Caves & Associates
 

TIMELY TOPICS

October 23, 2006

DELAYED GRATIFICATION
Approaching retirement and terminations of traditional pensions are causing an increasing concern about receiving substantial, predictable retirement income. A survey of retirees found 38% are concerned they will deplete their savings and be left with only Social Security. Thus, many experts suggest delaying Social Security benefits to substantially improve post-retirement financial security.

Although a delaying strategy may at first appear unsupportable, the potential benefits are impressive. If you are born between 1943 and 1954, let’s assume you are eligible for $1,200 a month at the age of 62. By delaying benefits until you reach age 66, you are eligible for an extra 33 1/3% benefit. Therefore, you would boost your earnings to $1,600. The additional boost is to $2,112 at age 70, or more than 75% higher than your benefit at age 62. These figures do not include Social Security’s annual inflation adjustment.

Despite these impressive increases, many retirees begin receipt of their Social Security benefits as soon as possible. Some have valid reasons. Some reasonably believe they cannot afford to wait. Others do not find it sensible to wait because of an honest assessment of low life expectancy. However, most retirees don’t give it much thought, and it seems they don’t wait “just because.” Nevertheless, sooner is not necessarily better.

The “quantitative” debate over when to begin Social Security usually occurs when considering the “break-even” calculation. In other words, how long would you have to live in order for delayed benefits to be worthwhile even though you “missed” receiving early years’ payments? Suppose you are debating whether to take benefits at age 62 or 66. In order to calculate which age is better, assume that both benefits were invested at an after-inflation annual return of approximately 3%. If you were born between 1943 and 1954, thus receiving an extra 33 1/3%, you would break even at age 82. Coincidentally, the average 65 year old man can now expect to live until age 82. A woman can expect to live until almost age 85. Thus, the quantitative analysis is generally inconclusive.

When deciding whether or not to delay Social Security benefits, there are several important “qualitative” and tax factors to consider. If you are single and considering delay, you should be in good health and have an average, or above average, life expectancy. Second, if you are married and your family’s main source of income, while your health may not be exceptional, your spouse has the potential to live well beyond you. Though not always the case, your spouse’s survivor benefit will typically be based on your benefit. Thus, your potentially higher Social Security payments from delaying could live on long after you.

Third, consider taxes. Taking early benefits and delaying retirement account withdrawals could be quite costly, especially when you begin to take required minimum distributions at age 70 ½. The alternative is to accelerate retirement account withdrawals to sustain your retirement lifestyle while you await commencement of your delayed higher Social Security benefits. This alternative can make a lot of sense if you are in a low or moderate income tax bracket in retirement because of the relationship between Social Security income and total income when determining taxability of the former. 

Finally, and we think most importantly, Social Security provides valuable “excess longevity” insurance. Everyone has the possibility of outliving their life expectancy, and thus running through their retirement savings. In this case, you’ll be receiving much more generous checks from Social Security because you delayed your benefits. Half of all retirees live well beyond their life expectancy, and it is important to plan as though you will too. In conclusion, this apparently simple decision can be rather complicated and quite important. Let us know if we can help.

 
INCREASED “KIDDIE TAX” DECREASES APPEAL OF CUSTODIAL ACCOUNTS
              

For a long-time, a favorite strategy of high income earners has been to transfer income to a family member in a lower tax bracket. This strategy normally results in attempts to transfer income from parents to their children. Many times the context is saving for higher education because many parents, well aware of the dramatically increasing cost of college, are seeking tax-advantaged ways of saving for potentially enormous bills (imagine three kids to private schools). Since parents can’t assign or give their earned income to their children (exception: employ them in the family business), they give income-producing assets to their children so the (unearned) investment income is taxed at a lower bracket (hopefully). As further background, we’ve mentioned previously our strong advocacy of so-called Section 529 college savings plans. They allow quite large transfers to children, and the investment earnings are tax-free to both parent and child if used for higher education costs. 

What’s timely and topical is that Congress has recently changed the way children’s investment income is taxed to the detriment those who have established a custodial account (UTMA) or an account held in the child’s name. Until now, investment income earned by children age 14 or older was taxed at the child’s own lower tax rate. For younger children, any unearned income over $1,700 would be taxed at the parents’ higher rate. The goal of employing UTMA’s for college savings was to gradually add to the account, taking advantage of the $1,700 tax shelter while the account value was fairly low during the child’s early years and then benefiting by the child’s low tax bracket after age 13 when the increasing account value would generate higher investment income. Under the new law, if a child is under the age of 18, not 14, unearned income in excess of $1,700 per year will be taxed at the parents’ tax rate (rather than the child’s lower tax rate). The result will generally be a larger tax bill for the family. 

Fortunately, the good news is the tax change does not apply to accounts designed specifically for college savings, such as Section 529 plans. Unfortunately, money from custodial accounts cannot be directly transferred into the more advantageous Section 529 plans. Any custodial holdings must first be liquidated, which will likely result in a significant capital gains tax bill.

A few strategies remain for existing UTMA’s. If funds are used for the child’s benefit and are not expenses typically the responsibility of the parent (food, shelter, etc.), UTMA monies can be used for a variety of purposes, including the child’s pre-college education expenses, after school programs, and even camps and educational trips. Since the UTMA pays for expenses you would otherwise pay for out of pocket, use your savings to make deposits into a Section 529 account. Consider this strategy for assets in the UTMA which will have the least onerous tax effect when liquidated. Additionally, the way in which an UTMA is invested can make a large difference in the amount of taxable income earned. Moving into municipal bonds or indexed equity funds can help keep the taxable income under 
$1,700. Also, postponing selling assets until the child is 18 will allow the family to be taxed at the lower rate and is logical if the funds are not intended for college expenses.
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