Asset Equalization Among Spouses: Why It’s Important

By info@landmarkwealthmgmt.com,

One of the more challenging things to plan for is the risk of losing the capacity to care for yourself in your latter years.   It is an unpleasant thought to all of us, yet something that is very important to consider.    According to a 2018 article in the Wall Street Journal, a couple that reaches age 65 has a 70% chance that one of them will need some form of Long Term Care (LTC).  

A LTC issue can be addressed in more than one way.  Some people choose to purchase LTC insurance.   However, these policies are not only expensive, but rarely cover the entire liability.  Additionally, those policies that are structured as annual premium payments will often have sizeable premium increases from time to time. 

Another way to address such concerns is via the proper estate planning.   This can be done at various stages, which often includes the use of an asset protection trust later in life, which might permit one to shelter a substantial portion of their net worth from creditors, thus allowing for access to programs like Medicaid which may assist in the rendering of LTC services.   The flexibility in the transfer of assets is paramount in implementing such an approach.   Unfortunately, not all assets are so easily transferred among family members, or retitled. 

One such example is that of the qualified retirement plan assets, which are often the largest liquid asset to many Americans.   IRA’s, 401k’s, 403B’s, 457 plans and several other retirement plans are all treated essentially the same for tax purposes with a few minor differences.   As it relates to estate planning in the face of a possible LTC concern, these plans can present some asset transfer problems.   In order to qualify for Medicaid benefits, the recipient must essentially spend down the majority of their resources before qualifying for coverage.  

In the case of non-qualified or non-retirement assets (bank accounts, joint brokerage account…etc.), a transfer to a spouse can typically be made just before qualifying for coverage.  A transfer to an asset protection trust, or other family member is typically subject to a 5-year look back period.   However, such a transfer is not typically a taxable event.   Yet, the transfer of a qualified asset first requires a taxable distribution. 

Imagine a scenario in which a retiree has saved 1 million dollars in a 401k plan to finance the retirement expenses of both spouses.  If the entire 1 million is under the name of the one individual who is then subsequently diagnosed with a debilitating illness, these funds would have to be at least partially spent down before qualifying for benefits.   Medicaid rules typically Do Not require that the entire principal of the account to be spent down.  Instead, the plan must go into what is known as “permanent pay status”, in which a monthly income must be drawn from the retirement account using a specific formula, and then used to fund the LTC costs of a nursing home.   While most stays in a nursing home don’t typically last more than a year or two, this is not always the case.  A number of possible medical diagnosis such as Alzheimer’s Disease can result in a very prolonged and costly stay.  During such time, the retirement funds that were used to fund the everyday expenses in retirement are no longer available to the alternate spouse.   If that was the primary source of income, this can be quite problematic. 

In such cases, there is little that can be done once the problem presents itself other than taking very large distributions from retirement accounts before the application of Medicaid benefits, which will result in a substantial tax liability to the couple, further depleting the source of retirement funding.

The best form of planning to prevent such a scenario is to address this well in advance.   Younger couples should focus on retirement asset equalization.   This is an approach in which you attempt to save towards retirement accounts equally under each spouse’s name to the extent possible.    If one spouse has a pension benefit and the other a 401k, than it’s wise to focus the bulk of the savings on the spouse without the pension.  It is possible to measure commuted value of a pension benefit by reverse engineering the projected payment amount, and then calculating how much would need to be saved in a liquid retirement account to achieve a similar annual annuity payment equal to the pension benefit.  This will help guide you as to how close the retirement saving values are for each spouse. 

In the case of a single income family, this presents a greater challenge.  One way to help mitigate this problem is utilizing what is known as the IRA spousal contribution.   While annual IRA contributions are capped at lower dollar values than a typical employer retirement plan, a working spouse can contribute towards the IRA of non-employed spouse annually as a spousal contribution.   The maximum contribution in the tax year 2020 is $6,000 ($7,000 if over age 50).    Utilizing the spousal contribution early on can mitigate the risk of accumulating too much tax-sheltered savings under one spouse’s name.   In such an example, it is wise to first make sure that you have saved the maximum amount in the employer plan to receive any employer matching contributions before utilizing the spousal contribution, as to not leave any benefits uncaptured.  It’s also important to take into account the tax considerations of each method of saving.   The tax deductibility of a spousal contribution can be limited based on the household’s adjusted gross income.      

There are always advantages and disadvantages to each scenario.  However, addressing these concerns in advance is a wise choice.  Working actively with a financial planner can address some of these concerns before they become a problem in the future.

  Filed under: Articles
  Comments: Comments Off on Asset Equalization Among Spouses: Why It’s Important

Required Minimum Distributions: Minimizing the Tax Impact

By info@landmarkwealthmgmt.com,

A required minimum distribution (RMD) refers to the amount of annual withdrawal an investor must take from their qualified retirement accounts (IRA’s, 401k’s, 403b’s etc.) once they have attained 70 ½ years of age.  The IRS maintains a mortality table for investors to use in order to calculate what amount they must withdraw each year.  This table has you divide your December 31st account balance by your stated IRS life expectancy to arrive at the annual figure.   The withdrawal becomes taxable ordinary income in the tax year it is received.  Any failure to meet the withdrawal can trigger a 50% penalty on the amount taken in addition to the taxes due.   ROTH IRA’s are exempt from the RMD calculation because they are made up of after-tax contributions, with tax free withdrawals.   It should also be noted that if you are still employed full time and participating in an employer retirement plan after age 70 ½, that plan is exempt from the RMD until you separate from service. 

 In many cases, investors live off of the income that is generated from these retirement accounts, and often take more than the required distribution.  However, in some cases investors have saved quite a bit, or have other income sources that support their lifestyle, such as a pension or even employment beyond age 70 ½.   In such examples, the RMD simply creates an unnecessary tax burden that is undesirable.   As a result, there are a couple of ways to either eliminate or defer this tax impact,  yet for many investors they may not always be desirable. 

Charitable Giving

Investors who are already charitably inclined may find this to be an attractive option.   The IRS permits a tax-free withdrawal from your IRA in the amount of the RMD not to exceed $100,000 annually once you have reached RMD age, as long as the withdrawal is paid directly to the charity.  The amount taken will be counted as part of the amount needed to satisfy your annual RMD.  This is known as a Qualified Charitable Distribution (QCD).  This must be donated directly to a publicly registered 501(c)(3) charity, not a private foundation set up by someone or some group.    This is not meant to disparage many of the private charities that do wonderful work, but rather to prevent fraud.   The funds cannot be sent to a donor advised charitable fund that will eventually fund the charity, nor can you take possession of the funds and then make the contribution.   

The $100,000 or less withdrawal must be met before the RMD is satisfied in order for this tax exemption to be realized.  As an example, you cannot spend $150,000 on yourself in IRA withdrawals and then send $100,000 to a public charity as part of a separate withdrawal.  In the case of those looking to make a charitable contribution, it is prudent to do that first early in the tax year, and then apply any amount withdrawn above the charitable contribution to your own taxes. 

It is not necessary to itemize your income tax return in order to use the QCD.   This is important under the new tax law.   Many retirees have less debt or in some cases no debt.   Typically, their children are independent, leaving them with nominal itemized deductions.  Under the newest tax laws which took effect in 2018, the standard deduction was doubled to $12,000 per person.   If you are over 65 years of age, there is another $1,300.  In the case of a married couple that has reached the age in which they must take their RMD’s, their standard deduction is a combined $26,600 annually.   While they have may have limited deductions, they may still have substantial assets.   So under the QCD, they can still take the standard deduction and then utilize this charitable deduction in addition. 

Qualified Longevity Annuity Contracts (QLAC’s)

A QLAC is a type of annuity contract that will not eliminate the tax on your RMD, but rather defer it.  This can be attractive if you have reason to believe that your income tax rate will decline in the future.  Perhaps someone who is working past age 70 ½, or has some other income payment that is finite might be a candidate.

The way a QLAC works is similar to that of a traditional annuity payment.   It allows you to fund the annuity the same way an immediate annuity would be funded for a lifetime payment, except the income is deferred until as late as age 85.   An investor can fund the lesser of $130,000 or 25% of their qualified retirement accounts to fund the QLAC.   This becomes a single premium payment, which creates a guaranteed lifetime income payment in the future, and delays the tax impact for as much as nearly 15 years.

The guaranteed payments can have a joint annuitant similar to other annuity products to protect you in the event that you pass away at a younger age without realizing the full income benefit.  In such an example, if you purchase a QLAC at 70 ½, and your spouse is 10 years younger than you, there is a high probability your spouse will outlive you.   Should you pass away at age 72, and your spouse lives to 95, they would continue to collect the same income if you opted to make them a joint annuitant.  However, the insurance company would base the payments on the mortality schedule of the younger annuitant, which invariably will lower your annual income when you begin to collect.

QLAC’s were designed to be longevity insurance, as the name implies.  The QLAC can also be used to defer the tax liability temporarily, but not without consequence.   If you were to calculate the internal rate of return on locking up $130,000 at age 70 ½ for 15 years to generate an income at age 85, you’d likely find a nominal growth rate being provided by the insurance company based on historical standards, which may not make sense in the grand scheme of your financial plans.   Typically, it will make more sense to realize the RMD and its tax consequence at 70 ½ while continuing to grow the assets.

There are no generic answers that apply to everyone, and as such we evaluate your own scenario based on its individual merits. 

  Filed under: Articles
  Comments: Comments Off on Required Minimum Distributions: Minimizing the Tax Impact

Exchange Traded Funds: Not Always a Passive Approach

By info@landmarkwealthmgmt.com,

The use of exchange traded funds (ETF’s) has become widespread in recent years.   The early incarnation of the ETF was essentially an Index fund which could be traded on an exchange intraday, as opposed to a traditional index fund which was bought and sold directly via the issuing mutual fund company. 

In recent years, a number of active managers have begun to launch actively managed versions of ETF’s in which there is a traditional manager, no different than a traditional mutual fund.  However, they are not without their differences.  

A mutual fund had at one time certain structural advantages for an active a manager in which they were not forced to disclose their holdings until the end of each quarter.  In theory, a manager may have taken a position in a particular security, then liquidated the position in between quarterly filings, and their competitors would have no public knowledge of what they bought or sold.   This makes it much more difficult to “front run” the activities of another manager.  Front running is process in which either an individual investor or another manager may steal your ideas by monitoring the purchases or sales you are making.  Because many of these funds are so large, it can take several days to implement a new purchase or sale, making the fund more vulnerable to front running.  Investment firms spend vast amounts of money on research, which ultimately defines their strategy.  So obviously they don’t want anyone else to utilize those research dollars by implementing their actions before they have a chance to complete their trading.     As such, the ETF version was less attractive to active managers. 

However, a new Securities & Exchange Commission (SEC) approval in early 2019 now makes it permissible for an ETF to conduct business without having to disclose their holdings daily.  This ruling was on the basis that the ETF provider can now use a “trusted agent” to serve as the middleman who holds the portfolio information and uses a confidential account to create and eliminate shares on behalf of the fund company.   This ruling will allow fund companies to create new versions of their products in which transparency concerns will no longer be relevant.     

It’s important to point out that the mutual fund structure already has this benefit.  So why the need to create an ETF version?

The answer is that there are still some other structural advantages to the ETF version over a traditional mutual fund.  A mutual fund often had to keep a sizeable cash position in order to address redemptions as they receive requests.  Simultaneously they need to invest cash as those new dollars come into the portfolio.  It is not always possible to get all the cash invested or liquidated that quickly, so there is often a lag between what the manager wants to allocate to, and what they are actually invested in at any given point in time.   Because the ETF shares are traded on an exchange, much of the buying and selling is transacted from one investor to another, which does not require the manager to maintain a large cash position and enables them to stay fully invested.  This also limits the internal trading of the portfolio, which helps limit the funds operating costs, making it more attractive to investors. 

Additionally, ETF’s can utilize what are known as in-kind exchanges.  Traditional mutual funds redeem shares for cash, which can potentially generate capital gains inside the portfolio of a mutual fund.  These gains are ultimately passed onto the shareholders of the fund as a tax liability.   In an ETF structure the portfolio can swap out positions that have a higher cost basis and don’t generate high capital gains, if any at all.  The higher volume and more liquidity the ETF achieves in the marketplace, the less likely it is that a capital gain will be realized. 

Ultimately, we have seen no solid evidence that active equity managers outperform their corresponding benchmarks across the entirety of the global stock market with any degree of consistency.  As a result of this data, we tend to implement a more passive approach to equity market exposure when constructing client portfolios.   

However, if as an investor one wishes to engage in the use of active management, the ETF options are likely to expand in the wake of this new SEC ruling.  More importantly, it’s important for the individual investor to understand what they are buying, as not all ETF’s are passive index funds anymore. 

  Filed under: Articles
  Comments: Comments Off on Exchange Traded Funds: Not Always a Passive Approach