Thursday, July 10, 2014

How Much of Your Social Security Benefit is Actually Taxed?

If Social Security is your only source of income, it is unlikely that your monthly benefit is subject to taxation. However, people with substantial income outside of Social Security may have to pay federal income taxes on their benefits. In fact, it is possible that as much as 85 percent of your Social Security payout is taxable.

To determine whether you are required to pay taxes on your benefit, the first step is to determine what the federal government deems your “combined income.” Your “combined income” is one-half of your Social Security benefit, plus all other income received during the year. Other income might include wages earned, capital gains recognized, dividends and interest collected, pension benefits received, and IRA funds distributed during the year.

For instance, consider a retired couple that receives an annual pension benefit of $20,000, takes an IRA distribution in the amount of $10,000, and receives $15,000 in Social Security benefits. This couple’s other income would total $30,000 (the pension and the IRA distribution). One-half of the Social Security benefit, or $7,500 would then be added to the other income to create a “combined income” of $37,500.

If a couple filing a joint tax return has a “combined income” of less than $32,000 ($25,000 for individuals), then all Social Security benefits are free of taxation. However, if the figure is between $32,000 and $44,000 ($25,000 and $34,000 for individuals), then as much as 50 percent of the Social Security benefit may be taxable. Further, if the “combined income” is greater than $44,000 ($34,000 for individuals), than as much as 85 percent of the Social Security payout may be taxable.

So should couples do everything necessary to keep their “combined income” below $32,000 (the 50 percent threshold), or even $44,000 (the 85 percent threshold)? Fortunately, the tax system is progressive, meaning that just because a couple might fall in the bracket causing as much as 50 percent of their Social Security benefit to be taxable, not all of their benefit is necessarily taxed as such. 

For example, our sample couple with a “combined income” of $37,500 might be concerned that they are paying taxes on 50 percent of their Social Security benefit because that is the bracket they fall in. This would cause half of their $15,000 Social Security benefit, or $7,500, to be taxable. Fortunately, it is only the $5,500 of benefits received that pushes the couple’s “combined income” over and above the $32,000 threshold that is actually considered 50 percent taxable. As a result, only $2,750 (half of the $5,500 of “combined income” over the $32,000 threshold) of Social Security benefits is taxable. In this instance, the taxpayers are only paying taxes on 18 percent ($2,750/$15,000) of their Social Security benefits.

Now suppose our imaginary couple received not $15,000 in total Social Security benefits, but $15,000 each, leading to a total benefit of $30,000. Assuming the same $20,000 pension benefit and $10,000 IRA distribution, the couple’s “combined income” would now be $45,000 (half of the $30,000 in Social Security benefits received plus the $30,000 of other income). 

This provides another illustration of how the progressive tax system prevents higher-income taxpayers from feeling the need to do everything they can to get their “combined income” under the $44,000 threshold just to avoid the 85 percent bracket. First, a “combined income” of $45,000 clearly fills the entire 50 percent bracket of $32,000 - $44,000. Consequently, the entire $12,000 of Social Security benefits received within that range will be 50 percent taxable (or $6,000 of benefits received will be taxable). Additionally, another $1,000 of benefits over and above the $44,000 threshold will be 85 percent taxable, meaning another $850 of benefits are taxed. This means a total of $6,850 ($6,000 from the 50 percent taxable bracket, and $850 from the 85 percent taxable bracket) of Social Security benefits received will be taxable. Still, however, of the $30,000 of Social Security payments received by our couple, only 23 percent ($6,850/$30,000) ends up being taxable.

Taking this one step further, we can deduce that income outside of a Social Security benefit (the combination of pension benefits, IRA distributions, capital gains, etc) must be greater than $44,000 for there to even be a possibility that as much as 85% of a Social Security benefit would be taxable. If this other income portion of the “combined income” is less than $44,000, then at least some of our Social Security benefit will fall in the 50 percent threshold, if not the 0 percent threshold.

Here is a useful calculator to determine the taxability of your Social Security benefit.

The point of this exercise is twofold. First, understanding the factors that may cause a Social Security benefit to be more or less taxable provides us with an advantage from a financial planning perspective. Second, it is important to realize that just because our “combined income” passes a threshold causing some of our Social Security benefit to be taxable doesn’t mean that the resulting tax liability is catastrophic. In fact, once realizing that the increase in tax liability from having some additional income is so inconsequential, some retirees may be more likely to spend and enjoy their retirement, which is the point of financial planning in the first place.

2014 Market Review: What Do We Know?

If you pay close enough attention to the news media you'll eventually learn that much emphasis is placed on pundits' forecasts, but very little consideration is given to how accurate the projections turn out. When 2014 started, there were some pretty widely-accepted expectations regarding the investment environment. Let’s take a minute to review those anticipations and analyze how precise they turned out to be.

One of the most universally accepted beliefs going into 2014 was that interest rates were on the cusp of rising, and that consequently, bond returns would drop. (Of course, this has been the expectation for around five years now, but that is a discussion for a later time.) Investors were questioning whether they should reduce or eliminate the bond portion of their portfolios until the rate increase occurred.

So have we experienced the rise in interest rates we were expecting? On 1/2/14, the yield on the 10-year Treasury note was 3%. As of 6/30/14, the yield on the same note was 2.516%. That's right -- interest rates have actually decreased over the last six months. Did those who stuck with their investment strategies and maintained their bond positions experience a decline in their portfolio's value? Here is how a variation of different bonds have performed year-to-date (as of 6/30/14):
  • US Government Bonds (IEF): 4.89%
  • US TIPS (TIP): 5.25%
  • Corporate Bonds (LQD): 5.37%
  • International Bonds (IGOV): 5.66%
  • Emerging Market Bonds (LEMB): 6.42%
How about the equities side of the portfolio? In January, predictions for stocks were all over the map -- some predicted a full out correction (a loss of more than -20%), some predicted that we would keep chugging along at 2013's pace, and most predicted something somewhere in between. There were, however, many factors that were a common cause of concern.

The most widely accept fear among equity investors was the phasing out of the Fed's Quantitative Easing (QE) program. Investors worried that the Fed would begin lowering the amount of loans the government would buy from commercial banks each month, which would lower the availability of capital in the economy. Historically, less money in the system leads to less investing in new businesses, less innovation, and fewer jobs created.

So was the reduction of the Fed's Quantitative Easing a legitimate fear? In fact, this possibility has come to fruition. In December, the Fed was buying $85 billion per month of financial assets from commercial banks and other private institutions. The Fed has reduced this monthly amount during every meeting it has held this year, and that amount is now down to $35 billion per month. However, the key question is what impact has this had on the stock market. Here is how a wide basket of equities have performed year-to-date (as of 6/30/14):
  • Large Cap Stocks (IVV): 7.08%
  • Mid Cap Stocks (IJH): 7.57%
  • Small Cap Stocks (IJR): 3.30%
  • Foreign Stocks (IEFA): 4.34%
  • Emerging Markets (IEMG): 4.70%
  • Real Estate (IYR): 16.09%
  • Commodities (DJP): 7.32%
  • Gold (GLD): 10.27%
The last widely-held viewpoint at the beginning of the year was that 2014 was likely to be a year more volatile than anything we had experience in 2012 or 2013. There was a lot of clatter about valuations and PE ratios being too high, concern about the war in Ukraine, a consensus that China was about to experience a drastic decline in both imports and exports, and a general feeling that the market was due for a significant (if not healthy) pullback. Additionally, how much have we heard about unfavorable weather patterns over the last six months?

So has 2014 been a wild ride? The S&P 500 dropped by -5.51% from 1/22/14 - 2/03/14, and by -3.89% from 4/2/14 - 4/11/14. These are the only declines of more than 2% that the S&P 500 has experienced all year! Additionally, as of 6/30/14, the S&P 500 has now gone 54 consecutive trading days without an up or down move of greater than 1%, the longest stretch since 1995! By historical standards, 2014 is considered to be a very smooth ride.

The most significant lesson inherent in these numbers is that market expectations are essentially useless. Near the beginning of the year, the vast majority of experts anticipated interest rates to rise, bond values to drop, and volatility to increase. Unfortunately, pundits making projections are rarely held to their inaccurate forecasts and are allowed to continue making a living showing they have no greater knowledge than the average investor.

Of course, this is not to say that interest rates will never rise, that bond values will never decline, and that the market won't return to the roller coaster it is. In fact, all those things are certain to happen. Unfortunately, anyone who contends to know the uncertain part of this equation -- when -- likely doesn't actually know anymore than you or me. For this reason, having and sticking to a diversified investment strategy that coincides with a detailed financial plan is the most likely path to financial success.

Monday, June 2, 2014

The Smartest Things Said at the NAPFA Conference

Last month, over 300 fee-only financial planners gathered for NAPFA’s annual conference to hear the latest thinking on behavioral finance, investment management, health care, and more.  Here are a few of the smartest things said at the conference.

Speaker: Nick Murray, Author of Behavioral Investment Counseling
  • Ten thousand people retire every day and will continue to do so for the next 12 years.
  • According to the Annuity Mortality Table published by the Society of Actuaries, the last surviving spouse of a 62-year-old non-smoking couple will pass at age 92.
  • The dominant determinate of long-term real life investment outcomes is not investment returns but investment behavior.
  • The average retirement age is 62. The parents of these retirees were born between 1928 and 1932. Humans inherit our behaviors from our parents. Consequently, it is natural for retirees to be afraid of the market because their parents were afraid of stocks after growing up during the worst market collapse in history.
  • Neither investors nor financial advisors can control the economy, markets, or future investment performance. The only thing we can control is our behavior. Successful investors maintain and stick to a plan. Unsuccessful investors react to market movements.
  • The S&P 500 index recently obtained the level of 1,900 for the first time. When a 62-year-old retiree was born in 1952 the S&P was at 24.
  • A financial advisor’s pledge should be to keep clients from turning temporary losses into permanent losses. The most common way investors can lose money over time is if they panic. Selling makes losses permanent.
  • The four word death sentence of investors: “It is different this time.” The four word solution, which always trumps the death sentence: “This too shall pass.”
  • Inflation, the villain in the retirement story, has 3% written on its chest. The retiree superhero has a shield with 10% and a spear with 12% written on them (long-term returns of large and small cap stocks, respectively). Stocks must always be a significant portion of the retiree’s portfolio.
Speaker: Jim Otar, Author of Unveiling the Retirement Myth
  • If your withdrawal rate is less than 3% when you retire, you are not likely to outlive your money.
  • If your withdrawal rate is over 3% when you retire, luck will be the most important factor determining the success of your retirement. Inflation rates and the sequence of returns (whether the market does well or poorly in the early stages of retirement) will determine whether your funds last.
  • If your withdrawal rate is over 4%, your portfolio is not likely to increase in value over time.
  • A formula for calculating the number of years your portfolio will last given a 5% withdrawal rate: 4 + (360 / Market PE Ratio). For example, the market currently has a PE Ratio of about 25, so a 5% withdrawal rate would enable your portfolio to last for 18.4 years [4 + (360 / 25)].
  • If you have less money four years into retirement, chances are high you will outlive your money if you maintain the same pace of spending.
Speaker: Alan Blaustein, Co-Founder of and OpenSky
  • The Freedom of Information Act allows consumers to shop around for cost effective health care.
  • A lower joint replacement at Las Colinas in Irving, Texas, costs $160,832. The same procedure costs $42,633 at Baylor hospital. These hospitals are five miles apart.
  • Previously, 25% of doctors collected 75% of Medicare payments. Until recently, no one knew these doctors were significantly more expensive than their peers.
  • There is now a national marketplace for healthcare. It now makes sense to collect bids from hospitals across the country when requiring a major procedure.

Wednesday, May 21, 2014

Why I HATE Non-Publicly Traded REITs

As my experience in the financial planning and investment advisory industries has grown over the years, there is one investment that I've seen no logical reason to own -- non-publicly traded real estate investment trusts (REITs).

Josh Brown, one of my favorite analysts and author of nailed each of my frustrations with these products. Here is a significant excerpt from his post:

I consider non-traded REITs or nREITS to be part of the group of investments that are just absolute murderholes for clients – they pay the brokers so much that they cannot possibly work out (and they rarely do without all kinds of aggravation and additional costs).

Further, I have yet to hear a single credible explanation as to why a broker would recommend a non-traded REIT over a public REIT other than compensation. The only explanation that makes sense to me is that 7% is a lot more than the 1% commission you get doing an agency trade on a NYSE-traded REIT.

A reader with experience in the industry sent this to me and I found it hilarious. Below, a fictional, transparent conversation between an indie broker and his “client” that would never occur…

If Independent Brokers Were Transparent:


Before we wrap up our quarterly portfolio review I would like to talk to you about a new investment I think you might be interested in.  You have been looking for more income and this is an investment vehicle that pays a 7% dividend.


Sounds great, give me the details.


With your portfolio size and risk tolerance I would recommend a $100,000 investment.  Given that amount let’s first go over the fees. If you invest $100,000 I will be paid a commission of $7,000. My firm is going to get $1,500 – $2,000 in revenue share. My wholesaler, the salesman that works for the investment’s sponsor company, will get $1,000. He is a great guy, buys me dinner all of the time and takes me golfing. The sponsor company is going to get around $3,000 to pay for some of the costs they incurred in setting up the investment. So after Day 1 there will be around $87,000 left over to actually invest.  I bet you are getting excited.


Are you on drugs? Why would I pay 13% in fees on anything?


Don’t worry, it won’t feel like you are paying $13,000 in fees. The rules allow my firm to report your investment at $100,000 on your statement. You never really know what its worth but you will think you never lost money. Pretty sweet huh?


You have to be kidding.


No, this is a really good investment. Let me tell you about the income component before you jump to any conclusions. Like I said this investment pays a 7% dividend and the dividend won’t change.


That sounds high and how do you know it won’t change?


You see, the sponsor just picks the 7% dividend number out of thin air. Here’s how it works. You see the vehicle you are going to invest in is new and it’s going to take the firm a while before your net $87,000 is actually invested. Later on, maybe 2-4 years from now they will have the money fully invested and it will generate actual cash flow. So they just pay a quarterly dividend of 7% by giving you your money back.  This is great from a tax perspective because return of capital isn’t taxed as income.


Are we on hidden camera or something?


Ha, you are funny. I bet this next benefit will change your mind.


I hope so or I should start looking for another financial advisor.


This is the best feature. You can’t sell your investment until the sponsor has the opportunity to create liquidity. You might be locked up in this investment for 7-10 years.


This feels like the Twilight Zone. Your firm allows you to sell this crap?


Oh yeah, our firm sells a ton of it. In fact independent broker dealer firms like mine sold over $20 billion of these investments in 2013. Think about that. Reps like me made over $140 million dollars and our firms pocketed $20-$30 million.


This is crazy, what is this investment?


Non-traded REITs. $100,000 sound about right?

Josh touched on every part of these investments that I despise -- excessive commission paid to the so-called "financial advisor" (salesman), a supposed "dividend" that is really just paying the investor his own money back (essentially providing an interest-free loan), and a complete lack of liquidity and transparency.

When I begin working with a new client who owns one of these products, it is impossible to obtain accurate, current information on the investment (not even a true value is apparent). Even worse, if the client wants to sell the investment he would need to do so at pennies on the dollar. For the most part, once an investor purchases one of these products he just need to forget about it and hope that one day he can get his money back.

The bottom line is that if your advisor ever recommends a non-publicly traded REIT, I'd strongly recommend you walk out the door and start searching for a true financial advisor with a fiduciary responsibility to act in your best interest.

View Josh's post in full here.

Monday, April 14, 2014

Know Your Marginal Tax Bracket

In 2014, the federal tax brackets are 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%. For a taxpayer who is married and files jointly, regardless of how much the household makes, the first $18,150 of income after accounting for deductions and exemptions will only be taxed at the 10% rate. Similarly, any income the household makes that is more than $18,150 but less than $73,800 is taxed at the 15% rate. At that point, the next $75,050 is taxed at 25%, and so on. Consequently, not all income a household makes during the course of the year is taxed at the same rate. A marginal tax bracket is the tax rate that applies to the last dollar the household made.

It is crucial for all taxpayers to know their marginal tax rate. This information can help a client identify which type of investment accounts fits their situation best, how to structure an investment portfolio, and how to determine the value of certain deductions when filing their tax return.

Roth or Traditional Retirement Accounts

Contributions to traditional retirement accounts like IRAs and 401(k)s allow taxpayers to avoid recognizing income earned during the tax year and push the need to acknowledge the revenue into a future year.  This is valuable because many people are in a higher tax bracket during their working years than they are during retirement. For instance, for a person who is currently in the 25% marginal tax bracket, it may be advantageous to delay recognizing the income until the investor retires and has less income, causing him to be in only the 15% marginal tax bracket. Doing this would enable the taxpayer to avoid paying taxes at 25% and allow him to pay taxes at only 15%.

Alternatively, a Roth IRA or Roth 401(k) allows an investor to pay taxes on contributed income during the year it was earned but the money then grows tax-free. Consequently, a Roth retirement account is great for someone who believes they may be in a higher marginal tax bracket in the future. For example, a young employee in the early stages of his career who is in the 15% tax bracket but believes he may be in the 25% or 28% bracket in the future would benefit from paying all taxes on the income at his current rate of 15% and then getting tax-free investment growth. This would prevent the investor from having to pay the higher future tax rate of 25% or 28% on the invested dollars.

Knowing your marginal tax bracket can help you determine if you would favor paying taxes on your invested dollars at your current tax rate or if you believe you may benefit from pushing the need to recognize the income into a future tax year. This is a critical decision when planning for retirement and it can't accurately be made without knowing your marginal tax rate.

Capital Gains Rate

A long term capital gains tax rate is the rate that applies to the growth of any asset held for longer than a year that is not within a tax-advantaged account. If you buy stock outside a tax-advantaged account, or purchase investment property, any growth in the value of the investment will be taxed as capital gains when sold.

An investor's capital gains tax rate is determined by the investor's marginal tax rate. For most taxpayers the long term capital gains tax rate is 15%. However, if a taxpayer is in the 10% or 15% marginal tax bracket, the long term capital gains tax rate is an amazing 0%! Additionally, many taxpayers in either the 35% or 39.6% tax bracket may end up paying capital gains at a rate of 20%.

Clearly, knowing your marginal tax bracket will help you analyze the appeal of making investments outside of tax-advantaged accounts. People who qualify for the 0% capital gains tax should actively search for ways to take advantage of this benefit.

Additionally, knowing your marginal tax rate can help you determine the best time to recognize long-term capital gains. If your marginal tax rate will be 25% in 2014 -- leading to a capital gains tax rate of 15% -- but you believe your marginal rate will be 15% in 2015 -- leading to a capital gains tax rate of 0% -- it would save you money and lower your tax bill to defer recognizing long-term capitals gains until next year.


Annuities are promoted as a way for invested dollars to obtain tax-deferred growth. However, when money is withdrawn from an annuity it is taxed at the investor's marginal tax rate as opposed to his long term capital gains tax rate. Knowing your marginal tax bracket can help determine whether an annuity adds any value to your portfolio, or whether it could actually be detrimental.

Suppose an investor is in the 15% marginal tax bracket. If this person invests in an annuity, he will avoid paying taxes on any of the investment's growth until the funds are withdrawn from the annuity. However, at that point the investment's growth will be taxed at the taxpayer's marginal income tax bracket of 15%. Alternatively, if this same investor utilized a taxable investment account rather than an annuity, the investment's growth would be taxed at the investor's capital gains tax rate of 0%. In this case, investing in an annuity actually created a tax bill for this investor!

Clearly, knowing your marginal tax rate and your resulting capital gains tax rate can help you determine the best type of investment accounts for your personal situation.

Itemized Deductions

The value of your itemized deductions is essentially determined by your marginal tax bracket. For a simplified example, consider a taxpayer who could generate an additional $10,000 of deductions. Doing so would mean the individual would pay taxes on $10,000 of income less than he would without the deduction. If the individual is in the 15% tax bracket, generating the deduction would lower the person's tax bill by $1,500 dollars ($10,000 x 15%). However, if the individual is in the 25% tax bracket, the same deduction would lower the person's tax bill by $2,500 ($10,000 x 25%).

Consequently, knowing your marginal tax bracket can help determine when large itemized deductions should be taken. If you would like to donate funds to your favorite charitable institution, knowing which year you will be in the highest marginal tax bracket can help you determine the best time to make the contribution.

Marginal Tax Rates Change

Many people's income is relatively constant year-after-year. For these people, there may not be much fluctuation in their marginal tax bracket. However, any time you have a significant increase or decrease in income recognized during a year, your marginal tax rate may change. Whenever possible, it is best to anticipate how your current marginal tax rate might compare to your future marginal tax rate. This is another strong factor that can impact all the key financial decisions effected by your marginal tax rate.