Outside Economics

Hardly anyone likes taxes, but some are more offensive than others. Here are three that are pretty big offenders. I don’t think folks mind paying some taxes, but it’s when it takes nearly five months of work to hit tax freedom day that it becomes a greater burden. Not to mention the waste that is found in government, so these three taxes can and ought to be fixed.

Alternative Minimum Tax - AMT

Once upon a time, Congress dreamed up the alternative minimum tax (AMT), which is an add-on to the “regular” federal income tax. The stated reason for the AMT was essentially to make sure that the rich who benefit from multiple federal income-tax breaks still have to pay at least something to the Treasury. Oddly enough, the rules for this tax were poorly crafted, thereby allowing for creative math to come into play, of course, erring on the side of the IRS.

One can consider the AMT as a separate tax system. The AMT will affect certain types of income that are tax-free under the regular tax system, while not allowing some regular tax deductions. Also, the maximum AMT rate is “only” 28%, versus 39.6% under the regular tax system.

The most likely AMT victims are upper-middle-income individuals who pay relatively high state and local income and property taxes and have spouses and kids. The truly rich ($750,000+) are rarely affected, and this is for two reasons.

First: Their marginal regular federal income rate is 39.6%, while the maximum AMT rate is 28%. So the regular tax bill for a person with really high income will usually exceed the AMT bill. On the other hand, folks in the upper-middle-income zone may have enough regular tax deductions that they pay an average regular tax rate lower than the AMT rate. If so, they will get hit with the AMT.

Second: Many tax breaks for really high-income folks are already cut back under regular tax rules before they even get to the AMT calculation. For instance, the passive activity loss rules restrict tax benefits from traditional tax-shelter investments like rental real estate and limited partnerships. And if your income exceeds certain limits, you’ll run into phase-out rules that chip away or eliminate your personal and dependent exemption deductions, your biggest itemized deductions, and your tax credits. So you may have little or nothing left to lose under the AMT rules. In contrast, folks in the upper-middle-income zone often have lots to lose, such as significant deductions that are allowed for regular tax but disallowed under the AMT rules. As a result, they wind up owing the AMT.

You are allowed a relatively generous AMT exemption, which would be the equivalent to a deduction when calculating your AMT bill. But unfortunately, the exemption is phased out at higher income levels. If your AMT bill exceeds your regular tax bill, then of course you will owe the higher AMT amount.

Varying factors make it difficult to figure out who will be affected by the AMT and who won’t. But here are some general guidelines:

• Your income is high enough ($250,000 or more) that a good part or all of your AMT exemption is phased out.
• You have relatively hefty deductions for state and local income and property taxes under the regular tax rules (say, $20,000 or more). These deductions are not allowed under the AMT rules.
• You have a spouse and several kids, which translates into four or more personal and dependent exemption deductions under regular tax rules. These deductions are not allowed under the AMT rules.
• You exercised an in-the-money incentive stock option (ISO). The so-called bargain element (the difference between the market value of the shares on the exercise date and the ISO exercise price) does not count as income under the regular tax rules, but it counts as income under the AMT rules.
  • You have a significant deduction for home equity mortgage interest. Under the regular tax rules, you can deduct interest on up to $100,000 of home-equity loans. But under the AMT rules you can only deduct interest on loan balances of up to $100,000 that are used to acquire or improve a first or second residence.
  • You have write-offs for miscellaneous itemized deduction items (such as investment expenses and fees for tax advice and preparation) under regular tax rules. These deductions are disallowed under the AMT rules.

Social Security or FICA Tax

The second tax that has some serious flaws is the Social Security tax. It can be just as expensive as the federal income tax for many folks, especially self-employed individuals.

If you are an employee, your wages will be reduced by the 12.4% Social Security tax up to the annual wage ceiling. Half the Social Security tax bill (6.2%) is withheld from your paychecks. The other half (also 6.2%) is paid by your employer.

Unless you closely examine your pay stubs, you may be completely unaware of how much the Social Security tax is actually costing you. Potentially, a lot! The Social Security tax wage ceiling for 2014 is $117,000, and it will be even higher next year. If your wages meet or exceed the $117,000 ceiling for this year, the 2014 Social Security tax hit will be a whopping $14,508 (12.4% x $117,000).

If you are self-employed as a sole proprietor, partner, or limited liability corporation (LLC) member, you know the full cost of the Social Security tax all too well. That’s because you must pay the entire 12.4% rate out of your own pocket, via the self-employment tax.

But there is a disconnect between the Social Security tax and the benefits. While the Social Security tax ceiling increased by 2.9% from 2013 to 2014 (from $113,700 to $117,000), Social Security benefits only increased by 1.5%. This scenario has occurred routinely in the past few years, and they aren't stopping now! According to Social Security Administration projections, the Social Security tax ceiling in 2022 will be $165,600, which equates to a $20,534 Social Security tax bill (12.4% x $165,600). That is a hefty tax, especially considering it is in addition to regular income tax as well as all the other taxes!

Social Security Benefits Tax

And this leads us to the third unfair tax. When you start receiving Social Security benefits, you may be surprised to discover that between 50% and 85% of your payments get hit with federal income tax (the taxable percentage goes up with your income). Incredible, right?

As I just explained, you already paid Social Security tax years ago in the form of withholding from your wages or the self-employment tax. Plus, you already paid federal income tax on those Social Security taxes years ago, because they were included as part of your taxable salary or self-employment income. Now you are paying tax on the benefits too. That amounts to double taxation, or maybe even triple taxation depending on how you look at it. While retirees with very low income, less than $32,000 per year, won’t get taxed on their Social Security benefits, everybody else will take a hit.

Tell us what you think about these taxes are they a burden on your family? How would you solve the problem of these taxes?

Last week I discussed some of the factors that go into the decision about when to take Social Security. The discussion was primarily based on working the numbers and coming to the basic conclusion that it is an entirely individual choice based on one's financial situation. This week I want to add to this discussion some of the qualitative aspects of life that should not be neglected when making such a decision.

To give an example of what I have in mind for this discussion, consider some of these questions: Will I be better able to do some of the things I have always wanted to do if I take Social Security earlier rather than later? If I wait on taking Social Security will I have the stamina, interest and motivation to do the things I want to do now, later in life?

Last week I showed that the payout is often larger by waiting a few years to take Social Security, however, will waiting enhance the quality of your life? Would you be wiser to take it at a younger age and use the lesser amount to fund some of the life experiences (travel, toys, etc.) that you may not have the stamina or interest to pursue later in life?

The US Travel Association reports that the average age of leisure travelers is 47.5 years old. Mature travelers comprise 36 percent of leisure travel volume (18% are 65+, 18% are 55-64). Nearly two in ten (19%) are 45-55, 17% are 35-44, 20% are 25-34 and 8% are 18-24 years old. I give this statistic because many people dream of traveling once they retire. The majority of travelers- 36%- are over age 55. Will you have the money and the stamina to fulfill your travel dreams? Would the decision to take Social Security earlier help you reach that goal?

The American Psychological Association reports that a number of physical changes occur as adults reach age 65. The most common are listed below.

• Hearing impairment among older adults is often moderate or mild, yet it is widespread; 48 percent of men and 37 percent of women over age 75 experience hearing difficulties.
• Visual changes among aging adults include problems with reading speed, seeing in dim light, reading small print, and locating objects.
• The amount of time it takes to respond to features in the environment once they are detected is typically slower among older adults.
• The proportion of older adults needing assistance with everyday activities increases with age. Nine percent of those between ages 65 and 69 need personal assistance, while up to 50 percent of older Americans over 85 need assistance with everyday activities.
• The top five causes of death among older adults are heart disease, cancer, cerebrovascular disease (relating to the blood vessels that supply the brain), pneumonia and flu, and chronic obstructive pulmonary disease. In spite of a decline in physical health, two-thirds of older adults who are not living in institutions (such as nursing homes) report their health to be good, very good, or excellent compared with others their age. What's important to remember about people over age 65 is that while many begin to experience some physical limitations, they learn to live with them and lead happy and productive lives.

These statistics can help us factor in the very real changes in health that we experience as we age. Not that everyone will experience some or all of these health challenges, but to simply acknowledge that the older we get, the more physical limitations we can expect. What do you want to do with your life before physical limitations set in that would thwart your dreams?

The point is that there is a qualitative dimension to this choice that is often overlooked or ambiguously lumped in the statement of 'individual choice'. People often forget to take into consideration the aging process with its diminished energy and somewhat constricted abilities, and therefore run the risk of not achieving their dreams and dying with a pot full of money. Abraham Maslow once commented that you can pay too much for money.

In researching for this article, I wondered, how are seniors spending their money? Below is a chart showing the top five areas that seniors are spending their money. It may surprise you to see education listed. This is typically due to either contributions to a grandchild’s college fund or else paying off college loans that were co-signed by the seniors.

Now see how those expenditures change as seniors age past 75.

Seniors spending reflects their hobbies. For 65 to 74 year-olds, for instance, notice that two of the top five fastest-growing expenditure categories are miscellaneous entertainment, which includes exercise equipment, photography equipment, campers, boats and other motorized recreational vehicles, and electronics; and pets and hobbies, which not only includes expenses for pets and pet supplies, but also toys, games, tricycles and playground equipment.

The Baby Boomers are far more active than their parents were. They have traveled more places, participated in more sports, and likely climbed more mountains. All resulting in an active lifestyle, that will be interesting to watch as they continue to age; how and when will they start to slow down?

According to the Bureau of Labor Statistics, the number of seniors age 75 and older are around 12,147,000 with a mean after-tax income of about $34,245 and a mean expenditure of $34,395.

One more thing that is noteworthy to mention is that 25 years ago, the credit card debt of seniors was negligible, and now it is around $5000 for seniors aged 75 years or older. I hope these statistics give you an idea of how to plan for your senior years. It isn't just about the numbers, but it is very much about the quality of life you want to maintain during those years.

I would like to share the story of a dying 85 year old man imagining how he would've lived his life differently if given the chance. It is found in the book Living, Loving & Learning by Leo Buscaglia, who discovered it in a journal of humanistic psychology.

He says, "If I had my life to live over again, I'd try to make more mistakes next time. I wouldn't try to be so perfect. I would relax more. I'd limber up. I'd be sillier than I've been on this trip. In fact, I know very few things that I would take so seriously, I'd be crazier. I'd be less hygienic. I'd take more chances, I'd take more trips, I'd climb more mountains, I'd swim more rivers, I'd watch more sunsets, I'd go more places I've never been to. I'd eat more ice cream and fewer beans. I'd have more actual troubles and fewer imaginary ones.

You see I was one of those people who lived prophylactically and sensibly and sanely hour after hour and day after day. Oh, I've had my moments, and if I had it to do all over again, I'd have more of those moments. In fact, I'd try to have nothing but beautiful moments- moment by moment by moment.

I've been one of those people who never went anywhere without a thermometer, a hot water bottle, a gargle, a raincoat, and a parachute. If I had to do it all over again, I'd travel lighter next time. If I had to do it all over again, I'd start barefoot earlier in the spring and stay that way later in the fall. I'd ride more merry-go-rounds, I'd watch more sunrises, and I'd play with more children, if I had my life to live over again. But you see, I don't."

The bottom line is that as we age, we may not want to travel as much, go out to the movies as much, or visit great grand-children who may be graduating from Kindergarten (as important as that may be). We may simply choose to stay closer to home and do less, simply because our perceived needs are changing and we discover that we want less. While this may be the case, and it is hard to predict, exactly how we will live at that age, choose to be happy with what you have. Manage your affairs so that when you do take Social Security it works for you and your life style, not just by the numbers. 

There is a great debate growing about when is the best time to start taking Social Security. There are pro's and con's on either side of the debate. But really, it all boils down to a very personal decision based on your specific situation.

The factors of when to take Social Security depend on two considerations: 1) the quantitative information, your work status between age 62 and your full retirement age; your life expectancy; your marital status; and your desire to protect your assets; and 2) the qualitative information, what are your goals during retirement, when do you anticipate slowing down, will you have the stamina or interest to pursue things later in life, say, over age 80, etc. This will be a two part article, first I will discuss the quantitative factors how each of these may affect your personal situation, next week I will discuss, perhaps the more important, qualitative factors.

If you have not yet reached your full retirement age as defined by Social Security (for most people that's about age 66) and you are still working, it will probably not make sense to start receiving your Social Security benefits. Why? Because if you earn over the Social Security earnings limit, your Social Security benefits will be reduced. Once you reach full retirement age your benefits will not be reduced regardless of other income you may earn (although your benefits may be taxed.)

If you live to your standard life expectancy, believe it or not, you will get almost the same amount whether you take Social Security early, or wait until later to take it. To see how this works, it helps to look at an example using real numbers, such as the one below.

Steve is age 61 and he is deciding when to take social security. Here are the numbers from his Social Security statement showing what he will get at which age:

• Age 62: $1,643 ($19,716 per year)
• Age 66: $2,238 ($26,856 per year)
• Age 70: $3,009 ($36,108 per year)

A 62 year old man has a life expectancy of nineteen years, or age 81. Social Security has a cost of living adjustment which provides an increase in benefit of 2% a year, but for now we’ll factor it without that. Here are the three possibilities:

• Assume Steve starts receiving benefits at 62. He gets $1,643 per month, or $19,716 per year, for 19 years. This is a total of $374,600.
• If he waits until age 66, he gets $2,238 per month, or $26,856 per year, for 15 years. He'll receive a total of $402,870.
• If he waits until age 70, he gets $3,009 per month, or $36,108 per year, for 11 years. He'll receive a total of $397,190.

Clearly, if Steve lives to life expectancy, he maximizes his lifetime income by taking Social Security benefits at age 66. When you factor in the 2% annual increases, Steve would expect the following total amounts:

• $450,320 if he started benefits at age 62
• $502,720 if he started benefits at age 66
• $514,800 if he started benefits at age 70

If Steve lives to age 81, he will maximize his lifetime income by waiting until age 70 to begin taking his Social Security benefits. In Steve's case, his break even age matches the average breakeven point which is 80, meaning if he waits until age 70 to begin benefits, he must live to at least age 80 to receive the same total dollars he would have received if he started taking benefits earlier. If you don't think you'll live past 80, you're better off claiming earlier. If you are married and think one of you will live past 80, it might make sense to delay.

Morningstar's Blanchett wrote a report, "When to claim Social Security" in The Journal of Personal Finance. He said "We find that females, married couples, retirees who expect to invest in relatively conservative portfolios during retirement, and retirees who have longer life expectancies are likely to benefit most from delaying Social Security benefits. On the other hand, retirees who have shorter life expectancies or invest more aggressively and believe they can achieve a relatively high return on their retirement portfolios would likely be better off taking Social Security earlier."

There are a lot of dollars at stake, and of course no one knows their life expectancy with certainty. However certain health and lifestyle factors will affect your own personal life expectancy. Just as an insurance company would do underwriting, I would suggest you do an analysis on your own personal life expectancy, using a life expectancy calculator that will ask you health and lifestyle related questions.

For singles, life expectancy is one of the primary factors to consider. For married couples, you have to consider more than just life expectancy. The way Social Security survivor benefits work, when you are married, upon the death of the first spouse, the surviving spouse can keep the larger of either their own benefit or their spouse's benefit. Because of this, there are ways for couples to coordinate how and when they each take benefits so they can get more as a couple.

I'm a strong believer in leaving an inheritance for my posterity. Using up retirement savings in lieu of potentially one day getting a larger Social Security check just doesn't achieve this goal. It makes more sense to use money that won't be there after I'm gone - i.e. Social Security - than to burn through things like cash savings, retirement account funds, and home equity. Personally, I'd rather try to save these assets, using Social Security (a source of income that I won't be able to pass on to descendants) to pay the bills rather than dipping into personal assets.

There are also a variety of strategies regarding Social Security. One is a switching strategy, which allows one spouse to claim another's benefits. For example, a married man who is 67 and doesn't need the benefits can claim his wife's benefits until he's 70, and let his own benefits continue to grow. When he turns 70, he can switch to his own benefits. Another switching strategy: A divorced woman who is 67 and had been married for at least 10 years can claim her ex-husband's benefits until she reaches 70, then switch to her own.

When to begin taking Social Security benefits is a very personal decision. Knowing the rules will help insure that you don't needlessly waste months of benefits that you could have received. If you have questions about when you should receive Social Security benefits, feel free to contact us for a free consultation. If you know of someone who may be at the threshold of this decision pass along this article to them, you may just save them some grief.

Note: Next week qualitative issues surrounding Social Security.

A Special thanks to Dan Perkins, PhD. who helped with these articles.

There are a few types of insurance coverage that are essential to have in this day and age. Disability insurance is one of those. If you die, your life insurance will take care of your family; but if you get hurt and become disabled, then what? The average monthly benefit from Social Security disability is $1,004 a month. Will that be enough to take care of your current needs?

Many people live such active lifestyles that the risks of a serious injury is very real. We all know someone who has been injured playing one sport or another, an auto accident, or simply injured falling off a ladder trimming the tree! It happens all the time – that is why we have Emergency Rooms at the hospitals!

Disability insurance helps protect a portion of your income and provides financial protection if you become disabled for an extended period of time. If you are permanently disabled, not only will you be unable to work, but you may also need financial resources to be cared for. Anyone who depends on their income to pay the bills or maintain their lifestyle should consider disability insurance protection.

Many companies offer great rates on disability insurance to their employees. You can also shop around for private insurance companies to find out their rates and policies. Make sure 65-70% of your current income is covered for an extended time period, usually until death or age 65.

A simple rule of thumb is the M.U.G.^® Plan = Mortgage, Utilities, & Groceries. Do you have enough disability insurance to cover these three very important expenses? Think of it this way, which job would you prefer:

There are some key features of disability insurance that are important to be aware of. A disability insurance policy can complement existing disability benefit coverage that may be available to you. A disability insurance policy is fully portable; you own the policy and so you can take it with you throughout your career. There are policies that offer flexible solutions for various income levels. Also, depending on how the policy is set up, the benefits may or may not be tax-free.

Determining whether your benefits are taxable depends on a few factors. These factors include what type of benefits you receive, whether the premiums were paid with pretax or after-tax dollars, and who paid the premiums (you or your employer).

The rules surrounding taxation of individual disability income insurance benefits are generally simple. When you pay the premiums with after-tax dollars, the benefits you receive are tax free. When you pay your premiums with pre-tax dollars, your benefits will be taxed. This rule of thumb is the case whether you are enrolled in a group plan, a cafeteria plan or a medical reimbursement plan. However, unlike health insurance premiums, you can't deduct premiums paid for disability insurance as a medical expense.

If you are enrolled in a group disability insurance plan sponsored by your employer, the tax-ability of your benefits depends on who pays the premium. If you pay the total premium using after-tax income, then your benefits will be tax free. On the other hand, if your employer pays the total premium and does not include the cost of coverage in your gross income, then your benefits will be taxable. If your premiums are split by you and your employer, then your tax liability will be split as well.

It comes down to this: If you never use your disability benefits, you'll save money by paying your premiums with pretax dollars. But if you do use your disability benefits, using after-tax dollars to pay your premiums places you in a better position.

Different rules apply to an employer who pays for a disability insurance policy on an employee. This may be the case if there is a key employee in the business. If the employer gets the benefit, then the premium is not deductible to the company, and the benefit is not taxable when received by the company.

All, part, or none of the disability benefits you receive through government disability insurance programs may be taxable. How much of the benefit is taxable and under what circumstances depends on the type of government disability benefit you are receiving. These government benefits include Social Security disability income, Medicare benefits, worker's compensation, veteran's benefits, military benefits, and Federal employee's retirement system benefits.

A lot relies on your income, perhaps even more than you think. If the unexpected happens – if you become too sick or hurt to work – would your savings or the disability benefits you receive through your employer be adequate?  As always, consult a trusted professional for advice.

I know what your saying, "It will never happen to me!" Right?

Recently I was told that there are 3-4,000 people per month in the Dallas Metro area who turn 65; the baby boomers are entering retirement in full swing. That is a lot of folks who are now descending on the local social security offices to collect the long awaited benefits, for, which they contributed many years.

Many folks wonder if they will ever receive any benefits, due to the financial state of the country and in particular the Social Security Administration (SSA) Trust Fund. I have always told people that the money may not be there, but you will be paid. After all, when have you known the government to shutter an agency and send over 68,000 government workers out on the street to find another job? It just doesn’t happen.

At times, when I find a really good cartoon, I cut it out of the paper, like the one attached. This says drawn in winter 1990, 24 years ago when the baby boomers were in their early 40’s. Fast forward to 2014 and it seems nothing has changed!

So now, that we have established that Social Security will be there, now comes the question of how or when to take the benefit? There are several strategies to the challenge of maximizing the Social Security payment, while keeping the tax man at bay.

Here is one idea. Most people don’t know that they can “file and suspend”, meaning that they can file for the benefit and then immediately suspend receiving the benefit until they are a few years older. This strategy may be best used when one spouse has a higher income than the other. The spouse with the higher income files and immediately suspends receiving the benefit, while the lower-earning spouse files and receives half of the benefit.  While the one benefit is suspended it continues to grow until the suspension ends.  Once the higher-earning spouse reaches age 70, both can collect their own benefits in full.

While many people continue to work during the early years of retirement, they will want to watch how their income is paid to them so they can minimize the taxes on their Social Security. They may want to take money from their IRA’s first before receiving Social Security, thus reducing the taxable income from that source early on. This may help keep Social Security payments from being taxed if payments are put off for a few years.