Supreme Court Bolsters Beneficiary Rights

A 2013 decision by the U.S. Supreme Court illustrates the importance of updating beneficiary forms regularly. If you don’t, your desired heirs can lose a valuable asset.

            This case, Hillman vs. Maretta, had its genesis in 1996, when Warren Hillman married Judy Maretta. Warren was a federal employee, so he named Judy as the beneficiary of his group term life insurance policy. The couple was divorced after two years, and Warren subsequently married Jacqueline. Warren and Jacqueline were still married in 2008 when Warren died; that life insurance policy’s death benefit was nearly $125,000.

            As it turned out, Warren had never changed the beneficiary designation on the policy. Thus, Judy received the death benefit, and Jacqueline went to court to get the money from Judy.

State versus federal

The case took place in the state of Virginia, which has passed a state law saying that a divorce or annulment revokes a beneficiary designation relating to death benefits. That sounds like it should have settled the matter, but Warren’s life insurance policy was created under the Federal Employees’ Government Life Insurance Act (FEGLIA), a federal law, and the U.S. Constitution states that federal law will trump state law when there’s a conflict.

            Nevertheless, Jacqueline still had a card to play. Virginia has another law saying, in essence, that if death benefits are turned over to a former spouse because of such a conflict, that former spouse is liable for the amount in question, payable to the person who otherwise would have collected. Thus, Jacqueline (Warren’s widow) sued Judy for the amount of the insurance proceeds.

Court conflicts

Did federal law override state law, giving the life insurance benefits to Judy? All parties agreed that was the case. But did the second Virginia law prevail, allowing Jacqueline to ultimately collect the death benefits from Judy? That was the question dividing the Virginia courts and bringing the matter to the U.S. Supreme Court.

            In 2013, the Supreme Court decided Hillman vs. Maretta in favor of Judy, the former spouse and the designated beneficiary. “FEGLIA establishes a clear and predictable procedure for an employee to indicate who the intended beneficiary shall be,” the Supreme Court noted, so federal employees have an “unfettered freedom of choice in selecting a beneficiary and to ensure the proceeds actually belong to that beneficiary.” State law can’t overturn that federal law’s intent, the Court ruled.

            Not every case will come down in favor of a former spouse. ERISA, a federal law covering retirement plans, gives a current spouse certain rights to death benefits from an employer’s retirement plan, unless that right has been formally waived. Nevertheless, beneficiary conflicts can be time consuming, expensive, and stressful, especially if large amounts are at stake. Regularly updating all beneficiary forms can spare your loved ones from fighting what might wind up being a losing battle.

Paired Plans

• ·       In most 401(k) and similar plans, an amount left by a participant who has not received benefits will automatically go to the surviving spouse.
• ·       If a participant wishes to select a different beneficiary, the spouse must consent by signing a waiver.
• ·       This waiver must be witnessed by a notary or a plan representative.

Time to Trim Stocks?

In 2013, the benchmark Standard & Poor’s 500 Index returned more than 32%, and the average domestic stock fund was up more than 31%, according to Morningstar. Major domestic stock market indexes are at or near record levels, as of this writing. Since the nadir of the financial crisis in early 2009, stocks have enjoyed a powerful five-year run.

 Is it time to move out of stocks, or at least trim your holdings?  Most commentators advise against trying to time the market. There’s no way of knowing if we’re at the top of the market, as we were in 2000 and 2007, or if we’re just beginning an 18-year bull run like the one we enjoyed from 1982 to the 2000 peak.

Rebalancing act

Market timing may not be recommended, but many financial advisers favor the concept of rebalancing your portfolio. Here, you determine an asset allocation to suit your investment goals and your risk tolerance. If your actual allocation departs from the plan, you’ll act to get your investment mix back on the chosen path.

            Example 1: Megan Harris has a basic asset allocation of 65% stocks and 35% bonds. After a few years of a bull market, Megan’s $400,000 portfolio is $300,000 in stocks (75%) and $100,000 (25%) in bonds. To rebalance, Megan would sell $40,000 of stocks and buy $40,000 of bonds. This would bring her to $260,000 in stocks (65%) and $140,000 in bonds (35%).

            Note that Megan will still have a substantial amount invested in stocks, so she will continue to profit if stocks perform well. At the same time, she will have less exposure to a possible stock market reversal.

            The Megan Harris example is extremely simplified. Today, many financial advisers advocate a portfolio that’s diversified among multiple asset classes. Megan might hold international and domestic equities, large company and small company stocks, high grade and lower quality bonds, real estate securities, commodities and so on. Each asset class will have an allocation, and periodic rebalancing can keep the mix on track.

Tax tactics

One advantage of continual rebalancing is that it encourages investors to sell after assets have appreciated and buy other assets that are currently out of favor. Long term, that can be a formula for successful investing. It’s also a formula for realizing taxable gains. Some astute planning can reduce the tax bill, though.

            One approach is to rebalance by executing your asset sales in a tax-favored retirement plan such as a 401(k) or an IRA. Then, any gains on the sale won’t be taxed right away. By building up a substantial amount in such an account and holding a blend of asset classes in there, you’ll increase your ability to rebalance without triggering taxes.

            Another tax reduction method is to sell assets from a large holding within your portfolio, acquired at different times. Specify the shares you’d like to sell, choosing those with the least tax impact.

            Example 2: As in our previous example, Megan Harris wants to rebalance her portfolio by selling $40,000 of stocks. She sells $15,000 of stock funds held inside her 401(k), avoiding a current tax bill, but Megan would like to sell another $25,000 of stocks in her taxable account.

            Megan holds a large position in mutual fund ABC, which she has amassed over several years. She wants to reduce her exposure to this fund, so she sells $25,000 worth of fund ABC in her taxable account. When instructing her broker to make this sale, Megan specifies which shares to sell, choosing those that (a) have declined since her purchase or (b) have relatively small paper profits. Among the gainers, Megan focuses on the shares that have been held more than one year and, thus, qualify for the favorable tax rate on long-term capital gains.

             Yet another way to reduce the tax on rebalancing gains is to build up a bank of capital losses by periodically selling assets that lose value after you buy them. Such capital losses can offset taxable capital gains.

          

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Business Owners Get More Bang From Flex Plan Bucks

Although all the effects of the Affordable Care Act (ACA) are still unclear, it’s likely that health insurance costs will continue to increase in the future. Business owners may require greater health plan contributions from participating employees. In addition, this health care law already has made it more difficult for individuals to deduct medical outlays: For most taxpayers, only expenses over 10% of adjusted gross income (AGI) are tax deductible, versus a 7.5% hurdle under prior law. (The 7.5% rule remains in place through 2016 for individuals 65 and older and their spouses.)

            In this environment, business owners stand to benefit substantially by offering a health flexible spending account (health FSA). These plans allow employees to set aside up to $2,500 per year that they can use to pay for health care expenses with pretax dollars.

            Example 1: XYZ Corp. offers a health FSA to its employees. Harvey James, who works there, puts $2,400 into the plan at the beginning of the year. Each month, $200 will be withheld from Harvey’s paychecks, and he’ll owe no income tax on those amounts.

            Going forward, Harvey can be reimbursed for his qualified medical expenses that are not covered by his health plan at XYZ. Possible examples include health insurance deductibles, copayments, dental treatments, eyeglasses, eye surgery, and prescription drugs. Such reimbursements are not considered taxable income. Thus, Harvey will pay those medical bills with pretax rather than after-tax dollars.

Health FSAs and the Affordable Care Act

Under the ACA, there are limitations on an employer offering a health FSA to their employees. Standalone health FSAs can only be offered to provide limited scope dental and vision benefits. An employer can only offer a health FSA that provides more than limited scope dental and vision benefits to employees if the employer also offers group major medical health coverage to the employees.

Additionally, an employer can make contributions to an employee’s health FSA. However, under the ACA, the maximum employer contribution the plan can offer is $500 or up to a dollar-for-dollar match of the employee’s salary reduction contribution.

Ultimately, these additional new rules can affect whether an employer can offer a health FSA and the amount of any optional employer match.

Employer benefits

A health FSA’s benefits to participating employees are clear. What will the business owner receive in return? Chiefly, the same advantages that come from offering any desirable employee benefit. Recruiting may be strengthened, employee retention might increase, and workers’ improved morale can make your company more productive.

            There’s even a tax benefit for employers, too. When Harvey James reduces his taxable income from, say, $75,000 to $72,600 by contributing $2,400 to a health FSA, he also reduces the amount subject to Social Security and Medicare withholding by $2,400. Similarly, XYZ Corp. won’t pay its share of Social Security or Medicare tax on that $2,400 going into the health FSA.

Counting the costs

However, drawbacks to offering an FSA to employees do exist. The plan, including reimbursements for eligible expenses, must be managed. Many companies save headaches by hiring a third-party administrator to handle a health FSA, but there will be a cost for such services.

            In addition, companies offering health FSAs to employees should have enough cash to handle a large demand for reimbursement, especially early in the year.

            Example 2: Kate Logan also works for XYZ and she chooses to contribute $1,800 to her health FSA at the beginning of the year: $150 a month, or $75 per each semimonthly paycheck. Just after her first contribution of the year, Kate submits paperwork for a $1,000 dental procedure. XYZ might not have trouble coming up with $1,000 for Kate, but there could be a problem if several employees seek large reimbursements after making small health FSA contributions.

Using It, Losing It

Employers also should be sure that employees are well aware of all the implications of health FSA participation. For years, these plans have been “use it or lose it.” Any unused amounts would be forfeited at year end.

            Example 3: Mark Nash participated in an FSA offered by XYZ several years ago. He contributed $2,000 but spent only $1,600 during the year. The unspent $400 went back to XYZ.

            In 2005, the rules changed. Now, if the FSA permits, participants have until mid-March of the following year to use up any excess. If XYZ had adopted this optional grace period, Mark Nash would have had an extra 2½ months to spend that leftover $400 on qualified medical costs.

            Yet another change occurred in late 2013—a $500 option. Under this provision, FSA plans can be amended to allow each employee a carryover of up to $500, from one year to the next. Plans with this $500 carryover provision cannot allow a grace period as well. If your company now has an FSA with this optional grace period, it will have to amend the FSA to eliminate the grace period in order to add the $500 carryover provision. 

            In addition to explaining all of the rules on possible forfeitures, employers offering an FSA should be sure their employees know about a possible impact on Social Security benefits. As mentioned, FSA contributions aren’t subject to Social Security; those contributions aren’t included in official compensation, for Social Security purposes. Employees should know that reduced compensation today might reduce Social Security benefits tomorrow. Companies that spell out all the FSA implications to workers may reduce misunderstandings and future complaints.

Mixing IRA Distributions With Social Security

Many workers save for the future in a 401(k) or another employer sponsored retirement plan. Contributions avoid income tax, and the same is true for investment earnings inside the plan. Often, 401(k) participants roll over the money to a traditional IRA after they retire, which extends the tax deferral.

Many people try to keep their IRAs intact as long as possible, continuing tax free buildup inside the plan.

Example 1: Alice Wells retired at age 62. To make up for her lost earnings, Alice draws down her taxable accounts, so her IRA can keep growing untaxed. Alice’s plan is to wait as long as possible before taking distributions from her IRA. (She’ll have to take at least the required minimum distributions from her traditional IRA after age 70½.)

However, once she retires, Alice finds that she is still short of cash flow. She can start to receive Social Security retirement benefits as early as age 62, so Alice puts in her claim to get the additional monthly income. 

Lower brackets are likely

Alice’s strategy, as described, is followed by many seniors. That is, they take Social Security early and eventually tap their IRA. That may not always be the best approach.

What might indicate taking a different route? Taxes, for one thing. The value of tax deferral depends on your tax bracket. The higher your bracket, the more putting off the IRS makes sense.

Suppose Alice typically was in a 28% or 33% tax bracket during her working years. In 2014, those brackets cover single taxpayers with about $90,000 to $400,000 of taxable income after deductions. Deferring income tax while she worked saved Alice 28 cents or 33 cents on the dollar.

Now that she’s retired, Alice’s taxable income is sharply reduced. In our example, Alice can tap her IRA for cash flow and keep taxable income below $90,000, which would put her in the 25% bracket. At 25 cents on the dollar, tax deferral isn’t as valuable as it was during her working years. On the other hand, taking IRA distributions and paying 25% tax isn’t as painful as it would be in a higher bracket.

Indeed, many retired couples are in the 15% bracket now, which goes up to nearly $75,000 of taxable income, after deductions. Such couples will owe even less tax on IRA distributions.

A plumper pension

There’s another reason to consider reversing the plan to take Social Security early and IRA distributions late. The longer you wait to start Social Security, the larger your monthly benefits will be.

Example 2: Suppose that Alice Wells has an earnings history that would qualify her to receive $2,000 a month at 66, which Social Security considers the “full retirement age” for people now in their 60s. If Alice starts Social Security at age 62, she’ll get only 75% of that benefit: $1,500 a month, plus cost-of-living adjustments (COLAs), for the rest of her life.

On the other hand, Alice can wait as late as age 70 to start Social Security. That would increase the monthly payment from her full retirement age by 32%, from $2,000 to $2,640 a month, plus all the COLAs along the way.

 Not counting COLAs, waiting from 62 to 70 will increase Alice’s annual benefit from $18,000 a year to $31,680 a year, which she’ll receive for the rest of her life.

Once Alice starts to receive Social Security, those much larger payments may reduce the amounts she’ll need from her IRA. If that’s the case, Alice will be substituting Social Security dollars, which are partially taxed under current law, for traditional IRA distributions, which usually are fully taxable.  

    

Building up Social Security benefits might have another appeal for married couples. When the first spouse dies, the survivor will receive the decedent’s Social Security payments, if they are larger than the benefits the survivor had been receiving. Thus, waiting to start Social Security may provide extra cash flow for a surviving spouse.

This plan to tap your IRA early and wait to start Social Security will help some people but not others. Calculations involve each individual’s health and work history as well as some complicated navigation through the tax code. When you are ready to make your decision, our office can help you determine a course of action likely to maximize cash flow and income security as you grow older.

SEP- Self-Employed Pension

Simplified employee pension (SEP)  plans are commonly used by self-employed individuals and others with part-time self-employment income. In addition, SEPs can offer many benefits to small companies, so business owners may want to consider using a SEP for themselves and the firm’s workers.

On your own

Self-employed individuals choose SEPs for several reasons. 

• There are virtually no costs or paperwork to setting up and maintaining a SEP. 
• Many financial firms offer them, and the investment options are broad. 
• Contribution limits are generous, with a $52,000 maximum for 2014.

 (SEP contributions may be as high as 25% of compensation, but special rules effectively limit contributions to around 20% of your net self-employment income.)

 In addition, SEPs offer a rare opportunity to make retroactive tax deductions. Each year, you can deduct SEP contributions made until the filing date of your tax return, including extensions.

            Example 1: Beth Carson, a freelance graphic artist, qualifies for a $15,000 SEP contribution based on her 2013 earnings. On April 1, 2014, Beth contacts a mutual fund company and creates a SEP, funded with a check for $15,000. As long as Beth makes the contribution by the time she files her 2013 tax return on April 15, she can take a $15,000 tax deduction on that return. If Beth can’t make that deadline, she can request an automatic filing extension until October 15, giving her an extra six months to make a deductible SEP contribution.

Strictly business

Small companies also can use SEPs . Again, the simplicity of such plans, the flexibility, and the high ceiling for contributions may make SEPs appealing to business owners. Employers must fill out and retain IRS Form 5305-SEP to establish the plan, but there are no subsequent required filings with the IRS. The downside is that a SEP is funded entirely by employer contributions; SEPs are different from 401(k)s and similar plans, which are funded largely by employees’ salary deferrals.

 To set up a SEP for your company, you merely have to sign a document with the financial firm you have chosen. Then you must notify each eligible employee about the plan and create an account (a SEP-IRA) for each qualified employee at the financial firm. Once the plan is established, your company must make equivalent contributions for each eligible employee, as a percentage of compensation.

 Example 2: ABC Corp. has two co-owners and four employees. If the owners want maximum SEP contributions of 25% of their pay, the company also must contribute 25% of pay to the SEP-IRAs of the other four employees. (See the Trusted Advice box for guidelines for which employees must be included in a SEP.)

Fortunately, SEP-IRAs are flexible. Even if ABC makes a 25% contribution in a given year, it can make a contribution of any percentage of pay in the following year. The company also can skip contributions altogether, if cash is tight.

 With a SEP, business owners have plenty of time to decide about contribution levels. You can set up and make deductible contributions to a SEP plan as late as the due date (including extensions) of your company’s income tax return for that year. Therefore, your company still has time to set up a SEP plan and make deductible contributions for 2013. 

SEP Requirements

When a company has a SEP plan, it must include all employees who have done all of the following:

o   Reached age 21

o   Worked for the company in at least 3 of the last 5 years

o   Received at least $550 in compensation from your business for the year, subject to annual cost-of-living adjustments in later years

Your company can impose less restrictive requirements, such as reaching age 18 or working there for 3 months.

Certain union members and nonresident aliens may be excluded.

Miles, and Miles, and Miles

Scene 1, Godwin & Associates, CPA offices.  March 10, 2013.  Jonathan Godwin is meeting with a small business client regarding tax deductions for his company’s 2012 corporate tax returns.

Jonathan – “So, I see you have indicated your business mileage at 24,650 for 2012.”

Client – “Yes, I have.  I know that sounds high, but I was on the road a tremendous amount last year.”

Jonathan – “I have no problem with that at all.  Can you get me a copy of your mileage log so I have it for my files?”

Client – Crickets…

Jonathan – “You do maintain a mileage log, right?  We talked about this last year as I recall.”

Client – More crickets…

This isn’t an uncommon conversation for me during tax season.  I ask that question of everyone who claims mileage, knowing that in the event of an audit, if there was no mileage log the deduction would be disallowed without even a second thought.  The rules are clear…no log, no deduction.

The federal mileage rate for 2013 is $.565/mile for business travel.  Deductible mileage includes travel to meet with a client; your trip to the bank to make a deposit; your trip to my office to meet and discuss your tax situation; your trip to an open house; your trip to show a house….you get the picture. Just don’t include any personal travel in there, and if your primary office is at your real estate company’s home office, then don’t deduct travel from your personal residence to the office (that’s commuting, not business travel). To say that this deduction is valuable to my real estate clients is a massive understatement, so please do yourself a favor and keep the mileage log.

Last year, Meghan bought several and placed them in our main conference room.  So, if you don’t want to buy one, then come by here and get one for free.  I won’t judge you.  After all, it cost the actor in the above scene a tax deduction of $13,927 at today’s mileage rate for not having the log.  That’s worth a trip to our office….we’ll even throw in some coffee to go.

You Complete Me

I played tennis throughout my childhood and teenage years....and I mean, I played all the time.  These days, when I play, there is no comparison between the talent I displayed then and now.  One thing hasn't changed, however.  I can tell immediately when I hit a shot in the sweet spot of the racket....that perfect point where the ball flies off the racket at an optimal speed and lands exactly where I intended.

I discovered a new sweet spot for my CPA firm the other day when a new client decided to expand its engagement with us to include CFO services.  When the owners first posed the question to me, I was very intrigued but wary because everyone has a different definition of "CFO services."  They wanted a true financial partner, someone with whom they could share and discuss new business ideas, and someone who would share an opinion with them even if it went against their own.  Of course they need tax preparation and planning, but those necessary compliance services take a back seat to the "big picture work" that adds an extreme amount of value to their business.

We started working with this new client three months ago and I'm as excited as I have ever been about an engagement.  I'm also excited about what this means for us as we build a new practice specialty.  I felt confident after our initial meeting that we would work well with this new client for a common cause. But, it was brought home after a conversation where I brought him an idea and he said to me:

"You complete me."

 It's a match made in heaven in my opinion.

Is it time to discover your new sweet spot?