Risk of changes to the tax code As our country’s debt grows, there will be a greater tendency for our elected officials to leave no stone unturned as they search for new sources of revenue. Does this mean we are at greater risk that the tax rates applied to withdrawals from our IRAs, 401(k) and other tax-postponed retirement plans will be higher in the future? Does it mean that we are at greater risk that some future Congress will vote to strip away the significant tax advantages that exist in our Roth IRAs and permanent life insurance policies? Does it mean that we are at risk of losing the deduction on the home mortgage interest we pay? Managing your exposure to the risk of changes in the tax code can be just as important as limiting your exposure to investment losses or inflation.  Risk of changes to the Social Security The fact that workers contribute to Social Security through payroll taxes causes many to feel they have earned a “right” to their future retirement income. And while this may be true enough in a moral sense, like it can with all federal entitlement programs, Congress can change the rules regarding eligibility, and it has done so many times over the years. Risk of changes to economic policy Will the Federal Reserve continue to increase the supply of money in the economy and increase the risk of high future rates of inflation? Or, at some point will inflation or some other challenge force it to put the brakes on, but do it in a way that results in turmoil in the financial markets? For good or bad, our government has the power to make changes to the laws that can significantly affect entitlement programs, taxation, monetary policy and many other things that can either directly or indirectly impact a retired person’s finances and security. How can we possibly anticipate all of these risks and prevent them from happening? Of course, we can’t prevent this from happening, but we can take steps to manage our exposure to these risks. Few things will be more important than your future retirement. And the way time flies, it will happen before you know it. We can help you plan for the inevitable.
0 Comments
 A person’s entire outlook during her retirement is often much brighter if she has a reliable, consistent, income promised to last her for as long as she lives. Even better is if that income will increase with inflation, and that upon her death, a portion of that protected income will continue to a survivor spouse. One of the biggest differences between retirees who have adequate sources of reliable, consistent, lifelong income and retirees whose income is based more on some do-it-yourself formula for converting a portfolio into income is that the former are able to spend money with more confidence. Think about it: if the security of your income is completely tied to the inevitable ups and downs of the financial markets, you may have money to spend this month, but since you are unsure what your account balances will be next month, you don’t have lot of confidence about spending your money. But when you know there will be a protected income check in your mailbox next month, and each month thereafter, you can more confidently spend your income. The great news is that you do have a pension. It’s your public pension, and of course, it is your Social Security retirement benefit. Perhaps you’re thinking, “What’s the big news, everyone knows about Social Security and I know I will get income from it.” It’s true, everyone does know about Social Security, but unfortunately few understand the importance of properly managing it. In fact, the very idea of managing Social Security retirement benefits is a foreign concept to most people. While people know they must manage their investments to protect them from risks, few realize how important it could be to their future security to manage their Social Security retirement benefit. For some, proper management of this benefit can lead to greater after-tax spendable income and an overall reduction in many of the risks to which they might otherwise be exposed. Social Security provides a source of reliable, consistent, lifelong income, so you want it to be as large as possible. To see how easy it is to increase the amount of your monthly benefit check, you must first understand that there is a great deal of flexibility with regards to the age at which you can start receiving your benefit checks. In fact, if you are married, the choices and different combinations of possible start dates for you and your spouse literally number in the thousands.  Unfortunately, far too many people make choices that may not be in their best interest, and because of this, they might forfeit tens, or even hundreds of thousands of dollars in protected, tax-advantaged income over their lifetimes. Think of it this way. Uncle Sam (the provider of the benefit) sits down with you and says, “You can start receiving your benefit at age “X” and receive a monthly income of $1,900. Or, you can start receiving your benefit at an older age of “Y” and receive a monthly income of $2,250. What Uncle Sam doesn’t tell you is that you also have the option of starting your benefit at any other age between A and Z, and the benefit amounts will all be different. Your choice of start dates of either your worker’s benefit or your spousal benefit will change the amount of the check you receive for the rest of your life. And the amount isn’t different based only on the year you reach a certain age; it will be different based on the month within the year you decide to start your benefit. Few things will be more important than your future retirement. And the way time flies, it will happen before you know it. We can help you plan for the inevitable.
Social Security is subject to a unique tax treatment. Part of your benefit is taxed currently, and part is tax-free. But the portions of what is taxed and what is tax-free are rather fluid, and will depend in large part on the amount and most importantly, the sources of your income. To determine the taxable portion of your Social Security, the IRS takes all of your income and, figuratively speaking, puts it in a bucket to determine the total. The more that ends up in this bucket, the greater the percentage of your Social Security benefit that is taxable. But there is one very important thing to understand about these tax calculations: not all of your income necessarily goes into this bucket. If and how much of your income goes into the bucket is in large part based on the source of that income.  For example, 100 percent of the income you receive from your 401(K0, IRA or other tax-postponed retirement plan goes into the bucket, but only 50 percent of the income your receive from your Social Security goes into the bucket. Now think about that for a minute. If only 50 percent of the Social Security benefit you receive is included, doesn’t it stand to reason that your taxable income might reduce if a larger portion of your total income came from Social Security? To make this important point clearer, assume that we have two individuals. They both have the same total income.
Few things will be more important than your future retirement. And the way time flies, it will happen before you know it. We can help you plan for the inevitable.
Mention the word “risk” to the three pigs from the children’s story and they see a scary vision of a wolf trying to blow down their house. Many people have a frightening view of risk, but it will most likely be one of investment losses destroying their retirement security. But even the smartest, brick-building pig would have met with tragedy if he only concerned himself with the sole risk of a huffing and puffing wolf. He needed strategies to protect himself from other risks, such as the wolf coming down his chimney. In much the same way, to keep our retirements secure, we must have a plan to protect ourselves from more than just the risk of volatile investments. Sometimes we can focus so much on reducing one form of risk that we can increase other, equally destructive risks.  A person determined to avoid the risk of investment losses could keep her life savings under her mattress. This would protect her savings from volatile investments, but what good does that do her if in the future she finds that she’s out of money because her savings never grew? During the market meltdown of 2008, many retirees, even those with well-diversified investment portfolios, saw the value of their holdings plunge by as much as 30 percent, 40 percent or more. Vowing to never again be exposed to this kind of risk, some of these people moved most or perhaps all of their savings into bank CDs and government-backed bonds. But if long-term interest rates paid on these protected instruments are less than the rate of inflation, these people may have destined themselves to a steady erosion of their wealth with consequences potentially as destructive as the risks of investment losses. Please do not misunderstand and assume that this article is in some way devoted to convincing risk-averse readers that they should have their money invested in the stock market. While in moderation, this might make sense for a great many readers, the point of raising these issues is more to help recognize that multiple risks must be managed during retirement, and that the steps we take to reduce one kind of risk might actually increase our exposure to another form of risk if we are not careful.  Few things will be more important than your future retirement. And the way time flies, it will happen before you know it. We can help you plan for the inevitable.
Regardless of where the bond is placed on this risk vs. reward pyramid, between the date it is first issued and the end of its term, investors can buy and sell these bonds just like any other investment. But the price at which any bond can be bought or sold will not necessarily be the same price as it was when it the bond was originally issued. This means that any investor who sells her bond before the end of its term must accept the risk that she could get back less than the amount she originally paid for the bond. The reason for this potential for loss is due to another form of risk commonly referred to as interest rate risk.  Interest rate risk is the potential that the value of a bond will go down as overall interest rates go up. To understand why, consider the following example. Suppose you have $1,000 in a bank CD that is maturing. The bank tells you that if you renew the CD for four more years, it will pay you interest on your money at the rate of three percent annually. You like the protection that FDIC insurance provides, but because you are concerned with the potential for inflation risk and the risk that you might outlive your savings, you decide to look for an alternative offering a higher rate. You find a bond that is issued by an institution you believe is so rock-solid that the potential risk of default is non-existent. The bond has a 20-year term and the issuer guarantees to pay you a higher rate of four percent annually. You like the interest rate offered, but you are a little concerned about the length of the bond term. This concern goes away when you are told that should you ever need your money, you always have the option of selling the bond at any time prior to the end of its term. You purchase the bond and are content earning your additional one percent interest, but only until a few years later when you see an advertisement in the newspaper showing that your former bank is now offering a four-year CD paying an even higher five percent interest. Now you are not so happy earning four percent on your bond. A simple solution might seem to be to sell your bond and deposit the proceeds in the CD that’s now paying a higher rate.
However, while it is true that the bond can be sold at any time, the potential problem is that there is no guarantee that anyone would purchase your bond for the same price you paid. In fact, if a potential buyer could just as easily deposit their money in a bank CD paying five percent interest, why would they ever purchase your bond that only pays four percent? What you will likely be forced to do in order to sell your bond is to reduce its price and take an investment loss. Few things will be more important than your future retirement. And the way time flies, it will happen before you know it. We can help you plan for the inevitable. Because a bond entitles its owner to income and capital return, the strength and security of the institution borrowing the money is of prime importance. One risk that bond holders are exposed to is the risk that the institution defaults on the bond. This is the same risk that any lender faces. A bank attempts to assess how creditworthy a person is before lending that person money, because the bank must always be concerned that the borrower might default on the loan. When you invest in bonds, you are in effect taking on the role of the banker lending money. And as banks do, you must manage the risk that your borrower (the institution issuing the bond) won’t default. It is primarily due to this potential default risk that bonds have their own risk vs. reward pyramid.  At the bottom of this pyramid there is less risk of a default. Here, we find bonds issued by institutions believed to be the most secure. There are few more secure bonds than those issued by the U.S. Federal government. Because of this, you find these bonds at the very bottom of the pyramid. Higher up on the pyramid, you find bonds issued by large corporations: those that have been in business for a long time, with stellar financial strength and a long history of creditworthiness. And still higher on the pyramid, you find bonds issued by smaller, newer corporations with less of a track record. Higher still will be bonds issued by some corporations and perhaps even some municipalities that are facing financial difficulties. On the risk side, the idea is that as you move up the pyramid, there is a greater risk of default, because the bonds are issued by less and less creditworthy corporations and institutions. On the reward side, the interest rates you earn on these bonds also increases as you move up the pyramid. The more secure and creditworthy the bond issuer is, the less chance they will default, and the easier it is for them to attract purchasers of their bonds. The easier it is to attract a purchaser because of creditworthiness, the less interest the issuer will have to pay on their bonds. Again, U.S. Federal Government bonds are at the bottom of the pyramid, and the reason is both that the risk of default is so low and also that the reward they provide, or the interest they pay, is low as well. As you move up the pyramid, the risk of default increases, and because of it, the bond issuers have a more difficult time attracting purchasers. To get others to purchase their bonds, the bond issuers have to reward them for taking higher risk by providing a higher rate of interest paid. Few things will be more important than your future retirement. And the way time flies, it will happen before you know it. We can help you plan for the inevitable.
 For many people, the difference between a retirement filled with enjoyment, fun and security and a retirement dominated by worry, concern and fear depends on a single factor: income. But there are a number of words that must be placed in front of the word “income” before you can get what you really need. Ample Income Lifetime Income Inflation-Adjusted Income Tax-Efficient Income And perhaps the most important one of all: Spendable Income Spendable income means what remains of your income after taxes that is available to spend on the things you need and want throughout retirement. Generally speaking, there are two ways you can try to increase spendable retirement income. One approach is to attempt to increase the growth rates or returns on your savings and investments. A one or two percent increase in return each year can make a big difference in the amount of income your portfolio can provide. Unfortunately, from a risk management perspective, we know that in order to get a boost in return we must either select financial instruments higher up on the risk vs. reward pyramid, meaning more risk of investment loss, or instruments higher up on the time vs. reward pyramid, meaning committing our money for longer terms or maturity dates. But for some, there may be another option that should at least be considered. If we can find a legal way to reduce the amount of taxes we must pay on our income, then we end up with a greater amount of net after-tax spendable income. For example, assume your savings along with your Social Security provides you with a total annual gross taxable income of $80,000, and that taxes consume 25 percent of that. You are left with $60,000. This is enough to meet your basic, essential living expenses necessary to keep a roof over your head, buy groceries, pay your medical bills and for other essentials. Unfortunately, little remains for vacations, to pay country club dues, buy gifts for the grandkids, go out to dinner or do the other things that might make life more enjoyable. Let’s say you would like an extra $4,000 a year to go on an ocean cruise or other trip. If you have savings of $400,000, one solution would be to figure out a way to increase the annual rate of return it generates by 1 percent ($400,000 X 1% = $4,000). If the rate of return currently generated on your savings equals six percent, you would have to figure out a way to boost the overall return to seven percent to generate the additional $4,000. And again, this will likely require that you either expose your savings to a greater risk of investment loss or commit your savings for longer periods of time. A possible alternative is to try to generate an additional $4,000 by reducing your tax rate from 25 percent to perhaps 20 percent. Now, instead of having a net after-tax income of $60,000 ($80,000 – 25%), you would have $64,000 ($80,000 – 20%). Your spendable income increases by $4,000. As long as you used a legal method to reduce your taxes, it potentially becomes a way of increasing your spendable income without increasing exposure to the risk of investment losses. From a risk management perspective, it doesn’t get much better than that. Few things will be more important than your future retirement. And the way time flies, it will happen before you know it. We can help you plan for the inevitable.
 The benefit amount you will receive from Social Security will be based on your work and earnings history as well as the age at which you start your benefits. For example, assume that an individual born in 1952 had a work and earnings history that would generate a monthly benefit of $1,000 when started at the earliest possible age of 62. The following table shows how that benefit amount increases for each year that he delays the start of his benefit.  The longer you delay the start, the larger your benefit will be. Pensions and many income annuities are based on the same principle. Pick an early start age and your income amount will be less; delay the start age and you’ll receive a larger lifelong income. Like pensions and fixed income annuities, Social Security is not an investment vehicle. It is very specifically designed as an income vehicle for the purpose of providing you a lifetime income. However, it might be of interest to consider how large of a balance you would need to have in an investment account in order to generate the same income provided by Social Security. Assuming the investment “could” support a cash flow to you of five percent of the balance annually, the table below shows the approximate balances you would need in order to match the same Social Security income amounts referred to in the prior table.  When you look at it this way, you could say that if you did not have Social Security, you would need to accumulate an investment balance of $239,940 by age 62 in order to generate a monthly income of $1,000, assuming that investment vehicle would support a five percent cash flow. Or, by age 70, your investment vehicle would need a balance of $422,284 to support a monthly income of $1,760, assuming a five percent cash flow. One way to look at the difference between starting your Social Security benefit at age 70 and starting it at age 62 is that the extra $760 ($1,760 - $1,000) of monthly income you receive is like having an extra $182,354 ($422,294 - $239,940) in an investment account. Whether the strategy of starting a lower benefit early or the strategy of starting a larger benefit later appears best mathematically will depend on the assumptions you use: how long you expect to live, what rate of return you expect to earn on your investments, the level of future cost of living adjustments, and even the tax rates you assume you must pay. Because these assumptions — especially regarding how long we will live — can be highly inaccurate, the best we might do is to guess which strategy would be best. Few things will be more important than your future retirement. And the way time flies, it will happen before you know it. We can help you plan for the inevitable.
|
RSS Feed
Services |
|