Author Archives: Edi

HARP and Traditional Refinance

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Refinancing your mortgage may seem ideal and particularly pressing when you are contacted by a “HARP specialist” anxious to point out that the rates are better than ever and the deadline to apply fast approaching. If you are considering such a move, let us first check to see if refinancing makes sense AND if you even qualify for or should use the HARP program.

Let’s begin by reviewing when and why we would take the time, make the effort, and incur the cost of a refinance. Refinancing is often done with the intention to lower interest paid, lower the monthly payments, or to change the terms of the mortgage. You may not realize that refinancing also restarts your amortization and could cost you in hidden ways by having you pay more interest over the mortgage period. A refinance is really a new mortgage where the new mortgage pays off your old mortgage and you work with the new product. The refinance may be ideal for the lender, but not always appropriate for you.

Traditionally refinanced mortgages are either for the balance of the previous mortgage OR for a higher balance by taking cash out. These are referred to as a “simple” or a “cash out” refi. Every time you do a refinance, your finances have to be in tip-top shape and you must select the right lender. Too often clients, for convenience, will use their current bank to refinance their mortgage, which may not offer the best terms or the easiest process. Regardless, you will be asked to verify your income. Moreover, you must have at least 20% equity (home-to-loan value, or LTV) if you don’t want to pay the mortgage insurance. The process for ALL refinancing will require that you gather documents and find the right lender, then submit an application, which the lender must respond to within 3 days with a good faith estimate (citing all costs). Once you accept, it may feel like ‘hurry up … and wait’ since the lender now has 2-3 months to respond. They will often come back to you for more information or clarification, so it turns into a back-and-forth experience. Eventually, you’ll lock-in a rate for another 30 days while verifying the final paperwork.

In the 2008-9 crisis, properties were valued lower (in most areas) and in some cases homes were worth less in the market than the mortgage debt (i.e., “underwater”). Since this was only a paper lose, it was only a problem for families with high-rate mortgages, an immediate need to sell, and with strained budgets. Sadly, these home owners were often denied a refinance to take advantage of much lower interest rates, reduce monthly mortgage costs or provide a more stable fixed-interest mortgage. It was to address this stressful financial situation that several programs were created. One, discussed below, is the HARP program.

“HARP” is the Home Affordable Refinance Program, a federal-government program established after the last housing crisis to assist homeowners with refinance (at today’s lower mortgage rates) even if their current mortgage is underwater. The goal of the program is to allow borrowers to refinance into a more affordable or sometimes a more stable mortgage product.

The HARP program ends December 31, 2016 and, as happens often before a deadline, we find an increased flurry of lenders trying to convince every home owner that they are the ideal candidate for this government program. HARP mortgages are not for everyone.

The first version of HARP had too many limits and in 2012 the HARP 2.0 program was created eliminating some of those limits. Notably, the underwater limits were removed, appraisals no longer needed, the refinance process streamlined, some fees for being ‘underwater’ eliminated, and allowance made for less stringent verification of income (to include not just W2 statements but also 12 months of saved mortgage payments).

The biggest difference between the traditional and HARP mortgages is that you don’t have to have an LTV ratio lower than 125%—the HARP program eliminated this limit. You could obtain a lower rate mortgage even if your home is still worth much less than your own mortgage.

As I’ve stated, HARP is often used to reduce mortgage interest and reduce monthly payments, but others use HARP to convert adjustable rate mortgages (also referred to as ARM-loan) into a more predictable, fixed-loan program (usually 30 years) or if it fits within your budget, a 15- year mortgage that helps you build equity faster.

HARP was never intended for individuals who are near bankruptcy or who have not paid or can’t pay their mortgages. Rather, it is intended for those who have managed to stay current on their mortgage payments, and yet, are not able to change to lower rates since they no longer qualify for a traditional refinance either because of lower income or decreased equity.

In my experience, HARP is a difficult option to pursue because the home owner not only needs to be current on their mortgage, the mortgage needs to be under Fannie Mae or Freddy Max and therefore must be “conforming.” Conforming loans have maximum limits of $415K to $625.5K depending on the location of the single family dwelling. Most Bay Area homes have mortgages that easily exceed these values. They are also only valid if the mortgage was acquired by Freddie Mac or Fannie Mae before June 1, 2009 (an arbitrary date stemming from the crisis).

Because the regulations are rather document heavy and include many exceptions, some lenders have adopted their own versions, so you may need to change your lender to obtain the best HARP loan. Even though the process was to be streamlined, implementation fell far below expectations. The lender’s representative often lack enough knowledge, causing a great deal of frustration to an already stressed individual/family. For example, clients thought they had to use the same lender and that it only applied to their primary home—this is not the case. You can use any lender and HARP can be used on any mortgage that is backed by Fannie Mae and Freddie Mac. The goal is to support those underwater because of the 2008-9 crisis.

Regardless of whether you are considering refinancing through HARP, other government programs or a private lender, you must always examine the total costs AND the purpose for the refinance. If you’ve recently completed a refinance then you need to have a really compelling reason before considering yet another refinance. If you need to increase cash flow then look for low closing costs but expect you’ll pay more interest in the long term. BUT if your purpose for the refinance is to cash out equity or to change some other aspect of your mortgage, then the upfront closing costs may be acceptable. At times, clients appear interested in refinance every few years largely because of lender contacts or advertising. Refinancing every few years can be a costly mistake. It is important to remember that each time you refinance you are starting with a brand new mortgage which will restart the amortization. Restarting amortization is good for the lender, but, not always good for you.

There are a couple of lessons here. First, to truly take advantage of opportunities like HARP you need to be on top of your finances. You also need to understand the product/plan that is offered. Ask yourself is this good for my financial situation? If unsure, drops us a line and we’ll check out the product and provide you with a product neutral opinion that is appropriate for your financial plan.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Medicare—Surprising facts and critical changes

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The goal in retirement (or financial independence after age 65) is to be able to support our lifestyle using accumulated assets, Social Security and Medicare. It has become evident that Social Security and Medicare had to change to continue to sustain future retirees. The loss of the Social Security ‘file and suspend’ strategy for anyone who is not 66 by the end of April, 2016 has received a lot of media attention. Yet, major changes in Medicare have garnered much less publicity although no less important to retirement planning.

From our retirement planning vantage point, we believe the new Medicare changes will add a significant wrinkle to what is a already a very fine balance between distributions from portfolios, income tax liability, and funding our client’s ideal retirement lifestyle.

This short educational article outlines a few surprising (even shocking) facts that everyone should know about Medicare. For more details (particularly those approaching 63 or are two years from switching to Medicare from employer plans), I recommend that you read, in detail, the annually released official US Government Medicare Handbook. The 2016 version of this booklet is available at https://www.Medicare.gov/pubs/pdf/10050.pdf

  • Medicare Alphabet Soup (A, B, C, D) are not all free – The 2.9% current premium paid to Medicare on your earnings while employed only provides for free Medicare Part A coverage. Part A only covers hospital insurance, not comprehensive health insurance. Medicare Part A participation, however, does provide access to the other Parts that, when taken together, can constitute a comprehensive health insurance plan able to meet specific needs. Part B is basic medical insurance. When combined with Part A it is termed “Original Medicare.” A and B combined isn’t enough to cover everything you’ll need. Part D is a premium paid for drug insurance. It is incredibly complex as specific drugs fall in and out of favor within each plan. On the other hand, Part C is an integrated health plan that usually includes Part A, B, and D. It is often called “Medicare Advantage.” Finally, you may encounter Medigap coverage (which has its own alphabet soup) to cover areas missed by Medicare A, B, C or D.
  • Basic Costs: Average costs are difficult to estimate and are often not as low as many expect. Part B would seem very well priced at less than $1,500 per year and yet in the real world we seldom find these ideal rates. Instead, we find health insurance through Medicare averages around $4K-6K per person per year. Moreover, rates are expected to rise significantly in 2018 because of surcharges.
  • Enrollment in Medicare is not all automatic and requires strict attention to timelines. Timelines appear long (for example, 7 months for the initial enrollment) but to avoid penalties and loss of coverage you will need to act early in the timelines (most wait until their birthday month and may find that they have a gap in insurance coverage even though they make the enrollment timeline). To avoid penalties, initial enrollment into Medicare is 3 months before your birthday month and extends to three months after. If you have approved coverage (for example, from an employer health plan) and need to transition to Medicare you will have a “Special Enrollment Period” with its own timelines that must be initiated prior to leaving your employer approved health coverage (excluding COBRA).
  • There are hefty penalties that stay with you for life if you miss an enrollment timeline – Penalties for missing enrollment timelines into Part B are currently an additional 10% of your normal premium cost for every 12 months delayed. Part D penalties are 1% per month delayed. These penalties continue throughout your enrolled life, meaning that you’ll pay more for the same coverage. For example, if you enroll 3 years later than required, the premium you pay for the same Medicare Part B coverage is 30% higher. If you also missed enrolling in Part D, the premium is 36% higher.
  • Once you enroll in Medicare you can no longer make H.S.A. contributions. Once you begin collecting Social Security you are required to enroll in Medicare Part A, which eliminates your ability to participate in certain plan features. For example, it disallows the annual tax-free H.S.A. contributions.
  • There is free personalized health insurance counseling. You should use it to design the best plan for yourself and to fully understand what you need to do each year to make the most of the health care plan you chose (given your expected annual health care needs). In addition, work closely with your Wealth Manager to ensure that you distribute your wealth in the least costly manner given your lifestyle and available assets.
  • Not all health insurance plans are available in all locations. When planning your Medicare health plan, use the community you are planning to retire into to get the most accurate list of health plans available. There is also a 5-Star rating website, provided by Medicare, to help you choose the best available plan in your area.
  • Since 2007 Medicare has been MEANS tested (i.e., dependent on income). Additional income-based premiums can come as a surprise, but what is perhaps more shocking are the new income limits that will begin in 2018. For the moment, surcharges to Medicare premiums begin at $85K and $170K MAGI (Modified Adjusted Gross Income for those filing as single or married filing jointly). Currently, the surcharges top out at $390/month or $4,700/year for Part B for those with MAGI greater than $214K and $428K (single versus married filings). Separate surcharges apply for other Parts. But take note—starting in 2018, the surcharges will apply to a lower MAGI. The largest surcharges will be for those with MAGI over $160K and $320K. An additional surprise is that the earnings that will be used to calculate your Medicare Premium surcharge (also known as the annual “Income Related Monthly Adjustment Amounts” or IRMAA) will be based on your income tax filing from two years earlier. For example, if you enroll in Medicare in 2018 they will use your 2016 taxes to estimate your IRMAA (there is a process to appeal surcharges).
  • The income included in determining additional premiums is based on your adjusted income PLUS any tax-free income (such as Muni bond interest) – MAGI (in these scenarios) includes all ordinary income (work earnings, pre-tax withdrawals, pensions, etc.), plus 50% of Social Security collected, plus tax exempt interest. It doesn’t include H.S.A. or Roth distributions or loan proceeds. Annual distribution will now need to be tightly connected to your MAGI.
  • A “cost of living” gift from the ‘Hold Harmless’ rule – For some, the “Hold Harmless” rule provides additional premium savings. This benefits those who have their Medicare Part B deducted directly from their social security. This rule prohibits increases in Medicare Part B premiums when there is no similar increase in Social Security benefits. The ‘Hold Harmless’ rule evaporates for anyone not deducting their premiums from Social Security, or if they pay additional premium surcharges (because of income limits), or if it is their first year in Medicare (plus a few other exceptions).

These changes to Medicare (and likely new changes in the future) will make it essential that your accumulated wealth be deployed in a manner that will allow you to have the necessary cash flow for your chosen lifestyle while maximizing the various MEANS adjusted benefits.

It has always been our recommendation that clients have more than just pre-tax savings, Social Security, and a pension to support their retirement distribution. Going forward, Roth and H.S.A. savings will unquestionably become even more powerful adjunct retirement planning tools since they are tax free and not part of Medicare MAGI Means testing.

Know the facts about Medicare. An educated consumer is better equipped to make sound choices leading up to retirement and much more likely to secure the retirement lifestyle they have in mind.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Important Changes To Social Security That May Impact Your Retirement Plans

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As you may be aware, significant changes to the Social Security program were signed into law November 2nd by President Obama (see news items in November “Nibbles”). As your financial advisor, I believe it is important to keep you abreast of these changes as they are likely to impact your retirement plans. Some clients will be required to take appropriate action over the next 5 months.

To be clear, the two Social Security planning strategies that were eliminated on November 2nd are still available to those older or turning 66 by April 29th, 2016 for “file and suspend” and those who are at least age 62 by December of 2015 for “Restricted Application.” These individuals are not affected by the November 2nd changes. However, anyone else will no longer have these strategies available in retirement.

At Aikapa, we will give priority to those that need to act immediately to retain ending benefits and then methodically work our way through the retirement plans of our other clients.

DETAILS ON THE ELIMINATED SOCIAL SECURITY PLANNING STRATEGIES

Two widely-used Social Security planning strategies were eliminated by Congress without much discussion, notice, or fanfare, impacting the retirement plans of many Americans.  The two strategies were “File and Suspend” and “Restricted Application for spousal benefits”.  The two strategies usually operated hand-in-hand, but could be employed separately. There are always tradeoffs to retirement planning strategies, but these two strategies typically added 3 to 5 years of additional coverage in retirement.

“File and Suspend” involved one person filing for Social Security at full retirement age (currently, it is 66 years old) and then suspending this filing. The net effect was that they’d file to collect on their Social Security record and then decline to collect.  These two actions allowed other family members to file for benefits based on the that person’s Social Security record while they continued to let their own Social Security benefit grow, often until age 70. Four years at 8% per year would have increased the Social Security benefit substantially. For those that didn’t immediately need the benefit, the option was an obvious “no brainer.”  According to the new rules, the option to File and Suspend ends for anyone that is younger than 66 by April 29th, 2016 (in other word, anyone born after April 29, 1950).

“Restricted Application for spousal benefits” allowed one person to file (i.e., the “filer”) based on their spouse’s record, but only after their spouse’s record was activated.  The spousal benefit was always ½ of the benefit entitled by the person who paid for the Social Security benefit (at full retirement age). The spousal benefits would be collected based on the spouse’s record allowing the filer to grow their own Social Security benefits.  Though often useful, this strategy of collecting based on a spouse’s Social Security benefits while allowing their own to grow will end for anyone younger than 62 as of December 31, 2015 (or those born after 1953).  According to the new rules, if your spouse files and suspends prior to April 29th or is collecting Social Security then you will be able to file a restricted application IF you turn 62 by December of this year.

If you were born prior to 1954 and these two strategies are relevant to your retirement plan, don’t be surprised to find that we’ll be reaching out to you this month.  If we don’t reach out to you this month, do let us know if you or your loved ones need assistance capturing these ending social security benefits.

For all of us, this is a reminder that all benefits are bound by rules that have planning consequences and require ongoing attention.  For many, this change to the Social Security program will mean either an adjustment to spending during retirement, or more likely, require additional annual savings prior to pre-retirement (or other wealth creation strategies).

Always feel free to call or let me know if you have any question with this or other financial matters.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

The skateboard champion and other stories

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As a way to put money away and save on taxes we often think of retirement accounts for the self-employed that include a simplified employee pension plan (SEP), an individual 401K-profit sharing plan (401K-PSP), or Defined Benefit (DB) plan. DB plans are the least used and yet the most powerful at reducing tax liability and quickly increasing your tax-deferred savings. To illustrate how DB plans can be used, I want to share with you how creative individuals were able to leverage their DB plan to save maximally and retire early.

  • The Skateboard Champion – A 30-year-old skateboarder plans ahead and saves $130K per year from winnings and endorsements. He will have saved $2.6M by the time he turns 50 (without considering any market growth).
  • The Lobster Fisherman – A 61-year-old fisherman from Maine pays himself $35K in payroll from his C Corporation and saves $60K per year for the last five years before retiring. His reward: an estimated $300K in accumulated additional savings for his retirement.
  • The Clothing Store Sales Rep – At 57 years of age the rep contributes $150K per year for herself and $12K for her young assistant until retirement at age 65. She accumulates another $1.2M not including growth.
  • The Lobbyist from Virginia – Beginning at age 48, the lobbyist contributes $145K/year for 7 years saving just over $1M by age 55.
  • The University Professor & Guest Speaker – Starting at age 54, the Prof contributes $42K per year from guest speaking engagements. He does this for 12 years and adds $502K in savings (excluding growth) to his already substantial university benefit plans.

DB plans provide the highest contribution amounts particularly when combined with a 401K. To take full advantage of this type of plan, a business must have sufficient profit and cash flow. DB plans, like a 401k, must be established in the same year and have specific requirements including annual tax filings. DB plans are not limited by the fixed maximum contribution found in SEP or 401K plans but instead are based on age, payroll and future benefit. This year, the maximum annual future benefit is up to $210K (this can amount to substantially more than a $210K contribution in any one year).

If you have a side business or are starting your own full time business consider the DB plan. Even though these are powerful, the best type of retirement savings plan for you is dependent on your business’ current and projected cash flow. As you can tell from the stories above, a well-designed DB Plan is not just for those over 50 or those with large earnings. It can be a very smart way to defer taxes today and provide for your lifestyle in the future.

Defined Benefit plans are not appropriate for everyone but I’ve seen them work for so many different people in unexpected situations that I thought I’d share some success stories with you.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Start of the Year Planning

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I’m often asked “how do I make sure that I (and my family) stay on track with
our finances?” Following are a few pointers to start the New Year off right.
Keep in mind, this isn’t about making resolutions (we all know how that goes), but
rather, building sound financial habits that will set you, and your family, in
good stead, now and in the future.

(1) TAKE STOCK. If you haven’t done so already, the first place to start is to
take stock of what was actually accomplished in 2015. This will be easier if you combine it with your preparations for filing your income tax. As a family, tally all of your statements (we send you a summary of the investments we manage but we’re willing to help you summarize your other assets as long as you send a year-end statement). This shouldn’t just be one person’s job – the point is to use the opportunity to enhance everyone’s awareness of how the money was earned and spent last year. It is also a time to see how well the reality matched the goals set at the start of 2015. Before you move forward you need to take stock of those items you can control. Don’t get too hung up on performance—the markets behave as they will and you’ll come out ahead as long as you have a low cost, high quality, diversified portfolio. Once you have such a portfolio, it is MORE important to determine how well you enjoyed the year than just
analyzing your spending habits.

Was this a good year for you? If so, what made it good or what made it less
enjoyable? As a family, what would you keep and what would you avoid
earning/spending if you had a choice? Life is about learning from what we do
and what we value but it should be based on your reality and your values.
Come away knowing how the year met with your expectations for a good life.

(2) DON’T GO IT ALONE. Think about how you can include others in this
process. This is particularly important in families where one person takes a
larger share of the family’s financial responsibilities. This “Start of the
Year” planning is an opportunity to develop closer communication
with anyone who is important to your financial future. First share
what was accomplished in 2015 and then decide what the family might want
or need in 2016. Do not forget that once you have set your goals you might
want to include financial professional(s) to ensure that you maximize and
implement all that is available. The power of building a strong financial
rapport over years will become evident during annual planning and when life
reveals unusual financial challenges.

You might also want to use this opportunity to share relevant annual decisions
and your process with any dependents so that they become participants in
helping the family attain goals for each year. For children this can be an
excellent learning experience and evidence of how finances are discussed and
handled in a family.

(3) GET BUY IN AND ACCOUNTABILITY. It is best to commit to
writing what was accomplished in 2015 and what you are targeting
in 2016. You should set a quarterly check-in to be sure that everyone is
committed throughout the year to what is decided at the start (this is most
important for the first couple of years and until this process becomes habit). The aim is to keep everyone on track and to determine if the goals and objectives are indeed
attainable.

(4) TRACK YOUR PROGRESS. Ideally you’ll let us help you track your
progress throughout the year by checking in with us, but we also encourage
you to make it a habit in your home.
Making financial decisions can be challenging at the best of times, if only
because they tend to have a ripple effect that isn’t always predictable.
Remember—when taking stock and making plans, it helps to keep the lines of
communication open, control what you can and target those things you value.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Caregiving for a Parent or Elder Can be Rewarding

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As I read the latest survey which found Americans unprepared for the complex and unpredictable realities of longevity and caregiving, I thought about my own experience. In my case, planning with parents for their wishes has allowed for open and frank conversations that helped to develop trust and understanding. It provided a chance to resolve and express unspoken sentiments and a time to see parents/in-laws as peers. It was also a time for them to share life enriching experiences. In the process of helping them plan for their lifestyle choices and care, I learned something more about them, myself and my family. In my situation it allowed me to recognize how much value I place on having intellectual and meaningful activities.

It was interesting to read, in the survey of caregivers, (called C.A.R.E.—Costs, Accountabilities, Realities, and Expectations) that 60% said caring for two aging parents can be more demanding than caring for two children (ages 3-5). It also found that 66% said that the extra costs involved would have a large financial impact on them, and, perhaps more significantly, 38% said they had not planned for these costs. Most respondents believe the shortfall would be offset from cuts to discretionary living expenses, retirement savings, or from another source of income.

This survey is particularly worthwhile because it reveals a disconnect between the perception and the reality of caring for an elder. The perception is that caregiving is mostly about grocery shopping, cooking and laundry. Whereas, experienced caregivers know that although chores and emotional support play a large part, it is financial support and personal hygiene that are the most stressful and anxiety building aspects of caregiving. The lesson here is that you can best assist your parent or elder by pointing out this disconnect—help with chores is fine and may be necessary, but thinking through how caregiving will be financed and how their physical needs will be met is paramount to avoiding serious challenges.

As they plan their caregiving you should encourage them to agree on the signs that will be used to indicate it is time to seek further assistance with their finances and physical care. It is during these caring conversations about their wishes that you can volunteer ways in which you are willing and able to be of help (but only after you’ve examined your own retirement plan).

As the off-spring of a parent that raised a family, that may have managed a firm and made countless complicated decisions during their careers, it can be difficult to envision your mother or father sometime down the road when logging onto the Internet or even frying an egg seem onerous tasks. A key ingredient to helping them along is to examine honestly what lies ahead and plan accordingly. Encourage them to remain connected to family (they will benefit from increased meaningful contact with a loved one) and to build a fiduciary team for their physical, mental and financial wellbeing. With the right type of built-in support along the way, their retirement can truly be the “golden years,” an immensely satisfying and productive time.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Identifying Your “Retirement Paradise”

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For most of our clients their ideal retirement location or “Retirement Paradise” is in the Bay Area (or other high cost areas), near family and friends and a stimulating environment, but high taxes and the cost of living cause many to re-evaluate.
For those choosing to remain in the Bay Area, the purchase of a smaller home (downsizing) is often used as a way to reduce expenses or to make their home better suited for independent at-home aging.  To remain in the Bay Area (or other high cost areas) retirement saving goals must be very aggressive and fully funded to support the same lifestyle during retirement.

Some consider moving to lower cost US states and even overseas. The idea of downsizing away from California (or your home state), as a way to reduce expenses and bolster available retirement funds may not be as easy as selecting the lowest tax or lowest cost location.  Keeping in mind that retirement is not one uniform event, but a series of phases, let’s cover a few of the financial implications.

Relocating may indeed reduce some costs, but there are ramifications that are often overlooked.  For example, moving away from higher cost areas can reduce income taxes, but this may not offset the increased cost of travel, other taxes (such as real estate), services, and costs associated with changes to lifestyle.

We suggest that you give the town, state or country that you intend to relocate to a try for extended periods of time and at various seasons of the year with an eye toward evaluating how you will spend your retirement and what costs will be incurred. How does it feel to revisit the same place over several years? Can you see yourself developing the supporting network you’ll need as you grow older? How will your budget be changed?

Don’t underestimate the value of a community that can provide stimulating events that you would be interested in attending (the opera, symphony, music, college courses).  What about your family and friends? Will you want to be close to them while you age? What healthcare do you need and how does your future community support it?  Some areas have low taxes, but do they provide the services that you’ll need as you age?

If you enjoy particular hobbies, you’ll probably want to check out the ease of access to your interests, but don’t neglect other priorities such as transportation and communication. As you age, travel becomes more difficult, especially if you develop special needs. Give thought to public transit and convenience to major airports or rail lines. In our experience, clients will deliberately choose a populated community to move to (later in retirement) with well developed public transit.  Access to quality internet is also your lifeline to friends and family and to future independence.

Some states do not tax retiree income and some states provide extensive retiree services. Look to see which location provides benefits that you will need. Often states that do not tax an individual’s income have higher sales and property taxes, so you must do the numbers. Be mindful of Medigap policy costs and Medicare Part D (drug coverage) in your potential retirement paradise. Premiums can be lower in areas that have a lower cost of living or more retirees. The prohibitively high cost for healthcare and lack of services in some counties will likely surprise you.

It may seem a little pre-mature, but you should give some thought and consideration during the process of making your first retirement move to the possibility of a later move in life to be near loved ones or to an assisted-living facility. As we age, the process of moving becomes more challenging – though early in retirement it can be very exciting. You’ll find this stress can be reduced or avoided with some early planning and coordination.

A few words now about moving to a foreign country for some or all of your retirement years.  It is likely that you can find countries with a lower cost of living than the US and where you can maintain or enlarge your lifestyle, but you’d be well advised to examine this option over several extended trips.  If you are planning to remain abroad through only part of your retirement, you will need to determine how to fund your eventual return, or else how you will handle all retirement phases if you intend to remain permanently out-of-country.

All US “persons” (that’s the legal term for anyone deemed subject to US taxation authority) must file taxes annually. Typically the US has a treaty with other countries so that your earnings will not be double taxed, but most retirees do not work so double taxation is not a large concern. There are rules on what is or is not taxable to you as a resident of the foreign country and what is payable to the IRS. Consider that you will have to pay taxes on all pre-tax accounts, social security, pensions even while living overseas but you will likely avoid state tax. As a US person, you will have annual administrative financial filings (known as FBAR) while not residing in the US.  Healthcare is often an issue later in retirement (Medicare does NOT cover foreign health care costs) unless you verify that the services and specialties needed as you age are easily available in your new home.  Finally, currency differences will provide you with more purchasing power while the dollar is high. However, when the dollar drops, there may be a need to return to the US or find some other way to make up the shortfall.  These contingencies need to be planned for early so that you’ll have a framework regarding your choices later in retirement.

When planning for your retirement paradise, bear in mind the most important principle—to think beyond today and prepare as best you can for contingencies throughout all phases in retirement. As always, we’re here to listen and to help outline the implications of your choices for the various stages of retirement. Working together, we can examine financially realistic options so that you can make the best choices today while preparing for the realities of your “Retirement Paradise”.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Converting Sweat Equity to Personal Wealth

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If you are a small business owner, you’re probably familiar with the term “sweat equity.” Essentially, sweat equity is a measure of the added interest or increased value that you’ve created in your business through plain hard work (that is to say, through physical labor and intellectual effort). Typically, business owners just starting out don’t have the necessary capital or don’t want to hire a large staff to run the business or to purchase high-tech, so they put in untold extra hours, do much of the work themselves and try to “think smart” in terms of marketing or production. They often use this opportunity to develop a clientele and a business process they enjoy. If well designed it can be profitable, but at some point the owner must put in place strategies that can convert business profit into personal wealth.

In other words, to be considered a truly viable business, at least two things must happen (there are others, but for the purposes of this article we’ll just focus on two). One, you must evolve the business to the point where it is sustainable with only the amount of personal labor you want to dedicate and in a way that allows you to maximally build Owner Wealth while covering business cash flow needs. Moreover, the goal is a process that gives you a sense of accomplishment and satisfaction. This is what we call a “life-style” business. Or two, you must organize and prepare the business to a degree or footing that it can be sold for a profit, at least enough and in a manner that will allow you to retain the profit as personal or “Owner Wealth.”

I should note, for those who are not self-employed, that employees can also generate sweat equity for their firm by creating additional ways to increase the bottom line. For startups, you may defer your vacation and even put off earnings. All these things add value to the company, but employees will expect to receive some form of compensation either in the form of existing benefits (bonus, parental leave, or nonqualified plans) or in shares of company value.
As a business owner, the first question you must ask yourself is “What do I want my life to look like while I’m creating this equity, and what do I want to accomplish in the long term?” Once you answer this question, and only then, can we come up with a proper plan to support your direction.

It is our experience that business owners without such a plan likely encounter challenges that can undermine their ability to convert their equity to personal wealth. These challenges come either in terms of selling the business or ensuring that the life-style business is sustainable. For instance, there is a good chance that instead of generating wealth to your maximum potential, you’ll be funding Uncle Sam (and the California Franchise Tax Board) and coping with cash flow problems.

Presupposing your business is already generating profits, a well-tailored plan can (at least potentially) make a big difference in terms of retaining or accumulating Owner Wealth. Aside from using earnings to support current lifestyle, your business can create benefits that permit the owner to retain earnings for future use and reduce current tax liability, particularly important in California, where the tax liability on business owners with profitable business can exceed 50% of their business profit.

For example, a business owner with sweat equity from their start-up or life-style business that yields around $500K per year (after business expenses) might have a tax liability of $110K (IRS only) or $155K in California (see table below). Using available benefit tools/strategy an owner can (in this scenario) build wealth annually of about $230K. Much of their wealth is built from deferring taxable income and lowering their tax liability to $45K (or $70K within California).

table

Allowed to grow over 5, 10, or 20 years this strategy could (at a conservative 5% annual return) yield wealth of $1.3M, $2.9M and $7M respectively for the business owner. On its own, tax and benefit planning can yield a high conversion of sweat equity to Owner Wealth.

When starting a business, the last thing we ever think about is how we’ll exit from it and collect on all the hard-earned sweat equity we’ve invested. We’re usually focused on creating value and determining how we can generate sufficient earnings. Yet for some businesses it is only from a well-designed and planned sale that the owner will realize any personal wealth from their risk and hard work. For the owner of a life-style business, selling your firm may seem akin to selling off your first-born, but there comes a time in all our lives when such decisions are unavoidable, even advantageous. At the very least, it may be worth considering selling part interest in the business as a way of reducing workload and simultaneously augmenting Owner Wealth.

As an owner ready to sell you will want to be confident that you are choosing the right time, securing the best price, and structuring the transaction wisely. You’d be well advised to seek expertise in selling your business (particularly new entrepreneurs), and give plenty of thought to how it will impact Owner Wealth, which is all too often overlooked.

When considering how to exit from their business, entrepreneurs need to at least follow these 7 steps to maximize Owner Wealth.

  1. Plan your exit well in advance since the best fit team and solution may take time to identify and develop.
  2. Understand and acknowledge your emotional connection to the business. It can be deeply personal and leave you unsatisfied if not fully addressed – regardless of profit.
  3. Prepare the business for the sale so that it is financially attractive to the financial advisors of potential buyers.
  4. Choose experienced individuals in your specific type of business to guide you through the process of selling your business BUT include your personal advisor to ensure that the best exit also meets with your personal financial goals. Again, building a team that is right for you.
  5. Think clearly about family succession – don’t make assumptions on how your family or key employees feel about the business.
  6. Gauge the interest for a friendly buyer from co-owners, family, employees, vendors, and even customers.
  7. Develop a thorough wealth strategy plan. The wealth strategy plan should NOT be just about the business but should address how your efforts will be used to build your personal wealth and meet your personal goals.

Take the time to know yourself, know your goals and make absolutely sure your financial advisor has a clear picture of your objectives. Together, your plan will convert all that valuable sweat equity into wealth to fuel your dreams.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Building Wealth: Your Real Estate Asset

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Real estate is often purchased as a lifestyle asset (to live in) or as a commercial investment (to generate rental income). It’s also quite common for people to think of their home as both lifestyle and an investment. Certainly, the most common near-term goal for families is home ownership – many think it amounts to a “no brainer” investment (meaning they think their home is a great investment) when it actually costs them much more than they realize.

In our examination of annual return rates on residential and commercial real estate we find that real estate is by no means a no brainer investment. Real estate assets can indeed contribute to wealth creation if the purchaser buys for value, carefully manages maintenance/renovation costs, and the sale is handled with an eye to minimizing taxes on gain from the sale.

Your residence has the potential to be a large part of your wealth, particularly in the Bay Area, but it can also be your largest liability.

Lending institutions have different requirements when lending for an owner occupied residence than for commercial real estate. A primary residence can often be purchased with lower down payments and lower mortgage rates than non-owner occupied real estate. In addition, on the sale of the owner occupied residence the gain will often fall under the capital gain exclusion rules which allow couples to exclude $500K from their income, tax free. This is one of the few opportunities to realize gain completely tax free. Couples who want their residence to be an investment rather than a lifestyle asset should consider selling their home once the gain (market value above basis) in their home approaches the $500K cap gain exclusion. This doesn’t mean you have to buy bigger or smaller or move away from your neighborhood but it does mean that you must sell a property to capture this tax free gain.

If a couple bought a home for $600K, made no renovations and 5-10 years later it is worth $1M they could choose to sell their home and retain the $400K gain tax free. They could repeat this process several times in a couple’s lives and each time a sale is completed the gain can be retained tax free. At the end of 3 rounds (there are residence requirements for each exclusion to be allowed) this couple could have managed to clear (net) well over $1M tax free. Despite this unparalleled opportunity to build tax free wealth, most home owners will buy one home and live in it until retirement. A well purchased property will still yield gain but much of it will be taxed. A home purchased at $600K that sells for $1.8M in retirement will have $500K of the gain tax free but $700K will be taxed at capital gain rates federally and at regular income rates by the state.

A residence can turn into a large liability when the debt burden is too high, when the home renovations do not yield increased value for resale, when the home requires a lot of maintenance, and when the location is no longer appealing (loss of home value appreciation).

Unlike residential home purchases, real estate purchased for investment is first valued on its ability to generate sufficient income and not as much on its appreciation. Before buying an investment property the property is thoroughly analyzed from various perspectives. An APOD (Annual Property Operating Data) is the principal tool to understand the cash flow, return rate, and profitability that can be expected from a prospective property. Once a property passes the APOD test (primarily for risk assessment) then the tax shelter provided by such an investment and the impact of the time value can be used to determine if this is an appropriate investment. Not surprisingly, much of the success of these investments stem from proper usage of tax rules. The value of the annual depreciation (using Schedule E) is well known. An equally important tax tool is a 1031 exchange. In a 1031 exchange the value of the investment property you own can be used to buy a second investment property of the same or greater market value while deferring tax payments on the gain.

In short, both residential and non-owner occupied real estate can be part of your investment plan. Unlike market investments it is more difficult to identify and protect against unexpected events and the illiquid nature of ‘real’ assets. Managing real estate to attain investment value requires thoughtful deliberate actions that may not always be aligned with your personal wishes (far from being a “no brainer”). Investing in real estate can reap big rewards, but entails doing a lot of meticulous research, taking only risks that are necessary, covering for contingencies, working with an experienced team, and then allowing time to do the work.

If you need help deciding whether a real estate purchase fits with your long term goals, give Aikapa a call.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Financial Decisions: Taming unhealthy habits

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I’ve always been fascinated by how and why we continue with habits (behaviors) we know to be intrinsically out of line with what we want. There’s plenty of literature to explain the biology, particularly related to marketing and Artificial Intelligence (AI), that illustrate how our brains make decisions. I wrote an article some years ago on the science behind financial decision making (“Taming Our Irrational Brain,” Association for Women in Science Magazine, Summer 2009, Vol 39, No 3). If you’re interested in the science you may find it a good place to start. In summary, I think understanding how to change our decision making process begins with a deeper understanding of ourselves.

Choosing among competing options is a fundamental part of life. Historically cognitive processes or reflexive stimulus-driven automatic reactions. To deal with the massive and complex number of choices we face on an ongoing basis, individuals use multiple “systems” that offer tradeoffs in terms of speed and accuracy, but can optimize behavior and decisions under different situations. We shift quickly from “use your head” to “go with your gut” making daily decisions heart wrenching. This clutters the brain and adds uncertainty to decisions – making decisions stress-filled.

Ideally we would have automatic behaviors that keep us aligned with our planned (cognitive) objectives. I believe that sustainable change has to be linked to a simple consistent and believable process that can support you during stress-filled times. Though there are different approaches to creating these behaviors I will focus on Charles Duhigg’s three-step process for changing habits (he refers to them as CUE-REWARD-ROUTINE) and add my own thoughts as we go along. Obviously, my focus is on developing healthy financial habits.

  1. First, we need to acknowledge what it is that we want to change and what it is that we wish to attain. What financial behavior are we interested in changing? We need to visualize what we’d like to see instead of our current behavior.
  2. We must then identify the triggers for this behavior (or “CUEs”). Duhigg suggests that we ask ourselves what we were doing right at the time, who were we with, where we were, and, what we were doing just before the behavior. One of his best examples is when you get up to get a snack in the middle of your work – what were you doing just before you got up? What was your trigger? Some people have similar triggers for spending beyond their budget and, yes, even for making buy/sell decisions on their portfolio.
  3. Next, we must understand what “reward” we obtain from this particular behavior (habit). This step is essential because we need to find something equally rewarding to successfully implement a change in our reaction when we next experience the same trigger. The new reward must be one that is both doable and strong enough to replace the current reward but also in line with our plan. Was the reward for getting a snack really to satisfy hunger, or were we bored, or in need of social interaction or just anxious? For example, consider the person who checks their portfolio every time they feel the trigger. Their reward may be to talk to people about it (social interaction) or it may be boredom (interacting with a different software) or it may be something else. This individual will first need to identify the trigger that prompts them to check their portfolio often and determine what reward they receive for doing this action.To change a reaction to a particular trigger, the goal is always to identify a substitute reward that is aligned with your well-being and your plan. For example, going for a walk alone or with friends, taking up a mental or physical activity that is positive–anything that will actually yield the change you are hoping to make.
  4. Then lock it in, so to speak, by establishing a “routine” around both the triggers and reactions that will make the new habit permanent. If the reward is strong enough, over time it will seem less and less routine, even enjoyable. In our fast moving world more and more decisions are made quickly, even without thought. It doesn’t help that marketers are out to manipulate our choices at every turn even if it means deviating us from our personal wishes (after all that is their job). This imposes a degree of stress if not countered by healthy habits. Ultimately, a well-lived life is all about making daily choices that enhance our chances of achieving the goals we set for ourselves.

It is evident that establishing any new behavior (habit) needs a belief system and a support system that you can reach out to during stressful times to ensure that you don’t revert to the original behavior. I find that for some clients Aikapa has become this support system as they strive to adjust financial habits and align them with their financial plan. It’s our job to help clients remember the reason(s) why these behaviors are important and to help them visualize their financial rewards on an annual basis. We do this through client meetings and by examining savings, investment portfolio and retirement plans.

In short, attaining financial wealth and peace of mind are indeed possible when you can develop habits that work for you. It is our mission to educate and help you build a stress reduced financial life while maximizing your wealth. If you are working on building a new financial habit to support your dreams, don’t forget to include Aikapa as part of your support team.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com