Thursday, March 6, 2014

Rich Kids, Poor Kids (Part 3)

Rich Kids, Poor Kids (Part 3)
Bert Whitehead, M.B.A., J.D. ©2014

This is the third of three related blogs covering a broad topic:

  • Part 1: A View of our World Through our Grandchildren's Eyes in 100 Years
  • Part 2: Intergenerational Tax and Financial Strategies to Leave a Family Legacy
  • Part 3: The Most Important Lesson to Teach Our Children Now

The foremost lesson for children is to always save 10 percent of all of their income—whether from their allowance, babysitting earnings, or gifts, as well their gross earnings and investment income. Even during retirement, save 10 percent of your income.
Often people think that “save” means to put money away for spending later, rather than investing their savings to grow their financial base, or building “investment capital.” When we refer to savings in this context, we are referring to saving money for investment, not to spending the principle.

As children develop the habit of continually saving 10 percent of their income, their total capital will grow. This is an opportunity to teach them the basics of investing, starting with a savings account or money market. Once they have accumulated enough, move their investments to an S&P 500 Index mutual fund; these are offered at a low price by Vanguard and other no-load funds. They have very low minimums if automatic investment is selected, so savings can be transferred monthly from the savings account to the mutual fund.

Once the child’s investment capital savings reaches a total of more than three times their annual savings, they will experience the “Miracle of Compounding.” This is the tipping point when they will realize that the amount earned from their investment capital now exceeds the amount they are saving each year. At this point, their capital mushrooms exponentially and their wealth is created through their savings and investments.

There is a widespread misconception that rich people become wealthy by taking money away from poor people. The truth is that wealthy people are rich because they always invest part of their earnings. Poor people who spend more than they earn always stay poor. Even people who make a lot of money often still spend more than they make, so they never become wealthy. But people without much money are never broke if they always save 10 percent!

Tyrone Solee wrote an article that beautifully explains the difference between people who are wealthy, and people who are simply rich. To summarize:

The main difference between being rich and being wealthy is knowledge. Wealthy people know how to make money, while rich people only have money. Being wealthy is defined as that status of an individual’s existing financial resources that supports his or her way of living for a longer duration, even if he or she does not work to generate a recurring income. Rich people, on the other hand, may get money in an instant such as inheritance or winning a lottery. However, because of lack of proper mindset and poor money management skills, all of it can be lost in a short period of time. In essence, wealthy people are financially free while rich people are not.

The name of this game is Capitalism and the winners are those who at some point are able to live off the earnings from their money instead of by the sweat of their brow. This is true freedom and an important lesson for all of our children. Rich kids always save 10 percent of their income and poor kids always spend every last dime!

Monday, February 17, 2014

Rich Kids, Poor Kids (Part 2)

Rich Kids, Poor Kids (Part 2)
Bert Whitehead, M.B.A., J.D. ©2014

This is the second of three related blogs covering a broad topic:

  • Part 1: A View of our World Through our Grandchildren's Eyes in 100 Years
  • Part 2: Intergenerational Tax and Financial Strategies to Leave a Family Legacy
  • Part 3: The Most Important Lesson to Teach Our Children Now

As discussed in the previous blog, our society is increasingly split between rich kids with a good educational and health foundation, and poor kids with a disadvantaged upbringing likely to hinder their futures. While we can’t restructure dysfunctional families, we can do our best to ease the way for our own children and grandchildren.
We send the best and brightest in our society to Washington to figure out what policies we need to become a better country. Frequently these policies are structured as tax incentives that reward specific financial actions. I believe that those of us who learn about these tax policies and follow the will of Congress are acting in the most patriotic way possible. I suggest three strategies for consideration: Donor Advised Funds, Roth conversions and Intergenerational Strategies.

Donor Advised Funds for Tax Benefits and Philanthropic Options

Donor Advised Funds (DAF) enable individuals and families to set aside funds, tax-free, under the umbrella of a 501(c)3 nonprofit foundation. Most brokerage companies (Schwab, Fidelity, etc.) and many large non-profit and community organizations (Jewish Federation, Southeast Michigan Community Foundation, etc.) offer these DAFs to all individuals at a nominal cost. Each DAF manages its funds, directing contributions to nonprofit groups chosen by the donor(s).

For taxpayers in the top tax bracket, giving $1,000 in cash to a DAF results in a $400 tax saving. However, if $1,000 in appreciated stock is donated to a Donor Advised Fund, the donor saves $400 through the income tax deduction and up to an additional $200 by avoiding the capital gains tax on the appreciated stock.

Our society depends on taking care of one another and these tax incentives make philanthropy more financially appealing. When my family gets together annually, each member identifies a nonprofit organization for a $100 deduction from the Whitehead Donor Advised Fund, and we make the grants online accordingly. When older grandchildren are away at school or jobs and unable to join us, they email me their choices for charities. This is a good way to develop a family commitment to help others.

Roth Conversions

Another way to save taxes for future generations is to convert IRAs to Roth IRAs. The money converted to the Roth IRA is taxed now, and future earnings accrue totally tax-free.  Withdrawals after retirement age are not taxed, and there is no required minimum distribution, which is normally required at age 70 1/2. Upon the death of the taxpayer, the spouse pays no income tax as the beneficiary of a Roth IRA. After the death of the second spouse the Roth IRA accounts can be passed on to their children, who will also receive the distribution from the Roth IRA tax-free. They can then elect to withdraw it gradually, with the minimum required distribution based on their life expectancy at the time they inherit the Roth IRA.

When IRA funds are converted to a Roth IRA, the transferred funds are subject to taxation as ordinary income. Generally conversions are made after significant wealth has accumulated and the taxpayer is in a much higher bracket. This disincentive to elect Roth IRA conversions can be mollified, however, with astute tax planning.

For example, while high income taxpayers are not allowed to contribute directly to Roth IRAs, they can fund non-deductible IRAs (the maximum contribution is currently $6,500 per year). The non-deductible IRA does not provide a tax benefit other than that the earnings accrue tax-deferred. The significant tax advantage is that the IRA can be converted later to a Roth IRA and taxes are assessed only on the accumulated earnings, not the original basis.

Intergenerational Tax Strategies

The creation of a Donor Advised Fund and conversion of an IRA to a Roth IRA can be combined for maximum tax benefit. By establishing a DAF, the tax deductions for the funds contributed to it can offset taxes on the funds converted to a Roth IRA.

Establishing a DAF and utilizing Roth Conversions are very effective ways to pass on our philanthropic values and conserve assets for future generations of our families.

Since these strategies can be somewhat complex, it is important to work with a tax professional to implement them correctly.

Wednesday, February 5, 2014

Rich Kids, Poor Kids (Part 1)

Rich Kids, Poor Kids (Part 1)
Bert Whitehead, M.B.A., J.D. © 2014

This is the first of three related blogs covering a broad topic: reviewing the impact our legacy will have on our children and grandchildren.

·         Part 1: A View of our World Through our Grandchildren's Eyes in 100 Years

·         Part 2: Intergenerational Tax and Financial Strategies to Leave a Family Legacy

·         Part 3: The Most Important Lesson to Teach Our Children Now

Most of us who are baby-boomers or older had grandparents who had no indoor plumbing, no car, and remembered the Great Depression and World War II as personal experiences. Our grandchildren can't imagine we grew up without TV, computers, cell phones, or satellites. Today's children are the first generation who didn't learn their childhood games from their parents, and many of us don't have the technological skills to understand their games -- or even our smart phones.

Think about the world their grandchildren will face. We can't fathom the changes of the next 100 years --- from significant economic upheavals to likely wars with battles that will leave devastation beyond the nightmares we have seen.

Considering the next 100 years compared to the past century forces us to think through what the next generations must do to assure their survival and prosperity. Our parents and grandparents lived in a very different era, and we should think about strategies to further prosperity --- not only for our families but our communities.

Facing the Future

Our children are not likely to be as affluent as their parents. Some say it will be the first generation to be poorer than their parents. The gap between the rich and poor is expanding at a frightening rate.

In addition to the wealth and earning gap of the past 30 to 50 years, there has been a widening educational gap in our country. High school graduation rates, ACT scores, and reasoning and comprehension skills have plummeted until our country ranks 25th among 50 first-world countries, down from #1 during the 1950s. Poor schools get worse and the best schools get more expensive and elite. Additionally, 35 percent of our higher education resources are now devoted to students from China, Japan, South America and the Arab countries, as compared to 5 percent 50 years ago; this is a seven-fold increase.

Even though educational progress seems grim by the standards of our childhood, few of us can match the technological prowess of our grandchildren. It seems that the evolutionary process started hardwiring kids’ brains differently after about 1965. Maybe "being smart" in the 2200s will mean something entirely different in an overwhelmingly technological world, one in which setting up your TV remotes will be considered a simple task.

Indeed, ACT and SAT scores as we know them may become irrelevant in the next few generations. A hundred years ago, a classical education based on theology, philosophy, and languages was considered the cultural foundation for the future. Accelerating changes in critical thinking, scientific knowledge and specialized fields of inquiry require a much more advanced base.

Extended Life Expectancy

Life expectancy was 46 years in 1900 and had increased to 78 years by 2000. As a result, Social Security as we know it will end within a few decades, because there will be too few workers to support the large number of baby boomer retirees. Many actuaries predict that more than 50 percent of the American children born during this century will be centenarians. However, economic and demographic trends tend to be self-correcting. Certainly life expectancy won’t continue to increase unless we address the primary health threats that we face: obesity, sedentary lifestyles and increasing stress.

To summarize, there is a widening gap between the haves and the have-nots, between the educated and the uneducated, and between the healthy and the unhealthy. Many factors contribute to these anomalies; generally the poorest among us not only have the fewest financial resources, but also the least education and the shortest life expectancy. Solving the income inequality issue, the glaring education gap and the health disparities within our society cannot be done independently.

Parenting Skills Are Key

The overriding common denominator between the haves and the have-nots in our society is the quality of their parenting. 40 percent of American children are raised in single-parent homes and others grow up with dysfunctional adults. Even among two-parent households, financial conditions usually necessitate that both parents work so that neither spouse is available to be the primary nurturer and teacher of children.

These children are less likely to have balanced, nutritional meals and may not be taught healthy habits. Children raised in dysfunctional homes are likely to live in an underprivileged environment. Their children will likely also be economically disadvantaged, as poverty is normalized in their world. When basic needs aren't met, the value of education is not paramount.

Of course we alone can’t change the course of mankind. Our primary goal is to do what is best for our own families. We are in a position to influence and reinforce the well-being of our progeny by laying a sound financial foundation. There are perfectly legal tax strategies which our government has designed that enable families to improve their lives and those of their children. I’ll cover these in my next blog.

Monday, December 2, 2013

A Skeptic's View of Long-Term Care Insurance

A Skeptic's View of Long-Term Care Insurance

Bert Whitehead, M.B.A., J.D. © 2013

Recently an elderly client asked me whether she should purchase Long-Term Care (LTC) insurance. Her neighbor who sold this insurance often mentioned the importance of this coverage, particularly since my client's spouse had died and she didn't want to "ruin her daughter's old age" by having her daughter become her caretaker.
LTC insurance policies are designed to cover the costs of custodial care for an elderly or disabled person who becomes so frail that they need help with at least "two activities of daily living," such as bathing or eating. These policies appeal to people who have no one to care for them, or who do not want to burden a spouse or children if they cannot care for themselves.

These policies are aggressively sold because insurance sales people generally make higher commissions on LTC insurance than any other policy. Moreover the annual premiums have increased so much over the past ten years that people who bought policies then cannot afford the policies now, or have to agree to reduced coverage. Premiums can increase continually without a ceiling.

Insurance companies have vastly underestimated the costs of long-term care benefits; even the government dropped long-term care in the Affordable Care Act because it was determined to be too expensive. Faced with rising life expectancies and increasing costs for medical care, more than 100 insurance companies have stopped offering LTC insurance during the past ten years. It’s difficult to determine the strength of insurance companies that continue to offer these policies.

In my experience, LTC insurance is over-priced and often sold to people who don't need it. The worst part is that when people have to use it they’re more likely to feel frustrated, disappointed and dissatisfied than to enjoy the comfort and peace of mind they expect.

Claims for benefits are routinely challenged by insurance companies, and policy holders are often determined to be ineligible for benefits based on the fine print in their policies. People who make the claims are saddled with an overwhelming continuing administrative task as companies require more and more documentation to support claims.

Who Needs It?

It is better to self-insure yourself whenever you can. Insurance companies are like casinos: they know what the odds are, and simply adjust their payouts to assure profits. LTC, however, is a relatively new offering. When I grew up, my grandmother went to the county hospital when she became senile -- nobody considered LTC insurance. So our generation is the first to face this issue and insurance companies don't have enough experiential data to price it. Since life expectancy has risen so fast, and medical technology and expense have mushroomed, companies selling LTC have had to continually scramble to raise prices, reduce coverage and, of course, contest claims.

One of the reasons LTC is relatively costly is that sales people are paid higher commissions to sell it than any other non-investment insurance policy. Policies are sold aggressively and are very difficult to compare. The primary components of a long-term care policy are the daily benefit rate, the length of coverage, and the level of inflation coverage. Sales people are paid higher commissions based on the various options they suggest and sell. 

If you select $250/day coverage when you are 55, the cost would be $2,065 per year and would cover benefits for 3 years. Even ignoring the reality that premium costs will rise faster than the inflation rate, from the start this policy would create a "pool" of only $273,750.

Let's face it: if you end up in a nursing home, you're not going anywhere else. Right now if you live within your means and save 10% a year (even after retirement), you may well have enough to self-insure. Certainly those with $1 million in financial assets (or $2 million for a couple) should be able to self-insure.

Fifty percent of Americans who have less than $250,000 in financial assets probably can't afford the luxury of LTC. You will have to make do with Social Security benefits, Medicare and Medicaid if you qualify. So let's consider those with more than a $250,000 but less than $1 million in total assets who are over age 60.

What are your chances of needing LTC?

  • ·         Insurance sales people stress that two-thirds of people age 65 will need LTC in their lifetime.

  • ·         A nursing home can cost more than $70,000 per year.

But what they don't tell you is:

  • ·         More than 70% of seniors will have less than $25,000 in private out-of-pocket expenses for nursing home care during their lifetime.

  • ·         Only 5% of seniors will need to pay $50,000 or more per year for long-term care for more than 5 years.

If you are considering LTC:

There is impartial information available online, e.g. Long-Term Care: What Are the Real Risks?  If you currently have an LTC policy, have it reviewed by a fee-only financial advisor before you cancel it.

Keep in mind that policies generally cover only three years of nursing home care and older policies that covered up to six years are seldom available any more. There are also options to convert current life insurance policies so that they can serve double duty and provide LTC insurance if that is needed. If you decide you need LTC, check your life insurance policies to see if they are convertible. 

Thanks to Shari Cohen and Laura Webber for editing