FMP

Trillions of dollars are held in Individual Retirement Accounts (IRAs), but no dollars will remain in those IRAs forever. Traditional IRAs are tax-deferred assets, meaning income taxes are not paid when money is contributed to the accounts, but income taxes are due when money is distributed from the accounts. To prohibit the indefinite deferral of income taxes on IRA assets, the IRS established Required Minimum Distribution rules to ensure all IRA assets will eventually be distributed and taxed. If the Required Minimum Distribution (RMD) rules are not followed, the IRS will assess a 50% penalty tax on any IRA assets not distributed as required.

The first RMD from an IRA must occur before April 1 of the year following the year the IRA owner reaches age 70 and 1/2. The second RMD must occur before December 31 of the year following the year the IRA owner reaches age 70 and 1/2. All subsequent RMDs must occur before December 31 of each following year, and the RMDs continue annually for the remaining lifetime of the IRA owner. An IRA owner may begin taking distributions before age 70 and 1/2, but those earlier IRA distributions will not affect the RMD rules that apply once the owner reaches age 70 and 1/2.

The RMD may be taken as any number of withdrawals throughout the year as long as the sum of those withdrawals is equal to at least the RMD amount for that year. An individual may withdraw more than the RMD amount, but withdrawals in excess of the RMD for the current year cannot be applied to the RMD for future years. If an individual has more than one IRA, the RMDs must be calculated for each IRA but do not need to be withdrawn from each IRA proportionately as long as the individual’s total IRA withdrawals for the year are equal to at least the sum of the RMDs for all the IRAs.

The amount of the RMD for each year is calculated by dividing the previous year-end balance of the IRA by a distribution period number which depends on the age of the IRA owner and/or the beneficiary of the IRA owner. In most cases, the applicable distribution period is found in the Uniform Lifetime Table in Appendix C of IRS Publication 590. The IRA owner must use the distribution period number that corresponds with the age he or she attains each year. If the spouse of the IRA owner is more than 10 years younger than the IRA owner and is the sole beneficiary of the IRA, the applicable distribution period is found in the Joint Life and Last Survivor Expectancy Table in Appendix C of IRS Publication 590.

These RMD rules apply to traditional IRAs but not to Roth IRAs. For Roth IRAs, income taxes are paid when money is contributed to the accounts, but income taxes are not due when money is distributed from the accounts. The IRS has little reason to require distributions from Roth IRAs during the lifetimes of Roth IRA owners because those distributions are generally tax-exempt. Now following is an example of how the RMD calculation applies to traditional IRAs.

Abuela has two IRAs, and the balances of those IRAs at the end of last year were $60,000 and $90,000. Her 70th birthday is in May of this year, so she reaches age 70 and 1/2 in November of this year. She will be required to take her first RMD before April 1 of next year. She references the Uniform Lifetime Table and finds the distribution period is 27.4 for the year she turns age 70. She divides her $60,000 IRA balance by 27.4 to calculate her RMD for that account is $2,190. She divides her $90,000 IRA balance by 27.4 to calculate her RMD for that account is $3,285. Abuela must withdraw at least $5,475 combined from her two IRAs between now and April 1 of next year.

Abuela’s two IRA balances at the end of this year are $50,000 and $80,000. Her 71st birthday will be next year, and so she will be required to take her second RMD before December 31 of next year. She references the Uniform Lifetime Table and finds the distribution period is 26.5 for the year she turns 71. She divides her $50,000 IRA balance by 26.5 to calculate her RMD for that account is $1,887. She divides her $80,000 IRA balance by 26.5 to calculate her RMD for that account is $3,019. Abuela must withdraw at least $4,906 combined from her two IRAs between January 1 and December 31 of next year.

The Required Minimum Distribution rules are not overly complicated, but should be strictly followed to avoid severe tax penalties. Additional details about IRAs and RMDs can be found in IRS Publication 590. The IRS also provides RMD worksheets for guidance in these calculations. If you have an IRA and would like help calculating and planning for RMDs, please contact your accountant or financial planner for assistance.



Do you have a defined benefit pension plan through your employer? Then at some point your employer may offer you options regarding how you want receive payment of your pension in retirement. You may be presented options to receive a one-time lump sum payment or to receive monthly annuity payments for a stated period of time. How can you decide which would be the best benefit payout option for you?

You can compare the present value of the annuity payments to the lump sum payment option by asking this question: If you took the lump sum payment, what rate of return would you need to earn on that lump sum balance in order to withdrawal a monthly amount equal to the annuity payments option? Then you compare that answer to the rate of return you expect to earn in your investment portfolio. You should take the lump sum if your expected rate of return will be higher. You should take the annuity payments if your expected rate of return will be lower. The comparison is simple if your annuity payments are offered for a fixed number of years, but if the annuity payments are offered for your lifetime or your beneficiary’s lifetime, the answer will also depend on your assumptions about life expectancy. Here are a couple examples of the evaluation process.

Statler is age 65 and retired. His former employer offers to pay him a lump sum of $250,000 now or pay him $1,000 per month starting now and continuing until the latter of his or his wife’s death. Statler expects to predecease his wife, so he will base his calculations on her life expectancy. His wife is age 60, and her life expectancy is age 90, so the assumed annuity payout period would be 30 years. The question Statler should ask is what rate of return would he need to earn on a $250,000 lump sum in order to withdraw $1,000 per month from that balance for the next 30 years? Based on a time value of money calculation, he finds 2.6% per year would be his required rate of return. Statler expects his investment portfolio to earn more than 2.6% per year over the next 30 years, so he decides to take the lump sum payment option.

Waldorf is age 62 and retired. His former employer offers to pay him a lump sum of $300,000 now or pay him $2,000 per month starting at age 65 and continuing until his death. His life expectancy is age 85, so the assumed annuity payout period would be 20 years. The question Waldorf should ask is what rate of return would he need to earn on a $300,000 lump sum in order to withdraw $2,000 per month from that balance starting in 3 years and continuing for 20 years? Based on a time value of money calculation, he finds 3.8% per year would be his required rate of return. Waldorf does not expect his investment portfolio to earn more than 3.8% per year over the next 23 years, so he decides to take the monthly annuity payment option.

Your pension payout evaluation may require multiple comparisons if your employer offers several different annuity options, including different start ages and different survivor benefits. Even for basic evaluations, you cannot know future rates of return or ages of death, so you probably cannot produce a definite answer to whether a lump sum or annuity would provide the larger payout over your lifetime. The answer will depend on the assumptions you make. If you would like assistance with your pension payment decision, please contact your financial advisor for an evaluation customized to your particular situation.



Are you ready to buy a home? How much can you afford? Should you buy as much as you can afford?

To afford a home purchase, you first need to have enough liquid assets for the down payment and closing costs. The amount you need for a down payment depends on the amount of your mortgage loan. You should supply a down payment equal to at least 20% of the lesser of the purchase price or the home value in order to avoid paying private mortgage insurance. The closing costs charged by your mortgage lender can be an additional few thousand dollars but will greatly depend on your specific mortgage terms. You may also be required to fund an escrow account at closing, which the lender will use to pay your property taxes and homeowners insurance when due. You can contact mortgage lenders to collect total closing costs estimates based on your prospective home purchase.

In determining how much cash you need for the down payment and closing costs, you should remember to maintain sufficient liquid assets for an emergency fund. The amount you need for an emergency fund depends on your specific cash flow situation, but most people should maintain liquid assets equal to at least three to nine months of expenses. You should not utilize your emergency fund for the home purchase down payment because you may need those funds for unexpected expenses after moving into your new home. You should have enough total liquid assets to cover the down payment, closing costs, and your emergency fund.

To afford a home purchase, you also need enough cash flow to pay the ongoing costs of home ownership. Estimate how much will be your total costs for the mortgage payment, homeowners insurance, property taxes, homeowners association fees, maintenance services, and all home utilities. You can receive most of these cost estimates from your mortgage lender and real estate agent. Compare those expected home ownership costs to your current living expenses. If you are currently spending as much or more for your residence, then you should be able to transition to the new home without sacrifices in your budget. If your net cash flow will decrease as a result of moving to the new home, you need to determine where you would sacrifice in other areas of your budget. You must maintain a positive cash flow while owning the home in order to replenish your emergency fund when needed.

Mortgage lenders will estimate what price house you can afford by assuming certain percentages of your income will be allocated to housing expenses and other debt repayments, but you should view the amount they tell you as a price limit rather than a price target. How much income you actually want to dedicate to housing expenses will depend on your other financial plans. For example, you may want to spend less than you can currently afford if you plan to increase spending on other goals like growing your family. On the other hand, you may want to spend all that you can currently afford if you expect your income will increase much faster than inflation and you are willing to delay increased spending on other goals.

The main benefit of spending less than you can currently afford is that you allow some flexibility in your budget for any expected or unexpected changes in your cash flow. The biggest risk in buying a home for less than you can afford is that you could potentially outgrow a lower priced home sooner than you would a higher priced home. You should avoid cycling through your home too quickly in order to provide the home adequate time to appreciate enough to cover all your fixed costs of buying and selling the home. Assuming you will be satisfied living in your home for the next several years, spending less than you can afford would be a financially wise decision. You will better enjoy your home if you can comfortably afford your home.



You can have too much of a good thing. One such case is investment diversification. Diversification is the practice of investing in a variety of different securities in order to reduce security-specific risk. For example, if you invest all of your money in one company, the success of your investment depends entirely on the performance of just that one company. But if you invest your money evenly among ten different companies, no more than ten percent of your initial investment will depend on the performance of just one company.

You may be wondering how could you possibly have too much diversification. If owning ten securities reduces your risk, then owning one hundred securities should reduce your risk more, and owning one thousand securities should reduce your risk even more. As you increase the number of securities held in your investment portfolio, you increase the level to which your portfolio represents the market as a whole. This result may be perfectly acceptable for investors who seek to capture average market performance in their portfolios. However, investors who seek to perform better than the market average will discover that excessive diversification can make those returns more difficult to achieve.

The effect diversification has on investment performance can be observed in mutual funds. The performance of a large cap mutual fund that owns 300 stocks is more likely to resemble the average performance of all large cap stocks compared to a large cap mutual fund that owns just 30 stocks. When a mutual fund’s holdings are limited, it has more security-specific risk, but it also has the potential to perform significantly above the category average if security selection is successful. When a mutual fund’s holdings are very widespread, it has less security-specific risk, but it lacks the potential to perform significantly above the category average because its holdings may represent nearly the whole category.

Investment costs should be considered in the diversification of your portfolio. Your investment performance will not be enhanced by diversifying among many different investment managers if their combined average performance ultimately equals the average performance of the market. If an actively-managed mutual fund is diversified to the extent that it holds a majority of the securities that represent a category, the mutual fund’s performance may not exceed the category average enough to justify its expense ratio. In this case, you may want to consider a low-cost index fund that attempts to replicate the performance of that category.

Diversification is an excellent strategy for reducing risk. While diversification can eliminate security-specific risk, diversification cannot eliminate market risk, which is caused by market factors that affect all securities. A very diversified portfolio may perform similar to the categories it represents, which as long as costs are minimized, is great for investors who want to replicate average market performance. For investors attempting to perform better than the market, diversification is still a valuable strategy if practiced in a more limited form.



You can accelerate the growth of your investment portfolio in one of two ways: increasing your contributions or increasing your investment return. People often focus on how to increase their investment returns when they ultimately have no control over how the investment markets will perform. Those people may not realize the amount they save can affect their portfolio growth more than how they invest. Let’s review an example.

Tom and Ron enroll in their employer’s retirement savings plan and start with $0 account balances. Tom contributes $5,000 per year. Tom’s investments perform well and return 8% per year for 20 years, so his account balance grows to $228,810. His co-worker, Ron, contributes $8,000 per year. Ron’s investments do not perform as well and return only 4% per year for 20 years, but his account balance grows to $238,225. Notice that even though Tom’s annual investment return was double that of Ron’s, the larger account balance after 20 years belongs to Ron because he saved $3,000 per year more than Tom.

When it comes to your investment portfolio, focus your efforts on what you can control. You can control which investments you select, but you cannot control how your investments will perform. If you believe a poor investment experience may thwart your financial goals, consider how you could potentially increase the amount you save. The factor you can control may be the factor that has the greatest effect.



The Patient Protection and Affordable Care Act, commonly referred to as Obamacare, was passed by Congress and signed into law by President Obama on March 23, 2010. The multiple provisions of the health care law are scheduled to become effective over a period of several years following passage. Among those provisions are new Medicare taxes that become effective on January 1, 2013.

The current tax rate for the Medicare portion of the FICA payroll tax is 1.45% for employees and 1.45% for employers, or 2.9% for self-employed persons. This rate applies to every dollar of earned income, meaning the tax rate does not change as income increases. However, starting in 2013, the Medicare tax rate will be higher for many people with incomes above certain levels.

Single taxpayers with earned incomes above $200,000 and married filing jointly taxpayers with earned incomes above $250,000 will pay an additional 0.9% of Medicare taxes on earned incomes above those threshold amounts. This additional tax applies to the employee portion of the Medicare taxes, so employees will pay an effective tax rate of 2.35% on their earned incomes above the threshold amounts. For example, a married couple with $350,000 of earned income would pay 1.45% of Medicare taxes on their first $250,000 of earned income and 2.35% of Medicare taxes on their next $100,000 of earned income.

The new law also implements a Medicare tax for unearned incomes above certain levels. Unearned income can be interest, dividends, capital gains, annuities, rents, royalties, or other passive activity. Single taxpayers with modified adjusted gross incomes above $200,000 and married filing jointly taxpayers with modified adjusted gross incomes above $250,000 will pay an additional 3.8% of Medicare taxes on the lesser of (1) their unearned incomes or (2) their modified adjusted gross incomes above those threshold amounts. Modified adjusted gross income in this case is defined as adjusted gross income plus the net foreign income exclusion.

Here are a few examples to illustrate how the Medicare tax will apply to unearned incomes. A single person with $300,000 of earned income and $25,000 of unearned income would pay 3.8% of Medicare taxes on $25,000 of unearned income because his unearned income is less than his total income above the threshold. A married couple with $150,000 of earned income and $150,000 of unearned income would pay 3.8% of Medicare taxes on $50,000 of unearned income because their total income above the threshold is less than their unearned income. A married couple with $25,000 of earned income and $200,000 of unearned income would not pay Medicare taxes on any unearned income because their total income is below the threshold.

The new Medicare taxes will generate billions of dollars in funding for the Patient Protection and Affordable Care Act. Taxpayers with incomes below the $200,000 and $250,000 threshold amounts may not be concerned with the new Medicare taxes in 2013, but because the income thresholds are not scheduled to increase for inflation, a larger percentage of taxpayers may be subject to this tax in future years. However, the new Medicare tax may not survive forever because many taxpayers support the repeal of Obamacare. The law’s future will depend on the actions of our elected officials.



Tax planning enables individuals to arrange their cash flows in a way that minimizes the amount of taxes they pay over their lifetimes. The scenario below illustrates how a taxpayer with fairly predictable cash flows might engage in income tax planning. This fictional scenario should not be considered as personalized tax advice.

Jim and Pam are married, in their 30s, have two minor children, and live in Texas. They are planning for their federal income tax liability for 2012. They believe their income this year will place them in the 25% marginal tax bracket, but they would like to stay in the 15% marginal tax bracket if possible. They are comfortable maximizing their use of the 15% tax bracket because they believe their marginal tax rate will be higher than 15% in the future. They also prefer to be in the 15% marginal tax bracket because for 2012, this would make them eligible for the 0% tax rate on qualified dividends and long-term capital gains.

For 2012, taxable income above $70,700 falls into the 25% marginal tax bracket, so Jim and Pam will want to target a taxable income of no more than $70,700. Taxable income is calculated by subtracting the standard or itemized deductions and personal exemptions from adjusted gross income. They expect their itemized deductions (sales taxes, property taxes, mortgage interest, charitable gifts) to total $14,800 and personal exemptions ($3,800 per family member) to total $15,200. Adding these amounts to $70,700, they calculate their adjusted gross income should not exceed $100,700 in order to avoid the 25% marginal tax bracket.

This year, Jim and Pam expect to have $110,000 of earned income and $5,000 of investment income. In order to limit their adjusted gross income to $100,700, they want to defer at least $14,300 of income into tax-deferred retirement accounts. Jim is covered by a 401k plan at work, so he can defer earned income to his traditional 401k account. Just in case their income or deductions are slightly different than expected, Jim decides to defer $17,000 to his 401k account (the 2012 limit) which will lower their adjusted gross income to $98,000. Pam also wants to contribute for retirement, but they will have already lowered their taxable income to the 15% marginal tax bracket using the tax-deferred 401k. Pam decides to contribute $5,000 to a Roth IRA, so they pay income taxes at 15% on her contribution now rather than defer those taxes until retirement.

Taxes are an important component of financial planning because almost any time wealth is transferred, taxes will be levied. To minimize tax liabilities, one should be familiar with the tax laws, which are always subject to change. For personalized tax planning advice, please consult with a CPA or CFP® professional.



If you are like most Americans, you probably have liabilities on your personal balance sheet, whether they be home loans, car loans, student loans, or credit cards. When you have multiple loans or debts, you might wonder how you should allocate your payments to each. The simple answer is you should pay the most to what costs you the most. Which debt is costing you the most will depend on a couple of factors.

First of all, you should probably pay at least the minimum required payment for each loan you have in order to avoid late penalties or additional service fees. If you are making the required payments and still have additional funds you want to allocate to debt repayment, you should compare the rates and terms of your loans to determine which is most expensive. The rate is the percent of interest charged, and the term is the length of the repayment schedule. When you have two loans with the same term, the loan with the higher rate costs you more. When you have two loans with the same rate, the loan with the longer term costs you more.

The comparison is not always that simple if you have multiple loans with different rates and different terms. You could have a lower-rate loan cost more if the term is longer, or you could have a shorter-term loan cost more if the rate is higher. To determine your most expensive loan in these cases, add up the cumulative interest expense for each loan through the length of the shortest term loan. Then divide that cumulative interest of each loan by the current balance of each loan. The highest percentage calculated, the most cumulative interest relative to the loan balance, is your most expensive loan over the period evaluated.

Notice the balances of the loans are never a factor in comparing interest expenses. Large balance loans may seem more expensive because they require more dollars of interest to be paid, but a large-balance loan with a low rate and short term will cost less than a small-balance loan with a high rate and long term. The correct way to determine the most expensive loan is to divide the dollar amount of cumulative interest by the dollar amount of the loan balance.

Comparing your loan costs is important when trying to pay off loans in the most cost-efficient order. These evaluations do not consider the opportunity cost of paying down debt. You could possibly earn more by investing your additional funds than you would save by paying off your loans more quickly. But if your primary goal is to pay down debt, allocate your additional funds to the loan that is most expensive.



Two of the most unpredictable variables affecting the success of a retirement plan are life expectancy and investment experience. In retirement plans, we usually simulate these variables based on probabilities of historical results. We first assume a life expectancy by evaluating what percentage of people have lived to certain ages. We then develop a plan that would have been successful in a certain percentage of past investment time periods. When we combine these probabilities of life expectancy and investment return, we may amplify the probability of success for a retirement plan.

Let’s consider a plan that assumes a 50% life expectancy, meaning half of people live beyond that age, and a 80% historical success ratio, meaning one-fifth of past time periods had a lower investment return. The plan would fail only if the person lives longer than 50% of people AND if the investment return is worse than 80% of past time periods. Because plan failure depends on both events occurring, the probability of success is amplified. To calculate this, we multiply the probabilities of both events to find their combined probability. [(1-0.50) x (1-0.80) = 0.10] There is a 10% chance both events occur; therefore, the combined probability of success for that scenario is 90%.

We should be cautious regarding how the combination of conservative assumptions for life expectancy and investment experience can magnify the probability of success. Let’s consider a plan that assumes a 25% life expectancy and a 88% historical success ratio. The plan would fail only if the person lives longer than 25% of people AND if the investment return is worse than 12% of past time periods. [(1-0.25) x (1-0.12) = 0.03] There is a 3% chance both events occur; therefore, the combined probability of success for that scenario is 97%. These assumptions may cause the plan to be more conservative than was originally intended.

Although we may like retirement plans that have little chance of failure, few people want to feel constrained due to overly conservative plan assumptions. Most people want to spend what they can before death rather than leave behind a large estate. We must strike a comfortable balance between the amount of spending and the probability of plan success. If the life expectancy and investment returns do not follow the plan projections, the spending level or other variables can usually be modified later in life to compensate. What an individual considers to be an acceptable probability of success may depend on his or her circumstances. Ultimately, each individual has to decide what probability of success he or she feels comfortable targeting in a retirement plan.



As you may have noticed by the advertisements, a currently popular trend in retirement planning is to calculate “your number.” This refers to the amount of savings you need to have at retirement. From a marketing perspective, “your number” attracts consumers who prefer simplicity and an easily defined goal, but from a financial perspective, “your number” does not address all the dynamic variables of retirement planning. Retirement planning is more complex than just a number.

Retirement planning is a process that continues over your lifetime, not a one-time occurrence. You cannot calculate “your retirement number” now and carry that same number around for years expecting it to remain static until you retire. During your lifetime, “your number” will be affected by many variables that can unexpectedly change, such as incomes, expenses, savings rates, tax rates, inflation rates, asset allocations, and investment performance. Your retirement plan should be updated and modified as these changes occur so that you can adjust the other variables to maintain an acceptable probability of reaching your goals.

Retirement planning allows you to map a course of actions from now until your death. Just knowing “your retirement number” is like having a destination without having directions. You need directions such as how much to save and where to invest in order to reach your goals. You should also recognize that death, not “your number,” is the ending destination point in your retirement plan. Even though you might reach “your number” by retirement, you could still run out of money before death if variables such as inflation rates, investment returns, and portfolio withdrawals are different than planned.

The advertising of “your number” has been beneficial for retirement planning awareness, but consumers should recognize that just calculating “your number” is not an adequate substitution for a comprehensive retirement plan. A retirement plan should be developed, implemented, monitored, and modified as needed over your lifetime to help you achieve your goals. If you would like help with this process, please consult with a CFP® professional who provides financial planning services.