The Tax Problem No One is Telling You About

©Cramgroup.com 2007, Marc Cram, CFP®

You have been saving diligently now for many years, looking forward to the day, not too far down the road, when you can retire and begin living off those hard saved dollars. You have done everything the gurus and planners have told you to do. You have used the vehicles they suggested, invested in the products they sold and taken advantage of every tax saving idea you have read about. You were even smart enough to move into cash in March of 2000 (well, maybe not that smart). You are going to be ok though, right? Maybe not!
Regardless if this is you or you have been planning to save for retirement as soon as you get that last bill paid off, it is time for you wake up to the tax problem that nobody mentioned to you until now.

How many times have you heard or been told that you are going to be in a lower tax bracket when you retire? Is that true and do you believe it? If it is true then putting all of that money into those tax-deferred vehicles may still be a good idea, but if it is not true, what are you going to be looking forward to?

Let’s start with some simple logic. First, what sort of income would you like to live on in retirement? My guess is that you would like to keep your standard of living about the same as it is today. What is your current tax bracket and how many deductions do you currently have? Most people have at least a mortgage deduction and if the kids are still at home you get a deduction for them. If you are smart you might even have a home based business that affords a few more deductions. So, you have current income (fully taxed) and current deductions.

What are you hoping or planning will happen before retirement? The kids are gone (and not coming back), the house is paid for and your income is replaced by your investments, right? Great plan but what happens to your taxes if your dream comes true? Every dollar coming in is fully taxed and you have lost every deduction you had. Does that sound like you being in a lower tax bracket?

Now let’s think through a little more of the problem. There are about 80 million baby boomers out there getting ready to join you in retirement. According to the Congressional Budget Office about 50% of them are on track to save enough money but are unlikely to experience the kinds of returns their parents did. In addition, there is no guarantee that the public benefits that were paid to your parents will be there for these future retirees. They are also likely to live at least 2 years longer in retirement than their parents which means that they will need either more assets or better growth of their assets if they want to maintain their lifestyles.

If you got from the last paragraph that there are also 50% who have not saved enough for their retirement then you are starting to get the picture that taxes may well be going up just when we need more money to fund our retirement and that as more and more boomers retire that need will only increase. This, my friend, is the part no one is talking about and this is the dilemma you will need to address for yourself, now, regardless of how close retirement is to you.

Does it make sense to be shoveling extra dollars into those tax-deferred savings plans if you know that just when you need to pull it out it is going to be taxed at rates even higher than today? Do you realize that if you live a normal retirement (from 65 – 85) and tax rates just stayed the same, you will pay 10% more in taxes on the money coming out of these plans as you saved by putting it in those plans? What kind of retirement planning is that?

So, what is a boomer to do? If what I just laid out makes sense to you, then you have only a couple choices in front of you to overcome this problem. First, stop overfunding your 401k plans. Put in whatever amount your company will match but don’t keep compounding your future tax problem by adding more to it. Next you could begin putting more money into your taxable accounts. At least this way you will be paying taxes at current rates and you can hope that congress will leave the capital gains rates alone for your entire retirement.

A better choice is to begin using vehicles that can create tax-free income in retirement. There are several that you should look into. First, you should be funding your Roth IRA if you can. You must be making less than $160,000 per year in joint income to be eligible though. If you can’t fund a Roth you might consider moving some or all of your IRA or 401k money into a Roth in 2010. That year anyone can make this conversion and have 2 years to pay the taxes on the transfer. This will effectively take that money and tax it at today’s tax rates and allow you to continue to grow it and use it tax-free in the future.

The next idea may sound strange but hang with me here as this might just be the real winner. Why not create a private retirement plan using cash value life insurance? If you have never considered this idea let me explain the benefits. First, life insurance, if properly structured, can create a nest egg that can grow tax-free, be accessed tax-free and passed on to your heirs tax-free. There is no limit to how much you can put into it, no requirement to ever take it out and the money is taxed only once, when it goes into the policy.

If we are using this as a cash accumulation vehicle we will want to structure it to be the most efficient it can be. We do that by buying the least amount of protection while putting as much money into the policy as fast as the tax laws will allow us to, without causing it to be classified as a modified endowment contract. A modified endowment contract functions much like an annuity which means that any money we take out will be taxed instead of being tax-free. If it is structured properly and held for 20 years or longer the internal costs are not much more than the average loaded mutual fund, about 1.5 to 2%.

There are also some great benefits to creating this supplemental retirement concept. Unlike your IRA or 401K, there are no restrictions on how or when you use the money inside the contract. You can even use it as your own banking source once it is fully funded. Why borrow money from the bank to purchase your next car or send your kids to college when you can borrow it from yourself, and pay it back to yourself. Your money is fully protected from lawsuits and creditors in most states and the dollars inside the policy never show up on college financial aid forms. And when you are ready to tap into it for retirement income, you can create a tax-free income stream that could be at least 50% greater than what you could create from those tax-deferred accounts.

If this idea makes sense to you, you will want to talk with someone who knows how these policies need to be structured and what type of policy would be the most advantageous for you. Regardless of what you have done in the past to plan for retirement, you should consider the ideas here as a way to overcome the tax problem no one has told you about, and to take control of your own financial future.

Marc Cram is a Certified Financial Planner™ and has been practicing in Triangle for 20 years. He lives and works in Durham, NC and can be reached through his web site at http://www.cramgroup.com/

Who or What is Responsible for the Sub-Prime Loan Debacle?

©Cramgroup.com 2007, Marc Cram, CFP®

There has been much ink spent lately on the problems in the housing market. Talk of people losing their homes because of bad loans, dishonest mortgage lenders and poor planning are rampant in most any paper you pick up today. In fact, much of the blame has been heaped on those exotic mortgage instruments and their misuse. People who are marginal borrowers (what we call the sub-prime market) have often been the subject of these stories and will be the ones most at risk from the changes that have already occurred and those yet to come. Not that these changes are all bad, but as usual those who least can afford it are the ones most affected.

I would like to shed a little light on these issues from my point of view as a Certified Financial Planner™ and someone who helps people use assets, like their home, to build wealth. First, is there abuse of the system out there in the market place? Certainly, but no matter what the regulatory agencies do to solve the problem, there will always be abuse. The real culprit, from my point of view, is our own unwillingness to take responsibility for our actions. If the lenders were more responsible they would do a better job of screening applicants and fitting them with the right mortgage products or even be willing to turn them down if they can’t be confident of repayment. If the borrowers were more responsible they would demand clear explanations of how these products work and what they can expect in subsequent years. They would also be willing to settle for a little less house than stretch themselves to dangerous limits.

Fortunately, we have been lucky here in the Triangle. We have not seen the big run up in values that have occurred in Florida, California or the Northeast. We also live in an area of the country that people are eager to move into and we still have plenty of open space to accommodate them. The issue here is one of degree. We don’t see the abuse that took place in these overheated markets but we still have people selling the same mortgage products with some of the same results.

The product most discussed is called the Option Arm or Pay Option Arm. Don’t get me wrong, this is a great product for the right borrower but it has been used by some to get people into homes that they clearly could not afford using a standard fixed rate loan or even a fixed rate interest-only loan. If you don’t know how these products work, the borrower has the option every month of paying either a 15 or 30 year amortized rate, a current interest-only rate or a minimum payment that usually starts at 2%. Now even though you have all of those choices you can bet that most people are going to choose the one that has the lowest out of pocket cost, the 2% rate.

If the current interest rate is 6% you can see that you are going to be adding to your mortgage every month rather than paying it down. In addition, the payment goes up only 7.5% per year but the interest rate is recalculated every month. If you lack the cash flow and or home values are rising at less than 4% you will begin to get into trouble very quickly, and that is what has happened to some.

Like any complex financial instrument, a mortgage must be managed if it is to be used successfully. This means that you need to forge a relationship with your lender that is deeper than just the “guy who wrote my mortgage”. You might also want to run this by your financial planner so that it is coordinated with your overall financial plan. The lenders that I refer my clients to know their business and are educated on the proper use of the products they sell. Since my advice includes using mortgages to access home equity I have to be confident that my clients will be well served and that their goals will be reached. This should be your goal too regardless if you are using your home as part of your wealth strategy or if you just want to pay it off as soon as possible.

Remember, it is your responsibility to create the discipline and take control of your own financial future. Mortgages are not your business so it is critical that you do your homework up front and ask the hard questions of those people who are advising you. If you have good advisors, get educated up front, and manage your assets in intelligent ways you will reach your goals with greater speed, comfort and safety, and that’s all any of us want.

Marc Cram is a Certified Financial Planner™ and has been practicing in Triangle for 20 years. He lives and works in Durham, NC and can be reached through his web site at www.cramgroup.com