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The Madoff Scam: What Can We Learn?

scandalNote: This is a re-publish of an article from early 2009 – but the lessons are still very useful in today’s world.

You’d have to be living under a rock to not know about the scandal of Bernie Madoff’s firm – wherein the supposedly legitimate Madoff bilked some of the most sophisticated investors in the world out of something like $50 billion. The Ponzi scheme has been around forever, for the very fact that it works – much to the chagrin of those caught in its web.

The bright spot for all of us (as long as you weren’t caught in the Madoff scheme) is that the losses we’ve all seen in the the stock market pale in comparison to the losses by Madoff investers. Plus, we have the opportunity to make it back (eventually). These folks lost literally everything invested there, in some cases entire life savings. The vexing part is that many of those folks should have known better. Included in the ranks of people who lost money with Madoff were big banks, Wall Street economists, and, surprisingly, Stephen Greenspan, an emeritus psychology professor who just published a book titled Annals of Gullibility: Why We Get Duped and How to Avoid It.

So How Did This Happen? The way folks were fooled into believing this scheme is that Madoff had a reputation as a forthright and above-board individual. Why, he had once been the chairman of the Nasdaq stock exchange! Most of the large institutions victimized had personal relationships with Madoff and his marketing team, in part owing to the scammer’s earlier position on Wall Street. It is this kind of personal relationship that evokes trust and, in the wrong kind of individual, exploitation of that trust.

But the real enticement came from the consistency of the returns – not earth-shattering in scope, these were relatively modest returns of approximately 1% a month. Considered one month at a time, that’s pretty minimal, but even the average investor should have begun to ask questions when that return continued through up markets and down, with nary a change. Had Madoff offered 10% per month, he wouldn’t have even gotten off the ground, but with this smaller return folks came in by the busload, checkbooks in hand.

And lastly, he came across as an independently-wealthy individual. What motive would someone of his means have for stealing even a dime from someone else? As it turns out, he had every motive in the world, and appearances were quite deceiving.

Lesson #1 from Madoff: If it looks too good to be true, it probably is too good to be true.

Lesson #2 from Madoff: No one can deliver a 1% return per month, every month, in up markets and down. It just doesn’t happen.

What Else Can We Learn? One of the easiest ways to keep something like this from happening is to keep your investing simple. It seems that when complex investment activity is added to an investor’s portfolio, bad things can begin to happen. By complexity I mean getting involved in frequent trading, playing with options, shorting positions, fooling with derivatives, and things along those lines. These are the sorts of investments at the root of today’s financial crisis. While the products in question (mortgage derivatives) are not new to the scene, the history of these products was shaky at best even before September of last year – and we saw what happens when the “perfect storm” of risks comes together. With little forewarning, the entire house of cards comes falling down.

When asked his investment strategy, Madoff touted a complex “split-strike conversion” methodology. That was all the explanation given, and all that the investors (apparently) required. Whatever he was doing seemed to be working, and that was fine with anyone who cared to wonder. It’s unknown if Madoff ever invested a single dollar, or if he just churned the new money back out the door to the earlier investors, in the classic Ponzi style.

It is a common belief that there is a group of folks (the “smart money”) who can beat the market all the time. It’s my opinion that no such group or individual exists. Just look around you: if there was any “smart money” around, you’d have seen those companies or mutual funds faring well during the meltdown last quarter. Unfortunately there is no crystal ball – and given the firehose of information available to us these days, very little can escape notice.

This is not to say that no one ever beats the stock market averages. On the contrary, there are some mutual fund managers every year who beat the average, and some do it consistently (although not many). As I have mentioned on these pages in the past, less than 3% of all fund choices in a particular category will beat the index for an extended period. With odds like that, why not stick with the simple, tried and true index strategy?

Lesson #3 from Madoff: Keep it simple. Understand your investments, and why they make money.

In addition, Madoff acted not only as advisor, but also as brokerage for his client-victims. In other words, when making an investment, clients would just hand over the money to Madoff, rather than a third-party brokerage. With everything under one roof, Madoff was free to do whatever he wanted (and he did) with no checks and balances.

Lesson #4 from Madoff: Know where your money is going, and check on it regularly. Utilize a third-party between you and your advisor so that you can independently verify that your money is invested as you desire.

It’s a terrible thing that the folks who trusted Madoff have nothing to show for their lifetime of investing. Knowing what we know today, he probably still would have suckered in quite a few folks. But if we pay close attention to the lessons that we can learn from this scam, hopefully you and I will avoid being pulled in to the next scheme like this that comes along.

A Note for New Advisors

Businessman juggling fruit

Businessman juggling fruit

This post is for an advisor just starting out in their career. Their work could range from working for a large broker-dealer, to a small financial planning firm with a few employees. The main point of this post is to give the advisor reading it some hope and inspiration. Having had experience working for both a large broker-dealer and a small firm (here at BFP) my hope is to give some advice thoughts as the advisor shapes their career.

  1. First, you are in one of the greatest positions in your career. You have the choice of determining how you want your career path to look. Determine the path and what type of financial professional you want to be moving forward.
  1. Identify if you are a hunter or a farmer. If you decide to be a hunter, you will spend the rest of your career “going for the kill”. This means you will find yourself going after new clients almost always and it will likely be a byproduct of how you’re paid – on commission and likely with quotas. Often, clients don’t appreciate being “prey”. If you’re a farmer, you’ll spend a lot of time cultivating and nurturing relationships. The income may seem low at first (more on this in a bit) but after time, your relationships will bear fruit and your income will grow.
  1. If you take care of your clients, the money will follow. It can be difficult when we are so prone to short-term thinking, but giving up an immediate “sure thing” transaction for the benefit of the client will reap you huge rewards – both professionally and financially. When your clients see you care about them, and not your bottom line (or the company’s) they will trust you more and more, and trust you with their referrals. And by the way, don’t ask for referrals. If you’ve done your job, the referrals will come.
  1. Keep educating yourself. I’m not talking about the required CE that your licensing requires. I’m talking about taking continuing education because you want to learn. Think of it this way. Would you want to work with the person who only did CE at the 11th hour or the professional who took CE because he wanted to learn regardless of requirements? At a minimum, study and earn the CFP® designation. From there, pursue other designations such as the ChFC®, CLU®, etc.
  1. Are you a generalist or specialist? Some advisors choose to be generalists. This means that they can help clients in a number of areas and are qualified to provide general comprehensive financial planning. Specialists may hold themselves out to be an expert in a particular area, such as a specific retirement plan, Social Security, taxation, or estate planning. They may choose additional designations besides the CFP®. There are many successful financial professionals in either category.
  1. Find a mentor. Be proactive about finding an individual that reflects your beliefs, work ethic, and integrity (hopefully, all positive). They can help cut years in trial and error off of your learning curve. This can also tie into the second point above. Be willing to farm and cultivate this relationship. Don’t be afraid to accept a smaller wage in exchange for the mentor’s wisdom. Additionally, be willing to do “grunt” work without complaining or hesitation. You may not realize it now, but if you’re with the right mentor, your professional career will be greatly enriched.

My hope is that this can be beneficial for a new advisor or someone thinking about financial planning as a career. Please don’t hesitate to reach out to us if you have any questions. We promise to be candid.

New Rules for File and Suspend

file and suspendSo the heyday is over, file and suspend under the old rules is gone forever as of April 30, 2016. Those were the days, my friend. We thought they’d never end. We’d file and suspend forever and a day. But not any more…

Or, may we still file and suspend?

Of course we can still file and suspend, the rules are just more restrictive now. When you suspend your benefits these days, all benefits that are payable based upon your record are suspended as well. For example, if you have a child who is eligible for benefits based on your record, when you suspend your benefits the child’s benefits will be suspended as well.  The same goes for spousal benefits based on your record.

To be clear, the rules about suspending benefits are:

  • You must be at least Full Retirement Age
  • When you suspend benefits, your own benefit will not be paid to you
  • Since you are not receiving benefits, you will earn delay credits at the rate of 8% for every year of delay
  • ALL OTHER BENEFITS based on your record will also be suspended, including spousal benefits and child’s benefits

File and Suspend

Before the rules changed, it was common to file and suspend at the same time. Now, with the new rules, it would likely not make much sense to file and suspend at the same time.

The action of filing for benefits is enough to enable benefits for others (spouse or child) to receive benefits based on your record. Under the old rules, if you suspended your benefits, these auxiliary benefits could continue – so, file and suspend at the same time made a lot of sense. By doing so, you would enable others to receive the auxiliary benefits, while at the same time delaying your own actual filing to some later date, receiving the delay credits for the delay.

With today’s rules, file and suspend at the same time doesn’t actually accomplish anything for you, other than establish a filing date.

What you might do though, is file for benefits at one point, and then later suspend them. For example, if you are 62 years old and you have a child who is under 18 (for example’s sake we’ll say 12 years old), you could file for your own benefits and enable your child to receive benefits based on your record. When the child reaches age 18, he will no longer be eligible to receive the benefits – so you could suspend your benefits at this point (you’d be 68 by now) and receive an 8% increase to your benefits for each year that you delay.

The strategy above would be important to you to provide some benefits to the auxiliary dependents (such as a child or spouse) for a short period of time, while allowing you to then enhance your benefits later by suspending.

If the concept isn’t thrilling to you, you’re not alone. Suspending benefits just isn’t what it used to be.

401k Loan versus Early Withdrawal

loaned motorcycleWhen you have a 401k and you need some money from the account, you have a couple of options. Depending upon your 401k plan’s options, you may be able to take a 401k loan. With some plans you also have the option to take an early, in-service withdrawal from the plan.

These two options have very different outcomes for you, in terms of taxes and possible penalties. Let’s explore the differences.

401k Loan

If your plan allows for a 401k loan, this can be a good option to get access to the money, for virtually any purpose. Being a loan, there is no tax impact when you take out a 401k loan. Plus you can use the money for any purpose that you need, at any age.

As a loan, it must be paid back over the a five-year period (at most). You’ll pay interest on the loan, but since it is from your own account, you’re paying interest to yourself.

There is a limit of $50,000 for a 401k loan, or 50% of your account balance if that amount is less.

If you leave the employer (retirement or otherwise) and there is still a balance outstanding on your 401k loan, the outstanding balance will be considered a withdrawal from the 401k account – which is taxable as ordinary income and possibly subject to the 10% early withdrawal penalty (unless you meet one of the exceptions, see below).

If you are not currently employed by the sponsoring employer, a 401k loan is generally not available.

401k Withdrawal

If you’re still employed by the company and want to take a withdrawal from your 401k, the 401k plan must have an option to allow for in-service withdrawals. Often there are restrictions on the availability of an in-service withdrawal. For many plans it’s necessary to be above a certain age (such as 59½ years of age), or that a particular requirement is met, such as hardship by the employee, defined by the plan administrator.

In addition, if you’re taking a withdrawal from the plan instead of a 401k loan, the money withdrawn from the 401k plan will be taxable to you as ordinary income. Plus if you’re under age 59½ your withdrawal could be subject to an early withdrawal penalty unless you meet one of the exceptions. See the article 16 Ways to Withdraw Money From Your 401k Without Penalty to see the exceptions to the 10% penalty.

The good news is that you won’t have to pay the money back to the plan when you make a withdrawal as you would with a 401k loan.

A Risk Management Checklist

checklistAlthough many individuals have various risk management policies in place, sometimes those policies get brushed aside and every once in a while the dust needs to be wiped off of them and perhaps some updating needed. Here’s a checklist to consider the next time you review your risk management strategies.

  1. Auto Insurance – Review your coverage to make sure it’s still adequate. Liability limits of at least $250,000 should be the norm. Limits of $500,000 up to $1 million are better. If you drive an older car, consider raising your comp and collision deductibles or eliminating them altogether to save on premiums. Upside down on your car loan? Consider gap insurance. Better yet, don’t have a car loan.
  1. Home Insurance – Make sure your home is insured to its reconstruction cost. This is the cost to rebuild your home using today’s prices for materials, labor, etc. It is NOT the fair market value. Often these numbers are vastly different. Liability limits should be at least $250,000, but higher amounts up to $1 million are better. Have a collection, jewelry, or other unique items? Consider endorsing them specifically. Endorsements provide specific coverage and deductibles for the covered items and override any limits in the original policy. If you recently acquired a pool or trampoline talk to your company. These items may have special requirements or not be covered at all.
  1. Life Insurance – Review your beneficiaries. Life happens and you need to consider if they need to be updated, or in the case of a divorce or other life event, changed. What type of policy do you have? Are you paying too much? Do you need more coverage? Do you need less? If you have coverage through your employer, is it enough (chances are it’s not)? It pays to spend some time reviewing these questions. If you’re confused, call a competent financial professional.
  1. Umbrella Insurance – This often overlooked coverage is extremely important to your risk management plan. Often the least expensive insurance coverage (as it rarely is needed) it’s still important if the worst happens. Generally, it’s coverage that’s in place if an individual exceeds their liability limits in an auto or home claim. Policies with $1 million limits can be obtained for as little as a few hundred dollars annually.
  1. Disability Insurance – The odds of an individual becoming disabled during their working lifetime are greater than dying prematurely. Many employers offer group disability. This is a great benefit. Individuals without access to group disability should consider purchasing a policy outright to protect their income. Be sure to review the definition of disability in the policy. Generally, cheaper premiums mean stricter definitions of disability. This means that while the premium may be less, it may be very difficult to file a claim if the definition of disability is strict – such as any occupation. Review the elimination period (time deductible) of the policy. Generally, the longer them elimination period (how long you wait until the benefits pay) the lower the premium and vice versa.
  1. Health Insurance – Review your policy to see if the coverage still makes sense. Review how often you’ve used the policy. If you’ve seldom gone to the doctor or made claims, consider a policy with higher deductibles. This will save on premiums. If you have a high deductible policy, consider utilizing an HSA.
  1. Emergency Fund – Generally, make sure you have three to six month of non-discretionary income set aside. Personally, I like a year’s worth. To each their own. Having an emergency fund can help pay for higher deductibles in any of the policies mentioned above. The higher the emergency fund, the higher your deductibles can be. The more you save on premiums. Additionally, an emergency fund can help you avoid making a costly mistake by funding deductibles or emergencies with credit cards.

Finally, don’t wait for a claim to see what your coverage is. Or worse, let the loss be the impetus to get coverage in place. Insurance is meant to be preemptive, with the hope that you never need it. But if you and when you do, your entire wealth management plan isn’t destroyed. Risk management ensures that if the worst happens, you have a bad day or two, not a bad life.

Focus on the Things You Can Control

Left a good job in the city, workin’ for the man every night and day. But I never lost one minute of sleepin’ worryin’ ’bout the way things might have been.

— John Fogerty

heathrowSometimes the answer to our stresses in life is to get back to basics and figure out what’s important to us, as well as what things we can control in our life. In the song quoted above, Fogerty’s writing was most likely tempered by his recent discharge from the Army Reserve (1967), after which the protagonist explores an awakening to a simpler side of life, and what turns out to be important to him.

We are often faced with similar situations – maybe we’ve been laid off or some financial calamity strikes us, and from that perspective we often discover what’s really important to us. Other times we just come to realize that our life seems out of control, and we’re searching for a way to get our comfort level back. Most importantly we can learn to not “worry ’bout the way things might have been”, and instead focus on the things about our lives that we can control.

At times we worry about interest rates, inflation, overseas unrest, the current political cycle, whether stocks are going up or down, and the baggage retrieval system they’ve got at Heathrow*. None of these things are items that you can control – for example, stocks are going to go either up or down, and no amount of worry on your part will affect the end result. The same goes with obsessing over the interest rate or inflation. Nothing you can do will change the course of these things. It’s best just to let them go, and don’t worry about them.

Now, I’m not advocating a “don’t worry, be happy” attitude, at least not completely. But there is something to be said for not letting things get you down. This can be more easily understood if you think about your life resources that you have available to you as similar in that there is a finite amount of each that is yours to use as you please:

  1. Money
  2. Time
  3. Talent
  4. Energy

In our lives we’re always making choices about how to “spend” these resources. Setting aside money for the moment, the other three (time, talent and energy) can be exchanged for money, and you can use the money to provide yourself with more time (sometimes) and more talent. Energy is one that can’t be expanded easily – and this one is where you lose out by worrying too much.

You only have so much energy available to accomplish things in your life. Whatever amount of that energy that you spend worrying about whatever is on the business news channel, then you have that much less energy to teach your son to play catch. And the end result for your financial well-being is likely to be the same whether you’re playing catch or watching the business news circus.

In addition, we often allow “the way things might have been” to dig at us over time. This stress that we put upon ourselves has no purpose – as the saying goes, “don’t cry over spilled milk”. Learn from the bad things that have happened to you, for sure. But don’t let the bad things that happened to you in the past define your future.

You have control over certain things, and it’s different for everyone. Instead of worrying about the stock market, shut off the tv, play catch with your son (or daughter), and then use your extra energy to figure out a way to maximize your IRA contributions. You’ll be far better off in the long run.

* That line is from a Monty Python routine called I’m So Worried – not their best work, but if you’re amused by the Python, I recommend giving it a listen.

Changing Your SOSEPP – Once, just once

sosepp-carIf you’re taking (or planning to take) early distributions from an IRA using the 72(t) provision with a Series of Substantially Equal Periodic Payments, also known as a SOSEPP, you need to know a few things about this arrangement. For more information on SOSEPPs in general, see the article Early Withdrawal of an IRA or 401(k) – SOSEPP for more details.

Generally when you establish a SOSEPP you have to stick with your plan for the longer of five years or until you reach age 59½ years of age. However, the IRS allows changing your SOSEPP one time, and only one time. And then, the rules only allow changing your SOSEPP from either the fixed annuitization method or the fixed amortization method to the Required Minimum Distribution method.

This is the only exception allowed for changing your SOSEPP during its enforcement period, which is the later of five years after you started the SOSEPP or when you turn age 59½. The exception is documented in Rev. Ruling 2002-62, 2.03(b).

If you’re planning on changing your SOSEPP in a manner other than the above-described methods, you will effectively “break” the plan, meaning that the SOSEPP is no longer in place. Doesn’t sound like such a bad thing, right? That’s where you’re wrong though… because if you break a SOSEPP, there are some very nasty ways that the IRS will get back at you.

This can be as simple as increasing or decreasing the amount you withdraw slightly, or forgetting to make a withdrawal altogether, or possibly taking two distributions (a double-dip) in one year. There’s not much room for “forgive and forget” on this from the IRS. For more on the consequences of breaking a SOSEPP, see the article Penalties for Changing a SOSEPP.

There is no specific provision in the Internal Revenue Code for relief from the penalty if you have broken your SOSEPP.  On the other hand, the IRS has in some cases granted relief in several private letter rulings by determining that a change in the series of payments did not materially modify the series for purposes of the rules.

If the series is broken due to an error by an advisor (for example), some prior PLRs have been issued in favor of the taxpayer.  PLR 201051025 and PLR 200503036 each address the situation of an advisor making an error and the distributions were allowed to be made up in the subsequent year.  Bear in mind that PLRs are not valid for any other circumstances other than the specific one in the ruling, and cannot be used to establish precedence for subsequent cases.

But in reality, the likelihood of your getting a favorable PLR for your case of a broken SOSEPP is small – unfortunately, breaking the series usually results in application of the penalty for previous payments received, and the SOSEPP is eliminated.  If you wish to restart the series you can do so, but you are starting with a new five-year calendar (the series must exist for at least five years, or until you reach age 59½, whichever is later).

Don’t Forget to Make Your IRA Contribution by April 18!

forgetmenotsWhen filling out your tax return, it’s allowable to deduct the amount of your regular IRA contribution when filing even though you may not have already made the contribution.

You’re allowed to make an IRA contribution for tax year 2015 up to the original filing deadline of your tax return. This year, that date is April 18, 2016.

The problem is that sometimes we file the tax return way early in the year, and then we forget about the IRA contribution. As of the posting of this article, you have 1 week to make your contribution to your IRA to have it counted for tax year 2015.

What To Do If You Miss the Deadline

If you don’t make the contribution on time, you’re in for some nasty surprises unless you take some corrective actions.

If you find yourself on April 19, 2016 without having made your IRA contribution and you had deducted one from your taxes for 2015, you need to amend your return. This means that you’ll fill out a Form 1040X and eliminate the IRA contribution that you originally deducted from your income. This will (most likely) result in additional taxes that you’ll owe, so when you send in the amendment you’ll have to send an additional tax payment.

Failure to amend your return in a timely fashion will result in the IRS contacting you later, requiring you to pay the additional tax plus interest. In addition, since your tax return was erroneous, the IRS will consider this to be “under-reporting of income” and “under payment of tax” – both of which carry penalties. Even if it was an honest mistake, you’ll owe these penalties.

You may even owe some penalties and interest if you file your amendment right away, since technically you’ve under-reported and underpaid. But if you amend as soon as you can, these penalties and interest should be minimized.

Should I Pay Off My Student Loans or Start Investing?

Businessman juggling fruit

Businessman juggling fruit

I had an interesting question come my way from a student the other day and I thought I’d expand on my answer that I gave to the student. The question was whether he should pay off his student loans and then start investing, or if he should start investing first and pay off the student loans gradually.

If we really look at it, paying down any type of debt is very similar to making an investment in a guaranteed account paying interest on the equivalent of the interest rate on the debt. This student’s interest rate on his debt was approximately 7%. Paying this off would not be unwise and would be a great way to earn 7% risk free – only this method keeps the 7% out of the lender’s pocket and puts it into the borrower’s.

However, if we completely ignore investing and saving for retirement we can miss out on some of the crucial, early years of investing where a young investor can take advantage of time, and compounding. Even a small amount set aside on a regular basis can reap huge rewards and returns over time through the value of compounding.

So here was my answer to the student. Depending on his risk tolerance, if he thought he could earn a return higher than 7% (subject to much more risk) than he could consider investing now and simply paying down the debt through the regular monthly repayments. I advised that deferring the repaying was not recommended.

If he thought he was a more conservative investor then he could consider paying a much larger amount monthly to reduce the debt even more, then, when the debt is paid off, use the free cash flow to enhance retirement savings.

Additionally, I told the student if he was participating in a 401(k) with a match, to definitely save into the 401(k) at least up to the employer match. This is free money from the employer and everyone should take advantage of this. Furthermore, the student should be aware that his student loan interest paid is deductible up to $2,500 every year as an adjustment to income (above the line deduction).

While I had no blanket answer for this student, it hopefully gave him an idea as to how he should think about his retirement savings and debt. The good news is that he was at least thinking about these things, which feels good. Sometime you wonder if you’re making a difference.

Taxes and Your Child

childrenWhen a child has unearned income from investments in his or her own name, taxes can be a bit tricky. Depending on how much the unearned income is, part of it may be taxed at the child’s parent’s tax rate, for example.

Recently the IRS published their Tax Tip 2016-52, which details What You Should Know about Children with Investment Income. The text of the Tip is below:

What You Should Know about Children with Investment Income

Special tax rules may apply to some children who receive investment income. The rules may affect the amount of tax and how to report the income. Here are five important points to keep in mind if your child has investment income:

  1. Investment Income. Investment income generally includes interest, dividends and capital gains. It also includes other unearned income, such as from a trust.
  2. Parent’s Tax Rate. If your child’s total investment income is more than $2,100 then your tax rate may apply to part of that income instead of your child’s tax rate. See the instructions for Form 8615, Tax for Certain Children Who Have Unearned Income.
  3. Parent’s Return. You may be able to include your child’s investment income on your tax return if it was less than $10,500 for the year. If you make this choice, then your child will not have to file his or her own return. See Form 8814, Parents’ Election to Report Child’s Interest and Dividends, for more.
  4. Child’s Return. If your child’s investment income was $10,500 or more in 2015 then the child must file their own return. File Form 8615 with the child’s federal tax return.
  5. Net Investment Income Tax. Your child may be subject to the Net Investment Income Tax if they must file Form 8615. Use Form 8960, Net Investment Income Tax, to figure this tax.

Refer to IRS Publication 929, Tax Rules for Children and Dependents. You can get related forms and publications on IRS.gov.

Each and every taxpayer has a set of fundamental rights they should be aware of when dealing with the IRS. These are your Taxpayer Bill of Rights. Explore your rights and our obligations to protect them on IRS.gov.

Break Even Points for Social Security Filing Ages

break evenLast week my article 3 Myths About Social Security Filing Age included some information about year-to-year break even points for the various Social Security filing ages. This prompted some questions about the break even points between all filing ages, not just the following year.

So for example, what are the break even points between choosing to file at age 62 versus age 66 or age 70?

This article shows the approximate break even points between all of the various filing ages. The first chart shows the break even points when your Full Retirement Age is 66. To use the chart, select your first filing age decision on the left, then move right to the second filing age you’re considering:

image

So, for the decision between filing at age 62 versus age 66, you can see that the break even point is at the age of 78. Comparing filing at age 66 with age 70, the break even point is at age 82.

It should be noted that these break even points are the age you will be when cumulative benefits received at the later filing age becomes greater than the cumulative benefits received based on the earlier filing age. The specific break even points occur sometime during the year indicated, as the analysis is done on an annual basis (not month-to-month). In other words, the actual break even month might be any month during that year. With this difference in mind, the prior article has been updated to reflect the same. Previously the analysis showed the first full year that the later filing age was superior to the earlier filing age.

This second chart shows the break even points for when your FRA is 67. It is used exactly the same as the chart above.

image

As before, choose the first filing age in the left column, and then move to the right for the break even points for the various filing ages. If you were choosing between age 63 and 66, for example, the break even point is age 77. Between age 65 and age 70, the break even point is 82.

How to Save Money

minimize taxesMany individuals hear the mantra to start saving money early, put something aside for retirement, or start accumulating a nest egg. However, as much as those mantras are good advice, sometimes an individual needs a specific direction on how to get started. Hopefully, this post can provide some of that direction.

Whether you’ve just graduated high school, college, or have been working for a number of years, if you haven’t started saving for an emergency or retirement, there’s still time to do so. It’s never too late.

One of the first things an individual can do is simply take a look at what is coming in and what is coming out of their income. An easy way to do this is by looking at the last three month’s bank statements. This will give an excellent representation of what income was coming in and what was being spent. From there, start separating needs from wants in the expenses. Be honest with yourself. Are you seeing expenses that you really have to have? Can these be put to better use?

Once you’ve identified expenses that aren’t needs, tally them up for your monthly total. Here’s the fun part. Since you’ve already budgeted for these items and you’re already used to these being expenses, simply take that sum and have it put into a savings account (for an emergency fund) or open an IRA (for retirement). The nice thing about this step is it can be done automatically. At the beginning of each month you can have the sum automatically transferred to the savings or IRA and this reduces the “pain” of writing out a check or the effort if physically transferring the money yourself.

Additionally, if and when you have access to a retirement plan at work, such as a 401(k), you can apply the same principles. Choose a percentage of your gross income that you’d like to save (15% is an excellent start) and have it taken out of your check before you’re paid. This accomplishes two things: it takes care of the need to save and forces you to live off the rest. Furthermore, by saving a percentage of your income you automatically give yourself a raise to your retirement contributions any time you get a pay raise.

Saving doesn’t have to be daunting. It can be hard to start and confusing on what approach to take. If you’re willing to be honest with expenses (needs versus wants) and make your savings automatic, you may find it easier to save than you thought. And in just a few years’ time, you’ll have quite a bit of savings to show for it.

3 Myths About Social Security Filing Age

myth-myth-yethWe hear all kinds of things about Social Security filing age – that we should always delay as long as possible, that we will gain 8% every year that we delay, and that the “break even” point is 80 years of age.

This article takes a long hard look at these three “facts” about Social Security filing age and shows the real math behind them. All three are only true to a point – and as you’re planning your Social Security filing age, you should understand the real truth behind these three items.

First, let’s look at the concept of delay.

You Should Always Delay Your Social Security Filing Age to 70

This one is the easiest to understand why it’s wrong – but the component of truth in it can be important because it could work in your favor to delay. Of course an absolute like this is going to be proven incorrect in some circumstances.

If you happen to be able to delay your Social Security filing age and you live a long time after age 70, over your lifetime you will receive more from Social Security than if you file early. However, if you need the cash flow earlier due to lack of other sources of income, filing early may be your only choice.

Filing earlier can provide income earlier, but depending on your circumstances you may be short-changing your family by filing early. When you file early, you are permanently reducing the amount of benefit that can be paid based on your earnings record. Your surviving spouse’s benefits will be tied to the amount that you receive when you file, and so if you delay to maximize your own benefit and your spouse survives you, you’re also maximizing the benefit available to him or her. This is to assume that your surviving spouse’s own benefit is something less than your benefit.

John has a benefit of$1,500 available to him if he files at age 66, his Full Retirement Age (FRA). His wife Sadie has a benefit of $500 available at her FRA. If John files at his age 62, his benefit is reduced permanently to $1,125 per month. When John dies, assuming Sadie is at least at FRA, Sadie’s benefit will be stepped up to $1,237 (the minimum survivor benefit is 82.5% of the decedent’s FRA benefit amount).

On the other hand, if John delayed his benefit to age 68, he would receive $1,740 per month since he has accrued delay credits of 16%. Upon John’s death, Sadie will receive $1,740 in survivor benefits. By delaying his benefit 6 years, John has improved his surviving spouse’s lot in life by over $500 per month. Of course this has required him to come up with the funds to get by in life in the meantime, and so if he has the funds available this makes a lot of sense. If he doesn’t have other funds available, one thing that can help matters out is if Sadie files for her own benefit at age 62 – this will provide them with $375 per month while John delays his benefits.

The key here is that it’s often wise for the member of a couple that has the larger benefit to delay benefits for the longest period of time that they can afford, in order to increase the survivor benefit available to the surviving spouse. But it’s also often necessary for household cash flow to file earlier. As we’ll see a bit later, only the question of surviving benefits makes this delay a truism. Otherwise, it could be more beneficial to file earlier.

Increase Your Benefits by 8% Every Year You Delay Filing

This one again comes from a truth: for every year after FRA that you delay your Social Security filing age, you will add 8% to your benefit. But the year-over-year benefit differences are not always 8%, and often the difference is much less.

It is true that if you compare the benefit you’d receive at age 66 to the benefit you’d receive at age 67, it will have increased by 8%. However, if you compare your age 67 benefit to your age 68 benefit, it will have increased by 7.41%. This age 68 benefit is 16% more than the age 66 benefit, but only 7.41% more than the age 67 benefit.

The table below shows the differences across the spectrum of filing ages when your FRA is age 66:

Filing Age Difference
62
63 6.67%
64 8.33%
65 7.69%
66 7.14%
67 8.00%
68 7.41%
69 6.90%
70 6.45%

And this table shows what the differences are year-over-year if your FRA is age 67:

Filing Age Difference
62
63 7.14%
64 6.67%
65 8.33%
66 7.69%
67 7.14%
68 8.00%
69 7.41%
70 6.90%

So as you can see, only from one specific year, your FRA, to the following year, is the increase 8%. Otherwise, with only the exception of one filing age (the difference between 3 years before FRA and 2 years before), the year-over-year increase is less than 8%, and sometimes it’s less than 7%.

The Break Even Point is 80 Years of Age

I’ve often quoted this as a fact – rarely pinning it down to a specific year, but giving the range of around 80 years old. It’s not that simple though when you consider all of the different ages that an individual can file.

For example, when deciding between a Social Security filing age of 62 versus filing at age 63, your break even point occurs at age 77 (when your FRA is age 66).  But when deciding between age 63 and age 64 (with FRA at 66), the break even occurs at age 78.

On the other end of the spectrum, when choosing between filing at age 69 versus filing at age 70 (FRA of 66), the break even occurs at age 84 – considerably later than age 80. The break even for the decision to file at age 68 versus age 69 occurs at age 82.

The two tables below illustrate the ages at which the break even occurs between the various filing ages. This first table is when your FRA is 66:

Filing Age Break Even
62
63 77
64 78
65 76
66 79
67 80
68 80
69 82
70 84

And this table shows what the differences are year-over-year if your FRA is age 67:

Filing Age Break Even
62
63 77
64 75
65 78
66 79
67 79
68 81
69 83
70 85

So the year-over-year break even point ranges, depending on which Social Security filing age you’re considering. If the two options are earlier (before FRA) the break even point occurs before age 80. If at or around FRA, then the break even occurs right around age 80. But if the Social Security filing age you’re considering is near age 70, count on the break even being much later, as late as age 85.

IRS Reports 9 Common Tax Prep Errors

errorsUnless you’ve been under a rock for the past several years, you know that this time of year is tax season. If you haven’t already filed your 2015 income tax return, of course you’ve got some work ahead of you. Unfortunately filing your tax return often results in errors – and these can be quite costly in terms of delays in processing as well as potential penalties and interest if your error results in underpayment of tax.

In addition, an error on your return could result in missing out on refunds or credits that you are entitled to.

Recently the IRS issued Tax Tip 2016-42, which lists out 9 common filing errors that they see, and tips to avoid the errors. The actual text of the Tip follows:

Avoid Errors; File an Accurate Return

The IRS encourages you to file an accurate tax return. Take extra time if you need it. If you make an error on your return then it will likely take longer for the IRS to process it. That could delay your refund. You can avoid many common errors by filing electronically. IRS e-file is the most accurate way to file your tax return. Seven out of ten taxpayers can use IRS Free File software at no cost.

Here are nine common tax-filing errors to avoid:

1. Wrong or Missing Social Security Numbers.  Be sure you enter all SSNs on your tax return exactly as they are on the Social Security cards.

2. Wrong Names.  Be sure you spell the names of everyone on your tax return exactly as they are on their Social Security cards.

3. Filing Status Errors. Some people use the wrong filing status, such as Head of Household instead of Single. The Interactive Tax Assistant on IRS.gov can help you choose the right status. If you e-file, tax software helps you choose.

4. Math Mistakes. Math errors are common. Tax preparation software does the math for e-filers.

5. Errors in Figuring Tax Credits or Deductions. Many filers make mistakes figuring their Earned Income Tax Credit, Child and Dependent Care Credit, and the standard deduction. If you’re not e-filing, follow the instructions carefully when figuring credits and deductions. For example, if you’re age 65 or older or blind, be sure you claim the correct, higher standard deduction.

6. Incorrect Bank Account Numbers. Choose direct deposit for your refund. It’s easy and convenient.  However, be sure to use the right routing and account numbers on your return. The fastest and safest way to get your tax refund is to combine e-file with direct deposit.

7. Forms Not Signed.  An unsigned tax return is like an unsigned check – it’s not valid. Both spouses must sign a joint return. You can avoid this error by e-filing your taxes since you must digitally sign your tax return before you send it to the IRS.

8. Electronic Filing PIN Errors.  When you e-file, you sign your return electronically with a Personal Identification Number. If you know last year’s e-file PIN, you can use that. If you don’t know it, enter the Adjusted Gross Income from the 2014 tax return that you originally filed with the IRS. Do not use the AGI amount from an amended return or a return that the IRS corrected.

9. Health Care Reporting Errors. The most common health care reporting errors that taxpayers make involve failing to claim a coverage exemption and not reconciling advance payments of the premium tax credit. If you don’t have qualifying health care coverage but meet certain criteria, you might be eligible to claim an exemption from coverage and avoid an unnecessary payment when you file your tax return. If you enrolled in health coverage through the Health Insurance Marketplace and received advance credit payments, you must file a tax return to reconcile the advance payments made on your behalf with the amount of your actual premium tax credit.

Each and every taxpayer has a set of fundamental rights they should be aware of when dealing with the IRS. These are your Taxpayer Bill of Rights. Explore your rights and our obligations to protect them on IRS.gov.

Additional IRS Resources:

IRS YouTube Videos:

Taxes and the 401k Withdrawal

401k withdrawalIf you take a 401k withdrawal and the money in the 401k was deducted from your taxable income, you’ll be taxed on the funds you withdraw. Depending on the circumstances, you may also be subject to a penalty. There’s a lot of confusion about how the taxation works – and the taxation and penalties can be different depending upon the circumstances.

Taxation of the 401k Withdrawal

When you take a distribution of pre-tax money from a 401k plan, the amount of the 401k withdrawal that is pre-tax will be included in your income and will be taxed at your marginal income tax rate in that year.

Unless you meet one of the exceptions noted in the article 16 Ways to Withdraw Money From Your 401k Without Penalty, your 401k withdrawal will also be subject to a 10% early withdrawal penalty.

For example – if you have a 401k plan at a former employer and you are 45 years of age, unless your 401k withdrawal meets one of the exceptions, taxation would work like this for a $50,000 401k withdrawal:

Taxable Income before withdrawal $60,000
Tax (assumes MFJ) $8,072.50
Effective Tax Rate 13.45%
401k Withdrawal $50,000
Other taxable income $60,000
Total taxable income $110,000
Tax (assumes MFJ) $23,836.75
Effective Tax Rate 21.67%
Penalty (10%) $5,000
Total Tax and Penalty $28,836.75
Total Effective Tax Rate 26.22%

Nothing really dramatic about the first part, it’s just more taxable income and you’ve likely grown to understand the effect of the graduated tax schedule. But what will likely open your eyes is the fact that this $50,000 was actually taxed at a rate of 41.53%! Your 401k withdrawal of $50,000 resulted in $20,764.25 in taxes and penalties, so in effect you only “net” $29.235.75 from this withdrawal. Almost makes a payday loan look cheap by comparison.

On the other hand, if you met one of the exceptions (such as being age 59½ or older, the penalty would not apply. The effective tax rate on the 401k withdrawal is 10% less, at only 31.53%.

Mandatory Withholding

Another thing you need to understand about your 401k withdrawal is the mandatory withholding. Unless your 401k withdrawal is a direct rollover to another plan (such as an IRA), part of a Series of Substantially Equal Periodic Payments (SOSEPP, or 72t option), is a Required Minimum Distribution or a hardship distribution, there is a requirement for the administrator to withhold 20% from the 401k withdrawal.

This 20% is sent to the IRS and will be included as part of your withholding and estimated tax payments that will apply against your tax when you file. If the withholding was too much, you’ll get a refund of the extra withholding, just as you do from extra withholding or estimated payments.

Here’s a continuation of the previous example to illustrate withholding:

401k Withdrawal $50,000
Mandatory Withholding (20%) $10,000
Other Withholding (from W4 wages) $9,000
Total Withholding $19,000
Total Tax and Penalty (from prior) $28,836.75
Amount You Owe $9,836.75

As you can see, even though the mandatory withholding from the 401k withdrawal is substantial, it’s not enough in many cases to cover the tax and penalties from the withdrawal.

Information on the 403(b)

Image courtesy of KROMKRATHOG at FreeDigitalPhotos.net

Image courtesy of KROMKRATHOG at FreeDigitalPhotos.net

As many of our readers know, employees that work for a school district, hospital, university or other non-profit organization may have access to a retirement plan called the 403(b). Similar to its cousin the 401(k), the 403(b) works very similar in that it allows employee contributions, and the employer may or may not match a percentage of those contributions.

The 403(b) is also subject to the maximum contribution rules. In other words, an employee is allowed to contribute up to $18,000 annually if they’re under age 50 and those aged 50 and older are allowed an additional $6,000 catch-up contribution. Many of these plans also allow Roth contributions for their employees.

A unique aspect of the 403(b) that readers may not be aware of is the 15-year rule for contributions. Generally, the 15-year rule allows an employee with at least 15 years of service (and their plan allows it) to make an additional contribution to their 403(b). An employee’s years of service are the total number of years worked as a full-time employee for the same employer that maintains the 403(b).

The limit on additional contributions is increased by the least of:

  1. $3,000
  2. $15,000, reduced by the sum of:
    1. The additional pre-tax elective deferrals made in prior years because of this rule, plus
    2. The aggregate amount of designated Roth contributions permitted for prior years because of this rule; or
  3. $5,000 times the number of your years of service for the organization, minus the total elective deferrals made by your employer on your behalf for earlier years.

It’s also important to understand that the 15-year catch-up can be used in addition to the age-based catch-up. For example, if an employee (age 50 or older) qualified, they could contribute the maximum salary deferral for 2016 of $18,000. Then, they could contribute the 15-year catch up of $3,000. Finally, they would be allowed the age-based catch-up of $6,000. This totals a whopping $27,000.

An important point to understand is that if an employee qualifies for both the 15-year catch-up and the aged-based catch-up, amounts over the initial $18,000 employee deferral are applied to the 15-year rule first, then to the age-based rule.

For example, if an employee contributed $23,000 to his 403(b), the $18,000 maximum employee deferral is considered first, followed by the 15-year contribution. In the case, $18,000 is considered to be contributed first, followed by $3,000 for the 15-year serviced-based catch-up. The remaining $2,000 is then applied to the age-based catch-up limit.

While the age-based catch-up is based on an annual limit, the 15-year serviced-based catch-up is subject to a use test, lifetime, and annual limit. Additionally, employee deferrals to a 403(b) are subject to the aggregation rule if an employee is also participating in a 401(k), SIMPLE, another 403(b), etc., but not a 457(b). In other words, if an employee under age 50 has access to both  403(b) and a 401(k), the maximum she can contribute in total for both plans is still $18,000, not $36,000.

If you find yourself as a participant in one of these plans, it pays to check and see what your options are regarding how much you’re able to contribute.

Restricted Application – the Definitive Guide

this fellow didn't file a restricted applicationMuch has been written and discussed regarding the option to file a Restricted Application for Social Security spousal benefits, but there are still many, many questions. This article is an attempt at covering all of the bases for you with regard to restricted application.

The topic of restricted application is so popular these days because it’s being eliminated as a result of the Bipartisan Budget Act of 2015 (BBA15). In fact, if you were born on or after January 2, 1954, the changes to the rules have eliminated the option to file a restricted application for you altogether.

So – unless you were born on or before January 1, 1954, you might as well stop reading, because restricted application is not available to you. Period.

Restricted Application Rules

Okay, if you’re continuing to read, you (or your client, if you’re an advisor) must have been born early enough to be eligible for a restricted application. There are a few rules that you must be aware of for filing a restricted application:

  1. THERE IS NO DEADLINE FOR FILING A RESTRICTED APPLICATION OTHER THAN YOUR AGE 70. In other words, the upcoming deadline of April 30, 2016 has nothing to do with restricted application eligibility.
  2. You must be at or older than Full Retirement Age (FRA) to file a restricted application.
  3. You must not have filed for your own Social Security benefit previously. This includes File & Suspend.
  4. You may have previously received Social Security benefits as a young parent of a child under age 16, or as a child yourself under age 18. These benefits do not eliminate your eligibility for a restricted application.
  5. You cannot be actively receiving disability benefits. If you previously received disability benefits that were terminated some time in the past because the disability (or your eligibility) ceased, you may still be eligible for a restricted application.
  6. Your spouse must have filed for his or her own benefits. May also have suspended benefits, if the suspense was completed before April 30, 2016. But if the suspense was after April 30, 2016 you will not be eligible for spousal benefits until the suspense is lifted.
  7. If you are divorced and the divorce was finalized more than 2 years prior, your ex-spouse must only be at or older than 62 years of age, and is not required have filed for benefits. (*This is the exception to the rule in #6.)
  8. Only one member of a married couple may file a restricted application (doesn’t include ex-spouses).

Why Would You Want to File a Restricted Application?

A restricted application allows you to receive spousal benefits while delaying your own benefit, in order to accrue the delayed retirement credits (DRCs).

For example, Jeff and Cindy are both at FRA, age 66 this year. Jeff has filed for his benefits, in the amount of $2,000 per month. Cindy’s own benefit could be $900 if she filed now, but she wants to delay her benefit until age 70, when the DRCs will have increased her benefit to $1,188 (DRCs are 8% per year of delay).

Since Jeff has already filed for his benefit, and Cindy is at FRA in 2016 (therefore having been born before January 2, 1954), Cindy is eligible to file a restricted application for spousal benefits. She’ll receive a spousal benefit of $1,000 (50% of Jeff’s benefit at his age 66) and then her own benefit will accrue the DRCs since she has not filed for her own benefit.

For another example, Simon is 67 years of age and his wife Patty is 63 this year. Simon’s age 66 benefit would have been $1,500, and Patty’s would be $1,000. Patty has just retired from her job, and is filing for her own Social Security benefit. She’ll receive a reduced benefit in the amount of $800 since she filed early. Simon has not filed for Social Security benefits prior to this, as he intends to delay his filing until age 70.

Since Patty has filed for her own benefit and Simon is older than FRA in 2016 (therefore having been born before January 2, 1954), he is eligible to file a restricted application for spousal benefits. Simon will receive $500 per month for the coming three years, and then at age 70 he will file for his own benefit, which has increased to $1,980 with the DRCs.

So you can see, there may be much to be gained by filing a restricted application in the right circumstances.

How to File a Restricted Application

In order to accomplish the filing of a restricted application, you have four options to choose from. These options are listed below:

  1. Go to www.SocialSecurity.gov and apply using the online application. When you do this, fill out the application as if you will be receiving ordinary benefits, and there’s a question on the application which asks: If you are eligible for both retirement benefits and spouse’s benefits, do you want to delay receipt of retirement benefits? Answer this question “Yes”, and continue to complete the application. You have now filed a restricted application.
  2. You can file a paper application (Form SSA-1-BK is available online as well). Fill it out as if you were going to receive benefits, and then indicate in the REMARKS section “I want to restrict the scope of this application to spousal benefits only. I wish to delay filing for my own benefit to age 70.”
  3. Call 1-800-772-1213 to apply by phone. Tell the representative that you wish to file for benefits and restrict the application to spousal benefits only, and that you wish to delay filing for your own benefits to age 70 in order to earn the delay credits.
  4. Visit your local Social Security Administration office. Tell your representative that you wish to file for benefits and restrict the application to spousal benefits only, and that you wish to delay filing for your own benefits to age 70 in order to earn the delay credits.

That’s it. You don’t need to do anything else. It’s not necessary for your spouse to file & suspend (only to file), so the April 30, 2016 deadline for file & suspend doesn’t necessarily have anything to do with this.

And whoever is filing the restricted application definitely does not file & suspend – see the 3rd rule earlier in this article. File & suspend would actually derail your plan to file a restricted application.

The Spare Change Challenge

credit for delayingMany individuals who know me know that I’ll run in front of oncoming traffic to pick up a penny (or anything shiny for that matter). While some may think that this is a waste of time and that “it’s only a penny”, the fact is that the small change adds up. Whenever I get weird looks or folks laugh at the mention of a penny to be grasped, I always ask, “Would you walk past a $100 bill?” The point being, it all adds up. The tiniest snowflakes create earth-moving avalanches.

The small amounts I pick up are usually deposited into my kids’ piggy banks. When we’re together and we find money they call the change “lucky coins”. The interesting thing is that these lucky coins have gotten pretty heavy in their banks. Both of my kids can barely lift their piggy banks due to all of the luck we’ve come across. What I’ve never really done, it add it all up – at least over a specific period.

So here’s what I’d like to propose. And it’s something I’m going to do myself for the next year. Every coin I find and my kids find we’re going to keep track of and see what it adds up to over one year. This includes anything from pennies, to the occasional quarter to the rare dollar bill. I’m curious to see what it will all add up to over a year, and how that amount would grow over time at a compounded rate.

There’s a saying that there is no free lunch; this comes pretty close – free money. Should you decide to play along, drop us a note and tell us how you’re doing and how much you’ve acquired along the way. I’ll do the same. Keep an eye out…