratio of stocks vs. bonds/cash). But, how do you go about determining what that allocation should be? While there are lots of personal factors to consider and several different methodologies to use to answer that question, the approach we like to use is what I will call the “3 bucket model.” 

 

Three Bucket Allocation Model

In the bucket approach, you start out by estimating what your annual retirement “shortfall” will be (meaning by how much do your annual retirement expenses exceed your annual retirement net income). You then try to fill Bucket 1 with one year of this shortfall in a money market account. Next, you try to fill Bucket 2 with 7-10 years (or more) of this shortfall amount in a diversified fixed income (bond) portfolio. Lastly, fill Bucket 3 with the remainder of the portfolio in a diversified stock/bond mix. How aggressively Bucket 3 is allocated depends on how large the overall portfolio is and what the primary goal of the investor is (i.e., either protecting the corpus to provide a bigger spending cushion for the investor or growing the pot in an attempt to leave a larger amount for heirs or charity).

What this 3 bucket approach accomplishes is theoretically not having any funds you plan on needing in the next 7-10 years in the stock market. It also helps to avoid having to sell stocks at an inopportune time. If the stock market pulls back (as it inevitably will at various points during your retirement), you can pull any funds needed for living expenses from Bucket 1 or Bucket 2 and allow your stocks in Bucket 3 time to recover. 

If you are in retirement and can’t fill a 7-10 year bucket with conservative bonds, you may either need to be more aggressive with your investments then is ideal or you may need to reduce your annual spend. An illustrative example of this 3 bucket approach is set forth below.

 

Allocation Buckets

 

As you approach and enter retirement, managing your finances becomes much more complex. Determining how much you can safely spend each year and how to allocate your investments are just a couple of the many critical financial decisions you will face in retirement. Make sure you work with your financial advisor to put together a plan that meets your needs. If you don’t feel that your current advisor is providing adequate guidance in these areas, find one that will. Feel free to contact us for more information on this topic or to schedule a meeting to discuss your situation further.

 

 

[1] See https://www.lutz.us/planning-health-care-costs-retirement/ and https://pressroom.vanguard.com/nonindexed/Research-Planning-for-healthcare-costs-in-retirement_061918.pdf for more information on how to estimate healthcare and long-term care costs in retirement.

 

Important Disclosure Information
Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Lutz Financial), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Lutz Financial.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.  Lutz Financial is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice.  A copy of the Lutz Financial’s current written disclosure statement discussing our advisory services and fees is available upon request.

ABOUT THE AUTHOR

402.827.2300

jhefflinger@lutzfinancial.com

LINKEDIN

JOE HEFFLINGER, JD, CFP® + DIRECTOR & INVESTMENT ADVISER

Joe Hefflinger is a Director & Investment Adviser at Lutz Financial with over 14 years of relevant experience. He specializes in providing both financial planning and investment advisory services.

AREAS OF FOCUS
  • Financial Planning
  • Investment Advisory Services
  • Business Owners
  • Retirees
  • Corporate Executives & Professionals
AFFILIATIONS AND CREDENTIALS
  • Financial Planning Association, Member
  • Society of Financial Service Professionals, Member
  • Nebraska State Bar Association, Member
  • Omaha Bar Association, Member
  • Omaha Estate Planning Council, Member
  • Certified Financial Planner™
EDUCATIONAL BACKGROUND
  • JD, Creighton University School of Law, Omaha, NE
  • BS in Economics, Santa Clara University, Santa Clara, CA
COMMUNITY SERVICE
  • Partnership 4 Kids - Service League, Past Board Member
  • Omaha Venture Group, Member
  • Christ the King Sports Club, Member

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HASTINGS

747 N Burlington Avenue, Suite 401

Hastings, NE 68901

P: 402.462.4154

OMAHA

13616 California Street, Suite 300

Omaha, NE 68154

P: 402.496.8800

Toll-Free: 866.577.0780  |  Privacy Policy

All content © Lutz & Company, PC

 

LINCOLN 

601 P Street, Suite 103

Lincoln, NE 68508

P: 531.500.2000

GRAND ISLAND

3320 James Road, Suite 100

Grand Island, NE 68803

P: 308.382.7850

Qualified Charitable Donations: Using IRAs as a Charitable Piggy Bank for Investors

Qualified Charitable Donations: Using IRAs as a Charitable Piggy Bank for Investors

 

LUTZ BUSINESS INSIGHTS

 

Qualified Charitable Donations: Using IRAs as a Charitable Piggy Bank for Investors

NICK HALL, LUTZ FINANCIAL INVESTMENT ADVISER

 

Qualified Charitable Distributions, or QCDs, are a tax provision allowing people age 70 ½ or older to designate funds from pre-tax IRAs to be sent directly to a charity(s). Initially, QCDs were a temporary provision in the tax code as part of the Pension Protection Act of 2006. This was set to run through the end of 2007, however, after 2007 there were last-minute, and sometimes retroactive, legislative Acts that reinstated this provision for a year or two.

Finally, in December of 2015, the PATH Act made this provision permanent going-forward and eliminated the guessing game every year. The law permits any individual that is 70 ½ or older to gift up to $100,000 annually from a pre-tax IRA to a charity, or charities, of their choice. Normally, distributions from a pre-tax IRA are taxed as ordinary income and follow the marginal tax rate schedule. However, QCD legislation allows distributions to be made from the IRAs and shields them from tax returns so long as they go to a qualified charity. It is important to note that individuals must actually be age 70 ½ at the time of the QCD, not simply turning 70 ½ sometime that year.

 

BENEFITS

Satisfy Charitable Contributions and Supporting Greater Good

Most people make charitable contributions throughout the year to causes that are important to them. These range from weekly contributions to a church, contributions to local non-profits, donations to a college alma mater, or more national, far-reaching agencies. Utilizing the QCD provision is a great way to facilitate normal annual gifting or one-time pledges to organizations in a tax-free manner.

QCDs are permitted to any organization that qualifies as a 501(c)(3) charity. Doing a QCD can simplify charitable gifting by consolidating weekly or monthly giving into quarterly, semi-annually, or even annual gifts. There is no limit as to how many charities you can gift to.

 

Satisfy RMD

A major benefit of the QCD provision is that it can be used to fully or partially satisfy required minimum distributions (RMDs) from pre-tax IRAs. Upon reaching 70 ½, individuals must take out a percentage of their pre-tax IRAs, or 401(k)s, that have grown tax-deferred over their working years. Individuals can also utilize the QCD provision for an RMD on an inherited IRA if they are personally 70 ½ at the time of the distribution. The RMD is calculated by using the previous year-end balance of pre-tax retirement accounts and dividing this number by a life expectancy factor. The beginning RMD distributions for a married person is approximately 3.75% of their total pre-tax IRAs.

  • For example: Sam Smith, turned 71 in April 2018. He retired a few years ago and rolled over his old employer 401(k) into a pre-tax IRA. Sam took his first RMD in 2017 and the IRA balance on December 31, 2017 was $1,000,000. Sam would need to take out roughly $37,500 as his RMD from his IRA before December 31, 2018. For married couples, it is common for both spouses to have pre-tax IRAs that are subject to RMDs. The QCD provision allows people to use distributions sent directly to charity (or a check made payable to charity sent to them) to count towards annual RMDs.

 

Minimize Taxes

The above fictitious example of Sam Smith is a common scenario. Sam would have to recognize an additional $37,500 in ordinary income on his tax return, and his spouse may have an additional RMD that needs to be counted as income. Retirees often see their income rise in retirement upon reaching 70 ½ because of large RMD income.

Using the QCD can prevent pushing people into the next tax bracket if their RMD is big enough because it shields some or all RMD income which would normally be taxed. For others, utilizing the QCD provision can keep more of their Social Security income non-taxable, keep Medicare Part B and Part D premiums lower, and help others avoid the 3.8% net investment income tax by shielding RMD income from a tax return.

 

QCD Becoming More Prominent in the Wake of the Tax Cuts and Jobs Act of 2017

Many people make charitable donations by transferring highly appreciated stocks or securities from their taxable brokerage accounts to a donor-advised fund or organization like the Omaha Community Foundation charitable checkbook. This strategy avoids high capital gains and helps get an upfront deduction in the year securities are gifted, yet has the flexibility to gift proceeds to charities of their choosing over subsequent multiple years. We still think this is a worthwhile strategy for younger investors, but the new tax law has made the QCD even more powerful for those over age 70 ½. As a side note, QCDs are not permitted to be made into donor-advised funds but must be made payable or go directly to a charity.

Standard Deductions

The Tax Cuts and Jobs Act of 2017 (TCJA) brought on broad, sweeping changes to the tax code. One of the biggest changes was an expanded standard deduction and increased limitations on itemized deductions. A direct correlation of these changes included dramatic shifts in the tax benefit of making charitable donations.

Previously, the standard deduction for a married couple filing jointly (MFJ) was $12,700, with personal exemptions of $4,050. Thus, MFJ couples got $20,800 combined in standard deductions and personal exemptions. TCJA consolidated the standard deduction and personal exemptions into one larger standard deduction of $24,000 ($12,000 single filer). For those who are 65 and older, an additional $1,300 standard deduction is added per individual.

Itemized Deductions

Additionally, the new tax law significantly limits allowable itemized deductions. Namely, state and local taxes (SALT) and real estate taxes are now capped at a combined limit of $10,000 annually versus the old law allowing individuals to include the full amount of these taxes as itemized deductions. On top of this, miscellaneous itemized deductions (tax preparation, investment advisory fees, organization fees, safety deposit boxes, etc.) in excess of 2% of AGI were repealed for individuals.

As a result, the only deductions that are left are the $10,000 limit for SALT/real estate, home mortgage interest, charitable contributions, and medical expenses in excess of 7.5% of AGI (2018). Thus, more than 90% of the population will be filing the standard deduction in 2018 and beyond because they don’t have enough itemized deductions to eclipse the much higher standard deduction limits.

For many retirees, one of their major goals before retirement is paying off the mortgage. Without mortgage interest to deduct, the only eligible itemized deductions are from SALT/real estate taxes and charitable contributions (and maybe medical deductions). With SALT deductions now limited to $10,000 and no other eligible deductions, the first $14,000 or $16,600 (couples over 65) of annual charitable gifting for married couples has no tax advantage.

QCDs are unquestionably the way to gift for anyone over 70 ½ given these new tax laws because you are taking pre-tax funds and gifting them to charity—in essence getting a full tax deduction you might not otherwise get. Thus, the QCD provision has turned IRAs into Charitable Piggy Bank for those over the age of 70 ½.

 

Like any tax recommendations, we suggest you or a loved one speak with your CPA to discuss the merits of potentially using the QCD provision. It is not an all or nothing proposition. If you wish, you can designate only a small portion of your RMD to go to a specific charity or charities. At any rate, I would expect the QCD provision to continue to gain popularity as a great way for those over age 70 ½ to give to the charities of their choosing because of the recent tax law changes that have gone into effect for 2018.

 

 

Important Disclosure Information
Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Lutz Financial), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Lutz Financial.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.  Lutz Financial is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice.  A copy of Lutz Financial’s current written disclosure statement discussing our advisory services and fees is available upon request.

ABOUT THE AUTHOR

402.827.2300

nhall@lutz.us

LINKEDIN

NICK HALL, CFP® + INVESTMENT ADVISER

Nick Hall is an Investment Adviser at Lutz Financial with over eight years of industry experience. He specializes in comprehensive financial planning and investment advisory management services.

AREAS OF FOCUS
  • Financial Planning
  • Investment Advisory Services
  • Retirement Planning
  • Income Tax Planning
  • Social Security and Medicare Planning
  • Education Planning
  • Investment Product Research
  • Small Business Owners
  • High Net Worth Families in Transition
AFFILIATIONS AND CREDENTIALS
  • Financial Planning Association of Nebraska, Member
  • Certified Financial Planner
EDUCATIONAL BACKGROUND
  • BSBA in Finance and Business Management, Eller College of Management - University of Arizona, Tuscon, AZ
COMMUNITY SERVICE
  • Mount Michael Benedictine, Alumni Board President-Elect
  • Lutz Gives Back, Committee member
  • United Way, Volunteer
  • Salvation Army, Volunteer
  • Omaha Home For Boys, Volunteer
  • Susan G. Koman Race for the Cure, Volunteer

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5 Retirement Strategies for Small Business Owners

5 Retirement Strategies for Small Business Owners

 

LUTZ BUSINESS INSIGHTS

 

5 Retirement Strategies for Small Business Owners

JUSTIN VOSSEN, INVESTMENT ADVISOR, PRINCIPAL

We work with small business owners all the time. The entrepreneurial spirit runs through them all, and their passion for their businesses is evident each time we meet.  Most spend the waking hours of their day working on their business and trying to improve their craft in order to help their customers, their employees and their business succeed. Because of this laser focus, many small business owners don’t think about themselves when it comes to retirement. Too often, we find small business owners are over-reliant on the value of their business as their main source to fund retirement.

In fact, a Small Business Administration working paper (https://www.sba.gov/advocacy/saving-retirement-look-small-business-owners) written in 2010 showed the magnitude of the problem. The SBA noted that only about 18 percent of all business owners participated in a 401(k)/Thrift plan. Micro-businesses with fewer than 10 employees had 401(k)/Thrift plan participation of 10%. The good news is that as 401(k) plans have become easier and cheaper to manage, those numbers are increasing. However, in order for many to have a comfortable retirement, it’s important that these numbers keep improving.

So what can be done? While it’s not feasible for every small business to have a 401(k), they should at least examine their retirement plan options. For this reason, we produced five different strategies small business owners could employ depending on their businesses lifecycle stage.

 

Strategy #1 – I (and perhaps my spouse) am the only employee.

If you are self-employed or employed in a business with just your spouse, you have the ability to set up your own 401(k) plan. The advantage of this is the ability to do employee contributions each year as well as a tax-deductible profit sharing contribution from the company.

The solo 401(k) is a great option for self-employed individuals. This lets the owner/employee contribute up to $19,000 for 2019 ($25,000 if you are 50 and older) of their compensation indexed to inflation. In addition, the employer has the ability to contribute a tax-deductible profit-sharing contribution of up to 25% of compensation or of net self-employment income (net profit less half your self-employment tax and the plan contribution you made for yourself as an employee). The combined limit for those contributions in 2019 is $56,000 or $62,000 if you are 50 and older.

The employee contributions can also be post-tax and placed into a Roth 401(k), which will never be taxed again in the future. This is a good way to add tax-free distributions in retirement to your balance sheet.  Another benefit is that these 401(k) assets are protected by ERISA which means they are shielded against creditors of the company should something go wrong and the business fails.

In lieu of a 401(k) plan, you could do a SEP IRA designed for sole proprietorships and small business owners. You can be a sole-proprietorship, partnership, S or C Corporation or an LLC. This is only funded with employer contributions. Vesting is immediate, and you must contribute for all eligible employees. Contributions can be made up to 25% of compensation or $56,000 for 2019, whichever is less. Because of this higher contribution level and the fact it’s all employer-based, is the reason it’s most often used for sole-proprietorships that want to get the tax deduction for the contribution for the owner. A Roth option is not available in the SEP because it’s an employer contribution.

 

Strategy #2 – My company is growing, and I need a retirement plan to help recruit employees

In the instance where a company is growing fast and needs to attract workers, retirement plans are often used as a benefit to attract employees. For those looking to add a quick plan for themselves and the employees with minimal administration, a SIMPLE IRA can be used (for businesses with fewer than 100 employees).

This provides employees the ability to contribute up to $13,000 for 2019 ($16,000 for those 50 and older). It also provides a required employer match in one of two ways:

  1. Up to 3% of each employee’s compensation, but can be reduced to as low as 1% in any two out of five years
  2. 2% of each eligible employee’s compensation

Note: You must establish a SIMPLE plan between January 1st and October 1st of the plan year, and you may not maintain any other retirement plans in addition to the SIMPLE. You can set up the SIMPLE using a Form 5304-SIMPLE or Form 5305-SIMPLE with the IRS and notify your employees of its opening.

 

Strategy #3 – My company is established, and I am trying to find the best retirement plan for myself and my employees.

In this case, an employer may have been using a SIMPLE IRA or other plan and wishes to increase the amount that employees and owners can save for their retirement.

A 401(k) plan is probably the best choice in this situation. With a 401(k), you can customize (within regulatory requirements) vesting schedules, employer match, and profit sharing. For this article, we are going to talk about the Safe Harbor 401(k) plan which does not subject itself to discrimination testing because of its stated employer match characteristics.

Employees can contribute up to $19,000 for 2019 ($25,000 if you are 50 and older) of their compensation indexed to inflation to the 401-k plan. These contributions can be pre-tax into a traditional 401(k) or after-tax into a Roth 401-k (Roth distributions are tax-free in retirement).

For the employer match in a Safe-Harbor plan, an owner has two options. The first is matching 3% of employee deferrals plus 50% on the next 2% of employee deferrals.  You would not need to match if there were no employee contributions. Another option is to match a flat 3% of employee compensation regardless if they have contributions to the plan or not.

Obviously, this strategy provides good benefits for employees and owners. The safe harbor plan eliminates the need for discrimination testing and ensures maximization of deferrals for all employees regardless of compensation.

Additionally, if employers wanted to, a profit-sharing component could be added to the plan. There are a few ways to calculate the profit sharing piece that you should examine during plan design. Ultimately it could give owners the discretionary ability to make a contribution up to 25% of eligible payroll to an overall maximum contribution per eligible employee up to 100% of compensation not to exceed $56,000 or $62,000 for those over age 50.

Reporting requirements to the IRS would include an IRS Form 5500 and potentially an audit for those with more than 100 participants done by an outside CPA firm. The Department of Labor will also monitor fiduciaries to the plan.

 

Strategy #4 – My company is established and highly profitable. I would like to defer more money prior to taxes into a retirement plan, and the 401-k isn’t enough.

Something to consider in companies trying to maximize retirement contributions and pre-tax dollars is a Cash Balance Plan. Essentially, this is a defined benefit plan on top of their current 401(k). With the most anyone can save into a 401(k) plan being $56,000 or $62,000 annually, the addition of a cash balance plan could allow for somebody older than 60 to save more than $200,000 annually in pretax contributions.

Funding these types of plans requires contributions made directly from the business (no employee deferral) into a pooled account. The plan document and actuarial specifics determine how much each employee/owner would have allocated to each plan. The plan is then invested as a group, and an actuary must certify every year that the plan is properly funded. If it’s not, additional contributions from the firm maybe needed to “catch the plan up” to funded status.

Those leaving the plan may be able to roll their “asset value” out of the plan into IRAs of their own or keep assets in the plan ultimately allowing for distribution later.

Obviously, these plans require additional filings to the IRS and actuarial expense. These are optimal for smaller closely held businesses that are highly profitable. Many medical and legal practices offer these plans to their groups in order to provide for retirement and pre-tax savings.

 

Strategy #5 – I don’t need to add a retirement plan to my business as my employees don’t require it and I don’t want to provide any additional matching funds.

This is your choice as a business owner and is certainly an option. However, you should still try to diversify some funds outside your business.

If you or your spouse lacks access to a retirement plan at work, you have the ability to make a deductible contribution into an IRA of up to $6,000 or $7,000 as of 2019. This contribution can be made annually regardless of income if no plan is offered to you. Depending on your income you may also be allowed to contribute to an after-tax Roth IRA to provide for tax-free distributions at a later date.

It’s a good idea to take funds out of the business if they aren’t needed for two reasons: liability and diversification. Funds removed from the business would be less subject to any frivolous lawsuit filed against the company. Funds can be moved to a regular investment account to diversify into other assets outside your area, sector of the economy and safer assets you may need for a rainy day. Qualified dividends and capital gains taxes are often lower than income tax rates that may be generated by leaving assets in the business for growth.

Providing outside assets for your retirement lessens the stress that the value of the business has to provide. It allows for liquidity and diversified revenue streams that could lower your personal risk profile and financial reliance on the business.

 

Explore Your Options:

Whatever the case, there are multiple retirement plan options for small business owners to examine. While many focus on the need to reduce taxes, there are additional reasons such as diversification, employee recruitment, liability, and creditor protection. Be sure to consult with a qualified CPA and Investment Advisor who have expertise in retirement plans to find the option that is most appropriate for yourself, your employees and your business.

 

 

Important Disclosure Information

Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Lutz Financial), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Lutz Financial.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.  Lutz Financial is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice.  A copy of the Lutz Financial’s current written disclosure statement discussing our advisory services and fees is available upon request.

ABOUT THE AUTHOR

402.827.2300

jvossen@lutzfinancial.com

LINKEDIN

JUSTIN VOSSEN, CFP® + INVESTMENT ADVISER, PRINCIPAL

Justin Vossen is an Investment Adviser and Principal at Lutz Financial with over 20 years of relevant experience. He specializes in wealth management and financial planning.

AREAS OF FOCUS
  • Financial Planning
  • Wealth Management
AFFILIATIONS AND CREDENTIALS
  • Certified Financial Planner™
  • Financial Planning Association, Member
EDUCATIONAL BACKGROUND
  • BSBA in Economics and Finance, Creighton University, Omaha, NE
COMMUNITY SERVICE
  • St. Augustine Indian Mission, Board Member
  • Nebraska Elementary and Secondary School Finance Authority, Board Member
  • St. Patrick's Church, Trustee
  • March of Dimes Nebraska, Past Board Member

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We tap into the vast knowledge and experience within our organization to provide you with monthly content on topics and ideas that drive and challenge your company every day.

HASTINGS

747 N Burlington Avenue, Suite 401

Hastings, NE 68901

P: 402.462.4154

OMAHA

13616 California Street, Suite 300

Omaha, NE 68154

P: 402.496.8800

Toll-Free: 866.577.0780  |  Privacy Policy

All content © Lutz & Company, PC

 

LINCOLN 

601 P Street, Suite 103

Lincoln, NE 68508

P: 531.500.2000

GRAND ISLAND

3320 James Road, Suite 100

Grand Island, NE 68803

P: 308.382.7850