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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.

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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.

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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 balance of $1 million or more. 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.

There are many variables that 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 earning generating more earnings over time. The longer you wait, the larger the amount 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 off 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, 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 $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 to my clients replacing 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 the financial crisis of 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 the 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.

Reach out

If you need help growing your 401k savings, or learn how to manage your 401k investments, 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 and successful business owners.

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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.

Wealth sources

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.

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 and successful business owners.

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Why you need a Roth IRA

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 $122,000 or less in 2019, 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 $193,000.

There is a phaseout amount between $122,000 and $137,000 for single filers and $193,000 and $203,000 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.

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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.

 
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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.

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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