When we are young it is difficult to peer into the future 20, 30, 40 or more years and imagine needing physical assistance with some of the basic activities of daily living such as dressing or feeding ourselves. The reality of the matter is that many of us will need assistance at some point in our lives, and as medical advances contribute to longer life spans it becomes even more likely that we will need at least some help at some point in our lives. Planning for this stage of life is becoming more complicated as many insurers who provide long-term care insurance policies have recently exited this market.
The inspiration for this post came from an article that a client sent to me recently. The article discusses how Prudential, the Unum Group, and MetLife have all exited the long-term care insurance market. (Prudential will still sell group plans.) Many other carriers have raised their premiums so much that they have effectively exited the market as well. Several years ago John Hancock dominated this market and was the carrier of choice for myself and many of our clients. Now, Hancock does not even make the list of carriers that my agent will put on the quote when one my clients is considering a new policy.
How do the changes impact you? When someone reaches the decision to purchase long-term care insurance (see my Jan. 2011 post here) they now have fewer choices. Fewer choices almost certainly means higher premiums.
Another change that is occurring is that insurers who are still in the market have dramatically tightened their underwriting standards. I am increasingly finding that people under the age of 60 are being denied this insurance for a variety of health-related issues. I was interviewed this week by a journalist and was asked when people should consider the purchase of long-term care insurance. My answer was that as soon as someone has enough assets that they need protection for other family members. That means that regardless of your age (yes, even those under age 40!) should be thinking about this type of insurance. If you are waiting until you are in your 50’s in may be too late, and quite expensive.
A great long-term retirement plan includes planning for the stage of life where we could use some help. No matter how great your investment portfolio performs, the risks associated with needing long-term care can be quite significant. If you have not thought about these issues, I urge you to give them some consideration.
There is a new study that illustrates how Social Security claiming decisions impacts the longevity of a financial portfolio. As many of our clients know, I have been preaching the benefits of delayed Social Security benefits. This study reaches two important conclusions:
First, the decision to delay Social Security benefits can increase the longevity of the portfolio by as much as 10 or more years. The authors conclude that the greatest benefit is derived from those with portfolios of less than $1,000,000. (There is still a benefit of delay for those with larger portfolios it just that the impact is not quite as strong at higher levels of wealth.)
An important takeaway is for those who claim that they ‘cannot afford’ to delay their benefit. The authors held real spending constant and have shown that the delay is greatest for those with lower levels of wealth. I would argue that they cannot afford to claim benefits early!
The second important conclusion is that retirees can actual increase their real annual spending by delaying Social Security. If one recognizes that the decision to delay increases total expected lifetime benefits, it would seem to reason that one could spend more. Another aspect of this has to do with how Social Security benefits are taxed. If one is drawing down their retirement assets while they delay, they will need less of these assets starting at age 70 since they will be receiving a much larger benefit. For many folks, much of their Social Security will not be taxed with these lower required distributions from their financial portfolio.
Furthermore, the authors assume that the investor is drawing down funds from a pre-tax account (401k or IRA). What if the investor has assets in a non-retirement account that could be tapped while they delay? Since these assets are likely to be taxed at a much lower rate (capital gains for example), there are many strategies that could have other benefits such as converting IRA assets to Roth assets which would further lower required minimum distributions at age 70.5.
Finally, what about those who worry that Social Security is going broke? While I do agree that changes will have to be made to the system in the long-term, there is a very low likelihood that any changes will impact those over age 55. My best guess is that anyone over age 50 will not be materially impacted by any changes. And, as the authors point out, it is unlikely that any of these changes are going to be beneficial to those who decide to claim early. If the decision is made to push back normal retirement to age 68 or later, this will almost certainly have a detrimental impact on those seeking to claim early.
2012 may be well go down as the year when taxes were at their lowest point for a generation or more. For more than a decade now, Congress and Presidents have supported a multitude of temporary tax cuts. Some of these tax cuts have been extended once, twice, or even more than twice. As I review the landscape, it seems inconceivable to me that all of the ‘temporary’ tax cuts will be extended for 2013. Along with new taxes scheduled to begin next year as a result of the Affordable Patient Act (new health care law), it is a near certainty that some, or all of us will see some level of tax increases in 2013. What follows is a summary of different taxes that could be higher next year.
Payroll Taxes: This has been in the headlines quite a bit lately. For 2011 all workers have received a 2% payroll tax cut in the form of a lower tax on employee Social Security taxes paid. Normally, earned income is subject to a 6.2% Social Security tax on income earned up to $106,800 (2011) and $110,100 (2012). Last year the Social Security tax was reduced to 4.2%. In December, Congress agreed to a two month extension and just this past week it was officially extended for the remainder of 2012. Given the back-and-forth in Congress on the ‘temporary’ nature of this tax cut I would expect this tax cut to have a difficult time being extended once again. Especially since the politicians will no longer be up for re-election before this tax cut expires.
Planning Strategy: Since this applies to earned income there is very little planning that could be done, especially for wage earners who already earn more than $110,100. If you earn just under this amount and can somehow ‘move’ earned income from 2013 into this year, you may wish to do that if it is an option.
Additional Medicare Payroll Tax: the Medicare payroll tax applies to all earned income (unlike the Social Security tax). This tax is currently 2.9% and is paid half by the employee (1.45%) and half by the employer (1.45%). Starting next year, the payroll tax for the employee portion will be going up by .9% for those who have earned income above $250,000 (joint filers) or $200,000 (single filers). It is important to note that this extra .9% only applies to the income over these thresholds. So, if you are married and your earned income is $250,000 or less, this new additional tax will not apply to you. If your earned income is $275,000, then the .9% Medicare tax will apply only to the $25,000 over the limit. You would then pay an additional $225 in this example.
Stealth Tax Trap: for those of you who earn less than the limits listed above, do not let your guard down. These limits are NOT indexed for inflation. So each year, more and more workers will be paying this extra tax. For example, let’s say you are married and file a joint return and you have $225,000 in earned income this year. Let’s also assume that your income will increase by 3% per year in the future. In four years time your income will now exceed $250,000 and you will be ‘eligible’ for this additional Medicare tax on earned income.
Planning Strategy: like the payroll tax cut that will expire, this extra tax is difficult to plan for since no one wants to intentionally earn less money in the future. If there is some ability to ’shift’ earned income forward into 2012, then one should explore this possibility.
Medicare Surtax on Unearned Income: this is the one that is getting a lot of attention in financial planner circles. Starting in 2013 a new Medicare surtax of 3.8% will apply to all unearned income (interest income, dividend income, capital gain income) for those who have adjusted gross income above $250,000 (joint filers) or $200,000 (single filers). If your adjusted gross income is below these thresholds, then this new surtax does not apply. Let’s see the impact using an example: adjusted gross income is $300,000. Of this amount $225,000 is earned income and $75,000 is unearned income. In this example, the $50,000 over the $250k limit (joint filers) will be subject to this new 3.8% surtax. The taxpayer would then have to pay an extra $1,900 in taxes ($50,000 times 3.8%).
Let’s say the total income was the same, but $275,000 was earned income and $25,000 was unearned income. In this example, only the unearned income, or $25,000, is subject to the new surtax.
Stealth Tax Trap: once again, the limits for this new tax are NOT indexed for inflation. Eventually, many who will not initially pay this tax will pay it in the future.
Planning Strategy: there’s a bit more that can be done here since it involves unearned income. I think we will see more and more people using tax-exempt investments like municipal bonds in their taxable portfolios to help minimize the impact of this new tax. Depending on how much other tax rates go up (dividends and capital gains), we may see an entire shift in asset location and the use of tax-advantaged portfolios. One pitfall of restructuring one’s portfolio is the potential trigger of capital gains taxes. If one would have to incur a large gain this year simply to avoid a partial tax increase on unearned income in the future, one needs to balance the potential liability in the years ahead versus incurring a higher tax this year. November’s election may help provide some guidance in this area.
Comment on the new Medicare taxes: since these taxes are part of the healthcare law, it seems that these are the most likely taxes to go forward next year barring a total Republican takeover in Washington. It should also be noted that even if the Republicans win Congress and the White House, repealing the health care law will be nearly impossible. To do so, the Republicans would need a ’super-majority’ of 60 in the US Senate. Given that they currently hold a minority position of 47 that would seem highly unlikely in just about any scenario for the upcoming election. If President Obama is re-elected, then it is a sure thing that these taxes will go into effect next year.
Capital Gains Taxes: these are scheduled to go up next year under current law. In President Obama’s budget he is calling for a 20% rate on long-term capital gains for those who are in the top two tax brackets. (Primarily those above $250k once again- are you noticing a theme?) Currently the rate is 15% for those in the top four income tax brackets. (0% for those in the bottom two brackets.) Republicans oppose higher taxes on capital gains. My guess is that if Obama wins, he will likely be in a position to get this increase through, but the Republicans may be able to delay the implementation for a year or two. A Republican in the White House will almost certainly mean that any increase that occurs as a result of current law lapsing would be retroactively reversed.
Planning Strategy: if it becomes apparent after the election that these rates are going up and your income puts in in the cross-hairs of this tax increase, then shifting your taxable investments to tax-free municipal bonds would be one method to limit exposure to this in the future. We also may see folks ‘harvesting gains’ later this year and effectively resetting their cost basis on investments. This will be quite strange to see folks intentionally creating taxable income now to avoid a higher tax in the future.
Dividends: the current tax rate on ‘qualified’ dividends is 15% for those in the top four tax brackets. This is scheduled to revert to the taxpayers top marginal tax rate next year. President Obama’s budget assumes this as well. Republicans will certainly fight this. My guess is that they settle on a 20% rate for those in the top tax brackets as a compromise. A Republican victory in the presidential election will likely mean the rates on qualified dividends stay at 15%.
Planning Strategy: again, this will depend on the election results. If it looks like dividend taxes are going up to the top marginal tax rate, then folks will really be looking hard at tax-advantaged investments like municipal bonds.
Regular Income Taxes: yes, good old-fashioned regular federal income tax rates are scheduled to go back to the pre-Bush tax rates of the Clinton era. President Obama wants to make the current rates permanent for everyone in the bottom four tax brackets. He wants to see the top two tax brackets go back to 39.6% and 36.0% respectively from their current 35% and 33% rates. Republicans oppose this. If Obama wins, I’m thinking that a deal will be struck during the lame-duck session on this issue along with capital gains and dividends. If they do not strike a deal, then the new Congress will have to deal with this early next year.
Planning Strategy: if your top marginal tax rate is in the top two brackets and you expect to continue earning money at these levels into the future, then you may wish to consider any strategies possible to move income into 2012. If you have vested stock options that can be cashed in, you might want to do that in 2012. Again, a lot of decisions will hinge on the election but it is better to be prepared to take action now and begin thinking about these possible tax increases.
Alternative Minimum Tax: once again, Congress has not addressed the AMT issue for 2011. Most observers feel that an increased exemption, or ‘patch’, will be passed before the end of the year. But what happens in 2013 when politicians are not up for re-election? Who knows. This is just one more aspect of our tax code to be aware of that may increase your tax bill in the future.
Planning Strategy: not much can be done about the AMT now. This is one more issue that will need to be resolved after the election.
Summary: while there is not a lot of good news regarding taxes beyond this year, there is time for some planning. Those who educate themselves on what the future will bring with regards to higher taxes will best be prepared to minimize their future tax liability and take action this year.
I came across an article today from Larry Swedroe who is one of my favorite authors. In the article he discusses the fallacy of chasing hot investments, sectors, or asset classes. My favorite line from his article is that investors should behave more like a postage stamp. A postage stamp does one thing and one thing very well- it sticks to its letter until it reaches its destination. Investors should create and stick to their investment plan- asset allocation. This plan involves more than just buying and holding your investments. It means reviewing your investments and rebalancing as necessary to bring it back to its targeted levels.
I also recommend the Callan Periodic Table of Investment Returns which is far more interesting than anything you might remember from chemistry class. Whenever I show this to prospective clients I ask them to find the ‘pattern’ in the past returns of previous asset classes. (If you find one, please let me know!) What is really interesting is to view the returns of Emerging Markets over the past two decades. In the 1990s there were five years when this asset class was the worst performing asset class for that year. In the past decade it was at the bottom only once (in 2008) and that interrupted six years where it was the best performing asset class- and boy were those six really good years. When one stares at the ‘colors’ on this table and really thinks about how likely it is that anyone can choose in advance which asset class will do one year versus, it becomes painfully clear that the likelihood of that is close to zero!
My recommendation is to diversify across all asset classes and accept the fact that you will have some of your investments in the best and worst performing asset classes each year. By controlling the things you can control, like investments costs and taxes, and rebalancing as necessary across your investments, you will be far more likely to achieve your goals and reach your destination.
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