Two key considerations in retirement planning are ensuring that you outlive your retirement income and that your financial plan can withstand changes in the market. Pensions used to provide this assurance, but as these types of savings plans become rarer, you may have to create your own guaranteed retirement income.
Deferred income annuities (DIAs) are a sometimes-overlooked financial tool that fortify retirement portfolios and guarantee that retirees will have a cash flow, regardless of market ups and downs. While financial advisers generally will not recommend investing the majority of your portfolio in a deferred income annuity, many do advise retirees to include them in their portfolios.
Why are these financial tools such a good idea? The main reason is they provide a guaranteed income for life, whether you live to 80 or 100. While the income they generate may not be enough to cover all your living expenses, they can provide peace of mind and a reliable source of income in your retirement years.
How Deferred Income Annuities Work
Unlike other investments that produce income, deferred income annuities guarantee income as long as you are alive—no matter how long your lifespan. This works because DIAs operate on the concept of the “mortality credit,” which means that the assets from annuities whose recipients live for shorter periods of time stay in the “mortality pool” to work for recipients who live longer. DIAs are managed by insurers, who can share risk with other clients.
To build a DIA, a buyer invests a one-time amount or makes incremental payments to an insurer, who invests the money and guarantees a regular income later on. The investor can choose when to start taking payments, although most begin at age 80 or later to ensure they have an income in the last year of life.
The key to maximizing income from DIAs, which convert part of your savings into regular income, is to invest before you retire. An early start can mean a higher stream of income after you stop working. Financial advisers generally recommend DIAs for everyone except those who can’t afford to commit their money to an investment, as DIAs are not liquid.
There are several good strategies for investing in a DIA. First, make a DIA part of a diversified portfolio, since it is not impacted by market conditions. A DIA can stabilize income projections and provide assurance that your basic bills will be covered in retirement (along with other guaranteed incomes from sources such as Social Security and work pensions). Investing in a DIA incrementally long before your retirement date also is an excellent way to build your own pension fund.
You and your spouse can each buy your own DIA, or you can buy one as a couple with a joint payout that guarantees the surviving spouse will continue receiving payments. For those concerned that they will die before they receive payouts or before payouts exceed the amount of the original deposit, ask your insurer about a return-of-premium option that will give beneficiaries the original deposit back. Be aware that this option will reduce the payout amount a little.
Why DIAs Are a Good Choice
The biggest advantage of DIAs is that you don’t use them until many years after you’ve invested. For example, if you buy a DIA when you are 50 years old, but don’t withdraw income until you are 80, you’re benefiting from annuities growth after 30 years of compounding interest.
Unlike an IRA or 401(k), which also grows over time and offers tax advantages, a DIA that’s not in a retirement plan (aka a nonqualified annuity) does not require you to begin withdrawals at age 72 to defer taxes. Additionally, DIAs do not have limits on how much you can contribute each year.
DIAs also provide more flexibility in how you distribute your retirement savings. For example, if you retire at age 70 and invest part of your savings in a DIA that you won’t use until you are 85, you can use the rest of your retirement money for income during the 15 years between 70 and 85. This will allow you more freedom with your money early in retirement, because you know you have a guaranteed income planned for your later years.
When Should You Buy a DIA?
The best time to buy a DIA is five to 10 years before you plan to retire, usually between ages 55 and 65. This will lengthen the duration of your deferral period and increase the size of your payouts.
Deferring the payout also allows you to make additional investments in your DIA over a long period of time, taking advantage of potentially lower interest rates as rates fluctuate. Investing in an asset that provides guaranteed income also reduces the need to take on riskier investments or to sell your investments in a down market to generate cash flow.
A new year is a natural time for a fresh start and a new resolve, so there’s no better time to consider new ways to approach your finances in 2021—especially in light of the unusual circumstances that 2020 wrought on our finances and lives. Instead of setting out complicated resolutions that could be hard to stick with, consider adopting some of these more straightforward approaches that still can help you create a stronger, stabler financial position.
Save More Money
This resolution is the complement of the common resolve to spend less, and experts say it’s easier to follow. Rather than solely focusing on how you budget your money, try turning your attention to saving. You’ll be surprised at how much this shift can impact your finances.
First, decide now how much of your income you’d like to save every month based on your bills and salary. You may choose a percentage, such as 15 percent of your take-home income, or a dollar amount, such as $400 each month. Then, make sure you move the money into a savings or investment account or create a savings column in your budget to avoid absorbing it elsewhere, such as overspending on your credit card to compensate for the income now going to savings.
Track Your Spending
Whether your spending goals include buying a house, paying off a car loan, or spending less on groceries, keeping track of how much you spend is a vital first step to creating a budget to help you get there. When we estimate our spending, we often underestimate, which can lead to overspending and no progress toward larger financial goals.
You can figure out exactly how much you’re spending by examining old credit card and bank statements or using budget tracking software. Then, you’ll have a realistic idea of how much you spend and can make educated decisions about budgeting and saving—including chipping away at those big spending goals.
2020 provided some unique opportunities for spending changes that you may want to make permanent. Many people saved money due to restrictions on travel, dine-in eating, and entertainment venues. If your budget benefited, you may want to consider making those spending cuts permanent.
Focus on the Future
Sadly, COVID-19 cut many lives short unexpectedly, and it often left these people isolated in hospitals and assisted living facilities unable to consult with family, friends, or planners who could help them with financial paperwork. Future financial planning, whether it’s outlining your wishes for your estate or solidifying your retirement savings plan, is vital.
One smart resolution is to create a detailed retirement plan and stay with it. Do you want to continue your current lifestyle after you retire? Downsize your home and lifestyle? A planner can help you figure out how much you need to save to achieve your retirement goals and show you how to organize your financial documents to keep your spending and savings up to date. With a retirement plan in place, make it your resolution to follow it.
Estate planning is another key factor in planning for your financial future. A financial planner can talk to you about your goals for your estate and help you put plans in place now.
Pay Off Debt
Aside from causing anxiety, debt can hold you back from living the lifestyle you’d like and reaching big goals like traveling the world or purchasing a house. If you struggle with debt, resolving to pay it down is vital.
Financial planners recommend approaching your debt strategically. That means paying off higher-interest debt, such as credit card balances, first. You could also take a wider approach and focus your payments on debts that carry a specific interest rate and above.
Whatever approach you choose, resolve to understand the amounts and interest rates of your debt and create a strategy for tackling them in 2021. And that doesn’t necessarily mean paying them off completely. If repaying 25 percent of your balances in 2021 is realistic, set that as your goal. The satisfaction of reaching it will only serve as a motivator to continue working toward debt-free finances.
Build up Your Emergency Fund
If we’ve learned anything from 2020, it’s that life can change drastically, and sometimes that comes with unexpected financial ramifications such as a job loss or hospitalization. While financial experts recommend shoring up at least six months’ pay in savings for such situations, the Financial Industry Regulatory Authority found that almost half of Americans don’t have enough in an emergency fund. Without savings set aside, you are risking financial disaster.
Savings like this doesn’t happen quickly, so plan to build it gradually by committing to a monthly contribution to your emergency fund. Additionally, set this money aside for true emergencies—don’t dip into it to pay bills or offset extra spending if you can help it.
While the end of the calendar year often elicits tax and estate planning questions, the political uncertainty in 2020 has led to an increase in inquiries on the subject. One real estate appraiser in Manhattan told a news outlet before the Nov. 3 U.S. presidential election that he had fielded three times as many calls about estate planning than usual, and other financial advisors reported a similar increase in questions.
Now, with the Democratic Party poised to control the U.S. House of Representatives and the presidency in January, it’s possible that estate planning rules could change. Here’s a look what you need to know:
Tax Cuts and Jobs Act
Signed into law in late December 2017, the Tax Cuts and Jobs Act represented the largest revision to the federal tax code in 30 years. Many viewed the overhaul as favorable to wealthy individuals and corporations, as it reduced the top corporate tax rate to 21% and doubled the amount of assets that an individual could transfer before federal estate and gift taxes take effect to approximately $11.6 million in 2020 for individuals and about $23 million for married couples. Any assets transferred over those amounts can be taxed at a rate as high as 40%.
While Joe Biden, the winner of the 2020 presidential election, has not yet taken office, he has given some indications as to changes to the estate tax rules that he will support. The 2017 exemptions will expire in 2025, and they will decrease to an individual maximum transfer amount of around $5 million, although it appears that under Biden they could end sooner.
According to the Tax Policy Center, Biden’s plan will reduce the amount of assets an individual can transfer tax-free when they pass away to $3.5 million and cap individual gifts at $1 million. Estate taxes on gifts and estates also could increase to 45%.
Biden also has suggested he is interested in eliminating a tax code provision known as “step-up basis” that would exempt heirs from paying taxes on gains accumulated before the estate holder’s death. This means that an heir could sell an asset immediately after the estate holder dies and likely pay no or few capital gains taxes on it.
Overall, Biden’s potential changes would mean that people could transfer fewer assets without paying estate taxes.
How to Respond
Tax advisors and financial planners are providing plans and advice for maximizing an estate during these uncertain times.
Take advantage of current rates—For clients concerned about potential changes to estate tax provisions in 2021, one option is to transfer assets now before the high exemption rate potentially drops. One drawback to early gifting, however, is that your own net worth will decrease as you begin transferring large amounts to your heirs. For example, if you’re worth $16 million, then transferring $10 million now to avoid estate taxes could have an adverse effect on your own finances. Financial experts advise considering whether you can actually afford the gift now, and if you do transfer the assets, how that will impact your life. It may be worthwhile for your heirs to pay more in estate taxes in order to maintain your current financial situation. “Giving these assets away could leave you financially vulnerable, and this is so important to consider—especially now, in the time of COVID, when there is so much uncertainty,” Stacy Francis, a financial planner based in New York City, recently told Kiplinger. “While saving on taxes is extremely important, it’s not the sole reason to give money away to charity or family members.”
Worry less about step-up basis changes—While eliminating step-up basis could help to fund Biden’s initiatives and proposals, in actuality it could prove to be a logistical nightmare. Financial experts say that while the idea has been circulating in Washington for several years, changes to the tax law have never been enacted because of the amount of paperwork that it would require and its potential impact on taxpayers. Easier and more traditional changes that also could increase revenue include expanding capital gains taxes and reducing the estate tax exemption.
Be patient—While the fate of the current estate tax exemptions is uncertain, you can begin distributing your estate tax-free to your heirs through smaller gifts. The current rules allow individuals to give away $15,000 tax-free each year to individuals. This means that you could gift each of your children and grandchildren that amount with no tax penalty, and your spouse could do so, as well. You may also opt to move your estate to a trust, which could provide greater stability for your assets. Regardless of how you manage estate planning, financial advisors recommend choosing a strategy that fits your needs and long-term plans. Most importantly, they say, people should work with a financial advisor on estate planning and avoid panicking when times become difficult.
President-elect Biden will need the support of Congress to enact major changes to the federal tax code. That means that he’ll likely need a Democrat-controlled Senate, and that hangs in the balance right now. Both of Georgia’s Senate seats will be decided in run-off elections in early January, and the outcome will determine the balance of power in the Senate. If both of the Democratic candidates win, the Senate will be evenly split, and Vice President-elect Kamala Harris would break the tie.
Investing your money, whether in the stock market or a retirement account, is a good way to take advantage of compounding interest and secure your financial future. However, understanding risk levels and investment products can take time, and many new investors fall into the same trap as they navigate financial markets and make decisions about their money.
Here are some of the most common mistakes that first-time investors make—and how to avoid them.
Mistake #1: Not Selecting the Right Advisor
Financial advisors can teach you about financial markets and products and provide helpful input as you make decisions about your money. However, your parents’ or friend’s financial advisor might not be the best advisor for you.
Rather than choosing someone you know works with, do some research yourself. You’ll want to ask what type of clients these potential advisors typically work with, what they could do for you, what their investment philosophy is, and what services and products they offer.
Mistake #2: Making Trendy Investments
Likewise, don’t make investment choices based only on the recommendations of others. Be particularly wary of celebrity endorsements. Companies may be using celebrities’ fame to try to get you to invest. In some cases, celebrity-endorsed investment products are scams.
A better practice is to research the investment product. Does it fit your financial goals? In choosing this product, are you just going along with a trend or will the product truly be a good addition to your portfolio?
Mistake #3: Making Your Own Market Predictions
It makes sense to buy stocks when the market is low and sell them when it’s high. But the real art comes in figuring out the timing. Is the market at its highest point now, or should you wait one more week to sell? Is this really rock bottom for this company, or could you wait one month and get it for even better deal?
Rather than putting energy into predicting a stock’s ups and downs, financial advisors recommend taking a long-term, measured approach to investing. That means buying shares on a regular schedule rather than basing purchases on market predictions.
Mistake #4: Being Overconfident
Some first-time investors enter the market with an abundance of confidence, sure that they will get big returns on their well-timed stock purchases and sales. However, overconfidence can lead to major rookie mistakes, according to financial planners.
Most importantly, don’t misinterpret the market’s movements as confirmation that you made good decisions about the timing of your investment. Trading often to “beat the market” typically doesn’t work, even for investors who read the news and keep up with trends.
A better approach is to slow down on trading decisions and focus on creating a diverse array of investments. When you take a realistic viewpoint about your investment decisions and returns, you’ll make better decisions that will get you closer to your financial goals.
Mistake #5: Overvaluing Cost
In the stock market, the sticker price isn’t always an indicator of value. For example, a $6 stock may not be a bargain if the company is new and unproven. Likewise, a $3,000 price tag is not necessarily an indicator that the stock is valuable.
Rather than drawing assumptions about stocks based on their price, new investors are advised to research each stock’s value by looking at factors such as their past performance, growth potential, and leadership.
Mistake #6: Panic Selling
When the stock market tanks, it can be hard to resist the urge to dump your stocks in fear that the market will drop even lower in coming days. However, more than 90 percent of investors identify this emotional reaction as a top mistake that investors make. Unfortunately, panic selling typically ends in financial loss.
That’s because selling stocks at a low price locks in your losses and eliminates any chance you have to benefit from the almost certain recovery that will follow. For example, in March of 2020, S&P losses totaled 34 percent, and in the US, investors sold out of more than $325 billion in mutual fund positions, according to Strategic Insight. Those investors then couldn’t take advantage of the market’s 20 percent rebound a month later.
Financial advisers recommend laying low when the market turns downward. Stick with a long-term investment strategy instead of short-term decisions and wait for the inevitable market correction that will erase those losses.
Mistake #7: Holding on to Returns
While it may be tempting to spend your returns, or earnings, from the market, a better strategy is to invest them back in the market. This practice, which is called compounding, will help your money grow faster. With a commitment to savings and compounding, over time your investments should flourish.
Due to the pandemic, colleges across the United States are starting to rethink their approach to how to provide an education. In response, many families are wondering whether paying for a college education is worthwhile right now.
Recent statistics bear out this trend. In October, the National Student Clearinghouse Research Center reported that undergraduate enrollment is down 4%. Experts attribute the decrease to concerns about contracting COVID-19, a dislike of online learning, and issues with families not being able to afford tuition. Some students are opting to take a gap year or to postpone college.
While reconsidering your college plans may be an option for some, financial planners advise families to continue saving—at least in some form—for their children’s college education. The following is some information and advice on how to manage your 529 college savings plan as the educational system navigates COVID-19.
Community College An Option
One popular option for students who don’t want to virtually attend a pricey university is to enroll in community college, which is generally a less expensive choice. Some financial advisors recommend that parents pay the lower tuition for community college out-of-pocket rather than draw on their student’s 529 plan, a popular education savings plan that allows families to invest money that has already been taxed into several investment options. Your earnings grow tax-free, and withdrawals for qualified expenses are not taxed.
This approach offers several benefits. Parents can continue contributing to their child’s 529 account and increase its long-term growth potential. In addition, they will not be withdrawing money from their student’s college savings account and taking a loss during an economic downturn. Students can also take out separate loans for community college and use the 529 proceeds later to repay up to $10,000 of those loans (principal and interest), a one-time option now available under the recently passed SECURE Act. As an added bonus, up to $10,000 in 529 plan distributions can be put toward the educational debt of each of the beneficiary’s siblings, including stepsisters and stepbrothers.
Continue to Contribute
The market ups and downs over the last year may set off warning alarms for your 529 college savings plan. Your account balance may drop, which may make the plan seem less valuable. The statistics back this up. According to data from the College Savings Plans Network, the average account reached a high of $26,054 in 2019, but now it is down to an average of $25,657.
Even with so much uncertainty, advisors recommend that families continue contributing to their 529 college savings plans as much as they can. Recent research finds that many are doing just that—total investments in 529 plans have risen to nearly $374 billion, a record. Investors value the savings plans’ tax-free deductions when the funds are used for qualified educational expenses such as tuition and books.
“When it comes to 529 college savings, staying the course is an essential component of a successful long-term savings strategy,” stated Michael Frerichs, the chairman of the College Savings Plans Network, in a recent interview with CNBC.
Other Ways to Use the Money
COVID relief legislation that was passed earlier this year allowed families who had paid for tuition from their 529 plans—before classes were moved online due to the pandemic—to receive refunds from the colleges. As long as the money was deposited back into the 529 plan within 60 days, the withdrawal was not taxed.
While families have the option to leave the money untouched, there are other ways they could use it because the law allows for 529 funds to be used to pay for a variety of qualified educational expenses. Up to $10,000 per year can be spent on private school tuition for each younger child per year (private, public, or religious education for students in kindergarten through 12th grade), and in many states that amount can be applied to reduce the taxable income of the parent or grandparent who started the fund.
The money also can be used to pay for apprenticeship programs, vocational school, and other post-secondary institutions that participate in the U.S. Department of Education student aid program. Qualified expenses also include computer software, textbooks, and supplies.
The Long-Term Outlook
For families with younger children, now may be a good time to think about what higher education will look like in a decade. Some experts predict that post-COVID, the cost of a college education will become even more expensive. In order to compensate, you can change the asset allocation of your 529 plan portfolio, making it more aggressive or conservative based on your feelings about the market.
Parents may want to explore other savings options, as well, so that they can work around the restrictions on the 529 plan. Other good investment choices include U.S. Treasury bonds, one of the safest—and slowest—investments, or stocks, which will be more volatile but could provide a much larger payoff. Parents also could consider a Roth IRA savings account, which offers the tax savings of a 529 account without the restrictions.
While the 2020 U.S. presidential race remains front-page news, the outcome of the Nov. 3 election could significantly impact your income, tax bracket, and tax burden, as any changes in government officials could potentially alter the federal tax code in 2021. While neither presidential candidate has released a detailed tax plan, the information provided during recent campaigning has offered some clues as to how each candidate might approach tax policy. The composition of the U.S. House and Senate after the election will also determine the future of US tax policy, as bills altering the tax code must pass through Congress.
Here’s what we know about where the U.S. presidential candidates stand on issues of taxation:
Capital gains and dividends—Currently, the top tax rate on capital gains and dividends is 20% for individuals with incomes over $441,450 and for married couples filing jointly who make more than $496,600. President Donald Trump has indicated that he would reduce the capital gains tax rate from 20% to 15%, while Democratic candidate Joe Biden would remove exemptions for capital gains and dividends for incomes that exceed $1 million.
Estate tax exemption—For 2020, the estate tax exemption is approximately $11.6 million, and it’s scheduled to revert to $5.8 million in 2025. Trump supports an extension of the exemption, while Biden would keep the planned 2025 reversion.
Individual tax rates—For individual with incomes of more than $518,400 and married couples filing jointly with incomes of over $622,050, the top marginal rate is 37%. Trump would retain this rate and add a 10% rate cut for middle-class taxpayers. The current rate of 22% applies to individuals with incomes of over $40,125 and married people filing jointly who have incomes of over $80,250. Biden has indicated that his policy would restore the pre-2017 rate of 39.6% for taxable income of more than $400,000.
With this information in mind, financial planners are offering advice on how to manage your finances in order to maximize your wealth throughout the upcoming months.
Pre-Election Financial Strategies to Consider
Roth IRA—In order to reduce the tax burden on your individual retirement savings, financial planners recommend converting traditional IRA accounts to Roth IRAs. The reason? When you withdraw money from a traditional IRA, it’s taxed, and right now the income tax rates are relatively low. If a Democratic majority takes office in 2021, income tax rates could increase, and traditional IRA withdrawals would be taxed at the higher rate. While deposits into a Roth account are taxed, the balance will grow tax-free.
While switching to a Roth account will trigger a tax bill for making a withdrawal, you will likely will be financially better off in the long term with a Roth IRA. Additionally, don’t forget to claim losses this year on deductible items, such as depreciation on an eligible rental property that you own. The savings may be enough to offset any fees charged in a Roth IRA conversion.
Estate planning—One tax strategy to consider is to give to your heirs a financial gift before the end of 2020, as it’s unclear what will happen to the estate tax exemption. Currently, due to tax revisions passed in 2017, the estate tax exemption was doubled to more than $23 million per couple. While this benefit is set to expire in 2025, a change in the governing majority could move up the expiration date and reduce the exemption amount to pre-2017 levels. Financial advisors recommend taking advantage of tax-free gifts to heirs now and giving up to the annual exemption level.
Americans have enjoyed a relatively low tax rate on profits from the sale of investments that they have owned for more than a year. However, Democrats have discussed the possibility of increasing tax rates on long-term capital gains above the rates set during the 2017 tax overhaul. For high earners, this could mean as much as a two-fold increase in the top capital gains tax rate.
If the possibility of an increase in the long-term capital gains rates looks likely in 2021, a good strategy could be selling off profitable stocks now in order to take advantage of a lower tax rate.
Wait Before Making Any Major Decisions about Your Finances
Since it’s impossible to predict exactly how the election results will affect your taxes, financial advisors recommend that you wait before making any big decisions about your investment strategies. Some point to the lessons learned from 2012, when people sold more than they could afford based on speculation.
Some advisors recommend thinking through a 10-15 year investment plan and making decisions within that framework—even with the uncertainty that lies ahead. If you are compelled to rethink your investments now, consider compromising. For example, you could convert part of your traditional IRA to a Roth IRA now and then decide about whether to convert the remaining balance after the election.
“The election will happen, and we’ll know the results. But we won’t know what the tax plan will be this year,” said Bryan D. Kirk, Fiduciary Trust International director of estate and financial planning, in a New York Times article.