Taxes in retirement

As you go through life, you will encounter several "life-changing" moments.  Some are good, such as graduating college or having a child, while others are bad, such as losing a parent or going through a divorce.  These moments can also bring changes to your financial life, including how much tax you owe and how it is paid.  

This article addresses taxes in retirement.  I realize this is not chronologically accurate, but it is an issue that several people are not prepared for when they enter retirement.  

Income and deductions

A retired taxpayer will likely have very different income and deductions than they had earlier in life, maybe even than the year before.  Their wage income will be replaced by distributions from retirement plans, investment income and Social Security.  Personal exemptions for children and mortgage interest will be replaced by charitable contributions and medical expenses.  Changes in income and deductions must be considered when determining how much tax will be owed each year.

Social Security

There's no easy way to say it: if you have other sources of income, up to 85% of the gross Social Security benefits you receive are taxable.   This often comes as a surprise to retired taxpayers, because there is often no tax withholding against this income.  However, you can elect to have Federal withholding taken from your SS benefits if you don't want to change the withholding on your retirement distributions.  Fortunately, SS benefits are not taxed in several states.

Paying taxes

The most challenging part of determining taxes in retirement is determining your income from all sources and electing tax withholding to cover all of it (or pay estimated taxes).  If you are taking distributions from a retirement plan, they will give you the option to withhold taxes on that distribution.  But, this withholding will be based on that distribution alone, and most likely will not cover investment income or Social Security benefits.  The key is to set your withholding high enough to cover taxes on all of your income, not just one source.  

In all, it is important for individuals that are nearing or entering retirement to meet with their tax advisor to determine tax implications of retirement.  Your tax advisor will consider changes in your income and deductions and advise on how much to withhold from retirement distributions or quarterly estimated tax payments that need to be made.  

Gifts and Inheritances

There is often times confusion amongst taxpayers about the nature of gifts and inheritances, both for tax and basis purposes.  They can both be misconstrued as the same thing, but they are very different.  It is important to consult professional legal or tax advice regarding gifts and inheritances.  

Gifts

Gifts can be made by individuals to other individuals at their discretion.  Individuals can make gifts of up to $14,000 (2015) without reporting the gift.  Gifts over that amount require reporting on an annual gift tax return.  A recipients basis in the gift is typically the donor's adjusted basis (cost) in the gift when it is given.  There are special rules when the fair market value (FMV) of a gift is less than it's adjusted basis.  The recipient does not report the gift under any circumstance, unless it generates income or is sold for a gain/loss in the future.  

Transfers at death (inheritance)

Transfers received as a result of an individuals death (commonly known as an inheritance) are not taxable to the recipient, and their adjusted basis is typically the FMV of the assets on the date of death.  These assets only become taxable if they generate income or are sold at a gain/loss in the future.  If the transfer is made into a trust, the beneficiary might be required to report the income of the trust on their individual tax return.  

Application

In this scenario, let's say Sue has common stock with an adjusted basis of $10,000 and a current FMV of $13,000.  She gifts this stock to her son, Bob.  Sue does not file a gift tax return because the value of the gift is less than $14,000.  If Bob sells the stock once he receives it, he will have a capital gain of $3,000 because of the difference in the adjusted basis and the FMV.  

On the other hand, let's say Sue dies and Bob inherits the stock and immediately sells it.  He will have no capital gain or loss, because the FMV of the stock at the date of death will become his adjusted basis, which is also the same when he sells it.  

Taxpayers with assets they want to pass on should consult professional legal and tax advice in order to develop a gifting plan and a strong will to benefit their heirs or charitable organizations.  

Op Ed: A Millenial's View of Social Security

Social security is a pyramid scheme.  Bigger than Enron and Madoff and the calling cards Michael Scott was selling on The Office.  

I preface this by saying everyone that pays into the Social Security system (SS) deserves to benefit from those contributions at some point.  Receiving a SS check each month is evidence that you spent a long career working hard and you are benefiting from a system you paid into.  You can Google "social security benefits" and find hundreds of articles on when to start drawing SS, how spousal benefits work, and how much more you can get if you don't start drawing until 68 instead of 65.  These people are at the  "top of the pyramid".  But what about those of us at the bottom of the pyramid, looking up and wondering what will be left if we ever get to the top?  

SS was passed by Congress and signed into law by President Roosevelt in August 1935.  This was a part of a nationwide recovery after the Great Crash and depression in the late 20's and early 30's.  A complete history of SS can be found at the SSA website (in case you forgot it all from high school history like I did).  

In general, the program was designed to help older Americans that had lost all of their savings.  Almost 80 years later, the program is still in existence.  The program is funded through FICA taxes, which are withheld from an employee's paycheck at a rate of 6.2% and then matched by the employer.  Once an employee's wages reach a certain threshold ($117,000 for 2014) they are no longer subject to the FICA tax (Medicare never phases out, and is a whole other debate for another time).  

The problem is, every dollar a 30 year old worker puts into the system is paying benefits for someone in their 60s and 70s, hence the "pyramid".  The result is my kids will be paying the benefits for my parents, leaving my grandkids to pay for my benefits.  Furthermore, the SS system is heavily underfunded, meaning that it projects to have greater liabilities in the future than expected assets/income.  This is why you will hear some politicians suggest raising the minimum age when Americans can begin to draw SS benefits - so as to delay the number of new people signing up for benefits a little bit further down the road.  

In a perfect world, I would like the option to not contribute to the SS system, and also bypass the future benefits.  I have been educated on retirement accounts and insurance and understand my responsibility for myself and family in retirement.  Unfortunately that is not feasible for a variety of reasons, mainly being that if I quit contributing to the system, they will not be able to meet their current liabilities.  You can't do away with the program, because It would be impossible to draw a line in time and say "everyone from this age and older gets it, and everyone younger doesn't get it".  You also can't apply income limits, because the higher wage earning Americans pay more into the system through the FICA taxes.  

Absent any major overhauls, the greatest looming problem in my opinion, especially for Millenials, is that eventually the government will have to find a way to rectify the deficit in the SS program.  According to the 2014 Trustees Report, SS and Medicare payments accounted for 41% of all Federal expenditures in fiscal year 2013.  Since these benefits are set in stone and will increase as more baby boomers hit retirement, the only way to fix the deficit is to raise revenue i.e. some form of taxation.  It could be in the form of higher FICA rates which would affect take-home pay, or it could be in the form of a special "other tax" like the net investment income tax that is designed to siphon tax revenue from a specific group of taxpayers.  

If you are currently drawing SS or will be drawing it in the next 10 years - thank you for your years of hard work contributing to our economy.  You deserve the benefits from the system you paid into, and I will gladly pay in so that you can reap the rewards of your long career.  But I'm not counting on anything for me because in the next 35 years someone will figure out that the system is broken and unsustainable.  And I'm not sure my grandkids will be as willing to foot the bill as I am.

Idea$ 2014 - August: Credit Cards

In the world of personal finance credit cards have a bad reputation.  They can give people a false sense of how much money they can spend and lead to high interest and finance charges.  But, if used with appropriate discipline, credit cards can be a powerful tool in your financial universe.  What follows is a look at different types of credit cards and some of the best ways they can be used.  

Disclaimer

Before we begin, I will offer the disclaimer that I have found there are two golden rules when it comes to credit cards.  First, never spend more on the card than you can pay off when the bill comes due.  Second, always pay the card off each month i.e. never carry a balance.  By following these rules you will never have to pay interest or finance charges on your card, which can be large sums and lead to ultimate financial ruin.  

Cashback cards

Credit cards with a cashback feature provide the cardholder with cash in conjunction with certain purchases they make with the card.  One of the most popular is Discover's 5% Cashback Bonus program.  This program gives the cardholder cash back of up to 5% on qualifying purchases, which vary during the year.  For example, right now users of this card get cash back on all of their gasoline purchases through the end of September.  If you spend $100 on gas this month, you will get $5 credited to your cashback account which can be used to pay your bill, buy merchandise, or transferred to your bank account.  Cashback cards are great tools for people that only use a credit card for certain purchases, like gas and groceries.  

Cards with points

Credit cards that offer a points structure come in many different forms.  You have American Express, which gives you points on each purchase that you make.  These points can be used to buy merchandise from American Express, used on their travel website, or even used at Amazon to buy merchandise.  Then you have travel cards with airlines which give you miles instead of points.  These miles can be cashed in for plane tickets once you have earned enough.  Finally, you have store credit cards which give you points to be used as discounts on future purchases.  These cards are good tools for people that use credit cards a lot, buy a ton of plane tickets, or are always buying new things at their favorite store.  Plus, many of these cards have bonuses where, once you have spent a certain amount of money on the card during the year, they will give you extra points!  These cards are also great for people that have a lot of work expenses that are reimbursed.  If you have to buy your own plane ticket for a work trip and submit your receipt for reimbursement, you get to keep the points.  I don't see anything wrong with using credit card points to get a new set of golf clubs because you were on 25 airplanes last year!

Store credit cards

Store credit cards is an area where you can get the most bang for your buck with the proper discipline.  Here's a common example.  You need to buy a new refrigerator that's going to cost $2,000, but you don't have that kind of cash right now.  You see on the TV that your local appliance store is running a zero payments / zero interest for 18 months special on their store credit card.  The rules of these promotions are pretty simple - the interest on the purchase accrues for 18 months and then hits as soon as that period expires.  The trick is, if you pay the card off before the 18 months, you pay zero interest.  Basically, the store has financed the purchase for you.  So you go down to the appliance store, buy the refrigerator with their credit card, and then take the balance and divide by 17.  You divide by 17 to make sure you pay the card off before the promotion ends.  Make that payment each month and - voila! - now you have a new refrigerator, and you paid no interest or finance charges.  This is the only situation where the golden rules discussed above do not apply.  

Conclusion

In conclusion, credit cards can be a useful financial tool if used correctly.  By never carrying a balance and always paying the card off at the end of the month, you can earn cashback or points and a little more interest on your checking account.  A helpful tool is to treat credit card transactions just like they are cash transactions on your budget.  Look at your statement each week and make sure you are not overspending.  

Savings bonds

When my wife and I got married, we opened a joint checking account at our local bank.  It was a basic checking account which is all we needed, but it came with the use of a safe deposit box free for a year.  Me, believing I was now a "grown up" because I was married, owned a house and had a salary job, jumped at the chance to protect our most precious belongings in said safe deposit box.  I immediately went through our home and gathered up everything I thought, at the time, that we could not live without were our house to burn to the ground.  I took these items back to the bank and stored them in our new safe deposit box.  

Last year when our first child was born, as most parents do we began looking at our budget to find ways to make buying diapers, wipes and baby clothes less painful by cutting other expenses.  That's when we saw the $40 annual charge for the safe deposit box on our bank statement.  

Tax tip: fees paid for safe deposit boxes are subject to the miscellaneous itemized deductions in excess of 2% of AGI on Schedule A of Federal Form 1040.  If you pay a fee for having a safe deposit box, remember to give that information to your tax preparer.

Since I could not recall exactly what was in the safe deposit box, we set a reminder for one year later to clean the box out so as to save the $40 a year.  Last week, the reminder popped up and I rushed back to the bank, excited to see what was in the box before closing it out.  The contents of the box: our original signed marriage license, a copy of the title insurance to our first house, and a stack of savings bonds.  As I looked over the savings bonds, some which we had received more than 25 years ago, I started to wonder what they were worth now.  

Beginning the year I was born and for most years until I turned 18, my grandmother would give me a $50 Series EE savings bond on my birthday.  This type of savings bond is purchased with a fixed interest rate, and it earns interest for 30 years.  For example, the first bond I received was a $50 bond with a fixed interest rate of 4%.  Using the savings bond calculator at the Treasury Direct website, I discovered that this bond will mature in January, and is currently worth approximately $113.  That is a 126% return!  I used the calculator to build the entire inventory of our savings bonds and discovered that we owned $850 of bonds that had been originally purchased for $450 and are now worth $925.  This results in a total return on our savings bond portfolio of 105.75%.  

Savings bonds can be cashed in at most financial institutions.  When the bond is cashed in, you will receive a 1099-INT for the interest portion of the bond.  In the example above, I would receive a 1099-INT for $63, because that is the amount of interest the bond accrued over 30 years.  This interest is paid on government obligations and is subject to Federal tax, but in some cases might be exempt from state taxes.  

The Treasury Direct website has several resources for savings bonds and other types of US Government obligations.  However, the key to successful investing in savings bonds is to hold them as close to maturity as possible.  In January I fully intend to take my first savings bond down to the bank, cash it in, and then take my family out to a nice dinner.  If my grandmother was still with us I know that's what she would have wanted.