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Taxes for retirees

Turbo Tax

Many financial plans for retirement dangerously ignore income taxes. There are several taxes and penalties for retirees, and you need to incorporate them into your plan so you know what you can and cannot afford to do in a sustainable manner. Below are some items that you need to include in your calculations.

1. Social Security is tax-free only if your adjusted-gross income is less than $32,000 (for a joint tax return). If your adjusted gross income (joint) is between $32,000 and $44,000, then 50% of your social security income is taxed at ordinary income rates. If your adjusted-gross income (joint) is over $44,000, then you pay ordinary income tax on 85% of your social security income.

2. There is an Obamacare 3.8% sur tax for those whose adjusted-gross income is over $250,000 for someone single. This sur tax is for capital gains, selling anything for a profit. Before you say, “that doesn’t apply to my income level,” remember that your income may get some large boosts with: withdrawals from a 401(k) or IRA, or if you are selling a second home, rental property, or business interest.

3. Withdrawing money from qualified retirement accounts before age 59 ½ will result in a 10% tax penalty. Far worse is the 50% tax penalty if you fail to make a minimum required distribution from your IRA once you are age 70 ½.

4. Medicare Part B charges you an increasing amount of money, the higher your adjusted gross income may be. Medicare is deducted from your social security retirement payment. This extra-monthly tax starts at $85,000 for singles of $121.80, and maxes out at $268.00 per month for singles earning over $129,000.

All states have different tax plans that affect retirees. There are several tax-related policies you should be aware of and if they may apply to you:

  • Interest and dividends taxed? Are there any limits?
  • Social security retirement pay taxed?
  • Pension payments taxed? Are there any limits?
  • Military pay or disability pay taxed?
  • Inheritance and Estate Taxes?

It is no surprise that retirees move to another state or location after they retire to reduce their tax burden. I have a retired relative who just purposely moved to a state for their no-income tax policy and it will save him nearly $40,000 every year.

A thorough retirement plan will have all of these tax elements mapped out for your particular circumstances. The alternative is to retire and discover too late that high taxes in your state or type of income is unaffordable, and then you have to go back to work. A neighbor discovered this three years after he retired. He and his wife moved to an expensive city with high property taxes, so he was forced to go back to work. Unfortunately, he is bitter about it and having difficulty with the physical demands of the job.

Avoid long-term care insurance plans

long term insurance

Insurance plans that cover custodial care at a nursing home is a failed business model; and it is now showing up in unaffordable insurance premiums.

First, a little history on long-term care insurance plans. Back in the 80s and 90s, government budgets were struggling with increasing numbers of people on Medicare and Medicaid. One of the most expensive health services is providing full-time care to someone unable to care for themselves. To reduce the number of people receiving money for this care, states tried to offload them by providing favorable terms for insurance companies to offer a new product; called long-term care. This insurance product would financially support people who needed temporary full-time care so the government wouldn’t have to pay for it. As part of the program, Medicare and Medicaid wouldn’t start until all of someone’s assets were fully depleted to pay for their care.

Insurance companies tried setup long-term care policies but there is a problem. Actuarially, the plans could only support people for a maximum of 3 years and remain slightly affordable. While some policy holders needed care for less than three years (where the insurance worked for them), a huge number of policy holders needed many more years of care. So there are lots of people who paid for the insurance, ran through it in 3 years, and still lost all of their savings to pay for their government care. (I mention in my book that you are better off self-insuring for the 3 years that these plans last.) It turns out that insurance companies failed to take into consideration the increasing longevity and increasing cost of health care. These two components have tripled the already-expensive premiums on these insurance policies. Even with these high premiums, insurance companies are still losing billions on these policies and many have abandoned long-term care. Genworth alone loses over $100 million a year on their long-term care policies.

As the math is catching up with insurance companies, consumers are feeling the pinch. Some policies have increased their premiums by over 400% in just 2 years. All of this is because the arithmetic simply does not work for long-term care insurance. The industry is struggling to survive by coming up with hybrid ideas, such as linking it with a life-insurance policy. But until there is a new insurance model that works, my best advice is to self-insure and save the money you would have spent on your long-term care insurance. By doing this, you’ll be way ahead financially because additional premium increases will continue. If you are unable to afford these increases and cancel your policy, then all of the money you’ve paid to keep your policy in force will have been wasted.

Wedding expense dilemmas

wedding cake topper

The average cost of a wedding is $32,000. But there are regional differences: New York City is triple that amount at $90,000, while Idaho and Utah average $16,000. These wedding averages do not include the cost of a wedding ring (average of $5,600) and a honeymoon (average $5,000).

Aside from eloping and skipping it all, what are some ways to reduce the cost of the event?

The venue is normally the largest expense. Having the wedding somewhere free (at someone’s home or a park with a canopy) or a cheaper, non-traditional location (restaurant, museum) will have the biggest impact on a wedding’s budget. Most weddings are on Saturday, so it is cheaper to schedule it on Friday or Sunday. You can also save 15% by scheduling off-season in the Fall or Winter.

  • A Destination Wedding can be cheaper if it is a package deal (with only a few attendees); otherwise it dramatically increases the costs for the couple and all attendees.
  • Reduce the number of guests and bridal party.
  • Hire a DJ instead of a band. Or the cheapest entertainment is an iPod with your own music mix.
  • To reduce food costs, make it a daytime reception, offer a buffet of snacks, such as heavy hors d’oeuvres instead of a full sit-down meal with expensive entrees.
  • Select only a couple flowers that are in season, use a lot of greens, then reuse the bridesmaid’s bouquets into centerpieces at the reception. Cheap but charming centerpieces can be as simple as bowl of fruit or antique mason jars with a ribbon and candle; or hanging votives from branches.
  • If a cash-bar is too tacky, limit the bar choices to only beer and wine instead of a full bar. Or add a signature cocktail with one type of liquor. Have just enough champagne for toasts.
  • Display a small professional wedding cake and then from a back room, supplement with a less-expensive sheet cake to cut up for guests.
  • E-mail save-the-date notifications instead of mailing them, and search how to make do-it-yourself invitations.
  • Shop at second-hand stores for a wedding gown. There are many websites such as OnceWed.com or PreOwnedWeddingDresses.com.
  • Have the ceremony performed by a trusted friend, there are laypeople that can be ordained online to perform the vows (except for the state of Virginia).
  • Only take photos or video of important moments: aisle, vows, kiss, cutting cake, first dance, etc.

Create a target budget that is affordable first, and only then, fill out items within that budget. Remember that a wedding is basically a short ceremony followed by a party lasting a few hours. Do not join the masses that severely overspend on their wedding and find themselves struggling financially for years trying to pay it all off with interest.

Estate planning calamities

Legal cases

The failure to have an estate plan leaves an ongoing calamity for spouses, children, and anyone else relying upon the deceased. It is unbelievable that there are:

  • Parents or spouses without life insurance
  • Elderly without a valid Power of Attorney
  • Spouses without an updated Living Trust, let alone a Will

No one expects to be infirmed or pass away unexpectedly, but these things happen. Acting responsibly means addressing these matters long before they may occur. When estate planning is not addressed there is a long list of unfavorable and predictable consequences. For example, a relative in his 30s died in a car crash. As tragic as that was, it was compounded by having a wife and three children for whom there was no life insurance, who will face financial struggle. Neither did he have a Will or Trust, so his wife needlessly had to pay probate taxes. In another case, a friend’s elderly father unexpectedly experienced dementia. Since he failed to setup a Power of Attorney (let alone a Will), the court had to approve decisions for his care and estate when he passed away. Since there is a girlfriend with no legal standing and an ex-wife, plus children by both, it is now impossible to distribute assets according to his wishes. Instead, the probate court must follow the state’s allocation formula.

It is a cheap and easy task to get legal forms to do your own estate planning. Some employers even provide this as an employee benefit. If you don’t want to do it yourself or your financial life is complicated, the most you’ll pay for a complete plan, with free ongoing support and updates going forward, is $1,200 to $2,500. Without the free ongoing support, an estate plan can with Living Trusts cost as low as $500-$750. Before you dismiss this as an expensive amount of money, know that it will cost somebody many multiples of that to deal with all of the consequences of not having an estate plan in place. But most issues cannot be fixed in any way after the fact, death or mental incapacity.

The rules for guardianship, inherited retirement accounts, and many others are complicated. Don’t allow complications to stop you from doing what needs to be done. Hire experts and get proper documents signed and in-force before they are needed. Update them when circumstances change. Every year there is someone famous that passes away with no estate plan or an out-of-date one that causes havoc and unnecessary taxes for potential heirs. I review everything related to estate planning once a year to determine adjustments for our circumstances now, or in the future. (If you’ve read my book then you know that this also includes a total insurance review and credit rating review). It is my best advice that you do the same, right away.

Minimize your financial ice cubes

ice cubes

One of your most important financial goals is to increase your net worth. Your net worth is defined as your assets minus your liabilities. Your financial stability depends upon increasing your net worth over any time period you care to track it: weekly, monthly, quarterly, or annually.

There are two common ways to increase your net worth:

  1. Pay down debts of any kind
  2. Add to savings, investments, or retirement accounts

If you are already performing these two tasks, that is a good start. From my experience, one of the biggest impediments to increasing your net worth is purchasing what I call, financial ice cubes. These are physical objects that excessively melt with time or use, just like ice cubes on a hot day. When you purchase these items, you are getting something in hand of value for your money. But these are items whose worth devalues with wear or time; faster than you’d expect. When these items are necessities for you, how you purchase them and maintain them can dramatically slow the melting process.

Some sample items that are melting ice cubes include:

Cars, laptops, televisions, recreational vehicles, computers, smartphones, jewelry, tablets, boats, and game consoles. There are many hobbies and sports that require buying ice cubes, for example collecting, hockey, bicycling, hunting, skiing, and any type of racing.

When you purchase these consumables, do you buy them brand new at the highest price or used at a much lower price? Do you pay in cash or buy on credit, paying interest? These ongoing financial decisions will place you on one of two financial paths. One of them has a dramatically higher net worth than the other. Which path are you currently on?

Along with financial ice cubes, another financial mistake that impairs your net worth is failing to consider all of the expenses when you are evaluating whether to rent or own something. For example, my friend bought a financial ice cube. A new Polaris snowmobile for a little over $9,000. I asked him how much it would have cost for a 10-year old model that was similar. He replied around $1,200. I told him this implies that his snowmobile is depreciating by $780 per year ($9,000-$1,200)/10 years. I then asked him how many times he uses it a year. He said at least twice but no more than 4, depending on the snowfall. OK, the $780 divided by 4 is $195 and divided by 2 is $390. So his cost, depending upon whether he uses it 2-4 times a year costs him $195 to $390 per use. However, he could rent a snowmobile for $40 an hour, for a lot less money, and not have to maintain or store it himself. (Of course, he may get a lot of satisfaction putting on aftermarket parts and tinkering with it as a hobby). However, that isn’t always the case and glaring financial mistakes like this can be clarified by doing this simple renting vs. owning financial analysis. For another example, an acquaintance is a pension manager and she was considering buying a vacation home until I slowly went over how it was colossally cheaper and more convenient for her family to rent a place instead.

Day by day, you are making financial decisions that have a dramatic impact on your net worth. How well you approach and evaluate these decisions can make a monumental increase or decrease of your net worth. Please take the time to evaluate them carefully.

Oil industry splits into strong and weak financial hands

oil pump

There is a common analogy used in financial matters about strong and weak hands. A strong-handed player refers to a participant that has deep pockets, conviction, and a sober long-term perspective. Contrarily, a weak-handed player refers to a participant with little or no money, fickle, and a desperate short-term perspective. When you are investing, which participant are you closer to?

When the price of crude oil remained above $100, many in the oil industry became accustomed to that high price. Starting 18-months ago, oil plummeted with increased production from fracking and recently touched $26 a barrel. The longer the price of crude oil remains under $40, the more oil companies will struggle when their business plan and loans require oil to be over $80 just to break-even.

As the price of oil has fallen, there have been 67 weak-handed oil companies that have gone bankrupt, and 150 more that cannot service their debts for much longer. Meanwhile, there are some strong-handed companies making preparations to buy competitors at low prices. First, Exxon-Mobil raised $12 billion in a bond sale to purchase competitors. Those oil firms with lots of debt and high costs will be weak-handed in those negotiations. Exxon also did this a few years ago when extraordinarily low natural gas prices imperiled many companies in that industry, and bought them up cheap. Marathon Oil has raised $7.5 billion in the last two months to both safeguard their credit rating and position themselves to acquire rivals. Hess Corp. also raised money this year for the same reasons. One successful shale-oil executive issued the largest IPO this year: $450 million on his plan to purchase bargains in the oil industry with his new company, Silver Run Acquisition Corp.

This pattern recurs in every industry as business cycles and price trends rise and fall. The strong vs. weak hands is an important question in many areas: how would you rate your employer? How would you rate your investments? How would you rate yourself as an investor? In any way that you can, you want to become a strong-handed investor and work for strong-handed employers that will continue to thrive in any kind of market environment.

Politicians bemoan sovereign competition

burger king patch

The reality for anyone opening or operating a business is to evaluate locating it where you get the best sovereignty services. This is referring to how that area is governed by both local and national authorities. Some considerations include:

  • Is crime or corruption high or low?
  • Which does the government respect more: protecting liberty or its own control?
  • Is there a high or low level of excessive regulations?
  • Is there a high or low level of government debt and mismanagement?
  • And finally, are taxes high or rising, or are they low or falling?

Taxes are a very big consideration when there is a large gap among different sovereign areas. This is because the companies operating in a high-tax locale cannot compete against a similar company that is domiciled in a low-tax locale. The low-taxed company will continually have more money available for: research, product development, marketing, higher salaries and benefits to attract better workers, buying higher quality raw materials, accessing lower loan rates, and many other reasons. Each year this financial gap will continue to benefit the lower-taxed company and punish the higher-taxed company.

In this way, there is an easy allegory for locating your business in a high-taxed country, state, or city; and that is entering a running competition. In this case, you are the only competitor in the race that must drag a 50-pound weight the entire time. What is your chance of ever winning a race with this limitation? Zero. And each day is a new race for business customers so that your company can thrive.

When companies realize that they are competitively hindered from tax disparities, they relocate to survive. There are countless examples of both individuals and companies relocating when a U.S. city or state raises their tax rates. For a long time now the U.S. has the highest corporate-tax rate in the world, 39.1% while the average for industrialized nations is only 25%.

In order to remain globally competitive, companies have been ex-patriating from the U.S. to more favorable tax locales for years. Whenever a high-profile company leaves the U.S., Washington politicians impose more penalties and regulations that prevent additional companies from leaving. Passing a law that imprisons companies is easier to do than the hard work of making your country more competitive with reasonable tax rates. But imprisoning a company is also self-defeating in the long term because the business will choose to expand overseas where it is treated better, and not here.

One of the last ways that a public company can ex-patriate to a country with more favorable treatment is called a “tax inversion.” This is when a U.S. company merges with a foreign company located in a country with lower corporate taxes, and re-incorporates in that country. Several large companies that you may recognize have done this: Burger King, Sara Lee, Fruit of the Loom, Seagate, and Pfizer. The latest big company that used an inversion to flee high taxes is Johnson Controls. They are a $23 billion dollar automotive-manufacturing company and they will save $150 million – each and every year going forward – by moving to Ireland.

Politicians call moving your corporate domicile an “unpatriotic-tax dodge.” But I view these companies as welcomed heroes that are helping to put pressure on lazy politicians to actually get to work and focus them on completing the correct task: To make the U.S. the most attractive location to domicile any business by every quality metric; which includes a reasonable tax structure for both individuals and corporations. Plus, everyone with these inversion stocks in their portfolios (which is likely to be anyone with a pension or stock fund) will receive permanent financial gains.

What does financial capability mean?

lottery scratch offs

The majority of people that win lottery jackpots are financially worse off in only 5 years, than if they hadn’t won any money. How is that even possible? The normal path for lottery winners is: spending too much money and then borrowing an increasing amount of debt until it is unaffordable, and then they are insolvent. In my opinion, the primary reason they end up worse off is that: your net worth cannot exceed your financial capability for very long.

What determines your personal financial capability?

Your behavior and goals toward money. For example, the current balance of your savings account, investment account, and debts reflect your former financial capability. How these balances change during this month reflects your current financial capability. Are you someone that can save money? What percentage of your income can you consistently direct toward savings? Do you consistently make poor investments that fall in value? What percentage of your income can you consistently direct toward paying down your debts? In this way, your financial statements reflect your financial capability in black and white. This is why lenders and potential financial partners want to know your credit rating and the state of your finances.

When you have savings, does it never go beyond a certain plateau because you end up spending it? I know people that are continually shopping for homes, cars, boats, handbags, or antiques. I am not surprised when they show off their latest acquisition because it is their hobby and passion. For some of these people, their shopping hobby is beyond their financial means and is killing their potential saving and investment account balances. Their financial capability is simply unable to move beyond a certain level of savings.

Capability also applies to debts, some people always find a way to be in debt. When their debts shrink, they find reasons to rack up more debts. For example, a friend’s boss always has $300 cash in his wallet. But he can never save $300, so he has to borrow it from his bank. Each month, he pays the interest to keep the $300 in his wallet. It may sounds insane to you and I, but that is simply his level of financial capability. He does not yet have a motivation to begin saving, let alone a philosophy to support building a permanent habit of saving money.

To make the point more obvious, handing someone money that is beyond their financial capability is exactly like handing a 4-year old a loaded gun. The 4-year old does not understand the intrinsic danger of the gun, has no firearm-safety training, and is highly likely to cause accidental damage by shooting something. This is my analogy for lottery winners and how they end up financially worse off: they had a low financial capability and did not improve upon it. The new money was more than they could handle and so they lost it all, and then some. And that is how they end-up financially worse off after winning.

You can easily determine your financial capability by looking at your finances month to month. Are they consistently improving or deteriorating? Have they plateaued or making steady improvement? Now, you have a choice to make: Are you willing to improve your financial capability or leave it to happenstance? Are you willing to confront and shore up your weaknesses or let them destroy your finances?

U.S. Social Security trust has begun its decline

social security - 2029

The U.S. social security system is a trust fund for retirees once they reach an eligible age. Since its inception, the program has been expanded to cover additional people who do not pay in (such as spouses, ex-spouses, children, and others). This expansion of recipients, combined with unfavorable demographics, and the entire program has become financially unsustainable. The Social Security Administration periodically projects when it will become insolvent. Just 25 years ago, the insolvency date was way past 2070. But every 5 or 10 years, this insolvency date is moved earlier than expected with their latest projected insolvency date being as soon as 2029. That is just 13 years from now.

Along with projections of insolvency, there are groups and famous economists claiming the opposite, that social security will never face decline. The only small adjustment that needs to be made is to remove the income cap so high earners will pay social security tax on all of their income, and in addition, reduce the payout to high earners, then the program will be fine. It is my opinion that these optimistic theories are incorrect, they haven’t examined the arithmetic.

In 2010, social security started paying out more in benefits than is was taking in, part of the coming demographic of a surge of retiring Baby-Boomers. The trust’s assets receive interest income, but in 2015, it was no longer enough to cover net payments and the trust had its first reduction in value, $3 billion in 2015. But this loss of value wasn’t expected to occur for several more years. Every projection of insolvency moves closer in time, not further out in time. This is because the Social Security Administration, like all government forecasts, use impossibly unrealistic outlooks of economic growth and employment that never come to pass.

All of the surpluses that social security accrued for decades will be gone by 2029. Unless benefits are reduced by 29%, the only option is to borrow more money or print more money. Neither of these options are sustainable for long periods. The federal government has already begun reducing social security benefits. They do this by artificially reducing the cost-of-living adjustment that is made once a year. The government takes the inflation rate, then removes any item with high inflation, replaces any item with medium inflation, and so only low or no-inflation items remain. One of the reasons that the official inflation data are manipulated is so that there are small annual payment increases for a host of government payments and debts, including anyone on social security.

My best advice is to not be lulled into a false sense of security – that you’ll be receiving your full-expected social security payment. Provide your own retirement funding through saving and investing so that you don’t have to worry about whether social security benefits will be reduced.

(Part 2 of 2) The unintended consequences of negative interest rates

negative interest rates

When a central bank imposes negative interest rates on the banking system, the theory is that it makes banks more willing to lend money and bank accounts become less desirable as a location for money. A negative interest rate is actually a tax and everyone avoids taxes, if they are able. The central bank hopes that the tax will prompt people to spend money instead of holding or saving it in a bank. While this may occur, it also prompts other activities, unintended consequences, which counter the central bank’s goal of stimulating the economy with new spending.

Just a few unintended consequences that I can think of include:

  1. Banks become disintermediated in the economy as people close accounts, use more cash for transactions instead of credit cards, and seek alternatives to bank accounts to store their money. Again, even this is problematic because the U.S. is a $17 trillion economy with only $850 billion in actual paper currency. The financial system is an upside-down pyramid resting on a tiny portion of actual cash, the rest is digital. If everyone went to the bank to withdraw their money, few people could walk away with cash. When this recently happened in Argentina, Greece, Cyprus, and others, people panic and hoard cash. Again, this is the opposite of the intention of negative interest rates. To reduce or eliminate cash transactions today, many countries are also imposing low limits on allowable cash transactions (France €1,000; Spain €2,500; Italy €1,000; Uruguay $5,000; Greece still limits how much cash you can withdraw from a bank; Denmark, Sweden, and Israel want to phase-out cash altogether; U.S. banks report cash transactions over $5,000 to regulators; Chase Bank now prohibits cash in their Safe Deposit Boxes).
  1. If the flight from bank accounts grows large enough, then this would erode banks’ capital, forcing them to sell loans to increase their capital reserve balance. This could stress the banking system, similar to how the subprime loan crisis began in 2008.
  1. Where will money land that is withdrawn from the banking system? In my opinion, it will likely go to the same place where excess liquidity has gone since 2008: the U.S. stock market, U.S. real estate, and for the wealthy, expensive trophy collectibles. These three are likely in price bubbles already and these bubbles would be exacerbated by negative interest rates.
  1. Retirement plans are ruined. When bonds and savings accounts pay closer to 0% instead of 6%, you have to save a whole lot more money to grow your retirement balances up to their target level. So people are forced to save more instead of spend more to spur the economy. When safe and stable investments pay next to nothing, it also forces everyone to become a speculator in order to earn any return on their money. Speculating is a difficult business for professionals, let alone amateurs. I predict that mass speculation is unlikely to turn out well for retirement account balances.
  1. Aside from the U.S. dollar, the world’s reserve currency, many currencies have been debased by various forms of quantitative easing. These currencies become more impaired the more negative that interest rates become. There is a risk that the U.S. dollar will also become an impaired currency as well; as printing money and borrowing more money has been unable to stimulate its weak economy since 2008.
  1. Negative interest rates are also likely to create two other inversions. First, the interest-rate yield curve, which normally slopes upward further out in time, may flatten or invert so investors will avoid long-term bonds. The second is commodity contango, referring to the spot price is normally lower than the futures price and this may flip into backwardation, where the futures price is abnormally lower than the spot price. This could create many usual effects, one of which is that commodity ETF’s would likely have automatic losses and move down even though the spot price of their commodity hasn’t moved.

Today, around 20% of the world’s economies have negative interest rates. Canada and other countries in economic struggle are considering joining them. The U.S. has held interest rates near zero for 8 years to jump-start its economy, but that has not worked. So it is likely that negative interest rates could be tried in the U.S. as well. As proof, the Federal Reserve’s latest stress test guidelines in January 2016 included for the first time: negative yields on short-term U.S. Treasuries.

If negative interest rates are introduced by the U.S. Federal Reserve, then my best advice is to consider:

  • Holding a few months of expenses worth of cash outside of the banking system. It is better to be early and prepared than late on a short-term run on cash.
  • Be nimble with stock market and real estate investments. While these assets will move up in price initially, be ready to exit or at least hedge if they begin a sustained fall.
  • If financial assets get into trouble simultaneously (the U.S. dollar, stocks, and bonds), then consider placing some money into hard assets such as precious metals to offset the decline in paper assets.

 

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