Annuities—Times are a-changing!!

Americans have invested approximately $661 billion in an estimated 6 million variable annuity contracts with benefit guarantees (according to insurance industry researcher Limra in the April 20-21, 2013 Weekend Investor section of the Wall Street Journal). Such products were sold with the promise of a guaranteed retirement benefit that could be “reset” higher if the underlying investments perform well. These products also carried higher fees than the normal “immediate” annuities that started annual payments in exchange for a lump sum contribution.

The decline in long term interest rates has impacted some of the insurance companies who provide such annuities in a negative manner—so much so that the companies are changing provisions of the contracts sold in previous years. Some of these changes include limiting the investment options within the annuity, prohibiting additional contributions to the contract, raising contract fees, and even buying back (or offering alternatives for switching) the contracts themselves. We are experiencing client questions about such changes. Question: would an insurance company want to change a contract that was performing (i.e. making them money) at expected or better rates? The answer is usually “NO.” Therefore, when an annuity contract owner is offered an “opportunity” to switch or modify an annuity contract, it should be viewed quite carefully.

If you hold an annuity contract, there are several things which you should definitely do:

• Read the correspondence—Insurance companies usually give advance warnings of changes they are making to annuity contracts. That warning may come in a letter that looks like “standard document language” i.e. many pages with lots of small print; do not ignore what that letter is telling you. Some of the proposed changes may have a negative impact on your contract.
• “Reset” Opportunities- Some annuity contracts offer “guaranteed minimum income benefits” (GMIB) which can be reset over the life of the contract. That benefit level may change based on the investment performance of the underlying investments. That reset change may also allow for a change (increase) in the fee charged for the GMIB option. Weigh the cost/benefit carefully.
• “Trade-In the Contract”-Some insurers are offering to buy back the “old” contract in favor of a “new” offering. The new contract may not (usually does not) contain terms as favorable to the annuity holder as the old contract in terms of fees and/or benefits. Keep in mind that an advisor may be working on commission and such a trade-in could result in new commissions for the advisor.

Annuities are complex products. They usually carry fees that are higher than investing in the underlying investments directly and the sales commissions can restrict access to the funds invested subject to conditions outlined in the prospectus. One should never invest in an annuity without completely reading the prospectus and understanding the nature of the investment. We, at Paragon Advisors, do not use products that are commission based; hence we have very little need for such products. We will be glad to assist you in evaluating any contract (or proposed changes thereto) you may have.

Tax Time Again!!

Yes, we know it’s only August; however, now is a good time to review your 2013 tax status and (if necessary) do some preliminary planning. As you know, we at Paragon Financial Advisors do not prepare taxes and we advise you to consult your tax professional to ensure any suggestions made here are applicable to your particular circumstances. That being said, there are some items that may be worthy of your consideration.  This list is, of course, not inclusive of all items that might be beneficial to you.

Tax Free Income-SEC football at Texas A&M is about to start. As you know, hotel/lodging arrangements for football weekends are at a premium. Did you know you can rent your home for less than 15 days a year and the rental income is tax free? Often known as the “Masters’ Provision” because homeowners used it to rent their homes for the Masters Golf Tournament in Augusta, Ga., this tax benefit might prove useful to families willing to rent their home for home game weekends. However, be sure and visit with your property owner’s association and/or insurance company for possible conflicts or prohibitions before doing such a rental.

Required Minimum Distributions from and IRA- Congress has extended the provision allowing a maximum of $100,000 of a required minimum distribution (for account holders older than 70 ½) to be made directly from an IRA to the charitable organization with no tax consequences. The donor does not receive a charitable donation for the amount donated; however, the amount donated is not counted in taxable income. With the health care tax increases becoming effective in 2013, reducing taxable income can be very advantageous. Be sure to make arrangements well enough in advance to allow the charity to receive payment prior to the end of year; we recommend that you initiate such transfers no later than mid-November.

Capital Gains/Loss Harvesting- The stock market is at all time high levels. However, many people have losses carried forward from 2008. Review your portfolio gain and loss positions (selling gains to offset losses) so you can realize some of your current market gains with no tax consequences.

Charitable Donations-As you consider your end of the year donations, consider gifting appreciated assets (stocks) to the charity in lieu of cash. You can gift the stock and get credit for donations at current market value regardless of your cost basis. You do not have to pay capital gains on the stock as you would if you sold the stock and gave cash to the charity.

“Step-up”  in Basis at Death- While considering tax harvesting provisions, keep in mind that appreciated assets receive a “step-up” in basis at the first death of a spouse in community property states (or at death of the owner in separate property states). If a couple bought stock at $25 per share originally and the stock is now valued at $125 per share, sale of the stock would incur taxes on a gain of $100 per share (at ordinary income or capital gains rates depending on how long the stock had been owned). Transferring the stock to children would mean the original cost ($25 per share) would be passed to the children subjecting any subsequent gain on sale above that basis to income taxes. However, at the death of the first spouse, the stock value is “stepped up” to the market value as of the date of death and taxes on gains to that point are not calculated. Obviously this is not a preferred method of tax planning, but in those cases where medical/age conditions apply, one should be aware of it.

Estate Tax Exemption Portability- One provision of the 2013 tax changes was the exemption of $5 million per person exemption from estate or gift taxes. Therefore, a couple could shelter $10 million from estate taxes. That amount was indexed for inflation; the 2013 exemption amount is $5.25 million per individual. In addition, that exclusion amount is “portable” i.e. a deceased spouse’s estate can transfer to the surviving spouse any unused portion of that estate/gift exemption. However, an estate tax return must be filed to take advantage of this portability benefit.

As tax rates increase and deductions decrease, tax planning becomes even more critical. We, at Paragon Financial Advisors, will work with you and your chosen tax professional to integrate tax benefits into your financial planning. Please do not hesitate to call us for review of your account.

Variable Annuities

Those of you with whom we have discussed variable annuities know that we at Paragon Financial Advisors are not fans of variable annuities. Our basic reasoning has been that variable annuities usually have high fees (for the insurance costs in addition to fund management expenses), required holding periods to avoid significant redemption penalties, and thus lower investment returns to you (the annuity holder). They also turn gains on investments that could potentially taxed as capital gains into gains taxed as ordinary income.

 The Wednesday, March 13, 2013 Houston Chronicle carried an excellent article by nationally syndicated personal finance writer Scott Burns. We would highly recommend you read the entire article at his website that can be found HERE . To pique your interest, we will quote some of his comments here to give you a general flavor of his opinion of variable annuities and with which we completely agree.

“According to the Morningstar variable annuity database, a typical VA contract carries insurance costs of 1 percent to 1.25 percent.”

 “…the fee burden becomes punitive in a low rate period. Over the last five years…the Vanguard Total Market Index (a proxy for all U.S. stocks) returned 2.18 percent a year. So … with an insurance expense of 1.1 percent a year, the cost of the insurance wrapper was 50 percent of your return.”

“…it would have been a bit worse if you had invested in the Vanguard 500 Index (a proxy for domestic large cap stocks) because … its return over the last five years was 1.57 percent, indicating a 1 percent insurance wrapper cost would have taken 64 percent of the return.”

 “The return from a variable annuity is taxed, upon withdrawal, at ordinary income rates.”

“Much of the return from a broad index fund … will be taxed at the capital gains rate. …now 20 percent, up from 15 percent last year.”

Mr. Burns is a proponent of indexing and he also discusses the performance issues associated with variable annuities vs. indexing. Anyone considering the purchase of a variable annuity will find this discussion a worth while read.

 

Taxes-Planning Strategies

We at Paragon Financial Advisors are not accountants and urge you to verify any items we discuss with your tax professional to determine its implications in your particular situation. We also do not believe you should “let the tax tail wag the investment dog.” That is, your investing should not be dependent solely on tax considerations. However, tax consequences certainly should be considered when all other things are equal. Taxes can have a significant impact on your total economic well-being. It is in that spirit that we discuss the Congressional resolution (enacted at the last minute) to the fiscal cliff.

In our past blogs, we have discussed quite a few items pertaining to the resolution of the debt situation currently facing the US. We would encourage you to read those blogs as they lead to the suggestions we make here on ways to prepare for your future. Some of these suggestions are to avoid known items of tax increase and some are designed to position you for changes that may be forthcoming in an environment where Congress is seeking additional revenues. Consider the following:

• Utilize strategies to reduce taxable income, thereby avoiding higher tax brackets on ordinary income/capital gains/interest/ and the 3.8% health care tax.
• Maximize contributions to retirement plans, IRA’s, FSA’s, HSA’s, etc.
• Seek deferred compensation agreements with your employer if available.Maximize the use of tax deduction strategies (charitable contributions, mortgage interest, etc.)
• Consider Roth strategies (contributions, conversions, Roth 401(k)) as a way to hedge against future tax increases.
• Consider a Roth IRA conversion if below the income thresholds.
• Investigate Roth conversion options in 401(k) plans which have now been expanded to include all participants.
• Invest in municipal bonds to generate tax free income (in taxable investment accounts).
• Extremely favorable for those in higher tax brackets especially since municipal interest is currently free from income tax as well as the 3.8% health care surtax.
• For those over age 70 ½ who face required minimum distributions from IRA’s, make donations to qualifying charities from the RMD amount (up to $100,000 maximum in 2013) as a way to avoid the RMD from increasing your taxable income.
• Consider the sale of appreciated assets (or gifting assets to other family members in lower tax brackets) to take advantage lower capital gains rates (0% or 15%).
• Considering the low interest rate environment, do some of the estate planning techniques (such as a Grantor Retained Annuity Trust) make sense for you?
• Consider, if appropriate, some of the advanced wealth transfer strategies (grantor trusts, dynasty trusts, family limited partnerships, etc.) while these strategies are still available.

As usual, we at Paragon Financial Advisors are here to assist you and your family in the long range planning of your financial well-being. Please do not hesitate to give us a call.

Pensions To Lump-sums

Retirees from large companies who have been drawing retirement checks may face a new option. Their former employer may offer to swap them a lump sum payment now in exchange for all future retirement checks. An interesting offer but one that requires very close scrutiny.

First of all—why is the past employer making such and offer? Pension payments are generally made from defined benefit plans, i.e. plans that guarantee the retiree a prescribed benefit based on retirement age, length of employment service, and salaries earned while working. Note here that the employer is bearing all investment risk—the employer must contribute enough money into the plan such that the contributions plus investment earnings will provide the retirement benefits to the retiree over his/her expected lifetime. National media stories are abounding about corporate retirement plans and their underfunded status(i.e. the plans do not have adequate assets to meet the projected pension obligations). That problem has been compounded because the estimated plan earnings assumption has been very difficult to achieve for many plans because of investment performance over the past decade.

Another change working in favor of the employer is a change in allowable interest rates for lump sum calculations. The basic assumption in a lump sum distribution is that the employer will provide the retiree a lump sum of money that can be invested by the retiree to replicate the pension payment stream over the retiree’s life expectancy. The lower the interest rate assumption, the greater the amount of lump sum dollars that were required. Historically, US Treasury security interest rates were the assumed interest rates for lump sum calculations. Plan administrators can now use corporate bond interest rates in their lump sum calculations; those corporate bond interest rates are higher than the Treasury securities. The net impact—the higher the assumed interest rate, the lower the amount of lump sum dollars needed.

The bottom line—some pension plan administrators are attempting to remove retirees from their plans and the offer may not be in the best interest of the retiree. Should you or someone you know face such a choice, we at Paragon Financial Advisors will be happy to assist you in analyzing this decision.

Happy Days Are Here Agian??

The stock market is bumping up against all-time highs. The question is why. Are these legitimate levels based on fundamentals or is the excessive liquidity being pumped into the money supply simply going into stock because it’s the better (?) place now. David A. Rosenberg (Chief Economist & Strategist) at research@gluskinsheff.com had some interesting comments in his Economic Commentary of March 25, 2013. He commented on the lack of economic recovery (“… the worst recovery in recorded history.”) and gave the following statistics:

• Industrial production: -1.2% (1.2% lower than the previous cycle peak)

• Manufacturing output: -4.3%

• Real manufacturing and trade sales: -1.7%

• Total payrolls: -2.2%

• Full time employment: -5%

• Real personal income ex transfers: -4.5%

• Real disposable personal income per capita: -6.2%

And this performance is in the wake of:

• Four years of $1 trillion deficits
• Four years of 0 interest rate policies
• A tripling of the Fed balance sheet (QE1, QE2, Twist, QE3, etc.
• Bailout stimulus

Hummm-let me think about that!!!

Shocking Trends in College Expenses and College Debt Necessitate Earlier Planning for Families

The July 2013 issue of Bloomberg Businessweek found HERE includes troubling trends in college expenses as originally presented by the Federal Reserve Bank of New York, National Center for Education Statistics.  Since 1999 and adjusted for inflation, tuition has increased more than 50%.  As costs continue to rise, if sources of college funds fall short of what is needed, student loans are taking up more of the slack.

The problem is magnified by the fact that congress missed the deadline for making a change on July 1^st meaning the subsidized Stafford loan rate has doubled from 3.4% to 6.8%.

What can you do?  Saving for future college costs can seem ominous but there are things you can do now to get a jump start.  Always discuss any options presented with your financial advisor prior to acting.

529 College Savings Plan – Numerous states sponsor 529 College Savings Plans through various institutions.  A 529 plan is a great way to begin savings for college.  Contributions for 2013 can be as much as $14,000 per donor for a child ($28,000 for a married couple).  There is a 5-year rule allowing donors to make contributions of $70,000 per donor for a child ($140,000 for a married couple).  Using this rule the one-time gift is treated as having been contributed over a 5 year period.  There are several planning strategies that can be utilized with this type of account.

Coverdell Education Savings Account – While not as generous as the limits for a 529 plan, the Coverdell Education Savings Account (ESA) is another potential savings vehicle allowing the accumulation of assets on a tax free basis if used for college.  For 2013, individuals may contribute as much as $2,000 to a Coverdell ESA if they qualify under the income limitations.

Scholarships – Seek out scholarship opportunities diligently.  Begin compiling a list of possible avenues now and continue to add to the list as you find new opportunities.  Research what is required for each one and work with your child to ensure they are not just eligible but hopefully near the top of candidates applying.

Grants – If you qualify for grants, by all means accept them!  If you need help with the FAFSA process find a financial advisor in your area who is knowledgeable about college financial aid.

Part-time employment during high school and college – Although it may not be an answer for everyone, consider encouraging the student to contribute towards their future by partially paying their own way. 

Encourage an entrepreneurial spirit in kids – Children are creative beings, capable of so much.  Encourage them to realize their potential through setting a good example.  Find a mentor or teacher who can help them develop ideas into potentially viable businesses that could succeed beyond expectations.

Most importantly, begin saving and preparing now instead of waiting.  Every dollar contributed helps towards the end goal.  Structure a proactive plan of seeking out opportunities and saving early so there is less reliance on student loan debt which is becoming more unreasonable.

 

 

 

Applegate, Evan. "Correlations: Student Debt Explodes." Bloomberg Businesswek. 1 July 2013: Page 18. Print.

Applegate, Evan. "Correlations: Student Debt Explodes." Bloomberg Businesswek. 1 July 2013. www.businessweek.com Web. 2 July 2013