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Medicare is Not Automatic

Jun 24th, 2019
by jblankenship.
1 comment

automatic electric monophone 40 by alexkerheadIf you’re nearing age 65, there’s something you need to know: unless you’re currently receiving Social Security benefits (having filed early), you need to take action to make sure you receive your Medicare benefits in a timely fashion.

Timing

What this means is that you can sign up for Medicare up to three months prior to your 65th birthday. You must sign up within the period from three months before until four months after your 65th birthday, or you’ll face possible penalties. By signing up during that seven month period, your coverage will be on-time and you’ll begin being billed for Medicare Part B.

If you fail to sign up during that seven month window, you’ll have to wait until the next general enrollment period, which is January 1 through March 31, and your benefits won’t begin until the following July 1. Signing up late, you will be assessed a 10% penalty on your Part B premium for each year that you’ve delayed signup.

Exception

If you happen to still be employed and are receiving your medical coverage at least as good as Medicare (known as a creditable plan), you’re not required to enroll and won’t be penalized for delaying. After your employment ends (and thereby the medical coverage), you have a special eight month enrollment period when you can sign up for Part B without penalty.

If you sign up while still covered by the employer plan or in the first month after the coverage ends, your benefits will begin on the first day of the month that you enroll. If you enroll at any time after that but during the following seven months remaining in the special enrollment period, your coverage will begin on the first of the following month.

Just like the other enrollment period, if you delay until after it has expired you’ll need to wait until the next general enrollment period to enroll and your coverage won’t begin until July afterwards.

If you are actively receiving Social Security benefits when you reach age 65, you will be automatically enrolled in Medicare. But don’t leave it to chance: you should check with SSA in the 2 to 3 months before your 65th birthday to make sure you have coverage coming to you. In addition, you’ll want to check out the other coverage(s), such as Medigap, Medicare Advantage, and/or Medicare Part D, prescription drug coverage.

Posted on Jun 24th, 2019
by author: jblankenship.

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Posted in: Medicare, Social Security.
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Integrating Roth IRA With Social Security Benefits

Jun 18th, 2019
by jblankenship.
3 comments

There are some great benefits to be had from converting funds from a traditional IRA or a 401k to a Roth IRA. But that doesn’t mean that everyone within earshot should just willy-nilly go off and convert their IRAs to Roth IRAs. One factor that many folks likely haven’t thought about is integrating Roth IRA with Social Security to reduce taxes.

Taxation of Social Security

As you may be aware, depending upon your “provisional income”, various amounts of your Social Security benefits may be taxable. At this time, for example, if your provisional income is more than $34,000 (or $44,000 for a married couple), then up to 85% of your benefits would be taxed. Less than $34,000 ($44,000 for a married couple) but more than $25,000 ($32,000 for marrieds), up to 50% of your Social Security benefit is taxable. Less than $25,000 ($32,000 for a married couple) and your Social Security benefit may be untaxed.

Provisional income is your adjusted gross income (AGI, the amount in line 7 of form 1040) plus tax-exempt interest earned for the year, plus ½ of the amount of your Social Security benefit. So the trick is to limit your AGI, in order to reduce the amount of Social Security benefits that are taxed, if possible. One way to do this is to generate income from a Roth IRA, which is not only tax-free, but isn’t counted toward the AGI.

A Tale of Two Taxpayers

Two taxpayers, Stevie and Christine, both age 62 and retired, have vastly different outcomes for their tax situations. For simplicity’s sake, we’ll say that both women are single, and are collecting identical Social Security benefits of $20,000, and that each has a total income requirement of $60,000 each year. In addition, each of the women has a pension available, which will either pay out a $40,000 payment each year, or is available as a lump sum for rollover at the amount of $600,000.

Stevie

Stevie decides to take the pension payments of $40,000 per year. Come tax time, she learns that she will have to pay tax on 85% of her Social Security benefit ($17,000) because her provisional income adds up to $50,000, which is above the $34,000 limit mentioned above. So the tax on this amount ($40,000 pension plus 85% of SS, or $17,000) is $5,714, or roughly 9.5% of her total income. Assuming that nothing changes about the situation, Stevie can count on paying around 9.5% of her income in tax for the rest of her life.

Christine – Option 1

Christine, on the other hand, takes a look at the numbers and decides that it might make more sense to attack the situation differently. She takes the lump-sum payout from her pension plan and rolls the money over into an IRA. If Christine were to simply leave things this way and start taking a distribution of $40,000 each year, she would have exactly the same tax treatment that Stevie is getting. However, if Christine should decide to do a conversion of the IRA to a Roth IRA in 2019, she would be paying tax of approximately $188,000, leaving her with a net balance in the Roth account of roughly $412,000.

Now Christine pays no tax (under current laws) for the rest of her life! Given that her provisional income cannot be more than the limits, her Social Security benefit will never be taxed. And since all of her income comes from the Roth IRA, there is no tax owed at all. But this is a very high price to pay up front – roughly 1/3 of her IRA account. Christine would need to take this tax-free income for around 32 years, as long as income tax rates stay the same. If the income tax rates rise, the break-even time would be less, of course.

Christine – Option 2

But what if Christine instead took her income requirement each year (the same as Stevie), paying the roughly 9.5% tax, but then took an additional amount from the IRA and converted it to a Roth? If she converts $50,000 in the first two years, the additional tax would amount to roughly $11,200 each year. Having done this for two years, Christine can take (for example) $5,000 of her required income from the Roth. The result is to reduce the amount of her provisional income to only $45,000, thereby reducing the amount of her Social Security benefit that is taxed each year to approximately 70%. Now Christine’s annual tax would be reduced to $4,204, a savings of $1,500 per year in taxes.

Christine – Option 3

What if Christine did the conversion of $50,000 for five years in a row, paying a total of $56,000 in tax? Her provisional income is now only $40,000, reducing the amount of her Social Security benefit that is taxed each year to approximately 50%. The difference, $10,000 each year, is taken from the Roth IRA at no tax impact. Now Christine’s annual tax is reduced to $3,094, a savings of $2,700 per year in taxes.

Summary

There’s a lot of math going on in this article! The point was to show how this Roth IRA conversion activity isn’t just a question for the rich. It can have an impact on folks at all levels of income. It can be very costly to do nothing! On the other hand it can be quite lucrative to do some planning for integrating Roth IRA with Social Security. As always, talk to your financial professional before making any dramatic moves, just to make sure you’ve got it right.

Note – for the purpose of illustration, I used current tax rates throughout the examples. I realize that rates are likely to increase in years ahead. This will only make the illustrations I’ve done here look better for the Roth conversion early on at our historically low rates (in most cases).

Posted on Jun 18th, 2019
by author: jblankenship.

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Posted in: financial planning, Roth conversion, Roth IRA, roth ira conversion, Social Security, tax.
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Saving for College

Jun 7th, 2019
by sraskie.
1 comment

If you’re a parent or plan to be one, chances are you are considering ways to pay for your child’s college education. You may have a goal of sending them to public or private school, with the hope of helping them graduate college with little, if any debt.

Whether or not your goal is to fully fund your child’s education or to help as best you can, there are some options to consider saving as much as you can to reach or education savings goal.

One option to consider is a 529 college savings plan. 529 plans allow money to be contributed specifically for many of the costs of higher education. Money that goes into the account grows tax-deferred, and money withdrawn for qualified college education expenses (tuition, room & board, books, fees) is tax-free.

Many states sponsor their own college savings plans, and some allow a state tax deduction for contributions. Currently, there are no federal tax deductions allowed for 529 contributions. 529 plans also have no income limits – meaning that regardless of income, anyone can contribute to a 529 plan.

Additionally, 529 plans have very high lifetime contribution limits ranging from about $300,000 to $400,000 in total, depending on the state plan. However, the maximum annual contribution limited is $15,000 which is the annual gift tax exclusion. This amount is $30,000 for couples who file jointly. States may also limit the amount of your state tax deduction on contributions.

There is an exception to the annual limit rule which is exclusive to 529 plans. Individuals can make a 5-year pro rata contribution totaling $75,000 (the $15,000 per year exemption multiplied by 5). For married couples filing jointly, the amount is $150,000 (the $30,000 per year exemption multiplied by 5). These numbers are for 2019 and are usually increased annually.

529 plans allow only one beneficiary per 529 plan. The beneficiary may be changed at any time. For example, parents with two children may own one 529 plan with the oldest child named as beneficiary, and then simply change beneficiaries to the younger child when the oldest graduates. Parent can also own one 529 plan for each child. If you’re not a parent yet but want to get started, you can open a 529 plan, name yourself beneficiary, and then simply change the beneficiary to your child when he or she is born.

The money in your 529 plan can be invested according to your risk tolerance or timeline. Many plans have predetermined portfolios of stock and bond mutual funds based on your child’s age, or they allow you to choose your own allocation based on the funds available.

If the money in a 529 plan is used for non-qualified education expenses the earnings become taxable at your ordinary income tax rates and are also subject to a 10% penalty. States may also recapture any tax deductions taken on contributions.

Exceptions to the 10% penalty include if the beneficiary dies, becomes disabled, or receives a scholarship. It’s important to note that in these exceptions, only the 10% penalty is waived. The earnings are still taxable when withdrawn.

Finally, when the time comes to apply for financial aid (grants or student loans) you will likely find yourself filling out the Free Application for Federal Student Aid (FAFSA®). This form essentially determines how much you can contribute toward the costs of college by determining your expected family contribution. 529 plans are considered an asset of the parent (assuming the parent owns it) and the percentage for inclusion in the expected family contribution is much less than assets owned by your child.

Posted on Jun 7th, 2019
by author: sraskie.

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Posted in: 529, 529 plan, college savings.
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4 Ways You Can Make IRA Contributions – Without a Job!

Jun 5th, 2019
by jblankenship.
1 comment

ira contributions can help pay for a barn

Photo credit: diedoe

If you know the rules, you must know that one of the main requirements for making contributions to an IRA is that you must have earned income. For most folks, that means you have a job… but it doesn’t have to. Below are four ways that you can have “earned income” without a job – plus a few ways to make contributions without having paid ordinary income tax on the wages. These exceptions are for either kind of IRA: traditional or Roth.

Four Ways to Contribute to an IRA Without a Job

  1. If your income is solely from exercising non-qualified stock options. When you exercise non-qualified stock options, the taxable component of the option exercise is considered taxable income, and therefore is eligible for contribution to an IRA.
  2. Alimony. If you receive alimony, it is taxable as ordinary income, which is eligible for IRA contribution. This only applies to alimony from a divorce that occurred before 2019 – alimony from a divorce in or after 2019 is not considered taxable income, and therefore could not be used to fund an IRA if that’s your only income.
  3. Scholarships and Fellowships. If these are taxable, reported in box 1 of a W2 form, they’re considered earned income for contribution to an IRA.
  4. Spousal contribution. If your spouse has earned income (and you have none or not enough to make a maximum contribution), you are eligible to make an IRA contribution based on your spouse’s income. The limit is that the total of all IRA contributions (yours and your spouse’s) cannot exceed the earned income of the working spouse.

A Few Ways to Make Contributions Without Paying Tax on the Income

  1. Non-taxable combat pay. If reported in box 12 of your W2 form, this no-tax money also eligible for contribution to an IRA or Roth IRA.
  2. Exempt students. If a student has exempt earnings from a job, that income can be used to make IRA or Roth IRA contributions.
  3. If your income is less than your deductions or the standard deduction. In this case, effectively you are not paying tax on the earnings – but the IRA contribution is based upon your Modified Adjusted Gross Income, so you can still make an IRA contribution with the non-taxed funds.

In the above 3 examples, unless circumstances dictate otherwise, you should strongly consider contributing the non-taxed income to a Roth IRA. In either case you wouldn’t likely have a need to deduct a traditional IRA contributions from your income (since none of your income is taxable), and so the Roth IRA makes the most sense. The contributions and any growth on them will always be tax free (under current law).

Posted on Jun 5th, 2019
by author: jblankenship.

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Posted in: IRA, retirement plan, tax.
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Are you leaving Social Security benefits on the table?

Jun 3rd, 2019
by jblankenship.
2 comments
leaving-social-security-benefits-on-the-table

It happens more often than you think. Without a good understanding of the rules, you might make a move that results in leaving Social Security benefits on the table.

There are a couple of ways this can happen. Let’s start out by identifying the types of benefit we’ll be covering in this article: 

  • retirement benefits based on your own working record (RIB)
  • spousal benefits based on your spouse’s or ex-spouse’s working record (SRIB)
  • survivor benefits based on your late spouse’s or late ex-spouse’s working record (WIB)

Our first example of leaving Social Security benefits on the table relates to the interplay between the retirement benefit, which we’ll shorten to RIB, and the spousal benefit, which we’ll refer to as SRIB. (These acronyms stand for Retirement Insurance Benefit and Spousal Retirement Insurance Benefit, respectively.)

Ben and Anita are age 70 and 74 respectively. Anita has been collecting her RIB since she reached Full Retirement Age (FRA, age 66), but Ben has been delaying receipt of his benefit until he reaches age 70, which allows him to accrue the delayed retirement credits of 8% per year of delay.

The problem is that Ben and Anita didn’t know about the restricted application option available to folks born before 1954. Since Ben was born in 1949 (reaching 70 in 2019), he could have been collecting a SRIB (spousal benefit) from his FRA (also 66) while continuing to delay his own benefit to age 70. Because Anita had already filed for her own RIB at her age 66, when Ben reached age 66 he could have started collecting an SRIB equal to 50% of Anita’s benefit, with no affect on his future RIB.

Since they weren’t aware of this option, unfortunately it’s gone forever for them, now that Ben has reached age 70. It’s possible to retroactively file for the SRIB up to 6 months prior – which is something Ben should do ASAP. But that’s all the farther back he can go to correct this oversight. So he’s left 3 1/2 years’ worth of SRIB on the table.

If we go back in history to four or more years ago and educate Ben and Anita, we could ensure that Ben, having been born before 1954, files a restricted application for spousal benefits. Then he’ll begin to collect the SRIB, while still delaying his own RIB filing to age 70.

This same option is available to Ben if he and Anita were divorced, as long as their marriage lasted at least 10 years. 

Unfortunately, this type of restricted application is only available to folks who were born in 1954 or earlier – so if you (or your spouse) are not at least 65 in 2019, this example won’t apply to your situation.

The second example of leaving Social Security benefits on the table deals with the coordination of your own retirement benefit (RIB), with the survivor’s benefit, which we’ll refer to as WIB (WIB stands for Widow(er)’s Insurance Benefit).

Karen is a widow, her husband Leon died five years ago at the age of 63. Leon had not started collecting Social Security benefits at the time of his death. Karen will turn 62 in July of this year, and she’s planning to retire at that time. She called the local SSA office to set an appointment to find out about her benefits.

When Karen meets with the Social Security folks, they ask her about her marital status, and Karen provides Leon’s identifying information. It turns out that, if Karen was to file for the WIB (survivor benefit) based on Leon’s record, she could receive an additional $10 per month! Karen’s RIB at this point is $1,000, and the WIB is presently $1,010. Of course, Karen says yes, she’d like to receive that extra $10 (in the words of Geddy Lee, “Ten bucks is ten bucks!”).

The problem is that the Social Security folks didn’t tell Karen that she could have started receiving her own RIB at age 62, and then later, upon reaching Full Retirement Age she could switch over to the WIB, which would have increased by an additional $230 per month by that time! In the meantime, she’d be collecting the RIB (that was $10 less than the WIB at that point), but then later she could bump up her total monthly benefit by $230.

This is accomplished by another type of restricted application – an application restricted to retirement benefits only. In this case, Karen would tell the SSA folks that she only wants to file for her RIB, delaying filing for the WIB until later. 

This could also be deployed in the opposite manner – Karen could choose to restrict her application to only the WIB, and then later file for her own RIB. Assuming she waited until her FRA, using our fictitious example, her RIB would have increased to $1,333 by FRA. During the intervening four years, Karen would continue to receive the $1,010 WIB every month.

The critical point here is that Karen must know two things when she files for benefits: 1) which benefit will eventually be the larger, so that she can delay that one and collect on the other; and 2) that she must restrict her application at her present age to only the benefit she’s collecting at that point.

If Karen doesn’t take care to restrict her application, SSA will process the application as if she was applying for all available benefits at that point. You might think it’s a trivial thing, but the problem is that unless Karen restricts her application at that stage, she will be unable to apply for the other benefit later. In other words, upon reaching Full Retirement Age, Karen could not apply for the RIB (since she’s been collecting the larger WIB) if she did not restrict her application to only the WIB when she first applied. SSA will tell her that she cannot apply for RIB at this point because she applied for all available benefits back when she was 62. And there’s no “do-over” for this problem, much the same as in the first example.

SSA doesn’t tell you this – you have to know it on your own. SSA staff are famous for not providing advice when you are consulting with them. It seems that their primary objective is to get you the largest benefit possible at that given point in time – even if a greater benefit could be had later, by taking the time to restrict the application to only the benefit currently being received.

It’s up to you to know how this all works, and to be your own advocate as you go through the application process. Otherwise you may be leaving Social Security benefits on the table.

 

Posted on Jun 3rd, 2019
by author: jblankenship.

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Posted in: restricted application, Social Security, social security benefits, Social Security spousal benefit, social security survivor benefits, Spousal Benefit, survivor benefits, widow.
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401k Loans Double-Taxed? Not so fast, conspiracy theory-breath

May 28th, 2019
by jblankenship.
13 comments

It has long been an urban myth that when you take out a loan from your 401k that you’re being double-taxed on the amount of your loan… but this isn’t so. This is a very pervasive myth – lots of folks will agree with it out of hand, but it’s not correct, when you work out the details. Let’s start with an explanation of why people believe that they’re being double taxed.

Double-Tax Scenario

You take out a loan from your 401k for $10,000. You make arrangements to pay this back in 10 monthly payments of $1,010, with the extra $10 representing the interest on the loan (the rate isn’t important to this example). As you pay this money back into the account, the payments are made with after-tax dollars. Fast forward to your retirement – you’re ready to start taking distributions from your 401k. All of those payments that you receive from your 401k will be taxed as ordinary income, including the $10,000 that you took out as a loan.  Double-taxation, right?

conspiracy theory

Photo credit: jb

Wrong. To borrow a phrase, here’s what happened:

The Real Story

You take out a loan from your 401k for $10,000. You use that money to buy something… let’s say it’s bubble gum. Normally when you buy bubble gum, you have to buy it with after-tax dollars. The 401k loan proceeds are not taxed when you take them out, but the dollars you’re paying it back with have been taxed. This is the same as if you had bought the bubble gum with your own money from your earnings, because that money is taxed when you earn it. So when you pay the money back into the account with after-tax dollars, you’re economically the same as if you had paid it with your after-tax savings.

Maybe the following examples will help… the assumed tax rate is 20% for simplicity.

No loan. You want to buy $10,000 worth of bubble gum. You must earn $12,500 in from your job in order to have $10,000 in take-home, or after-tax, money for the purchase. So, income tax included, it has cost you $12,500 to purchase the gum.

With a loan from the bank. You want to buy $10,000 worth of bubble gum. You take out a loan from the bank for $10,000 and make arrangements to pay it back in 10 installments of $1,010 per month. As you pay back the loan, you must earn gross income of $1,262.50 (at 20% tax) to make the $1,010 payments. In the end, it has cost you $12,625, tax and interest included, to purchase the gum.

With a loan from your 401k. You want to buy $10,000 worth of bubble gum. You take out a loan from your 401k for $10,000 and make arrangements to pay it back in 10 installments of $1,010 per month. As you pay back the loan, you must earn gross income of $1,262.50 (at 20% tax) to make the $1,010 payments.  In the end, it has cost you $12,625, tax and interest included, to purchase the gum, just the same cost as the bank loan. However, since you’re paying yourself the interest, your 401k account will have grown by $100 (the interest payments) with this activity.

End Result

So the end result is that you’re only taxed on your 401k funds upon distribution. If you don’t stop and think about how your money is treated for all other purposes, it might seem like an unfair situation – but economically, you’re no worse off with this loan versus any other loan (actually a bit better since you receive the interest in your 401k). And the interest is the only difference between taking this loan and just paying for it out of your regular take-home pay.

One last thing: When you took the loan from your 401k, that $10,000 was no longer invested in your account, right?  Well, it may not show up in your balance, but in effect, you have invested that money in a loan to yourself. After you’ve paid back the loan and the interest, you’ll have growth of that original $10,000 to a total of $10,100 (10x the $1,010 loan payments).

Note:  the foregoing explanation was not intended to be an endorsement of using a 401k loan. There can be detrimental consequences if you are unable to pay it back, or if you lose your job – in either case you’ll be taxed and penalized on the amount of the loan. You’re always best off to use all other sources of credit – and then count backwards from a million – before going ahead and taking a loan from your 401k.

Posted on May 28th, 2019
by author: jblankenship.

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Posted in: 401k loan, retirement plan, tax.
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Renter’s Insurance

May 24th, 2019
by sraskie.
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renters insurance policyIf you’re considering living in an apartment or currently reside in one, it’s important to make sure you have renter’s insurance. Renter’s insurance is an often-overlooked risk management tool for an overall financial plan, but it’s critical for protecting your assets and liability.

Renter’s insurance covers your personal property in your apartment. This includes clothes, furniture, electronics – pretty much all your stuff. It also provides liability coverage. This means that if you’re liable for damages to the apartment complex, someone’s injured in your apartment, or you’re liable for other damages, the liability coverage provides an amount to help pay for these damages. In other words, if you’re found liable or negligent it doesn’t come out of your pocket. The renter’s insurance pay for it.

A typical renter’s insurance policy can provide $15,000 of protection for your personal property (you can get more if needed) and $100,000 for liability coverage. However, consider $300,000 of liability coverage or higher, just to be safe. You may also consider an umbrella policy to provide liability coverage above and beyond your renter’s policy (for catastrophic losses).

The cost for renter’s insurance is relatively cheap. You can expect to pay about $150-$200 in annual premiums. This could differ depending on your location, personal property, etc. Bundling your renter’s policy with your auto insurance with the same company may also save you money with a multi-policy discount.

So, if you’re a recent graduate just starting out or currently renting an apartment, consider getting a renter’s insurance policy or reviewing your current policy for updates. For a small amount of money per year it will provide thousands of dollars in coverage.

Posted on May 24th, 2019
by author: sraskie.

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Posted in: renters insurance.

Why is Index Investing a “No Brainer”?

May 20th, 2019
by jblankenship.
2 comments

For those of you who have read much of my writing on the subject, you’ll recall that I generally recommend working with index investments when we have them available. In this article I will do my best to help you understand some of the reasons why I recommend index investing.

What is Index Investing?

In order to understand why index investing is a good option, I need to explain first what I mean by an index. In general, an index investment is a representative investment covering a market, sector, or asset class. The S&P 500 is an index for example, representing the asset class of the 500 largest publicly-traded companies in the US marketplace. The Vanguard Total Market Index is an index that represents the entire spectrum of domestic (US) publicly-traded companies. There are many other examples, including the Lehman Brothers Aggregate Bond Market Index (all publicly-traded bonds in the US marketplace). The Morgan Stanley Capital International (MSCI) Europe, Australasia, and Far East (EAFE) index represents the entire markets of the following countries: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, The Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom. Since these indexes represent an entire marketplace, they are often used as the benchmark against which managed (non-index) funds are measured.

eggs-basket

Photo credit: steelo

There are mutual funds and exchange-traded funds that track these various indexes. If you’ll recall, one of the first tenets of successful investing is to diversify – don’t put all of your eggs in one basket. By investing in one of these indexes, the investor is taking an ownership stake in all of those companies at once. What a great, simple way to diversify!

These indexes do not require a professional manager to oversee them, because they represent an entire marketplace. The makeup of the index only changes by an outside force (S&P replacing one company in the 500 with another, for example). Because of this, there is very little overhead (fees and expenses) to reduce your return within index investing. Also, since we aren’t changing investments by selling a company’s stock that is out of favor and buying one that we think might provide better returns in the future, transaction costs are limited, and excess taxation of capital gains is limited as well.

What Are Managed Investments?

On the other side of the coin from Index Investments is the group of mutual funds called Managed Investments. These are investment vehicles where a manager (or team of managers) chooses a group of companies (stocks or bonds) to invest in. Over time, this group of investments must be monitored to ensure that the individual companies are producing the expected results. If a company appears to be underperforming  or has changed intrinsically, that stock is sold and another company is chosen to replace it in the fund. All of this analysis requires lots and lots of research, review, and day-to-day management. That management costs a lot of money – often upwards of 1% of the fund’s holdings each year – as opposed to less than ¼% for many index funds.

7276279The idea is that the professional management team is a bunch of very smart guys and gals, and being very smart guys and gals, they can potentially get you a better return than you could get by just buying an index fund. Care to guess how often that happens, consistently? Less than 5% of the time, according to records, and that doesn’t include all of the funds that are eliminated or merged due to underperformance.

So – the first “wrong” with investing in managed mutual funds is that you’re taking a chance that your chosen smart guys and gals (the managers of the fund you’ve chosen) will happen to be in that top 5% that beats the index investment. And you’re paying something like four times (or more) in expenses to get there. But people still love a gamble, and so managed funds remain very popular. But why?

Under The Covers

Let’s take a look at why some managed mutual funds appear to be a good gamble.

Mutual fund companies introduce lots of funds every year. As an example let’s say a fund company introduces ten new funds in the year. Each fund has a fair-haired boy (or girl) managing the fund, and the manager does his or her level best to produce a good return. For the most part, since these funds haven’t been marketed to the public much, the fund company puts some of their own money in the fund;  this is called “incubation”, it’s a way for a fledgling fund to build a track record before investment of a lot of money in marketing. At the end of the year, nine of the ten new funds have poorly underperformed, but one of the funds outperformed the indexes by a wide margin – let’s say it’s by more than 20%.

The nine poor-performing funds’ monies are merged with the one winner fund (or some other fund), bolstering it’s asset size, and the marketing begins. Investors hoping for that “one in a million” investment are drawn to this new fair-haired investment manager because of the fantastic return that his or her guidance produced in the past year. Now is when it gets interesting…

The Interesting Part

I mentioned before about how less than 5% of all mutual funds consistently outperform the entire market index. That’s because it is very difficult to individually pick and choose 50 or 100 companies that will do better than the market (or index). The entire market has a track record of increasing in value over 80% of the time, year in and year out. Imagine trimming that 10,000+ group of investment choices to a manageable group of 50 to 100 stocks (or bonds) that will do better than everyone else! It’s very, very, difficult, indeed – and most managers do not do this – and certainly not consistently year after year.

So, what happens is that after the fund has had it’s initial “home run” season, where it outperformed the market by 20% or more, is that the fund attracts all kinds of attention and investors. In the second year, lots more money pours into the fund after the aggressive marketing, and the manager does his or her best to reproduce the result from the previous year. Amazingly enough, maybe she does it, but this time only by about 2% overall – and the expense ratio of the fund eats one percent right away. But look at her track record:  over the span of two years, she’s outperformed the index by an average of 11%! Why would you NOT invest in this fund??

After the second year where the manager just squeaked out a positive result, not wanting to lose investors’ funds, she becomes more conservative. Now she begins to more closely track the index against which her fund is compared, rather than whatever magic was used to produce the first year’s stellar results. At the end of this year, the fund doesn’t quite meet the index’s return, but it’s pretty close (until you take out the additional 1% of expenses). But again, the marketing points out that, over a three-year period, this manager has outperformed the index by almost 7%. Again – you’d be a dummy to not invest with that kind of result, right?

And so it goes… eventually this fund’s returns each year are always coming up just short of the index, and after a good run of five years, the fund is folded into the next best thing. Lather, rinse, repeat…

Backing Data

I wanted to give you some additional data on the above activity, so I ran some screens using readily available tools (like Yahoo! Finance, Morningstar, etc.). The results were quite interesting: on one screener I looked for mutual funds that performed in the top 20% in each of the previous five years, and 3 funds were the result, one of which was an index fund.

So next, I looked at all funds created during calendar year 2013, and took their rankings for 2014, 2015, 2016, 2017 and 2018.  Not one of the funds that was in the top 20% for 2014 repeated for all five years, and only a very small percentage of that top 20% ever showed up again in the top 20% for the succeeding four years.

Of course this isn’t definitive research and it doesn’t prove anything conclusively. I’ve found it doesn’t pay off to spend too much time checking these things out, because the result remains the same.

One other item that was not factored in is called survivorship bias.  This is the phenomenon that occurs because only the surviving funds, those that had good performance, are available for result comparison in subsequent years. From our example above, nine of the ten new funds created by our fictitious mutual fund company were shut down after the first year. So now, being non-existent, the poor results that those funds brought forth are not included in any screening reports, making the results (of only the surviving funds) look much better overall.

Bottom Line

At any rate, I wanted to provide you with this explanation of yet another problem seen in the investing world. I think it can best be summed up by comparing investing with gambling at a casino. Everyone knows that gambling odds are always in favor of the “house”. The individual gambler might hit it big once in a blue moon, but in general the gambler pretty much always comes out on the short end. On the other hand, with the odds in the favor of the casino, owning a casino (or casino stock) might be a pretty good way to make a lot of money.

In the investing world, it pays off to own the “casino” – that is, to own the entire marketplace – instead of playing the games of managed mutual funds. Owning the marketplace (via index investing) gives you the benefit of an 80% opportunity for an increase in your holding each and every year, for a very low expense ratio.

Posted on May 20th, 2019
by author: jblankenship.

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Posted in: index funds, investing.

How QDRO Impacts NUA

May 15th, 2019
by jblankenship.
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Photo credit: jb

Don’t let the alphabet soup in the title put you off. If you’ve never come face-to-face with a QDRO you might not need to know this – but then again, the basic underlying premises are good information to understand…

First some definitions, just so we know what we’re talking about:

QDRO: Qualified Domestic Relations Order – this is a method for permitting distributions from a qualified retirement plan (not an IRA) in the event of a divorce. How a QDRO works is that, upon the decreed division of assets, if a retirement plan (such as a 401(k) or 403(b)) of one spouse is chosen as an asset to be divided and a portion given to the other spouse, a QDRO is issued. The QDRO allows the division to occur without penalty… otherwise, making a distribution from a qualified plan before age 59½ would result in penalty and possible taxation, as we all know. The QDRO provides a way (allowed by the IRS) for the receiving spouse to rollover the funds into an IRA of his or her own, without tax or penalty to either spouse.

NUA: Net Unrealized Appreciation – this is a special provision from qualified retirement plans that allows the employee to elect to treat company stock differently from all other assets in the plan when making a distribution from the plan. Essentially, you pay ordinary income tax on the basis, original cost, of the stock in your employer’s (actually former employer’s) company, and then place the stock in a taxable brokerage account. At this point, any gains on the stock are subject only to capital gains tax (rather than ordinary income tax, which is a much higher rate). The trick is that you can only do this maneuver one time, and the distribution must be in a lump sum of all your 401(k) account holdings. Everything in the account that is not company stock can be rolled over into an IRA and maintain tax deferral as usual. It’s critical to note that this can be the only distribution of funds from the account. If you were to distribute any amount, even a small amount from the employer plan in a previous year, you are no longer eligible to use the NUA provision on this employer account.

QDRO and NUA

So the question comes up – if a QDRO distribution occurs for your account, and that distribution includes company stock: does this “bust” the original employee’s ability to later have the company stock treated with the NUA privilege, since the rule states that the distribution must be a one-time single lump-sum distribution?

(drum roll…) The answer is NO.  A QDRO is a division of the account, and though technically a distribution has occurred, this distribution does not impact the remaining account’s ability to take advantage of the NUA provision. The employee can go ahead and, upon separation from service, perform the lump-sum distribution of the stock and rollover the remainder into an IRA and get the NUA treatment for the stock.

Now, if you’re really astute, the last paragraph made you think of another question (it’s okay to admit it if you aren’t tax-geeky enough to have thought of this question): Can the ex-spouse (the one receiving a split of the employee’s plan) elect NUA treatment of any stock that was included in his portion of the account?

(drum roll…) The answer is a qualified YES. The qualification is this: As long as the rest of the account is eligible to be distributed (to include NUA treatment), the QDRO’d portion of the account can also take advantage of this provision.

In other words, although the ex-spouse of the employee could rollover the QDRO’d qualified retirement plan into an IRA at any time, if the account contains appreciated employer stock (stock of the former spouse’s employer) – it may be in the best interest of the receiving spouse to wait until the employee reaches age 59½ or leaves employment (termination or retirement), so that she can take advantage of the NUA provision. Otherwise, any rollover will squash this option forever.

Example

Here’s a quick example to illustrate: Dick and Jane are divorcing.  Dick has a 401(k) plan with his employer, including some stock in his employer. Part of the divorce includes a QDRO to give Jane half of the 401(k) plan.

Once the QDRO is completed, Dick still has his original 401(k) account (albeit diminished by half), and Jane has an account in the plan of equal size. Jane can rollover those funds into an IRA at any time, if she chooses, without penalty. However, since the account holds highly appreciated company stock, in order to qualify for NUA treatment, she must maintain the account in the 401(k) plan until Dick terminates employment, retires, or reaches age 59½. At that time, she can pull the lump-sum distribution for NUA treatment and rollover the rest into an IRA. Dick can elect NUA treatment for his account when he terminates employment or retires.

Now you may be wondering about that picture… the button is the prize that a person gets when in a seminar with Natalie Choate, the renowned IRA expert – if you happen to ask a question that she is unable to answer. I asked the above questions of Mrs. Choate recently and received the button. No disrespect for her whatsoever – as an admirer of her work, I am proud of the button and wanted to share it here.

Posted on May 15th, 2019
by author: jblankenship.

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Posted in: IRA, net unrealized appreciation, NUA, qdro.
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Pension Payout: Annuitize or Rollover (Cash)?

May 8th, 2019
by jblankenship.
5 comments

cash by Franco FoliniIf you happen to be in one of those jobs (there can only be a handful left at this point, right?) that has a traditional pension plan, you may be faced with an important decision. When you’re ready to retire (did I just hear angels singing?) – you have to decide if you’ll take annuitized payments, or if you cash out the plan and roll it over to an IRA.

These “traditional” pension plans are referred to as defined benefit (or DB) plans – meaning that your benefit is defined as a determined amount. This benefit is usually based on a combination of your longevity in the job, plus your ending salary. You’re probably familiar with these computations: an example is a pension that is 2% per year of employment, multiplied by the average of your final five years of salary. So if you worked at a job for 25 years and your final five years’ salary average was $80,000, your annuity would equal $40,000 – which is $80,000 times 2% times 25 years. Often the calculations are more complicated, but that’s the gist of how they work.

In addition, your plan may also offer a cost of living adjustment, or COLA. With a COLA, each year the amount of your annuity payment is increased according to an inflation index such as the CPI, or a fixed rate such as 3%.

There are often other options to choose, such as the pension payout period. It might be for your lifetime (a “life annuity”), for you and your spouse’s lifetimes (a “joint and survivor annuity”), or over a set period of time, like 10 or 20 years (a “period certain annuity”). Quite often, unless there is a survivor option (such as a joint and survivor annuity) or a set period of time (like the period certain annuity), upon your death there will be no residual benefit from the plan. It is because of this that many folks look with favor upon the final option:  the cash-out and rollover.

Cash Out and Rollover

Most often these DB plans also offer an option to receive a cash value settlement for the plan. The amount of the settlement is a discounted value of the future cash flows (the pension payments) that you could expect to receive. For example, the pension mentioned above (the $40,000 per year payment, with no COLA) for a 62 year old retiree might have a cash-out value of $400,000. This may seem like a pretty nice amount of cash. However, this is where some folks act too quickly. (Actuaries, if you’re out there, I just picked some numbers out of the air.  I don’t know if they’re realistic or not. Forgive me!)

I get it – $400,000 in hand seems like it would be worth more than a future promise to pay $40,000 a year. Because, what happens if you die two years into the plan? As mentioned before, unless you have a survivor element in the pension plan, there will be nothing left for your heirs. There’s a lot more to consider than just the amount of the payout and your lifespan.

Things to Consider

It’s important to look at the provisions of the plan and all of the available options in order to determine what’s the best route to take. Each of the various payout options (life annuity, joint and survivor, period certain, etc.) needs to be examined to understand how the cash-out payment is calculated. (This is where it pays to know and work with a financial advisor.)

As you look at the various pension alternatives, consider them in comparison to one another. Sometimes the company subsidizes the survivor benefit to a degree, making a joint and survivor annuity more beneficial than either the single life or the cash-out option. In addition, sometimes for an early retirement option, the pension itself (over all payout options) is subsidized by the company, or “sweetened” to make retirement more attractive to the potential retiree.

As mentioned before, your health and the health of your spouse (as it impacts your lifespan), plus your other financial resources and lifestyle goals need to be considered as you look at the plan options. You also want to consider the financial strength of the company whose pension you’re considering, as well.

Example

Going back to our example: the cash-out payment of $400,000 should be considered against the other pension payout options. The single-life payout was calculated at $40,000 per year for your life. What if the joint and survivor pension payout option was calculated at $36,000, and your spouse is also age 62? This means that you would instead receive $36,000 over your life and the life of your spouse if you predecease him or her. First of all, which option is a better deal? And secondly, is one or the other better than the lump sum cash payout?

We have to make some assumptions when calculating the values of these options. According to actuarial tables, using a joint and survivor option will statistically result in more years of payments, even if the two lives are the same age. Therefore, when comparing a single life annuity to a joint and survivor annuity, we assume that the joint and survivor annuity will be paid out for a longer period of time.

Using a 5% discount rate, the value of the joint and survivor payout is worth approximately 10.8% more (in present value) than the single life annuity. In other words, if you bypass the joint and survivor option, you’re giving up that potential 10.8% of extra value. Another way to look at it is that you’re giving your company a gift of the extra value by not choosing the J&S option.

Either of the pension options are also better than the cash payout – from a strictly financial standpoint, as long as you live to whatever the projected mortality age is for your plan (I used 82 for the example).  This is because the rate used to discount the present value of your future cash flows was 5%. This means that you’d need to get a return of something more than 5% from your lump-sum cash payout during that time frame in order to break even. Keep in mind that this 5% is a guaranteed rate – as long as you live long enough.

Of course, if your health is poor (or you have a family history of life-shortening health problems), you may benefit by taking the lump sum, for the “bird in the hand” benefit. However, if you happen to live longer than the actuarial tables project, you might be in the unenviable position of outliving your funds.

These are some of the issues you need to consider. This has been a very rough example but it should help you to understand the importance of looking before you leap.

It’s often very attractive to choose the cash-payout option since there are many inherent problems with the defined benefit pension plans. But you shouldn’t make the decision willy-nilly. It pays to examine the numbers closely, and if necessary hire someone to look at the numbers with you. You should know what you’re possibly giving up with each choice versus the alternatives.

Posted on May 8th, 2019
by author: jblankenship.

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Posted in: financial planning, IRA, pension, retirement plan.
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Principles of Pollex – Saving 10% of Income

May 6th, 2019
by jblankenship.
2 comments

thumb xray by akeg(In case you are confused by the headline: a principle is a rule, and pollex is an obscure term for thumb.  Therefore, we’re talking about Rules of Thumb.)

I like rules of thumb, as a rule of thumb… I think we all generally want difficult issues in our lives to be boiled down to a simple, easy-to-understand statement.  These rules of thumb are everywhere, all around us. Heck, there’s even a whole website dedicated to rules of thumb, where you can find rules on all kinds of subjects, as diverse as how to outrun a crocodile to changing your answers on a test.

Save 10% of Your Income

Let’s start with one of the basics you might hear regularly: Save 10% of your income. Like most all rules of thumb, this one is very general in nature, but it provides a good starting point.

This starting point is best for someone starting the savings process at an early age – perhaps in your twenties or thirties. If you started to save 10% of your income at an early age and kept up the habit over your lifetime, you’d be bound to have a significant sum of money put aside when retirement comes. (You might be interested to note that this particular rule of thumb is one of the base recommendations in the book “The Richest Man in Babylon” which I wrote a summary of some time ago.)

The problem is that many folks don’t start early in life, and by the time they get around to saving in earnest (maybe in their forties), 10% savings will likely be woefully inadequate – 25% to 30% may be more appropriate.

The other, likely bigger problem with the 10% rule is that it doesn’t account for your timeline or the purpose or goal for the savings. The assumption of the rule of thumb is that you have a long timeline, meaning 30 or more years, and that your goal is retirement at some poorly-defined rate of income, such as 80% of pre-retirement income (see below). These two assumptions don’t fit everyone – although they could fit some people in general, your mileage may vary, quite a bit. If your timeline is shorter (say 10 to 15 years or less) or your goal is for a higher retirement income your percentage of savings should be higher, possibly much higher. If your goal is something altogether different, like a downpayment on a home (in a short timeline but of a specific, small-ish amount), 10% would be too much – although you will likely benefit on other goals by saving at least 10% starting at any time.

So, for a starting point, for someone with a relatively long timeline and a vague goal to aim for, 10% isn’t a bad place to start. Start with 10% (or however much you can afford) and adjust upward over time. It’s better than no rule at all, in my opinion.

Posted on May 6th, 2019
by author: jblankenship.

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Posted in: financial planning, principles of pollex, retirement savings, rules of thumb, saving.
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When it Makes Sense to Take Social Security Early

May 1st, 2019
by jblankenship.
2 comments

fries with gravy by tweber1In this blog many times we’ve covered how beneficial it can be to delay receiving Social Security benefits as long as you can. An example of this discussion is in the article Ah, Sweet Procrastination – it makes good financial sense to delay receiving your benefit to age 70 in many cases, but of course not all.

The reason delayed filing can be such a great benefit is that this government-backed income stream is pretty much as good as you can get, in terms of longevity insurance. When you start receiving the benefit, you’ll continue to receive it through your entire life. When you start receiving your benefit impacts the amount that you will receive for your life. Plus, depending upon the amount of your spouse’s benefit, it will impact the amount that your spouse would receive as a Survivor’s Benefit as well.

But there are times when it may make more sense to begin receiving your benefit earlier…

Starting Early

Circumstances require it. If you’re in ill health, have a shortened life expectancy, or have very limited other resources, it may be necessary to start taking your Social Security benefit early. The financial calculations that we do that explain how delaying receipt of benefits is the better choice, always assume that the recipient will live to at least age 80 or beyond and can get along using other resources until filing at age 70. If one or the other (or both) of these circumstances is not the case for you, it likely makes more sense to begin taking your benefit earlier.

Spouse with a relatively small benefit. If the spouse with the lower wage base has earned a relatively small benefit and intends to switch over to a Spousal Benefit as soon as it makes financial sense, it might make more sense to start taking the smaller benefit early, even though it is reduced. In this case the financial impact of starting to take the benefit early doesn’t amount to a significant reduction in real dollars, so taking the benefit for several years is just extra “gravy on your french fries”, in a manner of speaking.

Social Security doesn’t matter to you. If you have more funds than you really need and the Social Security benefit is of very little real benefit to you – or if you consider the Social Security system a “safety net” for needy folks, you might want to start early. Or you may choose to not take the benefit at all.

Psychological impact. If you simply cannot stand the thought of leaving your Social Security benefit in the government’s hands any longer than necessary and you feel it’s to your best interest to start early (even in the face of facts to the contrary), then by all means start taking benefits early. If that’s what it takes to ease your mind, you should do it. Life’s too short to be wrought up over such matters.

Closing Thoughts

As stated before, in many cases it makes the most financial sense for the spouse with the higher earned benefit to delay benefits to age 70, but not in all cases. In order to really get a good handle on how these calculations would work for you, it may help to hire a professional advisor to run through the numbers with you.

Posted on May 1st, 2019
by author: jblankenship.

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Posted in: Social Security, social security benefits, Social Security spousal benefit.
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Medicaid and Retirement Accounts

Apr 29th, 2019
by jblankenship.
8 comments

Statistics tell us that approximately 25% of us will need some sort of extended long-term nursing care during our lives – and as our life spans increase with improvements in medical care, this number is likely to increase.

Most of us have experienced family or friends needing this type of long-term nursing care. Since Medicare doesn’t provide much in the way of long-term care benefits, the individual is left with three possible sources to pay for long-term care:

  1. private payments from your savings and other sources
  2. long-term care insurance coverage (LTCI)
  3. Medicaid

hardians-wall

Photo credit: diedoe

Given the tremendous costs for long-term care, many individuals are faced with the distinct possibility that any savings that they have amassed over their lifetimes (and that they hoped to pass along to their heirs) could be quickly wiped out or drastically reduced with a stint in a skilled-care facility. Then who will take care of the wall?

Medicaid

Briefly, Medicaid was originally introduced in 1965 (alongside Medicare) as a “safety net” for healthcare, primarily to help the poverty-stricken. Along in the late ’80’s, it became clear that this safety net could be beneficial to people of modest means as well. So the laws were adjusted to allow for additional beneficiaries of the program through some simple planning. Later during the early ’90’s, the eligibility requirements were tightened up a bit, but with planning, certain beneficiaries can still receive Medicaid benefits.

Eligibility for Medicaid is based upon the assets available to the individual – only about $2,000 is allowed to remain in savings vehicles. Community (joint, owned by both members of a married couple) accounts are subject to special rules, and depending upon how your state chooses to administer the program, half of these jointly-held accounts could be considered eligible assets. Other assets, including primary residences, annuities, and life estates, receive special treatment under Medicaid eligibility rules as well.

Retirement Accounts and Medicaid Eligibility

How are your IRA, 401(k), and other accounts viewed with regard to Medicaid eligibility? As a general rule, retirement accounts are included as available assets. Even if the individual is under age 59½ and otherwise ineligible for distributions without penalty. The retirement accounts must be liquidated before the individual can be eligible for Medicaid coverage.

One way to protect assets from liquidation is if the account is in periodic payment status. This might mean the account is subject to Required Minimum Distribution (RMD) either due to age 70½ requirement or if the IRA is inherited and subject to inherited RMD. In some states, an account in periodic payment status is considered an income source rather than an asset. The circumstances might help to protect the account’s assets from being included in total for Medicaid eligibility.

For example, if an individual was in RMD status due to being over age 70½, his account would be considered in payment status. If the account was worth $200,000, this amount would not be counted against him for Medicaid eligility, but the periodic income stream would be. If he is age 72, his annual required payment from the account would be roughly $7,812, which would be considered for his income budget, approximately $651 per month. If this was his only income, that amount would be paid to the nursing home – with the balance of the cost of the nursing care paid by Medicaid.

If the individual is married and the other spouse is not applying for Medicaid, there are allowances made for monthly minimum maintenance (of the non-Medicaid spouse) as well. In 2019, the maximum monthly maintenance needs allowance is $3,160.50. This is the most in monthly income that a community spouse is allowed to have if her own income is not enough to live on and she must take some or all of the institutionalized spouse’s income. The minimum monthly maintenance needs allowance for the lower 48 states remains $2,057.50 ($2,572.50 for Alaska and $2,366.25 for Hawaii) until July 1, 2019.

Not all states utilize a minimum and maximum income allowance. Some states use just one figure that falls somewhere between the federally set minimum and maximum figures. For example, as of 2019, New York, Texas, and California all use a standard monthly figure of $3,160.50 (the maximum), and Illinois uses a standard monthly figure of $2,739.

What About a Roth IRA?

So, if you’re thinking ahead you’re wondering how this impacts a Roth IRA… since a Roth IRA is not subject to minimum distribution rules. Rightly so – the Roth IRA is never in a payment status as long as the original owner is living. As such, your own Roth IRA assets are counted toward Medicaid eligibility status. These assets would have to be spent down before the individual could become eligible for Medicaid.

Bottom line…

So the bottom line is that you need to consider lots of things as you think about Medicaid eligibility. If you have significant assets available, you could be better off to consider a Long-Term Care Insurance (LTCI) strategy, as otherwise your assets might have to be spent down and quite possibly depleted. Unfortunately there isn’t a “rule of thumb” to use in determining whether LTCI makes sense. Each individual’s situation will be a little different, taking into account medical history, family medical history, asset base, age, etc.. This is the sort of analysis that you need to do as you near retirement age in order to consider whether or not LTCI or Medicaid could be a part of your future healthcare plans.

Posted on Apr 29th, 2019
by author: jblankenship.

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Posted in: financial planning, health insurance, IRA, Medicaid, Social Security.
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To Gift or Inherit? Deciding When to Bequeath Assets

Apr 26th, 2019
by sraskie.
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After beneficiaries are named and you understand how assets are distributed at death, we need to discuss the tax implications of gifted and inherited assets. The following is a description of the tax implications of non-qualified assets (those not in 401(k)s or IRAs) received by beneficiaries if gifted during lifetime or inherited after death.

Our example will use stocks in a brokerage account as the assets demonstrating the tax implications of assets gifted during lifetime or inherited at death.

Let’s assume that an individual has a brokerage account and they initially purchased $250,000 worth of stock in the account. Several years have gone by and the account as grown to $500,000. For tax purposes the basis in the account is $250,000. The individual is contemplating gifting the account to their beneficiary.

If the individual decides to gift the account during their lifetime to their beneficiary, the beneficiary receives the assets and acquires the same tax basis as the original account owner. This transfer of basis, called carryover basis, means that if the beneficiary then sells any or all the stocks in the account, the beneficiary’s tax basis is $250,000. So, if the beneficiary sold the entire account for its current value of $500,000, the taxable gain would be $250,000 – the difference between the carryover basis of $250,000 and the sales price of $500,000.

On the other hand, if the original account owner decides not to gift the account during their lifetime and instead waits until dying for the beneficiary to inherit the account, the beneficiary receives the assets and a new basis is established. This new basis, called a step-up (or step-to) in basis, means that the beneficiary’s tax basis is the fair market value of the account assets on the account owner’s date of death.

In this example, if the fair market value of the stocks is $500,000 when the account owner dies, the beneficiary’s new tax basis is $500,000. Thus, if the beneficiary sold the account for $500,000, the tax liability to the beneficiary would be zero. Any gains or losses on the inherited $500,000 would be subject to short- or long-term gains and losses, depending on the beneficiary’s holding period after inheriting the assets.

This same tax basis situation would apply to mutual funds, ETFs, real estate, and other non-qualified assets. Of course, the intentions of the individual gifting or leaving the assets after their death is entirely their prerogative – which may supersede regardless of the tax implications to the beneficiary.

Posted on Apr 26th, 2019
by author: sraskie.

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Posted in: tax, tax basis.
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How Property Transfers At Death

Apr 24th, 2019
by sraskie.
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divorce throws a curve
Photo courtesy of Bec Brown via Unsplash.com.

When you die, the way in which your property is handled will depend on the type of documents (or lack thereof) you’ve set up before your death. The following is a summary of the ways your property transfers to heirs when you pass away.

Life Insurance. At death, life insurance proceeds are passed to your beneficiaries (and in most cases, tax free). For example, if you have a life insurance policy with a face amount of $500,000, when you die, your beneficiaries receive the $500,000 face amount tax free.

When you purchase life insurance, you name your beneficiary or beneficiaries – those who receive the death benefit when you die. Most married couples will name each other as beneficiaries on their respective polices, some will name charities, and other will name other relatives, individuals, or trusts. Life insurance contracts generally avoid probate (the legal process of validating a will and division of property), unless you name your estate beneficiary (a bad idea) or fail to name a beneficiary (also a bad idea).

Annuities. At death annuities operate the same way as life insurance regarding beneficiaries. A big difference however, is the tax treatment. Even though an annuity may pay a death benefit, in most cases it is taxable to the beneficiary. This is different from life insurance death benefits that are received tax free. Any taxable annuity death benefits are taxed as ordinary income.

Trusts. Trusts can be established either during your lifetime or at your death. They may also be revocable (changeable) or irrevocable (not changeable). Trusts are set up by a grantor (the person wanting the trust) and assets are placed in the trust, managed by a trustee, for the benefit of the trust beneficiary. When you die, the assets in the trust are still managed by the trustee for the benefit of the beneficiary. Like annuities and life insurance, trusts avoid probate.

Brokerage Accounts. When you have a brokerage account where you hold stocks, bonds, mutual funds, or ETFs it’s called a non-qualified brokerage account. The non-qualified means that it’s not a 401(k) or IRA. When you open this type of account, you are given the option to name a beneficiary on the account should you die. At death, the property passes to the beneficiary. The beneficiary also receives special tax treatment on the account. Brokerage accounts also avoid probate.

Retirement plans. When you have retirement plans such as 401(k)s and IRAs you also name beneficiaries who get the account assets when you die. The tax treatment of the assets will depend on the account (Roth or not), and what the beneficiary chooses to do with the assets (sell them all or take minimum distributions). Brokerage accounts avoid probate.

Wills. A will is a written legal document that directs how and to whom your assets are dispersed after your death. Wills also name a guardian(s) for minor children should both parents die. Wills also name an executor for your estate that helps direct where assets go, what assets to sell, and filing the final tax return for the deceased and or the estate.

As mentioned before, probate is the process of validating a will. Thus, it’s a public process, and often long and expensive. Additionally, the documents mentioned above supersede the language in a will. In other words, if your will states that your kids get your IRA assets at your death, but your IRA beneficiary is another person or entity, the IRA overrides the language in the will.

Dying without a will means dying intestate. Dying intestate means that the state determines how your assets are divided, who gets them, and if you have minor children, who becomes their guardian. Different states have different laws, but be assured, the laws may differ from what your intentions are or who you think should get your assets or be guardians. Don’t risk it. If you don’t have a will, or your beneficiaries named, consider taking care of this today.

An extremely important point not to be overlooked is the need to update your beneficiaries or documents whenever you have a life changing event. Life changes mean births, deaths, divorces, job changes, etc. For example, if you get divorced and remarry, and forget to change your beneficiary from your ex-spouse to your new spouse – and you die – your ex-spouse is still the beneficiary and gets the property. It is paramount to update your accounts, estate documents, insurance policies, and retirement plans to reflect any life changes.

Posted on Apr 24th, 2019
by author: sraskie.

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Posted in: estate planning.

Celebrating 15 years: Financial Planning 101

Apr 19th, 2019
by jblankenship.
2 comments
Original layout of Financial Ducks In a Row

On this date fifteen years ago, April 19, 2004, this blog was officially launched. The article below was the first post ever, and I’ve reposted it here in celebration of the 15 year anniversary of Financial Ducks In A Row.

I have not edited the content below, it’s exactly the same as it was originally posted back in 2004.

A lot has changed over the years, and I continue to enjoy sharing sound financial principles, information and advice through this medium, and I hope to keep it up for a long time into the future.

Nine Essential Tips for a Bright Financial Future

1. See a lawyer and make a Will. If you have a Will make sure it is current and valid in your home state. Make sure that you and your spouse have reviewed each other’s Will – ensuring that both of your wishes will be carried out. Provide for guardianship of minor children, and education and maintenance trusts.
2. Pay off your credit cards. Forty percent of Americans carry an account balance – not good. Create a systematic plan to pay down balances. Don’t fall into the “0% balance transfer game” as it will hurt your FICO score. Credit scores matter not only to credit card companies but to insurance companies as well; you can avoid an unpleasant increase in your insurance rates by managing your credit wisely.
3. Buy term life insurance equal to 6-8 times your annual income. Most consumers don’t need a permanent policy (such as whole life or universal life). Also consider purchasing disability insurance; think of it as “paycheck insurance.” Stay-at-home spouses need life insurance, too! Note: Each family’s needs are different. Some families have a need for other kinds of life insurance, so you should review your situation carefully with an insurance professional or two before making decisions in this area.
4. Build a 3 to 6 month emergency fund. Establish a home equity line of credit before you need it – this can take the place of part of your emergency fund.
5. Don’t count on social security! Fund your IRA each and every year. If you don’t fund it annually, you lose the opportunity. Fund a Roth IRA over a traditional IRA if you qualify.
6. If offered, contribute to your 401(k), 403(b) or other employer-sponsored saving plan. Use your company’s flex spending plan to leverage tax advantages. If you don’t use your flex plan or fund your retirement plan annually, you lose the opportunity – and the tax advantages – for that year.
7. Buy a home if you can afford it. Maintain it properly. Build equity in your property. You’ll have much more to show for your money spent than a box full of rental receipts!
8. Use broad market stock index funds and direct purchase government bonds to reduce risk, minimize costs and diversify your portfolio. If you have limited options, for example in your 401(k) plan, make sure that you diversify across a broad spectrum of options. Don’t over-weight in any one security, especially your employer’s stock – remember ENRON?

If you are unsure about your financial affairs or you have financial goals such as retirement planning, college funding, business succession or estate planning that you’d like help achieving, call Blankenship Financial Planning at 217/488-6473 to schedule a no-cost, no-obligation “Get Acquainted” meeting to discuss your situation.

Posted on Apr 19th, 2019
by author: jblankenship.

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Posted in: #noTOP, financial planning, personal finance.

Roth IRA Eligibility

Apr 15th, 2019
by jblankenship.
5 comments

roth?

Photo credit: diedoe

The Roth IRA is a very valuable retirement savings vehicle. There are several reasons that the Roth IRA is so valuable, including:

  • qualified withdrawals are tax free
  • withdrawal of regular contributions is available at any time for any reason
  • there is never a Required Minimum Distribution for the original account owner
  • beneficiaries can receive distributions from the account tax-free

With all of these benefits, you can see why the Roth IRA has become a very popular option for retirement savings, as well as for estate planning. So the question now becomes: Am I eligible to contribute to a Roth IRA?

Roth IRA Eligibility

The eligibility requirements for a Roth IRA are as follows:

  1. You must have earned income. This means you receive compensation in the form of wages, salaries, tips, professional fees, bonuses, commissions, self-employment income, nontaxable combat pay, and taxable alimony or maintenance. If you are married and you had no earned income (or your earned income is less than the maximum Roth IRA contribution amount), your Roth IRA contribution may be based on your spouse’s earned income.
  2. Your Modified Adjusted Gross Income (MAGI) must be less than:
    1. $193,000 (for 2019) if your filing status is Married Filing Jointly or Qualifying Widow(er); or
    2. 122,000 (for 2019) if your filing status is Single, Head of Household, or Married Filing Separately (and you did not live with your spouse at any time during the year); or
    3. $10,000 if your filing status is Married Filing Separately and you lived with your spouse at any time during the year.

And that’s it. You are not limited by participation in an employer-sponsored plan as you are with deductibility of a traditional IRA. There are a few limiting factors, though:

  1. You cannot contribute more than your earned income.
  2. A spousal contribution is allowed, as long as the total of contributions to personal and spousal IRAs doesn’t exceed the total of your own and your spouse’s earned income.
  3. You are limited by an annual amount (for 2019 it’s $6,000 plus an over age 50 “catch up” of $1,000). Your total IRA contributions (traditional and Roth added together) cannot exceed that annual limit.
  4. When your MAGI reaches a certain amount, your contribution amount will begin to be limited.  You can visit this page for more details on the MAGI limits and how they are applied.
Posted on Apr 15th, 2019
by author: jblankenship.

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Posted in: IRA, retirement plan, Roth IRA.
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Calculating the Spousal Benefit

Apr 10th, 2019
by jblankenship.
4 comments

Difference_engine_ScheutzThe Spousal Benefit is one of the most confusing aspects of the Social Security retirement benefit system. It may be vaguely familiar that the spouse with the lower wage base is eligible for 50% of the higher wage base spouse’s benefit, or something like that…

How is the Spousal Benefit actually calculated?

Calculating the Spousal Benefit

Here’s how the Spousal Benefit is calculated:

First of all, the Spousal Benefit is based upon a differential – between 50% of the other spouse’s Primary Insurance Amount (PIA) and his or her own PIA.

So what’s the calculation? Let’s look at an example:

Let’s say there’s a couple, both the same age with a Full Retirement Age (FRA) of 66, and the wife has a substantially lower wage base (and therefore a lower benefit) than the husband. At age 62, she files for the her own reduced benefit based on her own record, from a PIA of $800. Her benefit is reduced to $600 due to filing early.

The husband’s PIA is $2,000 per month.

Later on, when they reach age 66, the husband files for his Social Security benefits. The wife is now eligible for a Spousal Benefit, because one of the enabling factors for a Spousal Benefit is that the other spouse has filed for his or her own Social Security benefit. The Spousal Benefit is based on the differential between 50% of the husband’s PIA ($2,000 X 50% = $1,000) and her PIA ($800). The PIA is used to calculate this differential, not her benefit, even though her benefit is reduced since she filed early. The differential between those two factors is $200 ($1,000 minus $800). The differential is then added to her reduced benefit for a total benefit of $800 (reduced benefit of $600 plus the differential of $200). For simplicity, COLAs have not been included in this example.

Let’s adjust the example:  Same couple, only now the wife waits until her FRA to begin drawing her own benefit, which is the same time as the husband. Now her Spousal Benefit differential will still be $200 (the differential between 50% of his PIA and her PIA), so her total benefit will now be $1,000 (her unreduced PIA of $800 plus $200 differential).

Now, what if the wife is younger? As long as she’s at least age 62, she can begin receiving the Spousal Benefit once her husband applies for benefits. It’s important to know though, that if she decides to file for the Spousal Benefit prior to her FRA, the Spousal Benefit factor is correspondingly reduced (as would be her own benefit if she filed early).

Instead of 50% of her husband’s PIA, at her age 62 the Spousal Benefit factor would be reduced to 35% of her husband’s PIA, and then the differential calculated as explained before. At age 63 the Spousal Benefit factor would be 37.5%; at age 64, 41.7%; and at age 65 it would be 45.8%. This reduction is calculated as 25/36ths of one percent for each month before her FRA up to 36 months, plus 5/12ths of one percent for each month more than 36 before FRA. The reduction factor is then taken against the original 50% factor to determine the actual percentage of the husband’s PIA to be used in calculating the Spousal Benefit differential.

In this manner, the reduction is 25% for the closest 36 months to FRA, and then an additional 5% for each year more than 3 before FRA that the filing for Spousal Benefits is completed. If you file for Spousal Benefits exactly 4 years before your FRA, the Spousal Benefit factor is reduced by 30%, as an example. So instead of 50%, the most your Spousal benefit could be is 35% (which is a reduction of 30% applied to the original 50%).

In all cases except for someone born before 1954*, filing for a Spousal Benefit deems filing for your own benefit. Also, whenever eligible for a Spousal Benefit, if you file for your own benefit deemed filing requires that you have also filed for the Spousal benefit. This can result in unexpected reductions to both types of benefit if you weren’t prepared for this.

*If born before 1954 and you’re over FRA, it is possible to file solely for Spousal Benefit while delaying your own benefit to a later date. If you file for a Spousal benefit before reaching FRA, deemed filing applies to you no matter what your date of birth is.

Keep in mind that the examples above denoted the wife as the spouse receiving the Spousal Benefit – but the roles could be reversed, depending upon the circumstances.

I hope this clears things up a bit. It’s a very confusing component to understand, but this should have helped to clear things up – let me know if you have any questions, as always!

Posted on Apr 10th, 2019
by author: jblankenship.

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Posted in: Deemed Filing, Social Security, Social Security spousal benefit, Spousal Benefit.
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Taxation of Social Security Benefits

Apr 1st, 2019
by jblankenship.
5 comments

taxation of social security You’d think that, after working all your life and now that you’re in a position to retire and start taking Social Security retirement benefits, that you could get a break and not have to pay income tax. But alas, Social Security retirement benefits may be taxable to you, depending upon your income level. And in truly typical bureaucratic style, it’s not a simple question to determine 1) IF your benefit is taxable; or 2) what rate or amount of your benefit is taxable; or even 3) what income is counted to determine if your benefit is taxable. (If you’d like to read some more about this subject, check out my book, A Social Security Owner’s Manual.)

Determining Provisional Income

In order to figger out if your Social Security benefit is to be taxed at all, we first have to calculate a relatively unknown sum known as Provisional Income (PI). What this boils down to is your Adjusted Gross Income plus any tax-exempt income, plus any excluded foreign income, plus 50% of your gross Social Security benefit. If you’re interested in just which lines on the 1040 return these are, here’s a list:

  • Form 1040 Line 1, 2a, 2b, 3a, 3b, and 4b, plus Schedule 1, Line 22, plus 50% of your Social Security benefit – these income lines are all added together.
  • Subtract the deductions (Schedule 1, Line 36) from the income items – if this number is zero or less, you don’t have to calculate any more. Your Social Security benefit is not taxable.
  • IF, on the other hand, you come up with a positive number after this calculation, this number is your Provisional Income.

Once you’ve determined the Provisional Income, you’re ready to look at the “Base Amount”.

Comparing to Base Amount

So you have your Provisional Income calculated, now you need to compare that number to the Base Amount for your filing status. So, if your filing status is Married Filing Jointly, your Base Amount is $32,000. If your filing status is Single, Head of Household, Qualifying Widow(er) or Married Filing Separately and you lived apart from your spouse for the entire calendar year, your Base Amount is $25,000. (Note: if your filing status is Married Filing Separately and you lived with your spouse at any time during the calendar year, see the special section at the bottom of this article for information about your benefit’s taxability.)

Okay – so now that you know your Base Amount, you compare that number to the Provisional Income number that you came up with previously. If your Provisional Income is less than your Base Amount – you can stop, because none of your Social Security benefit is taxable.

However (and there’s always a “however” in life, right?) if your Provisional Income is greater than the Base Amount – hang in there, you have some more figgering to do. And guess what?  There’s more complexity involved! Yippee!

Incremental Amount

If you’ve determined that your Provisional Income is greater than your Base Amount. This indicates that some of your Social Security benefit is going to be taxed. This next calculation determines just how much of the benefit will be taxed. If your Base Amount is $32,000 (your filing status is Married Filing Jointly) then you have an Incremental Amount of $12,000. If your Base Amount is $25,000, then your Incremental Amount is $9,000.

When you subtract the Base Amount from your Provisional Income – is the figure you’ve come up with more or less than your Incremental Amount? If less, then 50% of the Provisional Income minus the Base Amount will be taxable, and you’re finished with calculations. (Don’t worry, we’ll work through a couple of examples to try to clear this up.) If the amount that you came up with was greater than your Incremental Amount, then at least 85% of the amount above the Incremental Amount plus the Base Amount will be taxed – but more calculations are required.

Final Calculation

If the amount of Provisional Income is in excess of your Base Amount plus the Incremental amount, which is your Excess Provisional Income, there is another calculation to complete. Take 50% of your Incremental Amount, and compare it to 50% of your overall Social Security benefit. Whichever number is smaller, add that number to 85% of your Excess Provisional Income. Then lastly, multiply your total Social Security benefit by 85%, and compare this number to the one you just came up with – whichever is smaller is the amount of Social Security benefits that is taxable.

Confusing enough? Let’s walk through a couple of examples to clarify.

Example 1 – Married Filing Jointly

1) AGI Excluding SS Benefits $30,000
2) + Tax exempt interest $1,000
3) = Modified AGI $31,000
4) + 50% of SS Benefits $10,000
5) = Provisional Income (PI) $41,000
6) – Base Amount (BA) $32,000
7) = Excess PI over BA $9,000
8) – Incremental BA $12,000
9) = Excess PI (if <0, enter zero) $0
10) Smaller of line 7 or line 8 $9,000
11) 50% of line 10 $4,500
12) smaller of line 4 or line 11 $4,500
13) 85% of line 9 $0
14) Add lines 12 and 13 $4,500
15) SS Benefits times 85% $17,000
16) Smaller of line 14 or 15 is your taxable benefit $4,500

Example 2 – Married Filing Jointly

1) AGI Excluding SS Benefits $50,000
2) + Tax exempt interest $2,000
3) = Modified AGI $52,000
4) + 50% of SS Benefits $10,000
5) = Provisional Income (PI) $62,000
6) – Base Amount (BA) $32,000
7) = Excess PI over BA $30,000
8) – Incremental BA $12,000
9) = Excess PI (if <0, enter zero) $18,000
10) Smaller of line 7 or line 8 $12,000
11) 50% of line 10 $6,000
12) smaller of line 4 or line 11 $6,000
13) 85% of line 9 $15,300
14) Add lines 12 and 13 $21,300
15) SS Benefits times 85% $17,000
16) Smaller of line 14 or 15 is your taxable benefit $17,000

Hopefully these two examples will clear things up a bit. If you are in one of the Single filing statuses, substitute your BA ($25,000) and Incremental BA ($9,000) where applicable.

Married Filing Separately, Having Lived With Your Spouse

If you have filing status of Married Filing Separately and you lived with your spouse at any time during the year, 85% of your Social Security benefit is always taxable. This is the maximum amount that can be taxed using the calculations illustrated above.

Posted on Apr 1st, 2019
by author: jblankenship.

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Posted in: income tax, Social Security, tax.
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Credits and Deductions

Mar 29th, 2019
by sraskie.
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Let’s talk a little bit about tax credits and tax deductions. Both can be used to help reduce or avoid taxation but behave differently when it comes to doing so.

Tax deductions are beneficial because help lower the amount of your income subject to taxation. Deductions may be either “above the line” or for AGI, or “below the line” or from AGI. The line in the sand in this scenario is of course, AGI (adjusted gross income).

Above the line deductions are beneficial because they reduce gross income to arrive at AGI. A lower AGI may result in being able to take advantages of other benefits in the Internal Revenue Code (IRC) such as being able to contribute to a Roth IRA and qualifying for additional tax credits (discussed below).

Common above the line deductions include pre-tax 401(k) contributions, student loan interest, deductible contributions to a traditional IRA, HSA contributions, and self-employed business expenses (Schedule C).

Once AGI is reached, below the line deductions can be applied. Below the line deductions lower AGI further, to arrive at taxable income. Below the line deductions are going to come from either itemized deductions (Schedule A) or the standard deduction – a deduction everyone qualifies for and varies in amount based on filing status. You may either itemize or take the standard deduction, but you cannot do both.

If you itemize, you’ll use Schedule A. Common deductions on Schedule A include medical and dental expenses, home mortgage interest, state and local taxes, and charitable contributions. Some deductions on Schedule A (such as medical and dental) are subject to a floor of AGI. An AGI floor means that the expenses may be deducted once they’re higher than the floor. For example, if your AGI is $100,000 and the deduction has a floor of 10%, then any expenses above $10,000 would be deductible.

Once all deductions have been taken, you arrive at your taxable income. It’s here where the applicable tax rates are applied, and your tax is calculated. However, you may still benefit from tax credits.

Tax credits reduce the amount of tax owed on a dollar-for-dollar basis. Whereas deductions reduce taxable income, credits lower the amount of taxed owed. For example, if you owe $2,000 in taxes but have $1,500 worth of credits, then your net taxed owed would be $500. In some instances, your tax credits may eliminate any taxes owed. In fact, you may even qualify for a refund based on your credits exceeding the tax you owe (called refundable or partially refundable credits).

Naturally, the specific credit(s) you may qualify for depends on your situation. For example, parents can take advantage of the child tax credit, American opportunity tax credit, child and dependent care credit, and the earned income tax credit. Other credits you may be eligible for are the lifetime learning credit, saver’s credit, adoption credit, and residential energy credit.

To see what credits and deductions make the most sense for your situation, talk to a tax professional such as a CPA that specializes in taxes, an EA, or tax attorney. You don’t want to leave money on the table or pay more tax than required.

Posted on Mar 29th, 2019
by author: sraskie.

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Posted in: income tax, income tax credit, refunds, saver's credit, tax, tax credits, tax deduction, tax deferral.

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