Zynergy

Retirement Planning

FAQ: Can You Expect to Receive Dividends on Your Equity Compensation?

Bill Gallagher

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Expecting Dividends?

Many companies pay out part of their profits to shareholders as a dividend.  While dividends typically consist of cash distribution, there are times when a company may decide to issue a stock dividend.  When it comes to dividends and your equity compensation, it is essential to understand the type of equity compensation you received (e.g., restricted stock units, restricted stock awards, stock options) because this will help determine not only if you’re eligible to receive dividends, but also how those dividends will be treated for income tax purposes.  I will limit this discussion to restricted stock units (RSUs) and restricted stock awards (RSAs); as an employee who owns stock options, you will not receive dividends until you exercise the option and become a shareholder. 

Before we dive into whether you receive dividends on the shares of stock granted as part of an equity compensation package (Part 1), a quick review of RSUs and RSAs is in order.  When an employee is granted RSUs:

  • Employees do not own the shares outright on the grant date.
  • Employees must satisfy a vesting period before they are considered the owner.
  • RSUs represent a future promise made by your employer.
  • Shares are only issued to the employee after a vesting period.

Unlike RSUs, when an employee is granted RSAs, the stakes are given to them on the grant date. In other words, the employee will own the shares as of the grant date. However, it is important to note that even though they own the shares, these shares are held in an escrow account until the employee satisfies the vesting period.

Dividends & Equity Compensation

Regarding dividends and equity compensation(Part 2), the keyword is shareholder, as only shareholders are eligible to receive dividends. When an employee is granted RSUs, and since they are not considered a shareholder until they satisfy the vesting requirements, they will not receive any dividends during the vesting period. However, when the employee and those dividend payments receive the RSU shares vest, dividends will be considered dividend income and may be eligible for the preferential dividend income tax rates.

On the other hand, when an employee receives a grant of RSAs, they are considered a shareholder as of the grant date. Therefore, as a shareholder, the employee will receive dividends that are paid during the vesting period. However, for tax purposes, the IRS treats the employee as if they do not own the stock yet. Any dividend income received during the vesting period will be considered compensation income, and dividends will be reported on the employee’s W-2. This means they will not qualify for the lower tax rates that apply to most dividend income. However, any dividends received after the vesting period qualify for the preferential dividend tax rates. (Part 3)

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If you find yourself in a fortunate position where your company is providing you with equity compensation, you will want to ensure you know the type of equity you received along with the grant date and vest date. In addition, I would strongly suggest you reach out to your financial planner to get a comprehensive look at how your equity compensation can help you achieve your goals and objectives.

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Congratulations! You just received word that your employer has decided to offer you equity compensation, in the form of company stock, as part of your overall compensation package. While equity compensation is a great way to boost your savings to help you achieve your goals and objectives, it requires special attention. There are several types of equity compensation that you can receive, and each type comes with its own set of terms and income tax characteristics. Therefore, if you receive (or already have received) equity compensation, now is the time to familiarize yourself with your specific grant(s) terms and conditions. Equity compensation awards do not come with an instruction manual. Companies typically do not have equity compensation specialists on staff to provide personal financial advice or guidance on how you should handle your grant. While they can guide you through the process and mechanics, they are not in the position to make personal financial planning recommendations. Here are 3 Things to Know When You Receive Equity Compensation.

Impact On Your Financial Situation

Your company will provide a copy of the plan document with your grant agreement these documents provide important, useful information but are typically filled with tax calculations and other technical jargon, which may confuse some. The plan document describes the plan’s overall structure and contains specific terms and conditions, including what kinds of awards can be granted and who will be eligible to receive them. Plan documents are often customized to the issuer’s unique situation; therefore, if you have received equity compensation from a previous employer, do not assume that your current employer’s plan will operate in the same fashion. On the other hand, the grant agreement will specify the details for your individual grant. This will include the name of the grant recipient, the effective date of the grant, type of award, number of shares of stock covered, exercise price, vesting schedule, and the award’s expiration date.

To determine how the equity grant impacts your financial situation, you will need to look no further than the grant agreement. This is where you will find most of the pertinent information you need. The three items you want to make sure you understand are:

  • Type of award you received
  • Grant Date
  • Vest Date

Type of Award

Equity compensation comes in many forms however the most common types include restricted stock awards, restricted stock units, incentive stock options, non-qualified stock options, and employee stock purchase plans. Each of these types of plants operates in a different fashion and each has its own tax characteristics. Therefore, for you to determine how your grant impacts your financial situation you will first need to understand what type of grant you received. If you are interested in learning more about these plans and their different tax characteristics, please see our previous blog posts on the subject (Equity Compensation Series – Part 1 Restricted Stock Awards (RSA) and Restricted Stock Units, Equity Compensation Series – Part 2 Employer Stock Options, and Equity Compensation Series – Part 3 Employee Stock Purchase Plans.)

Grant Date

The grant date is the date in which the award is approved by your company’s board of directors and granted to you. It is important to note that even though you have received a restricted stock or stock option grant you will most likely not own the underlying shares or options as of the grant date. Instead, you will receive ownership in the shares and/or options over the course of time (1-year, 3-years, 5-years, etc.) as you maintain employment with the company. This process is referred to as vesting.

Vest Date

The vesting date is the date on which you take ownership of all or a portion of your award. As mentioned above, equity grants are typically subject to a vesting schedule. This means that you receive ownership of all or a portion of the shares of stock or options over a period of time, as long as you stay employed with the company. Let’s say that your employer granted you 200 shares of stock, subject to a vesting period of 1 year. This means that after 1 year of service, assuming you are still employed by the company, you will take ownership of the 200 shares.

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Equity compensation has become more and more popular over the years, and if you find yourself in the fortunate position where your company is providing you with equity compensation, then you will want to make sure you know the type of equity you received along with the grant date and vest date. In addition, I would strongly suggest you reach out to your financial planner so that you can get a comprehensive look at how your equity compensation can help achieve your goals and objectives.

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Frequently Asked Questions: What Types of Employer-Sponsored Retirement Plans are Available for the Self-Employed Individual?

by Bill Gallagher, CFP®, MPAS®

Many small business owners are so engrossed with running their company on a day-to-day basis that they neglect to save for retirement. This is not because they don’t think saving for retirement is important, but rather, they have so much on their plate that they tend to put it on the back burner. While establishing a retirement plan for their company has the obvious benefit of saving for retirement, it can also provide for some tax savings (either at the personal level or company level). Below are three of the most popular retirement plans that small business owners utilize for their retirement savings:

Simplified Employee Pension Plan (SEP-IRA)

A SEP IRA is a Traditional IRA, but for self-employed individuals and small business owners. Contributions made to a SEP IRA are tax-deductible and the investments grow tax deferred. When distributions begin in retirement they will be taxed as ordinary income in the year distributed. Please note, any money distributed prior to age 59 ½ may be subject to the 10% IRS early withdrawal penalty. The major advantage of SEP IRAs over Traditional IRAs is the amount a self-employed individual can contribute. In 2022, individuals are limited to a $6,000 annual contribution ($7,000 if they are age 50 and over) to their Traditional IRA. However, establishing a SEP IRA will allow the business owner to contribute up to 25% of their net self-employment income, not to exceed $61,000.

SEP IRAs are flexible, easy to establish, and involve minimal disclosure and reporting requirements. Contributions can be made in different amounts from year to year and can be made up to the tax filing deadline for the previous year (or later if you file an extension). SEP IRAs are a great fit for a business owner who has no, or few, employees. If the business has employees, and the owner decides to contribute to his/her own SEP IRA, then the owner is required to contribute to the employee’s SEP IRA on their behalf if the employee is age 21 or older, has worked for the business for at least three of the past five years, and received a minimum of $650 in 2022. If an employee has met these requirements, then the owner must make the same contribution, as a percentage of salary, to the employee’s SEP IRA.

Savings Incentive Match Plan for Employees (SIMPLE IRA)

The SIMPLE IRA is a retirement savings plan that is tailored to the needs of small business owners who have less than 100 employees. One of the great features of this plan is the ability for the employees to make contributions to their own account so that they can save for their own retirement. This contrasts with the SEP IRA, where all the contributions are made by the employer. The maximum amount the employee can contribute to his/her SIMPLE IRA is $14,000 (in 2022). If the employee is age 50 and over, then they can contribute an additional $3,000 (in 2022). An eligible employee will also be able to receive a company contribution (via a match) into their SIMPLE IRA. This contribution will not only help encourage participation in the plan but can also help boost the employee’s retirement savings. There are two options the company has when it comes to making contributions to their employees’ accounts. The first formula is a dollar-for-dollar match, up to 3% of the employee’s compensation. The other option is for the company to make a non-elective contribution equal to 2% of each employee’s compensation, regardless of whether the employee elects to make contributions.

Like the SEP IRA, SIMPLE IRAs plans offer low start-up and annual costs. In addition, eligibility requirements for employees are low. An employee is eligible to participate in a SIMPLE IRA if they received at least $5,000 in compensation during any of the two preceding calendar years and expect to earn at least that much during the calendar year of participation.

Solo 401(k)

The Solo 401(k) is designed for the business owner who does not have employees (or whose only employee is their spouse). One of the great features of a Solo 401(k) plan is the ability for the business owner to make contributions to his/her plan in addition to receiving a contribution from the company (in the form of a profit-sharing contribution). As an “employee” of the business, the owner can contribute up to $20,500 (in 2022). Those age 50 and over can contribute an additional $6,500 (in 2022) to their Solo 401(k). In addition, as the “employer,” you can make a profit-sharing contribution up to 25% of compensation. However, it is important to note that total contributions to the plan (employee plus employer) cannot exceed $61,000 (or $67,500 for those over age 50) in 2022.

While a Solo 401(k) is flexible in its design, it is not as easy to maintain as a SEP IRA or SIMPLE IRA. For example, the plan must be established by December 31, there are reporting requirements (IRS Form 5500 must be filed every year when the plan balance reaches $250,000), and the IRS requires that contributions be “recurring and substantial” in order for the plan to remain active. However, unlike a SEP IRA and SIMPLE IRA, the owner can add a Roth feature to his/her Solo 401(k). This would allow him/her to make post-tax “employee” contributions to the plan, providing for tax-free growth and income in retirement.

Installing a retirement plan for your company can be a great way to maximize your retirement savings on a tax-favored basis. However, since you are both the employee and the employer, and since contribution limits change on an annual basis, you should have a conversation with your financial advisor and tax professional so they can help choose the right plan for your particular company, based upon your personal goals and objectives.

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Do I Have Enough For A Comfortable Retirement? 

Great question, and one that we get a lot!  Unfortunately, no universal “magic number” will apply to everyone.  Since everyone has a different financial situation, lifestyle, health situation, and legacy plans, it would not be prudent for me to say that everyone needs $1,000,000, or $2,000,000, or perhaps more to live a financially worry-free and comfortable retirement.   Some people can retire comfortably with a much smaller portfolio than someone with a higher portfolio balance.  While there are some rules of thumb that you can apply to your situation, relying on these rules of thumb may not put you where you need to be to live comfortably in retirement.  When we talk about retirement planning, we always say that lifestyle and cash flow are just as important as the size of the portfolio.  

How much income will I need in retirement to live my desired lifestyle?  

If you would like to travel the world and purchase a vacation home in retirement, your lifestyle will demand a higher amount of retirement income than someone who likes to stay close to home and live a life of leisure. Retirement planning is not a savings number but an income. 

It is important to remember that your portfolio will not be the only source of income available to you in retirement.  Many people tend not to factor in Social Security, pension income, or perhaps a period of semi-retirement income when they are planning for their retirement.  These sources of income are critical because they can be applied to your lifestyle expenses, potentially reducing the amount you need to draw from your portfolio. 

 

For example, let’s assume a 65-year-old newly retired individual has a lifestyle that calls for $5,000 per month in income.  Let’s also believe that he/she will receive a monthly Social Security benefit of $1,500 and a monthly pension payment of $750.  When we apply these income sources to their needs, we can determine that this retiree will fall short of their monthly income need by $2,750.  To bridge the income gap, this retiree will need their portfolio to support a monthly withdrawal of $2,750.  Suppose the 4% safe withdrawal rule is applied. In that case, which states that an individual can comfortably withdraw 4% of the total balance of their portfolio in the first year of retirement and adjust that amount for inflation every year after that without running the risk of running out of money over 30 years – we can calculate that this retiree will need a portfolio balance of $825,000 to support their retirement needs.  

As we can see from the example above, planning for retirement is more about understanding your lifestyle, represented by your income need, instead of the amount you have saved in your portfolio.  If you plan on retiring soon, you must begin to define your retirement lifestyle because that will drive the amount of income you will need.

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If you own shares of your company’s stock within your employer-sponsored retirement plan (e.g. 401(k), profit-sharing plan, etc.), you will have several options available to you when you retire or are eligible to take a distribution from your plan. If you find yourself in a position where your company’s stock has appreciated significantly, you may want to consider utilizing the net unrealized appreciation (NUA) tax strategy. This strategy will provide an employee with the ability to maintain their company’s stock position while also providing the potential for tax savings. Before we review the mechanics of the NUA strategy, let’s first cover the rules and regulations surrounding the strategy.

In order for an employee to be eligible for the NUA strategy he/she must own actual shares of their company’s stock within their employer-sponsored plan, and satisfy one of the following conditions:

  • Death
  • Attainment of age 59 ½
  • Separation of service/retirement
  • Permanent disability (for self-employed individuals only)

At this point you may be asking yourself “What is the NUA and how could the strategy be beneficial to me?“ In simple terms, the NUA is the difference between the price the employee initially paid for company stock (its cost basis) and its current fair market value. I think the best way to explain the NUA is through an example:

  • Ten years ago an employee purchased 500 shares of company stock within their employer plan for $20 per share (resulting in a cost basis of $50,000.) Over the last ten years, the stock price increased significantly, and it is now worth $300 per share, and now the overall value of the stock position is worth $150,000. The NUA in this example is the difference between the current value ($150,000) and the cost basis ($50,000), or $100,000.

Now that we know how to calculate the net unrealized appreciation, let’s discuss how the strategy works and why it can have the ability to provide an employee with some tax savings. If the employee experienced one of the events listed above, then they will need to decide about what they do with their employer-sponsored retirement plan: do they roll over the balance to an IRA or leave it where it is? Regardless of which option they choose, when they begin taking distributions from either their IRA or employer plan, those distributions will be taxed as ordinary income in the year distributed. If the employee is under the age of 59 ½ at the time of distribution, then the IRS will also apply a 10% penalty on the distribution.
However, if the employee elects the NUA strategy with the shares of company stock, they will be able to convert the taxation of the NUA ($100,000 in our example) from ordinary income into a long-term capital gain. The benefit of turning ordinary income into a long-term capital gain is the preferential tax treatment awarded to long-term capital gains. Long-term capital gains are taxed at either 0%, 15%, or 20% (depending on your income tax bracket). However, the employee must be aware that they will not be able to completely escape ordinary income tax with the NUA strategy. This is because the IRS will include the cost basis of the shares ($50,000) in the employee’s income for the year.

  • Continuing our example from above, the employee decided to retire earlier this year when he/she was 62 years old. Let’s also assume that he/she will be in the 24% tax bracket over the course of their retirement. If they elected to perform the NUA strategy, then only $50,000 will be taxed at 24% this year while the NUA of $100,000 will be taxed at 15% when he/she chooses to sell all or a portion of the shares.

As far as mechanics, it is important to note that the employee must distribute the entire balance of their employer-sponsored plan within one tax year (although he/she doesn’t have to take all the distributions at the same time). In addition, in order to take advantage of the NUA strategy, the shares of company stock must be distributed “in-kind” to a taxable brokerage account. Once there, the employee can choose to either hold onto the shares or sell them to diversify their holdings.

If you are considering implementing the net unrealized appreciation strategy it is important to work out the various tax scenarios and incorporate them into your financial plan so that you can determine the best option given your financial situation. Therefore, I would suggest that you work closely with your financial advisor and/or tax professional to ensure that the strategy is implemented correctly.

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Russia’s decision to invade Ukraine has caused a lot of uncertainty for investors. First and foremost, the main concern is the safety of the Ukrainian people and their sovereignty. However, there are side effects from the invasion that are being felt outside of Russia and Ukraine that have investors concerned. So, what does the Russian invasion mean for investors? What are some things investors can do to help alleviate the impact of the side effects on their personal financial situation? Below you will find three of the main investor concerns and how they can help counteract the impact.

Inflation – While inflationary pressure has been building over the past several months (due to a higher demand for goods and supply chain disruptions caused by the COVID-19 pandemic) we now have a new dynamic to deal with – Russia’s invasion of Ukraine. Many investors know that Russia’s main export is oil, but not everyone knows that it does not end there. Russia also supplies the world with other natural resources, including wheat, lumber, and metals (aluminum, palladium, nickel, and titanium). These natural resources are needed to drive our cars, heat our homes, and build new homes. In addition, metals are used in everything from automobiles to cell phones, to electric car batteries, to aerospace products. Russia has not yet decided to cut off the West from oil delivery or other natural resources. I find it hard to believe that Russia would move in this direction (as the Russian economy would have a very difficult time insulating that shock), but we cannot put anything past Vladimir Putin. Given the uncertainty of the invasion and Putin’s response to the West’s economic sanctions, the prices of these natural resources have increased over the past few weeks. While the US and its allies have committed to releasing 60 million barrels of oil from the Strategic Oil Reserve, this may not alleviate all of the pricing pressure. Therefore, it is safe to assume that prices will remain at an elevated level for the foreseeable future.

So, how can you best prepare yourself for higher inflation? First, you need to understand where your money is going. That is why we recommend that you track your expenses to determine what areas of your spending are more vulnerable to an increase in prices (e.g. heat, gasoline, electric, groceries). Once you understand your spending habits, review your budget. If higher prices at the pump or at the grocery store are causing strain on your budget, then you may need to adjust your spending in other areas. Typically, the first line item to look at is your discretionary expenses (or non-essential expenses). This can include dining out, entertainment trips to Starbucks, travel, etc. If you are feeling the pinch from higher prices then perhaps you can skip a night out, make fewer trips to Starbucks, or perhaps put the new TV purchase on hold for a few months.

Higher Interest Rates – The US Federal Reserve has two primary objectives: to maintain high employment and maintain stable prices. In response to the strong economic recovery coming out of the COVID-19 pandemic and growing inflationary pressure, the US Federal Reserve has decided to pull back on economic stimulus. To that end, the US Federal Reserve will most likely increase short-term interest rates. In fact, Federal Reserve Chairman Jerome Powell indicated that he supports an increase of .25% in interest rates in March. While some investors may welcome higher interest rates and a higher rate of return on their savings, it is not all good news. Higher interest rates can lead to a slowdown in economic growth and thus lower stock returns. In addition, higher interest rates can have a negative impact on the housing market and those who carry variable interest rate debt.

How best can you prepare for higher interest rates? If you are someone who carries credit card debt or if you have a variable interest rate loan, now is a great time to take action. As interest rates increase, the rate on variable interest rate debt will increase as well, leading to higher monthly payments. Paying off your credit card debt will not only help reduce the amount of interest you pay, but it will also free up money that you can put towards building an emergency fund or saving for retirement. If you have another type of variable rate debt, now would be a good time to look into refinancing the loan into a fixed-rate loan. Interest rates today are still historically low, so you may be able to find a good deal on a fixed-rate loan.

Stock Market Volatility – One thing I can say with certainty is that the stock market does not like uncertainty. Unfortunately, today there is no shortage of uncertainty. We do not know what the outcome of the Russia-Ukraine conflict will be; we do not know if Russia will try to move into NATO countries, we do not know if inflationary pressures will ease over the next few months, and we do not know how high-interest rates will go. Therefore, investors need to brace themselves for a period of higher stock market fluctuation. During times of uncertainty, the stock market is more sensitive to breaking news headlines. Any particular headline can cause the market to swing dramatically in any direction.

It is times like these that remind us of the importance of a well-diversified portfolio. In addition, you want to make sure that you are rebalancing your portfolio at least once a year to ensure your allocation is aligned with your risk tolerance. Turn off the financial news and remain disciplined. The stock market could be down 2.5% one day and up 3.0% the next day. Watching the financial news could cause an investor to panic, which can lead them into making a bad financial decision. Remember, investing is a long-term strategy. The markets are going to experience periods of above-average returns and periods of below-average returns. The economy is going to experience periods of economic expansion and periods of recession. But we know that the market heads higher over time. As an investor, you never want to take a short-term view of a long-term investment.

 

 

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Frequently Asked Questions: Financial Advisor Designations?

If you have been searching for, and interviewing, financial advisors lately, you may have found that some advisors carry certain financial advisor designations (e.g. CFP®, CFA, CPA, etc.). If you are confused about what these letters represent, and have some questions, you are not alone. Many advisors choose to further their education so that they gain the knowledge and fine-tune their advice so that they can serve their clients better. But how do you select an advisor that is right for your needs? Below I will highlight three of the more commonly held financial advisor designations in hopes that it will clear some of the confusion and lead you to find the advisor that is best suited to meet your needs.

Certified Financial Planner (CFP®)

The Certified Financial Planner™ designation is awarded by the Certified Financial Planner Board of Standards to those individuals who meet rigorous education, training, and ethical standards. Before an individual may call oneself a Certified Financial Planner™ he/she must first meet an education requirement which includes completing financial planning coursework and holding a bachelor’s degree from an accredited college or university. He/She will then need to demonstrate that they attained the knowledge and competency to provide comprehensive financial planning bypassing the CFP® exam. Upon passing the exam he/she will need to complete (or have completed) 6,000 hours of professional experience related to the financial planning process and agree to adhere to the CFP Board’s ethical and professional standards for the practice of financial planning. A CFP®, unlike other types of financial advisors, is held to a fiduciary standard. Therefore, they must provide financial advice and guidance that is in their client’s best interest.

Through the financial planning process, a CFP® will help its clients create and monitor a financial plan. They typically start out by determining your financial goals and assessing your current financial needs. They will then move on to providing advice on everything from specific investments to saving for a down payment on a home, to planning for retirement. You will also find that some CFP®s specialize in a certain area such as divorce and retirement planning, while others tend to work with specific clients, like small business owners or retirees. Therefore, it is important to understand what type of advice you need so that you can select the advisor who best fits that need.

Chartered Financial Analyst (CFA®)

The Chartered Financial Analyst (CFA®) designation is awarded by the CFA Institute and is awarded to financial professionals who are competent in investment analysis and portfolio management. The CFA Institute’s mission is to promote and develop a high level of education, ethical, and professional standards in the investment industry. In order to earn the CFA® designation, an individual must demonstrate his/her expertise in financial research, portfolio management, risk analysis, and risk management. Similar to the CFP® designation, the requirements of becoming a CFA® are rigorous and can take several years to complete. Before an individual can call himself a CFA® he/she must have a bachelor’s degree, 4,000 hours of relevant work experience over at least three consecutive years, and pass a series of three, six-hour exams. Lastly, he/she must adhere to the CFA Institute’s Code of Ethics and Professional Conduct.

The skillset of a CFA® is focused on high-level investment management, economics, financial reporting, corporate finance, and complex equity investing strategies. Therefore, they are typically employed at large financial institutions and asset managers where they perform investment research and analysis. However, you may find some who serves as the Chief Financial Officer (CFO) for a company or who choose to work in the public sector for the Federal Government or a local government. The main difference between a CFP® and a CFA® comes down to who they work with. A CFA® typically works with corporate clients on the investment analysis side, while a CFP® works with individual investors to build a financial plan.

Certified Public Accountant (CPA)

Certified Public Accountant is a professional designation awarded to a licensed accountant. Unlike the CFP® and CFA®, the CPA license is issued by the Board of Accountancy in each state. Therefore, the requirements to obtain a CPA license will differ among the states; however, all states will require a certain level of accounting education to become a CPA. In most states, this includes 150 credit hours in college-level accounting and some states may even require relevant work experience before being licensed to practice as a CPA. In addition, an individual must pass the Uniform CPA Exam and may be required to complete an ethics course.

While the CPA designation is common among tax preparers and accountants, you will find that CPAs are employed in many fields across multiple industries. Some CPAs will choose to help individuals with tax preparation and filing, while others may provide bookkeeping services, financial reporting, and auditing for large corporations. You may also find some CPAs who provide investment advisory and financial planning services.

While there are many financial advisor designations available today, most of them do not carry the same level of education requirements and time commitment that the above designations do. This is why the designations listed above are considered to be the gold standard in the financial services industry. When working with a financial advisor, you want to make sure that they are not only competent in their advice but that they are acting in your best interest. When you choose to work with a  CFP®, CFA®, and/or CPA you can be confident that you will be in good hands.

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Q: What is rebalancing and why is it important? 

A: Rebalancing your portfolio involves shifting your investments among different asset classes to keep your portfolio in line with your target allocation.  Not only does this approach ensure that you are buying low and selling high, but can also eliminate the temptation to time the market.  Since we cannot consistently predict what a particular asset class will do in the future, it is impossible to know the optimum time to sell an asset to maximize profits.  But by rebalancing your asset allocation at least once a year, you will be taking advantage of market volatility and using it in your favor.  You will also be keeping your portfolio in line with your risk tolerance so that you can achieve your long-term goals.  

Asset classes (i.e. stocks, bonds, real estate, commodities, etc.) do not move in lock-step with each other.  For example, when stock prices are heading higher, bond prices tend to fall.  The opposite is also true: when stocks prices are declining, bond prices will typically increase.  This performance dynamic will result in a shift in your asset allocation, and if not monitored appropriately, could leave your portfolio exposed to a higher rate of fluctuation, perhaps more than you are comfortable with.   

For example, let’s say a newly retired individual chose to invest her retirement savings in a portfolio that consisted of 60% stocks and 40% bonds, which is consistent with her risk tolerance.  Let’s further assume the stock market performed very well over the first two years of her retirement.  Without rebalancing her portfolio, she may be surprised to find that her retirement portfolio now consists of 80% stocks and 20% bonds.  This mix will be outside her comfort zone and if the stock market begins to decline, she will experience a larger decline in her portfolio due to the higher exposure to stocks.  Higher fluctuation in her portfolio may cause panic and leave her no other option other than to liquidate her portfolio, at what could be a large loss.  Therefore, in order to eliminate trying to time the market and avoid panic selling, you want to make sure that you rebalance your portfolio at least every year in an effort to bring your asset allocation back in line with your risk tolerance.  

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When you were gathered around the TV with friends and family getting ready to celebrate the beginning of the New Year, I am sure that the last thing on your mind was your budget.  I get it; budgeting is not fun or exciting, but it is one of the most important things to put in place in your journey to financial freedom.

The beginning of the year is the optimal time to take some time to reflect on what it is that you would like to accomplish over the course of the next twelve months.  Would you like to retire? Purchase a new home or a vacation home? Pay down debt? Increase your retirement savings?   Whatever your goals are, the first thing that you need to do is to review your budget.  Understanding how you are spending your money will allow you to make the necessary changes so that you can align your spending with your goals and objectives.  If you do not have a budget in place, then there is no better time than now to start.

The first step in budgeting is determining where you are spending your money.  Therefore, it is critical to track your expenses, because it is only then that you can understand where your money is going.  If you do not know where your money is going, then you will most likely have a difficult time making changes to your spending habits going forward.  It is typically easier for many people to have a good understanding of their fixed expenses (e.g. mortgage, rent, utilities, car payment, cell phone, etc.) because they tend to be the same amount from month to month.  However, an area where most people struggle is understanding the number of their variable expenses.  Variable expenses are those expenses that change from month to month (e.g. groceries, dining out, entertainment, clothing, etc.)  Having a tracking system in place will allow you to stay on top of both your fixed expenses and variable expenses, providing you with the vital information you need in order to achieve your goals.  There are a variety of ways to track expenses (pen and paper, a spreadsheet, or a software program).

At Zynergy Retirement Planning, we recommend our members to utilize Mint.com.  Mint.com is a free service that allows you to link your various checking accounts and credit cards so that you can get a comprehensive view of your total spending. Once you have all your accounts loaded into the software, take a look at your spending over the past twelve months.  Is your spending consistent with your goals, objectives, and values?  If so, you are on the right path to financial freedom.  However, if your spending is not in-line with your goals you now have all the information that you need to make the necessary changes to get where you want to be.  It is also important to note that you should monitor your budget over the course of the year.  You do not want to create it and then walk away.  Life happens and there will be changes to your financial situation over the course of the year.  Incorporating these changes into your budget will help you remain on target to accomplish your goals.   

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It is that time of year again…time to work on your New Year’s resolutions and start fresh with your finances. While many think about their resolutions in terms of eating better, exercising, reading more, etc., not many people think about it in terms of their finances.  The beginning of the new year is a great time to think about how you can improve your finances so that you can achieve your goals.  Whether it includes buying a home, saving more for retirement, putting away money for a child’s college education, creating a budget, paying down debt; having a financial plan and a strategy for the year ahead can be a great way to reduce stress and put you in control of your financial life.  If you want 2022 to be a better year for your money, consider incorporating some of the items below into your New Year’s resolutions:

  • Create a budget – I will be the first to admit that budgeting is not a fun exercise.  However, a solid financial plan starts with a well-thought-out budget.  A spending plan can not only help you make progress towards your financial goals but can also help reduce stress throughout the year.  Consider tracking your expenses via a software program to get a good understanding of where your money is going.
  • Build an emergency fund – An emergency fund is a cornerstone of a financial plan. It is a great way to ensure that you are covered should you need cash to cover an emergency.  This way you do not have to rely on a credit card or dip into your long-term investments to get the cash you need.  While the textbooks say that you should have three to six months of your living expenses in an emergency fund, this could be an overwhelming number for some to achieve in the short term.  For those who do not have an emergency fund at this time, I would suggest that you commit to saving at least $1,000 in your emergency fund.  Once there, you can add to the fund over the course of the year should you find yourself with excess cash flow.  Better yet, choose a time frame in which you would like to target for a fully-funded emergency fund.  This way you can add the monthly amount going into your emergency fund to your budget.
  • Pay down debt – If you have outstanding credit card balances or other debt with a high-interest rate, then now is a good time to commit to eliminating your debts for good.  Perhaps it would make sense for you to refinance your debt into a lower interest rate.  Refinancing your debt may provide you with a lower monthly payment, which will improve your monthly cash flow.  These extra dollars can be applied to extra principal payments on your debt, redirected into your emergency fund, or put aside and invested for other long-term goals.
  • Make sure you get your free money – Do you have access to a retirement plan (401k, 403b, TSA) at work?  If so, do you know if your company offers a matching contribution?  Contributing to a retirement plan is an excellent way to save for retirement in a tax-efficient manner.  Most companies that have a retirement plan, but not all, will match an employee’s contributions, up to a certain amount.  This is virtually free money! If your company has a matching program in place then I would suggest that you take full advantage of the match, or at least as much as your budget will allow.  Do not leave free money on the table.
  • Review risk tolerance – If you experienced a life change over the past year or if you are expecting a change in the new year, then now is a good time to take a fresh look at your risk tolerance.  Understanding how you respond to market risk can have a positive, or negative, impact on your ability to achieve your goals.  If you are taking on too much risk than you can handle and we find ourselves in the middle of a bear market, how will you respond? If you are like most investors, you will most likely sell at the bottom and not be around for the recovery.  This can have a devastating impact on your long-term financial security.  Have an honest conversation with yourself about your risk tolerance.  Ask yourself: if the market drops 30% or 40%, how is that going to make me feel?  Will that cause me to abandon my long-term investment plan? If so, you may want to think about reallocating your portfolio so that it is in line with your risk tolerance.
  • Rebalance portfolio –Rebalancing your portfolio involves shifting your investments among different asset classes to keep your portfolio in line with your target allocation.  Not only does this approach ensure that you are buying low and selling high but can also eliminate the temptation to time the market.  Since we cannot consistently predict what a particular asset class will do in the future, it is impossible to know the optimum time to sell an asset to maximize profits.  But by rebalancing your asset allocation at least once a year, you will be taking advantage of the market.  You will also be keeping your portfolio in line with your risk tolerance so that you can achieve your long-term goals.
  • Review insurance – Reviewing your various insurance policies is a great way to not only to know how much you are paying for these policies but, more importantly, to determine if you have too much insurance – in which case you can probably save some premium dollars by reducing the coverage – or not a sufficient amount of insurance – in which case you may need to increase your coverage in certain areas.  Creating an inventory of your insurance policies (life, disability, auto, homeowners, renters, etc.) is a great first step in understanding the cost and coverage of your policies.
  • Estate planning documents – I know that it is never easy to talk about estate planning.  However, it is extremely important that you have the basic estate planning documents in place.  These include a Last Will and Testament, Power of Attorney, and Medical Directive.  Not only will these documents name your beneficiaries but will also allow you to name a trusted person, or persons, who you would like to take your place should you not be in the position to make financial or medical decisions for yourself.  If you already have these documents, it is still important to review them from time to time to ensure that they are consistent with your current estate planning goals.

Take control of your finances, and start fresh this new year with a plan for how you are going to handle your cash! We are here to help, so if you have any questions, feel free to contact Zynergy Retirement today.

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Are you planning on taking the leap into retirement in the New Year?  Choosing to retire is a big step, and you want to be sure that you are setting yourself up well for a secure retirement.  If you haven’t already, now is a good time to get your financial house in order so that you are fully prepared for the exciting journey ahead of you.  Getting your financial house in order involves preparing your retirement budget, knowing your sources of retirement income, understanding where your investment accounts are located, and how they are invested.  In addition, this is also a good time to think about how you are going to spend your time in retirement.  Now that you do not have to deal with the daily commute and a busy work schedule, how are you going to fill the hours of your day in retirement? Below you will find five important tasks you should complete over the next few months as you head into retirement.

  1. Prepare your retirement budget – Setting a budget is one of the most important things you can do leading up to and in retirement.  When reviewing your budget, it is important to separate your expenses into two categories: (1) essential expenses and (2) discretionary expenses.  Essential expenses are those that must be paid.  These include things like rent, mortgage, utilities, and groceries.  Discretionary expenses represent voluntary spending.  These are items that you would like to purchase, but they are not mandatory.  Discretionary spending is drawn from the money that is left over after paying your essential expenses.  
  1. Understand your retirement income – Once you have completed your budget, you will then want to understand where your income is going to come from.  The main source of retirement income for many Americans is Social Security, but it could also include a monthly pension payment or a stream of income from an annuity.  Once you know your income sources, you will then want to compare them to your expenses.  If you are like most people, once you retire, your expenses will likely be higher than your income.  In this situation, you will need to supplement your income from your savings and investments. Understanding how much income your portfolio needs to provide will help in determining how your portfolio should be invested.  
  1. Review your risk tolerance and asset allocation – When you retire, you will be transitioning from the accumulation stage of life to the decumulation stage.  The accumulation stage involves saving as much as you can and investing those savings at a level of risk you are willing to accept.  However, upon retirement, you will begin to draw from your portfolio to help supplement your income.  Therefore, the way you invest in retirement is very different than how you invest prior to retirement.  By reviewing your risk tolerance and asset allocation before heading into retirement, you can assure that your portfolio is positioned in such a way that it can provide the income you need, and reduce volatility.  
  1. Contemplate where you want to live – Have you given any consideration to where you would like to live in retirement?  Some of the reasons people move in retirement include: to be in a more favorable climate, to be closer to other family members, to be closer to people their own age, or to reduce their cost of living.  Whatever the reason, moving can have a significant impact on your finances and your quality of life.  If you are thinking about moving and you have narrowed down your search to a few areas, it may be a good idea to spend a few weeks or even a few months in each location.  This way you can get a feel of the local community and activities that are available. 
  1. Maintain an active and social lifestyle – Upon retirement, many people lose their sense of self-worth and often feel isolated.  Since they are no longer working, they feel like they are no longer contributing to society.  In addition, they lose the daily interactions with colleagues and co-workers that they have become accustomed to.  As a result, it is not uncommon for new retirees to slip into depression.  Studies have shown that an active retirement lifestyle leads to better mental and physical health.  Therefore, you should start thinking about how you will stay active in retirement.  Perhaps you can join a gym, a social club, find a hobby, or work part-time.  All of these will go a long way to ensure a long and happy retirement.  

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With the recent spike in inflation, mainly due to higher demand and a shortage of goods coming out of the pandemic, many retirees are concerned about the impact increased prices will have on their monthly budget.  Add in the fact that this is happening around the busiest shopping season of the year, many retirees are wondering if there are ways in which they can save money on holiday gifts.  If you are retired and living on a fixed income, below you will find some ways in which you could save money on gifts this holiday season. 

Shop online/bundle orders

While shoppers showed up enforce at brick-and-mortar stores on Black Friday, over the past few years retailers have pushed a lot of their deals online.  Whether it is meant to reach a larger customer base, accommodate those who may not want to stand in line, or perhaps to pass along the deals to those who are not yet comfortable going into a crowded store, online deals are abundant this year, and you can still find these deals today.  If you are shopping online, be sure to search for promotion codes.  These codes may apply a discount to your order or provide free shipping.  If you are unable to find any codes but would like to save money on shipping costs, then it may make sense to combine your orders.  Many retailers require you to spend a certain amount before they provide free shipping, so combining orders may get you over the threshold. 

Use old gift cards

Do you have old gift cards sitting around? I know I do! If so, they can be a great way to save money during the holiday season.  There are two approaches that you could take with gift cards.  The first is to regift the gift card; this way the recipient can spend the money on something they want.  However, I understand that some people feel that giving a gift card can seem like an insincere gift.  Therefore, instead of giving the gift card, you could use the gift card to purchase a gift that you know they would like.  I can ensure you that they will never know that you used the gift card to purchase the gift. 

Group gift

A group gift can be a great way to save money, especially if you have multiple children or grandchildren.  Instead of purchasing multiple less-expensive gifts, you could ask other family members to go in on a big gift together.  Not only will the recipient be happier with a bigger gift, but the group can all share in the joy on the face of the individual who received the gift – which is a gift in and of itself. 

Share experiences instead of money

Not all gifts have to be purchased.  In fact, one of the best gifts you can give is you.  This can come in the form of spending time with your loved ones or simply sharing your experiences.  Perhaps you have a secret family recipe that you never shared with anyone.  Instead of just gifting the recipe, it may be a nice idea to cook the meal together.  This way you can share where you got the recipe from and pass along your passion for cooking.  Do you have a family heirloom that is important to you?  If so, this may be a great opportunity to pass it along to the next generation.  Not only will they receive the heirloom, but they can hear the story behind it and why it is important to you.  I have a strong feeling that the memory of cooking that special meal or hearing the story of the family heirloom will last longer than any gift you could purchase. 

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Q:  How can I protect my investment portfolio and savings from a rise in inflation?

A: Inflation is discussed a lot in today’s environment.  Whether it be an impact on your grocery bill, filling up your car, or your daily Starbucks run, many are wondering how they can hedge their investment portfolio and other savings against a rise in inflation.  

Here are some short-term hedges that can be used to help protect your portfolio and savings from rising inflation:

  • Treasury Inflation-Protected Securities (TIPS): When purchasing fixed-income securities, investors face purchasing power, or inflation, risk.  As you can imagine, inflation reduces the purchasing power of the dollars that you receive from security.  In an effort to protect investors from the impact of inflation, the U.S government first introduced TIPS in 1997. TIPS pay a fixed rate of interest, but the principal amount of the bond is adjusted by changes in the Consumer Price Index (CPI) every six months.  As inflation increases, the interest paid on the bond increases, and if deflation occurs, the interest on the bond decreases. 
  • Series I Savings Bonds:  I-bonds are another type of fixed income security that is issued by the U.S. government.  The “I” in I-bonds stands for inflation, which means that the interest rate is a component of both a fixed interest rate and the CPI that will adjust up or down every 6-months based on inflation data.  If inflation rises, the interest rate of the bond goes up.  If inflation falls, so will the interest rate.
  • Stocks:  Inflation can actually be good for stocks, up to a certain point.  Inflation typically begins to increase when the economy is expanding.  These periods of economic expansion are often associated with rising employment, leading to increased consumer spending, which translates into higher corporate profits.  Higher corporate profits will most likely result in a higher demand for the company’s stock, which will translate into rising stock prices. 
  • Commodities:  Think of a commodity (i.e., gold, oil, copper, lumber, etc.) as the inputs needed to create a particular good or service.  Unlike bonds, and to some extent stocks, commodities tend to increase in value during inflationary periods.  As the demand for goods and services increases, the price of those goods will increase, which will increase the prices of the commodities it takes to produce those goods and services. 

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By Bill Gallagher, CFP®, MPAS®

Will You Pass on What you Have Learned?

“When gone am I, the last of the Jedi will you be.  The Force runs strong in your family.  Pass on what you have learned.” – Yoda

It is tough not to listen to Yoda; I mean, he lived for 900 years.  He has seen a lot during his life and was always willing to pass on the wisdom of his years to others.  Before Yoda’s spirit became “one with the Force,” he shared some of this wisdom with Luke Skywalker.  His message was simple: the galaxy needs the Jedi, and it is up to Luke to teach the “ways of the Force” to the next generation.  Yoda understood that by teaching the Jedi traditions to the younger generation, there will always be someone there to protect the galaxy from the darkness.  As I thought more about Yoda’s advice, I realized how this message can be related to financial planning, especially when we think about estate planning.

Non-Financial Aspects of Financial Planning

Over the years as a financial planner, I have learned that the numbers only tell half of the story.  Some may say that the numbers tell the whole story, but there are many non-financial aspects of financial planning that I believe is just as important as the financial aspects.  While we can apply this message to many financial planning topics, let’s take a minute and think about this within the context of estate planning.  I am sure that when someone mentions estate planning the first few things that come to mind for many people, including myself, are the financial aspects.  Will my estate be subject to estate or gift taxes? What is the cost of probate? What are the costs associated with my final expenses? How much will ultimately be leftover for my spouse or the children?  Don’t get me wrong, these are very important financial aspects which you need to consider.  You want to ensure that the full value of your estate passes effectively and efficiently to your loved ones.  However, this is not where the conversation should end.  There are other important, non-financial considerations everyone should take into account when it comes to estate planning.  For example, have you thought about the family traditions you would like to pass along to the next generation?  

Family Traditions & Values

Family traditions help provide family members with a sense of togetherness and can create positive memories that can be shared not only today but also in the future.  They are a way of passing the family’s values, heritage, and culture from generation to generation.  It is important to remember that it was these traditions that shaped your childhood and made you into the person you are today.  Therefore, they should not be overlooked.  I know that life can be hectic at times, and it is easy to take family traditions for granted.  That is why it is crucial to take some time to reflect on these traditions, because if you neglect to, then they will go away with you.  When you are reflecting on these traditions it may be helpful to think about the positive memories you have from your childhood.  Perhaps you shared special moments or activities with your parents, grandparents, or siblings.  Maybe it was cooking Sunday dinner with your grandmother, or working in the garage with your grandfather, or gathering around the fireplace and telling the stories of the older family generation.  Passing down these traditions will create a strong bond between family members and provide the following generations with the same fond memories.

As you can see, the financial planning process is not all about numbers.  There are non-financial aspects of your life that you need to incorporate into your financial plan in order to get the full story.  Aligning your financial goals with your non-financial will provide you with the opportunity for success.  And when it comes to estate planning, do as Yoda suggested and “pass on what you have learned.” 

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Do You Know Where to Go from Here?

By Bill Gallagher, CFP®, MPAS®

“Would you tell me, please, which way I ought to go from here?”

“That depends a good deal on where you want to get to”, said the Cat.  

“I don’t much care where”, said Alice.

“Then it doesn’t matter which way you go”, said the Cat. 

“-so as long as I get somewhere”, Alice added as an explanation. 

“Oh, you’re sure to do that”, said the Cat, “if you only walk long enough.”

I was watching Alice in Wonderland with my daughter recently, and as a financial planner, I couldn’t help but relate the above dialog between Alice and the Cheshire Cat to financial planning and investment management.  To me, this dialog represents why it is so important for individuals to take time to define their life goals and objectives within the context of a comprehensive financial plan and an investment policy statement.  

While the underlying message in the dialog above is true, if you don’t know where you’re going, any road will get you there – it does not get to the heart of the issue as it relates to someone who is trying to plan for their future.  Yes, any road will get you there, but “there” may not be where you want or need to be. 

Those who have gone through the process of designing a roadmap for their goals will most likely achieve those goals more effectively and efficiently than those who do not have a plan.  The road may not always be smooth, and there will be many detours along the way, but with a personal guide in your hands you will be able to navigate around and through those detours to get back on track more quickly than if you did not have a course of action. 

Whether you are in the accumulation stage of saving for a goal (e.g. retirement, education, new home, vacation home, etc.) or are in retirement, and drawing income from your portfolio, it is extremely important that you establish your goals and objectives within the context of a comprehensive financial plan, thereby creating your personal roadmap.  It is also important to ensure that your assets are invested appropriately given your goals, objectives, and risk tolerance.  Investments are tools we use to get from where we are to where we want to be, and to get there efficiently, your investment portfolio should be governed by an investment policy statement (IPS).  

What Is An IPS?

While the financial plan serves as a strategic guide for your life goals, an IPS is a process of implementing your investment program.  Properly aligning your risk tolerance with your goals and objectives will help you deal with any surprises down the road.  I like to think of an IPS as a framework for a well-diversified portfolio through which you can expect to generate acceptable long-term returns, at the level of risk you are willing to accept.  It is within this framework that you consider and define your risk tolerance as an investor.  The importance of fully exploring and understanding your risk tolerance cannot be overstated, as your risk tolerance will specify your overall target asset allocation and will help in establishing the investment guidelines relating to the selection of your portfolio assets.  

What is Included in the Investment Policy Statement?

The principal reason for developing an IPS is to establish a course of action that will be followed through different market cycles.  This includes periods of market volatility when emotional or instinctive responses might otherwise prompt less than prudent actions.  Without such guidelines, research has shown that investors often make investment decisions that may be inconsistent with prudent investment management principles, their financial objectives, and their risk tolerance.  All too often, during extended bull market rallies and severe bear markets, investors take a short-term view of a long-term investment strategy and end up making decisions that can cause irreparable harm to their financial situation.  Having a financial plan and IPS to reference in times of market volatility may help bring your goals and objectives back into focus and remind you of the long-term nature of your investment portfolio. 

Risk & Return

By now many people understand the relationship between risk and return.  In general, for an investor to achieve above-average investment returns, he or she must be willing to accept a higher degree of risk.  While this relationship between risk and return exists, for most investors, “risk” has more to do with the potential for the loss rather than for the potential of investment gains.  Too much loss triggers a fear response that often causes the investor to abandon their investment strategy, in some cases doing irreparable harm to their financial situation.  One measure of risk tolerance, then, is the investor’s emotional capacity to accept market volatility and their subsequent response to it. 

An equally important, but often less considered measure of risk tolerance is an investor’s financial capacity for a loss of capital.  Financial risk capacity is determined to be the amount of loss a person can sustain before compromising his or her ability to achieve their financial goals and objectives.  Financial capacity can often only be determined through the completion of a comprehensive financial plan or analysis.  

In some cases, one’s emotional capacity may exceed their financial capacity for loss.  Even though the investor may truly be able to hold through a significant market decline, their individual circumstances, and the timing of the decline – and any recovery from it – may put financial goals in jeopardy.  Like a scale, risk needs to be balanced between the fear response and the need for returns to achieve the investment goals.  Understanding the relationship between emotional and financial risk influences how aggressively or conservatively a portfolio might be invested.  

The use of a financial plan and IPS is considered best practice.  Developing a solid financial plan and IPS is not a typical exercise for most investors.  It requires a significant understanding of one’s goals and tolerance for risk, and provides support for following a well-conceived, long-term investment plan – especially during turbulent or exuberant times; a plan which, as the Cat said, “depends a good deal on where you want to get to.”

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Q: What does the bid and ask on a stock quote mean?

A: Not many investors know that there are three parties involved in a stock trade (1) the buyer, (2) the seller, and (3) the market maker.  While investors understand the first two, not everyone knows or understands the important roles the market maker plays in stock trading.  These include maintaining an orderly market and quoting stock prices. 

Q: What is the bid price? 

A: The bid price is the price the market maker quotes as the current willing buyer of shares.  Therefore, the bid price is the price an investor receives when they sell a stock to this buyer.  The bid price will be below the ask price.  For example, an investor would like to sell 100 shares of Apple when the bid-ask quote is $100-$102 and the size of the order is 100 shares.  If the investor placed an order to sell 100 shares at the market (or market price), then the order will execute at the bid price of $100. 

Q: What is the ask price? 

A: The ask price is the price the market maker quotes as the current willing seller of shares.  Therefore, the ask price is the price an investor pays when they purchase a stock from this seller.  The ask price will be above the bid price.   For example, an investor would like to purchase 100 shares of Apple when the bid-ask quote is $100-$102 and the size of the order is 100 shares.  If an investor placed an order to purchase 100 shares at the market (or market price), then the order will execute at the ask price of $102. 

Q: What is the difference between the bid price and ask price?  

A: The difference between the bid price and the ask price is referred to as the spread.  The spread represents that amount of the market maker’s profit.  Continuing our example from above, we can determine that the spread between the bid price and the ask price is $2 per share.  Therefore, the market maker’s profit on the trade of 100 shares bought at $100 and then sold to someone else only moments after at $102 is $200.  This is also the amount of money a customer could potentially lose when buying and selling often.  The market maker is compensated for providing this liquidity while the customer pays for the benefit of her liquidity.

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By Bill Gallagher, CFP®, MPAS®

If you are considering working with a financial advisor, or if you have been working with one for many years, it is important to know how your financial planner is compensated.  In addition, it is important to know if the financial advisor acts as a fiduciary, as that may have an impact on the services provided, and the way in which you pay for those services.  There has been a lot of talk over the past few years regarding the term fiduciary.  While many people understand the definition of a fiduciary, they may not fully understand how the term impacts the financial advice they receive.  If your financial advisor is a fiduciary, then she is both legally and ethically required to provide financial advice and guidance that is in your best interest.  In addition, as a fiduciary, she is required to disclose any, and all, conflicts of interest that may come up over the course of the relationship. If you are in the market for a financial advisor, please be sure to add these questions to your list while you are going through the interview process: 

  • Are you a fiduciary?
  • Do you act as a fiduciary 100% of the time? 
  • How are you compensated? 
  • Do you earn a commission on the sale of any financial product?
  • What is the total cost to work with you?

While the responses you receive will vary among advisors, financial advisors typically operate within three compensation models:   

Fee-only

A fee-only financial planning firm will be registered with the Securities and Exchange Commission (SEC) as a Registered Investment Advisor (RIA).  RIAs are held to a higher standard as they must act in a fiduciary manner.  In a fee-only setting, 100% of the advisor’s compensation will come directly from the people she works with.  A fee-only financial advisor will not earn or accept any commissions or third-party kickbacks from any investment providers.  Typically, the fees are calculated as a percentage of assets under management (AUM) and are deducted directly from your account(s), on a quarterly basis.  This compensation model ensures that the advisor is acting in a fiduciary manner, where she and the client are on the same side of the table – the advisor will do better when the client does better.  In addition, since the advisor is earning a fee, she is not enticed to make any recommendations that would result in her selling an investment product to generate a commission.  Therefore, the financial advice in this setting is objective, and not contingent on any specific product(s).  

For those that are comfortable managing their own investment accounts but would like to engage a financial advisor for financial planning services, a fee-only advisor may be able to accommodate.  For example, a fee-only financial advisor may offer to complete a comprehensive financial plan for a flat fee or provide an hourly service where she can work on a specific financial project for her client.   

Commission-based 

A commission-based financial advisor, or registered representative, is often affiliated with a broker-dealer.  A broker-dealer is a firm that sells its own products or another financial company’s products to its customers.  A broker-dealer, and its registered representatives, are not held to the same fiduciary standard as an RIA. Therefore, a financial advisor who earns a commission is not necessarily required to act in your best interest.  Yes, she has to make sure the investment product she recommends is suitable for your situation, but she is not required to put your financial interests first.  Therefore, the relationship between you and the commission-based advisor tends to be more transactional, as opposed to an ongoing, financial advice-driven relationship.  When the advisor sells you a certain product, she will receive a commission directly from the investment provider.  The amount of the commission tends to be a certain percentage of the investment amount and can range from high to low.  For example, if you invest $250,000 into an annuity that pays the advisor 6% commission, the advisor will receive a payment of $15,000 directly from the insurance company.  

Fee-based

A fee-based advisor is registered as an RIA as well as a broker-dealer, and therefore earns both a fee and a commission.  Since a fee-based advisor is dually registered, she is not required to act as a fiduciary 100% of the time, or when outside the financial planning arena.  Similar to a fee-only advisor, a fee-based advisor will charge an AUM fee. In addition, she may charge a separate fee for financial planning services.  However, unlike a fee-only advisor, the fee-based advisor may also receive a commission on certain investment products that she sells to her clients.

As we can see from the financial advisor compensation models above, it is important to understand how you pay for financial advice, the type of financial planning service you receive, and if your advisor is required to act in a fiduciary capacity.  If you require a comprehensive financial plan and ongoing advice, perhaps a fee-only or fee-based model would be appropriate for your needs.  However, if you are comfortable managing your own investment accounts but need some advice on which products to purchase, a commission-based advisor may be the right fit.  By understanding the different compensation models and how the advisor is registered (RIA or broker-dealer) you can make an informed decision on what is the best fit for your needs.  

 

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By Bill Gallagher, CFP®, MPAS®

Q: What is a rollover?

A: A rollover is when you move funds from your 401(k) plan to a Traditional IRA, Roth IRA, or another employer-sponsored plan. There are two types of rollovers: a direct rollover and a 60-day rollover.

When you elect a direct rollover (or trustee-to-trustee transfer), the funds are transferred directly from your 401(k) to your IRA. As you never take possession of the funds, there are no tax consequences on the distribution. With a direct rollover, your 401(k) provider will either electronically transmit the balance directly to your new custodian or issue a check made payable to your IRA. For example, let’s say that Joe Smith would like to do a direct rollover from his 401(k) to his Charles Schwab IRA. In this situation, his 401(k) provider will send him a check that reads as follows: “Charles Schwab FBO Joseph Smith IRA”.

When you elect a 60-day rollover your 401(k) provider will send a check directly to you, made payable to you. Upon receipt, you can deposit the funds into your checking account and use them as you see fit. Providing that you re-deposit these funds into your IRA within 60 days of the distribution you will avoid the income tax consequences associated with the withdrawal. If the funds are not deposited into your IRA within 60-days, then the distribution will be taxed as ordinary income and the IRS will assess a 10% early withdrawal penalty if you are under 59 ½ at the time of the distribution.
Please note: if you elect a 60-day rollover, your 401(k) provider is required to withhold 20% of the taxable portion of the distribution. While you can still roll over the full amount of the distribution, you will need to make up the 20% that was withheld from your other assets.

Q: When can I roll over my 401(k) to an IRA?

A: Your ability to elect a rollover is mainly contingent upon your employment with the company. Most 401(k) plans, but not all, only allow you to initiate a rollover when you terminate your employment, either voluntarily or involuntarily. Therefore, it is not until you leave your employer when you are eligible to roll over your 401(k) to an IRA.

However, some 401(k) plans allow employees of a certain age (typically 59 1/2), to elect a rollover even when they are still employed with the company. This is referred to as an in-service rollover. Not all plans offer this feature, so it is important for you to check with your plan sponsor to determine if this option is available to you.

Q: How do I initiate a rollover?

A: Before you initiate the rollover, you will need to decide on where the funds will be deposited. If you would like to roll over the funds to an IRA, and you do not have an IRA, then this will be a good time to get one established at a bank or brokerage firm. Once your IRA is created, you will need to contact your 401(k) provider and inform them that you would like to roll over the funds from your 401(k) to your IRA. The 401(k) provider will provide you with the paperwork that you will need to complete in order for them to process the rollover.

Q: Can I roll over both pre-and post-tax money to my IRA?

A: You can roll over both your pre-tax and post-tax money from your 401(k) to a Traditional IRA or Roth IRA. In order to avoid taxation on the pre-tax portion, you would elect this portion to be rolled over to your Traditional IRA. However, if you happen to have funds in a Roth 401(k) or if you have made after-tax contributions to your 401(k), you would elect these funds to be rolled over in a Roth IRA. This way you can continue to take advantage of the tax-free distributions in retirement. It is important that this be handled correctly as it can be difficult to unravel. It is best to receive two separate checks (one for the pre-tax portion and one for the after-tax portion) from the 401(k) provider to keep the transactions orderly and clean.

Q: What are the benefits of rolling over my 401(k) to an IRA?

A: There are two main benefits associated with rolling over your 401(k) to an IRA. The first benefit is the ability to get access to a wider array of investment options. Typically, 401(k)s offer a limited selection of investment options and you may find it difficult to fully diversify your portfolio. While most of the major asset classes (stocks, bonds, cash) may be covered, you may find it difficult to diversify your portfolio further within those asset classes. If you establish your IRA with a brokerage firm, you will have the ability to fully diversify your portfolio as you will be able to invest in individual stocks, bonds, ETFs, and mutual funds. The second advantage of rolling over your 401(k) to an IRA is the potential to reduce your investment fees and expenses. Traditionally, 401(k)s have been associated with higher fees. Most companies, but not all, spread out the cost of maintaining the 401(k) plan across their employee base, leading to higher fees for the participants in the plan. In addition, most plans incorporate active mutual funds, as opposed to index funds which carry lower fees. Rolling the funds into an IRA will provide you with the ability to access low-cost index ETFs.

There are some disadvantages to rolling funds into an IRA, however. One of the main disadvantages of an IRA is the fact that you cannot take a tax-free loan from your IRA should you need to access the funds prior to retirement. Most plans allow employees to access the funds in their 401(k) through a loan feature. While there is a limit on how much an employee can borrow against their 401(k), it is an option should they find themselves in a financial pinch.

 

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By Bill Gallagher, CFP®, MPAS®

With more and more companies offering equity compensation packages to their employees, it is important for those receiving these benefits to understand the features of these different types of compensation. In my previous articles we discussed restricted stock awards (RSA), restricted stock units (RSU), and stock options. This article will focus on employee stock purchase plans. 

An employee stock purchase plan provides a way for an employee to purchase shares of their company’s stock through payroll deduction. Not only is this a convenient way for an employee to purchase stock but the plan may allow the employee to purchase stock at a discount, which is not available for purchases made through the stock market. While the IRS has set a cap on the dollar amount ($25,000) of stock that an employee can purchase during the course of the year it is still a great way to become a shareholder in your company. Before we take a closer look at the mechanics and taxation of ESPPs, let’s first review the terminology associated with these types of plans.    

  • Enrollment period (or grant date) – the period during which the employee can contribute to the ESPP via salary/bonus deferrals. 
  • Purchase date – the date in which the company purchases the shares on their behalf. 
  • Lookback period – if there is a lookback period then the company will purchase the shares either based on the value at the end of the enrollment period or at the end of the enrollment period, whichever is lower. 

There are two types of employee stock purchase plans (1) non-qualified ESPP and (2) qualified ESPP. While the mechanics of these two plans are similar, they carry different income tax characteristics. In the non-qualified ESPP space, if an employee purchases the shares at full price (no discount), then she will not have to report income at the time of purchase. Upon sale, she will need to report the profit or loss as a capital gain or loss. 

  • Example: An employee is participating in her company’s non-qualified ESPP. Over the past three months she has contributed a total of $5,000 to her ESPP. On July 1, 2021 (the purchase date) the market value of the stock is $50 per share. Therefore, the company purchases 100 shares of stock on her behalf. Since the employee paid for the full value of the shares, she will not have to report compensation income upon purchase. If she sells the shares on July 2, 2022, or thereafter, she will report the gain or loss as a long-term gain or loss. However, if she sells the shares on or before July 1, 2022, then she will report the gain or loss as a short-term-gain or loss. 

What would happen if the employee purchased the shares at a discount? In this situation, the difference between the fair market value of the shares on the purchase date and the amount paid for the shares (after applying the discount) will be reported as compensation income and subject to income tax withholding. When the shares are ultimately sold, any profit or loss will be treated as a capital gain or loss. The good news is that the basis in the shares is equal to the amount she paid for the shares plus the amount included in her compensation. 

  • Example: Continuing our example from above, instead of paying for the full value of the shares, let’s assume that she receives a 10% discount. If the current market value of the stock on the purchase date is $50 per share, then she will be able to purchase the shares for $45 (after applying the discount). Therefore, if the company purchased 100 shares on her behalf, she would report $500 ($5 discount x 100 shares) as compensation income. Her basis in the shares will equal $5,000 (the amount she paid for the stock plus the amount included as compensation income) which will be the measuring point for capital gains or losses when she decides to sell the shares. 

When we compare the taxation of non-qualified ESPPs to qualified ESPPs we see that the rules are far more complex. However, with this complexity comes the ability for employee to not have to report compensation income when she purchases the shares, even if she purchases them for at a discount. In order to take advantage of this tax benefit, the employee must meet both of the following special holding periods: 

  • The stock must be held for one year after the first date of the offering period, and 
  • The stock must be held for more than two years after the employee receives, or purchases, the stock. 

If the employee sells her shares before the special holding period is met (early disposition), she must report compensation income equal to the difference between the purchase price and the price at the end of the offering period.  

  • Example: The fair market value of the stock $20 per share at the beginning of a three-month offering period and $21 at the end of that period, at which time the stock is purchased. The employee stock purchase plan offers a 15% discount from the lower of those values (lookback period), so the employee purchases the stock at $17 per share. If she sells the stock before satisfying the special holding period, she will report $4 per share of compensation income, which is the difference between the $21 value and the $17 purchase price. 

It is important to understand that the employee must report compensation income even if she doesn’t have a profit when she ultimately sells the stock. 

  • Example: As we saw above the employee had to report compensation income of $4 per share. She paid $17 for the stock, and as we know, the $4 per share of compensation income is added to her basis. Therefore, her basis in the shares will equal $21 (the amount she paid for the shares plus the amount included as compensation). If she sold the stock for $15 per share, she would report a capital loss of $6 per share but still need to report the $4 per share of compensation income. However, if she sells the stock for a profit, she will report the profit as a capital gain. 

If you are reaching for the Advil at this point, you are not alone! But hang-in there, we are almost at the finish line. 

What happens when the employee satisfies the special holding period? In this situation the employee may have to report compensation income, even if the sale takes place after the special holding period has been satisfied. The good news is that if the employee does not have to report compensation income if she sells the stock for a loss. This is different than we saw above. However, if the stock is sold at a profit, then she will have to report compensation income. The amount of compensation income is the lesser of the amount of her profit or the difference between the market value of the stock at the beginning of the offering period and the amount you paid for the stock. 

  • Example: Continuing the example from above, the value of the stock at the beginning of the offering period is $20 per share and she purchased the shares for $17 per share (after taking into account the discount) at the end of the offering period when the stock is worth $21 per share. If she sells the stock at $25 per share, after meeting the special holding period, she will have to report compensation income in the amount of $3 per share (the difference between $20 and $17). This is less than the $4 per share we saw above. In addition to the compensation income, she will incur a capital gain of $5 per share (the difference between her basis of $20 per share and the sales price of $25 per share). 

With equity compensation becoming more popular, it is important for employees to not only understand the form of equity they receive but to also understand the tax consequences. In addition, it is important to incorporate the equity you receive in your overall financial plan. How does the equity impact your long-term goals and objectives? How does the equity fit into your risk tolerance and other investments?  What is my tax situation? Does it make sense to participate in my company’s employee stock purchase plan? Should I sell the shares before meeting the special holding period? If you find yourself in the fortunate position where your company is providing you with equity compensation, then I would strongly recommend you reach out to your financial planner so that you can get a comprehensive look at how the equity compensation impacts your financial situation.

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By Bill Gallagher, CFP®, MPAS®

With more and more companies offering equity compensation packages to their employees, it is important for those receiving these benefits to understand the features of these different types of compensation. In my previous article we discussed restricted stock awards (RSA) and restricted stock units (RSU). This article will focus on employee stocks options, which include:

Before we get into the features of employee stock options, I think it is important to cover some of the terminology associated with this form of equity compensation:

  • Grant or award – when you receive the stock option from the company
  • Vesting – the time that you have to wait before you can exercise an option
  • Vesting period – the time period over which the options become vested, as set out in the option agreement
  • Exercise – when you notify the company that you would like exercise your option to purchase stock
  • Exercise price or strike price – the price you pay for the underlying shares of stock when you exercise an option. For example, when you have an option to purchase 500 shares at $10 per share, $10 is the exercise price.
  • Spread – the difference between the current value of the stock and the strike price

An employee stock option is the right to purchase shares of company stock at a predetermined price. The two types of employee stock options are:

  1. Non-qualified stock options (NQSO)
  2. Incentive stock options (ISO)

While NQSOs and ISOs share similar mechanical features, they are very different from an income tax perspective. The good news is that the employee does not have to report income upon the grant of options or when the options vest. However, when an employee chooses to exercise their options, they may have to report the income in the year of exercise. And this is where it gets tricky. In the event an employee exercises a NQSO she will have income to report. However, if she exercised an ISO, she would not have to report the income, but she may have to pay alternative minimum tax (AMT). As you can see there are many moving parts with the income tax associated with employee stock options. So let us now take at the tax characteristics of both NQSOs and ISOs.

As mentioned above, an employee does not have to report income when she grants NQSOs or ISOs. In addition, she will not have to report income as the options vest over time. It is only when she chooses to exercise the options when she will have to report the income. When the options are exercised, she will have to report income equal to the spread. As a reminder, the spread is the difference between the current value of the stock and the exercise price (the amount you pay for the stock). This income is reported as compensation income and is reported on the employee’s W-2. Therefore, the amount is subject to federal, state, Social Security, and Medicare withholding.

  • NQSO Example: An employee receives a NQSO grant for 500 shares of company stock with an exercise price of $10 per share. The options are subject to a one-year vesting period. The employee will not have to report compensation income when she receives the grant or when the options vest in one year. Eighteen months later she decides to exercise her options. At that time the current market value of the stock is $25 per share. Given these facts, she will need to report the spread of $7,500 as compensation income in the year of exercise. This amount will be included on her W-2 and will be subject to tax withholding.

Since the $7,500 was included in income, this amount is added to the price she paid to purchase the shares ($5,000) and her basis, for purposes of measuring capital gains tax when she eventually sells the shares, will be $12,500.

  • Continuing our example from above, if the shares are sold for $17,500, she will have a capital gain of $5,000 (the difference between the market value at sale and her basis). If she held the shares for more than a 12-month period after the exercise date, then the $5,000 gain will be considered a long-term capital gain, which will be subject to a more favorable tax rate. However, if the shares were held less than a 12-month period after the exercise date, then the $5,000 will be reported as a short-term capital gain and taxed at her marginal tax rate.

When we compare the taxation of NQSOs to ISOs we will see that the rules are more complex. However, with this complexity comes the opportunity for employees to convert some or all of the profit (the spread) into a long-term capital gain, which is subject to a lower tax rate than ordinary income. Unfortunately, the IRS does not allow this tax benefit without a caveat – the alternative minimum tax (AMT). In order to take advantage of converting the spread as a capital gain, the employee must meet both of the following special holding periods:

  • The stock must be held for one year after the date of exercise, and
  • The stock must be held for more than two years after the option was granted

If the stock is sold before these requirements are met the transaction will be considered a disqualifying event, in which case the spread is subject to ordinary income.

  • ISO Example: On July 1, 2021 an employee receives an ISO grant for 500 shares of company stock with an exercise price of $10 per share. The options are subject to a two-year vesting period. The employee will not have to report compensation income when she receives the grant or when the options vest in two years. On August 1, 2023, after the options have fully vested, she decides to exercise her options. At that time the current market value of the stock is $25 per share. Since these are ISOs, she will not need to report the spread of $7,500 as compensation income in 2023. However, this amount will be added to the AMT calculation for the year, which may result in her paying additional tax in the form of AMT. If she sells her shares after August 1, 2024, then all of her profit (including the amount of the spread) will be taxed as a long-term capital gain.

What happens if the employee sells her shares before the end of the special holding period? In this event, she will disqualify the options from the tax benefits awarded to ISOs and taxed similar to NQSOs.

  • Disqualifying Disposition Example: On July 1, 2021 an employee receives an ISO grant for 500 shares of company stock with an exercise price of $10 per share. The options are subject to a two-year vesting period. The employee will not have to report compensation income when she receives the grant or when the options vest in two years. On August 1, 2023, after the options have fully vested, she decides to exercise her options. At the same time, she decides to sell all of the newly acquired shares at the current market value of $25 per share. Since she did not hold the shares for one year after exercise, she will disqualify the shares from the special tax benefit. Therefore, the spread of $7,500 will be included as compensation income for the year and her basis in the shares will equal $12,500 (the amount she paid for the stock and the spread), resulting in a capital gain of $12,500. Since the shares were held less than one year the gain will be considered a short-term capital gain.

Now that we understand the mechanics of employee stock options and how they are taxed I would like to briefly cover a few different options an employee has in order to purchase the shares.

  • Cash exercise: with a cash exercise the employee pays for the shares out-of-pocket. For example, an employee has an option to purchase 100 shares of company stock at $10 per share. When she exercises these options, she will need to write a check to her company in the amount of $1,000.
  • Cashless exercise (or sell-to-cover): when an employee chooses a cashless exercise, she will instruct her company to liquidate enough of the shares to cover the purchase amount. The net shares will then be delivered to the employee.
  • Stock Swap: if the employee already owns shares of company stock, she may be able to use those shares to cover the purchase amount. The employee would swap the shares she owns with her company for the newly issued option shares.

With equity compensation becoming more popular, it is important for employees to not only understand the form of equity they receive but to also understand the tax consequences. In addition, it is important to incorporate the stock options you receive in your overall financial plan. How do stock options impact your long-term goals and objectives? How does the equity fit into your risk tolerance and other investments? What is my tax situation? Should I exercise and hold the shares? Or should I consider a cashless transaction? If you find yourself in the fortunate position where your company is providing you with equity compensation, then I would strongly recommend you reach out to your financial planner so that you can get a comprehensive look at how the equity compensation impacts your financial situation.

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By Bill Gallagher, CFP®, MPAS®

With more and more companies offering equity compensation packages to their employees, it is important for those receiving these benefits to understand the features of these different types of compensation. I would like to cover all of the popular forms of equity compensation, including:

This article will focus on restricted stock units (RSUs) and restricted stock awards (RSAs). I will then follow-up with two more articles where I’ll address stock options and employee stock purchase plans. We will cover the basic features of each form of equity compensation and the taxation of these benefits.

Before we get into the features of restricted stock awards, I think it is important to cover some of the terminology associated with these plans:

  • Grant Date – the date upon which the award is approved by the company’s board of directors
  • Grant price – the fair market value of the stock on the grant date
  • Vesting – the process through which shares are earned over a period of employment
  • Vesting period – the time period over which shares become vested, as set out in the option grant agreement
  • Vesting value – the fair market value of shares that vest on the vest date

A restricted stock unit (RSU) is a right to receive stock after you have satisfied certain conditions imposed by your employer. The most common condition is to remain employed with the company for a certain amount of time. But other conditions may exist. For example, your employer may impose a condition that is based on you reaching a certain sales goal or your team completing a project before the deadline. If these conditions are not satisfied, then you do not receive anything. It is important to remember that when it comes to restricted stock units you do not own the shares until you have earned them – by satisfying the vesting period. This means that you will not receive dividends the company may pay prior to the date you met the conditions. However, some companies may provide a dividend equivalent for those that were granted RSUs.

When we compare RSUs with RSAs we will see many similarities however there are two important differences to keep in mind. Unlike an RSU, when an employee receives an RSA she receives the stock upfront, but she must earn the right to keep them – by satisfying the vesting period. Therefore, since the employee receives the shares upfront, she will be eligible to receive any dividends paid prior to the vest date. However, it is important to note that dividends paid on unvested stock will be considered compensation income, and therefore not eligible for the lower tax rates associated with qualified dividends. Another feature that is available with RSAs is the ability for the employee to make an 83(b) election. This feature can provide multiple tax benefits, which I will discuss later in the article.

Typically, equity grants are subject to a vesting schedule. This means that you receive a portion of the shares of stock over a certain period of time, as long as you stay employed with the employer. Let’s say that your employer granted you 500 shares of stock, subject to a vesting period of 5 years. This means that each year you are with your employer you will receive 100 each year for 5 years.

The good news is that in the majority of cases an employee does not owe tax when they receive a grant of restricted stock. However, when the employee has completed the vesting requirements and receives the shares, she will need to report the value of the vested shares as compensation income. The amount will be reported as wages and included on her W-2. Therefore, this value is subject to federal, state, Social Security, and Medicare tax withholding.

  • Taxation Example: An employee receives an RSU grant for 100 shares of company stock, subject to a one-year vesting period. The total value of the shares on the grant date is $20,000 but the shares are worth $30,000 when she satisfies the vesting requirement one-year later. The employee will not have to report compensation income when she receives the grant. However, when the shares vest, she will need to include $30,000 as compensation income, which will be subject to tax withholding.

Since the $30,000 was included in income, this amount becomes the basis for purposes of measuring capital gains tax when she eventually sells the shares.

  • Continuing our example from above, if the shares are sold for $35,000, she will have a capital gain of $5,000 (the difference between the market value at sale and her basis). If she held the shares for more than a 12-month period after the vest date, then the $5,000 gain will be considered a long-term capital gain, which will be subject to a more favorable tax rate. However, if the shares were held less than a 12-month period after the vest date, then the $5,000 will be reported as a short-term capital gain and taxed at her marginal tax rate.

As I mentioned above, the 83(b) election can provide multiple benefits, but there are some risks involved as well. When an employee makes an 83(b) election when she receives a grant of RSAs the tax consequences change. When the 83(b) election is made, the employee includes the full value of the shares as compensation income in the year in which she is granted. It is important to note that the IRS must be notified of the election within 30 days after you receive the stock. The benefits of the 83(b) election include:

  • Since the employee pays tax at grant, she does not have to report any compensation income when the shares vest.
  • Any dividends received before the shares vest will not be treated as compensation income. Instead, they can qualify for the lower tax rates.
  • For capital gains purposes, the employee’s holding period for the stock begins on the date she received the grant. Therefore, the 12-month holding period for long-term capital gain treatment starts as of the date of grant, not the date of vest.

It might be helpful to review the 83(b) election in the context of an example.

  • An employee receives an RSA grant for 1000 shares of company stock, subject to a one-year vesting period. The total value of the shares on the grant date is $10,000. She feels that the stock price will increase over the next year, so she decides to file an 83(b) election. Therefore, the $10,000 will be reported as compensation income in the year of grant. Let’s say that one year later, when the shares vest, the total value of the shares is $50,000. By making the 83(b) election, she avoids having to include the $50,000 as compensation income because she already paid the tax on shares. Therefore, she saved herself some significant tax dollars by reporting $10,000 of compensation income, instead of $50,000. In addition, she will qualify for long-term capital gain treatment on the sale of the shares sooner than had she not made the 83(b) election.

At this point you may be saying to yourself, “why wouldn’t an employee always make the 83(b) election when they receive restricted stock?” First, it is important to remember that the 83(b) election is only available for RSAs, and not RSUs. In addition, there are some risks that must be contemplated before making the election, including:

  • The employee will need to report compensation income earlier than would otherwise be necessary.
  • The value of the shares could decrease between the grant date and vest date. In this scenario the employee would pay more tax than necessary.
  • The employee could terminate employment before the shares vest. In this situation, the employee would have paid tax when it would not have been necessary and get nothing back in return.

With equity compensation becoming more popular, it is important for employees to not only understand the form of equity they receive but to also understand the tax consequences. In addition, it is important to incorporate the equity you receive in your overall financial plan. How does equity impact your long-term goals and objectives? How does the equity fit into your risk tolerance and other investments? Should you make an 83(b) election? If you find yourself in the fortunate position where your company is providing you with equity compensation, then I would strongly recommend you reach out to your financial planner so that you can get a comprehensive look at how the equity compensation impacts your financial situation.

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By Bill Gallagher, CFP®, MPAS®

In a recent Smartasset study, “Where Retirees are Moving – 2021 Edition”, they examined data from states and cities across America to determine the most popular locations for retirees. Based on the results, Florida and Arizona top the list of where retirees are moving. North Carolina, South Carolina, and Texas round out the top five states. This is not surprising as these states are associated with favorable climates and tend to be more tax-friendly for retirees than other states. In addition, these states have a lower cost-of-living and offer more affordable housing. Retirees on a fixed budget are finding these locations to be desirable. However, while these financial benefits do exist, it is important for retirees to make sure they think through some of the non-financial aspects of relocation including:

  1. Moving away from family
  2. Moving away from their social network
  3. The availability of healthcare.

For most people, their family is more important to them than anything and where they derive their most enjoyment. Retirement is a time when you can focus on spending more time with your loved ones and enjoying the richness they bring. Whether it is spending time with your children, taking care of the grandchildren, or bonding with other family members, retirement can be a great time to strengthen the family ties. Retirees who are contemplating relocation in retirement must bear in mind that they will potentially be moving away from family. While this may not be a concern for some retirees as they tell themselves that the children and grandchildren will visit a few times per year or that they will travel back home to see them, sometimes things do not work out this way. Travelling can be expensive and with adult children busy in their careers with grandchildren in school, it may be difficult for them to visit as frequently as you would like. In addition, your health may prohibit you from travelling back home to visit. All of this results in less frequent visits than planned. And while technology will allow you to meet with your family virtually, I think it is safe to say that it is not quite the same as an in-person visit. Family can also be especially important as you age, potentially relying on their help. It is tough for family members to deal with aging issues from far away.

Some retirees have spent many years in their home. Perhaps they moved in soon after their marriage and decided to build roots there. After years of being involved with the children’s school and being a part of the community, they built a strong social and support system. Unfortunately, they cannot take that same network with them if they relocate. This is not to say that you cannot build a new social network after relocation. In fact, many people enjoy building new relationships and getting involved in a fresh community. However, building relationships can be difficult for many. If health becomes an issue, especially in the beginning stages of being in the new community, it could be even harder to build the same type of support system they had at home.

It’s inevitable that as we age, we will all need some level of health care. Whether it is access to a geriatric physician, a specialist, a hospital, a rehabilitation center, or a continuing care facility we need to make sure that we have access to these facilities during the time in our life when we will need them the most. Therefore, it is important to understand not only the types of healthcare facilities you will have access to in the new location, but also the quality of the care available. The last thing you would want to do is to move from an area with a high-quality level of care to a place where the care is drastically lower. For some, after their family, their health is the most important consideration. Therefore, you want to make sure that you will have access to the care you will need when you should need it.

For all of these reasons, it is important for retirees to make sure they understand the non-financial impacts associated with relocation. These include being away from their family for an extended period of time, building a new social network and support system, and their access to high-quality health care facilities in the new location. My recommendation for those thinking about relocating in retirement is to do their homework. Do not settle on a location just because it is popular. Consider renting as your first step of the process. Renting a house in different locations will provide great insight to the local community and climate. This will also give them the chance to see what it is like to be away from their family and friends. The last thing you would want to have happen is to rush a decision and end up regretting it down the road. As with most aspects of life, where you retire is not a “one-size fits all” decision. Decide on your priorities, do your homework, and even try living in various areas before you finalize a move. These steps will almost certainly lead to the retirement of your dreams!

Reference:
Horan, S. (2021, February 17). Where Retirees are Moving – 2021 Edition. Smartasset. https://smartasset.com/financial-advisor/where-retirees-are-moving-2021#:~:text=In%202019%2C%20there%20was%20a,more%20than%2027%2C900%20moved%20elsewhere.

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FAQ: Why are my bond funds losing value? I thought bonds were supposed to be safe?

Investors generally associate bond investments with price stability and safety. Even though bonds are considered conservative investments (especially when compared to stocks), bond prices fluctuate. However, it is important to note that bond prices historically have not varied as widely as stock prices. If you would like to learn more about bonds, please see my previous article: “Should Bonds Be Included in My Portfolio?”

One of the main things that cause bond prices to change is interest rates. Bond prices and interest rates have an inverse relationship with each other. When interest rates increase bond prices decrease, and vice-versa. Let’s take a look at an example that may help with understanding this relationship:

Let’s say you have $1,000 that you would like to invest in a bond. You have two choices available. The first bond is trading in the secondary market and will pay you 3% interest while the second bond is a newly issued bond that will pay you 5% interest. Let’s also assume that both bonds have identical risk characteristics. As an investor, who is looking to maximize your return, you would not purchase the 3% bond on the secondary market when you could invest the same amount of money in the newly issued bond that will provide more interest. Therefore, the market price of the 3% bond would have to decline in order for you to have a comparable return on the investment.

In addition, the price of a bond with a longer time to maturity is more sensitive to changes in interest rates than the price of a bond with a shorter time to maturity. Therefore, the price of a 30-year U.S. Treasury bond will experience more volatility than a 10-year U.S. Treasury bond given a similar change in interest rates.

So, you may be asking yourself; “with the recent increase in interest rates why would I invest in bonds?” One of the main reasons you would own bonds is to add a level of diversification to your portfolio. This diversification can be extremely helpful during periods of time when stocks are struggling. Bonds can act as a ballast to your portfolio during periods of falling stock prices, because during these times bond prices tend to stay stable or increase. This occurrence is known as the “flight to quality”. As stock prices decline, investors tend to sell their stock holdings and reinvest that money in bonds (especially high-quality bonds like U.S. Treasuries) in an effort to stabilize their portfolio.

When it comes to investing, the goal is to understand that the value of your investments (i.e. stocks, bonds, real estate, etc.) will fluctuate overtime but it is best to hold them for the long-term and try not to pay attention to the day-to-day price swings.

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Bonds: Should they be included in my portfolio?

By Bill Gallagher, CFP®, MPAS®

What is a bond?

A bond is a financial instrument that represents a loan from the investor to a government entity or a corporation. The majority of bonds today are issued by the U.S federal government, its agencies, municipalities, and U.S. corporations. There are two key features of bonds that differentiate them from other financial instruments:

  1. Regular coupon payments
  2. Maturity

When an investor purchases a bond, they are, in essence, lending their capital to the issuing entity. In return, the entity will pay the bondholder interest (either quarterly, semi-annually, or annually) for a stated period of time. At the end of that period the bond will mature, and the entity will return the bondholder’s original investment. The maturity of a bond can range anywhere between five to thirty years. While bonds have historically carried lower volatility than stocks, there are risks involved. Bondholders will find that they are exposed to default risk, interest rate risk, inflation risk, and reinvestment rate risk.

How can I purchase bonds?

There are two main ways in which an investor can purchase bonds:

  1. Purchase individual bonds
  2. Purchase a bond mutual fund or exchange-traded fund

Investors can purchase an individual bond through a broker or directly from the U.S. Government (in the case of a U.S. government bond). An investor may decide to purchase an individual bond if they were targeting a certain maturity date or stated level of interest. While an investor has the ability to purchase a variety of bonds it typically requires a large sum of money to build a well-diversified portfolio of individual bonds. Therefore, many investors choose to invest in a bond mutual fund or exchange-traded fund. A bond fund provides the investor with access to a diversified portfolio of bonds, with a lower initial investment. Before investing in a bond fund, it is important to be aware of the fees associated with the fund. In addition, it’s important to understand what type of bonds the fund is investing in. There’s a difference, in terms of risk, between investing in a short-term government bond fund (low risk) and a high-yield corporate bond fund (high risk).

Why should I include bonds in my portfolio?

Most people purchase bonds for interest payments. A retiree may want to invest a portion of her money in bonds so that she can use the interest payments to supplement her retirement income. However, bonds can also act as a ballast to the portfolio when you hit stormy seas. During periods of uncertainty and weak economic fundamentals, stock prices tend to decline. However, during these difficult periods bond prices tend to rise. The opposite is also true – when stock prices rise, bond prices tend to decline. Therefore, bonds can be used in combination with stocks, not only to create a diversified portfolio but to help reduce overall volatility (risk) and maximize the portfolio’s risk-adjusted return. This approach may also provide the investor with a more comfortable ride and not cause her to panic during periods of stock market declines.

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Traditional IRA or Roth IRA: Which is the Right IRA for You?

By Bill Gallagher, CFP®, MBA

More and more, Americans are taking charge of retirement and establishing savings plans to help build their retirement nest eggs. The type of individual retirement account (IRA) you choose can significantly affect you and your family’s long-term savings. So, it’s important to understand the similarities – and the differences – between Traditional IRAs and Roth IRAs in order to select the option which is best for you.

When comparing IRAs, questions often arise around the considerations relating to both contributions and distributions. In addition, many clients ask if they should consider converting their Traditional IRA to a Roth IRA. The answers to these questions can have a significant impact on one’s tax situation over the balance of their lifetime. The following can help provide a basic overview of both Traditional IRAs and Roth IRAs. In addition, we provide a brief discussion on Roth IRA conversions to help clients navigate through the nuances of the conversion process.

TRADITIONAL IRA

Contributions

By now, many people are aware they can make an annual tax-deductible contribution to a Traditional IRA. (1) In 2021, an individual (regardless of age) who have earnings from employment may contribute up to $6,000 to a Traditional IRA. In addition, those who are age 50 and over are allowed to make a catch-up contribution in the amount of $1,000.(2) However, many people are surprised when their accountant tells them that they may not receive the full deduction for their contribution.

This deduction limitation is based on two factors: your modified adjusted gross income (“AGI”), and your active participation in an employer-sponsored retirement plan. (3) For example, in the case of a married couple who are both active participants in an employer-sponsored retirement plan, and whose 2021 modified AGI is greater than $125,000 ($76,000,000 for a single filer), no deduction will be allowed.

While the tax deduction may be phased out, or even eliminated for certain high-income taxpayers, it should not dissuade them from making a non-deductible, after-tax contribution to a Traditional IRA. Even though a tax deduction will not be allowed, contributions to the Traditional IRA will grow tax-deferred over the course of the individual’s life. Individuals who choose to make an after-tax contribution to a Traditional IRA will need to keep track of these non-deductible contributions (IRS Form 8606) to ensure that these contributions are not taxed again upon distribution from the Traditional IRA during retirement.

Distributions

To the extent an individual has made tax-deductible contributions to a Traditional IRA, any distributions from the IRA are considered ordinary income and will be taxed accordingly in the year of the distribution. In addition to ordinary income tax, distributions prior to age 59 1⁄2 are subject to a 10% penalty.(4) However, there are certain situations in which the IRS will waive this 10% penalty. According to “IRS Publication 590-B – Distributions from Individual Retirement Accounts”, these exceptions include:

  • You have unreimbursed medical expenses that are more than 7.5% of your adjusted gross income,
  • The distributions aren’t more than the cost of your medical insurance due to a period of unemployment,
  • You are totally and permanently disabled,
  • You are the beneficiary of a deceased IRA owner,
  • You are receiving distributions in the form of an annuity,
  • The distributions aren’t more than your qualified higher education expenses,
  • You use the distributions to buy, build, or rebuild a first home (up to $10,000),
  • The distribution is due to an IRS levy of the qualified plan,
  • The distribution is a qualified reservist distribution.

Because non-deductible contributions made to a Traditional IRA are treated as an investment in the contract (cost basis), when withdrawn these contributions are not considered taxable income. However, the earnings portion of the non-deductible Traditional IRA is considered ordinary income and will be taxed accordingly. In addition, if the distribution is made prior to age 59 1⁄2, a 10% penalty may apply to the portion attributable to the earnings. The calculation that determines the tax-free and taxable portions of distributions is complex when both deductible and non-deductible contributions are commingled in a Traditional IRA. Please refer to IRS Publication 590-B for more details on the tax treatment of such distributions.

Another important feature of Traditional IRAs is the Required Minimum Distribution (“RMD”). The RMD is the mandatory amount that must be distributed from a Traditional IRA on an annual basis, starting on April 1st of the year following the year in which an IRA owner attains the age of 72.(5) The amount of the RMD is based on the year-end balance of the Traditional IRA and the IRA owner’s life expectancy.

The Required Minimum Distribution will have a direct impact on the IRA account owner’s tax bracket during retirement. If the IRA owner fails to consider how the RMD will impact his or her tax bracket during retirement, they may find themselves in a higher tax bracket once distributions commence, especially if the Required Minimum Distributions are sizable. At that point, there would be little the individual could do to help alleviate the tax burden. In such cases, it may be prudent to begin withdrawing smaller amounts from the IRA before 72 with the expectation of being in a lower tax bracket.

Another strategy the IRA owner may implement today that may save some tax dollars over the course of his lifetime is referred to as a Roth conversion. Roth conversions are discussed below.

ROTH IRA

Contributions

Unlike a Traditional IRA, contributions to a Roth IRA are made with after-tax dollars and are not tax-deductible.(6) For 2021, an individual (regardless of age) who have earnings from employment may contribute up to $6,000 to a Roth IRA. As we saw with Traditional IRAs, those who are 50 years of age and older may make a catch-up contribution of $1,000.

Another difference between Traditional IRAs and Roth IRAs is the fact that contributions to a Roth IRA are phased out, and eventually eliminated, based on an individual’s modified adjusted gross income. For example, in 2021 a married couple must have a modified adjusted gross income of under $198,000 ($125,000 for single filers) to make the maximum contribution to a Roth IRA.(8)

Distributions

Unlike distributions from a Traditional IRA, qualified distributions from a Roth IRA are tax-free.(9) Qualified distributions are defined in the Internal Revenue Code as:

  • Distributions that are made after the five-year period for which a contribution was made to a Roth IRA.
  • Distribution under the following circumstances:
    • Made after the date you reach age 59 1⁄2,
    • Made because you are disabled,
    • Made to a beneficiary of your estate after your death, or
    • One that is made to a first-time homebuyer ($ 10,000-lifetime limit). (10)

However, should an individual take a non-qualified distribution, the amount allocable to earnings will be subject to ordinary income tax (and a 10% penalty if the distribution was made prior to age 59 1⁄2). It is important to note that an individual can always distribute the number of his contributions at any time on a tax-free and penalty-free basis. In fact, any distributions from a Roth IRA shall be treated as coming from annual contributions first, from conversion contributions second, and finally from earnings.(11)

Another important feature of the Roth IRA is the fact that a Roth IRA owner is not forced to take Required Minimum Distributions from his Roth IRA.(12) This feature can be extremely beneficial to the taxpayer who doesn’t need to draw on his Roth IRA assets to support his or her lifestyle expenses in retirement. In this situation, the funds within the Roth IRA continue to grow unencumbered on a tax-deferred basis over the balance of their lifetime.

Roth Conversions

Now that we understand the similarities and differences between Traditional IRAs and Roth IRAs, we can take a closer look at a strategy that could potentially lead to a more tax-efficient environment during an individual’s retirement. This strategy is referred to as a Roth conversion. A Roth conversion is the process of withdrawing funds from a Traditional IRA and depositing the proceeds into a Roth IRA. When a conversion is completed, the amount converted will need to be reported as ordinary income, in the year of conversion.(13) In a Roth conversion, the 10% penalty is waived for individuals who convert prior to age 59 1⁄2. However, if an individual who is not 59 1⁄2 uses the funds from his Traditional IRA to pay the tax liability resulting from the Roth conversion, the 10% penalty will be imposed on the amount used to pay the tax. Therefore, in most situations, a Roth conversion works well when the individual has enough money set aside in non-IRA accounts to pay the tax liability.

The first step in the Roth conversion process is to determine if the conversion makes sense for an individual given his or her unique financial situation. As mentioned earlier, it is extremely important for an individual to have a clear understanding of their current tax bracket and expected tax bracket in retirement to determine if the conversion is right for them. Once this is determined, they must then decide on the timing of the conversion. Given one’s tax situation, does it make sense to convert all the assets in his Traditional IRA in a single year, or would it be more beneficial to perform a series of annual conversions over the course of several years? The latter would allow the individual to spread out the tax liability over the course of multiple years.

One situation where a Roth conversion may have its place is during the early stages of retirement, especially in the years leading up to an individual’s age 72. It is during this time when an individual may find themselves in a lower tax bracket because they are no longer working, and are not yet required to take mandatory distributions from a Traditional IRA. This could be a great time for an individual to perform a series of partial conversions each year leading up to age 72. By implementing these conversions, and theoretically reducing the number of assets remaining in the Traditional IRA, the amount of the required minimum distributions at 72 should be lower, thus reducing the overall tax liability.

Another situation where a Roth conversion may make sense is seen in the fortunate case of an individual that does not need the assets in his Traditional IRA to support his or her lifestyle needs during retirement. In this situation, a Roth conversion may be implemented for generational planning purposes by essentially prepaying the future income tax for his heirs. While this prepayment may be thought of as a “gift”, it does not count toward one’s annual gift tax exclusion or against the taxpayer’s lifetime exemption amount. (14)

As we can see, while implementing a Roth IRA conversion may increase tax efficiency, the decision should not be taken lightly. One must have a clear understanding of their current tax bracket and expected tax bracket in retirement to make an informed decision. The decision should not be made in a vacuum, but rather, through collaboration with your tax advisor and financial planner. In this way, you can determine if a Roth conversion is right for you.

Sources

  • (1) I.R.C. §219(a)
  • (2) I.R.C. §219(b)(5)(B)
  • (3) I.R.C. §219(g)
  • (4) I.R.C. §72
  • (5) I.R.C. §401(a)(9)(C)
  • (6) I.R.C. §408A(c)(1)
  • (7) I.R.C. §408A(c)(4)
  • (8) I.R.C. §408A(c)(3)
  • (9) I.R.C. §408A(d)(1)
  • (10) I.R.C. §408A(d)(2)
  • (11) I.R.C. 408A(d)(4)
  • (12) I.R.C. §408A(c)(5)
  • (13) I.R.C. §408A(d)(3)(A)
  • (14) Cymbal, Kenneth & Barrett, Tom. (2016). Increasing the Odds of Making a Successful Roth IRA Conversion. Journal of Financial Service Professionals. Vol. 70(3). May 2016. Pg. 49- 63.

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In June 2013, the National Institute on Retirement Security published the results of a study entitled “The Retirement Savings Crisis”, Is it Worse Than We Think?” The main purpose of the study was to determine if American households are financially prepared for retirement. The results of the study were rather sobering, as it suggests the majority of households are not as well prepared as they may have thought. Some of the highlights from the study were:

  • More than 38 million working-age households (45%) do not own any retirement account assets, whether in an employer-sponsored 401(k) plan or in IRAs.
  • The average working household has virtually no retirement savings. When all households are included – not just those with retirement accounts – the median retirement account balance is just $3,000 for all working-age households and $12,000 for those households near retirement.
  • 92% of working households are not on target to meet their retirement goals.

If this trend continues, Americans will likely need to find other ways by which to support their lifestyle during retirement rather than rely on retirement savings. Typically, the fallback position centers on either the decision to defer retirement by working to an older age or to make sacrifices to lifestyle and spend less. Neither of these is necessarily attractive to someone who has reached the point where retirement is a serious consideration.

HOME EQUITY TO THE RESCUE?

Those who own a home are in a unique position whereby they may have the opportunity to utilize the equity in their home to help fill the income or asset gap should they have a retirement income shortfall.

There are four primary ways by which an individual can access the equity in their home:

  • Home Equity Loan (or second mortgage)
  • Home Equity Line of Credit (“HELOC”)
  • Home sale and downsize
  • Home Equity Conversion Mortgage (Reverse Mortgage)

Following is a brief overview of each of these strategies. Each has its own advantages and disadvantages. Before deciding to implement any of these strategies it is important to speak with your financial advisor to determine the best course of action given your unique financial position.

Home Equity Loan

A Home Equity Loan allows a homeowner to access their home equity by taking a lump sum of money that will need to be paid back over a certain specified period of time (i.e. 10 years, 15 years or 30 years).

The advantages of a Home Equity Loan include:

  • A home equity loan carries a fixed interest rate. A retiree can plan on the loan payment being fixed for the entire term of the loan. This can be helpful for those that are on a fixed budget.
  • The interest the borrower pays on the loan may be claimed as a mortgage interest deduction. According to IRS Publication 936, the Federal Government allows the borrower to deduct the interest from the loan as long as the proceeds were used to buy, build, or substantially improve the borrower’s home. Further, a borrower can deduct home mortgage interest on the first $750,000 ($375,000 if married filing separately) of indebtedness. However, higher limitations ($1,000,000 ($500,000 if married filing separately)) apply if the borrower is deducting mortgage interest from indebtedness incurred before December 31st, 2017.

The disadvantages of a Home Equity Loan include:

  • The full balance of the loan begins to accrue interest as soon as the funds are disbursed. This may cause the borrower to pay more interest over time.
  • The borrower must start repaying the loan soon after it is disbursed. These payments may place a constraint on the borrower’s cash flow which could lead them to deplete their investment assets to help fill the income gap.
  • Because the home equity loan is an amortizing loan, each installment includes repayment of principal as well as interest. As such, the earliest payments on the loan largely interest, with very little reduction in the outstanding loan balance.
  • To qualify, the borrower must undergo a credit check and prove their financial assets and sources of income to the lender. Proving sources of income for retirees may prove difficult, as many have no employment income.
  • If the retiree is unable to meet the loan’s obligations, he or she may find themselves in a position of defaulting on the loan, resulting in foreclosure on the home.
  • Given the disadvantages associated with these loans, according to Allen (2015), a Home Equity Loan is typically an appropriate strategy for those retirees with a high-risk tolerance and sufficient sources of income.

Home Equity Line of Credit (HELOC)

A home equity line of credit is another way for a homeowner to access their home equity. When a borrower is approved for a HELOC, he or she does not receive a lump sum payment. Instead, the funds can be drawn upon when and as needed up to the amount of the credit line.

The advantages to a Home Equity Line of Credit include:

  • They are typically easier to establish than a traditional home equity loan, and closing costs are typically below that of a home equity loan.
  • The initial interest rate charged on a HELOC is typically lower than interest rates on home equity loans.
  • Interest is assessed on the amount the homeowner borrows against the home’s equity, not on the full amount of the line of credit.
  • The interest the borrower pays on the loan may be claimed as a mortgage interest deduction. According to IRS Publication 936, the Federal Government allows the borrower to deduct the interest from the loan as long as the proceeds were used to buy, build, or substantially improve the borrower’s home. Further, a borrower can deduct home mortgage interest on the first $750,000 ($375,000 if married filing separately) of indebtedness. However, higher limitations ($1,000,000 ($500,000 if married filing separately)) apply if the borrower is deducting mortgage interest from indebtedness incurred before December 31st, 2017.

Disadvantages include:

  • Interest rates are not fixed and are typically tied to a published interest rate such as the Prime Rate. The rate of interest calculated on the outstanding loan balance will therefore vary over time. In a rising interest rate environment, the borrower can find that the amount of the monthly payment may rise to a level that further squeezes their budget.
  • If the retiree is unable to meet the loan’s obligations, they may find themselves in a position of defaulting on the loan, resulting in foreclosure.
  • While the underwriting process may not be as stringent as for a home equity loan, to qualify, the borrower must undergo a credit check and prove their financial assets and sources of income. Proving sources of income for retirees may prove to be difficult as they typically have no employment income.

Home Sale and Downsize

Another way for a retiree to access home equity is by selling their existing home and downsizing.

Advantages include:

  • The liquidity gained from the sale may be used to purchase a new home that is perhaps better suited to the homeowner’s needs.
  • When “downsizing”, the homeowner can reduce or eliminate mortgage payments if the new home is purchased for cash or with a smaller mortgage.
  • To the extent the cost of the new home is less than the proceeds from the sale, excess proceeds can be invested to help provide additional income to help support the homeowner’s lifestyle.
  • Downsizing to a less expensive home may also reduce carrying costs like the amount being paid for taxes, homeowner’s insurance, utilities, etc.

Disadvantages include:

  • The decision to sell requires that the homeowner overcome the emotional hurdle of selling the home where many family memories were made.
  • To the extent the home is sold for more than its cost basis, the homeowner may have to pay tax on the capital gains from the sale. However, homeowners filing a joint return may be eligible to exclude the first $500,000 of capital gain from taxation. ($250,000 for those filing a single return). IRS Publication 523 states that the exclusion is available if you owned the home and used it as your primary residence during at least 2 of the last 5 years before the date of sale, you didn’t acquire the home through a like-kind exchange during the past 5 years, and you didn’t claim any exclusion for the sale of the home that occurred during a 2-year period ending on the date of sale of the home.

Home Equity Conversion Mortgage (Reverse Mortgage)

Lastly, a homeowner that is at least 62 years old may access the equity in their home through what is often referred to as a reverse mortgage. To be eligible for a reverse mortgage the home must be a single-family home or a 2 to 4-unit home with one unit occupied by the borrower. Certain condominiums and manufactured homes (trailers, etc.) will also qualify if they meet the requirements.

The amount a borrower may receive through a reverse mortgage depends on the following factors: (1) the age of the youngest borrower or eligible non-borrowing spouse, (2) the current interest rate, and (3) the lesser of the appraised value of the home or the mortgage limit of $822,325 (as of January 1, 2021) imposed by the FHA on reverse mortgages.

A reverse mortgage is referred to as a non-recourse, asset-based loan that does not require repayment until the borrower leaves the home (Allen, 2015, p. 75). Reverse mortgages are appropriate for those who would like to age in place (i.e. remain in their home), have enough financial resources to maintain the home (i.e. paying property taxes, homeowner’s insurance, etc.), and for those who may be looking to supplement their retirement income or to provide an emergency fund.

The clear majority of reverse mortgages in the United States are Home Equity Conversion Mortgages, which are regulated and insured by the Federal Government by the Department of Housing and Urban Development (HUD) and the Federal Housing Authority (Pfau, 2016, p. 45). For many years, reverse mortgages were sold inappropriately by lenders which often included high-pressure sales techniques and carried sizable loan origination fees. As a result, the Federal Government made changes to the reverse mortgage facility, increasing the regulations associated with them to protect the borrower by ensuring they have the financial wherewithal to continue to maintain the property.

As mentioned above, one of the major benefits of a reverse mortgage is to allow the homeowner to age in place. However, just because the home may be subject to a reverse mortgage does not mean that the borrower must remain in the home. The borrower can sell the home, but just like a conventional mortgage, they must repay the reverse mortgage loan balance when the home is sold. In addition, the homeowner can leave the home to his heirs. The heirs will inherit the home upon the death of the borrower. However, before the heirs receive title to the property, they must repay the reverse mortgage loan balance. If the heirs are not interested in keeping the home, they have the option of selling it. Again, they would be responsible for repaying the reverse mortgage balance upon the sale of the home.

Advantages of reverse mortgages include:

  • The ability to access the equity in one’s home, within limits, via a lump sum, an open line of credit, or through regular monthly disbursements without having to make loan repayments, as long as the borrower remains in the home. Please note, if the borrower lives with a spouse who is a co-borrower, then the co-borrowing spouse may continue to live in the home should the borrower move to a nursing home or assisted living facility.
  • Proceeds from a reverse mortgage may be used to pay off an existing first mortgage, home equity loan, or HELOC (within the stated limits), thereby eliminating principal and interest payments on such loans. Since re-payments are not required on the reverse mortgage, the borrower can substantially reduce their monthly out-flows.
  • According to IRS Publication 936, payments received under a reverse mortgage are considered loan advances. Therefore, disbursements received are not taxable.
  • A reverse mortgage is especially beneficial for those that do not have sufficient balances in retirement savings. Implementing a reverse mortgage will provide them access to otherwise “dead equity” that can help them fill any retirement income gaps.

Although reverse mortgages have some benefits, retirees need to be aware of some of their disadvantages.

Disadvantages of reverse mortgages include:

  • Origination fees and closing costs can be high.
  • The principal amount of the loan plus interest must be repaid upon the death of the borrower, or if the home is no longer the borrower’s principal residence (or the borrower moves out due to health reasons for 12 months or longer), or if the borrower defaults on the terms of the loan.

If you are close to retirement, or in retirement, and are looking for ways to utilize your home equity to supplement your income it is important that you speak with your financial advisor to make sure that any of the above strategies are appropriate for your unique financial situation.

  • Allen, James, R. (2015). Using the Personal Residence for Retirement Income. Journal of Financial Service Professionals. 69(4). Pp 71-79.
  • Pfau, Wade. (2016). Reverse Mortgages: How to use Reverse Mortgages to Secure Your Retirement. McLean, VA. Retirement Researcher Media.
  • Rhee, Nari. (2013). The Retirement Savings Crisis: Is it Worse Than We Think? Washington, DC. National Institute on Retirement Security.
  • United States Department of the Treasury. Internal Revenue Service. Publication 936 (2019): Home Mortgage Interest Deduction. Internal Revenue Service.

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