Trusts and Taxes

Taxation on trusts warrants consideration. Trust income is subject to income taxation at one of two levels: 1) at the trust level if the income is retained in the trust, or 2) at the individual level if the income is distributed from the trust to the individual trust beneficiary. Since trust income is taxed at the maximum federal tax rate at relatively low levels of Income (39.6% at $11,950 in 2013), income is usually distributed to individual beneficiaries. 

 

Texas does not have a state income tax at this time; therefore, federal income tax rules are the primary consideration for Texas trusts. That is not the case everywhere. It is no secret that some individual states are facing significant challenges in financing their state operations. Those states are frequently turning to trusts for tax revenues.

 

The first consideration is state income taxes on trust income. Forty three states have a state income tax and thus tax income the trust earns. Seven (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming) do not have state income taxes. The old rule was taxation by the state in which a trust has its “principal place of administration.” States are now attempting to tax trusts when there are other, minimal jurisdictional contacts.

 

In almost all cases, income earned by the trust in the state is taxed according to the state income tax rates. Income earned outside the state is not taxed at the state level. However, there are more attempts to tax the entire trust income at the state rate if some jurisdictional conditions apply. Some of these conditions include the following:

1. The deceased creator of the trust lived in the state at the time of death.
2. The grantor of a lifetime trust lived in the state at the time the trust was created.
3. The trust was administered according to the state’s trust laws.
4. One of the trustees lives or does business in the state.
5. One of the beneficiaries of the trust lives in the state.

Thus, consider a trust that became irrevocable under the following conditions:

1. The grantor lived in one state when the trust became irrevocable.
2. Two individual trustees reside in separate states from the grantor’s state.
3. Two trust beneficiaries reside in two separate, different states.

The trust could then be subject to state income taxes in five different states; the amount subject to state taxation could vary depending on allocation methods used by the state’s taxing authority.

Trusts created in Texas, administered in Texas, with Texas trustees and beneficiaries face federal taxation problems. However, with an increasingly mobile population, a review of wills creating trusts and existing trusts warrant a review of conditions.

We, at Paragon Financial Advisors, assist our clients in reviewing their estate/trust planning.  Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

Social Security and Medicare

There are times we read things that cause us to say, as my friend puts it, “I’ll have to think on that.”  Such a time occurred as I read an article in the April 28, 2014 Investment News (pg. 40) written by Mary Beth Franklin. The basic premise was that, in some cases, Medicare costs could exceed the Social Security benefit that one receives. Let’s look at that possibility.

Social Security and Medicare-2014

For 2014, the Social Security tax rate is 6.20% of the first $117,000 of earned income (a maximum tax of $7,254). The Medicare tax rate is 1.45% of all income earned (no upper income exclusion). Thus, most employees pay 7.65% of the first $117,000 earned in Social Security (OASDI) and Medicare (HI) taxes. That is the employee portion only; employers pay an equivalent amount. Self- employed individuals pay a tax rate of 15.30%. As of Jan 1, there is an additional 0.9% Medicare tax (added by Obamacare legislation) on individuals earning greater than $200,000 and couples earning greater than $250,000.  Thus, the maximum tax rate could be 8.55% (6.20% + 1.45% + 0.9%).

Now consider Medicare costs. Medicare Part B (medical insurance) is deducted from an individual’s Social Security benefit every month. There are two components: one for medical expenses and one for prescription drug services. Since the prescription drug service costs vary by location/plan, we will discuss only the medical insurance costs. As one’s income level increases, so does the cost of medical insurance (i.e. an increase in the amount deducted from monthly Social Security benefits). That scale (for 2014) is shown below:

Modified Adjusted Gross Income (MAGI)            Part B Premium                Drug Plan

Indiv <$85k; Couple<$170K                                  $104.90/month                 Per plan

Indiv $85k-$107k; Couple $170-$214k                  $146.90                            Plan + $12.10

Indiv-$107k-$160k; Couple-$214k-$320k             $209.80                            Plan + $31.10

Indiv-$160k-$214k; Couple-$320k-$428k             $272.70                            Plan + $50.20

Indiv->$214k; Couple->$428k                               $335.70                            Plan + $69.30

 

The maximum Social Security benefit in 2014 is $2,642 at full retirement age. The cost of living allowance adjustment (COLA increase) for 2014 was 1.5%. Therefore, a high income individual might be receiving at most $2,236.90 ($2,642-($335.70+$69.30)) less his/her individual prescription plan costs. (Note: These figures were taken from the Social Security website and are applicable for 2014; they change each year).

What’s to Come?

One needs to spend only a short amount of time watching news/economic television channels to see numerous discussions that “something must be done” about entitlement programs (Social Security/Medicare). The current trajectory is unsustainable. Various solutions have been proposed: 1) Increase taxes, 2) Raise the retirement age for Social Security benefits, 3)Means test benefits (those individuals with higher incomes will receive lower/no benefits from Social Security), or some combination thereof. The purpose of this blog is not to suggest solutions for the problem; that is in the political arena and, given current political conditions, who knows what will happen. Our purpose is to suggest that plans must be made for significant changes in health care expenses as one prepares for retirement.

Health care costs are expected to increase by 5-7% per year and Social Security benefits to increase by 2% (unless changes are made to the COLA adjustment index- such as use of a “chained CPI” calculation-but that is another discussion entirely). Bottom line—health care expenses will consume a greater proportion of Social Security benefits (if any are received) in the future.

In previous a previous blog found HERE we have discussed costs of health care under the current Medicare plans. They are significant—providing approximately $300-400,000 for a couple in excess of existing Medicare benefits. Any changes made in the current plan will only exacerbate the shortage of money needed for health care in retirement.

What to Do?

Prudent financial planning requires that one take appropriate action to prepare for contingencies that appear possible or probable. If one looks down, sees a steel rail on the left, a steel rail on the right, and a bright light down the tracks in the distance, a good course of action might be to step off the railroad track. So what does one do? Work longer? Save more? Spend less? Move to a lower cost of living state? Purchase long term care insurance?

We at Paragon Financial Advisors do not sell any commercial products (insurance, etc.).  We help our clients evaluate personal circumstances and assist in determining the best course of action.  Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

Not Getting Older-Just Wiser!

My parents taught me to respect my elders. As I get older, it’s getting harder and harder to find anyone more elderly than I. However, there are some advantages to ageing (other than the obvious one of a longer life span).  I thought I would mention just a few in this blog.

Age 50-Investing

Unfortunately, many Americans have not saved adequately for retirement. Because of that, contribution limits for certain qualified plans have been increased for those persons age 50 or older.  These “catch up” provisions are designed to allow individuals to save more in the years before they retire. Persons age 50 and older can contribute as much as $23,000 of their pre-tax pay into a 401(k) or 403(b) plan; that’s $5,500 more than allowable contributions for younger individuals. An additional $1000 is allowed for contributions into an IRA or Roth IRA ($6,500 per year vs. $5,500 for younger individuals).

Age 55

Normally, withdrawals from an employer qualified plan prior to age 59 ½ are penalized for premature distribution (10% penalty plus ordinary income tax). There is an exception for employee’s age 55 that leave their employer (retire, are laid off, or quit). Those employees may access their qualified plans without the premature penalty. Note that this exception does not apply to IRAs so there are rollover planning considerations here. Not converting to a self-directed IRA would allow the departing employee to access their funds without the premature distribution penalty.

At age 55, people may also contribute an additional $1000 (in 2014) into health savings accounts.

Age 59 ½

At 59 ½, individuals are free from penalties for withdrawing from most retirement plan accounts (IRAs, employer retirement accounts if you are no longer working, annuities, etc.). Also, at 59 ½, moneys converted from a traditional IRA to a Roth IRA are no longer subject to the requirement of staying in place for five tax years or being subject to a penalty.

Age 65

At 65, you can make nonmedical withdrawals from a health savings account without the 20% penalty. The money is taxable but it grew tax deferred from the date of contribution. 

Another big consideration is Medicare eligibility with the associated required costs for many individuals. There are planning considerations that are required at this age as you begin your Social Security/Medicare arrangements.

Age 70 ½

At 70 ½, you reach the age of required minimum distributions (RMDs) from IRAs and most employer retirement plans. The IRS has allowed tax deductible contributions and tax deferred growth in such plans; now it’s time to “pay the piper.” There is a mandated rate of withdrawal required from qualified plans beginning at this age; failure to withdraw that amount will result in ordinary income taxes plus a 50% tax penalty on the amount that should have been withdrawn.

A popular tax break in 2013 allowed individuals who have RMD requirements to make charitable contributions from their RMD amount directly to a church/charity with no tax consequences. There is no tax deduction for the amount donated but that amount is not included in taxable income. Although currently expired, there is a general expectation that this provision will be reinstated for 2014.

What to Do?

While we at Paragon Financial Advisors do not prepare taxes, we can help our clients plan their financial affairs to minimize tax consequences while attaining financial goals. Individual circumstances should be reviewed with your tax professional. By the way, don’t forget to ask for the “senior discounts” allowed by restaurants, hotels, airlines, etc. Ages for these may vary with the business involved.  Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

Paragon Perspectives

How long can a good thing last?  This summer has been quite mild in comparison to the past several Texas summers, but as many of us know, one strong high pressure system can change all of that.  The stock market and Texas weather may have a few things in common. Over the last 18 months the stock market has been performing well, but how long will it last and is there a bubble brewing?   


We at Paragon Financial Advisors manage client assets primarily for the long term, depending on the client’s goals, objectives, and risk tolerance.  When constructing an investment portfolio consideration is given to diversification, current investment environment, and which investment vehicle is the best fit for a portfolio (ETFs versus actively managed funds for example). This quarter's newsletter discusses three different investment topics.


The first article is a market commentary which outlines strengths and weaknesses in the economy.  The second article “ETFs Versus Actively Managed Funds” discusses what one should consider when choosing between ETFs and Actively Managed Funds.  The last article examines some broad points on types of diversification: the normal diversification between stocks and bonds and the diversification within a certain asset class. 


How long will this current bull market last and is there a bubble brewing in the stock market?  Only time will tell for sure! Therefore, we will continue to review economic data, asset allocations, and asset diversification to guide us as we move into the remainder of this year and into next year.


Sincerely,


David Hailey CTFA® CFP®


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