Maintaining Sustainable Withdrawal Rate in Retirement – by John Jastremski

What is a sustainable withdrawal rate?

A withdrawal rate is the percentage that is withdrawn each year from an investment portfolio. If you take $20,000 from a $1 million portfolio, your withdrawal rate that year is two percent ($20,000 divided by $1 million).

However, in retirement income planning, what’s important is not just your withdrawal rate, but your sustainable withdrawal rate. A sustainable withdrawal rate represents the maximum percentage that can be withdrawn from an investment portfolio each year to provide income with reasonable certainty that the income provided can be sustained as long as it’s needed (for example, throughout your lifetime).

Why is having a sustainable withdrawal rate important?

Your retirement lifestyle will depend not only on your assets and investment choices, but also on how quickly you draw down your retirement portfolio. Figuring out an appropriate withdrawal rate is a key factor in retirement planning. However, this presents many challenges and requires multifaceted analysis of many aspects of your retirement income plan. After all, it’s getting more and more common for retirement to last 30 years or more, and a lot can happen during that time. Drawing too heavily on your investment portfolio, especially in the early years, could mean running out of money too soon. Take too little, and you might needlessly deny yourself the ability to enjoy your money. You want to find a rate of withdrawal that gives you the best chance to maximize income over your entire retirement period.

A sustainable withdrawal rate is critical to retirement planning, but it can apply to any investment portfolio that is managed with a defined time frame in mind. It’s also fundamental to certain types of mutual funds that are managed to provide regular payments over a specific time period. For example, some so-called distribution funds, which are often used to provide retirees with ongoing income, are designed to distribute all of an investor’s assets by the time the fund reaches its targeted time horizon. As a result, the fund must calculate how much money can be distributed from the fund each year without exhausting its resources before that target date is reached.

Tip: Each distribution fund has a unique way of addressing the question of a sustainable withdrawal rate. Before investing in one, obtain its prospectus (available from the fund), and read it so you can carefully consider its investment objectives, risks, charges, and expenses before investing.

How does a sustainable withdrawal rate work?

Perhaps the most well-known approach is to withdraw a specific percentage of your portfolio each year. In order to be sustainable, the percentage must be based on assumptions about the future, such as how long you’ll need your portfolio to last, your rate of return, and other factors. It also must take into account the effect of inflation.

Example: John has a $2 million portfolio when he retires. He estimates that withdrawing $80,000 a year (adjusted for inflation) will be adequate to meet his expenses. John’s sustainable withdrawal rate is four percent, and he must make sure that his portfolio is designed so that he can continue to take out four percent (adjusted for inflation) each year.

Other approaches to withdrawal rates

A performance-based withdrawal rate

With this approach, an initial withdrawal rate is established. However, if you prefer flexibility to a fixed rate, you might vary that percentage from year to year, depending on your portfolio’s performance. Each year, you would set a withdrawal percentage, based on the previous year’s performance, that would determine the upcoming year’s withdrawal. In years of poor performance, a portfolio’s return might be lower than your target withdrawal rate. In that case, you would reduce the amount you take out of the portfolio the following year. Conversely, in a year when the portfolio exceeds your expectations and performance is above average, you can withdraw a larger amount.

Example: Fred has a $2 million portfolio, and withdraws $80,000 (four percent) at the beginning of his first year of retirement to help pay living expenses. By the end of that year, the remaining portfolio balance has returned six percent, or $115,200–more than the $80,000 he spent on living expenses. For the upcoming year, Fred decides to withdraw five percent of his portfolio, which is now worth $2,035,200 ($2 million – $80,000 + $115,200 = $2,035,200). That will give him $101,760 in income for the year, and leave his portfolio with $1,933,440. However, during December of that second year of retirement, his portfolio experiences a seven percent loss; by the end of the year, the portfolio has been reduced by the $101,7600 Fred withdrew at the beginning of the year, plus the seven percent investment loss. Fred’s portfolio is now worth $1,798,099. Fred reduces his withdrawals next year–the third year of his retirement–to ensure that he doesn’t run out of money too soon. (For simplicity’s sake, this hypothetical illustration does not take taxes in account, and assumes all withdrawals are made at the beginning of the year.)

Important: If you hope to withdraw higher amounts during good years, you must be certain that you’ll be able to reduce your spending appropriately during years of lower returns; otherwise, you could be at greater risk of exhausting your portfolio too quickly. And be sure to take inflation into account. Having other sources of reliable, fixed income could make it easier to cushion potential income fluctuations from a performance-based withdrawal rate, and handle emergencies that require you to spend more than expected.

A withdrawal rate that decreases or increases with age

Some strategies assume that expenses in the later years of retirement will be lower as a retiree becomes less active. They are designed to provide a higher income while a retiree is healthy and able to do more.

Example: Bill sets a six percent initial withdrawal rate for his portfolio. However, he anticipates reducing that percentage gradually over time, so that in 20 years, he’ll take only about three percent each year from his portfolio.

Caution: Assuming lower future expenses could have disastrous consequences if those forecasts prove to be wrong–for example, if health care costs increase even more sharply than they have in the past, or if a financial emergency late in life requires unplanned expenditures. Even assuming no future financial emergencies and no unexpected increases in the inflation rate, this strategy would require discipline on a retiree’s part to reduce spending later, which might be difficult for someone accustomed to a higher standard of living.

Other strategies take the opposite approach, and assumes that costs such as health care will be higher in the later retirement years. These set an initial withdrawal rate that is deliberately low to give the portfolio more flexibility later. The risk, of course, is that a retiree who dies early will leave a larger portion of his or her retirement savings unused.

Consider the impact of inflation

An initial withdrawal rate of, say, four percent may seem relatively low, particularly if you have a large portfolio. However, if your initial withdrawal rate is too high, it can increase the chance that your portfolio will be exhausted too quickly. That’s because you’ll need to withdraw a greater amount of money each year from your portfolio just to keep up with inflation and preserve the same purchasing power over time. For a retirement portfolio, that can become problematic, since the amount withdrawn is no longer available to generate income in future years. An appropriate initial withdrawal rate takes into account that inflation will require higher withdrawals in later years.

Example: Jean has a $1 million portfolio invested in a money market account that yields five percent. That gives her $50,000 of income that year. However, inflation pushes up prices by three percent over the course of the year. That means Jean will need more income–$51,500–the next year just to cover the same expenses ($50,000 x.03=$1,500). Since the account provides only $50,000 of income, the additional $1,500 must be withdrawn from the principal. That principal reduction, in turn, reduces the portfolio’s ability to produce income the following year. In a straight linear model, principal reductions accelerate, ultimately resulting in a zero portfolio balance after 25 to 27 years, depending on the timing of the withdrawals. (This example is a hypothetical illustration and does not account for the impact of any taxes.)

Inflation is one reason you can’t simply base your retirement income planning on the expenses you expect to have when you first retire. Costs for the same items will most likely continue to increase over your retirement years, and your initial withdrawal rate needs to take that into account to be sustainable.

There’s another inflation-related factor that can affect your planning. Seniors can be affected somewhat differently from the average person by inflation. That’s because costs for some services that may represent a disproportionate share of a senior’s budget, such as health care and food, have risen more dramatically than the Consumer Price Index (CPI)–the basic inflation measure–for several years. As a result, seniors may experience higher inflation costs than younger people, and therefore might need to keep initial withdrawal rates relatively modest.

What determines whether a withdrawal rate is sustainable?

  • Your time horizon: The longer you will need your portfolio to last, the lower the initial withdrawal rate should be. The converse is also true (e.g., you may have health problems that suggest you will not need to plan for a lengthy retirement, allowing you to manage a higher withdrawal rate).
  • Anticipated and historical returns from the various asset classes in your retirement portfolio, as well as its anticipated average annual return: Though past performance is no guarantee of future results, the way in which you invest your retirement nest egg will play a large role in determining your portfolio’s performance, both in terms of its volatility and its overall return. That, in turn, will affect how much you can take out of the portfolio each year without jeopardizing its longevity.
  • Assumptions about market volatility: A financial downturn that reduces a portfolio’s value, especially during the early years of withdrawal, could increase the need to use part of the principal for income. It could also require the sale of some assets, draining the portfolio of any future income those assets might have provided. Either of those factors could ultimately affect the sustainability of a portfolio’s withdrawal rate.
  • Anticipated inflation rates: Determining a sustainable withdrawal rate means making an assumption about changes in the cost of living, which will likely increase the amount you’ll need the portfolio to provide each year to meet your expenses.
  • The amounts you withdraw each year: When planning your retirement income, your anticipated expenses will obviously affect what you need to withdraw from your retirement portfolio, and therefore affect its sustainability. However, because this is one aspect over which you have at least some control, you may find that you must adjust your anticipated retirement spending in order to make your withdrawal rate sustainable over time.
  • Any sources of relatively predictable income, such as Social Security, pension payments, or some types of annuity benefits: Having some stability from other resources may allow greater flexibility in planning withdrawals from your portfolio.
  • Your individual comfort level with your plan’s probability of success.

As with most components of retirement income planning, each of these factors affects the others. For example, projecting a longer lifespan will increase your need to reduce your withdrawals, boost your returns, or both, in order to make your withdrawal rate sustainable. And of course, if you set too high a withdrawal rate during the early retirement years, you may face greater uncertainty about whether you will outlive your savings.

Example: Mary’s financial professional tells her that given her current withdrawal rate and asset allocation strategy, there is an 80 percent chance that her retirement savings will last until she’s 95 years old. Mary has several choices. If she wants to increase her confidence level–maybe she prefers a 95 percent chance of success–she might reduce her yearly spending, try to increase her portfolio’s return by changing her asset allocation, direct a portion of her portfolio into an investment that offers a guaranteed lifetime income, or some combination. On the other hand, if she’s a risk taker and is comfortable with having only a 75 percent chance that her portfolio will last throughout her lifetime, she might decide to go ahead and spend a bit more now. (This is a hypothetical illustration only, not financial advice).

Income-only withdrawals vs. income and principal

Many people plan to withdraw only the income from their portfolios, intending not to touch the principal unless absolutely necessary. This is certainly a valid strategy, and clearly enhances a portfolio’s sustainability. However, for most people, it requires a substantial initial amount; if your portfolio can’t produce enough income to meet necessary expenses, an income-only strategy could mean that you might needlessly deprive yourself of enjoying your retirement years as much as you could have done. A sustainable withdrawal rate can balance the need for both immediate and future income by relying heavily on the portfolio’s earnings during the early years of retirement, and gradually increasing use of the principal over time in order to preserve the portfolio’s earning power for as long as possible.

Planning to use both income and principal requires careful attention to all the factors mentioned above. Also, in establishing your strategy, you should consider whether you want to use up all of your retirement savings yourself or plan to leave money to heirs. If you want to ensure that you leave an estate, you will need to adjust your withdrawal rate accordingly.

Your decision about income versus income-plus-principal should balance the need for your portfolio to earn a return high enough to sustain withdrawals with the need for immediate income. That can provide a challenge when it comes to allocating your assets between income-oriented investments, and investments that have the potential for a higher return but involve greater volatility from year to year. You may need to think of your portfolio as different “buckets”–for example, one “bucket” for your short-term living expenses, another bucket that could replenish your expenses bucket as needed, and another bucket invested for the long term.

Estimating lifespan

In general, life expectancies have been increasing over the last century. Life probabilities at any age are listed on the Social Security Administration’s Period Life Table, available under the Actuarial Publications section of its web site.

Regularly updated longevity estimates are published in the National Center for Health Statistics’ National Vital Statistics Reports.

However, be aware that averages are not necessarily the best guide when determining how long an individual portfolio may need to last. By definition, many people will live beyond the average life expectancy for their age group, particularly those who have a family history of longevity. Also, average life expectancies don’t remain static over an individual’s lifetime; a 30-year-old may have an average life expectancy of 76, while a 76-year-old may have a life expectancy of 85.

Couples will need to consider both individuals’ life expectancies when planning a sustainable withdrawal rate.

Establishing a comfort level with uncertainty

As noted previously, setting a sustainable withdrawal rate requires many assumptions and forecasts about what will happen in the future. Changing any of the variables may increase or decrease the level of certainty about whether your portfolio will last as long as you need it to. Increasing certainty about the outcome may require reducing your withdrawal rate or revising your investment strategy. Conversely, increasing your withdrawal rate, especially in the early years of retirement, may also increase the odds that your portfolio will be depleted during your lifetime.

The challenge is to balance all factors so that you have an acceptable level of certainty about the portfolio’s longevity consistent with providing the level of income needed over your expected lifetime and the risk you’re willing to take to provide it.

One increasingly common method for estimating the probability of success is the Monte Carlo simulation. This technique uses a computer program that takes information about your portfolio and proposed withdrawal strategy, and tests them against many randomly generated hypothetical returns for your portfolio, including best-case, worst-case, and average scenarios for the financial markets. Based on those aggregated possibilities, the program calculates your portfolio’s probability of success. Monte Carlo simulations also allow you to revise assumptions about lifespan, withdrawal rates, and asset allocation to see how changing your strategy might affect your portfolio’s chances. Though the process offers no guarantees, it does take into account potential fluctuations in your portfolio’s year-to-year returns. The result is a more sophisticated analysis than simply establishing a withdrawal rate based on a constant rate of return on your investments over time.

Some retirement income strategies tackle the question of uncertainty by including not only income sources that pay variable amounts, but also sources that provide relatively fixed or stable income, or lifetime income that is guaranteed. Just remember that the purchasing power of any fixed payment amounts can be eroded over time by inflation.

Once you’ve established an initial withdrawal rate, you probably should revisit it from time to time to see whether your initial assumptions about rates of return, lifespan, inflation, and expenses are still accurate, and whether your strategy needs to be updated.

Conventional wisdom about withdrawal rates

The process of determining an appropriate withdrawal rate continues to evolve. As baby boomers retire and individual savings increasingly represent a larger share of retirement income, more research is being done on how best to calculate withdrawal rates.

A seminal study on withdrawal rates for tax-deferred retirement accounts (William P. Bengen, “Determining Withdrawal Rates Using Historical Data,” Journal of Financial Planning, October 1994), looked at the annual performance of hypothetical portfolios that are continually rebalanced to achieve a 50-50 mix of large-cap (S&P 500 Index) common stocks and intermediate-term Treasury notes. The study took into account the potential impact of major financial events such as the early Depression years, the stock decline of 1937-1941, and the 1973-74 recession. It found that a withdrawal rate of slightly more than four percent would have provided inflation-adjusted income for at least 30 years. More recently, Bengen used similar assumptions to show that a higher initial withdrawal rate–closer to five percent–might be possible during the early, active years of retirement if withdrawals in later years grow more slowly than inflation.

Other studies have shown that broader portfolio diversification and rebalancing strategies can also have a significant impact on initial withdrawal rates. In an October 2004 study (“Decision Rules and Portfolio Management for Retirees: Is the ‘Safe’ Initial Withdrawal Rate Too Safe?,” Journal of Financial Planning), Jonathan Guyton found that adding asset classes, such as international stocks and real estate, helped increase portfolio longevity (although these asset classes have special risks). Another strategy that Guyton used in modeling initial withdrawal rates was to freeze the withdrawal amount during years of poor portfolio performance. By applying so-called decision rules that take into account portfolio performance from year to year, Guyton found it was possible to have “safe” initial withdrawal rates above five percent.

A still more flexible approach to withdrawal rates builds on Guyton’s methodology. William J. Klinger suggests that a withdrawal rate can be fine tuned from year to year using Guyton’s methods, but basing the initial rate on one of three retirement profiles. For example, one person might withdraw uniform inflation-adjusted amounts throughout their retirement; another might choose to spend more money early in retirement and less later; and still another might plan to increase withdrawals with age. This model requires estimating the odds that the portfolio will last throughout retirement. One retiree might be comfortable with a 95 percent chance that his or her strategy will permit the portfolio to last throughout retirement, while another might need assurance that the portfolio has a 99 percent chance of lifetime success. The study (“Using Decision Rules to Create Retirement Withdrawal Profiles,” Journal of Financial Planning, August 2007) suggests that this more complex model might permit a higher initial withdrawal rate, but it also means the annual income provided is likely to vary more over the years.

Don’t forget that all these studies are based on historical data about the performance of various types of investments, and past results don’t guarantee future performance.

Market volatility and portfolio longevity

When setting an initial withdrawal rate, it’s important to take a portfolio’s volatility into account. The need for a relatively predictable income stream in retirement isn’t the only reason for this. According to several studies in the late 1990s by Philip L. Cooley, Carl M. Hubbard, and Daniel T. Walz, the more dramatic a portfolio’s fluctuations, the greater the odds that the portfolio might not last as long as needed. If it becomes necessary during market downturns to sell some assets in order to continue to meet a fixed withdrawal rate, selling at an inopportune time could affect a portfolio’s ability to generate future income. And a steep market downturn, or having to sell assets to meet unexpected expenses during the early years of retirement, could magnify the impact of either event on your portfolio’s longevity because the number of years over which those investments could potentially have produced income would be greater.

Withdrawal rates and tax considerations

When calculating a withdrawal rate, don’t forget the tax impact of those withdrawals. For example, your withdrawal rates may need to cover any taxes owed on that money. Depending on your strategy for providing income, you could owe capital gains taxes or ordinary income taxes. Also, if you are selling investments to maintain a uniform withdrawal rate, the tax impact of those sales could affect your withdrawal strategy. Minimizing the tax consequences of securities sales or withdrawals from tax-advantaged retirement savings plans could also help your portfolio last longer.

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Active vs. Passive Portfolio Management – by John Jastremski

One of the longest-standing debates in investing is over the relative merits of active portfolio management versus passive management. With an actively managed portfolio, a manager tries to beat the performance of a given benchmark index by using his or her judgment in selecting individual securities and deciding when to buy and sell them. A passively managed portfolio attempts to match that benchmark performance, and in the process, minimize expenses that can reduce an investor’s net return.

Each camp has strong advocates who argue that the advantages of its approach outweigh those for the opposite side.

Active investing: attempting to add value

Proponents of active management believe that by picking the right investments, taking advantage of market trends, and attempting to manage risk, a skilled investment manager can generate returns that outperform a benchmark index. For example, an active manager whose benchmark is the Standard & Poor’s 500 Index (S&P 500) might attempt to earn better-than-market returns by overweighting certain industries or individual securities, allocating more to those sectors than the index does. Or a manager might try to control a portfolio’s overall risk by temporarily increasing the percentage devoted to more conservative investments, such as cash alternatives.
An actively managed individual portfolio also permits its manager to take tax considerations into account. For example, a separately managed account can harvest capital losses to offset any capital gains realized by its owner, or time a sale to minimize any capital gains. An actively managed mutual fund can do the same on behalf of its collective shareholders.
However, an actively managed mutual fund’s investment objective will put some limits on its manager’s flexibility; for example, a fund may be required to maintain a certain percentage of its assets in a particular type of security. A fund’s prospectus will outline any such provisions, and you should read it before investing.

Passive investing: focusing on costs

Advocates of unmanaged, passive investing–sometimes referred to as indexing–have long argued that the best way to capture overall market returns is to use low-cost market-tracking index investments. This approach is based on the concept of the efficient market, which states that because all investors have access to all the necessary information about a company and its securities, it’s difficult if not impossible to gain an advantage over any other investor. As new information becomes available, market prices adjust in response to reflect a security’s true value. That market efficiency, proponents say, means that reducing investment costs is the key to improving net returns.
Indexing does create certain cost efficiencies. Because the investment simply reflects an index, no research is required for securities selection. Also, because trading is relatively infrequent–passively managed portfolios typically buy or sell securities only when the index itself changes–trading costs often are lower. Also, infrequent trading typically generates fewer capital gains distributions, which means relative tax efficiency.

Before investing in either an active or passive fund, carefully consider the investment objectives, risks, charges, and expenses, which can be found in the prospectus available from the fund. Read it carefully before investing. And remember that indexing–investing in a security based on a certain index–is not the same thing as investing directly in an index, which cannot be done.

Blending approaches with asset allocation

The core/satellite approach represents one way to employ both approaches. It is essentially an asset allocation model that seeks to resolve the debate about indexing versus active portfolio management. Instead of following one investment approach or the other, the core/satellite approach blends the two. The bulk, or “core,” of your investment dollars are kept in cost-efficient passive investments designed to capture market returns by tracking a specific benchmark. The balance of the portfolio is then invested in a series of “satellite” investments, in many cases actively managed, which typically have the potential to boost returns and lower overall portfolio risk.

Note: Bear in mind that no investment strategy can assure a profit or protect against losses.

Controlling investment costs

Devoting a portion rather than the majority of your portfolio to actively managed investments can allow you to minimize investment costs that may reduce returns.
For example, consider a hypothetical $400,000 portfolio that is 100% invested in actively managed mutual funds with an average expense level of 1.5%, which results in annual expenses of $6,000. If 70% of the portfolio were invested instead in a low-cost index fund or ETF with an average expense level of 0.25%, annual expenses on that portion of the portfolio would run $700 per year. If a series of satellite investments with expense ratios of 2% were used for the remaining 30% of the portfolio, annual expenses on the satellites would be $2,400. Total annual fees for both core and satellites would total $3,100, producing savings of $2,900 per year. Reinvested in the portfolio, that amount could increase its potential long-term growth. (This hypothetical portfolio is intended only as an illustration of the math involved rather than the results of any specific investment, of course.)
Popular core investments often track broad benchmarks such as the S&P 500, the Russell 2000® Index, the NASDAQ 100, and various international and bond indices. Other popular core investments may track specific style or market-capitalization benchmarks in order to provide a value versus growth bias or a market capitalization tilt.
While core holdings generally are chosen for their low-cost ability to closely track a specific benchmark, satellites are generally selected for their potential to add value, either by enhancing returns or by reducing portfolio risk. Here, too, you have many options. Good candidates for satellite investments include less efficient asset classes where the potential for active management to add value is increased. That is especially true for asset classes whose returns are not closely correlated with the core or with other satellite investments. Since it’s not uncommon for satellite investments to be more volatile than the core, it’s important to always view them within the context of the overall portfolio.

Tactical vs. strategic asset allocation

The idea behind the core-and-satellite approach to investing is somewhat similar to practicing both tactical and strategic asset allocation.

Strategic asset allocation is essentially a long-term approach. It takes into account your financial goals, your time horizon, your risk tolerance, and the historic returns for various asset classes in determining how your portfolio should be diversified among multiple asset classes. That allocation may shift gradually as your goals, financial situation, and time frame change, and you may refine it from time to time. However, periodic rebalancing tends to keep it relatively stable in the short term.

Tactical asset allocation, by contrast, tends to be more opportunistic. It attempts to take advantage of shifting market conditions by increasing the level of investment in asset classes that are expected to outperform in the shorter term, or in those the manager believes will reduce risk. Tactical asset allocation tends to be more responsive to immediate market movements and anticipated trends.

Though either strategic or tactical asset allocation can be used with an entire portfolio, some money managers like to establish a strategic allocation for the core of a portfolio, and practice tactical asset allocation with a smaller percentage.

Note: Asset allocation and diversification are methods used to help manage investment risk; they do not guarantee a profit or protect against investment loss.

 

Securities offered through FSC Securities Corporation, member FINRA / SIPC . Investment advisory services offered through The Retirement Group, LLC, a registered investment advisor which is not affiliated with FSC Securities Corp. Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, or legal advice. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.

 

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The Benefits of Tax-Advantaged Savings Vehicles – by John Jastremski

Taxes can take a big bite out of your total investment returns, so it’s helpful to look for tax-advantaged strategies when building a portfolio. But keep in mind that investment decisions shouldn’t be driven solely by tax considerations; other factors to consider include the potential risk, the expected rate of return, and the quality of the investment.

Tax-deferred and tax-free investments

Tax deferral is the process of delaying (but not necessarily eliminating) until a future year the payment of income taxes on income you earn in the current year. For example, the money you put into your traditional 401(k) retirement account isn’t taxed until you withdraw it, which might be 30 or 40 years down the road!

Tax deferral can be beneficial because:

  • The money you would have spent on taxes remains invested
  • You may be in a lower tax bracket when you make withdrawals from your accounts (for example, when you’re retired)
  • You can accumulate more dollars in your accounts due to compounding

Compounding means that your earnings become part of your underlying investment, and they in turn earn interest. In the early years of an investment, the benefit of compounding may not be that significant. But as the years go by, the long-term boost to your total return can be dramatic.

Taxes make a big difference

Let’s assume two people have $5,000 to invest every year for a period of 30 years. One person invests in a tax-free account like a Roth 401(k) that earns 6% per year, and the other person invests in a taxable account that also earns 6% each year. Assuming a tax rate of 28%, in 30 years the tax-free account will be worth $395,291, while the taxable account will be worth $295,896. That’s a difference of $99,395.

This hypothetical example is for illustrative purposes only, and its results are not representative of any specific investment or mix of investments. Actual results will vary. The taxable account balance assumes that earnings are taxed as ordinary income and does not reflect possible lower maximum tax rates on capital gains and dividends, as well as the tax treatment of investment losses, which would make the taxable investment return more favorable, thereby reducing the difference in performance between the accounts shown. Investment fees and expenses have not been deducted. If they had been, the results would have been lower. You should consider your personal investment horizon and income tax brackets, both current and anticipated, when making an investment decision as these may further impact the results of the comparison. This illustration assumes a fixed annual rate of return; the rate of return on your actual investment portfolio will be different, and will vary over time, according to actual market performance. This is particularly true for long-term investments. It is important to note that investments offering the potential for higher rates of return also involve a higher degree of risk to principal.

Tax-advantaged savings vehicles for retirement

One of the best ways to accumulate funds for retirement or any other investment objective is to use tax-advantaged (i.e., tax-deferred or tax-free) savings vehicles when appropriate.

  • Traditional IRAs – Anyone under age 70½ who earns income or is married to someone with earned income can contribute to an IRA. Depending upon your income and whether you’re covered by an employer-sponsored retirement plan, you may or may not be able to deduct your contributions to a traditional IRA, but your contributions always grow tax deferred. However, you’ll owe income taxes when you make a withdrawal.* You can contribute up to $5,500 (for 2016 and 2017) to an IRA, and individuals age 50 and older can contribute an additional $1,000 (for 2016 and 2017).
  • Roth IRAs – Roth IRAs are open only to individuals with incomes below certain limits. Your contributions are made with after-tax dollars but will grow tax deferred, and qualified distributions will be tax free when you withdraw them. The amount you can contribute is the same as for traditional IRAs. Total combined contributions to Roth and traditional IRAs can’t exceed $5,500 (for 2016 and 2017) for individuals under age 50.
  • SIMPLE IRAs and SIMPLE 401(k)s – These plans are generally associated with small businesses. As with traditional IRAs, your contributions grow tax deferred, but you’ll owe income taxes when you make a withdrawal.* You can contribute up to $12,500 (for 2016 and 2017) to one of these plans; individuals age 50 and older can contribute an additional $3,000 (for 2016 and 2017). (SIMPLE 401(k) plans can also allow Roth contributions.)
  • Employer-sponsored plans (401(k)s, 403(b)s, 457 plans) – Contributions to these types of plans grow tax deferred, but you’ll owe income taxes when you make a withdrawal.* You can contribute up to $18,000 (for 2016 and 2017) to one of these plans; individuals age 50 and older can contribute an additional $6,000 (for 2016 and 2017). Employers can generally allow employees to make after-tax Roth contributions, in which case qualifying distributions will be tax free.
  • Annuities – You pay money to an annuity issuer (an insurance company), and the issuer promises to pay principal and earnings back to you or your named beneficiary in the future (you’ll be subject to fees and expenses that you’ll need to understand and consider). Most annuities have surrender charges that are assessed if the contract owner surrenders the annuity. Annuities generally allow you to elect to receive an income stream for life (subject to the financial strength and claims-paying ability of the issuer). There’s no limit to how much you can invest, and your contributions grow tax deferred. However, you’ll owe income taxes on the earnings when you start receiving distributions.*

Tax-advantaged savings vehicles for college

For college, tax-advantaged savings vehicles include:

  • 529 plans – College savings plans and prepaid tuition plans let you set aside money for college that will grow tax deferred and be tax free at withdrawal at the federal level if the funds are used for qualified education expenses. These plans are open to anyone regardless of income level. Contribution limits are high–typically over $300,000–but vary by plan.
  • Coverdell education savings accounts – Coverdell accounts are open only to individuals with incomes below certain limits, but if you qualify, you can contribute up to $2,000 per year, per beneficiary. Your contributions will grow tax deferred and be tax free at withdrawal at the federal level if the funds are used for qualified education expenses.
  • Series EE bonds – The interest earned on Series EE savings bonds grows tax deferred. But if you meet income limits (and a few other requirements) at the time you redeem the bonds for college, the interest will be free from federal income tax too (it’s always exempt from state tax).

Note: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans. More information about specific 529 plans is available in each issuer’s official statement, which should be read carefully before investing. Also, before investing consider whether your state offers a 529 plan that provides residents with favorable state tax benefits. The availability of tax and other benefits may be conditioned on meeting certain requirements. There is also the risk that the investments may lose money or not perform well enough to cover college costs as anticipated. For withdrawals not used for qualified higher-education expenses, earnings may be subject to taxation as ordinary income and possibly a 10% federal income tax penalty.

The information in these materials may change at any time and without notice.Securities offered through FSC Securities Corporation, member FINRA / SIPC . Investment advisory services offered through The Retirement Group, LLC, a registered investment advisor which is not affiliated with FSC Securities Corp. Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, or legal advice. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. 

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Teach Your Children Well: Basic Financial Education – by John Jastremski

Even before your children can count, they already know something about money: it’s what you have to give the ice cream man to get a cone, or put in the slot to ride the rocket ship at the grocery store. So, as soon as your children begin to handle money, start teaching them how to handle it wisely.

Making allowances

Giving children allowances is a good way to begin teaching them how to save money and budget for the things they want. How much you give them depends in part on what you expect them to buy with it and how much you want them to save.
Some parents expect children to earn their allowance by doing household chores, while others attach no strings to the purse and expect children to pitch in simply because they live in the household. A compromise might be to give children small allowances coupled with opportunities to earn extra money by doing chores that fall outside their normal household responsibilities.
When it comes to giving children allowances:

  • Set parameters. Discuss with your children what they may use the money for and how much should be saved.
  • Make allowance day a routine, like payday. Give the same amount on the same day each week.
  • Consider “raises” for children who manage money well.

Take it to the bank

Piggy banks are a great way to start teaching children to save money, but opening a savings account in a “real” bank introduces them to the concepts of earning interest and the power of compounding.
While children might want to spend all their allowance now, encourage them (especially older children) to divide it up, allowing them to spend some immediately, while insisting they save some toward things they really want but can’t afford right away. Writing down each goal and the amount that must be saved each week toward it will help children learn the difference between short-term and long-term goals. As an incentive, you might want to offer to match whatever children save toward their long-term goals.

Shopping sense

Television commercials and peer pressure constantly tempt children to spend money. But children need guidance when it comes to making good buying decisions. Teach children how to compare items by price and quality. When you’re at the grocery store, for example, explain why you might buy a generic cereal instead of a name brand.
By explaining that you won’t buy them something every time you go to a store, you can lead children into thinking carefully about the purchases they do want to make. Then, consider setting aside one day a month when you will take children shopping for themselves. This encourages them to save for something they really want rather than buying on impulse. For “big-ticket” items, suggest that they might put the items on a birthday or holiday list.
Don’t be afraid to let children make mistakes. If a toy breaks soon after it’s purchased, or doesn’t turn out to be as much fun as seen on TV, eventually children will learn to make good choices even when you’re not there to give them advice.

Earning and handling income

Older children (especially teenagers) may earn income from part-time jobs after school or on weekends. Particularly if this money supplements any allowance you give them, wages enable children to get a greater taste of financial independence.
Earned income from part-time jobs might be subject to withholdings for FICA and federal and/or state income taxes. Show your children how this takes a bite out their paychecks and reduces the amount they have left over for their own use.

Creating a balanced budget

With greater financial independence should come greater fiscal responsibility. Older children may have more expenses, and their extra income can be used to cover at least some of those expenses. To ensure that they’ll have enough to make ends meet, help them prepare a budget.
To develop a balanced budget, children should first list all their income. Next, they should list routine expenses, such as pizza with friends, money for movies, and (for older children) gas for the car. (Don’t include things you will pay for.) Finally, subtract the expenses from the income. If they’ll be in the black, you can encourage further saving or contributions to their favorite charity. If the results show that your children will be in the red, however, you’ll need to come up with a plan to address the shortfall.
To help children learn about budgeting:

  • Devise a system for keeping track of what’s spent
  • Categorize expenses as needs (unavoidable) and wants (can be cut)
  • Suggest ways to increase income and/or reduce expenses

The future is now

Teenagers should be ready to focus on saving for larger goals (e.g., a new computer or a car) and longer-term goals (e.g., college, an apartment). And while bank accounts may still be the primary savings vehicles for them, you might also want to consider introducing your teenagers to the principles of investing.
To do this, open investment accounts for them. (If they’re minors, these must be custodial accounts.) Look for accounts that can be opened with low initial contributions at institutions that supply educational materials about basic investment terms and concepts.
Helping older children learn about topics such as risk tolerance, time horizons, market volatility, and asset diversification may predispose them to take charge of their financial future.

Should you give your child credit?

If older children (especially those about to go off to college) are responsible, you may be thinking about getting them a credit card. However, credit card companies cannot issue cards to anyone under 21 unless they can show proof they can repay the debt themselves, or unless an adult cosigns the credit card agreement. If you decide to cosign, keep in mind that you’re taking on legal liability for the debt, and the debt will appear on your credit report.
Also:

  • Set limits on the card’s use
  • Ask the credit card company for a low credit limit (e.g., $300) or a secured card to help children learn to manage credit without getting into serious debt
  • Make sure children understand the grace period, fee structure, and how interest accrues on the unpaid balance
  • Agree on how the bill will be paid, and what will happen if the bill goes unpaid
  • Make sure children understand how long it takes to pay off a credit card balance if they only make minimum payments

If putting a credit card in your child’s hands is a scary thought, you may want to start off with a prepaid spending card. A prepaid spending card looks like a credit card, but functions more like a prepaid phone card. The card can be loaded with a predetermined amount that you specify, and generally may be used anywhere credit cards are accepted. Purchases are deducted from the card’s balance, and you can transfer more money to the card’s balance whenever necessary. Although there may be some fees associated with the card, no debt or interest charges accrue; children can only spend what’s loaded onto the card.
One thing you might especially like about prepaid spending cards is that they allow children to gradually get the hang of using credit responsibly. Because you can access the account information online or over the phone, you can monitor the spending habits of your children. If need be, you can then sit down with them and discuss their spending behavior and money management skills.

 

NoteThe Consumer Financial Protection Bureau’s mortgage rules restrict certain interest-only mortgage loans and loans that result in negative amortization.

Securities offered through FSC Securities Corporation, member FINRA / SIPC . Investment advisory services offered through The Retirement Group, LLC, a registered investment advisor which is not affiliated with FSC Securities Corp. Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, or legal advice. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.

 

 

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How Secure Is Social Security? – by John Jastremski

If you’re retired or close to retiring, then you’ve probably got nothing to worry about–your Social Security benefits will likely be paid to you in the amount you’ve planned on (at least that’s what most of the politicians say). But what about the rest of us?

The media onslaught

Watching the news, listening to the radio, or reading the newspaper, you’ve probably come across story after story on the health of Social Security. And, depending on the actuarial assumptions used and the political slant, Social Security has been described as everything from a program in need of some adjustments to one in crisis requiring immediate, drastic reform.
Obviously, the underlying assumptions used can affect one’s perception of the solvency of Social Security, but it’s clear some action needs to be taken. However, even experts disagree on the best remedy. So let’s take a look at what we do know.

Just the facts

According to the Social Security Administration (SSA), over 60 million Americans currently collect some sort of Social Security retirement, disability or death benefit. Social Security is a pay-as-you-go system, with today’s workers paying the benefits for today’s retirees. (Source: Fast Facts & Figures About Social Security, 2016)
How much do today’s workers pay? Well, the first $127,200 (in 2017) of an individual’s annual wages is subject to a Social Security payroll tax, with half being paid by the employee and half by the employer (self-employed individuals pay all of it). Payroll taxes collected are put into the Social Security trust funds and invested in securities guaranteed by the federal government. The funds are then used to pay out current benefits.
The amount of your retirement benefit is based on your average earnings over your working career. Higher lifetime earnings result in higher benefits, so if you have some years of no earnings or low earnings, your benefit amount may be lower than if you had worked steadily.
Your age at the time you start receiving benefits also affects your benefit amount. Currently, the full retirement age is in the process of rising to 67 in two-month increments, as shown in the following chart:

Birth Year Full Retirement Age
1943-1954 66
1955 66 and 2 months
1956 66 and 4 months
1957 66 and 6 months
1958 66 and 8 months
1959 66 and 10 months
1960 and later 67

If you were born on January 1 of any year, refer to the previous year to determine your full retirement age.

You can begin receiving Social Security benefits before your full retirement age, as early as age 62. However, if you retire early, your Social Security benefit will be less than if you had waited until your full retirement age to begin receiving benefits. Specifically, your retirement benefit will be reduced by 5/9ths of 1 percent for every month between your retirement date and your full retirement age, up to 36 months, then by 5/12ths of 1 percent thereafter. For example, if your full retirement age is 67, you’ll receive about 30 percent less if you retire at age 62 than if you wait until age 67 to retire. This reduction is permanent–you won’t be eligible for a benefit increase once you reach full retirement age.

Demographic trends

Even those on opposite sides of the political spectrum can agree that demographic factors are exacerbating Social Security’s problems–namely, life expectancy is increasing and the birth rate is decreasing. This means that over time, fewer workers will have to support more retirees.
According to the SSA, Social Security is already paying out more money than it takes in. However, by drawing on the Social Security trust fund (OASI), the SSA estimates that Social Security should be able to pay 100% of scheduled benefits until fund reserves are depleted in 2035. Once the trust fund reserves are depleted, payroll tax revenue alone should still be sufficient to pay about 77% of scheduled benefits. This means that in 2035, if no changes are made, beneficiaries may receive a benefit that is about 23% less than expected. (Source: 2016 OASDI Trustees Report)

Possible fixes

While no one can say for sure what will happen (and the political process is sure to be contentious), here are some solutions that have been proposed to help keep Social Security solvent for many years to come:

  • Allow individuals to invest some of their current Social Security taxes in “personal retirement accounts”
  • Raise the current payroll tax
  • Raise the current ceiling on wages currently subject to the payroll tax
  • Raise the retirement age beyond age 67
  • Reduce future benefits, especially for wealthy retirees
  • Change the benefit formula that is used to calculate benefits
  • Change how the annual cost-of-living adjustment for benefits is calculated

Uncertain outcome

Members of Congress and the President still support efforts to reform Social Security, but progress on the issue has been slow. However, the SSA continues to urge all parties to address the issue sooner rather than later, to allow for a gradual phasing in of any necessary changes.
Although debate will continue on this polarizing topic, there are no easy answers, and the final outcome for this decades-old program is still uncertain.

In the meantime, what can you do?

The financial outlook for Social Security depends on a number of demographic and economic assumptions that can change over time, so any action that might be taken and who might be affected are still unclear. But no matter what the future holds for Social Security, your financial future is still in your hands. Focus on saving as much for retirement as possible, and consider various income scenarios when planning for retirement.

It’s also important to understand your benefits, and what you can expect to receive from Social Security based on current law. You can find this information on your Social Security Statement, which you can access online at the Social Security website, socialsecurity.gov by signing up for a my Social Security account. Your statement contains a detailed record of your earnings, and includes retirement, disability, and survivor’s benefit estimates that are based on your actual earnings and projections of future earnings. If you’re not registered for an online account and are not yet receiving benefits, you’ll receive a statement in the mail every five years, from age 25 to age 60, and then annually thereafter.

 

 

Securities offered through FSC Securities Corporation, member FINRA / SIPC . Investment advisory services offered through The Retirement Group, LLC, a registered investment advisor which is not affiliated with FSC Securities Corp. Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, or legal advice. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.

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Irrevocable Life Insurance Trust (ILIT) – by John Jastremski

One of the main reasons we buy life insurance is so that when we die, our loved ones will have enough money to pay off our remaining debts and final expenses. We also purchase life insurance to provide for our loved ones’ future living expenses, at least for a while. That’s why it may seem unfair that life insurance proceeds can be reduced by estate taxes. That’s right–the general rule is that life insurance proceeds are subject to federal estate tax (and, depending on your state’s laws, state estate tax as well). This means that as much as 40% (currently the highest estate tax rate) of your life insurance proceeds could be going to Uncle Sam instead of to your family as you intend. Fortunately, proper planning can help protect your family’s financial security.

The key is ownership

Generally, all the property you own at your death is subject to federal estate tax. The important point here is that estate tax is imposed only on property in which you have an ownership interest; so if you don’t own your life insurance, the proceeds will generally avoid this tax. This begs the question: Who should own your life insurance instead? For many, the answer is an irrevocable life insurance trust, or ILIT (pronounced “eye-lit”).

What is an ILIT?

An ILIT is a trust primarily set up to hold one or more life insurance policies. The main purpose of an ILIT is to avoid federal estate tax. If the trust is drafted and funded properly, your loved ones should receive all of your life insurance proceeds, undiminished by estate tax.

How an ILIT works

Because an ILIT is an irrevocable trust, it is considered a separate entity. If your life insurance policy is held by the ILIT, you don’t own the policy–the trust does.
You name the ILIT as the beneficiary of your life insurance policy. (Your family will ultimately receive the proceeds because they will be the named beneficiaries of the ILIT.) This way, there is no danger that the proceeds will end up in your estate. This could happen, for example, if the named beneficiary of your policy was an individual who dies, and then you die before you have a chance to name another beneficiary.
Because you don’t own the policy and your estate will not be the beneficiary of the proceeds, your life insurance will escape estate taxation.

Because an ILIT must be irrevocable, once you sign the trust agreement, you can’t change your mind; you can’t end the trust or change its terms.

Creating an ILIT

Your first step is to draft and execute an ILIT agreement. Because precise drafting is essential, you should hire an experienced attorney. Although you’ll have to pay the attorney’s fee, the potential estate tax savings should more than outweigh this cost.

Naming the trustee

The trustee is the person who is responsible for administering the trust. You should select the trustee carefully. Neither you nor your spouse should act as trustee, as this might result in the life insurance proceeds being drawn back into your estate. Select someone who can understand the purpose of the trust, and who is willing and able to perform the trustee’s duties. A professional trustee, such as a bank or trust company, may be a good choice.

Funding an ILIT

An ILIT can be funded in one of two ways:

  1. Transfer an existing policy–You can transfer your existing policy to the trust, but be forewarned that under federal tax rules, you’ll have to wait three years for the ILIT to be effective. This means that if you die within three years of the transfer, the proceeds will be subject to estate tax. Your age and health should be considered when deciding whether to take this risk.
  2. Buy a new policy–To avoid the three-year rule explained above, you can have the trustee, on behalf of the trust, buy a new policy on your life. You can’t make this purchase yourself; you must transfer money to the trust and let the trustee pay the initial premium. Then, as future annual premiums come due, you continue to make transfers to the trust, and the trustee continues to make the payments to the insurance company to keep the policy in force.

Gift tax consequences

Because an ILIT is irrevocable, any cash transfers you make to the trust are considered taxable gifts. However, if the trust is created and administered appropriately, transfers of $14,000 or less per trust beneficiary will be free from federal gift tax under the annual gift tax exclusion.
Additionally, each of us has a gift and estate tax applicable exclusion amount, so transfers that do not fall under the annual gift tax exclusion will be free from gift tax to the extent of your available applicable exclusion. The gift and estate tax applicable exclusion amount is equal to the basic exclusion amount of $5,490,000 (in 2017, $5,450,000 in 2016) plus any applicable deceased spousal unused exclusion amount. Both the annual exclusion and the basic exclusion amount are indexed for inflation and may change in future years.

Crummey withdrawal rights

Generally, a gift must be a present interest gift in order to qualify for the annual gift tax exclusion. Gifts made to an irrevocable trust, like an ILIT, are usually considered gifts of future interests and do not qualify for the exclusion unless they fall within an exception. One such exception is when the trust beneficiaries are given the right to demand, for a limited period of time, any amounts transferred to the trust. This is referred to as Crummey withdrawal rights or powers. To qualify your cash transfers to the ILIT for the annual gift tax exclusion, you must give the trust beneficiaries this right.

The trust beneficiaries must also be given actual written notice of their rights to withdraw whenever you transfer funds to the ILIT, and they must be given reasonable time to exercise their rights (30 to 60 days is typical). It’s the duty of the trustee to provide notice to each beneficiary.

Of course, so as not to defeat the purpose of the trust, the trust beneficiaries should not actually exercise their Crummey withdrawal rights, but should let their rights lapse.

The key duties of an ILIT trustee include:

  • Opening and maintaining a trust checking account
  • Obtaining a taxpayer identification number for the trust entity, if necessary
  • Applying for and purchasing life insurance policies
  • Accepting funds from the grantor
  • Sending Crummey withdrawal notices
  • Paying premiums to the insurance company
  • Making investment decisions
  • Filing tax returns, if necessary
  • Claiming insurance proceeds at your death
  • Distributing trust assets according to the terms of the trust

 

Securities offered through FSC Securities Corporation, member FINRA / SIPC . Investment advisory services offered through The Retirement Group, LLC, a registered investment advisor which is not affiliated with FSC Securities Corp. Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, or legal advice. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.  The information in these materials may change at any time and without notice.These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials.

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Credit Shelter Trust- by John Jastremski

Credit Shelter Trust
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What is a credit shelter trust?

A credit shelter trust (also called a B trust, family trust, or bypass trust) is an irrevocable trust typically used by a married couple to minimize federal estate taxes on their combined estates.

How does a credit shelter trust work?

Prior to 2011, individuals could only use the estate tax exemption that was allotted to him or her, and any unused exemption would be lost. A married couple could fully use their respective exemptions by splitting a spouse’s estate into a marital portion and credit shelter portion (this type of planning is often referred to as A/B trust planning). Here’s how it works:
A credit shelter trust is funded with assets sufficient to fully utilize the exemption of the first spouse to die. The trust can be funded during the spouses’ lifetimes or at the death of the first spouse to die.
The surviving spouse is given restricted access to and control over the assets in the trust. If the surviving spouse is given unrestricted access to and control over the assets in the trust, the assets would be included in his or her estate when he or she dies (which would have negated the sheltering purpose of the trust). The surviving spouse can receive:

  • All annual income earned by the trust
  • The annual, but non-cumulative right to withdraw the greater of $5,000 or 5% of the trust principal, for any reason
  • The right to invade the trust principal if necessary for his or her health, education, support, and maintenance (referred to as the “ascertainable standards”)

The surviving spouse can also be given a power to appoint all or any of the assets in the trust to a limited class of beneficiaries excluding himself or herself, his or her creditors, his or her estate, or the creditors of his or her estate (this is called a “special” or “limited power of appointment”). The surviving spouse can appoint the assets in the trust to the specified beneficiaries in any proportion that he or she desires. This allows the surviving spouse to appoint the assets to the beneficiaries who need the assets the most.

Bypass trusts can be funded using a formula or a disclaimer. If a disclaimer is used, the trust document should not include a special power of appointment provision.

The surviving spouse can also serve as trustee.

In some cases, it may be better to have other family members or a professional (e.g., a bank) serve as trustee, either alone or with the surviving spouse. A neutral trustee is especially appropriate in second marriages.

When the surviving spouse dies, the remaining assets in the trust pass estate tax free to the beneficiaries as named by the first spouse to die in the trust document, or as appointed by the surviving spouse.

If the trust will continue after the surviving spouse dies, the trust document may need to name a successor trustee, and the trust terms must comply with the rule against perpetuities.

An experienced attorney should draft the trust document because if it is not precisely drafted the trust may be deemed invalid.

Different rules apply to non-U.S. citizens.

The 2010 and 2012 Tax Acts allow the executor of a deceased spouse’s estate to transfer any unused estate tax exemption to the surviving spouse without the use of a credit shelter trust. The executor of the first deceased spouse’s estate must file an estate tax return on a timely basis and make an election to permit the surviving spouse to use the deceased spouse’s unused exemption.

Credit Shelter Trust Illustration

Suitable clients

  • Spouses with combined assets that exceed the estate tax exemption, which is $5,490,000 (in 2017, $5,450,000 in 2016 — double these amounts for a married couple).

Example

John and Mary are a married couple who own $9,860,000 in assets in 2017. Assume the basic exclusion amount is $5,490,000 and the top estate tax rate is 40%. The basic exclusion amount is assumed to increase by 2% annually (with appropriate adjustments for indexing and rounding applied to projections of the exclusion below), the estate assets are assumed to grow 4% annually, and Mary is assumed to die 10 years after John.
If John dies leaving everything to Mary, there will be no federal estate taxes due because, generally, the law allows an unlimited amount of property to pass to a spouse free of estate taxes. John’s estate elects to pass his unused $5,490,000 exclusion to Mary. Mary can live off the earnings of the entire $9,860,000 estate. When Mary dies, her entire estate will pass to their children. When Mary dies 10 years later, Mary’s estate will have grown to $14,595,209 and her basic exclusion amount will have increased to $6,700,000. Mary’s applicable exclusion equals $12,190,000 ($6,700,000 + John’s unused $5,490,000 exclusion). The excess of Mary’s estate over Mary’s applicable exclusion is subject to taxes. That means that $962,083 would have gone to the IRS and $13,633,125 would have gone to John and Mary’s children (assuming no other variables). Taxes would consume 6.6% of their combined estates.
Now, let’s say that John executed a will leaving an amount equal to his available exemption to a credit shelter trust, and the rest of his estate to Mary. Say John’s gross estate was $6 million. $5,490,000 passed to the trust tax free under John’s exemption, and $510,000 passed directly to Mary tax free under the unlimited marital deduction. Mary can live off the earnings of her $4,370,000 estate ($3,860,000 plus $510,000), and can also access the income earned by the trust, as well as the principal of the trust to the extent she needs it for her health, education, maintenance, and support.
If Mary died 10 years later, Mary’s estate will have grown to $6,468,668 and her basic exclusion amount will have increased to $6,700,000; the assets in the trust, which have grown to $8,126,541, would not have been included in her gross estate. John and Mary’s children would have received the entire corpus of the trust. Of Mary’s $6,468,668 estate, all of it would have passed to their children tax free under Mary’s exemption, and nothing would have passed subject to tax. That results in $0 that would have gone to the IRS and $6,468,668 that would have gone to John and Mary’s children. When their estates are combined, the children would have received $14,595,209. Taxes would consume 0% of the combined estates. By using a credit shelter trust, John and Mary’s children would have received an additional $962,083 of their parents’ estates that the IRS would have received had the trust not been used.

If John didn’t want the property to go outright to Mary, John could leave the residuary estate to a marital trust instead, naming Mary as the primary beneficiary. When a credit shelter trust is used in conjunction with a marital trust, the arrangement is usually called an A/B trust arrangement.

Calculations

Without Credit Shelter Trust
Mary’s Taxable Estate $14,595,209
Tentative Federal Estate Tax $5,783,883
- Unified Credit $4,821,800
Federal Estate Tax $962,083
***
Mary’s Estate $14,595,209
- Federal Estate Tax $962,083
Mary’s Net Estate $13,633,125
+ John’s Net Estate $0
Combined Net Estate $13,633,125
With Credit Shelter Trust
Mary’s Taxable Estate $6,468,668
Tentative Federal Estate Tax $2,533,267
- Unified Credit $2,533,267
Federal Estate Tax $0
***
Mary’s Estate $6,468,668
- Federal Estate Tax $0
Mary’s Net Estate $6,468,668
+ John’s Net Estate $8,126,541
Combined Net Estate $14,595,209
Net Estates
With Credit Shelter Trust $14,595,209
Without Credit Shelter Trust $13,633,125
Difference $962,083

Advantages

Achieves tax goal while giving surviving spouse maximum access to and control over trust assets

With this type of trust, if the children of the marriage are minors or have special needs, or if the surviving spouse were to otherwise need the money, he or she would be able to access the property that passes to the trust under the deceased spouse’s exemption (although access would be limited, see Disadvantages).

Preserves assets for descendants

Because assets that fund the credit shelter trust bypass the surviving spouse’s estate, they are preserved for the ultimate intended beneficiaries. This can be especially attractive when there are children from a previous marriage.

Protects assets from future creditor claims

Because a bypass trust is irrevocable, future creditors of the beneficiaries (the surviving spouse or the children) will be unable to reach the assets while they are in the trust. So, this strategy also works well if the children are adults and the parents don’t want them to own property outright for some reason. If this is the case, a spendthrift provision should be included in the trust agreement.

Disadvantages

Surviving spouse’s access to the credit shelter trust must be restricted

The deceased spouse can give the surviving spouse access to all, a portion, or none of the income from the credit shelter trust. If access to principal is allowed, it must be limited to health, education, maintenance, or support only. Health, education, maintenance, and support, or “HEMS”, are four magic words used by the IRS, and there’s some guidance about what they mean, but the surviving spouse will have to be careful when withdrawing principal to make sure the money’s use will fall within these parameters.

Adds complexity to the surviving spouse’s life

If the surviving spouse is trustee, he or she will have to maintain separate records for the trust, and ensure that he or she does not overstep the trustee’s powers. If a neutral trustee is used, the surviving spouse will have to cooperate with the trustee.

Impact of portability

For the estates of persons dying in 2011 or later, the executor may transfer any unused estate tax exemption to the surviving spouse.While this portability has some appeal, it also has issues:

  • In the case of multiple marriages, only the most recent deceased spouse’s unused exemption may be used by the surviving spouse.
  • Although the estate tax exemption is portable, the GST exemption is not. Couples seeking to create trusts for the benefit of their children and more remote descendants cannot take advantage of portability because the first spouse’s GST exemption cannot be transferred to the second spouse.
  • Any unused exemption is not indexed for inflation. As a result, if the assets transferred to the surviving spouse appreciate, the appreciation may be subject to estate taxation at the surviving spouse’s death.
  • Assets passing directly to an individual are subject to the claims of creditors, as explained above (see Advantages).
  • The executor must make an election on a timely filed estate tax return. Such an election, once made, is irrevocable.

The information in these materials may change at any time and without notice.Securities offered through FSC Securities Corporation, member FINRA / SIPC . Investment advisory services offered through The Retirement Group, LLC, a registered investment advisor which is not affiliated with FSC Securities Corp. Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, or legal advice. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials.

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Donor-Advised Fund-by John Jastresmki

What is a donor-advised fund?

Technically, a donor-advised fund is an agreement between a donor and a host organization (the fund) that gives the donor the right to advise the fund on how the donor’s contributions will be invested and how grants to charities (grantees) will be made. Contributions may be tax deductible in the year they are paid to the fund, subject to the usual limitations, if they are structured so they aren’t considered earmarked for a particular grantee. Though they can bear the donor’s name, donor-advised funds are not operated as separate entities like private foundations are, but are merely accounts held by the fund. The fund owns the contributions and has ultimate control over grants.

Donor-Advised Fund Illustration

The community foundation was the first type of host organization to offer donor-advised funds but, today, many financial institutions offer them, and many public charities have funds or will create a fund upon request.

How does a donor-advised fund work?

It’s easy to set up a fund account. The donor first signs a letter of understanding with the fund, establishes an account, names the account, and recommends an investment strategy. Then, the donor makes required minimum contributions of assets, which may include cash, marketable securities, and other types of assets, depending on the fund. The required minimum contributions vary from fund to fund, but are usually less than those required by private foundations.
During life, the donor (or the donor’s designee) can make ongoing, non-binding recommendations to the fund as to how much, when, and to which charities grants from the fund should be made. Additionally, the donor can offer advice to the fund regarding how contributions should be invested. The donor may suggest that, upon death, grants be made to charities named in his or her will or other legal instrument such as a revocable living trust. Or, the donor may designate a surviving family member(s) to recommend grants. However, the fund is not obligated to follow any of the donor’s suggestions–hence the name “donor-advised fund.” As a practical matter, though, the fund will generally follow a donor’s wishes. Distributions to grantees are typically identified as being made from a specific donor’s account, but they can be made anonymously at the donor’s request.

Donor-advised funds vs. private foundations

Both private foundations and donor-advised funds allow a person to take tax deductions now and decide later to whom to give. Both donor-advised funds and private foundations can be named to honor the donor, a family member, or other person.
A donor-advised fund usually receives contributions from many unrelated donors (though donors’ accounts are kept separate), while a private foundation is typically funded by one source (an individual, family, or corporation). While donors to a donor-advised fund may only offer advice regarding grants and investments, private foundations offer the donor exclusive control and direction over grants and investments, an attractive feature to some philanthropists.
However, various legal restrictions imposed on private foundations are not imposed on donor-advised funds, and the federal income tax treatment of a donation to a private foundation is less favorable than that afforded to a donor-advised fund. Because contributions to a donor-advised fund are considered gifts to a “public charity,” they may allow a greater income tax deduction than contributions to a private foundation. Furthermore, private foundations are required to distribute a minimum of 5% of their assets each year. Donor-advised funds have no such minimum distribution requirement (though some funds follow the 5% rule voluntarily), and donors may be allowed to let their accounts build up tax free for many years and be distributed only upon a specified date or upon the occurrence of a specified event.
Also, donor-advised funds do not need to fulfill many of the reporting and filing requirements that are imposed on private foundations. And because the fund handles any legal, administrative, and filing requirements (including tax returns), the donor is completely freed from these responsibilities. In addition, since separate accounts within a donor-advised fund are administered as part of the larger host organization, the administrative costs borne by the donor are generally lower than those incurred by a private foundation.

Endowed funds vs. non-endowed funds

Endowed funds only distribute income, not principal. These funds invest a donor’s assets in perpetuity for potential growth over time. Because they are permanent, endowed funds provide a lasting memory of the donor’s philanthropic nature.
Non-endowed funds permit a donor to make ongoing recommendations for grants up to the entire fund balance (principal and income). Such funds remain non-endowed, unless the donor specifies otherwise, until such time as the donor or the donor’s designees are no longer providing advice to the fund.

Income taxes

A donor can generally take an immediate income tax deduction for contributions of money or property to–or for the use of–a donor-advised fund if the donor itemizes deductions on his or her federal income tax return. The amount of the deduction depends on several factors, including the amount of the contribution, the type of property donated, and the donor’s adjusted gross income (AGI). Generally, deductions are limited to 50 percent of the donor’s AGI. If the donor makes a gift of long-term capital gain property (such as appreciated stock that has been held for longer than one year), the deduction is limited to 30 percent of the donor’s AGI. The fair market value of the property on the date of the donation is used to determine the amount of the charitable deduction. Any amount that cannot be deducted in the current year can be carried over and deducted for up to five succeeding years.
Additionally, donor-advised funds are not subject to the excise taxes levied against private foundations.

Gift and estate taxes

There are no federal gift tax consequences because of the charitable gift tax deduction, and federal estate tax liability is minimized with every contribution since donated funds are removed from the donor’s taxable estate.

Suitable clients

  • High-net-worth individuals
  • Individuals who have no children or ultimate beneficiaries
  • Individuals who do not want to leave too much money to their children
  • Individuals who do not want to be actively involved in the ongoing operations of their charitable plan
  • Individuals with highly appreciated assets

Example

Harry, Wilma, and their children own a business that has enjoyed financial success for many years. Harry and Wilma show their appreciation to their customers by making donations each year to many of their community’s charities. Harry and Wilma would like to continue the family legacy for successive generations, but no longer want the year-end stress of selecting the charities they want to support and distributing checks.
Harry and Wilma set up a donor-advised fund with a community foundation and donate half of their shares in the business along with an investment account. To open the donor-advised fund account, Harry and Wilma simply completed the host community foundation’s 3-page application form. Within a few hours, Harry and Wilma delivered the shares to the fund, and a short time later, their investment account was electronically transferred to the fund. Harry and Wilma incurred no legal or accounting fees for the set up.
Because of the host community foundation’s charitable status, Harry and Wilma can take an immediate income tax deduction for the fair market value of their shares and investment account. If Harry and Wilma had created a private foundation instead, their deduction would have been limited to their cost basis in the donated assets.
The fund subsequently sells the donated shares with no capital gains tax liability. The assets in the fund appreciate tax free, and when Harry and Wilma die, the assets will not be subject to estate taxes.
The fund will handle all the bookkeeping and tax reporting, make the ongoing investment decisions, and assume fiduciary responsibilities. Harry and Wilma can put their time and effort into running their business.
From time to time, Harry and Wilma recommend to the fund that grants be made to their favorite charities. The fund follows their recommendations whenever it is appropriate to do so, and makes the grants in Harry and Wilma’s names, and sometimes in Harry and Wilma’s children’s names.
Harry and Wilma name their children as successor advisors after they die.

Advantages

  • Lower contribution minimums (e.g., $10,000), easier and less costly to set up and maintain than private foundations or supporting organizations
  • Some involvement in grantmaking
  • Donors can obtain expert advice on grantmaking
  • Donors may receive immediate income tax deductions
  • Can reduce or eliminate capital gains, gift, and estate taxes
  • No excise tax or payout requirements
  • Accounts can be personalized or donors can give anonymously
  • Accounts may be transferable to the next generation

Disadvantages

  • Contributions are irrevocable
  • Lack of control over investments and grants; investment options may be limited
  • Grants may be limited geographically to a particular state or community, or by the fund’s charitable mission
  • Assets that pass to charity do not pass to heirs
  • Duration of donor’s philanthropy may be limited

Securities offered through FSC Securities Corporation, member FINRA / SIPC . Investment advisory services offered through The Retirement Group, LLC, a registered investment advisor which is not affiliated with FSC Securities Corp. Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, or legal advice. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice

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Dynasty Trustby – by John Jastresmki

What is a dynasty trust?

Each time one taxpayer transfers wealth to another, the transfer is potentially subject to federal transfer taxes, including gift and estate tax. The federal transfer tax system is designed to impose a tax on each and every generation (e.g., father to son, son to grandson, etc.). The transfer tax system accounts for the fact that a transfer might “skip” a generation by passing from parent to grandchild, for example. This is accomplished by imposing an additional tax whenever transfers of wealth are made to persons who are more than one generation below the taxpayer (e.g., father to grandson). This additional tax is called the generation-skipping transfer (GST) tax. GST tax is imposed at the highest estate tax rate in effect at the time of the transfer.

Additionally, most of the individual states impose their own transfer taxes. Together, these taxes can take an enormous bite whenever wealth is being handed down, and eventually eat away a family’s fortune. This can be troublesome to individuals with substantial wealth who would prefer to have their legacies benefit their own family members. It’s from these circumstances that the dynasty trust evolved.

A dynasty trust is created to provide for future generations while minimizing overall transfer taxes. With a dynasty trust, a taxpayer transfers assets to the trust. This transfer, from the taxpayer (the grantor) to the trust, is potentially subject to transfer taxes (although the taxpayer may use his or her exemption amounts to shield the transfer from tax). The trust then provides for future generations for as long as it exists. Although the trust assets effectively move from generation to generation, there are no corresponding transfer tax consequences.

How does a dynasty trust work?

Structuring the trust to last for generations

At one time, the laws of all 50 states prohibited a trust from lasting beyond 21 years after the death of the last beneficiary alive at the time the trust was created. This rule against perpetuities has been modified or abolished in many states. A trust created in one of those jurisdictions can be structured to last for many generations. Even in states that still maintain the rule, a trust can be created that will last for a substantial period of time.

Leveraging tax advantages

Although assets will be subject to transfer taxes when initially funding the trust, the assets (and subsequent appreciation) will be untouched by transfer taxes for as long as they remain in the trust.
Typically, dynasty trusts are funded with amounts that take full advantage of the grantor’s transfer tax exemptions. The federal gift and estate tax exemption equivalent amount is $5,490,000 (in 2017, $5,450,000 in 2016), and the GST tax exemption is also $5,490,000 (in 2017, $5,450,000 in 2016). These amounts can be doubled if both spouses are funding the trust. Though dynasty trusts can be created at death through a will or living trust, it may be more advantageous to create this type of trust during the grantor’s life because, if planned properly, the trust can continue to be funded transfer tax free with annual exclusion gifts (currently $14,000 per trust beneficiary).

As this type of trust is taxed more heavily on income, it may be more advantageous to fund the trust with non-income-producing property, such as growth stocks, tax-exempt bonds, and cash value life insurance. Other appropriate assets might include real estate, discounted property, and property expected to highly appreciate.

Protecting and preserving principal

To enjoy the tax benefits summarized above, access to trust property by the beneficiaries must be limited. The grantor can decide how narrow or broad the beneficiary’s access will be within those limits. For example, a grantor who wishes to give a beneficiary as much control as possible can name the beneficiary as trustee, and give the beneficiary the right to all income and the right to consume principal limited by the ascertainable standards (i.e., health, education, maintenance and support). The beneficiary can be given even more control by granting a special (or limited) testamentary power of appointment (i.e., the power to name successive beneficiaries, but not to himself/herself, his/her creditors, his/her estate, or the creditors of his/her estate).

Dynasty Trust Illustration

On the other hand, a grantor who wants to restrict access to the trust as much as possible can name an independent trustee who has sole discretion over distributions coupled with a spendthrift provision. The trustee will have full authority to distribute or not distribute income or principal to the beneficiary as the trustee deems appropriate. The spendthrift provision will prevent the beneficiary from voluntarily or involuntarily transferring his or her interest to another before actually receiving a distribution.
The greater the restrictions, the less likely creditors or other claimants will be able to reach trust property.

Suitable clients

  • High net worth individuals
  • Individuals with family heirloom assets (e.g., vacation home or jewelry) or who desire to keep assets within the family for more than one generation

Example

John and Mary, a married couple, own property with a net value of $10 million, which they would like to pass on to their children and future generations. John and Mary’s financial planner describes the following three scenarios:

  • Scenario 1 –John and Mary leave $10 million outright to their two children.
  • Scenario 2 –John and Mary leave $10 million to a trust for the benefit of their two children and then distributed to grandchildren.
  • Scenario 3 –John and Mary leave $10 million to a dynasty trust created in a state that has no rule against perpetuities.

Assume that a generation is 26 years, the estate and GSTT exemptions are $5,490,000, the estate tax rate is 40%, the growth rate is 7%, principal is not spent, and state variables and income taxes are ignored.
In scenario 1, $10 million passes to John and Mary’s children free from estate taxes. In 26 years, the money grows to approximately $58 million, but after estate taxes are deducted, John and Mary’s grandchildren receive approximately $39 million.
In scenario 2, $10 million passes to the trust free from estate taxes. In 26 years, the money grows to approximately $58 million and is distributed to John and Mary’s grandchildren.
In scenario 3, $10 million passes to the dynasty trust free from estate taxes. In 26 years, the money grows to approximately $58 million. 26 years later, the money grows to approximately $337 million that can provide benefits to John and Mary’s great-grandchildren and beyond.
Of course, this is a hypothetical illustration only, and is not indicative of any specific investment.

Advantages

  • Can be structured to preserve family wealth for generations
  • Minimizes transfer taxes
  • Can be structured to protect assets from spendthrift beneficiaries, spousal divorce claims, and unforeseen creditors and claimants

Disadvantages

  • Trust is irrevocable
  • Leaves future generations with limited flexibility to manage changes in circumstances

 

 

Securities offered through FSC Securities Corporation, member FINRA / SIPC . Investment advisory services offered through The Retirement Group, LLC, a registered investment advisor which is not affiliated with FSC Securities Corp. Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, or legal advice. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice

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Financial Basics for Millennials – by John Jastremski

With age comes responsibility, so if you’re a young adult in your 20s or 30s, chances are you’ve been introduced to the realities of adulthood. While you’re excited by all the opportunities life has to offer, you’re also aware of your emerging financial responsibility. In the financial realm, the millennial generation (young adults born between 1981 and 1997) faces a unique set of challenges, including a competitive job market and significant student loan debt that can make it difficult to obtain financial stability.

Poor money management can lead to debt, stress, and dependency on others. Fortunately, good money management skills can make it easier for you to accomplish your personal goals. Become familiar with the basics of planning now, and your future self will thank you for being responsible.

Figure out your financial goals

Setting goals is an important part of life, particularly when it comes to your finances. Over time, your goals will probably change, which will likely require you to make some adjustments. Start by asking yourself the following questions:

  • What are my short-term goals (e.g., new car, vacation)?
  • What are my intermediate-term goals (e.g., buying a home)?
  • What are my long-term goals (e.g., saving for your child’s college education, retirement)?
  • How important is it for me to achieve each goal?
  • How much will I need to save for each goal?

Once you have a clear picture of your goals, you can establish a budget that will help you target them.

Build a budget

A budget helps you stay on track with your finances. There are several steps you’ll need to take to establish a budget. Start by identifying your current monthly income and expenses. This is easier than it sounds: Simply add up all of your sources of income. Do the same thing with your expenses, making sure to include discretionary expenses (e.g., entertainment, travel, hobbies) as well as fixed expenses (e.g., housing, food, utilities, transportation).
Compare the totals. Are you spending more than you earn? This means you’ll need to make some adjustments to get back on track. Look at your discretionary expenses to identify where you can scale back your spending. It might take some time and self-discipline to get your budget where it needs to be, but you’ll develop healthy financial habits along the way.
On the other hand, you may discover that you have extra money that you can put toward savings. Pay yourself first by adding to your retirement account or emergency fund. Building up your savings using extra income can help ensure that you accomplish your financial goals over the long term.

Establish an emergency fund

It’s an unpleasant thought, but a financial crisis could strike when you least expect it, so you’ll want to be prepared. Protect yourself by setting up a cash reserve so you have funds available in the event you’re confronted with an unexpected expense. Otherwise you may need to use money that you have earmarked for another purpose–such as a down payment on a home–or go into debt.
You may be familiar with advice that you should have three to six months’ worth of living expenses in your cash reserve. In reality, though, the amount you should save depends on your particular circumstances. Consider factors like job security, health, income, and debts owed when deciding how much money should be in your cash reserve.
A good way to accumulate emergency funds is to earmark a percentage of your paycheck each pay period. When you reach your goal, don’t stop adding money–the more you have saved, the better off you’ll be.
Review your cash reserve either annually or when your financial situation changes. Major milestones like a new baby or homeownership will likely require some adjustments.

Be careful with credit cards

Credit cards can be useful in helping you monitor how much you spend, but they can also lead you to spend more than you can afford. Before accepting a credit card offer, evaluate it carefully by doing the following:

  • Read the terms and conditions closely
  • Know what the interest rate is and how it is calculated
  • Understand hidden fees such as late-payment charges and over-limit fees
  • Look for rewards and/or incentive programs that will be most beneficial to you

Contact the credit card issuer if you have questions about the language used in an offer. And if you are trying to decide between two or more credit card offers, be sure to evaluate them to determine which will work best for you.
Bear in mind that your credit card use affects your credit score. Avoid overspending by setting a balance that you’re able to pay off fully each month. That way, you can safely build credit while being financially responsible. Take into account that missed payments of any sort can cause your credit score to suffer. In turn, this could make it more difficult and expensive to borrow money later.

Deal with your existing debt

At this stage in your life, you’re probably dealing with debt and wondering how to manage it. A 2015 Pew Research study revealed that 86% of millennials have debt. (Source: “The Complex Story of American Debt,” July 2015) In particular, you might be concerned about how to pay off your student loan debt.
Fortunately, there are many repayment plans that make it easier to pay off student loans. Check to see whether you qualify for income-sensitive repayment options or Income-Based Repayment. Even if you’re not eligible, you may be able to refinance or consolidate your loans to make the repayment schedule easier on your budget. Explore all your options to find out what works best for you.

Beware of new borrowing

You’re doing your best to pay off your existing debt, but you might find that you need to borrow more (for example, for graduate school or a car). Think carefully before you borrow. Ask yourself the following questions before you do:

  • Is this purchase necessary?
  • Have you comparison-shopped to make sure you’re getting the best possible deal?
  • How much will this loan or line of credit cost over time?
  • Can you afford to add another monthly payment to your budget?
  • Will the interest rate change if you miss a payment?
  • Are your personal finances in good shape at this time, or should you wait to borrow until you’ve paid off pre-existing debt?

Weigh your pre-existing debt against your need to borrow more and determine whether this is a wise decision at this particular point in your life.

Take advantage of technology

Access to technology at a young age is one major advantage that benefits millennials, compared with their parents and grandparents when they were starting out. These days, there’s virtually an app or a program for everything, and that includes financial basics. Do your homework and find out which ones could be the most helpful to you. Do you need alerts to remind you to pay bills on time? Do you need help organizing your finances? Are you looking for a program that allows you to examine your bank, credit card, investment, and loan account activities all at once?

Researching different programs can also help with number crunching. Many financial apps offer built-in calculators that simplify tasks that may seem overwhelming, such as breaking down a monthly budget or figuring out a loan repayment plan. Experiment with what you find, and you’ll most likely develop skills and insight that you can use as a starting point for future planning.

Although apps are one way to get started, consider working with a financial professional for a more personalized strategy.

 

Securities offered through FSC Securities Corporation, member FINRA / SIPC . Investment advisory services offered through The Retirement Group, LLC, a registered investment advisor which is not affiliated with FSC Securities Corp. Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, or legal advice. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice

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