June Newsletter

26-May-2015

Welcome to the first edition of the Hanson & Co. Newsletter!  We will send out our Newsletter on a monthly basis, and occasionally more often if we come across information that we feel would be of a particular interest.

Pay attention to the Tax Calendar included with each issue.  This will be a helpful reminder about important filing deadlines (i.e. estimated tax payments, etc.) Copies of all Newsletters will be available on our website www.hcopc.com.  Also, be sure to like us on Facebook and Twitter.  Please enjoy!

Sincerely,

Hanson & Co. Staff

Mixing Your Money - Holding Stocks in Retirement Accounts

The stock market goes up and, as we’ve learned, it goes down. Despite the volatility, stocks have been excellent long-term investments for many decades, and there’s no reason to think that the future will be different. Regular investing in equities, through bull and bear markets, probably should be part of your strategy for building an investment portfolio you can tap in retirement.

Many people do virtually all of their investing in 401(k) and similar employer-sponsored retirement plans. They often roll those accounts into IRAs, continuing the tax deferral. If you’re in that category, you’ll do your stock market investing inside your retirement account; you can decide what portion to allocate to equities.

Mixing your money

On the other hand, you may have both a tax-deferred retirement account and a taxable investment account. That is, in addition to your retirement accounts, you might have one or more accounts with brokerage firms or mutual fund companies where any investment income is taxed each year. In that situation, where do your stocks belong? Individual circumstances may dictate the decision.

            Example 1: Jim Morgan is 33 years old with no plans to retire for at least 35 years. With such a long time horizon, Jim invests mainly in equities, where he expects the greatest long-term returns. Jim invests his 401(k) contribution in the stock market and also holds stock funds in his taxable accounts.

Other investors, especially those closer to retirement, may prefer to hold a mix of stocks, bonds, and other asset classes. Investors with such a diversified portfolio as well as taxable and retirement accounts must decide where to hold their stocks.

            Example 2: Barbara Owens, age 50, has a 401(k) account, a traditional IRA, and a brokerage account. Her desired asset allocation is 50% in equities and 50% in fixed income. Barbara can choose among these accounts for holding her stocks.

Bigger buildup

The case for holding stocks inside a retirement account is straightforward: They have higher expected returns. Morningstar’s Ibbotson subsidiary reports that large company stocks historically have returned around 10% a year, for patient investors. If Barbara contributes a maximum $24,000 to her 401(k) in 2015 and puts that money into stocks that return, say, 9% per year, that contribution would grow to around $96,000 in 16 years. Invested in bonds that earn, say, 6% a year, Barbara’s $24,000 contribution would grow to about $60,000 in 2031, which is when she plans to retire, roll her 401(k) into an IRA and start taking distributions.

Naturally, Barbara would rather have $96,000 in her IRA than $60,000. Keep in mind that difference is from one year’s contribution. If Barbara keeps investing her 401(k) money in stocks, year after year, and stocks approach historic norms, her retirement fund would be much larger than it would be with bonds. To keep her desired asset allocation and moderate portfolio volatility, Barbara can contribute to bond funds in her taxable brokerage account.

Tax treatment

If projected returns from stocks are higher than they are from bonds, why not hold your stocks in tax-deferred territory? In a 401(k) account or an IRA, the higher returns can be compounded without an annual reduction for income tax.

However, holding stocks in a tax-deferred retirement account means giving up some key tax advantages. Under current law, stock dividends taken in a taxable account usually are taxed at only 15%; some taxpayers owe 0% on dividends, whereas a 20% tax rate applies to investors in the highest tax bracket. The same bargain tax rates apply to long-term capital gains realized in a taxable account. What’s more, investors can take capital losses in taxable accounts—losses that can provide valuable tax advantages.

In a 401(k) or an IRA, taking capital losses won’t provide any tax benefit. Moreover, any distributions from such retirement accounts will be taxed as ordinary income, at rates that now go up to 39.6%. (The tax rates mentioned may actually be higher, because of various tax code provisions.) What could have been bargain-taxed stock dividends and long-term gains may be transformed into fully taxed IRA distributions.

Looking ahead

Today’s tax rates are meaningful, but what really will count are the tax rates in effect in the future, when you draw down your portfolio for retirement income. Perhaps you’ll have a low tax rate then, without earned income, so paying ordinary income tax on IRA distributions won’t be terribly painful. Alternatively, ordinary income tax rates may be much higher in the future, so the IRS’ share of your stock market gains could be greater when you withdraw those profits from your IRA.

No one has a crystal ball about future personal income and tax rates. Nevertheless, you should keep the tax aspects in mind when you decide whether to hold your stocks and stock funds in a taxable or tax-deferred account. Our office can help you crunch the numbers, so you can make informed decisions. 

Winning Social Security’s Waiting Game 

As more baby boomers move into their 60s, there is increased interest in Social Security retirement benefits. In particular, seniors must decide when to start. Currently, the full retirement age (FRA) for Social Security is 66. That age applies to people born from 1943 through 1954. FRA gradually increases for younger workers, reaching 67 for those born in 1960 or later.

You can start as early as age 62, but your benefits will be reduced. Alternatively, you can start as late as 70, which will entitle you to a higher benefit. If you start at 62, you’d get 75% of your FRA benefit; waiting after FRA increases your benefit by 8% a year. (Starting younger than FRA also will generate a reduction in benefits for those with substantial earned income, followed by a makeup in later years.)

            Example 1: John Anderson is entitled to a Social Security benefit of $2,500 a month at age 66, his FRA. If he starts at age 62, with little or no earned income, John will receive $1,875 a month (75% of $2,500). As another option, John could wait as late as age 70 to start and receive $3,300 a month (132% of $2,500).

            Thus, waiting from 62 to 66 increases John’s benefit by 33.3%. Waiting still longer, from 66 to 70, increases his benefit by 32%. By the eyeball test, John will get a benefit increase of about 8% a year for waiting. That government-backed hike may sound extremely appealing, when bank accounts and money market funds pay next to nothing.

Closer look

Running the numbers through a calculator, it turns out that the higher benefit is really a compound annual increase of just over 7%. That’s still appealing, in these low-yield times.

However, the percentage increase actually fluctuates as John moves through his 60s. The periodic increases are fixed, as a percentage of FRA, but the deferred benefit increases in size as John grows older.

            Example 2: At age 63, John would receive 80% of his FRA amount: $2,000 a month. That’s an increase of $125 a month, from his age 62 benefit of $1,875, so John’s boost for the year is about 6.7%. By starting at age 64, though, John would get $2,166 a month, 86²⁄₃% of his FRA amount. That’s an 8.3% increase for waiting that year, from age 63 to 64.

Crunching through the numbers, the annual percentage increase drops, rises again, and drops again until reaching a 6.5% hike from age 69 to a start at age 70.

Measuring the trade-off

Another way to make a decision on when to start Social Security is to see how much you give up by waiting, and how long the make-up period will be. If John waits from 62 to 70, he will relinquish 8 years of benefits (96 months) at $1,875 a month, or $180,000. He’d then collect $3,300 a month, an extra $1,425, so he’d catch up in 127 months. By the time John reaches age 81, he’d be ahead in total dollars collected, and the gap would grow in each succeeding month.

            Example 3: For another perspective, consider Kate Bennett, who also has an FRA benefit of $2,500 a month. Kate continues to work, so starting before her FRA doesn’t make sense. As mentioned, Kate could get a Social Security benefit of $3,300 a month by waiting until age 70.

            However, Kate doesn’t need to wait that long. By age 69, Kate could start Social Security and receive $3,100 a month. In the first year, she’d collect $37,200 in benefits. By waiting until 70, she’d get an extra $200 a month, so it would take her 186 months ($37,200 divided by $200) to catch up: 15½ years. Kate wouldn’t be ahead in total benefits until she’s approaching age 86.

Revising your outlook

The bottom line is that the ideal time to start Social Security can be a moving target. Starting at 62 might be a good choice if you need the cash immediately, have health concerns, or just want to get something back for all the taxes you’ve paid while you’re young enough for active pursuits. If you decide not to start at 62, you might consider waiting until at least age 64 to start to get the sizable 63-64 bump in benefits.

On the other hand, if you’re in relatively good condition, physically and financially, you might decide to defer after you reach FRA to get a larger Social Security benefit. Remember that you’re not locked in to an age 70 start if you can delay; you can start any time in between 66 and 70, if waiting is no longer practical.

Keep in mind that these calculations are relatively simple as they ignore taxes on benefits, cost-of-living adjustments, and any interim investment earnings. If you want to explore this topic further, our office can provide detailed projections for your specific circumstances.

Did You Know ?

Social Security retirement benefits are based on your 35 years of highest earnings. The earnings that are counted are subject to a cap: the maximum amount subject to Social Security taxation each year. The figure for 2015 is $118,500; the earnings cap was $3,000 when the Social Security program began in 1937.

Source: The Wall Street Journal