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.

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.

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 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.

* For the five years ending September 2011, only 9.72% of large-cap funds maintained a top-half ranking over five consecutive one-year periods. The results for mid-caps was only 6.08% of funds, and for small-caps it was only 3.27%. Random expectations would suggest a rate of 6.25%.

* Looking at longer-term performance, 12.23% of large-cap funds with a top-quartile ranking over five years ending 09/2006 maintained a top-quartile ranking over the next five years. For mid-caps it was only 20.22% and for small-caps it was 20.22%. Random expectations would suggest a rate of 25%.

* While top-quartile and top-half rates have been at or below levels one would expect based on chance, there is consistency in the death rate of bottom-quartile funds. Across all market cap categories, bottom-quartile funds have a much higher rate of being merged or liquidated.

The evidence continues to be clear that trying to successfully pick stocks over a long period of time is extremely difficult. There has been some news recently about the retirement of Bill Miller of the Legg Mason Value Trust fund which won Mr. Miller accolades for his 15 straight years of outperformance compared to the S&P 500 index. Unfortunately ,for many investors in his funds, for the five years ending December 31, 2010 his Value Trust fund was dead last among 1,187 US Large Cap funds tracked by Morningstar. Did Mr. Miller lose his touch suddenly? Or maybe, just maybe, his ‘winning’ streak was nothing more than luck. Of all the actively managed mutual funds out there it would seem that someone out there, by chance, is going to have an especially long winning streak. The problem for investors is this: how do you identify who this person is, AND, how do you identify this person in advance of their winning streak? Furthermore, how do you know when to get out before the inevitable losing streak begins? Identifying skill from luck is a daunting task.

Feel free to use the comments section below to add your thoughts.

When it comes to managing the rest of our financial lives there is no deadline. For example, beginning a savings program for a specific goal (a house, college, retirement) is often delayed due to ‘current’ circumstances. The excuses go on and on and then before you know it, years and even decades have gone by and nothing has been saved. There are other aspects of our financial lives that frequently get pushed to the side: purchasing insurance we know we should get, or setting that appointment with the estate planning attorney to draft crucial documents like wills and health care directives. There are of course other areas of our lives where we could all benefit from being more proactive: exercise and eating better are the obvious ones that many of us struggle with.

For me it simply helps to be reminded of Ben Franklin’s call to action. Once you start taking action you will hopefully develop the habit of taking action and do the things you know you should.

If there is one thing you have been meaning to do (financial or non-financial), take a moment and do it right now. You will feel much better for the rest of the day.

This notion of ‘controlling the debt’ is something to ponder. At a larger level we saw what happened in the middle of a financial crisis: those who controlled the debt (i.e. big banks) received the immediate attention of our political leaders. They controlled everything during that crisis. To this day, nearly three years from that crisis, the banks are doing just fine and most individual Americans are not doing just fine.

Now, let’s break this down to the individual level. Those who have little or no debt are less susceptible to control by others. (i.e. banks) They are more likely to have financial security or financial freedom. For the vast majority who are in debt to the banks, they are more likely to not feel in control of their financial situation and more likely to not feel optimistic about their financial future.

Is all debt bad? Well, no. For younger couples starting out in life the path to owning a home usually involves a mortgage. The problem that developed in our society was that very few people wanted to save for a proper down payment before buying that home. And now with the housing bust, so many people actually owe more than their house is worth. My prescription is for a minimum down payment of 20% before buying a home. (Ideally, this should be over 30%.) I actually think this should be mandated through government regulation. Given what has happened in the housing market over the past 10 years, do we really need another example of why this should be so?

Beyond a fixed rate mortgage, we need to think long and hard about borrowing for other purchases. A habit of saving for the things we want is not a lost art; it just seems to have been forgotten by so many.

Please use the comment form below for any additional thoughts or questions.

To qualify for the top 1% of earners in 2009 you needed an adjusted gross income at at least $343,927. Of course this just looks at income. There are certainly plenty of retired (or semi-retired) folks with a fairly large net worth who no longer have a large income. I’m sure the protestors on Wall Street would consider someone with a multi-million dollar net worth but a low tax obligation to be part of this 1% group.

So, if you are not in the top 1% of earners you are probably wondering where you may be relative to the rest of that make up the other 99%? The highest 5% of earners had adjusted gross income of at least $154,643. (The top 5% of filers paid 58.7% of total federal income taxes in 2009.) The top 10% had adjusted gross income of at least $112,124 and accounted for 70.5% of all federal income taxes paid. The bottom 50% of filers paid 2.25% of all federal income taxes.

Now, it is important to remember that the above numbers are for federal income taxes. Payroll taxes (Social Security and Medicare) are borne largely by those with incomes under $100,000 so while the bottom 50% of all filers only accounted for 2.25% of federal incomes taxes, the share of total tax burden for this group was certainly much higher.

Use the form below to leave a comment or ask a question.

Social Security is designed to provide income to older Americans through a payroll tax system. It has always been designed this way. It is in effect a social compact whereby younger workers pay for a certain level of income for older beneficiaries. It is not a program where you pay in and get nothing out. (That would be fraudulent!) Let’s understand some basic facts about the solvency of Social Security.

For quite some time now, Social Security has taken in (from payroll taxes) more than it has paid out to current beneficiaries on an annual basis. This ’surplus’ has accumulated in the Social Security Trust Fund which now has approximately $2.6 trillion. (I will not go into the details of the Trust Fund in this post.) In 2010, outlays exceeded receipts by nearly $49 billion dollars. How was this shortfall covered? By funds from the Social Security Trust Fund. In fact, interest alone in the trust fund was greater than $117 billion last year, so in spite of the fact that outlays exceeded receipts in 2010, the Trust Fund actually got larger!

Over the next 25 years it is expected that outlays will continue to be larger than receipts from payroll taxes so it will be necessary to use assets from the Trust Fund to meet promised obligations. But one must understand: even if Congress does nothing, benefits will be paid as promised based on current projections.

So, what would happen in 2036 if no action is taken? While the Trust Fund would be depleted, the program would still be taking in receipts from then current worker payroll taxes. It is anticipated that those receipts would still cover 77% of promised benefits to those who are then retired. So, for those who claim that younger workers will never see benefits from Social Security or describe the program as a ‘Ponzi scheme’ they are just plain wrong.

Whether Congress takes action sooner and makes the necessary benefit cuts (or increases in taxes), or the benefit cuts happen in 2036 because our leaders never get around to reforming the system, those of us who have 25 or more years to collect benefits will still get to collect benefits. They just may not be as great as the program is currently designed to do.

Please use the comment section below to add your thoughts or ask questions. Thank you to Michael Kitces for providing some of the information stated in this post.

Ok, let me comment on the volatile markets we are seeing. Market corrections are normal. Yes, they do not feel good, but they are normal and it is a reality of human psychology. It certainly appears as  if we have a negative feedback loop occurring as some folks watch the market go down and become ever more fearful that if they do not get out now their portfolios will fall even further in value. Here is the problem with that: what you are saying is that you can time the market better than others. Rather than succumb to the psychology of the herd, I recommend that you stick with your investment plan and view the current situation as an opportunity to rebalance your portfolio. Just a few weeks ago the market was about 20% higher. We know from past history the market will eventually recover what it has lost, so why not buy more shares now?

One of the reasons folks are quite fearful is a behavioral bias known as recency bias. They look at what has happened recently and incorrectly assume that the same pattern will continue. For example, the market has been down nearly every day now for two weeks so it is easy to assume that it will continue that way for the next two weeks. While I, nor anyone else, knows where the market bottom will be, the current psychology will change. It was not that long ago that the market went up 7 days out of 8 near the end of June/early July time frame. That too changed was we are now seeing.

I wish I could predict how long and how severe these market down turns will be. What I do know is that Warren Buffet said it best when he declared, “When everyone is greedy, be fearful. When everyone is fearful, be greedy.” Those who are serious long-term investors will look back on all this as an opportunity to rebalance their portfolios and buy stocks at a discount!

If you have a question or comment please feel free to use the comments section below.