Bob Klein’s article, Finance Long-Term Care for 10 Years was published in The Street’s Retirement Daily. Discover the benefits of a limited-pay long-term care plan.
Author: Robert Klein
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.
Bob Klein’s article, Stock Market Window of Opportunity was published in The Street’s Retirement Daily. How do staged Roth IRA conversion plans help you benefit from a stock market decline?.
It’s no secret that I’m a huge fan of fixed annuities as part of a retirement income plan. The purpose of including fixed annuities in a retirement income plan is to reduce the risk of your investment portfolio. Two features of fixed annuities that have traditionally made them a preferred investment choice when compared to similar-duration CDs are higher interest rates and tax-deferred growth.
There are two types of fixed annuities that can be used to reduce investment portfolio risk: fixed income annuities and fixed index annuities. This article will discuss how fixed index annuities can be used to reduce stock market risk.
What is a Fixed Index Annuity?
A fixed index annuity, or FIA, is a fixed annuity that offers a minimum guaranteed interest rate and potential for higher earnings than traditional fixed annuities based on the performance of one or more stock market indexes. FIAs can include lifetime income either with a minimum guaranteed withdrawal benefit (“MGWB”) or an optional income rider. Issue ages for most FIAs are 0 to 80 or 85.
There are two types of FIAs – single premium and flexible premium. A single premium FIA is a one-time investment whereas a flexible premium FIA allows for ongoing additions. Some insurance carriers place annual limits on the amount of premiums that can be added to their flexible premium FIAs.
When you purchase a FIA, you’re given the opportunity to allocate your initial premium between a fixed account and one or more indexing strategies. You can typically change your allocation during a 30-day window prior to each contract anniversary. The fixed account pays a fixed rate of return that currently ranges between 1% and 2%, depending upon the FIA.
Indexing strategies earn interest based on the performance of a defined stock market index, with the Standard & Poor’s 500 Index being the most popular offering. The measuring period for most indexing strategies is one year, however, two-year strategies are also available.
Fixed index annuities are subject to a declining surrender charge schedule that’s standard in all deferred annuities and is generally five to ten years. FIAs are meant to be held for the long term. Surrender charges help insurance carriers invest in longer-term bonds with higher yields and to recover initial fixed costs for setting up the contract. They also help actuaries price their deferred annuity products efficiently.
The majority of FIAs allow free withdrawals of up to 10% of the contract value or the initial premium beginning in the first or second year. Surrender charges apply only to excess withdrawals.
Losses are Eliminated and Positive Returns are Limited with a Fixed Index Annuity
Unlike a direct investment in an index where you participate in gains as well as losses, there are two basic differences when you allocate funds to an indexing strategy within a FIA:
- If the index’s return is negative, no loss is posted to your account.
- If the index’s return is positive, interest is credited to your account subject to a cap.
With a FIA, you don’t participate in losses. This is sometimes referred to as the “power of zero.” You also don’t participate in gains to the extent that the performance of a particular indexing strategy exceeds that of a defined cap.
FIA Indexing Strategy Examples
I will illustrate how FIA interest crediting works with some examples. Let’s assume that you invest $100,000 in a FIA and one of the indexing strategies that you choose is the S&P 500 one-year point-to-point strategy with a cap of 4%. Here are three different scenarios that occur during the first three contract years:
Year #1 – Return = 3%
Since the return is positive and it’s less than the cap of 4%, you’re credited with 3%, or $3,000, increasing your FIA account value to $103,000.
Year #2 – Return = 9%
Once again the return is positive, however, it exceeds the cap of 4%, therefore, you’re credited with 4%, or $4,120, increasing your FIA account value to $107,120. Although this is $5,150 less than the value of $112,270 through a direct investment in the S&P 500 Index, this needs to be balanced against the potential for loss.
Year #3 – Return = -12%
Since the return is negative, no interest is credited and you maintained your FIA account value at $107,120. Had you invested directly in the S&P 500 index instead of using a FIA indexing strategy, you would have realized a loss of $13,472, reducing your investment value to $98,798.
Gains are Retained with a Fixed Index Annuity
Unlike other types of investments, FIAs are unaffected by stock market declines. Although gains from increases in indexing strategies are limited by cap rates, they’re locked in.
The ability to shelter gains from subsequent losses isn’t available with most other types of equity investments. This benefit can be especially important for retired individuals who don’t have a long-time horizon to recover from sizable stock market losses.
The best way to illustrate this is with a multi-year example comparing an investment in the S&P 500 Index with a fixed index annuity S&P 500 indexing strategy for the duration of retirement using the following five assumptions:
- Investment of $1 million at age 65
- Annual withdrawals of $50,000 from age 65 to 90
- Annual rates of return per the “Return” column
- S&P 500 one-year point-to-point strategy with a cap of 4% and 7-year declining surrender charge schedule
- Free annual withdrawals of 10% of the contract value in the first 7 years
There’s “good news, bad news” for the S&P 500 Index investment. The good news is that it participates in 100% of the positive year returns. This includes nine years when returns are 10% or greater and 20 out of 21 years when the returns exceed the FIA S&P 500 indexing strategy annual cap of 4%.
The bad news for the S&P 500 Index investment is that it participates in 100% of the negative year returns. While there are only five negative return years, three of which are single-digit, the first three years are all negative returns: 18%, 12%, and 3%, respectively. This results in a decrease in value from $1 million at age 65 to $574,000 at age 67. After a one-year uptick to $608,000, the value of the S&P 500 Index declines until it reaches $0 at age 88 after a final withdrawal of $14,000.
The fixed index annuity S&P 500 indexing strategy is the winner. Although annual returns are limited to 4%, which is less than the S&P 500 index returns in 20 out of 21 positive return years, interest crediting of 0% in the five negative S&P 500 years preserves the FIA S&P 500 indexing strategy value for the duration of retirement without reduction for losses.
There’s a total net increase in value of $385,000 with the FIA S&P 500 indexing strategy, or $221,000 greater than the S&P 500 Index total of $164,000. This results in total withdrawals of $1.3 million or $136,000 more than the S&P 500 Index. Furthermore, values of the FIA S&P 500 indexing strategy exceed those of the S&P 500 index each and every year by $85,000 to as much as $276,000.
Conclusion
Defensive investment and protection strategies are the key to the success of a retirement income plan. Just like a HECM mortgage strategy can be used to protect against sequence of returns risk, fixed index annuities can provide a buffer against stock market risk. Both strategies are timely given the current 12+-year bull market.
If you don’t want exposure to losses with a potential decrease in available investments to draw upon throughout retirement, are unsatisfied with taxable CD rates, and are seeking tax-deferred growth with an opportunity to participate in the upside potential of the stock market, then you may want to consider diversifying into one or more fixed index annuities.
So here you are, crossing the threshold from earning a living to entering retirement. You worked hard for many years. You accumulated a sizeable, diversified investment portfolio. You purchased deferred income annuities to provide you with sustainable lifetime income. You hedged your bet with life insurance and long-term care insurance. Your will and other estate planning documents have been updated to reflect your current financial situation and goals. Everything’s in place for a financially successful retirement – or so you think.
Sequence of Returns Risk
What could possibly go wrong? Flashback to October, 2007 to March, 2009. After doubling in value from 7,200 to 14,200 in the five-year period beginning October 10, 2002 through October 11, 2007, the Dow Jones Industrial Average (DJIA) plummeted 7,700 points, or 54%, in just 17 months to a low of 6,500 on March 6, 2009.
Welcome to sequence of returns risk. They say there’s no greater teacher than first-hand experience. If you retired during those tumultuous 17 months and weren’t familiar with this dreaded investment risk, you were quickly immersed.
Sequence of returns risk is unique to the decumulation, or distribution, stage of retirement. The order of investment returns during this stage has an impact on how long a portfolio will last, especially if a fixed amount is being withdrawn. Negative returns in the first few years of retirement, if not protected, can significantly increase the possibility of portfolio depletion.
This article is particularly timely given the fact that the DJIA, which was at 35,600 when it was written, or about 1,000 points less than its November 8th record high of 36,565, is up over 29,000 points, or 448%, from its low of 6,500 on March 6, 2009. This translates to an average annualized return of 35%. Furthermore, there have been only two small down years since 2008: 2.2% in 2015 and 5.6% in 2018.
Three Sequence of Returns Risk Hypothetical Scenarios
Let’s illustrate sequence of returns risk with an example using three hypothetical scenarios, each of which includes the following five assumptions:
- Retirement age: 65
- Life expectancy: age 90
- Initial portfolio value: $1 million
- Annual withdrawals: 5% of the initial portfolio value, or $50,000, increasing by 3% each year
- Average rate of return: 7%
Please keep in mind that none of the scenarios considers the investment account type, i.e., non-retirement, Roth, or taxable retirement, nor potential federal and state income tax liability associated with taxable investment income, realized gains, and distributions from the account.
Scenario #1 – 7% Return Each Year
Although a scenario with the same rate of return each year throughout retirement never occurs in real life, it’s often used for illustration purposes. After taking withdrawals of $50,000 in the first year of retirement that more than double to $105,000 in the final year, the portfolio in Scenario #1 remains intact, decreasing from a value of $1 million at age 65 to $924,000 at age 90.
Scenario #2 – Good Early Years
The positive returns during the first 12 years, most of which are double-digit, enable the portfolio in Scenario #2 to increase in value from $1 million to almost $3 million at age 87 before three consecutive negative years reduce it to $1.8 million at age 90. This is double the value of $924,000 in Scenario #1 despite the fact that the average rate of return during the same period is identical, i.e., 7%.
Scenario #3 – Bad Early Years
Scenario #3 reverses the order of investment returns in Scenario #2, with negative returns of 18%, 12%, and 3% in the first three years, respectively. This reduces the portfolio value by $430,000, or 43%, going from $1 million to $570,000 in just three years at age 67. Despite the fact that the investment return in 12 of the next 14 years is positive and the average return from age 65 to 81 is a respectable 5%, the portfolio is depleted at age 81. Once again, the average rate of return is 7%.
Potential Solution – Maintain Withdrawals of $50,000 in All Years
In hindsight, the longevity of the investment portfolio in Scenario #3 could have been extended, and depletion avoided, had withdrawals not increased by 3% each year and simply remained at $50,000 for the duration of retirement. This is illustrated in Scenario #4 – Bad Early Years with Withdrawals of $50,000 Each Year.
The downside of Scenario #4 is the loss of purchasing power due to inflation. Assuming average annual inflation of 3%, purchasing power of the age 65 withdrawal of $50,000 is reduced by $27,000, or 54%, to $23,000 at age 90.
Scenario #4 is far from a perfect solution in real life. Assuming that it’s necessary to increase annual withdrawals by 3% each year to maintain the individual’s lifestyle, other sources of income would be required to support her financial needs. This might necessitate the sale of her house, assuming she is a homeowner, and associated downsizing.
Not to mention the fact that portfolio depletion could still occur if the individual lives past age 90. This is more likely if investment returns are unfavorable in one or more of those years or if she experiences an uninsured or underinsured long term care event.
HECM Reverse Mortgage – Insurance for Sequence of Returns Risk
A proactive planning solution that can be used strategically by homeowners beginning at age 62 to insure against sequence of returns risk is a home equity conversion mortgage, otherwise known as a HECM reverse mortgage. I recommend that you read Not Your Father’s Reverse Mortgage to familiarize yourself with HECMs and 5 Key Financial Metrics When Evaluating a HECM Reverse Mortgage to learn about an objective process for analyzing a HECM in any situation.
While there are several potential strategic uses of a HECM, one of the most, if not the most, important is to insure against sequence of returns risk. This is due to the fact that sequence of returns risk, by definition, is applicable to the first few years of retirement. The risk of portfolio depletion, if not protected, can increase significantly in the event that negative returns are experienced during this critical period.
How a HECM Reverse Mortgage Can Insure Against Sequence of Returns Risk
The best way to illustrate how a HECM reverse mortgage can insure against sequence of returns risk is with an example. In addition to the five assumptions used in Scenarios #1, #2, and #3, Scenario #5 – Bad Early Years with HECM Mortgage includes the following 13 assumptions:
- Apply for HECM at age 62.
- No mortgage when applying for HECM mortgage.
- Appraised home value of $1 million with assumed annual appreciation of 4%.
- HECM mortgage of 48.64% of the maximum 2021 FHA claim, or insurable, amount of $822,375, or $400,000, is approved.
- Initial mortgage insurance premium of 2% of $822,375, or $16,448.
- Initial loan amount is $25,000, which is equal to the total closing costs, including mortgage insurance premium of $16,448, origination fee of $6,000, and other closing costs totaling $2,552.
- HECM mortgage variable interest rate of 3.5% with a ceiling of 8.5%.
- Interest rate of 3.5% remains unchanged for the life of the loan.
- Annual mortgage insurance premium of 0.5% of the outstanding balance.
- No payments made on the HECM mortgage.
- Initial credit line of $375,000 (approved mortgage of $400,000 less initial loan amount of $25,000).
- Credit line variable interest rate of 3.5% with a ceiling of 8.5%.
- 100% of all withdrawals are taken from the credit line in years in which the investment account return is negative.
Per Scenario #5, withdrawals totaling $154,545 are taken from the HECM credit line instead of from the investment account from age 65 through age 67 when returns are -18%, -12%, and -3%, respectively. Withdrawals of $61,494 and $73,427 are also taken from the HECM credit line at age 72 and 78, respectively, when returns are -2% and -6%. Withdrawals from the HECM credit line total $289,465.
The strategy of taking tax-free withdrawals from the HECM credit line instead of the investment account in negative years results in the preservation of the investment account for the life of the plan. The effectiveness of this strategy in this scenario is supported by the following additional facts:
- The strategic withdrawals from the HECM credit line totaling $289,000 during the five negative return years, including $155,000 in the first three years, enabled the investment account to sustain itself for the duration of the plan.
- Whereas 100% of the HECM credit line withdrawals totaling $289,000 were tax-free, the investment account withdrawals during the same period in the non-HECM plan were fully taxable as ordinary income assuming a non-Roth retirement investment account and were potentially taxable as capital gains in a non-retirement account.
- The HECM credit line resulted in withdrawals from the investment account and credit line totaling $1.927 million ($1.638 million from the investment account plus $289,000 from the HECM credit line), or $845,000 more than the total withdrawals of $1.082 million in the non-HECM plan in Scenario #3.
- The investment account value in the HECM plan was $586,000 when the non-HECM investment account was depleted at age 81.
- The investment account value in the HECM plan was $110,000 at age 90.
- Despite the fact that withdrawals from the HECM credit line totaled $289,000, the credit line, which had a balance of $375,000 at age 62, increased to $419,000 at age 90.
- The combined balance of the investment account of $110,000 and HECM credit line of $419,000 resulted in total liquidity of $529,000 at age 90.
Cost of HECM Mortgage
The foregoing benefits associated with the HECM plan did not occur without cost. Obtaining insurance against sequence of returns risk and associated depletion of the investment portfolio came at a cost of $742,000, which was the amount of the HECM mortgage balance at age 90.
The HECM plan cost of $742,000 was well worth it when you consider the fact that the investment portfolio was intact at age 90 vs. depleted at age 81 in Scenario #3. Four other factors supporting the HECM strategy are as follows:
- Additional withdrawals of $845,000, $289,000 of which was tax-free.
- Liquidity of $529,000 at age 90.
- $419,000 of liquidity was in the HECM credit line which could have been used strategically for other purposes, including paying for long term care needs.
- Appreciation of the house of $2.119 million (value of $3.119 million at age 90 less $1 million at age 65) exceeds the mortgage balance of $742,000 by $1.377 million.
Two essential keys to this successful outcome include the fact that the HECM mortgage was obtained at age 62, the first year of eligibility, and there was no existing mortgage balance. This accomplished two things: (a) maximization of the HECM credit line and (b) minimization of the HECM mortgage balance.
Conclusion
Negative returns in the first few years of retirement, if not protected from sequence of returns risk, can significantly increase the possibility of premature portfolio depletion. A HECM mortgage, with its accompanying credit line, provides tax-free liquidity during this critical period to insure against this risk in lieu of taking potentially taxable distributions from an investment account that’s declining in value.
The proposed strategy enables you to ride out the storm whenever there are downturns in the market. It protects you from the temptation to sell when the market is on its way down and attempting to time the market when buying back in, both of which are generally losing propositions. All of this translates to peace of mind during the most critical stage of retirement, i.e., the first few years, that can last for the duration of retirement with proper planning.
Bob Klein’s article, Three Ways to Minimize Required Minimum Distributions, was published in The Street’s Retirement Daily. Short of not making contributions to a qualified retirement plan, there are three ways to minimize required minimum distributions.
When you contemplate your life, you can usually pinpoint pivotal moments that changed the trajectory of who you are today. Often times, there are one or more magical moments that you will never forget.
In the retirement planning world, age 62 is that moment. Until then, you accumulate assets for some unspecified future date when you will transition from working full time to perhaps part time, and then, in most cases, fully retire. Your primary source of income, i.e., employment, will eventually come to a grinding halt.
Beginning at age 62, several things will begin to quickly unfold that will require you to change your retirement planning mindset from asset to income accumulation. You will need to figure out how to convert the assets that you worked hard to save into a predictable income stream beginning on a specified date, or within a range of dates, that will enable you to match your projected financial needs in retirement. Furthermore, you will need to develop various strategies for creating after-tax retirement income in order to optimize the longevity of your assets for the rest of your life. Needless to say, this is no small task.
This article provides an overview of six proven strategies that can be implemented beginning at age 62 that are at the core of the transition from retirement asset to retirement income planning. Strategies #4 and #5 should be considered before age 62 whenever possible and strategy #6 when applicable. Most important, all potential strategies should be evaluated as part of a holistic retirement income plan.
Strategy #1: Defer Social Security Start Date
You can start your Social Security retirement benefits as early as age 62 or as late as age 70. Unless you’re no longer working and have no other sources of income or you have a life-threatening illness, it generally isn’t advisable to start receiving Social Security at age 62. This is due to the fact that benefits may be 30 percent less than what they would be at your full retirement age which is between 66 and 67 depending upon the year you were born.
Your Social Security benefits will increase by 8% per year plus cost-of-living adjustments for each year that you defer your start date between full retirement age and age 70. Social Security can be used to insure your, and, if married, your spouse’s longevity risk.
The decision regarding when to begin receiving Social Security retirement benefits should be carefully analyzed, especially if you’re married. In addition to locking in the amount of your benefit, you are also potentially establishing the amount of your spouse’s monthly payment in the event that you die first.
Strategy #2: Gain Unrestricted Access to Home Equity
As discussed in my 5 Key Financial Metrics When Evaluating a HECM Reverse Mortgage article, housing wealth, although it represents about one half of an average household’s net worth, is often ignored as a retirement income planning tool. There are numerous strategies that can be used to provide readily available tax-free liquidity to pay for planned and unforeseen expenses throughout retirement by monetizing a portion of the equity in one’s home.
Several of the strategies can be used in conjunction with home equity conversion mortgages, or HECMs, the most popular reverse mortgage program. You can qualify for a HECM beginning at age 62. All homeowners age 62 or older with or without a mortgage should evaluate a potential HECM for its ability to provide unrestricted access to an increasing tax-free line of credit without the downsides of a home equity line of credit, or HELOC.
When implemented early and used strategically to unlock illiquid home equity, a HECM reverse mortgage can be used to increase after-tax cash flow at opportune times throughout retirement while providing peace of mind.
Strategy #3: Reduce Medicare Part B and D Premiums
Medicare Part B and D premiums are determined using modified adjusted gross income (MAGI) from your federal income tax return two years prior to the current year. Assuming you enroll in Medicare when you become eligible at age 65, your MAGI from two years prior, or age 63, will determine your Medicare premiums at 65. 2021 Medicare Part B monthly premiums range from $148.50 to $504.90 per person depending upon tax filing status and 2019 MAGI
Medicare Part B and D premium planning should begin at age 62 when you’re one year away from having your income determine your premiums when you turn 65. You should incorporate the Medicare income brackets into your income tax projections every year for the rest of your life to determine the amount of your projected Medicare Part B and D monthly premiums. Using this information, you can develop strategies to reduce your projected MAGI and associated premiums.
You need to always keep in mind when planning Medicare premium reduction strategies that it’s a year-by-year proposition given the fact that premiums are determined using your MAGI from two years prior to the current year. If your income in a particular year is projected to experience an unusual spike that’s attributable to a one-time or infrequent event that will otherwise optimize your projected after-tax retirement income for several years, it will usually make sense to pay the increased Medicare Part B and D premiums in that year. Examples include a sizable strategic or market-sensitive Roth IRA conversion or an unusual increase in a business owner’s income that will enable a larger qualified business income (QBI) deduction that will result in a large amount of income tax savings.
Strategy #4: Roth IRA Conversion Window of Opportunity
A multi-year, or staged, Roth IRA conversion strategy is a great example of a retirement income planning technique that should ideally be implemented beginning 20 years before retirement. A ten-year window of opportunity begins at age 62 for doing a Roth IRA conversion, creating a greater sense of urgency for implementing this strategy. This corresponds to the ten years prior to the age 72 commencement of lifetime annual required minimum distributions, or RMDs, from retirement plans.
Roth IRA conversions beginning at age 62 will reduce your annual RMDs for the rest of your life. This can, in turn, potentially reduce your annual taxable income, Medicare Part B and D premiums, taxable Social Security benefits, and net investment income tax. To the extent that this occurs, this will increase after-tax retirement income and contribute to the overall goal of optimizing asset longevity. Reduced RMDs also reduce the survivor’s exposure to the widow(er)’s income tax penalty for couples.
Reduced RMDs can also reduce the value of taxable retirement plan accounts at death and, in turn, reduce taxable income for non-spouse beneficiaries. Given the fact that most non-spouse beneficiaries are subject to a 10-year payout rule for taking distributions from retirement plans and IRA accounts, a reduction in the value of taxable accounts will often result in less tax liability for children and other non-spouse beneficiaries.
Per Strategy #3, taxable income from Roth IRA conversions needs to be balanced against potential higher Medicare Part B and D premiums beginning at age 63. The reduction in RMDs and associated lifetime income tax savings beginning at age 72 can more than offset increased Medicare Part B and D premiums between age 63 and 72 if done strategically.
Strategy #5: Lock in Sustainable and Potentially Tax-Favored Lifetime Income
The fifth strategy – locking in sustainable and potentially tax-favored lifetime income, has gained in popularity as a result of the virtual demise of corporate pension plans. Besides Social Security, opportunities for receiving a sustainable lifetime income stream with built-in longevity insurance to reduce the risks associated with the stock market have dwindled in the private sector.
Immediate and deferred fixed income annuities are a natural fit for filling this gap in a holistic retirement income plan beginning at any age. Purchase of fixed income annuities takes on more urgency at age 62 due to the fact that the income start date for the majority of fixed income annuities will occur by age 72, leaving less time for deferred growth and increased lifetime income. The income start date is subject to the RMD rules when purchases are made from qualified accounts and traditional IRAs.
Income optimization is the appropriate benchmark that should be used when evaluating fixed income annuities for inclusion in a retirement income plan. The goal is to design a comprehensive strategy that uses the least amount of assets to purchase the greatest amount of sustainable after-tax lifetime income that’s projected to pay for expenses not covered by Social Security, pensions, and distributions from investment and other assets.
Fixed income annuities come in three flavors: single premium immediate annuities (SPIAs), deferred income annuities (DIAs), and fixed index annuities (FIAs) with income riders. SPIAs and DIAs enjoy a unique income tax advantage when purchased in a nonqualified, or nonretirement account.
Unlike FIAs with income riders that distribute ordinary income that’s fully taxable, SPIAs and DIAs are annuitized. Periodic payments include income and a return of premium, or investment. When held in a nonqualified account, the return of premium portion of each payment, which can be 50% or greater, is nontaxable. Once 100% of one’s investment has been received, future payments are fully taxable.
Strategy #6: Achieve Sizable Tax Savings and Tax-Favored Lifetime Income When Selling Highly Appreciated Nonretirement Assets
The sixth strategy, although it can be used by anyone at any time, tends to be implemented by individuals in their 60’s. Generally speaking, they’re the ones with highly appreciated nonretirement assets who are looking for a tax-favored lifetime income exit plan. This includes real estate, investment securities, and businesses.
This strategy is designed to reduce or eliminate income tax liability attributable to the capital gain that owners will realize from the sale of the highly appreciated asset by transferring a portion, or all, of the ownership of the asset from one or more individuals to a charitable remainder trust, or CRT, prior to the sale while providing tax-favored lifetime income. A CRT, which is a tax-exempt trust, is a long-standing IRS-blessed strategy when properly structured.
There are six benefits associated with a CRT:
- The capital gain on the sale of assets owned by a CRT is exempt from taxation.
- CRT funding creates a sizable income tax deduction equal to the projected remainder interest of the CRT that will eventually pass to one or more charities.
- The proceeds from the sale of CRT assets can be reinvested to provide a lifetime income stream for the beneficiaries.
- Most of a CRT’s annual income will be taxed at favorable long-term capital gains tax rates.
- A CRT is an excellent philanthropic tool since the remainder interest of the assets will be distributed to one or more chosen charities following the death of the surviving lifetime income beneficiaries.
- CRT assets avoid estate tax.
Six Proven Strategies
The six strategies that are highlighted in this article are proven strategies for creating and optimizing after-tax retirement income that can individually and collectively prolong the longevity of one’s assets in retirement. Each strategy can be implemented beginning at age 62 as part of a holistic retirement income plan.
Deferring Social Security start date (strategy #1) is a time-sensitive strategy. Once you start receiving Social Security, with some limited exceptions, it’s an irrevocable decision that, with the exception of potential cost of living adjustments, will lock in the amount of your periodic and lifetime payments and can also affect your spouse’s payments.
Gaining unrestricted access to home equity (strategy #2) through a HECM reverse mortgage should be implemented at age 62, the qualifying age, whenever possible to optimize the growth of, and after-tax distributions from, the credit line. Planning for reducing Medicare Part B and D premiums (strategy #3), which is an annual strategy, should be implemented beginning at age 62 since income from your federal income tax return beginning at age 63 will be used to determine your Medicare Part B and D premiums when you’re 65.
Roth IRA Conversions (strategy #4) and locking in sustainable and potentially tax-favored income (strategy #5) should be considered before age 62 whenever possible since there’s no restriction on the start date and earlier vs. later implementation can optimize after-tax lifetime income in retirement.
Achieving sizable tax savings and tax-favored lifetime income when selling highly appreciated nonretirement assets (strategy #6) is dependent upon (a) owning highly appreciated assets such as real estate, investment securities, or a business and (b) a desire to sell those assets.
Let the magic begin!
Housing wealth, although it represents about one half of an average household’s net worth, is often ignored as a retirement income planning tool. There are numerous strategies that can be used to provide readily available tax-free liquidity to pay for planned and unforeseen expenses throughout retirement by monetizing a portion of the equity in one’s home.
Several of the strategies are offered by home equity conversion mortgages, or HECMs, which is the most popular reverse mortgage program and is offered and insured by the Federal Housing Administration (FHA). You can qualify for a HECM beginning at age 62.
If you aren’t familiar with HECMs or simply need a refresher, I recommend that you read my June 10, 2020 Retirement Daily article, Not Your Father’s Reverse Mortgage. The biggest change since I wrote the article is an increase in FHA’s HECM lending limit from $765,600 in 2020 to $822,375 in 2021.
HECM Unlocks Home Equity Without the Downsides of a HELOC
A HECM is designed to unlock home equity for homeowners as needed through a readily available credit line without the downsides of a home equity line of credit, or HELOC. These include access for a specified number of years – typically ten, required minimum monthly payments, lender can freeze or cancel the loan, home is subject to foreclosure if minimum payments aren’t paid, and a requirement to repay the loan in full even if the borrower owes more than the home is worth. Perhaps most important, you may not qualify for a HELOC when you’re retired if your sources of income for repayment are limited.
All homeowners with or without a mortgage should evaluate a potential HECM beginning at age 62 since this is the eligible age. An evaluation should be done whenever contemplating refinancing or purchasing a new home or planning for other major financial changes. Whatever the situation, a HECM can increase cash flow, reduce expenses, and increase retirement savings.
The HECM Pentathlon
There are five key financial metrics that should be analyzed individually and collectively when considering a HECM. Just like a track and field pentathlon, you don’t need to score high in every event to win the gold medal. You may bask in glory after finishing low in the shot put, excelling in the 800 meters and 60-meter hurdles, and performing in the 75th percentile in the high jump and long jump.
Side-by-side projections of existing or potential refinancing of forward, or traditional, mortgages with one or more HECM scenarios applying each of the five metrics for the next 20 years should be prepared. This will enable you to evaluate the pros and cons of a HECM in your situation.
The remainder of this article will use three hypothetical scenarios to illustrate each of the five financial metrics. Please refer to Hypothetical Scenario List of Assumptions below for a list of assumptions used in the various scenarios.
Please keep in mind that the “Mortgage” scenario in each illustration refers to a forward, or traditional, mortgage. Please also note that the assumed increasing interest rates that are used to calculate accrued interest on projected HECM loan and credit line balances are greater than FHA’s “expected,” or initial, interest rate that’s required to be illustrated for the life of a loan on a projected amortization schedule when applying for a HECM.
Metric #1: Projected Mortgage Balance
Most people entering retirement who own a home still have a mortgage, home equity loan, or outstanding HELOC balance. Many of these won’t be paid off for 10 to 20 years. Even if you have a minimal or no mortgage balance, you should consider a HECM if access to tax-free liquidity is or will be important to you during retirement.
There are two primary advantages of a HECM over a forward, or traditional, mortgage: (a) no required loan payments and (b) ongoing access to a tax-free line of credit that increases by the loan interest rate and elective payments.
- Traditional mortgage balance of $300,572, with assumed monthly payments of $1,600, is paid down over 20 years, with a projected balance of $21,985 at age 82.
- HECM #1 balance of $325,572, which assumes no payments, increases to a projected balance of $807,340 at age 82.
- HECM #2 balance of $325,572, with assumed monthly payments of $1,600, is paid down over 20 years, with a projected balance of $124,749 at age 82.
Winner: Traditional mortgage by approximately $103,000 over HECM #2 and $785,000 over HECM #1
Metric #2: Projected Savings
Whenever you’re making mortgage payments, whether it’s on a traditional mortgage or electively on a HECM, you’re decreasing the amount that you could otherwise be saving. Likewise, when you don’t make payments on a HECM, which is what most people do, you have the opportunity to save money that would otherwise be used to make mortgage payments.
- Required traditional mortgage monthly payments of $1,600 reduces savings by $19,200 a year, or a total of $384,000 over 20 years.
- HECM #1, which assumes no payments over the first 20 years, results in annual savings of $19,200, or a total of $384,000 over 20 years.
- Elective HECM #2 monthly payments of $1,600 produces the same result as a traditional mortgage, i.e., annual savings reduction of $19,200, with a total of $384,000 over 20 years.
Winner: HECM #1 by $768,000 over traditional mortgage and HECM #2
Metric #3: Projected Net Worth
Projected net worth as it relates to the evaluation of a HECM is equal to the total of the projected mortgage or HECM balance, projected savings balance, and projected home value each year. The projected mortgage or HECM balance needs to be shown as a negative amount since loans reduce net worth.
- Traditional mortgage projected net worth increases from $599,428 to $1,566,026 at the end of 20 years.
- HECM #1 projected net worth, which assumes no payments, increases from $574,428 to $1,548,671 after 20 years.
- HECM #2, projected net worth, which assumes monthly payments of $1,600 totaling $384,000, increases from $574,428 to $1,463,262 after 20 years.
Winner: Traditional mortgage by approximately $17,000 over HECM #1 and $103,000 over HECM #2
Metric #4: Projected Line of Credit
As previously stated, one of the primary advantages of a HECM over a forward, or traditional, mortgage is ongoing access to a tax-free line of credit. Once again, the line of credit increases by the loan interest rate and elective payments.
As discussed in the “Reverse Mortgages No Longer a Program of Last Resort” section in my Not Your Father’s Reverse Mortgage article, research by Dr. Wade Pfau has shown that applying for a HECM earlier and using the HECM line of credit strategically throughout retirement can potentially increase retirement spending and provide for a larger legacy.
Both HECMs in the hypothetical scenario are illustrated with no credit line advances for the first 20 years to keep the illustrations simple. This results in a projected increasing line of credit for the duration of the illustration. Any advances from the credit line would reduce the projected line of credit balance.
- Traditional mortgage has no line of credit.
- HECM #1 projected line of credit, which assumes no payments, grows by the assumed interest rate, which begins at 2% and increases gradually to 5.5% in years 17 to 20, causing it to grow from $86,188 to $213,725 at the end of 20 years.
- HECM #2 projected line of credit, in addition to growing by the assumed interest rate, also increases by the monthly payments of $1,600, resulting in a tenfold increase from $86,188 to $895,316 after 20 years.
Winner: HECM #2 by approximately $681,000 over HECM #1 and $895,000 over the traditional mortgage
Metric #5: Projected Liquidity
Metrics #4 – projected line of credit and #5 – projected liquidity, when evaluated together, are the most compelling criterion favoring the use of a HECM as a retirement income planning tool for prolonging the longevity of retirement assets.
Projected liquidity is equal to the total of projected savings (metric #2) plus projected line of credit (metric #4). The ability to readily access funds from savings as a result of not making mortgage payments and/or from a readily available tax-free credit line during one’s retirement years, especially when alternative sources of income may be scarce or nonexistent, distinguishes HECMs as a unique planning solution.
Illustration #5 – Projected Liquidity
- Since there is no credit line available with a traditional mortgage, projected liquidity decreases by the amount of projected savings which is -$19,200 per year, or -$384,000 after 20 years.
- HECM #1 savings is projected to increase by $19,200 per year as a result of no credit line payments, or a total of $384,000 after 20 years. The credit line is projected to increase from $86,188 to $213,725 during the same period. Combining the two results in projected liquidity of $597,725 at the end of year 20.
- HECM #2’s monthly payments of $1,600, or $19,200 a year reduce projected savings by $384,000 after 20 years. The credit line, however, is projected to increase from $86,188 to $895,316 during the same period, resulting in projected liquidity of $511,316 at the end of year 20.
Winner: HECM #1 by approximately $87,000 over HECM #2 and $982,000 over the traditional mortgage
Illustration HECM Pentathlon Overall Winner
As stated in the beginning of the “HECM Pentathlon” section, there are five key financial metrics that should be analyzed individually and collectively when considering a HECM. Just like a track and field pentathlon, the overall winner is determined by the highest total score for all five events.
Assuming that a score of 5 points is assigned for 1st place, 3 points for 2nd, and 1 point for 3rd, the overall winner of the Illustration HECM Pentathlon with a total score of 17 points is HECM #1. (The crowd goes wild!) Traditional mortgage and HECM #2 tie for 2nd place with a total score of 13 points each.
Illustration HECM Pentathlon 1st Place – HECM #1 demonstrates the importance of analyzing all five metrics together. If you focus only on the mortgage balance, which is projected to increase from $326,000 to $807,000 in 20 years, you would never choose HECM #1. When you factor in projected savings and liquidity, both of which finished in 1st place, together with projected net worth and credit line, with both finishing in 2nd place, you have your HECM pentathlon overall winner.
Caution: It isn’t prudent to select a winner based on score alone in the HECM Pentathlon. This is a starting point and may not be the best option for you. If, for example, your priority is to have the highest line of credit with a large amount of liquidity 20 years from now to pay for potential long-term care expenses using tax-free funds, HECM #2 would be your clear choice provided that you’re comfortable with continuing to pay $1,600 per month for 20 years despite the fact that there’s no payment requirement with a HECM. As a reminder, assuming you remain in your home, you were planning on doing this anyway with your existing mortgage.
Per Illustration HECM Pentathlon 2nd Place – HECM #2, by continuing to pay $1,600 per month, or a total of $384,000 over 20 years, HECM #2 credit line balance is projected to be $895,000 in 20 years, or $681,000 greater than projected HECM #1 balance of $214,000. Projected HECM #2 liquidity is projected to be $511,000, or only $87,000 less than HECM #1 projected liquidity of $598,000. HECM #2 net worth is projected to be $1.463 million, or only $86,000 less than HECM #1 projected net worth of $1.549 million.
The fact that HECM #2 mortgage balance is projected to be $125,000, or $103,000 greater than the projected balance of $22,000 of your current traditional mortgage should be less of a concern, especially when you consider the fact that there’s no line of credit and your liquidity is projected to be -$384,000 in 20 years if you keep your current mortgage.
A HECM Isn’t for Everyone
Despite the fact that a HECM is a wonderful tool for unlocking home equity, it isn’t a good solution in every situation. One example would be if you’re planning on selling your home in the next five years. The initial costs associated with a HECM would generally not be justified in this case. You could, however, potentially use a HECM for purchase strategy when you sell your home if you buy a replacement home if that makes financial sense.
Also, individuals who (a) are focused only on paying off their traditional mortgage, (b) have already paid off their mortgage and are unwilling to borrow against their home, or (c) are unable to justify the value of having ready access to an increasing tax-free credit line during their retirement years relative to the initial costs aren’t good candidates for a HECM reverse mortgage.
Summary
A HECM can furnish you with a one-of-a-kind tool to unlock illiquid home equity, providing unfettered access to tax-free funds when you’re likely to need them the most, i.e., in your retirement years, without the downsides associated with a HELOC. The combination of no required loan payments and ongoing access to a tax-free line of credit that increases by the loan interest rate and elective payments is unique.
This article introduces a process for analyzing a potential HECM in any situation. The process includes five financial metrics that can, and should be, used individually and collectively to analyze the pros and cons of unlocking home equity. The inclusion of projected credit line advances to pay for one or more strategic outlays, e.g., projected long-term care expenses, would complete the analysis.
When the value of a HECM as a retirement income planning solution is understood, implemented early in retirement, and used strategically to unlock illiquid home equity, a HECM reverse mortgage can be used to increase after-tax cash flow at opportune times throughout retirement while providing peace of mind.
Shain Urwin, retirement mortgage specialist with Fairway Independent Mortgage, joins Bob Klein to discuss the new HECM lending limit and other timely planning issues and strategies related to HECM mortgages in FINANCIALLY InKLEIN’d™‘s new video, Exploring the NEW HECM Lending Limit with Shain Urwin!
Bob Klein’s article, Insure Sequence of Returns Risk with a HECM Mortgage was published in The Street’s Retirement Daily. A home equity conversion mortgage (HECM), better known as a reverse mortgage, can be used to manage and mitigate sequence of returns risk.
Tilney, a highly-regarded financial planning firm in England where workers are automatically enrolled in employer pension plans unless they opt out, surveyed 1,300 employees in 2018 regarding what they planned to do with their pension when they retire. The results were as follows:
- 40% said they didn’t know what they would do.
- 22% said they expected to keep most of it invested, taking some withdrawals.
- 10% would potentially cash it all in.
- 10% would use the pension to buy an annuity.
When the word “annuity” was removed as an option and replaced with a “pension that provided a guaranteed income for life,” 79% of respondents said that this was more appealing than a plan where the value and income varied each year. This was the result despite the disclosure that a traditional investment plan offered the prospect for higher returns.
Annuitized Income Enables Guilt-Free Spending in Retirement
David Blanchett and Michael Finke’s recent research paper, Guaranteed Income: A License to Spend, confirms Tilney’s survey results. Their ThinkAdvisor article, Why Annuities Work Like a “License to Spend” in Retirement, which summarizes their research, discusses the behavioral costs that may be experienced by retirees who fail to annuitize. Two of their key findings are as follows:
- Retirees who are behaviorally resistant to spending down savings may better achieve their lifestyle goals by increasing the share of wealth allocated to annuitized income.
- An annuity can not only reduce the risk of an unknown lifespan, it can also allow retirees to spend their savings without the discomfort generated by seeing one’s nest egg get smaller.
Annuitized income, whether the source is pensions, fixed income annuities, or Social Security, enables guilt-free spending in retirement. To the extent that the start date for Social Security benefits is delayed resulting in a higher lifetime benefit, this increases the enjoyment.
Income Annuities May Give Retirees a Psychological License to Spend
Perhaps Blanchett and Finke’s most interesting finding, which also confirms Tilney’s survey results, is that annuities may give retirees a psychological “license to spend” their savings in retirement. Blanchett and Finke cited the fact that “Surveys reveal a clear preference among retirees to live off income, and many don’t feel comfortable spending down assets to fund a lifestyle.”
Blanchett and Finke found that retirees who hold more of their wealth in guaranteed, or sustainable, income spend significantly more each year than those who depend on traditional investments. Specifically, retirees with similar wealth who have sustainable income will spend twice as much each year in retirement. Per Blanchett and Finke’s article, “every $1 of assets converted to guaranteed income will result in twice the equivalent spending compared to money left invested in a portfolio.”
Timing of Converting Assets to Sustainable Income
Assuming that you don’t want to depend exclusively on an investment portfolio for your retirement needs and you would like to include a “psychological license to spend” strategy with sustainable income as part of your retirement income plan, when should you purchase fixed income annuities?
The timing of fixed income annuity purchases, as well as purchase amounts, types of annuities, and location, i.e., nonqualified vs. qualified account, is best determined as part of a holistic retirement income plan. The objective of a retirement income plan is to optimize projected after-tax lifetime income to pay for projected inflation-adjusted expenses during different stages of retirement.
Income optimization, rather than investment return, is the appropriate benchmark that should be used when evaluating fixed income annuities for inclusion in a retirement income plan. The goal is to design a comprehensive strategy that uses the least amount of assets to purchase the greatest amount of sustainable after-tax lifetime income that’s projected to pay for expenses not covered by Social Security, pensions, and distributions from investment and other assets.
Enjoy a Guilt-Free Retirement
My personal experience as a financial advisor specializing in analyzing, recommending, and implementing retirement income planning strategies for clients for the last 12 years confirms David Blanchett and Michael Finke’s research. Clients who have retirement income plans that include a sustainable income component are more confident about their prospects for a successful retirement, less fearful of running out of money, and more likely to enjoy a guilt-free retirement.
In the unsolicited words of one of my long-time clients, “At 70 years old it’s good to reflect back on how a great financial advisor has set my wife and I up for a steady income stream so we can enjoy these senior birthdays very comfortably regardless of the stock market or politics that can affect a person’s retirement years.”
Furthermore, the earlier a “psychological license to spend” strategy with sustainable income is implemented as part of a holistic retirement income plan, the sooner pre-retirees and retirees are able to sleep better at night. The title of a recent Kiplinger article, Retirees with a Guaranteed Income are Happier, Live Longer, says it all.
President Biden’s American Families Plan includes proposed increases in the top marginal income tax rate from 37% to 39.6% and the top long-term capital gains tax rate from 23.8% to 43.4% for households with income over $1 million. Both changes would negatively impact investment returns for affected individuals.
Stock market-based investment strategies, with their exposure to higher ordinary and long-term capital gains tax rates are being reevaluated by investors and financial advisers alike. One strategy that is attracting more attention that will be virtually unscathed by the proposed tax increase is longevity insurance, more commonly known as fixed income annuities.
Three Types of Fixed Income Annuities
Fixed income annuities provide sustainable lifetime or term certain income and, as such, are well suited for retirement income planning. There are three types of fixed income annuities: single-premium immediate annuities (SPIAs), deferred income annuities (DIAs), and fixed index annuities (FIAs) with income riders.
Each of the three types of fixed income annuities serve a different purpose within a retirement income plan. Two of the three options, SPIAs and DIAs, are tax-favored when purchased in a nonqualified, or nonretirement, account. This makes them an excellent choice for those in higher tax brackets who are seeking to maximize after-tax sustainable income.
SPIAs can be an appropriate retirement income planning solution if you are retiring soon or are retired and have an immediate need for sustainable income. Income distributions can be as frequent as monthly or as infrequent as annually (depending on the options available from the insurer), as long as the first benefit is paid within one year of the contract’s purchase date.
DIAs are a better fit than SPIAs in most retirement income planning scenarios due to their deferred income start date. Deferral of your income start date increases the amount of your periodic income payment since the insurance company will be making payments to you for a shorter period of time assuming a lifetime payout.
100% of income distributions from FIAs with income riders are taxed as ordinary income whether they are in a retirement or nonretirement account. While their flexible income start date and potential death benefit are attractive features, income tax savings is not a strong suit of FIAs with income riders.
DIAs and SPIAs Unique Income Tax Advantage
DIAs and SPIAs enjoy a unique income tax advantage when they are purchased in a nonretirement account. Unlike FIAs with income riders that distribute ordinary income that reduces the accumulation value of the annuity contract, DIAs and SPIAs are annuitized.
The annuitization period is defined by the contract and is either a defined term, e.g., 10 years, or lifetime. Lifetime DIAs and SPIAs provide for an optional minimum payout period or lump sum payable to the annuitant’s beneficiaries to guarantee a minimum total payout.
The income tax advantage of DIAs and SPIAs is attributable to the allocation of each annuitized payment between income and a return of premium. The portion that is deemed to be a return of premium is your cost, or basis, and is nontaxable. Annuitization is analogous to amortization of a mortgage. When you make a mortgage payment, each payment is allocated between deductible interest and nondeductible principal.
In the case of a DIA or SPIA, the amount of each payment that is considered to be a nontaxable return of premium is calculated by applying an “exclusion ratio” to each monthly payment. The exclusion ratio is actuarially calculated by dividing the investment in an annuity contract by the total expected lifetime payments.
SPIA Tax Savings Illustration
To illustrate the income tax advantage of nonretirement DIAs and SPIAs, suppose you are a woman, and you purchase a SPIA for $100,000 when you are 65 years old. Let us further assume that the insurance company determines that you have a 22-year life expectancy, and they will pay you $475 a month for the rest of your life. Your lifetime payments are expected to total $125,400 ($475 x 12 x 22).
Your exclusion ratio is calculated by dividing your premium, or investment, of $100,000 by your expected lifetime payments of $125,400. The result is that 79.75%, or $379, of each of your monthly payments of $475 will be nontaxable for the first 22 years. 20.25%, or $96, of each monthly payment will be taxable. Even though your annual payments will total $5,700, the insurance company will report taxable income of only $1,154 for the initial 22 years.
What happens if you survive your 22-year life expectancy? You will continue to receive monthly payments of $475 for the rest of your life, however, 100% of your monthly payments will be taxable as ordinary income. This makes sense since your nontaxable payments for the first 22 years will have totaled $100,000 which is equal to your original investment.
Nonretirement DIAs and SPIAs Can Optimize After-Tax Retirement Income
DIAs and SPIAs, like all fixed income annuities, provide sustainable lifetime income. When purchased in a nonretirement account, they distinguish themselves further as a retirement income planning solution since their after-tax income is predictable.
Income tax rates have minimal impact on the amount of after-tax income from DIAs and SPIAs due to their exclusion ratio. Furthermore, any increase in marginal income tax rates will not affect most annuitants’ after-tax periodic payments until cost basis has been recovered. As illustrated, this will not occur until the annuitant survives her life expectancy beginning on the annuity purchase date.
The ability to optimize after-tax income from nonretirement DIAs and SPIAs can also result in spillover income tax and other savings. This includes the potential reduction of taxable Social Security benefits, reduced exposure to the 3.8% net investment income tax, increased potential deductibility of medical expenses, and the opportunity to reduce marginal income tax rates and Medicare Part B premiums. Each of these things individually and collectively can result in additional increased after-tax retirement income for the duration of retirement.
Nonretirement fixed income annuities, with their sustainable lifetime income and tax-favored status, offer a timeless tax and retirement income planning opportunity.
Located at the end of President Biden’s American Families Plan released on April 28th is the administration’s wealth redistribution plan titled “Tax Reform That Rewards Work – Not Wealth.” The section begins with the statement that the goal is to reverse provisions of the Tax Cuts and Jobs Act of 2017 and reform the tax code “…so that the wealthy have to play by the same rules as everyone else.”
Proposed Lifetime and Death Capital Gains Tax Rate of 43.4%
The American Families Plan would increase the top marginal income tax rate from 37% to 39.6%. In addition, the proposed top rate of 39.6% would replace the current long-term capital gains tax rate of 20% for households with income over $1 million. While income at this level is not the norm (539,000 income tax returns were filed in 2019 with 2018 adjusted gross income of more than $1 million, representing 0.4% of 141 million total returns filed), it is not unusual for business owners to cross the $1 million threshold when they sell a business.
Long-term capital gains tax rates for households with income over $1 million would almost double under President Biden’s plan, increasing 19.6% from 23.8% to 43.4% when you include the net investment income tax of 3.8%. Let us not forget about state income tax. Add on 13.3% if you live in California for a total marginal tax rate of 56.7% on all income, including long-term capital gains.
The proposed legislation would also eliminate the step-up in basis on unrealized gains exceeding $1 million at death. The step-up in basis allows individuals with appreciated assets to avoid income taxation on the appreciated value when they die. Unrealized gains exceeding $1 million at death would be taxed at a 43.4% rate unless the appreciated assets are donated to charity.
Eliminate Capital Gains on Business Sales with a CRT
Lifetime charitable giving has historically benefited individuals with highly appreciated non retirement assets such as real estate, investment portfolios, and businesses. Many savvy business owners who are planning on selling their business and want to reduce or eliminate income tax liability attributable to the capital gain that they will realize from the sale can use a long-standing IRS-blessed strategy called a charitable remainder trust, or CRT. A properly designed and administered CRT managed by an experienced investment advisor who specializes in CRTS and is familiar with their four-tier payout scheme can be used as the cornerstone of a successful business owner’s retirement income plan.
A CRT is a tax-exempt trust. The initial and one of the most important benefits of a CRT is that the gain on the sale of assets owned by a CRT is exempt from taxation. This includes ownership of a business interest.
Tax Proposal Creates Sense of Urgency for Implementation of CRT Business Sale Strategy
The proposed long-term capital gain tax rate increase of 19.6% has created a sense of urgency for business owners who are thinking about selling their businesses in the near future. The CRT strategy will increase in popularity with the proposed tax law changes. It will likely result in the acceleration of the sale of many businesses to avoid the increased tax liability attributable to long-term capital gains exceeding $1 million from the sale if the proposed changes are enacted.
It is important to keep in mind that the proposed tax legislation that’s part of the American Families Plan is in its early stages. The long-term capital gains tax rate increase of 19.6% and elimination of the step-up in basis at death are major departures from long-term fixtures of the income tax law, and, as such, are controversial and subject to modification.
Having said this, given the reality that one of the overriding goals of the current administration is redistribution of wealth as evidenced by the fact that the American Families Plan was released on the 98th day of the new administration, successful business owners have a lot at stake and need to act quickly before the proposed legislation or some form of it is enacted. Furthermore, business owners and others adversely affected by the proposed legislation need to keep in mind that any tax legislation that is enacted, whether it is in 2021 or 2022, could have an effective date as of the date of enactment or even a retroactive date.
CRT Funding Creates a Current Income Tax Deduction
When the CRT income beneficiary(ies) die, the remainder interest in the CRT is transferred to one or more charitable organizations specified in the CRT document. This creates a second income tax benefit to the business owner, i.e., a charitable contribution deduction, that can be used to offset otherwise taxable income.
The deduction, which is taken in the year that the business interest is transferred to the CRT, is the present value of the projected remainder interest of the CRT that will pass to one or more charities. The amount of the deduction can be hundreds of thousands of dollars or more depending upon the value of the business interest being transferred to the CRT and the age of the business owner and spouse if married. The allowable charitable deduction is limited to 30% of adjusted gross income, with excess amounts carried forward for five years.
CRT Lifetime Income Stream is Tax-Favored
The third income tax benefit enjoyed by a business owner who sells part or all of his/her business interest using a CRT is favorable taxation of CRT income. The net proceeds from the sale of a business interest owned by a CRT are reinvested by the CRT to provide a lifetime income stream to a designated beneficiary who is generally the business owner and his/her spouse if married.
The periodic income payment is calculated using either a fixed dollar amount if it is a charitable remainder annuity trust (CRAT) or a fixed percentage of the annually redetermined net fair market value of trust assets for a charitable remainder unitrust (CRUT). The taxation of CRT income, which is reported annually on Schedule K-1, is driven by the character of the income being distributed, taxed in the following order under a four-tier payout scheme: ordinary income, capital gains, tax free income, and principal.
Most of a CRT’s annual income will be taxed as long-term capital gains at a current top federal tax rate of 23.8% since the origin of a CRT from the sale of a business is untaxed long-term capital gains. CRT income classified as long-term capital gains will continue to enjoy favorable tax treatment if President Biden’s proposal is enacted provided that total taxable income in a given year is less than $1 million.
Potential CRT Income Tax Savings – Current Income Tax Law
In summary, income tax savings attributable to establishing and funding a CRT in connection with the sale of business includes three components: elimination of the capital gain from the sale of the business, a sizable charitable contribution deduction, and favorable income tax treatment of CRT lifetime income distributions.
The latter benefit is threatened if the administration’s tax proposal is enacted and taxable income in a particular year exceeds $1 million. When this occurs, it generally happens in the year of sale. It could extend to future years if the business is sold on an installment sale basis depending upon the selling price and the amounts received in subsequent years.
The easiest way to illustrate the initial and ongoing income tax savings from a CRT is with an example. The example applies current income tax law and includes the following eight assumptions:
- Sale of business on June 30, 2021 with long-term capital gain of $5 million
- Reinvestment of net proceeds of business if sold outright with a return of 5% split 50/50 between qualified and nonqualified dividend income
- Reinvestment of net proceeds of business if sold by CRT with annual distributions of 5% of prior year’s December 31st CRT value split 75/25 between long term capital gains and dividend income, with the latter split 50/50 between qualified and nonqualified dividend income
- Other ordinary income of $200,000
- Standard deduction with outright sale
- Married filing joint tax status
- Ages 63 and 59
- California resident
Cases #1 and #2 – Outright Sale of Business
The purpose of Case #1 is to calculate the income tax liability attributable to the long-term capital gain of $5 million from the sale of the business. Per the illustration, federal income tax would be $1.143 million, or 22.86% of the gain. California tax would be $623,000, or 12.46% of the gain, for total income tax liability of $1.766 million, or 35.32% of the gain.
Case #2 includes investment income of $81,000 and other ordinary income of $200,000, increasing taxable income from $4.975 million to $5.256 million. Total income tax liability increases from $1.766 million to $1.908 million, or 36.13% of total adjusted gross income.
Case #3 – Sale of 100% of Business by CRT
Case #3 assumes that 100% of the ownership of the business is transferred to a CRT prior to the June 30, 2021 assumed closing date. This would result in the following:
- Long-term capital gain of $0
- Charitable contribution deduction of $1.422 million with allowable deduction of $97,500 in 2021, $135,000 in 2022, and the balance of $1,189,500 carried forward for four years
- Total projected 2021 income tax liability of $52,000 or $1.856 million less than Case #2 tax liability of $1.908 million
- Reinvestable net after-tax proceeds of $4.9 million, or $1.8 million greater than Case #2 of $3.1 million.
- Annual investment income of 5% of the CRT value of $5 million, or $250,000, which is $88,000 greater than the projected annual investment income of $162,000 from the net after-tax proceeds from an outright sale
- $218,750, or 87.5%, of CRT investment income of $250,000 taxed at a 23.8% capital gains tax rate vs. $80,846, or 50%, of non-CRT investment income of $162,000 taxed at a 23.8% capital gains tax rate
- Total projected 2022 income tax liability of $75,000, or $18,000 less than Case #2 projected liability of $93,000
Enactment of the American Families Plan would result in additional federal income tax liability of 19.6% of $5 million, or $980,000, for an outright sale. Without a CRT, reinvestable net after-tax proceeds of $3.1 million would be reduced to $2.1 million, or 42.2%, of the long-term capital gain of $5 million.
CRT Assets Avoid Estate Taxation
Did I mention that there is another tax bill that Senator Bernie Sanders and the White House formally proposed on March 25th called the “For the 99.5% Act?” This proposal would reduce the federal gift and estate tax exemption of $11.7 million per individual to $3.5 million effective January 1, 2022. The “For the 99.5% Act” would also increase the estate tax rate from 40% to 45% on taxable estates exceeding $3.5 million, 50% on estates above $10 million, and 65% for estates over $1 billion.
A CRT is an excellent estate planning strategy for reducing estate tax. CRT assets avoid estate tax since the remainder of the CRT passes to charity at death, and, as such, it is excludable from one’s taxable estate. In the preceding example, the remainder value of the $5 million of assets transferred to the CRT would be excluded from the husband and wife’s estate.
Retirement Income Planning Essential When Evaluating CRT Strategy
A CRT is a powerful planning strategy that can be used as the cornerstone of a successful business owner’s retirement income plan. It offers the opportunity for sizable initial and ongoing income tax savings, increased sustainable lifetime tax-favored income, elimination of estate tax on CRT assets, and, last, but not least, a philanthropic/legacy component, i.e., the distribution of the remainder of the CRT to one or more chosen charities.
There are many situations where individuals who have used this strategy have accumulated a larger estate that has been distributed to their heirs than they would have without a CRT. This can occur when a CRT is combined with an irrevocable life insurance trust that purchases life insurance on the life of the business owner and his/her spouse if married using a portion of the income tax savings from implementing the CRT.
The CRT strategy, while it offers several significant benefits for business owners considering selling a business and for their families, is not for everyone. The implementation of a CRT generally should not be an all or nothing situation whereby 100% of the ownership of a business is transferred to a CRT.
It is important to strike a balance between CRT vs. individual ownership, weighing the pluses and minuses of each in a particular situation within the context of a holistic retirement income plan. Paying some income tax is not necessarily a bad thing – especially if you can do so at a federal tax rate of 23.8% vs. 43.4%.
Every year since 2014 when I purchased a fixed index annuity (FIA) with an income rider in my SEP-IRA, I have added $20,000 to it. Furthermore, I plan on continuing to do this until I retire.
Why did I purchase a FIA with an income rider in my SEP-IRA in 2014 and add to it each year? For the same reasons that I am making the recommendation to do so today.
Stock Market Euphoria is Cause for Evaluation
As I write this article, the Dow Jones Industrial Average (DJIA) is hovering at just below 31,000 after reaching an all-time high of 31,653.48 on February 22nd. The DJIA increased 13,440 points, or 74%, since its Covid low of 18,213.65 just 11 months ago on March 23, 2020.
While Covid-19 cases, hospitalizations, and deaths have all recently dropped and more people are getting vaccinated which has contributed to the sizable stock market increase, the party and associated euphoria will not last forever. With the exception of last year’s first quarter drop, the stock market has been on steroids since hitting a low of 6,469.95 on March 6, 2009 after declining 52% in 17 months beginning in October, 2007.
The DJIA has increased 480% in the last 12 years, or 40% per year on average, which is obviously not sustainable. Do the terms “bear market” or “reversion to the mean” ring a bell?
Pivot Into Sustainable Income
I have been extolling the virtues of making sustainable income the cornerstone of a retirement income plan since 2009 when I began specializing in retirement income planning. The 52% stock market decline in 17 months, combined with the elimination of secure lifetime income provided by private pension plans, created a perfect storm for implementing this strategy.
While my clients are happy with the 12-year increase in their portfolio values, I know from many years of experience that this state of exuberance is often short-lived. The reality is that their equity allocation is greater than what is targeted for their portfolio in several cases.
As a retirement income planner, I look for windows of opportunity for my clients to transfer slivers of their investment portfolio from the unpredictable fluctuation of the stock market to fixed income annuities that are designed to provide sustainable income that they can depend on throughout retirement.
There are three types of fixed income annuities that can be employed for this purpose: single premium immediate annuities (SPIAs), deferred income annuities (DIAs), and fixed index annuities (FIAs). Some FIAs have an income payout feature built into them while others require purchase of an income rider.
Add to Older Income FIAs
All payouts from fixed income annuities are calculated using mortality credits, or life expectancy, and current interest rates. If you invest in a SPIA or DIA today, your payout will be relatively low compared to three or more years ago because of declining interest rates. In the case of DIAs, this is true whether it is a new or an existing contract.
Income FIAs that were purchased between 2009 and 2018, including the one that I chose for my SEP-IRA in 2014, provide a unique opportunity for increased sustainable income payouts when new premium dollars are added compared to current SPIA, DIA and income FIA offerings. This is because the income payout for FIAs is calculated using a formula and the variables used to calculate the payout were more favorable and less likely to be tied to performance of the underlying contract accumulation value as is often done today.
The following four variables are responsible for higher income payouts in older income FIAs:
- Higher interest rates in the growth phase
- Wider availability of compound interest crediting in the growth phase
- Ability to extend initial growth phase interest crediting from 10 to up to 20 years
- Premium bonuses offered for longer periods of time, as much as five to seven contract years in some cases
Besides the more favorable variables, there was greater availability of flexible vs. single premium contracts. Funds cannot be added after the first contract year to a single-premium FIA. Flexible premium FIAs, on the other hand, allow for subsequent investments after the initial contract year. Some flexible premium FIAs do, however, place caps on the amounts of annual additions. Finally, qualified, or retirement plan annuities, such as my SEP-IRA, are subject to annual contribution limits.
Exercise Option to Extend Income FIA Growth Phase Interest Crediting
In addition to adding new premium dollars, anyone with an income FIA that was issued between 2009 and 2018 who has not begun taking income distributions should exercise their option to extend the initial growth phase interest crediting if this is available.
With the growing popularity of income FIAs beginning in 2009, a larger number of contracts offering the ability to extend interest crediting beyond 10 years are in play. If you have one of these contracts and have not started your lifetime income, it behooves you to exercise your interest crediting extension option.
This is a no-brainer since the crediting of additional interest, which can be for up to 10 years in some cases, will increase your income payout amount. The increase could be substantial if, for example, your contract provides for 8% compound interest crediting, you extend the growth period from 10 to 20 years, and you defer your lifetime income withdrawal start date.
Opportune Time to Purchase or Add Funds to Fixed Income Annuities
This is a great time to purchase or add funds to fixed income annuities as part of an overall retirement income plan given the continued escalating stock market highs. Shifting a portion of one’s investment portfolio to sustainable lifetime income at opportune moments is a proven long-term strategy, especially if you are within 20 years of, or in, retirement.
Employing this strategy can enable you to accomplish two important goals shared by all individuals doing retirement income planning: portfolio risk reduction and decreased likelihood of running out of money in retirement.
Surveys as well as personal and client experience show that having predictable retirement income results in reduced short- and long-term stress levels, fewer cases of insomnia, and less health issues in general. This unequivocally trumps the often short-lived euphoria associated with increasing portfolio values in a bull market.
2020 was an eventful year for required minimum distributions, commonly referred to as RMDs. There were two pieces of legislation that were effective in 2020 that produced three noteworthy changes affecting RMDs.
RMD Background
Before discussing the changes, some RMD background is in order. IRAs were enacted as part of the Employee Retirement Income Security Act (ERISA) in 1974. ERISA required IRA and retirement plan account owners to take taxable lifetime annual distributions from their accounts beginning at age 70-1/2 to offset tax savings received from making deductible contributions.
The annual RMD for plan participants and IRA owners is calculated by dividing the value of each account on December 31st of the previous year by a life expectancy factor for the current year from IRS’ Uniform Lifetime Table. All RMD’s must be distributed by December 31st each year. There is an exception for the initial withdrawal which must be taken by April 1st of the year following the year in which you turn 72, which was previously age 70-1/2.
Failure to take RMDs by the specified due date results in a 50% penalty on the shortfall. The penalty can be waived by IRS for good cause if appropriate steps are taken to correct the error in a timely manner.
RMD Beginning Age Increased to 72
The required beginning age was April 1st of the year following the year in which you turned 70-1/2 until 2020. The first legislative change, the SECURE Act, increased the RMD age from 70-1/2 to 72 for anyone reaching age 70-1/2 after December 31, 2019 for 2020 RMDs.
July 1, 1949 is the key date for determining whether you were required to take your initial RMD by April 1st of the year following the year that you turned age 70-1/2 or 72. Here are the rules:
- Anyone born before July 1, 1949 was subject to the age 70-1/2 RMD rule.
- Anyone born July 1, 1949 or later qualifies for the age 72 RMD rule.
10-Year Payout Rule
In addition to increasing the RMD age from 70-1/2 to 72, the SECURE Act eliminated the RMD regime for many retirement and IRA account beneficiaries who inherit accounts for deaths after December 31, 2019. These individuals are subject to a 10-year payout rule effective January 1, 2020.
There are five classes of “eligible designated beneficiaries,” or “EDBs,” who continue to be subject to the RMD rules instead of the 10-year payout rule. These include:
- Surviving spouses
- Minor children up to the age of majority, excluding grandchildren
- Disabled individuals who qualify under strict IRS rules
- Chronically ill individuals
- Individuals not more than ten years younger than the IRA owner
All other individuals, or “non-eligible designated beneficiaries,” or “NEDBs,” are subject to a 10-year rule whereby they must empty their accounts by the end of the tenth year after death. Examples of NEDBs include children after reaching the age of majority and grandchildren. Failure to empty accounts by the end of the tenth year following death results in a 50% penalty on any remaining balances.
RMDs Waived in 2020
The second legislative change that affected RMDs in 2020, although temporary, attracted the most attention. The Coronavirus Aid, Relief, and Economic Security Act, or CARES Act, which was signed into law on March 27, 2020 waived RMDs in 2020. I speculated about this possibility in my March 16, 2020 blog post.
The waiver included the following three types of RMDs:
- 2019 RMDs due by April 1, 2020 for anyone born before July 1, 1949 who delayed their initial RMD
- 2020 RMDs from company plans and IRAs
- 2020 RMDs for company plan, IRA, and Roth IRA beneficiaries not subject to the 10-year payout rule
IRS allowed individuals who took RMDs in the beginning of the year to return them to their retirement and IRA accounts up until August 31, 2020. This presented an opportunity to roll over, or convert, distributions to a Roth IRA rather than return them to their originating accounts.
RMD Vacation is Over
2020 was an unprecedented and confusing year for most people, including company retirement plan and IRA account owners and beneficiaries impacted by the RMD rule changes. The beginning age was increased from 70-1/2 to 72, the RMD regime was replaced by a new 10-year payout rule for many beneficiaries, and RMDs were waived. If this was not a wake-up call for the need for holistic retirement income planning, I don’t know what is.
Anyone who is a retirement plan or IRA account owner or eligible designated beneficiary needs to add distribution of RMDs to their 2021 to-do list if they have not done so already. If you did not take distributions from your retirement plan and IRA accounts in 2020, you may be surprised that the amount of your 2021 RMDs is greater than in 2019, requiring you to pay more income tax in 2021 than you did in 2019.
Given the fact that 2021 RMDs are calculated using December 31, 2020 account values, larger 2021 RMDs are a distinct possibility assuming you did not take distributions in 2020. Furthermore, this is more likely if you have an equity-based portfolio that benefited from favorable 2019 and 2020 stock market performance if you did not liquidate your equity holdings during the Covid-19 selloff.
You also need to start planning for how and when you will take distributions if you are subject to the 10-year payout rule since you don’t have the luxury of taking pre-determined RMDs using a generous IRS life expectancy table. Distribution timing is key, especially since income tax rates may increase before the scheduled 2025 sunsetting of many provisions of current tax law. It is critical that you work with your financial advisors to optimize the timing and amounts of your after-tax distributions and avoid a potential 50% penalty if you don’t empty your accounts within ten years.
Welcome to 2021! Your RMD vacation is over.
The goal of retirement income planning is to optimize the longevity of your after-tax retirement income to pay for your projected inflation-adjusted expenses. In addition to having adequate retirement assets, there are two ways to achieve this goal: (a) maximize income and (b) minimize income tax liability.
There are six stealth taxes that can increase your income tax liability and reduce your lifetime after-tax retirement income. All of them, except for one, have been in existence for several years. A couple are difficult to avoid due to their low-income thresholds. Although several taxes may not kick in until retirement, planning for each of them should begin long before and continue throughout retirement.
Stealth Tax #1: 10-Year Payout Rule
Let’s start with the new kid on the block – the 10-year payout rule. This was created by the SECURE Act and is generally effective for deaths after December 31, 2019. It applies to beneficiaries of retirement plans and IRA accounts.
Surviving spouses, minor children who are not grandchildren, and other “eligible designated beneficiaries” are unaffected by the 10-year payout rule. They can continue to take distributions from retirement plans and IRA accounts over their lifetime using the required minimum distribution, or RMD, rules.
Children after reaching the age of majority and grandchildren are classified as “non-eligible designated beneficiaries.” They are no longer required to take RMDs from their retirement and IRA accounts. They are instead subject to the new 10-year payout rule whereby they must empty these accounts by the end of the tenth year after death.
Distributions can be taken evenly over ten years or in random years so long as there’s no balance remaining in any retirement or IRA accounts by the end of the tenth year after death of the individual from whom you inherited the accounts.
Two potential types of stealth taxes have been created by the 10-year payout rule. The first type comes in the form of accelerated and potentially increased income tax liability compared to the RMD rules. The second type is a potential penalty assessed by IRS as an “additional tax on excess accumulations” of 50% plus interest on the balance of funds remaining in any retirement plan or IRA accounts at the end of the tenth year.
Stealth Tax #2: Social Security
Taxation of Social Security benefits, which began in 1984, is one of the stealth taxes that is difficult to avoid due to its low-income threshold. The threshold, which is referred to as “combined income,” is the total of adjusted gross income, nontaxable interest, and half of your Social Security benefits.
Single individuals with combined income of $25,000 to $34,000 are taxed on up to 50% of benefits, and up to 85% on amounts above $34,000. Joint return filers with combined income of $32,000 to $44,000 are taxed on up to 50% of benefits, and up to 85% on amounts exceeding $44,000. Unlike other income-sensitive thresholds, Social Security combined income amounts have never been increased for inflation.
Taxation of Social Security benefits is often a double stealth tax. The inclusion of up to 85% of benefits in taxable income, in addition to potentially increasing tax liability, can also increase marginal and long-term capital gains tax rates. Other potential fallouts include increased Medicare Part B and D premiums, increased exposure to net investment income tax, and increased widow/widower’s income tax.
Stealth Tax #3: Increased Medicare Part B and D Premiums
Medicare Part B and D premiums are determined using modified adjusted gross income (MAGI) from your federal income tax return two years prior to the current year. Assuming you enroll in Medicare at age 65, you will want to project and track your MAGI every year beginning at age 63.
Monthly premiums begin at $148.50. An Income Related Monthly Adjustment Amount (IRMAA) is added to this amount if your income is greater than $88,000 for single taxpayers and $176,000 for joint tax filers. Monthly premiums can be as high as $504.90 for those in the top income threshold, resulting in increased annual Medicare premiums of as much as $4,276.80 per person or $8,553.60 per couple.
Medicare Part B and Part D monthly premiums can increase significantly in a particular year because of an unusually large amount of income two years prior to the current year. This can include taxable gains from the sale of a residence or rental property or income from a sizable Roth IRA conversion.
Stealth Tax #4: Net Investment Income Tax
The net investment income tax has gone under the radar for a lot of taxpayers since its introduction in 2013. The tax is a surtax that is generally paid by high income taxpayers with significant investment income.
Single taxpayers with investment income and MAGI greater than $200,000 and married filing joint taxpayers with MAGI more than $250,000 are subject to a surtax of 3.8% on net investment income. This includes capital gains, interest, dividends, rental income, royalties, and nonqualified annuity income.
The net investment income tax effectively increases the 15% and 20% long-term capital gains tax rate by 3.8% for higher income taxpayers.
Stealth Tax #5: Widow(er)’s Income Tax Penalty
Stealth tax #5, the widow(er)’s income tax, is the stealthiest of all stealth taxes since most people aren’t aware of it, it’s the most difficult to plan for, and it can potentially increase tax liability significantly each year going forward once it applies.
Unfortunately, the income tax law is not kind to surviving spouses who don’t remarry. A widow or widower who has the same, or even less, income than the couple enjoyed will often be subject to higher federal, and potentially, state, income tax liability. This results from the transition from the use of married filing joint tax rates to single tax rates and a standard deduction of 50% of the married filing joint amount of $25,100, or $12,550, beginning in the year following the year of death of one’s spouse.
Stealth Tax #6: $10,000 Limitation on Personal Income Tax Deductions
Unlike the first five stealth taxes that directly increase income tax or Medicare premiums in the case of stealth tax #3, stealth tax #6 indirectly achieves the same result. The $10,000 limitation on the personal income tax deduction accomplishes this by eliminating a potentially large amount of one’s overall tax deductions for those affected by it. This has translated to reduced itemized deductions of tens of thousands of dollars or more in many cases since 2018.
This change, combined with the doubling of the standard deduction and reduced mortgage interest deductions, has reduced the percentage of taxpayers itemizing their deductions from approximately 31% in 2017 prior to the enactment of the Tax Cuts and Jobs Act to approximately 14% in 2019.
Stealth Tax Planning Opportunity: Staged Roth IRA Conversions
Although there are various retirement income planning strategies that can be implemented to address each of the six stealth taxes discussed in this article, there is one strategy that can reduce income tax liability attributable to the first five. The strategy to which I am referring and have espoused for many years, is a staged, or multi-year Roth IRA conversion plan.
The current low historic income tax rates that will expire after 2025 and potentially sooner provide a window of opportunity for Roth IRA conversions that many of us may never see again in our lifetime. If you’re in your 50’s or 60’s and you have traditional 401(k) plans, SEP-IRAs, and traditional IRAs, why wait until age 72 when the value of your plans has potentially doubled, and tax rates are potentially higher to pay income tax on your distributions?
When you do a Roth IRA conversion, or a series of Roth IRA conversions using a staged Roth IRA conversion plan, you eliminate taxation on the future growth of converted assets, reduce required minimum distributions (RMDs) beginning at age 72, and reduce dependency on taxable assets in retirement. This, in turn, allows you to reduce your exposure to the first five stealth taxes throughout your retirement years as follows:
- Reduce the value of taxable assets impacted by the 10-year payout rule
- Decrease the Social Security “combined income” threshold, potentially decreasing your percentage of taxable Social Security benefits
- Decrease modified adjusted gross income (MAGI) which can potentially reduce your Medicare Part B and D premiums beginning at age 65
- Potentially decrease your net investment income tax since this is calculated using MAGI
- Reduce the value of taxable retirement assets and your exposure to the widow(er)’s income tax liability if you’re married
Look Beyond Current Income Tax Rates When Planning for Retirement
The six stealth taxes discussed in this article can impact the success of your retirement in various stages of your life beginning long before you retire and continuing throughout your retirement. It behooves you to not get lulled into a false sense of security by today’s low federal income tax rates since they are scheduled to sunset after 2025 and this may occur sooner. While it is difficult, if not impossible, to predict future rates, it is better to err on the conservative side when planning for a long-term event like retirement that may not begin for many years.
Furthermore, it is crucial to look beyond rates to understand how stealth taxes can potentially derail your retirement. None of them is likely to be eliminated since each is responsible for billions of dollars of annual tax revenue. On the contrary, additional stealth taxes will be imposed as part of future tax legislation based on historical precedent. This is likely given the out-of-control federal deficit and the fact that stealth taxes are confusing and often fly under the radar – hence their name.