Step by Step Guide to Planning for Early Stock Option Exercise

Early Stock Option Exercise

Planning for Early Stock Option Exercise can be overwhelming and challenging. Many employees of early-stage startups and private companies receive equity compensation in the form of stock options and RSUs.

Planning for Early Stock Option Exercise

If you are one of these people, you probably want to understand how owning stock options will impact your long-term wealth.  The exact specifics of your equity compensation will vary widely from one company to another. There is also a vast range of possible outcomes in terms of the value of your equity and the timing of your liquidity event. Your tax implications depend on when and how you exercise your stock options and how long you hold your vested stocks. Furthermore, many employees will struggle with the high concentration of your net worth in a single company.  Burdened with many questions and a few answers, tech workers often delay early stock option exercise until closer to an IPO or other liquidity event

So, what do you do next? Here are some ideas that can help you navigate the complex world of equity compensation and early stock option exercise.

1. Know what you own

The best way to master your equity ownership is to take a step back and figure what you own. Reach out to your payroll department or stock option vendor and ask for more information about your stock option holdings.

In general, there are two types of employee stock options – Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). You will most likely own one or the other or some combination of the two. While they may look very similar on the surface, there are significant financial and tax differences between ISOs and NSOs.

ISOs, generally, offer a more favorable tax treatment. There are no taxes due upon your ISO’s exercise, but that can force you to pay an Alternative Minimum Tax.

In comparison, NSOs offer slightly little more flexibility but trigger an immediate taxable income at exercise. Both employers and other stakeholders can receive NSOs.

2. Keep track of key dates and figures

Keeping track of important dates and figures is the next step in mastering your stock options. In most cases, you must start from the moment you receive your job offer. In my article “Guide to understanding your job offer with stock options,” I discuss evaluating a job offer that includes a combination of salary and stock options. There are a handful of important dates and figures that you need to keep track of. Here is the alphabet of terms you have to remember – a number of shares, vesting dates, exercise dates, strike price, fair market value, and vested versus unvested shares.

Furthermore, as you continue working for the same firm, you may receive other stock option grants with different strike prices.  Create a spreadsheet or use the information provided by your option vendor to track all the numbers. It could be a bit cumbersome, but it can help immensely when making early stock options exercise decisions.

3. 83b election

Some companies may allow you for IRC § 83(b) election.  This IRS rule permits companies to offer an early exercise of stock options. When making this election, you will pay income taxes on the fair value of your stock options. The early election is incredibly lucrative for founders and employers of early-stage startups with low fair market value.

The 83(b) election is rarely done due to the complexities in calculating the value of an early-stage startup’s options. If you can determine the value at the time of the grant and decide to pursue this road, you will owe taxes on your options’ fair market value at the grant date. But no income tax will be due at the time of vesting. Another disadvantage of this strategy is the risk of the employee stock price falling below the grant date level. In this scenario, it would have been advantageous to wait until the vesting period.

4. Navigate your taxes

Managing and planning your taxes is by far the most challenging step in the process of early stock option exercise. The biggest hurdle comes from the uncertainty about having enough cash to cover your tax expense. Further on, frequent changes in the company’s fair market value and inability to sell vested shares complicate the process of planning your taxes.

Given so many moving parts, you are probably wondering what your best course of action is. For one, once you reach this junction, it is time to ditch Turbo Tax (no offense, I used it for many years in the past) and seek expert advice. Despite all uncertainty about the future, we advise our clients to start making regular tax projections. Taking a snapshot of your current circumstances will allow you to take an objective view of your finances and make informed financial decisions.

5. Plan ahead for Early Stock Option Exercise

In my practice, I often speak with folks whose employer is going public in a matter of days or weeks. A good number of them are considering exercising their stock options for the first time. There is a strong appeal in this do-nothing approach. You are waiting to exercise until the IPO eliminates a lot of uncertainty regarding your market price and liquidity. However, waiting has a significant trade-off – paying higher taxes and concentration of risk. The advice we give to all our clients is to plan ahead. Do not leave these critical financial decisions for the last minute. Even with the broad range of future outcomes, you could minimize your taxes and reduce your anxiety levels by taking small, measured steps.

What makes the Early Stock Option Exercise decisions so tricky is that there is no magic formula or one-size-fits-all solution that works for everyone. While working with numerous clients, I realize that we all face different circumstances and challenges. If one approach works wells for your colleagues, it may not work very well for you. When we work with our clients, we try to strike the right balance between managing uncertainty and planning for the future.

Tax Saving Moves for 2020

Tax Saving Moves for 2020

As we approach the end year, we share our list of tax-saving moves for 2020. 2020 has been a challenging and eventful year. The global coronavirus outbreak changed the course of modern history. The Pandemic affected many families and small businesses. The stock market crashed in March, and It had a full recovery in just a few months.

With so many changes, now is a great time to review your finances. You can make a few smart and simple tax moves that can lower your tax bill and increase your tax refund.

Whether you file taxes yourself or hire a CPA, it is always better to be proactive. If you expect a large tax bill or your financials have changed substantially, talk to your CPA. Start the conversation today. Don’t wait until the last moment. Being ahead of the curve will help you make well-informed decisions without the stress of tax deadlines.

1. Know your tax bracket

The first step of mastering your taxes is knowing your tax bracket. 2020 is the third year after the TCJA took effect. One of the most significant changes in the tax code was introducing new tax brackets.

Here are the tax bracket and rates for 2020.

Tax Brackets 2020

2. Decide to itemize or use a standard deduction

Another recent change in the tax law was the increase in the standard deduction. The standard deduction is a specific dollar amount that allows you to reduce your taxable income. As a result of this change, nearly 90% of all tax filers will take the standard deduction instead of itemizing. It makes the process a lot simpler for many Americans. Here are the values for 2020:

Filing status2020 tax year
Single$12,400
Married, filing jointly$24,800
Married, filing separately$12,400
Head of household$18,650

3. Maximize your retirement contributions

You can save taxes by contributing to a retirement plan. Most contributions to qualified retirement plans are tax-deductible and will lower your tax bill.

  • For employees – 401k, 403b, 457, and TSP. The maximum contribution to qualified employee retirement plans for 2020 is $19,500. If you are at the age of 50 or older, you can contribute an additional $6,500.
  • For business owners – SEP IRA, Solo 401k, and Defined Benefit Plan. Business owners can contribute to SEP IRA, Solo 401k, and Defined Benefit Plans to maximize your retirement savings and lower your tax bill. The maximum contribution to SEP-IRA and Solo 401k in 2020 is $57,000 or $63,500 if you are 50 and older.

If you own SEP IRA, you can contribute up to 25% of your business wages.

In a solo 401k plan, you can contribute as both an employee and an employer. The employee contribution is subject to a $19,500 limit plus a $6,500 catch-up. The employer match is limited to 25% of your compensation for a maximum of $37,500. In many cases, the solo 401k plan can allow you to save more than SEP IRA.

Defined Benefit Plans is an option for high-income earners who want to save more aggressively for retirement above the SEP-IRA and 401k limits. The DB plan uses actuary rules to calculate your annual contribution limits based on your age and compensation. All contributions to your defined benefit plan are tax-deductible, and the earnings grow tax-free.

4. Convert to Roth IRA

Transferring investments from a Traditional IRA or 401k plan to a Roth IRA is known as Roth Conversion. It allows you to switch from tax-deferred to tax-exempt retirement savings.

The conversion amount is taxable for income purposes. The good news is that even though you will pay more taxes in the current year, the conversion may save you a lot more money in the long run.

If you believe that your taxes will go up in the future, Roth Conversion could be a very effective way to manage your future taxes. 

5. Contribute to a 529 plan

The 529 plan is a tax-advantaged state-sponsored investment plan, allowing parents to save for their children’s future college expenses. 529 plan works similarly to the Roth IRA. You make post-tax contributions. Your investment earnings grow free from federal and state income tax if you use them to pay for qualified educational expenses. Compared to a regular brokerage account, the 529 plan has a distinct tax advantage as you will never pay taxes on your dividends and capital gains.

Over 30 states offer a full or partial tax deduction or a credit on your 529 contributions. You can find the full list here. If you live in any of these states, your 529 contributions can significantly lower your state tax bill.

6. Make a donation

Donations to charities, churches, and various non-profit organizations are tax-deductible. You can support your favorite cause by giving back and lower your tax bill at the same time.

However, due to the new tax code changes, donations are tax-deductible only when you itemize your tax return. If you make small contributions throughout the year, you will be better off taking the standard deduction.

If itemizing your taxes is crucial for you, you might want to consolidate your donations in one calendar year. So, instead of making multiple charitable contributions over the years, you can give one large donation every few years.

7. Sell losing investments

2020 has been turbulent for the stock market. If you are holding stocks and other investments that dropped significantly in 2020, you can consider selling them. The process of selling losing investments to reduce your tax liability is known as tax-loss harvesting. It works for capital assets held outside retirement accounts (401k, Traditional IRA, and Roth IRA). Capital assets may include real estate, cars, gold, stocks, bonds, and any investment property, not for personal use.

The IRS allows you to use capital losses to offset capital gains. If your capital losses are higher than your capital gains, you can deduct the difference as a loss on your tax return. This loss is limited to $3,000 per year or $1,500 if married and filing a separate return.

8. Prioritize long-term over short-term capital gains

Another way to lower your tax bill when selling assets is to prioritize long-term over short-term capital gains. The current tax code benefits investors who keep their assets for more than one calendar year. Long-term investors receive a preferential tax rate on their gains. While investors with short-term capital gains will pay taxes at their ordinary income tax level

Here are the long-term capital gain tax brackets for 2020:

Long-Term Capital Gains Tax RateSingle Filers (Taxable Income)Married Filing Separately
0%$0-$40,000$0-$40,000
15%$40,000-$441,450$40,000-$248,300
20%Over $441,550Over $248,300

High-income earners will also pay an additional 3.8% net investment income tax.

9. Contribute to FSA and HSA

With healthcare costs always on the rise, you can use a Flexible Spending Account (FSA) or a Health Savings Account (HSA) to cover your medical bills and lower your tax bill.

Flexible Spending Account (FSA)

A Flexible Spending Account (FSA) is tax-advantaged savings account offered through your employer. The FSA allows you to save pre-tax dollars to cover medical and dental expenses for yourself and your dependents. The maximum contribution for 2020 is $2,750 per person. If you are married, your spouse can save another $2,750 for a total of $5,500 per family.  Some employers offer a matching FSA contribution for up to $500. Typically, it would help if you used your FSA savings by the end of the calendar year. However, the IRS allows you to carry over up to $500 balance into the new year.

Dependent Care FSA (CSFSA)

A Dependent Care FSA (CSFSA) is a pre-tax benefit account that you can use to pay for eligible dependent care services, such as preschool, summer day camp, before or after school programs, and child or adult daycare. It’s an easy way to reduce your tax bill while taking care of your children and loved ones while you continue to work. The maximum contribution limit for 2020 for an individual who is married but filing separately is $2,500. For married couples filing jointly or single parents filing as head of household, the limit is $5,000.

Health Savings Account (HSA)

A Health Savings Account (HSA) is an investment account for individuals under a High Deductible Health Plan (HDHP) that allows you to save money on a pre-tax basis to pay for eligible medical expenses. The qualified High Deductible Plan typically covers only preventive services before the deductible. To qualify for the HSA, the HDHP should have a minimum deductible of $1,400 for an individual and $2,800 for a family. Additionally, your HDHP must have an out-of-pocket maximum of up to $6,900 for one-person coverage or $13,800 for family.

The maximum contributions in HSA for 2020 are $3,550 for individual coverage and $7,100 for a family. HSA participants who are 55 or older can contribute an additional $1,000 as a catch-up contribution. Unlike the FSA, the HSA doesn’t have a spending limit, and you can carry over the savings in the next calendar year.

Keep in mind that the HSA has three distinct tax advantages. First, all HSA contributions are tax-deductible and will lower your tax bill. Second, you will not pay taxes on dividends, interest, and capital gains. Third, if you use the account for eligible expenses, you don’t pay taxes on those withdrawals.

10. Defer income

Is 2020 shaping to be a high income for you? Perhaps, you can defer some of your income from this calendar year into 2021 and beyond. This move will allow you to delay some of the income taxes coming with it. Even though it’s not always possible to defer wages, you might be able to postpone a large bonus, royalty, or one-time payment. Remember, it only makes sense to defer income if you expect to be in a lower tax bracket next year.

On the other hand, if you expect to be in a higher tax bracket tax year next year, you may consider taking as much income as possible in 2020.

11. Skip RMDs

Are you taking the required minimum distributions (RMD) from your IRA or 401k plan? The CARES Act allows retirees to skip their RMD in 2020. If you don’t need the extra income, you can skip your annual distribution. This move will lower your taxes for 2020 and may cut your future Medicare cost.

12. Receive employee retention tax credit for eligible businesses

The CARES Act granted employee retention credits for eligible businesses affected by the Coronavirus pandemic. The credit amount equals 50% of eligible employee wages paid by an eligible employer in a 2020 calendar quarter. The credit is subject to an overall wage cap of $10,000 per eligible employee.

Qualifying businesses must fall into one of two categories:

  • The employer’s business is fully or partially suspended by government order due to COVID-19 during the calendar quarter.
  • The employer’s gross receipts were below 50% of the comparable quarter in 2019. Once the employer’s gross receipts went above 80% of a comparable quarter in 2019, they no longer qualify after the end of that quarter.

 

Effective Roth Conversion Strategies for Tax-Free Growth

Roth Conversion

Roth conversion of your tax-deferred retirement savings can be a brilliant move. Learn the must-know rules and tax implications of Roth Conversion before you decide if it is right for you.

Retirement Calculator

What is a Roth Conversion?

Roth Conversion is the process of transferring the full or partial balance of your existing traditional IRA into a Roth IRA. The conversion effectively moves tax-deferred retirement savings into tax-exempt dollars.

A critical downside of Roth conversion is that you need to pay income taxes on the converted amount. For that reason, it is beneficial to have additional taxable savings to cover the tax cost of the conversion.

Unfortunately, not everybody is the right candidate for Roth conversion. Consider your specific financial and tax circumstances before moving forward.

Watch your tax bracket

A crucial element of any Roth conversion decision making is your taxes. The strategy becomes feasible during low tax years or whenever you expect higher tax rates in the future. Higher future tax rates make a Roth IRA more appealing, while lower future tax rates would make a traditional IRA more attractive.

Consider your investment horizon

Generally, you will achieve a higher benefit if you perform your conversions earlier. Your Roth IRA will have time to grow tax-free for longer and will offset the cost of paying taxes upfront. 

Roth IRA 5-year rule

When you do a Roth conversion, you need to be mindful of the 5-year rule. The rule requires that 5 years have passed since your first Roth contributions before taking penalty-free withdrawals of your tax-free earnings.

You can still withdraw your original contributions at any time. However, your earnings are subject to the 5-year minimum restriction. If you do not meet the minimum 5-year holding period, your profits can be subject to ordinary income tax as well as a 10% penalty for early withdrawal.

Furthermore, each separate Roth conversion has a five-year limit. The Five-Year clock begins ticking on January 1st of the year when you make the conversion.

The advantages of Roth conversion

Converting your tax-deferred dollars to Roth RIA can have several financial and estate benefits.

Your money grows tax-free

Savings in your Roth IRA grow tax-free. As long as you meet the 5-year rule, you will not owe any taxes on your distributions. Roth IRA contributions are pre-tax. You are paying taxes beforehand but do not owe taxes on any future earnings.

In comparison, contributions to Traditional IRA are typically tax-deductible. When you take distributions from Traditional IRA, you have to pay ordinary income taxes on your entire withdrawal amount. 

Tax Diversification

If your future tax rate is uncertain for various reasons, you may want to diversify your tax risk through Roth conversion. You will benefit from holding both tax-deferred and tax-exempt retirement accounts. Tax diversification gives you more flexibility when it comes to future retirement withdrawals and tax planning. 

Asset Location

Asset location is a tax-optimization strategy that takes advantage of different types of investments, getting different tax treatments. Investors who own a variety of taxable, tax-deferred, and tax-exempt accounts can benefit from asset location. By doing Roth conversion, you can determine which securities should be held in tax-deferred accounts and which in Roth accounts to maximize your after-tax returns.

No Required Minimum Distributions

Traditional IRA rules mandate you to take taxable required minimum distributions (RMDs) every year after you reach age 72.

Alternatively, your Roth IRA does not require minimum distributions at any age. Your money can stay in the account and grow tax-free for as long as you want them.

Leave behind a tax-free legacy

The Roth IRA can play a crucial role in your estate planning. Your heirs who inherit your Roth IRA will receive a tax-free gift. They will be required to take distributions from the account. However, they will not have to pay any income tax on the withdrawals if the Roth IRA has been open for at least five years. Roth IRA is especially appealing if your heirs are in a higher tax bracket than you.

Keep Social Security income tax and Medicare Premiums low

Another hidden benefit of the Roth conversion is it could potentially lower your future social security income tax and Medicare Premiums.

Up to 85% of your Social Security checks can be taxable for individuals earning more than $34,000 and families receiving more than $44,000 per year.

Your Medicare Plan B premium will be calculated based on your reported income-related monthly adjustment amount (IRMAA) 2 years prior to your application. Even a dollar higher can push in a higher premium bracket,

Roth Conversion Strategies

With some planning, Roth IRA offers substantial tax-free benefits. Due to income limits, many retirement savers end up with significant amounts in tax-deferred accounts such as 401k and Traditional IRA. These plans give you initial tax relief to encourage retirement savings. However, all future distributions are fully taxable.

The Roth conversion may help you reduce your future tax burden and unlock some of the befits of Roth IRA. Here are some of the strategies that can be helpful in your decision process.

  

End-of-year Roth conversion

The stability of your income can be critical to your success. Each conversion must be completed by the end of each tax year. If your income is constant, you can process the conversion at any time. If your income is less predictable, your only choice will be to make your conversions towards the end of the year when you will have more visibility on your earnings.

Conversion during low-income years

The Roth conversion is generally more attractive during your low-income years when you will be in a lower tax bracket. The additional reported income from the conversion will add on to your base earnings. If you do the math right, you will be able to maintain your taxes relatively low. Analyze your tax bracket and convert the amount that will keep in your desired marginal tax rate.

Conversion during a market downturn

Another popular strategy is performing Roth conversion during a market downturn. A Roth conversion could become appealing if your Traditional IRA is down 20% or 30%. At the same time, you have a long-term investment horizon and believe that your portfolio will recover the losses over time.

Your largest benefit will come from the potential tax-free portfolio gains after the stock market goes higher. With this approach, your underlying taxes take a lower priority versus the ability to earn higher tax-free income in the future. However, you still need to determine whether saving taxes on future gains provides a higher benefit than paying higher taxes now.

Monthly or quarterly cost averaging

Timing the stock market is hard. The cost averaging strategy removes the headache of trying to figure out when the stock market will go up or down. This approach calls for making planned periodic, monthly, or quarterly, conversions. The benefit of this method is that at least part of your portfolio may benefit from lower stock values. It is a way to hedge your bets on surprising stock market moves. If your portfolio goes higher consistently throughout the year, your earlier conversions will benefit from lower stock values. If the stock market goes down in the second half of the year, your later-in-the-year conversion will produce a higher benefit.

Roth Conversion barbelling

This strategy makes sense if your annual income is variable and less predictable. For example, your income fluctuates due to adjustments in commissions, bonuses, royalties, or other payments. With barbelling, you perform two conversions per year. You make the first conversion early in the year based on a projected income that is at the high end of the range. The second conversion will occur towards the end of the year, when your income becomes more predictable. If your income is high, you may convert a much smaller amount or even nothing. If your earnings for the year are at the lower end of expectation, then you convert a larger amount.

Roth Conversion Ladder

As I mentioned earlier, each Roth conversion is subject to its own 5-year rule. The 5-year period starts on January 1st of the tax year of your Roth conversion. Every subsequent conversion will have a separate 5-year holding period.

The Roth Conversion ladder strategy requires a bit of initial planning. This approach stipulates that you make consistent annual conversions year after year. After every five years, you can withdraw your savings tax-free from the Roth IRA. In effect, you are creating a ladder similar to the CD ladder.

Keep in mind that this strategy only makes sense under two conditions. One, you can afford to pay taxes for the conversion from another taxable account. Second, your future taxable income is expected to increase, and therefore you would be in a higher tax bracket.

Conclusion

Roth Conversion can be a great way to manage your future taxes. However, not every person or every family is an ideal candidate for a Roth conversion. In reality, most people tend to have lower reportable income when they retire. For them keeping your Traditional IRA and taking distributions at a lower tax rate makes a lot of sense. However, there are a lot of financial, personal, and legacy planning factors that come into play. Make your decision carefully. Take a comprehensive look at your finance before you decide if Roth conversion is right for you.

15 Costly retirement mistakes

15 Costly retirement mistakes

15 Costly retirement mistakes… Retirement is a major milestone for many Americans. Retiring marks the end of your working life and the beginning of a new chapter. As a financial advisor, my job is to help my clients avoid mistakes and retire with confidence and peace of mind.  Together we build a solid roadmap to retirement and a gameplan to achieve your financial goals. My role as a financial advisor is to provide an objective and comprehensive view of my clients’ finances.  As part of my process, I look for any blind spots that can put my clients’ plans at risk.  Here is a list of the major retirement mistakes and how to avoid them.

1. Not planning ahead for retirement

Not planning ahead for retirement can cost you a lot in the long run. Delaying to make key decisions is a huge retirement mistake that can jeopardize your financial security during retirement. Comprehensive financial planners are more likely to save for retirement and feel more confident about achieving their financial goals.  Studies have shown that only 32% of non-planners are likely to have enough saved for retirement versus 91% of comprehensive planners.

Reviewing your retirement plan periodically will help you address any warning signs in your retirement plan. Recent life changes, economic and market downturns or change in the tax law could all have a material impact on your retirement plans. Be proactive and will never get caught off guard.

2. Not asking the right questions

Another big retirement mistake is the fear of asking the right question. Avoiding these

Here are some of the questions that my clients are asking –

  • “Do I have enough savings to retire?”
  •  “Am I on the right track?”.
  • “Can I achieve my financial goals?”
  • “Can I retire if the stock market crashes?”.
  • “Are you fiduciary advisor working in my best interest?” (Yes, I am fiduciary)

Asking those tough questions will prepare you for a successful retirement journey. Addressing your concerns proactively will take you on the right track of meeting your priorities and achieving your personal goals

3. Not paying off debt

Paying off debt can be an enormous burden during retirement. High-interest rate loans can put a heavy toll on your finances and financial freedom. As your wages get replaced by pension and social security benefits, your expenses will remain the same. If you are still paying off loans, come up with a plan on how to lower your debt and interest cost. Being debt-free will reduce the stress out of losing viable income.

4. Not setting goals

Having goals is a way to visualize your ideal future. Not having goals is a retirement mistake that can jeopardize your financial independence during retirement. Without specific goals, your retirement planning could be much harder and painful. With specific goals, you have clarity of what you want and what you want to achieve. You can make financial decisions and choose investment products and services that align with your objectives and priorities. Setting goals will put you on a successful track to enjoy what matters most to you.

5. Not saving enough

An alarming 22% of Americans have less than $5,000 in retirement savings. The average 401k balance according to Fidelity is $103,700. These figures are scary. It means that most Americans are not financially ready for retirement. With ultra-low interest rates combined with constantly rising costs of health care,  future retirees will find it difficult to replace their working-age income once they retire. Fortunately, many employers now offer some type of workplace retirement savings plans such as 401k, 403b, 457, TSP or SEP IRA. If your employer doesn’t offer any of those, you can still save in Traditional IRA, Roth IRA, investment account or the old fashioned savings account.

6. Relying on one source for retirement income

Many future retirees are entirely dependent on a single source for their retirement income such as social security or pension.  Unfortunately. with social security running out of money and many pension plans shutting down or running a huge deficit, the burden will be on ourselves to provide reliable income during our retirement years.  If you want to be financially independent, make sure that your retirement income comes from multiple sources.

7. Lack of diversification

Diversification is the only free lunch you can get in investing and will help decrease the overall risk of your portfolio. Adding uncorrelated asset classes such as small-cap, international and emerging market stocks, bonds, and commodities will reduce the volatility of your investments without sacrificing much of the expected return in the long run.

A common mistake among retirees is the lack of diversification. Many of their investment portfolios are heavily invested in stocks, a target retirement fund or a single index fund.

Furthermore, owning too much of one stock or a fund can cause significant issues to your retirement savings. Just ask the folks who worked for Enron or Lehman Brothers who had their employer’s stocks in their retirement plans. Their lifetime savings were wiped out overnight when these companies filed for bankruptcy.

8. Not rebalancing your investment portfolio

Regular rebalancing ensures that your portfolio stays within your desired risk level. While tempting to keep a stock or an asset class that has been on the rise, not rebalancing to your original target allocation can significantly increase the risk of your investments.

9. Paying high fees

Paying high fees for mutual funds and high commission insurance products can eat up a lot of your return. It is crucial to invest in low-cost investment managers that can produce superior returns over time. If you own a fund that has consistently underperformed its benchmark,  maybe it’s time to revisit your options.

Many insurance products like annuities and life insurance while good on paper, come with high upfront commissions, high annual fees, and surrender charges and restrictions.  Before signing a contract or buying a product, make sure you are comfortable with what you are going to pay.

10. No budgeting

Adhering to a budget before and during retirement is critical for your confidence and financial success. When balancing your budget, you can live within your means and make well-informed and timed decisions. Having a budget will ensure that you can reach your financial goals.

11. No tax planning

Not planning your taxes can be a costly retirement mistake. Your pension and social security are taxable. So are your distributions from 401k and IRAs. Long-term investing will produce gains, and many of these gains will be taxable. As you grow our retirement saving the complexity of assets will increase. And therefore the tax impact of using your investment portfolio for retirement income can be substantial. Building a long-term strategy with a focus on taxes can optimize your after-tax returns when you manage your investments.

12. No estate planning

Many people want to leave some legacy behind them. Building a robust estate plan will make that happen. Whether you want to leave something to your children or grandchildren or make a large contribution to your favorite foundation, estate, and financial planning is important to secure your best interests and maximize the benefits for yourself and your beneficiaries.

13. Not having an exit planning

Sound exit planning is crucial for business owners. Often times entrepreneurs rely on selling their business to fund their retirement. Unlike liquid investments in stocks and bonds, corporations and real estate are a lot harder to divest.  Seling your business may have serious tax and legal consequences. Having a solid exit plan will ensure the smooth transition of ownership, business continuity, and optimized tax impact.

14. Not seeing the big picture

Between our family life, friends, personal interests, causes, job, real estate properties, retirement portfolio, insurance and so on, our lives become a web of interconnected relationships. Above all is you as the primary driver of your fortune. Any change of this structure can positively or adversely impact the other pieces. Putting all elements together and building a comprehensive picture of your financial life will help you manage these relationships in the best possible way.

15. Not getting help

Some people are very self-driven and do very well by planning for their own retirement. Others who are occupied with their career or family may not have the time or ability to deal with the complexities of financial planning. Seeking help from a fiduciary financial planner can help you avoid retirement mistakes. A fiduciary advisor will watch for your blind spots and help you find clarity when making crucial financial decisions.

How to Survive the next Market Downturn

How to survive a market downturn

Everything you need to know about surviving the next market downturn: we are in the longest bull market in US history. After more than a decade of record-high stock returns, many investors are wondering if there is another market downturn on the horizon. With so many people saving for retirement in 401k plans and various retirement accounts, it’s normal if you are nervous. But if you are a long-term investor, you know these market downturns are inevitable. Market downturns are stressful but a regular feature of the economic cycle.

What is the market downturn?

A market downturn is also known as a bear market or a market correction. During a market downturn, the stock market will experience a sharp decline in value. Often, market downturns are caused by fears of recession, political uncertainty, or bad macroeconomic data.

How low can the market go down?

The largest-ever percentage drop by the S&P 500 index occurred on October 19, 1987 (known as The Black Monday), when the S&P 500 dropped by -20.47%. The next biggest selloff happened on October 15, 2008, when the S&P 500 lost –9.03%. In both cases, the stock market continued to be volatile for several months before reaching a bottom. Every time, the end of the market downturn was the start of a new bull market. Both times, the stock market recovered and reached historic highs in a few years.

What can you do when the next market downturn happens?

The first instinct you may have when the market drops is to sell your investments. In reality, this may not always be the right move. Selling your stocks during market selloff may limit your losses, may lock in your gains but also may lead to missed long-term opportunities. Emotional decisions do not bring a rational outcome.

Dealing with declining stock values and market volatility can be tough. The truth is nobody likes to lose money. The volatile markets can be treacherous for seasoned and inexperienced investors alike. To be a successful investor, you must remain focused on the strength of their portfolio, your goals, and the potential for future growth. I want to share nine strategies that can help you through the next market downturn and boost the long-term growth of your portfolio.

1. Keep calm during the market downturn

Stock investors are cheerful when the stock prices are rising but get anxious during market corrections. Significant drops in stock value can trigger panic. However, fear-based selling to limit losses is the wrong move. Here’s why. Frequently the market selloffs are followed by broad market rallies. A V-shape recovery often follows a market correction.

The hypothetical table below looks at the performance of $10,000 invested in the S&P 500 between January 4, 1988, and December 31, 2018. It’s important to note this hypothetical investment occurred during two of the biggest bear markets in history, the 2000 tech bubble crash and the 2008 global financial crisis. If you had missed the ten best market days, you would lose 2.4% of your average annual return and nearly half of your dollar return.

As long as you are making sound investment choices, your patience, and the ability to tolerate paper losses will earn you more in the long run.

2. Be realistic: Don’t try to time the market

Many investors believe that they can time the market to buy low and sell high. In reality, very few investors succeed in these efforts.

According to a study by the CFA Institute Financial Analyst Journal, a buy-and-hold large-cap strategy would have outperformed, on average, about 80.7% of annual active timing strategies when the choice was between large-cap stocks, short-term T-bills and Treasury bonds.

3. Stay diversified

Diversification is essential for your portfolio preservation and growth. Diversification, or spreading your investments among different asset classes (domestic versus foreign stocks, large-cap versus small-cap equity, treasury and corporate bonds, real estate, commodities, precious metals, etc.), will lower the risk of your portfolio in the long-run. Many experts believe that diversification is the only free lunch you can get in investing.

Uncorrelated asset classes react uniquely during market downturns and changing economic cycles.

For example, fixed income securities and gold tend to rise during bear markets when stocks fall. Conversely, equities rise during economic expansion.

4. Rebalance your portfolio regularly

Rebalancing your portfolio is a technique that allows your investment portfolio to stay aligned with your long terms goals while maintaining a desired level of risk. Typically, portfolio managers will sell out an asset class that has overperformed over the years and is now overweight. With the proceeds of the sale, they will buy an underweighted asset class.

Hypothetically, if you started investing in 2010 with a portfolio consisting of 60% Equities and 40% Fixed Income securities, without rebalancing by the end of 2019, you will hold 79% equities and 21% fixed income. Due to the last decade’s substantial rise in the stock market, many conservative and moderate investors are now holding significant equity positions in their portfolio. Rebalancing before a market downturn will help you bring your investments to your original target risk levels. If you reduce the size of your equity holdings, you will lower your exposure to stock market volatility.

5. Focus on your long-term goals

A market downturn can be tense for all investors. Regardless of how volatile the next stock market correction is, remember that “this too shall pass.”

Market crises come and go, but your goals will most likely remain the same. In fact, most goals have nothing to do with the market. Your investment portfolio is just one of the ways to achieve your goals.

Your personal financial goals can stretch over several years and decades. For investors in their 20s and 30s financial goals can go beyond 30 – 40 years. Even retirees in their 60s must ensure that their money and investments last through several decades.

Remain focused on your long-term goals. Pay of your debt. Stick to a budget. Maintain a high credit score. Live within your means and don’t risk more than you can afford to lose.

6. Use tax-loss harvesting during the market downturn

If you invest in taxable accounts, you can take advantage of tax-loss harvesting opportunities. You can sell securities at depressed prices to offset other capital gains made in the same year. Also, you can carry up to $3,000 of capital losses to offset other income from salary and dividends. The remaining unused amount of capital loss can also be carried over for future years for up to the allowed annual limit.

To take advantage of this option, you have to follow the wash sale rule. You cannot purchase the same security in the next 30 days. To stay invested in the market, you can substitute the depressed stock with another stock that has a similar profile or buy an ETF.

7. Roth Conversion

A falling stock market creates an excellent opportunity to do Roth Conversion. Roth conversion is the process of transferring Tax-Deferred Retirement Funds from a Traditional IRA or 401k plan to a tax-exempt Roth IRA. The Roth conversion requires paying upfront taxes with a goal to lower your future tax burden. The depressed stock prices during a market downturn will allow you to transfer your investments while paying lower taxes. For more about the benefits of Roth IRA, you can read here.

8. Keep a cash buffer

I always recommend to my clients and blog readers to keep at least six months of essential living expenses in a checking or a savings account. We call it an emergency fund. It’s a rainy day, which you need to keep aside for emergencies and unexpected life events. Sometimes market downturns are accompanied by recessions and layoffs. If you lose your job, you will have enough reserves to cover your essential expenses. You will avoid dipping in your retirement savings.

9. Be opportunistic and invest

Market downturns create opportunities for buying stocks at discounted prices. One of the most famous quotes by Warren Buffet’s famous words is “When it’s raining gold, reach for a bucket, not a thimble.” Market selloffs rarely reflect the real long-term value of a company as they are triggered by panic, negative news, or geopolitical events. For long-term investors, market downturns present an excellent opportunity to buy their favorite stocks at a low price. If you want to get in the market after a selloff, look for established companies with strong secular revenue growth, experienced management, solid balance sheet and proven track record of paying dividends or returning money to shareholders.

Final words

Market downturns can put a huge toll on your investments and retirement savings. The lack of reliable information and the instant spread of negative news can influence your judgment and force you to make rash decisions. Market selloffs can challenge even the most experienced investors. That said, don’t allow yourself to panic even if it seems like the world is falling apart. Prepare for the next market downturn by following my list of nine recommendations. This checklist will help you “survive” the next bear market while you still follow your long-term financial goals.

Your Retirement Checklist

Retirement checklist

A happy and financially secure retirement is a primary goal for many working Americans. I created a retirement checklist that will help you navigate through the complex path of retirement planning. For my readers who are serious about their retirement planning, follow these 12 steps to organize and simplify your planning process. My 12-step retirement checklist can be a practical roadmap regardless of the age you want to retire. Following these steps will ensure that you have reviewed all aspects of your life and how they can impact your decisions before and during your retirement. Here is the crucial retirement checklist of all the things you need to do in preparation for the next chapter of your life.

1. Know what you own

You have worked very hard for this moment. You have earned and saved during your entire career. Now it’s time to benefit from your hard work. The first step of your retirement checklist is understanding what you own. Don’t guess. Don’t assume. You need to thoroughly evaluate all your assets, real estate, businesses, and retirement savings. Everything that you have accumulated during your working years can play a pivotal role in your successful retirement.

2. Gather all your financial documents

On the second step of your retirement checklist, you need to collect all relevant documents that show your asset ownership – financial statements, trust documents, wills, property deeds. This will be an excellent opportunity to gather all your plan statements from old 401k and retirement plans. If you own a real estate, make sure you have all your deeds in place. If you are beneficiary of a trust, collect all trust documents. Check all your bank, saving accounts and social security statements. Make sure that you build a complete picture of your financial life.

3. Pay of off your debt

One of your main pre-retirement goals is to become debt-free. If you are still paying off your mortgage, student loans, personal loans or credit card debt, now it’s a great time to review your finances and come up with a payment plan that will help you pay off your debts and improve your retirement prospects.

4. Build an emergency fund

The emergency fund is your rainy-day money. It’s the money that covers unexpected expenses. So, you don’t have to dip in your regular monthly budget. It’s the money that will help you if you unexpectedly lose your job or otherwise unable to earn money. I recommend keeping at least six months’ worth of living expenses in a separate savings account. Ideally, you should have built your emergency fund long before you decided to retire. If you haven’t started yet, it’s never too late to create one. You can set aside a certain percentage of your monthly income to fill the emergency fund until you reach a comfortable level.

5. Learn your employee benefits

Sometimes employers offer generous retirement benefits to attract and retain top talent. Many companies and public institutions provide 401k contribution matching, profit sharing or a pension. Some employers may even offer certain retirement health care benefits. If you are lucky to work for these companies and public organizations, learn your benefits package. Ensure that you are taking full advantage of your employee benefits. Don’t leave any free money on the table.

6. Secure health insurance

A retired couple will spend, on average, $285,000 for healthcare-related expenses during their retirement. This cost is only going higher at a faster rate than regular inflation. Even if you are in good health, healthcare will be one of your highest expenses after you retire.

Medicare part A and part B cover only part of your healthcare cost including impatient and hospital care. They do not include long-term care, dental care, eye exams, dentures, cosmetic surgery, acupuncture, hearing aids and exams, routine foot care. You will be responsible for paying for Medicare parts D out of pocket through your private Medicare Advantage insurance. Medicare Advantage is a "bundled" plan that includes Medicare Part A (Hospital Insurance) and Medicare Part B (Medical Insurance), and usually Medicare prescription drug (Part D).

7. Maximize your savings

Unless you have a generous pension, you will have to rely on your retirement savings to support yourself during retirement. Your 401k and IRA will likely be your primary retirement income source. So even if you have championed your retirement savings, now it’s a great time to calculate if your accumulated savings can support you during retirement. To boost your confidence, maximize your retirement contributions to 401k plans, IRA and even taxable investment accounts. Once you reach 50, the 401k and IRA plans will allow making additional catch up contributions.

There is another compelling reason to save in tax-deferred retirement accounts. If you are in the prime period of your earnings, you are probably in a very high tax bracket. Maximizing your tax-deferred retirement contributions will lower your tax bill for the year. You can withdraw your money

8. Prepare your estate plan

Estate planning is the process of assigning trustees and beneficiaries, writing a will, giving power of attorney, and health directives. The estate plan will guarantee that your wishes are fulfilled, and your loved ones are taken care of if you die or become incapacitated. Creating a trust will ensure that your beneficiaries will avoid lengthy, expensive and public probate. Update your beneficiaries in all your retirement accounts.

Estate planning is never a pleasant topic or an ice-breaking conversation. The sooner you get it done the sooner will go on with your life.

9. Set your budget

Budgeting is a critical step in your retirement checklist. Once you retire, you may no longer earn a wage, but you will still have monthly expenses. Retirement will give you a chance to do things for which you haven’t had time before that. Some people like to travel. Some may pick up a hobby or follow a charitable cause. Others may decide to help with grandchildren. You may choose to buy a house and live closer to your kids. Whatever lifestyle you choose, you need to ensure that your budget can support it.

10. Create social security and retirement income strategy

The most crucial step in your retirement checklist is creating your income strategy. This is the part where you might need the help of a financial planner so you can get the most out of your retirement savings and social security benefits. Your retirement income strategy should be tailored to your specific needs, lifestyle, type of savings and the variety of your assets.

11. Craft a tax strategy

Even though you are retired, you still have to pay taxes. Up to 85% of your social security benefits can be taxable. All your distributions from your 401k plan and Traditional IRA will be subject to federal and state tax. All your dividends and interest in your investment and savings accounts are taxable as well.

Only, the distributions from Roth IRA are not taxable. As long as you have your Roth IRA open for more than five years and you are 59 ½ or older, your withdrawals from the Roth IRA will be tax-free.

Ask your financial advisor to craft a tax strategy that minimizes your tax payments over the long run. Find out if Roth Conversion makes sense to you.

12. Set your retirement goals

Retirement opens another chapter in your life. The people who enjoy their retirement the most are those who have retirement goals. Find out what makes you happy and follow your passions. Your retirement will give you a chance to do everything that you have missed while you were pursuing your career.

Final words

Navigating through your retirement checklist will be a reflection of your life, career, assets, and family. No one’s retirement plan is the same. Everybody’s situation is unique and different. Follow these simple 12 steps so you can enjoy and better prepare for your retirement. Be proactive. Don’t wait until the last minute for crucial financial decisions. Make well-informed choices so you can be ahead of life events and enjoy your retirement to the fullest.

12 End of Year Tax Saving Tips

end of year tax saving tips

As we approach the close of 2019, we share our list of 12 end of year tax saving tips. Now is a great time to review your finances. You can make several smart and simple tax moves that can help lower your tax bill and increase your tax refund.

The Tax Cuts and Jobs Act of 2017 made sweeping changes in the tax code that affected many families and small business owners. If the previous tax season caught you off-guard, now you have a chance to redeem yourself.

Whether you file taxes yourself or hire a CPA, it is always better to be proactive. If you are expecting a large tax bill or your financials have changed substantially since last year, talk to your CPA. Start the conversation. Don’t wait until the last moment. Being ahead of the curve will help you make well-informed decisions without the stress of tax deadlines.

1. Know your tax bracket

The first step of mastering your taxes is knowing your tax bracket. 2019 is the second year after the TCJA took effect. One of the most significant changes in the tax code was introducing new tax brackets.

Here are the tax bracket and rates for 2019.

End of Year Tax Tips

2. Decide to itemize or use a standard deduction

Another big change in the tax law was the increase in the standard deduction. The standard deduction is a specific dollar amount that allows you to reduce your taxable income. As a result of this change, nearly 90% of all tax filers will take the standard deduction instead of itemizing. It makes the process a lot simpler for many Americans. Here are the values for 2019:

End of Year Tax Tips

3. Maximize your retirement contributions

Most contributions to qualified retirement plans are tax-deductible and will lower your tax bill.

  • For employees – 401k, 403b, 457 and TSP. The maximum contribution to qualified employee retirement plans for 2019 is $19,000. If you are at the age of 50 or older, you can contribute an additional $6,000.
  • For business owners – SEP IRA, Solo 401k and Defined Benefit Plan. Business owners can contribute to SEP IRA, Solo 401k, and Defined Benefits plans to maximize your retirement savings and lower your tax bill. The maximum contribution to SEP-IRA and Solo 401k in 2019 is $56,000 or $62,000 if you are 50 and older.

If you own SEP IRA, you can contribute up 25% of your business wages.

In a solo 401k plan, you can contribute as both an employee and an employer. The employee contribution is subject to a $19,000 limit plus a $6,000 catch-up. The employer match is limited to 25% of your compensation for the maximum $37,000. Depending on how you pay yourself, sometimes solo 401k can allow you for more savings than SEP IRA.

Defined Benefit Plans is an option for high-income earners who want to save more aggressively for retirement above the SEP-IRA and 401k limits. The DB plan uses actuary rules to calculate your annual contribution limits based on your age and compensation. All contributions to your defined benefit plan are tax-deductible, and the earnings grow tax-free.

4. Convert to Roth IRA

The process of transferring assets from a Traditional IRA or 401k plan to a Roth IRA is known as Roth Conversion. It allows you to switch from tax-deferred to tax-exempt retirement savings. You can learn more about the benefits of Roth IRA here.

The conversion amount is taxable for income purposes. The good news is that even though you will pay higher taxes in the current year, it may save you a lot more money in the long run.

While individual circumstances may vary, Roth Conversion could be very effective in a year with low or no income. Talk to your accountant or financial advisor. Ask if Roth conversion makes sense for you.

5. Contribute to a 529 plan

The 529 plan is a tax-advantaged state-sponsored investment plan, which allows parents to save for their children’s future college expenses. 529 plan works similarly to the Roth IRA. You make post-tax contributions. Your investment earnings grow free from federal and state income tax if you use them to pay for qualified educational expenses. Compared to a regular brokerage account, the 529 plan has a distinct tax advantage as you will never pay taxes on your dividends and capital gains.

Over 30 states offer a full or partial tax deduction or a credit on your 529 contributions. You can find the full list here. If you live in any of these states, your 529 contributions can lower your state tax bill significantly.

6. Make a donation

Donations to charities, churches, and various non-profit organizations are tax-deductible. You can support your favorite cause by giving back and lower your tax bill at the same time.

However, due to the changes in the new tax code, donations are tax-deductible only when you itemize your tax return. If you make small contributions throughout the year, you probably will be better off taking the standard deduction.

If itemizing your taxes is crucial for you, then you might want to consolidate your donations in one calendar year. So, instead of making multiple charitable contributions over the years, you can give one large donation every few years.

7. Sell losing investments

The process of selling losing investments to reduce your tax liability is known as tax-loss harvesting. It works for capital assets held outside retirement accounts (such as 401k, Traditional IRA, and Roth IRA). Capital assets may include real estate, cars, gold, stocks, bonds, and any investment property, not for personal use.

The IRS allows you to use capital losses to offset capital gains. If your capital losses are higher than your capital gains, you can deduct the difference as a loss on your tax return. This loss is limited to $3,000 per year or $1,500 if married and filing a separate return.

8. Prioritize long-term over short-term capital gains

Another way to lower your tax bill when selling assets is to prioritize long-term over short-term capital gains. The current tax code benefits investors who keep their assets for more than one calendar year. Long-term investors receive a preferential tax rate on their gains. While investors with short-term capital gains will pay taxes at their ordinary income tax level

Here are the long-term capital gain tax brackets for 2019:

End of Year Tax Tips

High-income earners will also pay an additional 3.8% net investment income tax.

9. Take advantage of FSA and HSA

With healthcare costs always on the rise, you can use a Flexible Spending Account (FSA) or a Health Savings Account (HSA) to cover your medical bills and lower your tax bill.

Flexible Spending Account (FSA)

A Flexible Spending Account (FSA) is a tax-advantaged savings account offered through your employer. The FSA allows you to save pre-tax dollars to cover medical and dental expenses for yourself and your dependents. The maximum contribution for 2019 is $2,700 per person. If you are married, your spouse can save another $2,700 for a total of $5,400 per family. Typically, you should use your FSA savings by the end of the calendar year. However, the IRS allows you to carry over up to $500 balance into the new year.

Dependent Care FSA (CSFSA)

A Dependent Care FSA (CSFSA) is a pre-tax benefit account that you can use to pay for eligible dependent care services, such as preschool, summer day camp, before or after school programs, and child or adult daycare. It’s an easy way to reduce your tax bill while taking care of your children and loved ones while you continue to work. The maximum contribution limit for 2019 for an individual who is married but filing separately is $2,500. For married couples filing jointly or single parents filing as head of household, the limit is $5,000.

Health Savings Account (HSA)

A Health Savings Account (HSA) is an investment account for individuals under a High Deductible Health Plan (HDHP) that allows you to save money on a pre-tax basis to pay for eligible medical expenses.The qualified High Deductible Plan typically covers only preventive services before the deductible. To qualify for the HSA, the HDHP should have a minimum deductible of $1,350 for an individual and $2,700 for a family. Additionally, your HDHP must have an out-of-pocket maximum of up to $6,750 for one-person coverage or $13,500 for family.

The maximum contributions in HSA for 2019, are $3,500 for self-only coverage and $7,000 for a family. HSA participants who are 55 or older can contribute an additional $1,000 as a catch-up contribution. Unlike the FSA, the HSA doesn’t have a spending limit, and you can carry over the savings in the next calendar year.

Keep in mind that the HSA has three distinct tax advantages. First, all HSA contributions are tax-deductible and will lower your tax bill. Second, you will not pay taxes on dividends, interest, and capital gains. Third, if you use the account for eligible expenses, you don’t pay taxes on those withdrawals either.

10. Defer income

Deferring income from this calendar year into the next year will allow you to delay some of the income taxes coming with it. Even though it’s not always possible to defer wages, you might be able to postpone a large bonus, royalty, or onetime payment. Remember, it only makes sense to defer income if you expect to be in a lower tax bracket next year.

Reversely, if you are expecting to be in a higher tax bracket tax year next year, you may consider taking as much income as possible in this tax year.

11. Buy Municipal Bonds

Municipal bonds are issued by local governments, school districts, and authorities to fund local projects that will benefit the general public. The interest income from most municipal bonds is tax-free. Investors in these bonds are exempt from federal income tax. If you buy municipal bonds issued in the same state where you live, you will be exempt from state taxes as well.

12. Take advantage of the 199A Deduction for Business Owners

If you are a business owner or have a side business, you might be able to use the 20% deduction on qualified business income. The TCJA established a new tax deduction for small business owners of pass-through entities like LLCs, Partnerships, S-Corps, and sole-proprietors. While the spirit of the law is to support small business owners, the rules of using this deduction are quite complicated and restrictive. For more information, you can check the IRS page. In summary, qualified business income must be related to conducting business or trade within the United States or Puerto Rico. The tax code also separates the business entities by industry – Qualified trades or businesses and Specified service trades or businesses.

Qualified versus specified service trade

Specified service businesses include the following trades: Health (e.g., physicians, nurses, dentists, and other similar healthcare professionals), Law, Accounting, Actuarial science, Performing arts, Consulting, Athletics, and Financial Services. Qualified trades or businesses is everything else.

For “specified service business,” the deduction gets phased out between $315,000 and $415,000 for joint filers. For single filers, the phase-out range is $157,500 to $207,500.

The qualified trades and businesses are also subject to the same phaseout limits. However, if their income is above the threshold, the 199A deduction becomes the lesser of the 20% of qualified business income deduction or the greater of either 50 percent of the W-2 wages of the business, or the sum of 25% of the W-2 wages of the business and 2.5% of the unadjusted basis immediately after acquisition of all qualified property.

If this all sounds very complicated to you, it’s because it is complicated.Contact your accountant or tax adviser to see if you can take advantage of this deduction.

The biggest risks for your retirement savings

Biggest risks to your retirement savings

Whether you are just starting your career or about to retire, you need to understand the risks you are facing when you plan for your future retirement.

Most experts recommend that you should aim to replace about 80% of work income during your retirement. Part of your retirement income will come from Social Security. Other sources could be a public pension, IRAs, 401k, rental income, sale of real estate or business, royalties, or a part-time job. However, the 80% is not a definite number. The amount you need in retirement could vary substantially depending on your lifestyle, family size, number of dependents, health issues, and so on.

Social Security benefits

The maximum Social Security benefit in 2019:

  • $3,770 for someone who files at age 70.
  • $2,861 for someone at a full retirement age of 66
  • $2,209 for someone aged 62

For reference, very few people reach these upper limits. The average Social Security retirement benefit in 2019 is $1,461 a month. The average disability benefit is $1,234.

Unfortunately, the Social Security trust is already running a deficit. Currently, the Social Security is paying more benefits than all the proceed its receiving from the payroll taxes. Its reserve will be depleted by 2035. After that point, social security recipients will have to receive only a portion of their actual benefit. The current estimate is around 75%.

Pension Shortfall

Similarly to Social Security, most of the public and private pension plans nationwide have an enormous shortfall between assets and their future liabilities. According to a recent study by Pew Charitable Trust and Pension Tracker, US public pension shortfall is over $1 trillion. States like Alaska, California, Illinois, Ohio, Hawaii, and New Jersey have one of the highest pension burdens in the nation. Even after ten years of economic recovery and bull market, most state pension plans are not prepared to face another downturn. Policymakers must take urgent measures to close the pension funding gap, which remains at historically high levels as a share of GDP.

Low savings rate

With social security benefits expected to shrink, I advise my clients that they need to increase their savings in order to supplement their income in the future. Retirement savings in IRA, 401k and even a brokerage account will provide you with the necessary income during your retirement years.

Unfortunately, not everyone is forward-looking. The average 401k balance, according to Fidelity, is $106,000 in 2019, while the average IRA is $110,000. The sad reality is that most Americans do not save enough for retirement and we are facing a retirement crisis.

Not saving enough for retirement is the highest risk of enjoying your retirement years.

Relying on a single source

Many people make the mistake of relying on a single source of income for their retirement.  

Imagine that you were planning to retire in 2009 upon selling a piece of real estate. Or you had all your retirement savings in a 401k plan and the market just crashed 50%.  Many of these folks had to delay their retirement for several years to make up for the lost income. Similarly, selling your business can be risky too. With technology advancements, many businesses are becoming obsolete. You may not always be able to find buyers or get the highest price for your business.

We always recommend to our clients to have a diversified stream of retirement income. Diversifying your source will create a natural safety net and potentially could increase the predictability of your income in retirement.

Market risk

We all would like to retire when the market is up and our retirement account balance is high. However, the income from these retirement accounts like IRA, Roth IRA and 401k are not guaranteed. As more people relying on them for retirement, their savings become subject to market turbulence and the wellbeing of the economy.  Today, prospective retirees must confront with high equity valuations, volatile markets, and ultra-low and even negative yields.

In my practice, I use my clients’ risk tolerance as an indicator of their comfort level during market volatility. With market risk in mind, I craft well-diversified individual retirement strategies based on my clients’ risk tolerance and long-term and short-term financial goals.

Sequence of returns

The sequence of returns is the order of how your portfolio returns happen over time. If you are in your accumulation phase, the sequence of return doesn’t impact your final outcome. You will end up with the same amount regardless of the order of your annual returns.  

However, if you are in your withdrawal phase, the sequence of returns can have a dramatic impact on your retirement income. Most retires with a 401k or IRAs have to periodically sell a portion of their portfolios to supplement their income. Most financial planning software uses an average annual return rate to project future account balance. However, these average estimates become meaningless if you experience a large loss at the start of your retirement.

Our retirement strategies take the sequence of returns very seriously. Some of the tools we use involve maintaining cash buffers, building bond ladders and keeping a flexible budget.

Taxes

Your IRA balance might be comforting but not all of it is yours. You will owe income taxes on every dollar you take out of any tax-deferred account (IRA, 401k, 403b). You will pay capital gain taxes on all realized gains in your brokerage accounts. Even Social Security is taxable.

With skyrocketing deficits in the treasury budget, social security and public pensions will guarantee one thing – higher taxes. There is no doubt that someone will have to pick up the check. And that someone is the US taxpayer – me and you.

Managing your taxes is a core function of our wealth management practice. Obviously, we all must pay taxes. And we can not predict what politicians will decide in the future. However, managing your investments in a tax-efficient manner will ensure that you keep more money in your pocket.

Inflation risk

Most retirees have a significant portion of their portfolios in fixed income. Modern portfolio managers use fixed income instruments to reduce investment risk for their clients. At the time of this article, we are seeing negative and near-zero interest rates around the world. However, with inflation going at around 2% a year, the income from fixed-income investments will not cover the cost of living adjustments. Retirees will effectively lose purchasing power on their dollars.

Interest risk

Bonds lose value when interest rates go up and make gains when interest rates go down. For over a decade, we have seen rock bottom interest rates. We had a small blip in 2018 when the Fed raised rates 4 times and 1 year’s CDs reached 2.5%. At that point in time, many investors were worried that higher interest rates will hurt bond investors, consumers and even companies who use a lot of debt to finance their business. Even though these fears are subdued for now, interest rates remain a viable threat. Negative interest rates are as bad for fixed income investors as the high rates are. Unfortunately, traditional bond portfolios may not be sufficient to provide income and protect investors for market swings. Investors will need to seek alternatives or take higher risks to generate income.

Unexpected expenses

Most financial planning software will lay out a financial plan including your projected costs during retirement. While most financial planning software these days is quite sophisticated, the plan remains a plan. We can not predict the unexpected. In my practice, I regularly see clients withdrawing large sums from their retirement savings to finance a new home, renovation, a new car, college fees, legal fees, unexpectedly high taxes and so on. Reducing your retirement savings can be a bad idea on many levels. I typically recommend building an emergency fund worth at least 6 months of living expenses to cover any unexpected expenses that may occur. That way, you don’t have to touch your retirement savings.

Healthcare cost

The average health care cost of a retired couple is $260,000. This estimate could vary significantly depending on your health. Unless you have full health insurance from your previous employer, you will need to budget a portion of your retirement savings to cover health-related expenses. Keep in mind that Medicare part A covers only part of your health cost. The remaining, parts B, C, and D, will be paid out of pocket or through private insurance.

Furthermore, as CNBC reported, the cost of long-term care insurance has gone up by more than 60% between 2013 and 2018 and continues to go higher. The annual national median cost of a private room in a nursing home was $100,375 in 2018.

For future retirees, even those in good shape, healthcare costs will be one of the largest expenses during retirement. In my practice, I take this risk very seriously and work with my clients to cover all bases of their health care coverage during retirement.

Longevity

Longevity risk is the risk of running out of money during retirement. Running out of money depends on an array of factors including your health, lifestyle, family support and the size and sources of retirement income.  My goal as a financial advisor is to ensure that your money lasts you through the rest of your life.

Legacy risk

For many of my clients leaving a legacy is an important part of their personal goal. Whether funding college expenses, taking care of loved ones or donating to a charitable cause, legacy planning is a cornerstone of our financial plan. Having a robust estate plan will reduce the risks to your assets when you are gone or incapacitated to make decisions. 

Liquidity Risk

Liquidity risk is the risk that you will not be able to find buyers for your investments and other assets that you are ready to sell. Often times, during an economic downturn, the liquidity shrinks. There will be more sellers than buyers. The banks are not willing to extend loans to finance riskier deals. In many cases, the sellers will have to sell their assets at a significant discount to facilitate the transaction.

Behavioral risk

Typically, investors are willing to take more risk when the economy is good and the equity markets are high. Investors become more conservative and risk-averse when markets drop significantly. As humans, we have behavioral biases, Sometimes, we let our emotions get the worst of us. We spend frivolously. We chase hot stocks. Or keep all investments in cash. Or sell after a market crash. Working with a fiduciary advisor will help you understand these biases. Together, we can find a way to make unbiased decisions looking after your top financial priorities.

Final Words

Preparing for retirement is a long process. It involves a wide range of obstacles. With proper long-term planning, you can avoid or minimize some of these risks. You can focus on reaching your financial goals and enjoying what matters most to you.

Reach out

If you need help growing your retirement savings, reach out to me at stoyan@babylonwealth.com or +925-448-9880.

You can also visit my Insights page, where you can find helpful articles and resources on how to make better financial and investment decisions.

About the author:

Stoyan Panayotov, CFA, MBA is a fee-only financial advisor in Walnut Creek, CA, serving clients in the San Francisco Bay Area and nationally. Babylon Wealth Management specializes in financial planning, retirement planning, and investment management for growing families, physicians, and successful business owners.

Subscribe to get our new Insights delivered right to your inbox

The Secret to becoming a 401k millionaire

401k millionaire

How to become a 401k millionaire? Today, 401k plans are one of the most popular employee benefits. Companies use 401k plans to attract top talent. 401k plan is a powerful vehicle to save for retirement and become financially independent. According to Fidelity, there are 180,000 Fidelity 401(k) plans with a $1 million or more balance. Congratulations to you If you are one of them. There are still many helpful tips that can get you to reach your financial goals while keeping your investments safe.

You hear stories about people with a million dollars in their 401k plan. Then you look at your 401k balance, and it doesn’t look as high as you would like it to be.

The path to becoming a 401k millionaire

I hope this article will guide you on your path to become a 401k millionaire.

Many variables can impact your 401k account – age, salary, debt, tax rate, risk tolerance, plan fees, employee match.

Becoming a 401k millionaire is not as hard as it might seem. However, you need to follow a few simple rules that can get you on the right path.

“The best time to plant a tree was 20 years ago. The second-best time is now.”

Start saving early in your 401k

Saving early in your 401k will guarantee you the highest chance to become a 401k millionaire at the lowest cost.

I did the math for how much you need to contribute if you start fresh at any age. These numbers are based on assumptions for continuous monthly 401k contributions until reaching 65 with a 7% average annual market return for a 60/40 portfolio and 2% annual inflation.  Keep in mind that these assumptions are just assumptions and only for illustration purposes.  Your situation could be unique and could change the math dramatically.

401k Contributions by Age if you start fresh

 

Age|Monthly
Contribution
|Yearly
Contribution
|Lifetime
Contribution
25$387$4,644$190,404
30$560$6,720$241,920
35$820$9,840$305,040
40$1,220$14,640$380,640
45$1,860$22,320$468,720
50$3,000$36,000$576,000
55$5,300$63,600$699,600

 

What drives the growth of your 401k is the power of compounding. It’s the snowball effect of accumulating earnings-generating more earnings over time. The longer you wait, the larger you will need to contribute to reaching your 1-million goal.

If you are 25-years old and just starting your career, you need to save approximately $390 per month or $4,644 annually to reach the $1-million goal by the age of 65. Your lifetime contribution between the age of 25 and 65 will be $190,000.

When you start saving in your 30s, this target number goes to $560 per month. Your lifetime contribution between the age of 30 and 65 will be $241,920.

Your saving rate goes up to 1,220 per month if you start saving actively in your 40s and increases to $5,330 at the age of 55.

Take advantage of your employer match.

If my recommended monthly contribution looks like an uphill battle, don’t forget about your employer match. Many employers offer a 401k match to attract and keep top talent. The match could be a percentage of your salary, a one-to-one match, or an absolute dollar amount. If your employer offers a 4% match, at a minimum, you should contribute 4% to your 401k plan. Take full advantage of this opportunity to get free money.

Max out your 401k

In 2020, you can make up to a $19,500 contribution to your 401k plan. If you can afford it, always try to max out your contributions.

Catch-up contributions when 50 and older

If you are 50 years or older, you can make an additional $6,500 contribution to your plan. Combined with the $19,500 limit, that is a maximum of $26,000 in 2020.

Save aggressively

Obviously, owning $1 million is a big accomplishment. However, it may not be enough to sustain your lifestyle during retirement.  As a financial advisor, I recommend that my clients replace at least 80% of their income before retirement. If you are a high earner or plan to retire early, you need to save more aggressively to reach your goals.

Be consistent

An important part of the formula of becoming a 401k millionaire is consistency.  Saving every month and every year is a critical part of achieving your financial goals. On the contrary, large gaps could hurt your chances of reaching your financial goals.

Don’t panic during market turbulence.

The market can be volatile. Don’t let your emotions get the worst of you. Nobody has made any money panicking. During 2008-2009, many people stopped contributing to their 401k plans or moved their investments into cash. These folks never participated in the market recovery and the longest bull market in history. Stay invested. And think of this way. If the market goes down, your plan will invest your automatic monthly contributions at lower prices. You are already getting a deal.

Watch your fees

Higher fees can erode your returns and slow down the pursuit of your financial goals. I recently advised a 401k plan, where the average fund’s fees were 1.5%. In the age of ETFs and index investing, it is mind-blowing that some 401k plan still charges exuberantly high fees. If your 401k plan charges high fees, talk to your manager or HR representative, and demand lower fee options.

Be mindful of your taxes.

Taxes play a big role in 401k planning. Most 401k contributions are tax-deferred. Meaning that your contributions will reduce your current taxable income. Your investments will grow tax-free until you reach retirement age. You start paying taxes on your withdrawals. There are a couple of strategies you can implement to make your withdrawals to make more tax-efficient. You can reach out to me if you have any questions on that topic, as every situation is unique and could require a unique solution.

Roth 401k

Currently, some employers offer a Roth 401k contribution as an additional option to their plan. Unlike the tax-deferred option, Roth 401k contributions are made on an after-tax basis. Roth 401k contributions don’t have an immediate financial impact. However, if planned well, Roth contributions could help you immensely to reach your financial goals. For example, let’s assume that you are in a low tax bracket and your employers offer both tax-deferred and Roth 401k contributions. The tax-deferred option is usually the default. But if you are in a low tax bracket, your tax benefit will be minimal. In that case, maybe it’s worth selecting the Roth 401k.

Don’t take a loan

Under no circumstances you should take a loan from your 401k plan. No matter how dire the situation is, try to find an alternative.  Taking a loan from your 401k can set you back many years in achieving your financial goal of becoming a 401k millionaire. Obviously, all rules have exceptions, but before you take a loan from your 401k, talk to your financial advisor first for alternatives.

Keep a long-term view.

Life happens. Markets go up and down. You can lose your job or change employers. You need to pay off a big loan. Your car breaks down. You need money for a down payment on your first house. Something always happens. Circumstances change. Whatever happens, keep a long-term view. Your 401k plan could be the answer to your financial independence. Don’t make rash decisions.

The Smart Way to Manage Your Sudden Wealth

The Smart Way to Manage Your Sudden Wealth

Getting rich is the dream of many people. When your sudden wealth becomes a reality, you need to be ready for the new responsibilities and challenges. As someone experienced in helping my clients manage their sudden wealth, I want to share some of my experience.

Sources of sudden wealth

Your sudden windfall can come from many different sources – receiving an Inheritance, winning the lottery, selling your business or a real estate property, signing a new sport or music contract, royalties from a bestselling book or a hit song, or selling shares after your company finally goes public. Whatever the source is, your life is about to change. Being rich brings a unique level of issues.  Your new wealth can have a variety of financial, legal and core repercussions to your life.

Avoid making any immediate changes to your life

Don’t make big and hasty changes to your lifestyle. I recommend that you wait at least six months. Let the big news sink in your mind.  Let things settle down before quitting your job, moving to another city or making a large purchase. Keep it quiet. The next six month will give you a chance to reassess your life, control your emotions and set your priorities.

Figure out what you own

This is the moment you have been waiting for all your life.
You are probably very excited, and you deserve it. There are tons of things you want to do with your money. But before you do anything.  Take a deep breath. Figure out exactly what you own. Gather all necessary information about your assets. Maybe your sudden
windfall is in cash. However, your new wealth could be in real estate, land, stocks, art, gold, rare wines, luxury cars and so on. Not always your new fortunate can easily be converted into cash. Each wealth source is unique on its own and has specific legal and financial rules.

Build your team

Your financial life is about to become a lot more complicated. You will need a team of trusted experts who will help you navigate through these changes. Your financial team can help you understand your wealth.   They watch your back and flag any blind spots. Talk to your team and figure what are your options.

Hire a CPA

You are rich. And that’s a great news for the IRS and your state. There is a very good chance you will pay more taxes that you ever imagined. Start assembling your financial team by hiring a reputable CPA who
understands your situation and can steer you through the complex world of taxes.  Each source of wealth has unique tax rules. Find out what rules apply to you.

Hire a financial advisor

Look for a trusted fiduciary financial advisor with experience managing sudden wealth. A fiduciary advisor will look after your best interest and guide you in your new journey. Talk to your new advisors about your personal and financial goals and how to reach them with the help of your new wealth.

Have a financial plan

Ask your advisor to craft a financial plan that is tailored to your unique situation, specific needs and financial objectives. Figure out how
your sudden wealth can help you reach your goals – retire early, send your kids to college, buy a new house, become self-employed. The list is endless. Talk to your advisor about your risk tolerance. Many of my clients who earned a windfall have a low risk appetite. An important part of our conversation is how to reach their goals without taking on too much risk.

Protect your new
wealth

You need to take steps to protect your sudden windfall.  For a starter, try to keep

If your new money is sitting in your checking account, make sure you allocate it among several different banks and account types. Remember that FDIC insurance covers up to 250k per person per bank in each account category.

If you inherited real estate or art or some other type of physical
property make sure to have solid Insurance to protect you from unexpected events.  

In case you received stocks or other investments, speak to
your financial advisor how to hedge them from market volatility and losing value.

Have an estate plan

No matter how well you plan, life can be unpredictable. Getting a windfall is a great opportunity to update your estate plan or craft a new one. The estate plan will protect your loved ones and ensure your legacy in the face of the unknown. If something happens to you, your fortune will be used and divided per your own wish. The alternative is going through a lengthy and expensive probate process that may
not have the same outcome.

Pay off your debts

If you owe money, you have a chance to pay off your debts.  Credit cards debts and any personal loans with high interest should be your priority. Your new wealth can help your live a debt-free life. This is one area where working with a financial advisor will make a big difference in your life.  

Beware that many people who receive sudden windfall end up
borrowing more money and sometimes filing for bankruptcy.  Don’t be that person. You still need to live within
your means.

Plan your taxes

Depending on the source of sudden wealth you may owe taxes to the IRS and your state either immediately or sometime in the near future. Don’t underestimate your tax bill. Your CPA and financial advisor should help you understand and prepare for your current and future tax bills.

Don’t overspend

Many lottery winners and former athletes file for bankruptcy
due to poor spending habits, lending money to family and friends and money mismanagement.
The fact that you are rich doesn’t mean that you can’t lose your money. You need to be responsible. Talk to your advisor about your monthly budget and what you can afford.  

Be philanthropic

Making a donation is an excellent way to give back to the society and leave a legacy.  If you have a charitable cause close to your heart, you make a difference. Often time, charitable contributions can be tax-deductible and lower your tax bill. Talk to your CPA and financial advisors how you can achieve that.

Conclusion

Sudden Wealth can come in all shapes and forms – cash, real estate, land, ongoing business, royalties, stocks, and many others. Even though it might not be completely unexpected, the way you feel about after the fact might be shocking to you. Don’t let your emotions get the worst of you. Getting windfall is a great life accomplishment. And you should make the best out of it.  Work with your team of trusted professionals and build a long-term plan with milestones and objectives.

Reach out

If you are expecting a windfall or recently received a sudden wealth, reach out to me at stoyan@babylonwealth.com or +925-448-9880.

You can also visit my Insights page where you can find helpful articles and resources on how to make better financial and investment decisions.

Why you need a Roth IRA? Updated for 2020

Roth IRA

Do you have a Roth IRA? If you never heard about it, I hope this article will convince you to open one. Roth IRA is a tax-exempt investment account that allows you to make after-tax contributions to save for retirement.  The Roth IRA has a tax free status. It is a great way to save for retirement and meet your financial goals without paying a dime for taxes on your investments. The Roth IRA offers you a lot of flexibility with very few constraints.

1. Plan for your future

Opening a Roth IRA account is a great way to plan for your retirement and build your financial independence. The Roth IRA is an excellent saving opportunity for many young professionals and pretty much anyone with limited access to workplace retirement plans. Even those who have 401k plans with their employer can open a Roth IRA.

If you are single and earn $124,000 or less in 2020, you can contribute up to $6,000 per year in your Roth IRA. Individuals 50 years old and above can add a catch-up contribution of $1,000. If you are married filing jointly, you can contribute the full amount if your MAGI is under $196,000.

There is a phaseout amount between $124,000 and $139,000 for single filers and $196,000 and $206,000 for married filing jointly.

2. No age limit

There is no age limit for your contributions. You can contribute to your Roth IRA at any age as long as you earn income.

Minors who earn income can also invest in Roth IRA. While youngsters have fewer opportunities to make money, there are many sources of income that will count – babysitting, garden cleaning, child acting, modeling, selling lemonade, distributing papers, etc.

3. No investment restrictions

Unlike most 401k plans, Roth IRAs do not have any restrictions on the type of investments in the account. You can invest in any asset class that suits your risk tolerance and financial goals.

4. No taxes

There are no taxes on the distributions from this account once you reach the age of 59 ½. Your investments will grow tax-free.  You will never pay taxes on your capital gains and dividends either. Roth IRA is a great saving tool for investors at all income levels and tax brackets.

With an average historical growth rate of 7%, your investment of $6,000 today could bring you $45,674 in 30 years completely tax-free. The cumulative effect of your return and the tax status of the account will help your investments grow faster.

5. No penalties if you withdraw your original investment

While not always recommended, Roth IRA allows you to withdraw your original dollar contribution (but not the return) before reaching retirement, penalty and tax-free. Say, you invested $5,000 several years ago. And now the account has grown to $15,000. You can withdraw your initial contribution of $5,000 without penalties.

6. Diversify your future tax exposure

It is very likely that most of your retirement savings will be in a 401k plan or an investment account. 401k plans are tax-deferred and you will owe taxes on any distributions. Investment accounts are taxable and you pay taxes on capital gains and dividends. In reality, nobody can predict what your tax rate will be by the time you need to take out money from your retirement and investment accounts. Roth IRA adds this highly flexible tax-advantaged component to your investments.

7. No minimum distributions

Unlike 401k plans, Roth IRA doesn’t have any minimum distributions requirements. Investors have the freedom to withdraw their savings at their wish or keep them intact indefinitely.

8. Do a backdoor Roth conversion

Due to recent legal changes investors who do not satisfy the requirements for direct Roth IRA contributions, can still make investments to it. The process starts with a taxable contribution, up to the annual limit, into a Traditional IRA. Eventually, the contributions are rolled from the Traditional IRA to the Roth IRA.

9. Roth conversion from Traditional IRA and 401k plans

Under certain circumstances, it could make sense for you to rollover your Traditional IRA and an old 401k plan to Roth IRA. If you expect to earn less income or pay lower taxes in a particular year, it could be beneficial to consider this Roth conversion. Your rollover amount will be taxable at your current ordinary income tax level. An alternative strategy is to consider annual rollovers in amounts that will keep you within your tax bracket.

10. Estate planning

Roth IRA is an excellent estate planning tool. Due to its age flexibility and no minimum required distributions, it is a good option for generation transfer and leaving a legacy to your beloved ones.

Final words

Roth IRA is an excellent starting point for young professionals. It can help you reach your financial goals faster. So open your account now to maximize its full potential. Investing early in your career will lay out the path for your financial independence.

Reach out

If you’d like to discuss how to open a new Roth IRA or make the most out of your existing account, reach out to me at stoyan@babylonwealth.com or +925-448-9880.

You can also visit our Insights page where you can find helpful articles and resources on how to make better financial and investment decisions.

Essential Guide to Your Employee Stock Purchase Plan (ESPP)

Employee Stock Purchase Plan (ESPP)

What is Employee Stock Purchase Plan (ESPP)?

Employee Stock Purchase Plan (ESPP) is a popular tool for companies to allow their employees to participate in the company’s growth and success by becoming shareholders. ESPP gives you the option to buy shares of your employer at a discount price. Most companies set a discount between 10% and 15%. Unlike RSUs and restricted stocks, the shares you purchase through an ESPP are not subject to any vesting schedule restrictions. That means you own the shares immediately after purchase. There are two types of ESPP – qualified and non-qualified. Qualified ESPP generally meets the requirements under Section 423 of the Internal Revenue Code and receive a more favorable tax treatment. Since most ESPP are qualified, I will only talk about them in this article.

How ESPP works?

Your company will typically provide you with information about enrollment and offering dates, contribution limits, discounts, and purchasing schedules. There will be specific periods throughout the year when employees can enroll in the plan. During that time, you are required to decide if you want to participate and set a percentage of your salary to be deducted every month to contribute to the stock purchase plan. The IRS allows up to $25,000 limit for Employee Stock Purchase Plan contributions. Make sure you set your percentage, so you don’t cross over this limit.

At this point, you are all set. Your employer will withhold your selected percentage every paycheck. The contributions will accumulate over time and will be used to buy the company stock on the purchase date.

Offering period

Offering periods of most ESPPs range from 6 to 24 months. The longer periods could have multiple six-month purchase periods. Your employer will use your salary contributions that accumulate with time to buy shares from the company stock on your behalf.

ESPP look-back provision

Some Employee Stock Purchase Plans offer a look-back provision that will allow you to purchase the shares at a discount from the lowest of the beginning and ending price of the offering period.

Employee Stock Purchase Plan  Example

Let’s assume that on January 2nd, your company stock traded at $100 per share. The stock price had a nice run and ended the six month period on June 30 at 120. Your ESPP will allow you to buy the stock at 15% of the lowest price, which is $00. You will end up paying $85 for a stock worth $120.

The price discount is what makes the ESPP attractive to employees of high growth companies. By acquiring your company stock at a discount, the ESPP lowers your investment risk, provides you a buffer from future price declines, and sets a more significant upside if the price goes up further.

When to sell ESPP stock?

Some ESPPs allow you to sell your shares immediately after the purchase date, realizing an instant gain of 17.65%. Other plans may impose a holding period restriction during which you cannot sell your shares. Find out more from your HR.

ESPP Tax Rules

Employee Stock Purchase plans have their own unique set of tax rules. All contributions are pretax and subject to federal, state, and local taxes.

Purchasing and keeping ESPP stock will not create a tax event. In other words, you don’t owe any taxes to IRS if you never sell your shares. However, the moment you decide to sell is when things get more complicated.

The discount is as ordinary income

The first thing to remember is that your ESPP price discount is always treated as ordinary income. You will include the value of the discount to your regular annual income and pay taxes according to your tax bracket.

Qualifying disposition

To get a preferential tax treatment on your stock gains, you need to make a qualifying disposition. The rule requires that you sell your shares two years from the offer date and one year from the purchase date. Your gains will be taxed as long-term capital gains. The long-term capital gain tax rate varies between 0%, 15%, and 20% depending on your income. 

Disqualifying disposition

If you sell your shares less than two years from the offer date or less than one year from the purchase date, the sale is a disqualifying disposition. You will pay taxes on short-term capital gains as an ordinary income according to your tax bracket.

ESPP Dividends

Many publicly traded companies pay out dividends to shareholders. If your employer pays dividends, they will automatically be reinvested in the company shares. You will owe ordinary income tax on your ESPP dividends in the year when you receive them. Usually, the plan discount does not apply to shares purchased with reinvested dividends. Additionally, these shares are treated as regular stock, not part of your Employee Stock Purchase Plan.

Investment risk

Being a shareholder in a solid high growth company could offer a significant boost to your personal finances. In some cases, it could make you an overnight millionaire.

However, here is the other side of the story. Owning too much stock of a company in bad financial health could impose a significant risk to your overall investment portfolio and retirement goals. Participating in the ESPP of a company with a constantly dropping or volatile stock price is like catching a falling knife. The discount price could give you some downside protection, but you can continue to lose money if the price continues to go down. The price of General Electric, one of the oldest Dow Jones members, went down more than 65% in one year.

Remember Enron and Lehman

Many of you remember or heard of Enron and Lehman Brothers. If your company seizes to exist for whatever reason, you could not only lose your job, but all your investments in the firm could be wiped out.

You are already earning a salary from your employer. Concentrating your wealth and income from the same source could jeopardize your financial health if your company fails to succeed in its business ventures.

As a fiduciary advisor, I always recommend diversification and caution. Try to limit your exposure to your company stock and sell your shares periodically. Sometimes paying taxes is worth the peace of mind and safety.

Conclusion

Participating in your employer’s Employee Stock Purchase Plans is an excellent way to acquire company stock at a discount and get involved in your company’s future.

Owning company stock often comes with a huge financial upside. Realizing some of these gains could help you build a strong foundation for retirement and financial freedom. When managed properly, it can help you achieve your financial goals, whether they are buying a home, taking your kids to college, or early retirement.

Keep in mind that all ESPPs have different rules. Therefore, this article may not address the specific features of your plan.

 

Saving for college with a 529 plan

College savings with a 529 plan

What is a 529 plan?

The 529 plan is a tax-advantaged state-sponsored investment plan, which allows parents to save for their children college expenses.

In the past 20 years, college expenses have skyrocketed exponentially putting many families in a difficult situation.  Between 1998 and 2018, college tuition and fee have doubled in most private non-profit schools and more than tripled in most 4-year public colleges and universities.

College tuition and fees growth between 1998 and 2018.
Source: College Board

With this article, I would like to share how the 529 plan can help you send your kids or grandkids to college.

Student Debt is Growing

The student debt has reached $1.56 trillion with a growing number of parents taking on student loans to pay for their children’ college expenses. The total number of US borrowers with student loan debt is now 44.7 million.

Amid this grim statistic, less than 30% of families are aware of the 529 plan. The 529 plan could be a powerful vehicle to save for college expenses. Fortunately, 529 plans have grown in popularity in the past 10 years. There are more than 13 million 529 accounts with an average size of $24,057.

Let’s break down some of the benefits of the 529 plan.

College Savings Made Easy

Nowadays, you can easily open an account with any 529 state plan in just a few minutes and manage it online. You can set up automatic contributions from your bank account. Also, many employers allow direct payroll deductions and some even offer a match. Your contributions and dividends are reinvested automatically., so you don’t have to worry about it yourself. As a parent, you can open a 529 plan with as little as $25 and contribute as low as $15 per pay period. Most direct plans have no application, sales, or maintenance fees. 529 plan is affordable even for those on a modest budget.

529 plan offers flexible Investment Options

Most 529 plans provide a wide variety of professionally managed investment portfolios including age-based, indexed, and actively-managed options. The age-based option is an all-in-one portfolio series intended for those saving for college. The allocation automatically shifts from aggressive to conservative investments as your child approaches college age.

Alternatively, you can design your portfolio choosing between a mix of actively managed and index funds, matching your risk tolerance, timeline, and investment preferences. Some 529 plans offer guaranteed options, which limit your investment risk but also cap your upside.

Earnings Grow Tax-Free

529 plan works similarly to the Roth IRA. You make post-tax contributions. And your investment earnings will grow free from federal and state income tax when used for qualified expenses. Compared to a regular brokerage account, the 529 plan has a distinct tax advantage as you will never pay taxes on your dividends and capital gains.

Tax-exempt growth
529 plan versus taxable investment account
The chart hypothetically assumes a $6,300 annual contribution, a 5% average annual return and a 20% average tax rate on taxable income in a comparable brokerage account. The final year post-tax difference would be $14,539, without taking into consideration state tax deductions.on contributions and impact on financial aid application.

Your State May Offer a Tax Break

Over 30 states offer a full or partial tax deduction or credit on your 529 contributions. You can find the full list here. If you live in any of these states, your 529 contributions can lower significantly your state tax bill. However, these states usually require you to use the state-run 529 plan.

If you live in any of the remaining states that don’t offer any state tax deductions, such as California, you can open a 529 account in any state of your choice.

Use at Schools Anywhere

529 funds can be used at any accredited university, college or vocational school nationwide and more than 400 schools abroad. Basically, any institution eligible to participate in a federal student aid program qualifies. A 529 plan can be used to pay for tuition, certain room and board costs, computers and related technology expenses as well as fees, books, supplies, and other equipment.

The TCJA law of 2017 expanded the use of 529 funds and allowed parents to use up to $10,000 annually per student for tuition expenses at a public, private or religious elementary, middle, or high school. However, please check with your 529 plan as not all states passed that provision

Smaller Impact on Scholarship and Financial Aid

Many parents worry that 529 savings can adversely affect eligibility for scholarships and financial aid. Fortunately, 529 plan savings have no impact on merit scholarships. You can even withdraw funds from the 529 plan penalty-free up to the amount of the student scholarship.

For FAFSA, funds are typically treated as ownership of the parent, not the child, reducing the impact on financial aid application. A key component of the financial aid application is the Expected Family Contribution (EFC). Since 529 plans are considered parents’ assets, they are assessed at 5.64% of their value. For comparison, any accounts owned directly by the student such as custodial accounts (UTMAs, UGMAs), trusts and investment accounts are assessed at 20% of their value.

Lower Cost versus Borrowing Money

Starting the 529 plan early can save you money in the long run. The tax advantages of the 529 plan combined with the compounding growth over 18 years it will provide you with substantial long-term savings compared to taking a student loan.

529 plan provide Estate Tax Planning Benefits

Your 529 plan contributions may qualify for an annual gift tax exclusion of $15,000 per year for single filers and $30,000 a year for couples. The 529 plan is the only investment vehicle that allows you to contribute up to 5 years’ worth of gifts at once — for a maximum of $75,000 for a single filer and $150,000 for couples.

Other Family Members Can Contribute Too

Grandparents, as well as other family and friends, can make gifts to your 529 account. They can also set up their own 529 accounts and designate your child as a beneficiary. The grandparent-owned 529 account is not reportable on the student’s FAFSA, which is good for financial aid eligibility. However, any distributions to the student or the student’s school from a grandparent-owned 529 will be added to the student income on the following year’s FAFSA. Student income is assessed at 50%, which means if a grandparent pays $10,000 of college costs it would reduce the student’s eligibility for aid by $5,000.

Transfer funds to ABLE Account

Achieving a Better Life Experience (ABLE) account was first introduced in 2014. The ABLE account works similarly to a 529 plan with certain conditions. It allows parents of children with disabilities to save for qualified education, job training, healthcare, and living expenses.

Under the TCJA law, 529 funds can be rolled over into an ABLE account, without paying taxes or penalties.

Assign Extra Funds to Other Family Members

Finally, if your child or grandchild doesn’t need all the money or his or her education plans change, you can designate a new beneficiary penalty-free so long as they’re an eligible member of your family. Moreover, you can even use the extra funds for your personal education and learning new skills.

A financial checklist for young families

A financial checklist for young families

A financial checklist for young families…..Many of my clients are young families looking for help to build their wealth and improve their finances. We typically discuss a broad range of topics from buying a house, saving for retirement, savings for their kids’ college, budgeting and building legacy. As a financial advisor in the early 40s, I have personally gone through many of these questions and was happy to share my experience.

Some of my clients already had young children. Others are expecting a new family member. Being a dad of a nine-month-old boy, I could relate to many of their concerns. My experience helped me guide them through the web of financial and investment questions.  

While each family is unique, there are many common themes amongst all couples. While each topic of them deserves a separate post, I will try to summarize them for you.

Communicate

Successful couples always find a way to communicate effectively. I always advise my clients to discuss their financial priorities and concerns. When partners talk to each other, they often discover that they have entirely different objectives.  Having differences is normal as long as you have common goals. By building a strong partnership you will pursue your common goals while finding a common ground for your differences

Talking to each other will help you address any of the topics in this article.

If it helps, talk to an independent fiduciary financial advisor. We can help you get a more comprehensive and objective view of your finances. We often see blind spots that you haven’t recognized before.

Set your financial goals

Most life coaches will tell you that setting up specific goals is crucial in achieving success in life. It’s the same when it comes to your finances. Set specific short-term and long-term financial goals and stick to them. These milestones will guide you and help you make better financial decisions in the future.

Budget

There is nothing more important to any family wellbeing than budgeting. Many apps can help you budget your income and spending. You can also use an excel spreadsheet or an old fashion piece of paper. You can break down your expenses in various categories and groups similar to what I have below. Balance your budget and live within your means.

Sample budget

Gross Income?????
Taxes???
401k Contributions??
Net Income????
Fixed Expenses
Mortgage?
Property Taxes?
Utilities (Phone, Cable, Gas, Electric)?
Insurance?
Healthcare/Medical?
Car payment?
529 savings?
Daycare?
Non-Discretionary Flexible Expenses
Groceries?
Automotive (Fuel, Parking, Tolls)?
Home Improvement/Maintenance?
Personal Care?
Dues & Subscriptions?
Discretionary Expenses
Restaurants?
General Merchandise?
Travel?
Clothing/Shoes?
Gifts?
Entertainment?
Other Expenses?
Net Savings???

Consolidate your assets

One common issue I see amongst young couples is the dispersion of their assets. It’s very common for spouses to have multiple 401k, IRAs and savings accounts in various financial institutions and former employers. Consolidating your assets will help you get a more comprehensive view of your finances and manage them more efficiently.

Manage your debt

The US consumer debt has grown to record high levels. The relatively low-interest rates, rising real estate prices and the ever-growing college cost have pushed the total value of US household debt to $13.25 trillion. According to the New York Fed, here is how much Americans owe by age group.

  • Under 35: $67,400
  • 35–44: $133,100
  • 45–54: $134,600
  • 55–64: $108,300
  • 65–74: $66,000
  • 75 and up: $34,500

For many young families who are combining their finances, managing their debt becomes a key priority in achieving financial independence.

Manage your credit score

One way to lower your debt is having a high credit score. I always advise my clients to find out how much their credit score is.  The credit score, also known as the FICO score, is a measure between 300 and 850 points. Higher scores indicate lower credit risk and often help you get a lower interest rate on your mortgage or personal loan. Each of the three national credit bureaus, Equifax, Experian, and TransUnion, provides an individual FICO score.  All three companies have a proprietary database, methodology, and scoring system. You can sometimes see substantial differences in your credit score issued by those agencies.

Your FICO score is a sum of 64 different measurements. And each agency calculates it slightly differently. As a rule, your credit score depends mainly on the actual dollar amount of your debt, the debt to credit ratio and your payment history. Being late on or missing your credit card payments, maximizing your credit limits and applying for too many cards at once will hurt your credit score.

Own a house or rent

Owning your first home is a common theme among my clients. However, the price of real estate in the Bay area, where I live, has skyrocketed in the past 10 years. The average home price in San Francisco according to Zillow is $1.3 million. The average home price in Palo Alto is $3.1 million. (Source: https://www.zillow.com/san-francisco-ca/home-values/ ). While not at this magnitude, home prices have risen in all major metropolitan areas around the country. Buying a home has become an impossible dream for many young families. Not surprisingly a recent survey by the Bank of the West has revealed that 46% of millennials have chosen to rent over buying a home, while another 11% are staying with their parents.  

Buying a home in today’s market conditions is a big commitment and a highly personal decision. It depends on a range of factors including how long you are planning to live in the new home, available cash for a downpayment, job prospects, willingness to maintain your property, size of your family and so on.

Maximize your retirement contributions

Did you know that in 2019 you can contribute up to $19,000 in your 401k? If you are in your 50s or older, you can add another $6,000 as a catch-up contribution. Maximizing your retirement savings will help you grow your wealth and build a cushion of solid retirement savings. Not to mention the fact that 401k contributions are tax-deferred and lower your current tax bill.

Unfortunately, many Americans are not saving aggressively for retirement. According to Fidelity, the average person in their 30’s have $42.7k in their 401k plan. people in their 40s own on average 103k.

If your 401k balance is higher than your age group you are already better off than the average American.

Here is how much Americans own in their 401 plan by age group

  • 20 to 29 age: $11,500
  • 30 to 39 age: $42,700
  • 40 to 49 age: $103,500
  • 50 to 59 age: $174,200
  • 60 to 69 age: $192,800

For those serious about their retirement goals, Fidelity recommends having ten times your final salary in savings if you want to retire by age 67. They are also suggesting how to achieve this goal by age group.

  • By the age of 30: Have the equivalent of your starting salary saved
  • 35 years old: Have two times your salary saved
  • 40 years old: Have three times your salary saved
  • 45 years old: Have four times your salary saved
  • 50 years old: Have six times your salary saved
  • 55 years old: Have seven times your salary saved
  • 60 years old: Have eight times your salary saved
  • By age 67: Have 10 times your salary saved

Keep in mind that these are general guidelines. Everybody is different. Your family retirement goal is highly dependent on your individual circumstances, your lifestyle, spending habits, family size and alternative sources of income.

Know your risk tolerance level

One common issue I see with young families is the substantial gap between their risk tolerance and the actual risk they take in their retirement and investment accounts.  Risk tolerance is your emotional ability to accept risk as an investor.

I have seen clients who are conservative by nature but have a very aggressive portfolio. Or the opposite, there are aggressive investors with a large amount of cash or a large bond portfolio. Talking to a fiduciary financial advisor can help you understand your risk tolerance. You will be able to narrow that gap between your emotions and real-life needs and then connect them to your financial goals and milestones.

Diversify your investments

Diversification is the only free lunch you will get in investing. Diversifying your investments can reduce the overall risk of your portfolio. Without going into detail, owning a mix of uncorrelated assets will lower the long-term risk of your portfolio. I always recommend that you have a portion of your portfolio in US Large Cap Blue Chip Stocks and add some exposure to Small Cap, International, and Emerging Market Stocks, Bonds and Alternative Assets such as Gold and Real Estate.

Invest your idle cash

One common issue I have seen amongst some of my clients is holding a significant amount of cash in their investment and retirement accounts. The way I explain it is that most millennials are conservative investors. Many of them observed their parents’ negative experience during the financial crisis of 2008 and 2009. As a result, they became more risk-averse than their parents.  

However, keeping ample cash in your retirement account in your 30s will not boost your wealth in the long run. You are probably losing money as inflation is deteriorating the purchasing power of your idle cash. Even if you are a very conservative investor, there are ways to invest in your retirement portfolio without taking on too much risk.

Early retirement

I talk about early retirement a lot often than one might imagine. The media and online bloggers have boosted the image of retiring early and made it sound a lot easier than it is. I am not saying that early retirement is an illusion, but it requires a great deal of personal and financial sacrifice. Unless you are born rich or rely on a huge payout, most people who retire early are very frugal and highly resourceful. If your goal is to retire early, you need to pay off your debt now, cut down spending and save, save and save.

Build-in tax diversification

While most of the time we talk about our 401k plans, there are other investment and retirement vehicles out there such as Roth IRA, Traditional IRA and even your brokerage account. They all have their own tax advantages and disadvantages. Even if you save a million bucks in your 401k plan, not all of it is yours. You must pay a cut to the IRS and your state treasury. Not to mention the fact that you can only withdraw your savings penalty-free after reaching 59 ½. Roth IRA and brokerage account do not lower your taxes when you make contributions, but they offer a lot more flexibility, liquidity, and some significant future tax advantages. In the case of Roth IRA, all your withdrawals can be tax-free when you retire. Your brokerage account provides you with immediate liquidity and lower long-term capital gains tax on realized gains.

Plan for child’s expenses

Most parents will do anything for their children. But having kids is expensive. Whether a parent will stay at home and not earn a salary, or you decide to hire a nanny or pay for daycare, children will add an extra burden to your budget. Not to mention the extra money for clothes, food, entertainment (Disneyland) and even another seat on the plane.

Plan for college with a 529 Plan

Many parents want to help their children pay for college or at least cover some of the expenses. 529 plan is a convenient, relatively inexpensive and tax-advantageous way to save for qualified college expenses. Sadly, only 29% of US families are familiar with the plan. Most states have their own state-run 529 plan. Some states even allow state tax deductions for 529 contributions. Most 529 plans have various active, passive and age-based investment options. You can link your checking account to your 529 plan and set-up regular monthly contributions. There are plentiful resources about 529 plans in your state. I am happy to answer questions if you contact me directly.  

Protect your legacy

Many young families want to protect their children in case of sudden death or a medical emergency. However, many others don’t want to talk about it at all. I agree it’s not a pleasant conversation. Here in California, unless you have an established estate, in case of your death all your assets will go to probate and will have to be distributed by the court. The probate is a public, lengthy and expensive process. When my son was born my wife and I set up an estate, created our wills and assigned guardians, and trustees to our newly established trust.  

The process of protecting your legacy is called estate planning. Like everything else, it’s highly personalized depending on the size of your family, the variety of assets you own, your income sources, your charitable aptitude, and so on. Talking to an experienced estate attorney can help you find the best decision for yourself and your family.

I never sell insurance to my clients. However, if you are in a situation where you are the sole bread earner in the household, it makes a lot of sense to consider term life and disability insurance, which can cover your loved ones if something were to happen to you.

Plan ahead

I realize that this is a very general, kind of catch-all checkpoint but let me give it a try. No matter what happens in your life right now, I guarantee you a year or two from now things will be different. Life changes all the time – you get a new job, you have a baby, you need to buy a new car, or your company goes public, and your stock options make you a millionaire. Whatever that is, think ahead. Proper planning could save you a lot of money and frustration in the long run.

Conclusion

I realize that this checklist is not complete. Every family is unique. Each one of you has very different circumstances, financial priorities, and life goals. There is never a one-size-fits-all solution for any family out there. If you contact me directly, I will be happy to address your questions.

 

9 Smart Tax Saving Strategies for High Net Worth Individuals

9 Smart Tax Saving Strategies for High Net Worth Individuals

The Tax Cuts and Jobs Act (TCJA) voted by Congress in late 2017 introduced significant changes to the way high net worth individuals and families file and pay their taxes. The key changes included the doubling of the standard deduction to $12,000 for singles and $24,000 for married couples filing jointly, the elimination of personal exemptions, limiting the SALT deduction to $10,000, limiting the home mortgage interest deduction to loans of up to $750,000 versus $1,000,000 as well as comprehensive changes to itemized deductions and Alternative Minimum Tax.

Many high net worth individuals and families, especially from high tax states like California, New York, and New Jersey, will see substantial changes in their tax returns. The real impact won’t be completely revealed until the first tax filing in 2019. Many areas remain ambiguous and will require further clarification by the IRS.

Most strategies discussed in this article were popular even before the TCJA. However, their use will vary significantly from person to person.  I strongly encourage you to speak with your accountant, tax advisor, or investment advisor to better address your concerns.

1. Home mortgage deduction

While a mortgage tax deduction is rarely the primary reason to buy a home, many new home buyers will have to be mindful of the new tax rule limiting mortgage deductions to loans of up to $750,000. The interest on second home mortgages is no longer tax-deductible.  The interest on Home Equity Loans or HELOCs could be tax-deductible in some instances where proceeds are utilized to acquire or improve a property

2. Get Incorporated

If you own a business, you may qualify for a 20 percent deduction for qualified business income. This break is available to pass-through entities, including S-corporations and limited liability companies. In general, to qualify for the full deduction, your taxable income must be below $157,500 if you’re single or $315,000 if you’re married and file jointly. Beyond those thresholds, the TJLA sets limits on what professions can qualify for this deduction. Entrepreneurs with service businesses — including doctors, attorneys, and financial advisors — may not be able to take advantage of the deduction if their income is too high.

Furthermore, if you own a second home, you may want to convert it to a rental and run it as a side business. This could allow you to use certain tax deductions that are otherwise not available.

Running your business from home is another way to deduct certain expenses (internet, rent, phone, etc.). In our digital age, technology makes it easy to reach out to potential customers and run a successful business out of your home office.

3. Charitable donations

All contributions to religious, educational, or charitable organizations approved by the IRS are tax-deductible. The annual limit is 50% of your AGI (aggregate gross income) for most donations and 30% of AGI for appreciated assets.

While most often people choose to give money, you can also donate household items, clothes, cars, airline miles, investments, and real estate. The fair value of the donated items decreases your taxable income and therefore will reduce the amount of taxes due to IRS.

The TCJA made the tax planning for donations a little bit trickier. The new tax rules raised the standard deduction to $12,000 for singles and $24,000 for married couples filing jointly. In effect, the rule will reduce the number of people who are itemizing their taxes and make charitable donations a less attractive tax strategy.

For philanthropic high net worth individuals making charitable donations could require a little more planning to achieve the highest possible tax benefit. One viable strategy is to consolidate annual contributions into a single large payment. This strategy will ensure that your donations will go above the yearly standard deduction threshold.

Another approach is to donate appreciated investments, including stocks and real estate. This strategy allows philanthropic investors to avoid paying significant capital gain tax on low-cost basis investments. To learn more about the benefits of charitable donations, check out my prior post here.

4. Gifts

The TCJA doubled the gift and estate tax exemption to almost $11.18 million per person and $22.36 per married couple. Furthermore, you can give up to $15,000 to any number of people every year without any tax implications. Amounts over $15,000 are subject to the combined gift and estate tax exemption of $11 million.  You can give your child or any person within the annual limits without creating create any tax implications.

Making a gift will not reduce your current year taxes. However, making gifts of appreciated assets with a lower cost basis can be a way to manage your future tax payments and pass on the tax bill to family members who pay a lower tax rate.

5. 529 Plans

The TCJA of 2017 expanded the use of 529 plans to cover qualifying expenses for private, public, and religious kindergarten through 12th grade. Previously parents and grandparents could only use 529 funds for qualified college expenses.

The use of 529 plans is one of the best examples of how gifts can minimize your future tax burden. Parents and grandparents can contribute up to $15,000 annually per person, $30,000 per married couple into their child college education fund. The plan even allows a one–time lump-sum payment of $75,000 (5 years x $15,000).

Parents can choose to invest their contributions through a variety of investment vehicles.  While 529 contributions are not tax-deductible on a federal level, many states like New York, Massachusetts, Illinois, etc. allow for state tax deductions for up to a certain amount. The 529 investments grow tax-free. Withdrawals are also tax-free when used to pay cover qualified college and educational expenses. 

6. 401k Contributions

One of the most popular tax deductions is the tax-deferred contribution to 401k and 403b plans. In 2020 the allowed maximum contribution per person is $19,500 plus an additional $6,500 catch-up for investors at age 50 and older. Also, your employer can contribute up to $36,500 for a maximum annual contribution of $57,000 or $63,500 if you are older than 50.

The contributions to your retirement plan are tax-deductible. They decrease your taxable income if you use itemized deductions on your tax filing form. Not only that, but the investments in your 401k portfolio also grow tax-free. You will owe taxes upon withdrawal at your current tax rate at that time.

7. Roth IRA

Roth IRA is a great investment vehicle. Investors can contribute up to $6,000 per year. All contributions to the account are after-tax.  The investments in the Roth IRA can grow tax-free. And the withdrawals will be tax-exempt if held till retirement. IRS has limited the direct contributions to individuals making up to $124,000 per year with a phase-out at $139,000. Married couples can make contributions if their income is up to $196,000 per year with a phase-out at $206,000.

Fortunately, recent IRS rulings made it possible for high net worth individuals to make Roth Contributions.  Using the two-step process known as backdoor Roth you can take advantage of the long-term tax-exempt benefits of Roth IRA. Learn more about Roth IRA in our previous post here. 

8. Health Spending Account

A health savings account (HSA) is a tax-exempt saving account available to taxpayers who are enrolled in a high-deductible health plan (HDHP) The funds contributed to this account are tax-deductible. Unlike a flexible spending account (FSA), HSA funds roll over and accumulate year over year if not spent. HSA owners can use the funds to pay for qualified medical expenses at any time without tax liability or penalty. The annual contribution limits for 2018 are $3,450 per person, $6,900 per family, and an additional $1,000 if 55 or older. The owner of HSA can invest the funds similar to the IRA account.

In effect, HSAs have a triple tax benefit. All contributions are tax-deductible. Investments grow tax-free and. HSA owners can make tax-free withdrawals for qualified medical expenses.

9. Municipal bonds

Old fashioned municipal bonds continue to be an attractive investment choice of high net worth individuals. The interest income from municipal bonds is still tax-exempt on a federal level. When the bondholders reside in the same state as the bond issuer, they can be exempted from state income taxes as well.

Final words

If you have any questions about your existing investment portfolio, reach out to me at stoyan@babylonwealth.com or +925-448-9880.

You can also visit our Insights page where you can find helpful articles and resources on how to make better financial and investment decisions.

Market Outlook December 2017

Market Outlook December 2017

Market Outlook December 2017

As we approach 2018, it‘s time to reconcile the past 365 days of 2017. We are sending off a very exciting and tempestuous year. The stock market is at an all-time high. Volatility is at a record low. Consumer spending and confidence have passed pre-recession levels.

I would like to wish all my readers and friends a happy and prosperous 2018. I guarantee you that the coming year will be as electrifying and eventful as the previous one.

 

The new tax plan

The new tax plan is finally here. After heated debates and speculations, president Trump and the GOP achieved their biggest win of 2017. In late December, they introduced the largest tax overhaul in 30 years. The new plan will reduce the corporate tax rate to 21% and add significant deductions to pass-through entities. It is also estimated to add $1.5 trillion to the budget deficit in 10 years before accounting for economic growth.

The impact on the individual taxes, however, remains to be seen. The new law reduces the State and Local Tax (SALT) deductions to $10,000. Also, it limits the deductible mortgage interest for loans up to $750,000 (from $1m). The plan introduces new tax brackets and softens the marriage penalty for couples making less than $500k a year. The exact scale of changes will depend on a blend of factors including marital status, the number of dependents, state of residency, homeownership, employment versus self-employment status. While most people are expected to receive a tax-break, certain families and individuals from high tax states such as New York, New Jersey, Massachusetts, and California may see their taxes higher.

 

Affordable Care Act

The future of Obamacare remains uncertain. The new GOP tax bill removes the individual mandate, which is at the core of the Affordable Care Act. We hope to see a bi-partisan agreement that will address the flaws of ACA and the ever-rising cost of healthcare. However, political battles between republicans and democrats and various fractions can lead to another year of chaos in the healthcare system.

 

Equity Markets

The euphoria around the new corporate tax cuts will continue to drive the markets in 2018. Many US-based firms with domestic revenue will see a boost in their earnings per share due to lower taxes.

We expect the impact of the new tax law to unfold fully in the next two years. However, in the long run, the primary driver for returns will continue to be a robust business model, revenue growth, and a strong balance sheet.

Momentum

Momentum was the king of the markets in 2017. The strategy brought +38% gain in one of its best years ever. While we still believe in the merits of momentum investing, we are expecting more modest returns in 2018.

Value

Value stocks were the big laggard in 2017 with a return of 15%. While their gain is still above average historical rates, it’s substantially lower than other equity strategies.  Value investing tends to come back with a big bang. In the light of the new tax bill, we believe that many value stocks will benefit from the lower corporate rate of 21%. And as S&P 500 P/E continues to hover above historical levels, we could see investors’ attention shifting to stocks with more attractive valuations.

Small Cap

With a return of 14%, small-cap stocks trailed the large and mega-cap stocks by a substantial margin. We think that their performance was negatively impacted by the instability in Washington. As most small-cap stocks derive their revenue domestically, many of them will see a boost in earnings from the lower corporate tax rate and the higher consumer income.

International Stocks

It was the first time since 2012 when International stocks (+25%) outperformed US stocks. After years of sluggish growth, bank crisis, Grexit (which did not happen), Brexit (which will probably happen), quantitative easing, and negative interest rates, the EU region and Japan are finally reporting healthy GDP growth.

It is also the first time in more than a decade that we experienced a coordinated global growth and synchronization between central banks. We hope to continue to see this trend and remain bullish on foreign markets.

Emerging Markets

If you had invested in Emerging Markets 10-years ago, you would have essentially earned zero return on your investments. Unfortunately, the last ten years were a lost decade for EM stocks. We believe that the tide is finally turning. This year emerging markets stocks brought a hefty 30% return and passed the zero mark. With their massive population under 30, growing middle class, and almost 5% annual GDP growth, EM will be the main driver of global consumption.

 

Fixed Income

It was a turbulent year for fixed income markets. The Fed increased its short-term interest rate three times in 2017 and promised to hike it three more times in 2018. The markets, however, did not respond positively to the higher rates. The yield curve continued to flatten in 2017. And inflation remained under the Fed target of 2%.

After a decade of low interest, the consumer and corporate indebtedness has reached record levels. While the Dodd-Frank Act imposed strict regulations on the mortgage market, there are many areas such as student and auto loans that have hit alarming levels. Our concern is that high-interest rates can trigger high default rates in those areas which can subsequently drive down the market.

 

Gold

2017 was the best year for gold since 2010. Gold reported 11% return and reached its lowest volatility in 10 years.  The shiny metal lost its momentum in Q4 as investors and speculators shifted their attention to Bitcoin and other cryptocurrencies. In our view gold continues to be a solid long-term investment with its low correlation to equities and fixed income assets.

 

Real Estate

It was a tough year for REITs and real estate in general. While demand for residential housing continues to climb at a modest pace, the retail-linked real estate is suffering permanent losses due to the bankruptcies of several major retailers. This trend is driven on one side by the growing digital economy and another side by the rising interest rates and the struggle of highly-leveraged retailers to refinance their debt. Many small and mid-size retail chains were acquired by Private Equity firms in the aftermath of the 2008-2009 credit crisis. Those acquisitions were financed with low-interest rate debt, which will gradually start to mature in 2019 and peak in 2023 as the credit market continues to tighten.

Market Outlook December 2017

In the long-run, we expect that most public retail REITs will expand and reposition themselves into the experiential economy by replacing poor performing retailers with restaurants and other forms of entertainment.

On a positive note, we believe that the new tax bill will boost the performance of many US-based real estate and pass-through entities.  Under the new law, investors in pass-through entities will benefit from a further 20% deduction and a shortened depreciation schedule.

 

What to expect in 2018

  • After passing the new tax bill, the Congress will turn its attention to other topics of its agenda – improving infrastructure, and amending entitlements. Further, we will continue to see more congressional budget deficit battles.
  • Talk to your CPA and find out how the new bill will impact your taxes.
  • With markets at a record high, we recommend that you take in some of your capital gains and look into diversifying your portfolio between major asset classes.
  • We might see a rotation into value and small-cap. However, the market is always unpredictable and can remain such for extended periods.
  • We will monitor the Treasury Yield curve. In December 2017 the spread between 10-year and 2-year treasury bonds reached a decade low at 50 bps. While not always a flattening yield has often predicted an upcoming recession.
  • Index and passive investing will continue to dominate as investment talent is evermore scarce. Mega large investment managers like iShares and Vanguard will continue to drop their fees.

 

Happy New Year!

 

Final words

If you have any questions about your existing investment portfolio, reach out to me at stoyan@babylonwealth.com or +925-448-9880.

You can also visit our Insights page where you can find helpful articles and resources on how to make better financial and investment decisions.

About the author:

Stoyan Panayotov, CFA is the founder and CEO of Babylon Wealth Management, a fee-only investment advisory firm based in Walnut Creek, CA. Babylon Wealth Management offers personalized wealth management and financial planning services to individuals and families.  To learn more visit our Private Client Services page here. Additionally, we offer Outsourced Chief Investment Officer services to professional advisors (RIAs), family offices, endowments, defined benefit plans, and other institutional clients. To find out more visit our OCIO page here.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing,

 

6 Saving & Investment Practices All Business Owners Should Follow

6 Saving & Investment Practices All Business Owners Should Follow

In my practice, I often meet with small business owners who have the entire life savings and family fortune tied up to their company. For many of them, their business is the only way out to retirement. With this post, I would like to offer 6 saving & investment practices all business owners should follow.

Having all your eggs in one basket, however, may not be the best way to manage your finances and family fortune. Think about bookstores. If you owned one 20-30 years ago, you probably earned a decent living. Now, bookstores are luxuries even in major cities like New York and San Francisco. Technology, markets, consumer sentiments, and laws change all the time. And that is why it is vital that you build healthy saving and investment routines to grow your wealth, protect your loved ones, and prepare yourself for the years during retirement.

Start Early

I always advise my clients to start saving early and make it a habit. Saving 10-20 percent of your monthly income will help you build and grow your wealth. For instance, by starting with $20,000 today, with an average stock market return of 6 percent, your investments can potentially accumulate to $115,000 in 30 years or even $205,000 in 40 years.

Saving and investing early in your career can build a buffer to correct for any sidesteps or slip-ups. Starting to build your wealth early will provide the necessary protection against market drops and economic recessions and prepare you for large purchases like a new home, college tuition, a new car or even expanding your business.

Build a Safety Net

Life can often be unpredictable in good and bad ways. Having an emergency fund is the best way to guard your wealth and maintain liquidity for your business. I typically recommend keeping 6 to 12 months of basic living expenses in your savings account.

Even though my firm does not offer insurance, I often advise my clients especially those who are sole bread earners or work in industries prone to accidents to consider getting life and disability insurance. Good insurance will guarantee protection and supplemental income for yourself and your loved ones in case of unexpected work or life events.

Manage Your Debt

The last eight years of a friendly interest environment has brought record levels of debt in almost every single category. Americans now owe more than $8.26 trillion in mortgages, $1.14 trillion in auto loans, and $747 billion in credit cards debt. If you are like me, you probably don’t like owing money to anyone.

That’s great, however, taking loans is an essential part of any enterprise. Expanding your business, building a new facility or buying a competitor will often require external financing. Keeping track of your loans and prioritizing on paying off your high-interest debt can save you and your business a lot of money. It may also boost your credit score.

Set-up a Company Retirement Plan

The US Government provides a variety of options for businesses to create retirement plans for both employees and owners. Some of the most popular ones are employer-sponsored 401k, self-employed 401k, profit-sharing, SIMPLE IRA, and SEP IRA.

Having a company retirement plan is an excellent way to save money in the long run. Plan contributions could reduce current taxes and boost your employees’ loyalty and morale.

Of the many alternatives, I am a big supporter of 401(k) plans. Although they are a little more expensive to establish and run, they provide the highest contribution allowance over all other options.

The maximum employee contribution to 401(k) plans for 2017 is $18,000. The employer can match up to $36,000 for a total of $54,000. Individuals over 50 can add a catch-up contribution of $6,000. Also, 401k and other ERISA Plans offer an added benefit. They have the highest protection to creditors.

Even if you already have an up-and-running 401k plan, your job is not done. Have your plan administrator or an independent advisor regularly review your investment options.

I frequently see old 401k plans that have been ignored and forgotten since they were first established. Some of these plans often contain high-fee mutual funds that have consistently underperformed their benchmarks for many consecutive years. I typically recommend replacing some of these funds with low-fee alternatives like index funds and ETFs. Paying low fees will keep more money in your pocket.

Diversify

Many business owners hold a substantial amount of their wealth locked in their business. By doing so, they expose themselves to what we call a concentrated risk. Any economic, legal and market developments that can adversely impact your industry can also hurt your personal wealth.

The best way to protect yourself is by diversification. Investing in uncorrelated assets can decrease the overall risk of your portfolio. A typical diversified portfolio may include large-, mid-, small-cap, and international stocks, real estate, gold, government, and corporate fixed income.

Plan Your Exit

Whether you are planning to transfer your business to the next generation in your family or cash it in, this can have serious tax and legal consequences. Sometimes it pays off to speak to a pro.

Partnering with someone who understands your industry and your particular needs and circumstances, can offer substantial value to your business and build a robust plan to execute your future financial strategy.

 

The article was previously published in HVACR Business Magazine on March 1, 2017

Municipal Bond Investing

Municipal Bond Investing

What is a Municipal Bond?

Municipal bond investing is a popular income choice for many American.  The muni bonds are debt securities issued by municipal authorities like States, Counties, Cities and their related companies. Municipal bonds or “munis” are issued to fund general activities or capital projects like building schools, roads, hospitals and sewer systems. The size of the muni bond market reaches $3.7 trillion dollars. There are about $350 billion dollars of Muni bond issuance available every year.

In order to encourage Americans to invest in Municipal Bonds, US authorities had exempted the interest (coupon income) of the muni bonds from Federal taxes. In some cases when the bondholders reside in the same state where the bond was issued, they can be exempted from state taxes too.

Learn more about our Private Client Services

Types of Municipal Bonds

General obligation bonds are issued by municipal entities to finance various public projects like roads, bridges, and parks. General obligation bonds are backed by the full faith and credit of the issuing municipality.  Usually, they do not have a dedicated revenue source. The local authorities commit their abundant resources to pay off the bonds. Municipals rely on their unlimited power to tax residents to pay back bondholders.

Revenue bonds are backed by income from a particular project or source. There is a wide diversity of types of revenue bonds, each with unique credit characteristics. Municipal entities frequently issue securities on behalf of other borrowers such as water and sewer service, toll bridges, non-profit colleges or hospitals. These underlying borrowers typically agree to repay the issuer, who pays the interest and principal on the securities solely from the revenue provided by the conduit borrower.

Taxable Bonds. There is a smaller but growing niche of taxable municipal bonds. These bonds exist because the federal government will not subsidize the financing of certain activities, which do not provide a significant benefit to the general public. Investor-led housing, local sports facilities, refunding of a refunded issue and borrowing to replenish a municipality’s underfunded pension plan, Build America Bonds (BABs) are types of bond issues that are federally taxable. Taxable municipals offer higher yields comparable to those of other taxable sectors, such as corporate or government agency bonds.

 

Investment and Tax Considerations

Tax Exempt Status

With their tax-exempt status, muni bonds are a powerful tool to optimize your portfolio return on an after-tax basis.

Muni Tax Adjusted Yield

So why certain investors are flocking into buying muni bonds? Let’s have an example:

An individual investor with a 35% tax rate is considering between AA-rated corporate bond offering 4% annual yield and AA-rated municipal bond offering 3% annual yield. All else equal which investment will be more financially attractive?

Since the investors pays 35% on the received interest from the corporate bonds she will pay 1.4% of the 4% yield to taxes (4% x 0.35% = 1.4%) having an effective after-tax interest of 2.6% (4% – 1.4% = 2.6%). In other words, the investor will only be able to take 2.6% of the 4% as the remaining 1.4% will go for taxes. With the muni bond at 3% and no federal taxes, the investor will be better off buying the muni bond.

Another way to make the comparison is by adjusting the muni yield by the tax rate. Here is the formula.

Muni Tax Adjusted Yield = Muni Yield / (1 – tax rate) = 4% / (1 – 0.35%) = 4.615%

The result provides the tax adjusted interest of the muni bond as if it was a regular taxable bond. In this case, the muni bond has 4.615% tax adjusted interest which is higher than the 4% offered by the corporate bond.

 Effective state tax rate

Another consideration for municipal bond investors is the state tax rate. Most in-state municipal bonds are exempt from state taxes while out-of-state bonds are taxable at state tax level. Investors from states with higher state tax rates will be interested in comparing the yields of both in and out-of-state bonds to achieve the highest after-tax net return. Since under federal tax law, taxes paid at the state level are deductible on a federal income tax return, investors should, in fact, consider their effective state tax rate instead of their actual tax rate. The formula is:

Effective state tax rate = State Income Tax rate x (1 – Federal Income Tax Rate)

Example, if an investor resides in a state with 9% state tax and has 35% federal tax rate, what is the effective tax rate:

Effective state tax rate = 9% x (1 – .35) = 5.85%

If that same investor is comparing two in- and out-of-state bonds, all else equal she is more likely to pick the bond with the highest yield on net tax bases.

AMT status

One important consideration when purchasing muni bonds is their Alternative Minimum Tax (AMT) status. Most municipal bond will be AMT-free. However, the interest from private activity bonds, which are issued to fund stadiums, hospitals, and housing projects, is included as part of the AMT calculation. If an investor is subject to AMT, the bond interest income could be taxable at a rate of 28%.

Social Security Benefits

If investors receive Medicare and Social Security benefits, their municipal bond tax-free interest could be subject to taxes. The IRS considers the muni bond interest as part of the “modified adjusted gross income” for determining how much of their Social Security benefits, if any, are taxable. For instance, if a couple earns half of their Social Security benefits plus other income, including tax-exempt muni bond interest, above $44,000 ($34,000 for single filers), up to 85% of their Social Security benefits are taxable.

 

Diversification

Muni bonds are good choice to boost diversification to the investment portfolio.  Historically they have a very low correlation with the other asset classes. Therefore,  municipal bonds returns have observed a smaller impact by developments in the broader stock and bond markets.

For example, municipal bonds’ correlation to the stock market is at 0.03%. Their correlation to the 10-year Treasury is at 0.37%.

 

Interest Rate Risk

Municipal bonds are sensitive to interest rate fluctuations. There is an inverse relationship between bond prices and interest rates. As the rate go up, muni bond prices will go down. And reversely, as the interest rates decline, the bond prices will rise. When you invest in muni bonds, you have to consider your overall interest rate sensitivity and risk tolerance.

Credit Risk

Similar to the corporate world, the municipal bonds and the bond issuers receive a credit rating by the major credit agencies like Moody’s, S&P 500 and Fitch. The credit rating shows the ability of the municipality to pay off the issued debt. The bonds receive a rating between AAA and C with AAA being the highest possible and C the lowest. BBB is the lowest investment grade rating, while all issuance under BBB are known as high-yield or “junk” bonds. The major credit agencies have different methodologies to determine the credit rating of each issuance. However, historically the ratings tend to be similar.

Unlike corporations, which can go bankrupt and disappear, municipals cannot go away. They have to continue serving their constituents. Therefore, many defaults end up with debt restructuring followed by continued debt service. Between 1970 and 2014 there were 95 municipal defaults. The vast majority of them belong to housing and health care projects.

In general, many investors consider municipal debt to be less risky. The historical default rates among municipal issuances is a lot smaller than those for comparable corporate bonds.

 

Limited secondary market

The secondary market for municipal bonds sets a lot of limitations for the individual investor. While institutional investors dominate the primary market, the secondary market for municipal bonds offers limited investment inventory and real-time pricing. Municipal bonds are less liquid than Treasury and corporate bonds. Municipal bond investing tends to be part of a buy and hold strategy as most investors look for their tax-exempt coupon.

Fragmentation

The municipal bond market is very fragmented due to issuances by different states and local authorities. MUB, the largest Municipal ETF holds 2,852 muni bonds with the highest individual bond weight at.45%. Top 5% holdings of the ETF make 1.84% of the total assets under management. For comparison, TLT, 20-year old Treasury ETF, has 32 holdings with the largest individual weight at 8.88%. Top 5% make up 38.14% of the assets under management.

 

 

About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. Hs firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.

 

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing, Copyright: <a href=’https://www.123rf.com/profile_designer491′>designer491 / 123RF Stock Photo</a>

14 Effective ways to take control of your taxes

In this blog post, I will go over several popular and some not so obvious tax deductions and strategies that can help you decrease your annual tax burden. Let’s be honest.  Nobody wants to pay taxes. However, taxes are necessary to pay for pensions, social services, Medicaid, roads, police, law enforcement and so on. Most people will earn a higher income and grow their investments portfolios as their approach retirement. Thus they will gradually move to higher tax brackets and face a higher tax bill at the end of the year. IRS provides many tax deductions and breaks that can help you manage your tax burden. Taking advantage of these tax rules can help you reduce your current or future your tax bill.

These are general rules. I realize that we all face different circumstances. Use them as a broad guideline. Your particular situation may require a second opinion by an accountant, a tax lawyer or an investment advisor.

Learn more about our Private Client Services

 

1. Primary residence mortgage deductions

Buying a first home is a big decision. Your new neighborhood, school district, nearby services are all critical factors you need to consider before making your choice. If you own a primary residence (sorry, a vacation home in Hawaii doesn’t count), you can deduct the interest on your mortgage loan from your taxable income for the year. Your property taxes are also deductible. These incentives are provided by the Federal and state governments to encourage more families to buy their home.

There are two additional benefits of having a mortgage and being a responsible borrower. First, your credit score will increase. Making regular payments on your mortgage (or any loan) improves your credit history, increases your FICO score and boosts your creditworthiness. Your ability to take future loans at a lower rate will significantly improve. Second, your personal equity (wealth) will increase as you pay off your mortgage loan. Your personal equity is a measure of assets minus your liabilities.  Higher equity will boost your credit score. It is also a significant factor in your retirement planning.

Buying a home and applying for a mortgage is a long and tedious process. It requires a lot of legwork and documentation. After the financial crisis in 2008 banks became a lot stricter in their requirements for providing mortgage loans to first buyers. Nevertheless, mortgage interest on a primary residence is one of the biggest tax breaks available to taxpayers.

 

2. Home office deductions

Owning a home versus renting is a dilemma for many young professionals. While paying rent offers flexibility and lower monthly cash payments it doesn’t allow you to deduct your rent from your taxes. Rent is usually the highest expense in your monthly budget. It makes up between 25% and 35% of your total income. The only time you can apply your rent as a tax deduction is if you have a home office.

A home office is a dedicated space in your apartment or house to use for the sole purpose of conduction your private business. It’s usually a separate room, basement or attic designated for your business purposes.

The portion of your office to the total size of your home can be deductible for business purposes. If your office takes 20% of your home, you can deduct 20% of the rent and utility bills for business expense purposes.

 

3. Charitable donations

Monetary and non-monetary contributions to religious, educational or charitable organization approved by IRS are tax deductible. The annual limit is 50% of your AGI (aggregate gross income) for most donations and 30% of AGI for appreciated assets.

Most often people choose to give money. However, you can also donate household items, clothes, cars, and airline miles. The fair value of the donated items decreases your taxable income and therefore will reduce the amount of taxes due to IRS.

Another alternative is giving appreciated assets including stocks and real estate. This is one of the best ways to avoid paying significant capital gain tax on low-cost investments. For one, you are supporting a noble cause. Second, you are not paying taxes for the difference between the market value and purchase cost of your stock. Also, the fair market value of the stock at the time of donation will reduce your taxable income, subject to 30% of AGI rule. If you were to sell your appreciated assets and donate the proceeds to your charity of choice, you would have to pay a capital gain tax on the difference between market value and acquisition cost at the time of sale. However, if you donate the investments directly to the charity, you avoid paying the tax and use the market value of the investment to reduce your taxable income.

 

4. Gifts

Making a gift is not a standard tax deduction. However, making gifts can be a way to manage your future tax payments and pass on the tax bill to family members who pay a lower tax rate. You can give up to $14,000 to any number of people every year without any tax implications. Amounts over $14,000 are subject to the combined gift and estate tax exemption of $5.49 million for 2017.  You can give your child or any person within the annual limits without creating create any tax implications.

Another great opportunity is giving appreciated assets as a gift. If you want to give your children or grandchildren a gift, it is always wise to consider between giving them cash or an appreciated asset directly.  Giving appreciated assets to family members who pay a lower tax rate doesn’t create an immediate tax event. It transfers the tax burden from the higher rate tax giver to the lower tax rate receiver.

 

5. 529 Plans

One of the best examples of how gifts can minimize future tax payments is the 529 college tuition plan. Parents and grandparents can contribute up to $14,000 annually per person, $28,000 per married couple into their child college education fund. The plan even allows a one–time lump sum payment of $70,000 (5 years x $14,000).

529 contributions are not tax deductible on a federal level. However, many states like New York, Massachusetts, Illinois, etc. allow for state tax deductions up to a certain amount. The plan allows your contributions (gifts) to grow tax-free. Withdrawals are also tax-free when using the money to pay qualified college expenses.

 

6. Tax-deferred contributions to 401k, 403b, and IRA

One of my favorite tax deductions is the tax-deferred contribution to 401k and 403b plans. In 2017 the allowed maximum contribution per person is $18,000 plus an additional $6,000 catch-up for investors at age 50 and older. In addition to that, your employer can contribute up to $36,000 for a total annual contribution of $54,000 or $60,000 if you are older than 50.

Most companies offer a matching contribution of 5%-6% of your salary and dollar limit of $4,000 – $5,000. At a very minimum, you should contribute enough to take advantage of your company matching plan. However, I strongly recommend you to set aside the entire allowed annual contribution.

The contributions to your retirement plan are tax deductible. They decrease your taxable income if you use itemized deductions on your tax filing form. Not only that, the investments in your 401k portfolio grow tax-free. You will owe taxes upon withdrawal at your current tax rate at that time.

If you invest $18,000 for 30 years, a total of $540,000 contributions, your portfolio can potentially rise to $1.5m in 30 years at 6% growth rate. You will benefit from the accumulative return on your assets year after year.  Your investments will grow depending on your risk tolerance and asset allocation. You will be able to withdraw your money at once or periodically when you retire.

 

7. Commuter benefits

You are allowed to use tax-free dollars to pay for transit commuting and parking costs through your employer-sponsored program.  For 2017, you can save up to $255 per month per person for transit expenses and up to $255 per month for qualified parking. Qualified parking is defined as parking at or near an employer’s worksite, or at a facility from which employee commutes via transit, vanpool or carpool. You can receive both the transit and parking benefits.

If you regularly commute to work by a bike you are eligible for $20 of tax-free reimbursement per month.

By maximizing the monthly limit for both transportation and parking expenses, your annual cost will be $6,120 ($255*2*12). If you are in the 28% tax bracket, by using the commuter benefits program, you will save $1,714 per year. Your total out of pocket expenses will be $ 4,406 annually and $367 per month.

 

8. Employer-sponsored health insurance premiums

The medical insurance plan sponsored by your employer offers discounted premiums for one or several health plans.  If you are self-employed and not eligible for an employer-sponsored health plan through your spouse or domestic partner, you may be able to deduct your health insurance premiums.  With the rising costs of health care having a health insurance is almost mandatory.  Employer-sponsored health insurance premiums can average between $2,000 for a single person and 5,000 for a family per year. At a 28% tax rate, this is equal to savings between $560 and $1,400. Apart from the tax savings, having a health insurance allows you to have medical services at discounted prices, previously negotiated by your health insurance company. In the case of emergency, the benefits can significantly outweigh the cost of your insurance premium.

 

9. Flexible Spending Account

Flexible Spending Account (FSA) is a special tax-advantaged account where you put money aside to pay for certain out-of-pocket health care costs. You don’t pay taxes on these contributions. This means you will save an amount equal to the taxes you would have paid on the money you set aside. The annual limit per person is $2,600. For a married couple, the amount can double to $5,200. The money in this account can be used for copayments, new glasses, prescription medications and other medical and dental expenses not covered by your insurance.  FSA accounts are arranged and managed by your employer and subtracted from your paycheck.

Let’s assume that you are contributing the full amount of $2,600 per year and your tax rate is 28%. You effectively save $728 from taxes, $2,550 * 28%. Your actual out-of-pocket expense is $1,872.

One drawback of the FSA is that you must use the entire amount in the same tax year. Otherwise, you can lose your savings. Some employers may allow up to 2.5 months of grace period or $500 of rollover in the next year. With that in mind, if you plan for significant medical expenses, medication purchases or surgery, the FSA is a great way to make some savings.

 

10. Health Spending Account

A health savings account (HSA) is a tax-exempt medical savings account available to taxpayers who are enrolled in a high-deductible health plan (HDHP) The funds contributed to this account are not subject to federal income tax at the time of deposit. Unlike a flexible spending account (FSA), HSA funds roll over and accumulate year over year if not spent. HSA owners can use the funds to pay for qualified medical expenses at any time without tax liability or penalty. The annual contribution limits are $3,350 per person, $6,750 per family and an additional $1,000 if 55 or older. The owner of HSA can invest the funds similarly to IRA account and withdraw without penalty when used for medical expenses.

 

11. Disability  insurance

Disability premiums are generally not deductible from your tax return. They are paid with after-tax dollars. Therefore, any proceeds received as a result of disability are tax-free. The only time your benefits are taxable is when your employer pays your disability insurance and does not include it in your gross income.


12. Life insurance

Life insurance premiums are typically not deductible from your tax return if you are using after-tax dollars. Therefore, any proceeds received by your beneficiaries are tax-free.

Life insurance benefits can be tax deductible under an employer-provided group term life insurance plan. In that case, the company pays fully or partially life insurance premiums for its employees.  In that scenario, amounts more than $50,000 paid by your employer will trigger a taxable income for the “economic value” of the coverage provided to you.

If you are the owner of your insurance policy, you should make sure your life insurance policy won’t have an impact on your estate’s tax liability. In order to avoid having your life insurance policy affecting your taxes, you can either transfer the policy to someone else or put it into a trust.

13. Student Loan interest

If you have student loans and you can deduct up to $2,500 of loan interest.  To use this deduction, you must earn up to $80,000 for a single person or $165,000 for a couple filing jointly. This rule includes you,  your spouse or a dependent. You must use the loan money for qualified education expenses such as tuition and fees, room and board, books, supplies, and equipment and other necessary expenses (such as transportation)

14. Accounting and Investment advice expenses

You may deduct your investment advisory fees associated with your taxable account on your tax return.  You can list them on Schedule A under the section “Job Expenses and Certain Miscellaneous Deductions.” Other expenditures in this category are unreimbursed employee expenses, tax preparation fees, safe deposit boxes and other qualifying expenses like professional dues, required uniforms, subscriptions to professional journals, safety equipment, tools, and supplies. They may also include the business use of part of your home and certain educational expenses. Investment advisory fees are a part of the miscellaneous deduction.  The entire category is tax deductible if they exceed 2% of your adjusted gross income for the amount in excess.

 

About the Author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing,  Image Copyright: www.123rf.com

Incentive Stock Options

Incentive Stock Options

What is an Incentive Stock Option?

Incentive stock options (ISOs) are a type of equity compensation used by companies to reward and retain their employees. ISOs have more favorable tax treatment than non-qualified stock options. While similar to NQSOs, they have a few major differences:

  • ISOs are only granted to company employees.
  • They can only be vested for up to $100,000 of underlying stock value each year
  • ISO must expire after ten years
  • They are not transferrable
  • Long-term capital gain tax is due on the difference between the selling price and exercise price under certain conditions. To receive this tax benefit, ISO holder has to keep the stock for one year and one day after the exercise date and at least two years and one day from the grant date.
  • If the sale date does not meet the above requirements, ISO is disqualified as such and treated as NSO. In that case, you will owe ordinary income tax and short / long-term capital gain taxes
  • Options granted to shareholders with 10% or more ownership must be priced at least at 110% of the Fair Market Value and not be vested for five years from the date of the grant.
  • Alternative Minimum Tax is applicable on the difference between market price and exercise price in the year of exercise. You have to report the difference (also known as the bargain element) to IRS. This may have an impact on your final tax at the end of the year, depending on various other deductions.

Key dates

if you own ISOs, you need to keep track of these important dates:

Grant Date – the date when the options were awarded to you
Vesting Date – the date from when the options can be exercised
Exercise Date – the date when the options are actually exercised
Expiration Date – the date after which the options can no longer be exercised

Important price levels

In addition, you also need to keep a record of the following prices:

Exercise price or strike price – the value at which you can buy the options
Market price at exercise date – the stock value on the exercise date
Sell price – stock value when held and sold after the exercise date
Bargain element – the difference between market price and exercise price at the time of exercise

Tax Considerations of Incentive Stock Options

The granting event of ISOs does not trigger taxes. Receivers of incentive stock options do not have to pay taxes upon their receipt.

Taxes are not due on the vesting date, either. The vesting date opens a window for up to 10 years by which you will be allowed to exercise the ISO.

ISO exercise is not a tax event from the IRS perspective if you meet the holding period requirements by selling your stock after one year and a day after exercise and two years and a day after the grant date. Depending on when you sell the stock after the exercise date, six main scenarios can occur:

Scenario 1

You exercise your options and keep them. No tax due; however, you will have to make an adjustment for Alternative Minimum Tax for the amount of your bargain element.

Example: Let’s assume that you are granted ISO equal to 1,000 shares at the exercise price of $10. Your tax rate is 25%. On the exercise date, you exercise the options and decide to keep the shares indefinitely. The market price on that day is $15.

You are not required to report any additional ordinary income.

However, you must adjust your AMT for $5,000.

(15 – 10) x 1,000 = $5,000.

Scenario 2

You exercise your options and sell them in the same year, less than 12 months from the exercise date. This disqualifies your ISO and converts it to NSO. You will have to report ordinary income on your bargain element and short-term capital gain or loss taxes on the difference between the selling price and the market price at the exercise date. You do not need to adjust for AMT if you sell your ISO within the same calendar year.

Example: Let’s assume that you are granted ISO equal to 1,000 shares at an exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for three months in the same calendar when the price goes up to $18 and then sell all your shares.

You are required to report your bargain element of $5,000 as an additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25%, you will owe an additional $1,250 for taxes on $5,000 of extra income.

$5,000 x 25% = $1,250

You will also owe $750 on your $3,000 of short-term capital gains at your ordinary income level (See my posting about short and long term capital gains and losses)

(18 – 15) x 1,000 = $3,000

$3,000 x 25% = $750

Your total due to IRS will be $2,000

No AMT adjustment is due since you sold your shares in the same calendar year.

Scenario 3

You exercise your options and sell them in the next year, but less than 12 months from the exercise date. Your selling price is less than the market price at exercise. Since you sell less than a year after the exercise, your ISO is disqualified. Because your selling price is lower, IRS allows you to adjust your bargain element to the lower price

Example: Let’s assume that you are granted 1,000 shares at the exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for five months until the next calendar year when the price drops to $12 and then sell all your shares.

Your original bargain element is $5,000

(15 – 10) x 1,000 = $5,000.

Since the price dropped from $15 to $12, you are allowed to adjust down your bargain element to $2,000 and add it as additional ordinary income.

(12 – 10) x 1,000 = $2,000.

Since your tax rate is 25%, you will owe an additional $500 for taxes on $2,000 of extra income.

$2,000 x 25% = $500

Your total due to IRS will be $500.

You will also have to report an adjustment of -$3,000 ([12 – 15] x 1,000) for AMT in the new calendar year. This will “modify” your prior year AMT adjustment, which was equal to the original bargain element of $5,000.

Scenario 4

You exercise your options and sell them in the next year, but less than 12 months from the exercise date. Your sell price is higher than the market price at exercise. Since you sell less than a year after exercise, your ISO is disqualified.

Example: Let’s assume that you are granted ISO equal to 1,000 shares at an exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for 11 months in the next year…when the price goes up to $18 and then sell all your shares. Since you sold the shares before the 24-month mark, ISO shares are disqualified.

You are required to report your bargain element of $5,000 as an additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25%, you will owe an additional $1,250 for taxes on $5,000 of extra income.

$5,000 x 25% = $1,250

You will also owe $750 on your $3,000 of short-term capital gains at your ordinary income level (See my posting about short and long term capital gains and losses)

(18 – 15) x 1,000 = $3,000

$3,000 x 25% = $750

Your total due to IRS will be $2,000

 

You will also have to report an adjustment of $3,000 ([18 – 15] x 1,000) for AMT in the new calendar year. This will “modify” your prior year AMT adjustment, which was equal to the original bargain element of $5,000.

Scenario 5

You exercise your options and sell them after one year from the exercise date, but less than 24 months from the grant date. Since you sell less than two years after the grant date, your ISO is disqualified.

You will owe ordinary income and long-term capital gain taxes. Your total due to IRS will be $1,700

Example: Let’s assume that you are granted ISO equal to 1,000 shares at an exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for 18 months in the next year when the price goes up to $18 and then sell all your shares. Since you sold the shares before the 24-month mark, ISO shares are disqualified.

You are required to report your bargain element of $5,000 as an additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25%, you will owe an additional $1,250 for taxes on $5,000 of extra income.

$5,000 x 25% = $1,250

You will also owe $750 on your $3,000 of short-term capital gains at your ordinary income level (See my posting about short and long term capital gains and losses)

(18 – 15) x 1,000 = $3,000

$3,000 x 15% = $450

Your total due to IRS will be $1,700

You will also have to report an adjustment of $3,000 ([18 – 15] x 1,000) for AMT in the new calendar year. This will “modify” your prior year AMT adjustment, which was equal to the original bargain element of $5,000.

Scenario 6 

You exercise your options and sell them after one year from the exercise date, and after 24 months from the grant date. Since you meet the requirements for ISO, your sale is qualified.

Example: Let’s assume that you are granted ISO equal to 1,000 shares at an exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for twelve months after the exercise date and 24 months after the grant date when the price goes up to $18 and then sell all your shares.

You are allowed to report $8,000 of long term capital gain.

(18 – 10) x 1,000 = $8,000.

You will also owe $1,250 on your $8,000 of long-term capital gains at either 0, 15%, or 20%. Most people will have to pay 15% (See my posting about short and long term capital gains and losses)

$8,000 x 15% = $1,250

Your total due to IRS will be $1,250.

You will also have to report an adjustment of $3,000 ([18 – 15] x 1,000) for AMT in the new calendar year. This will “modify” your prior year AMT adjustment, which was equal to the original bargain element of $5,000.

How to minimize the tax impact of Incentive Stock Options?

  1. Meet the holding period requirements for one year after exercise and two years after the grant date. This will give you the most favorable tax treatment.
  2. Watch your tax bracket. Your tax rate increases as your income grow. Depending on the vesting and expiry conditions, you may want to consider exercising your options in phases to avoid crossing over the higher tax bracket. Keep in mind that tax brackets are adjusted every year for inflation and cost of living.
  3. AMT breakeven – you can exercise just the right number of shares to remain below the AMT tax level. Most accounting software will be able to calculate the exact amount.
  4. Use AMT credits when applicable. In the years when you pay AMT, you can rollover the difference between your AMT and regular tax due as a credit for futures years. The caveat is that AMT credit can only be used in the years when you pay regular taxes.
  5. You can donate or give as a gift your low-cost base stocks acquired through the exercise of ESO. You have to follow the holding period requirement to get the most favorable tax treatment.