The US stock market’s performance during the first quarter has been “interesting” once again.
Of course, no one is happy to see their stocks (and overall portfolio) go down in value, but there are some valuable lessons to glean from what’s been happening this year that are worth pointing out, because it highlights an absolutely critical principle every investor must understand. It is this…
When you’re well diversified, you’re never 100% happy. Let me explain.
Many Wyoming workers take advantage of employer retirement plans, like 401ks or 457s, which offer tax-deferred contributions as well as matching contributions from the employer. This is an incredible benefit that should seldom be passed up. Even when you don’t have access to a 401(k), IRAs are also available to help lower your taxes and get tax-deferred growth.
A problem comes, however, when an account holder reaches the age to begin Required Minimum Distributions, or RMDs. These are amounts of money that MUST be taken from the retirement account, and taxes paid on the withdrawal.
Most of us associate the new year with a fresh start, new opportunities & resolutions. I’ll admit, I’m a big goal setter because I’m still working on becoming the best version of myself. I have a variety of categories that I base my goals on, and of course, finance is always one of them.
As I’ve visited with friends and family about finance, the topic naturally leads to budgets. I often hear things like, “Budgets are so restrictive”, “I don’t want my money telling me what to do”, etc. I’ve spent a considerable amount of time thinking about these statements. I think we can all agree that wearing a belt cinched too tight is uncomfortable, and eventually gets removed and discarded as do best intentioned budgets. Is it possible to have a budget that doesn’t cut off the circulation? Is it possible to have a budget that gives you freedom instead of chains? I would say, Yes! I would like to let you in on my approach to an empowering budget.
Shortly after my husband graduated college, I was so tired of living the “poor” college life. That was behind us, but we still felt the money just didn’t ever go far enough, and we continued to live paycheck to paycheck. We were slaves to every dollar. We had all these obligations, and there wasn’t money left over for what we wanted to do. I started tracking and categorizing our spending. After a few months, I put together a budget with the approach of what I wanted our money to do for us. Our income remained the same, the expenses remained the same, but within a short period of time, we no longer felt broke. What changed? I shifted my perspective, my money was doing exactly what I told it to do.
If you’re ready to put your money to work for you, may I suggest these 5 tips.
Review your spending from the prior two months. Divide your spendings into specific categories. This will help you identify your spending habits, and allow you to put together a budget that similarly aligns with your spending. If you’ve ever been on a diet and you’ve made several drastic changes, the diet never seems to last long. Budgets are similar.
Keep your priorities as priorities. After reviewing your spending for the past two months, list out your financial priorities. As you put together your budget, keep your priorities as priorities. This is where you can identify frivolous spending, and you may even identify past priorities that are no longer priorities that can be eliminated. Perhaps your priorities are getting out of debt, buying a home, or attending the superbowl. Work towards these even if it’s in small amounts from each paycheck. Occasionally it is necessary to pause in one area to take care of an immediate need, but if you don’t quickly come back to our priorities, i.e., the things that make you happy, you’ll fall back into the trap of money slavery.
Be specific. You’ll find success in the details. My budget includes over 20 line items, and sometimes even more based on my priorities. These detailed categories can include things like: Amazon, eating out, entertainment, clothing, vacation, school lunch, dance lessons, rec sports, vehicle registration, etc.
Open additional saving(s) accounts. Have a place to move money that you’ve earmarked. It’s difficult to track your savings if it’s all going into one big saving account. Having different accounts gives you a visual of your progress and makes for easy tracking. Banks even allow you to name your bank accounts for easy identification.
Give yourself an allowance. Day in and day out you work tirelessly, and it’s difficult when you don’t ever feel like you see the benefit or get a perk for your hard work. When we first started giving ourselves allowances, we each got $10 every two weeks. My husband liked to spend a little at a time, I would save mine for a few paychecks, and then would spend it all at once. There's no right or wrong way. This is guilt free, “do as you please” money. I would strongly recommend getting this in cash for the most satisfaction.
As you can see, a budget doesn’t mean that you have to give up your passion or hobbies. A budget doesn’t mean you can’t do fun things. A budget shouldn’t be a punishment. A budget allows you to do those things intentionally. A budget allows you to save for big purchases and still reap the benefits of your hard work in the short game. That might look like paying off debt faster, eating out regularly, saving for a fishing boat, taking the trip of a lifetime, or supporting a daily habit of a Maverick run.
Budgets aren’t one size fits all. My budget won’t work for you, because our wants and needs are different. A budget should be tailored to your needs, wants, and circumstances, focused on your priorities. When done correctly, a budget will empower you because your money will intentionally do exactly what you intended it to do.
Passing on assets to kids or grandkids in a tax efficient way, like land from a family ranch, is a common challenge for Wyoming retirees.
Photo by Carol Highsmith's America on Unsplash
In working with Wyoming retirees, we are often asked about ways our clients can pass assets on to their children or grandchildren tax-free. We love getting questions like these, and it presents all sorts of planning opportunities.
Frankly, we can’t think of a better gift for your heirs than to pass on tax-free wealth, including land, properties, or investments. Here are some ways this can be done.
Roth IRAs are great ways to build tax-free wealth over time. We recently wrote about a way to accelerate this wealth-building tool using a tax strategy called Roth conversions. One of the great things about Roths is that withdrawals are tax-free.
But what happens if you pass away and your Roth IRA passes on to your heirs? Fortunately, those Roth funds can pass on to your heirs with the same tax-free status! That’s right–when your heirs inherit a Roth IRA from you, they take money from the Roth IRA completely tax-free as well. Current IRS rules do require inherited Roth IRAs to be fully depleted after 10 years from the original owner’s date of death, but all funds are tax-free to the heir.
Example: James passes away. He named his four children as equal beneficiaries to his Roth IRA. When he died, he had an account balance of $200,000. Mark, one of Jim’s children, inherits his share of the Roth IRA valued at $50,000. Mark has 10 years to completely empty his inherited Roth IRA. Mark could pull out all $50,000 and make a huge down payment on a new truck, but Mark is more savvy than that. He instead invests the funds for 10 years, earning 5% per year. Mark now has over $81,000, which he uses toward a down payment on an investment property…all tax-free.
(Note: As an added tax-free bonus, when Mark decides to sell the investment property, he can instead complete a 1031 exchange into a similar investment of real estate, land, or a rental, and delay any capital gains taxes he earned on his initial investment!)
Simply making gifts from your personal assets is probably the most straightforward way to pass tax-free wealth to your kids or grandkids. Sometimes retirees assume that passing on an asset as a gift is always subject to federal estate tax. Not really. There is a lifetime limit to how much you can give, but for all but the wealthiest people in the world, the limit is so huge it will never be met (about $13.99 million per “gifter”).
Example: Tina wins the lottery big time and wants to give most of the proceeds to her sister. Tina could give $13.99 million to her sister tax-free. This would use up Tina’s full lifetime gift exemption, and she will need to report the gift to the IRS, but that’s it.
Obviously the above example is pretty extreme. If you find yourself like most of us and lack so much substantial wealth, you can make tax-free gifts each year and avoid any reporting requirements on top of it. This is called the annual exclusion limit which is $18,000 in 2024. This means you could give $18,000 per year to as many people as you want–kids, grandkids, or complete strangers–and they receive the funds tax-free, and you give them tax-free and don’t have to report anything.
Gifting to minors can be particularly advantageous for them if you’re interested in helping them build wealth. UTMAs are special accounts which you can own, with the minor as a beneficiary. When funds are placed into the UTMA by you they constitute a gift. The funds grow over time, and earnings up to $2,500 per year are taxed at the minor’s tax rate, which when factoring in the minor’s standard deduction rate, usually results in little to no taxes owed. When minors reach the age of majority (18 in Wyoming) the UTMA account becomes property of the child–free and clear.
There are plenty of cases where you may not be interested in gifting assets to a child or grandchild before you pass away. After all, a gift in the government’s eyes is irrevocable, and once the transfer is completed, it’s all theirs to do whatever they want with it.
Assets passed on to your heirs upon your death, however, present an incredible way to pass on wealth free of capital gains taxes to your heirs.
Many assets, including real estate, stocks, bonds, mutual funds, and certain business interests receive what is called a “step-up in basis” upon your death. The basis of an investment is the cost of acquiring and/or improving the asset. Over time, many assets appreciate in market value. When you pass away and your heirs inherit one of these assets, a new basis is assigned to the asset which is the market value at the date of your death. This is called the “step-up” in basis.
Example: David purchased an investment property 30 years ago for $50,000. This is his basis. Over time the property has appreciated to a market value of $400,000. If David sold the property before his death and gifted the proceeds to his kids, he would owe capital gains taxes on the $350,000 gain ($400,000 market value minus $50,000 basis). This could result in a tax bill of tens of thousands of dollars owed by David. Instead, David could give the property to an heir upon his death. When David dies, the property is assigned a new basis of $400,000 (the current market value). David’s heir could then turn around and sell the property for $400,000 and owe no capital gains taxes ($400,000 market value minus $400,000 basis).
I hope this article has been helpful! We meet many Wyoming retirees searching for ways to maintain a meaningful legacy after they die by passing assets on to their heirs, while reducing taxes owed as well. These are a few common ways to make that happen.
If you’d like help implementing similar strategies, or finding other ways to reduce the lifetime tax burden of you and your heirs, we encourage you to reach out to us.
Roth conversions are like home renovations: Causing some destruction and raising costs temporarily, to create something of more lasting value. Photo by Milivoj Kuhar on Unsplash
At Hale Financial, we know many Wyoming retirees who would love to see their tax bill go down year after year. It may seem odd to you, then, that we plan to talk with many of our clients about paying more in taxes this year and next year through a process called a Roth conversion.
Why would we intentionally raise our clients’ tax bills? Have we gone mad?! In this article we’ll review the benefits of Roth conversions, with some focus on why they can make so much sense in 2024 and 2025.
A Roth conversion is when you withdraw funds from a tax-deferred account like a Rollover IRA or company retirement plan, but instead of sticking those dollars into your bank account, you put them into a Roth IRA. These withdrawals are taxable. There is no limit to the amount of money you can Roth convert, but the more you convert, the more tax dollars you pay. So why do it?
Most investors understand the benefit of Roth IRA dollars. You receive tax-free growth, and when you withdraw the funds from your Roth IRA, they come out tax-free.
The benefit of accessible tax-free funds should not be ignored. Consider a retired couple who lives on Social Security, a government pension, and has $500,000 in a Rollover IRA. They live comfortably year to year on this income. One year, however, they discover their roof has been leaking into their home behind a wall, causing an unseen mold issue. Insurance won’t cover it, but the mold needs to be removed and the roof repaired, resulting in a $40,000 bill.
What are their options? They can take out a loan, but this couple would rather avoid debt during retirement if they can, especially at today’s high interest rates. Their next best bet is a withdrawal from their Rollover IRA. The problem is, that $40,000 withdrawal is all taxable. If their taxable income for the year is $80,000, then about $13,000 of the withdrawal will be taxed at 12%, but the remaining $27,000 will be taxed at 22%...for a total tax bill of $7,500.
If this couple had Roth dollars, they could withdraw the funds for this much needed repair tax free.
The chart below illustrates the highest marginal individual tax rates over the last 100+ years in the US. Only the highest income Americans pay taxes at these rates, but the chart summarizes a general fact: tax rates in the past were higher than they are today. Most clients we work with at Hale Financial have a marginal tax rate of 12% to 24%.
If you’re at a historically low tax rate today, it can make sense to take advantage of that opportunity by intentionally paying more taxes today, rather than waiting to pay taxes later if or when tax rates rise. Roth conversions acknowledge this opportunity by paying the tax bill now, in exchange for tax-free growth and withdrawals in the future.
If the retired couple in the earlier example was regularly in the 12% marginal tax bracket, they could “fill up” that tax bracket with Roth conversions. 2024 and 2025 are prime opportunities to do so, since much of the current tax environment (such as lower marginal tax rates and a doubled standard deduction) is due to the Tax Cuts and Jobs Act of 2017, which has many provisions that go away at the end of 2025 unless they’re extended. Here’s an illustration of what their Roth conversion scenarios could look like:
Roth funds can be an incredible gift to your heirs as well. That’s because inherited Roth IRAs are not taxable when they pass to your heirs, and they can withdraw funds tax-free as well! Current IRS rules require non-spousal heirs (like children) to fully deplete inherited IRA accounts after 10 years, but this still gives you and them years and years of tax-free growth and tax-free withdrawals.
The original Roth IRA account holder never has a required distribution, allowing these funds to grow tax-free for decades.
Eventually, all tax-deferred IRA accounts have what is called required minimum distributions, or RMDs. For most retirees these required withdrawals begin between ages 72 to 75. The amount of the RMD is based on the ending account balance in the previous year. Completing Roth conversions can help reduce the balance in tax-deferred IRA accounts.
Roth conversions are all about understanding where your income will be, so you can intentionally convert additional income (through IRA withdrawals) into Roth dollars.
This means you need to do the work to accurately estimate your income in the year you’re considering a Roth conversion. This means gathering your latest pay stubs, interest and dividend payments, Social Security or pension payments, and small business income projections. You’ll also need to factor in capital gains through asset sales (like stocks or real estate), and any withdrawals you’ve already made from tax-deferred retirement accounts.
There is definitely some art to this, since you’ll never know precisely how much income you’ll make in a certain year until that year is through (and the Roth conversion deadline, December 31st, has passed).
When completing a Roth conversion, you’ll also need to have a source of funds to pay the taxes. Some figure they’ll withdraw extra funds from their IRA to cover these, but this usually adds to your tax bill in an unexpected way, since the funds withdrawn for the tax payment end up being taxable as well! It’s better to estimate how much in taxes you’ll owe from your Roth conversion, and pay the taxes from cash savings, checking, or a taxable investment account. These can be paid directly to the IRS at the time of conversion, which we highly recommend.
Finally, there are multiple “gotchas” in the tax code that can pop up when your taxable income increases. For example, increased income can raise the amount of your Social Security that’s taxed. It can also increase your Medicare Part B insurance premiums, or expose you to the Net Investment Income Tax. And of course, converting too much to a Roth IRA can push some of your taxable income into a higher marginal tax rate. As a result, it’s usually best to consult with a tax advisor before completing a Roth conversion, or a financial professional with software that can analyze the tax implications.
Roth conversions are a great opportunity to convert tax-deferred dollars into tax-free dollars. The benefits to doing so abound, but precautions need to be taken. 2024 and 2025 are ideal years to consider this strategy, until the fate of the 2017 tax cuts is more sure.
