School "Daze"

It’s that time of year again—students are moving into the dorms at colleges and universities all over the country. Traffic is increasing, restaurants are crowded, and all the other “problems” associated with students starting a new school year are at the forefront. It’s a new world for freshmen students; confusing and sometimes stressful. That stress is not limited to students, however. Parents are looking at rising education costs and looking for ways to pay for college expense. A frequent source of that funding comes from college savings accounts (such as 529 plans) and from extended family (grandparents). Those sources are our topic of discussion here.


The 529 college savings plans are sponsored by states and the funds in those plans are managed by large mutual fund companies (Vanguard, Fidelity, American Funds, etc.). After tax contributions placed into the accounts grow tax free as long as the funds withdrawn are used to pay for qualified college expenses (room, board, tuition, mandatory fees, books and equipment, etc.). Historically, parents have been the ones setting up 529 plans for children; the owner of the account is the person setting up the plan. However, with rising college costs and more affluence in the retiring baby boom generation, grandparents are funding 529 plans. That’s a great benefit for easing the financial burden on parents of college students. It can come with some hidden implications that should be addressed.


College personnel award financial aid to students based on the income and assets that students and their parents claim on the students Free Application for Federal Student Aid (FAFSA) form. Contributions from parents are not counted as student income for FAFSA purposes. That is true even when the funds come from a 529 plan owned by the parent. However, when funds come from other people (such as 529 plans owned by grandparents), the funds are counted as student income. Therefore, payments from a grandparent owned 529 plans could jeopardize the student’s eligibility for other forms of financial aid. Limitations (or loss) of grants, subsidized federal loans (on which the student is not charged interest while still in school), or work study programs funded by the government or college might come into play. The loss of such benefits could be significant. Prudent planning dictates consideration of such a loss in the total cost of a student’s education.


Are there ways for grandparents to fund college expenses and still get the tax free growth on the funds? Perhaps. The grandparents could possibly transfer ownership of the 529 plan to the parents prior to any withdrawal for college expenses. Some plans don’t allow a transfer of ownership and may count the transfer as a distribution (earnings are then subject to taxes and a penalty because the distribution was not used for allowable college expense). Another possible alternative would be to wait until the student’s last year in school before using 529 funds. The student (not attending graduate school) would not be filing another FAFSA for the following year; hence no income considerations. Care should be taken here though as some colleges require additional information that requires listing all accounts benefiting the student which are owned by other than the parents.


While students are facing the academic world (many for the first time), planning for college expenses should be done in advance. We, at Paragon Financial Advisors, will be happy to review the plans our clients have put in place. Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

Investing Beyond Stocks and Bonds

When you think of “investing”, what comes to mind? Did you think of the US stock market? You might have thought about bonds or other fixed income securities. What about real estate, commodities or other alternative investments? Although less common, they can provide significant benefits when combined with stocks and bonds. How can these investments benefit you? The answer lies in their correlation, or relatedness to other investments. Alternative investments typically have lower correlations with stocks and bonds; they often “zig” when others “zag”. These alternative investments increase the overall diversification of the portfolio, thus reducing risk (i.e., think fewer eggs in a single investment basket). Below are some examples of alternative investments and the importance of their inclusion within a portfolio.

Commodities

Inflation, or the general rise in prices, typically reduces company profits due to an increase in costs (e.g., cost to borrow money, cost of input materials, and cost of transportation). Commodities typically increase in value when interest rates are steady or rising. They may provide the investor a way to benefit when stocks are not performing well. Gold, and other commodities, typically have very low and often negative correlations with stocks. Commodities can also provide significant income from the production and transportation of oil and gas.

Other Investments

Due to the finite and absolute necessity characteristics of real estate, investors can benefit in a number of ways. Investors seeking income may find Real Estate Investment Trusts attractive due to their high yields. Others may prefer investments that benefit from the long-term appreciation of property values. Foreign investments provide exposure to markets less correlated to the United States; other economies sometimes expand when the US economy contracts. Access to frontier and emerging markets allow investors to benefit from faster growing economies and increased consumption from an expanding middle class. Very small companies often provide niche services or goods, frequently sheltering them from adverse events that affect larger companies.

Commodities and other alternative investments reduce risk by increasing exposure to a diverse set of asset classes. They frequently outperform when US stocks and bonds fumble. Although they are typically a small portion of a portfolio, the benefits of inclusion may be significant. In a diversified portfolio, alternative investments should lessen the volatility of the entire portfolio. Despite the correlation benefits, investors must realize that the individual alternative investment may have greater risk than traditional investments.

Have you reviewed your alternative investments lately? We at Paragon Financial Advisors look beyond the realm of US stocks and bonds, seeking investment opportunities across the globe. Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

The Value of a Job

I had a discussion with a friend today about the value of a job. Not the value of a job as a younger person, but the value of a job as a “phased in” retirement. Many baby boomers are facing the question “When should I retire?” Our discussion focused on some options available.

 

My friend is a professional and has the ability to continue working on a part time basis if he so chooses (earning approximately $75,000 per year). He is 65 years old and his marginal tax bracket is approximately 40%. His estimated social security benefit at full retirement age (age 66) is approximately $2400 per month.

 

Our discussion prompted some thoughts which I share here. Note that these thoughts are purely from a financial planning standpoint; they do not address the personal satisfaction questions of continued working vs. time use in retirement.

 

Social Security Benefits

 

Age 62

 

My friend has several choices concerning his social security benefit. He could have chosen to receive his social security benefit at age 62. He did not choose that option for several reasons:

1. At age 62, his monthly benefit would have been reduced by 25% (approximately 6% per year for each year of age before his age 66 full retirement age giving him only a monthly benefit of $1,800). That reduction in benefit is generally permanent and would continue for his life span.
2. If he continued to work, his social security monthly benefit would be reduced $1 for each $2 he earned in excess of $15,480 (this amount is applicable for 2014 –it changes annually)
3. He was not ready to quit working at that age.

Age 66

At age 66, my friend can choose to receive his full retirement age benefit of $2400 per month. He can continue to work with no reduction in social security benefit regardless of the amount he earns. He has another option at age 66. He can “file and suspend” his benefits which would allow his spouse to collect spousal benefits without affecting his or her future benefits. With a file and suspend election, he would file for his age 66 benefit but choose not to begin receiving his benefit payment. His spouse could begin drawing ½ of his benefit ($1200 per month) without affecting her social security benefits. The suspension of his benefit would allow his monthly benefit amount to increase as outlined in “Age 70” below.

Age 70

My friend can delay receiving his social security benefit until age 70; if he does, his monthly benefit will increase by 8% per year (or a total of 32%) for each year from age 66 to age 70. His monthly benefit at age 70 would then be $3,168. Note that his spouse could have been drawing spousal benefits for that four years or until she began drawing her own benefit.

Note: This social security discussion is a generalized one; you should discuss your particular circumstances with the Social Security Administration before making any decisions.

Investment Implication

There are consequences on my friend’s investment portfolio that should also be considered. His continued earnings of $75,000 per year for 4 years (age 66-70) are money that would not be withdrawn from his IRA. Since required minimum distributions (RMD) don’t start until age 70 ½, that amount could continue to grow tax deferred until he needed it or was required to withdraw for RMD purposes. At a conservative rate of return (the current 30 year US Treasury rate of 3.5%), the future value of not withdrawing for those 4 years is approximately $316,000. That is, his retirement portfolio will be about $316,000 more at age 70 if he continued working until that time.

What to Do?

Retirement is an individual decision that is dependent on many things (health circumstances, life style choices, economic factors, etc.).

We, at Paragon Financial Advisors, assist our clients in evaluating options available to them.  Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

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®


If you did not receive a copy of this quarter's newsletter please email info@paragon-adv.com to request a copy.