Is Life Insurance a Commodity?

Is Life Insurance a Commodity?

As an early disclaimer, I no longer sell life insurance nor do I receive compensation when my clients purchase it.  As you will soon learn, I have tried to distance myself from the commodity side of the business over the last couple of years. 

I started my professional career in the insurance industry.  My first sales meeting was about “understanding” annuities.  I learned more about life insurance, annuities, and long-term care insurance in one weekend than I could have possible imagined.  More importantly, I learned that I was perfectly capable - and better prepared - to sell it than the next guy.  I didn't believe that then and I certainly don't believe it today.  

As such, my first experience in the financial services industry gave me an extremely bad taste about life insurance.  I learned - to my own detriment - that life insurance is a product that is sold and not bought.  For example, I was taught that variable life insurance was a product that you had to sell over and over again to the same client in order to keep the client from allowing the policy to lapse (i.e. to prevent the client from stopping making premium payments).  During that time, I lost a lot of respect for the insurance industry and came to the conclusion that life insurance was a commodity based business.  In other words, find the lowest cost product and buy it.  

Over the last couple of months, I have had the opportunity to review that premise and have learned that I was wrong.  Life insurance is a knowledge based and personal business that, when done right, requires an enormous amount of expertise to get the right product in the clients hands at the best possible price.  Let’s take a look at those two examples. 

High Net Worth

I had a client that was recently looking to do something “safe” with several million dollars that was parked in cash.  The option is was to purchase a high yield bond that matured in 5 to 7 years or price out an insurance policy.  I called a bunch of people to try to price out insurance policies that could be competitive on day one.  The problem that I found with many insurance policies is that they take at least several years before the cash in the policy can start to produce positive returns.  

However, that only applies to 'off the shelf' policies.  Accredited investors can actually purchase a private placement policy which guarantees positive returns in the first year.  Positive enough that given some strategic thinking about insurance the policy will actually compete quite well with a high risk bond that is paying 6.5 - 7%.  

Again, I spoke with numerous insurance agents.  Several of them were simply trying to sell a commodity.  However, a few of them knew their products extremely well and began tailoring solutions around the needs of the client rather than pushing a standard solution onto the client.  Not only did they know about the product, but they understood enough about it to make sure that it was the right fit given the unique situation for our client.  They also helped us think through future planning concerns and opportunities that may arise as a result of the policy design they came up with.  

Pension Maximization

I was also going through a potential pension maximization strategy with someone recently.  What did I learn?  I learned that some insurance companies underwrite you based on your age on the date of the application while others underwrite you based on when you have been approved (which could be 6 to 8 weeks later).  I also learned that some insurance companies will actually allow you to buy down your age.  In other words, if you are about to hit your birthday and want to pay lifetime premiums based on the younger age you can essentially pay the insurance company a year of premiums and be underwritten at the younger rate.  

I also learned that insurance agents can actually negotiate with carriers based on your underwriting to get you better rates.  Additionally, some insurance companies will underwrite you as a non-smoker if you prove for a year that you can quit smoking while others will only underwrite you assuming that you have not smoked for a period of month or years.  It is probably obvious on those lines that carriers view all kinds of peculiarities differently and thus you may get better pricing from one company than from another.  

In other words, if you are looking at the lowest cost on the face of it, you could actually end up paying more than if you choose to work with a good life insurance agent who knows all of this PLUS more. 

Bottom Line 

I work in the advice business and should have recognized that paying for quality advice typically saves you money.  However, I let my initial impression of insurance impact the way that I view the industry.  Finding a good qualilty life insurance agent will save you time, money and frustration in the process of trying to obtain the best possible coverage.  

Yes, I realize that it is hard to determine who offers quality but I have learned that you can sense quality in a person just like you can sense quality in a product.  Ask some questions, listen to what they have to say and more importantly how they say it.  Then don't be afraid to move on to the next person until you find that person that understands their line of business.   I promise you will be rewarded.  

Needless to say, my two solutions earlier were solved by the same person - an extremely professional agent.  

Changing Your Tax Withholdings

Matching Your Taxes Now and the End of the Year

Several years ago, I was volunteering at an event to provide financial planning services to those who can't normally afford it.  I had a nice lady sit next to me who had fallen behind on her mortgage payments due to the economy.  She was going to be able to qualify for a mortgage modification program but she just couldn't quite come up with the extra monthly payments to figure out how to make it work.  She had brought in her paychecks (working two jobs), last tax return and a monthly expenses sheet that she had completed.  Two things jumped out at me: (1) she was still giving 10% of her income to her church and (2) she was withholding an enormous amount from her paychecks and receiving large refunds at the end of the year.  

I focused in on the charity first and reminded her that charity can start at home too.  She shrugged that conversation off pretty quickly and it was clear that I wasn’t going to win that discussion so I went straight to plan B.  We looked at her tax withholdings and her tax refund from last year and did some quick math.  If she would simply change her withholding to pay only what she needed to pay (i.e., no refund at the end of the year) she would have enough to pay the increased monthly payment plus a little additional to start contributing to her 401(k) again.  Voila!  Income shifting meant that this sweet lady who was so proud to own her house was going to be able to keep it. 

I recognize that not everyone faces the same choice - stop over withholding or lose your house.  However, it is similar in nature.  Over time, your ability to earn money on your money by not overpaying the IRS compounds and can have quite positive a wealth effect over paying too much and receiving a refund at the end of the year.  

Changing Your Income Tax Withholdings

When we start working for a company we usually spend the first day completing paperwork.  Lots of paperwork.  One of the pieces of paper hidden in that stack that we complete is the W-4 (http://www.irs.gov/pub/irs-pdf/fw4.pdf).  It is a vague looking IRS form that determines how much will be withheld from your paychecks for federal and state income taxes going forward - until you change it.  Most people likely spend a few minutes looking through it, guess at how to complete it, and then move on to the next sheet of paper.  There are two over-riding pieces of information that determine how much the Federal government and your state, if they have an income tax, will deduct from your paycheck.  The first is whether you are single or married and the second is how many allowances you have.  

What is an allowance?

Taxes are a complex beast so I won't get too deep in the weeds here.  An allowance is the IRS way of saying how much income do you want to exclude from being taxed.  On the Federal level each allowance is worth $3,900 in 2013.  This means that for each allowance that you claim, the withholding table excludes $3,900 of your income.  So if you income is $100,000 in 2013 and you claim one allowance, the withholdings table tells your company to exclude $3,800 of your income and then tax the rest according to the withholdings schedule.  In this case, a full $96,100 would be taxed even though it is likely that your taxable income for the year would be dramatically less than $96,100.  

One way to change this would be to look at your total number of deductions on your previous year’s tax return and divide that number by $3,900.  For example, if your total personal exemptions and itemized deductions last year was $30,000 then you would want to select either 7 or 8 allowances.  

What is the impact of Married versus Single

The primary impact of checking married or single on the withholding worksheet is it determines the rate at which your income is taxed.  Much like the tax return at the end of the year, your withholdings are taxed using a graduated formula. If you select Single or “Married, but withhold at the higher single rate” you are opting to have more taxes withheld at the higher tax rates.  This can be a good choice if you are high up in the income world and are impacted by certain phaseouts and/or have additional income outside of your salary. 

Summary

It is a lot of information but certainly worth reviewing your allowances and trying to figure out the best way to minimize the amount of taxes that you pay with each paycheck.  Of course, technology has become our friend and really helps in this instance.  You can get a better understanding of how much you should be withholding by visiting the IRS withholding calculator (http://www.irs.gov/Individuals/IRS-Withholding-Calculator)  

Good luck increasing your net pay so you can afford whatever it is that you can't right now - hopefully it is something worthy of your EARNED income.  

Do you want a tax refund?

The Myth of the Tax Refund

It’s that time of year again.  No not time for the ACC basketball tournament and March Madness, but that time of the year where everyone celebrates their tax refund.  It’s a time honored tradition where everyone is excited to get their money back from the Federal Government.  But should we celebrate it?  Let’s review the history of income tax withholdings first. 

History of Income Tax Withholdings

In 1943, Congress pushed through the Current Tax Payment Act which required taxpayers to stay current on their tax liability.  They accomplished this via a new withholding system applied to earned income (e.g., salary and wages). 

Prior to 1943, taxpayers didn’t have to pay throughout the year.  They simply had to pay “next year for taxes due this year.”  This made the US Treasury department a creditor to every single taxpayer in the country.  As the Federal government needed more revenue to fight World War II, it was necessary to expand the income tax base by taxing more citizens.  However, taxing more citizens meant that the quality of the debtors would decline unless a smoother way was made to collect taxes. 

It wasn’t just a deterioration of the income tax base that prompted Congress to pass the Current Tax Payment Act though.  The War was creating inflation.  And this meant that a dollar tomorrow was worth less to the Federal government than a dollar today.  It needed the revenue sooner and a withholding system was the perfect way to get it done.  Incidentally, it also made it easier for the Federal government to raise taxes in the future.  After all, a small increase in taxes owed every single pay period is not as tough to bear as a bigger check to cut at the end of the year. 

Congress had seen a successful withholding campaign implemented through the Bureau of Old-Age Benefits – which was one of three initial operating bureaus set up administer the Social Security Act.  So they passed a law that required citizens to pay income taxes on wages and salaries as the income is earned. 

Two Options with your withholdings

It is extremely unlikely that you will ever pay exactly what you owe in Federal income taxes - unless you owe nothing and you pay nothing.  Therefore, you really have two options: pay more than you owe throughout the year or pay less than you owe throughout the year.  If you pay more than you owe, then you get a refund at the end of the year.  If you pay less than you owe, then you write a check to cover the difference.  

So do you prefer to owe the government money or do you want to receive a refund?  

Lend Money to the Federal Government

Americans are known to spend.  It’s one thing that we do really well.  So the argument is that overpaying the Federal government is a method of creating savings.  The problem with this is that if Americans are truly spenders and not savers, most Americans will receive their tax refund and spend it.  So the question becomes do you prefer to spend your money now or in February, March or April when you receive your refund?  Or maybe more importantly, can you trick yourself into saving throughout the year.    

By overpaying income taxes, you need to realize that you are essentially giving the Federal government your money to spend as they will until you file your tax return.  At that time, they will send you back a check for what you owe – with no interest paid to you.  In essence, you have lent the government money through a no interest loan.  For all of those people complaining about not receiving interest on their checking account, beware as you are getting the same thing from the Federal government when you lend them money. 

Be Lent Money by the Federal Government

If you are a good saver then this is unquestionably the route for you.  If you can save money and be prepared to send a check to the Federal government in April then you have flipped the equation and received an interest free loan from the Federal government for the amount of taxes you owe them.  During times of higher interest rates, you could let that amount sit in a very safe checking account and earn you interest – with little to no risk.

You have to be careful though.  The Federal government (and state governments) recognizes that some individuals will try to minimize what they pay the government throughout the year so they require that you pay either 90% of current year taxes or 110% of your previous years tax liability.  If you don’t satisfy one of those two then you owe the Federal government an underpayment penalty. In other words, don’t stop paying them completely but do consider how

Conclusion

So it depends.  Are you a good saver?  If the answer is no, then you may want to change your habits and stop lending the Federal government money with no interest received.  If you are a good saver then stop lending money to the government and let it work for you.  Know your own limitations though.  Don't get caught thinking that you are a good saver when deep down you know that you aren't.  This could lead to further financial trouble, especially if you rely on a credit card to help you pay your tax bill come April. 

Is Tax-Free Always Better Than Tax-Deferred? 

There is an old saying that a bird in the hand is better than two in the bush.  I think about that when talking about Roth strategies because the old adage still applies, in many instances.  To put it in similar context, paying taxes today is better than paying taxes in the future – under the right circumstances.

The Roth account is a fairly new one - it was established by law on January 1, 1998 and remains a mystery to many people.  Nonetheless, the premise is quite simple.  You contribute money to the account and it grows tax-free until you take distributions. As long as you take distributions for a qualified reason - mainly retirement - you pay no income taxes upon distribution.  

Obviously that sounds too good to be true right.  In reality, tax-free growth is only good in certain circumstances.  Let's think about this a different way.  What would happen if I offered you $10,000 or $8,500 and that amount doubles in value at some point in the future - which one would you take?  In other words, the $10,000 now becomes $20,000 and the $8,500 now becomes $17,000.   You probably still want the $20,000 don't you?  

What if the $20,000 was in a 401(k) and your tax rate was 30% (meaning you get to keep 70% of the value after paying taxes)?  Now your $20,000 is only worth $14,000.  If the $17,000 is in a Roth account - meaning distributions are income tax free - then it is still worth $17,000 after taking the distribution.  In other words, in this instance taking $8,500 was better than taking $10,000 even after both doubled in value.  

Obviously, if your tax rate was only 10% then the $20,000 is still $18,000 after taxes (you get to keep 90%) and you would rather have $18,000 than $17,000, right?  If so, then taking the $10,000 was better than taking the $8,500 even after paying taxes in the future.

How do I know which is better?

With that bit of information, you can start to put together the picture of what makes a Roth account more successful than a traditional IRA or 401k.  Understanding your future tax rate can help you make an informed decision.  But that is only half of the picture because you need to know your current tax rate too.  

In essence, you are given $10,000 (though most of us earn it) every so often through work and you have decisions to make with that money. You can spend it (the popular American choice) or you can save it.  If you save it, the money can go into a savings account, a pre-tax account (IRA or 401k), or a Roth account.  There are valid reasons to save to a savings account but we are going to disregard that today and just focus on the decision to save it into a pre-tax account or a Roth account.  

If you choose to save $10,000 into a pre-tax 401k then the full $10,000 goes into the account – remember you pay taxes when it is distributed, not when it is contributed.  If you choose to save it into a Roth 401k then you have to pay taxes first – I know the persistent them of taxes is a real downer.  

If you are in the 15% tax bracket, then you can only contribute $8,500, not the full $10,000 (this is simplified for our discussion today).  The money grows over time and eventually you start taking distributions to support expenses in retirement.  The tax rate at which it goes into and comes out of the account determines the optimum way to save the money.  Ideally, you would contribute to a Roth account if your marginal tax rate is low today and expected to be high when taking distributions.  Alternatively, you would contribute to a traditional pre-tax account today if your marginal tax rate is high today and expected to be lower when you start taking distributions.  

Assume that you earn $10,000 and can contribute it to either a Roth account or a traditional account, your current tax rate is 25%, and you take a distribution when the account doubles in value.  This would mean that you can contribute $10,000 to a pre-tax account or $7,500 to a Roth account.  Which is better?

Future Tax Rate	15%	25%	39%
Roth Account Value	$15,000	$15,000	$15,000
Pre-Tax Account Value	$17,000	$15,000	$12,200

So the general principle is pay taxes when you know they are going to be the lowest. 

In other words, the bird in the hand is paying taxes today rather than in the future.  You know what you get today but the future is an unknown to all of us.  With that being said, Roth contributions still don’t make sense for everyone and should be used only in the right situations.  

What Happens to my Timeshare

What Happens to my Timeshare?

I had lunch the other day with a client – nice Italian meal – and we were talking about life so naturally vacations came up.  This client happens to own a timeshare in St. Thomas and was talking about taking a trip down there sometime soon.   As he was talking about it I realized that I had never thought about the estate planning issues around a timeshare.  In other words, what happens to a timeshare when you pass away? 

Joint ownership

The easy answer for most people that own a timeshare – couples – is that at the death of the first spouse it merely passes directly to the surviving spouse (who is typically the joint owner).  If the surviving spouse re-titles the house and splits the ownership with a child or sibling then the joint ownership nature remains and at the death of the first of the two the property passes to the second owner.  Repeat the process as long as the property is owned by two people (as long as it is not owned as Tenants in Common). 

Individually owned property

For individually owned property, it is not as simple.  Individually owned timeshares depend on what type of timeshare it is: deeded property or “right to use” property. 

      

      a.       Deeded property is the most common form of timeshare ownership in the US.  Having a deeded timeshare means that you have a deed that gives you full ownership rights to your parcel of the property.  This means that the clerk’s office in the county of the timeshare will have a record of your ownership. 

      

      b.      Right to Use property does not come with any ownership rights – meaning that you can’t pass it on to your heirs.  It typically expires after a certain number of years or with at your death. 

In other words, if you own a deeded property your heirs have to be concerned with the estate settlement of a timeshare but if you own a right to use timeshare then they don’t.  If you don’t know what type of timeshare you own, you should be able to determine it by looking at your contract.  If you can’t find your contract then you should be able to call the management company and ask. 

Deeded property

A deeded property is how we own our homes.  With a deeded property, you own physical property in the state, territory, or country where the timeshare is located. 

Therefore, when you die and there is no joint owner in the property it passes through probate according to the terms of your will.  Alternatively, if you have placed the property in your revocable living trust the property will avoid probate and pass according to the terms of your revocable living trust (if it is property in a foreign country or US territory you will have to check whether or not they recognize US trusts ). 

So the preferable method of timeshare ownership is clearly joint ownership or owning it through a revocable living trust.  Of the two, the revocable living trust is the preferred method because it is more permanent in nature. 

Problems

The challenge that I see is that passing a timeshare through probate can be an expensive process.  At a minimum you are likely talking about $1,000 to $1,500 in US.  However, if it is owned internationally you could be looking at a cost of as much as $3,000 to $5,000, potentially more.  Considering that the actual value of most time shares is less than $50,000 we are talking about a rather large cost to transfer ownership.

Conclusion

If you happen to own an international timeshare or one in a US territory, it becomes even more complicated because now your estate has to be settled in a foreign court.  I am not an attorney or an international law expert, but I do know that passing property through their courts system can be challenging and time consuming – both attributing to the higher estimated costs for timeshares owned internationally. 

What does this mean?  If you have a timeshare you need to figure out how it is owned (“right to use” or deeded property).  Once you know how it is owned you should talk with an estate attorney about the best way to structure your estate documents to pass the property at your death.   It may be that the cost of setting up a revocable living trust is similar to passing the property through probate at which you could determine that it is just as well to let you heirs deal with it.  Or you may realize that the headache and costs of the probate process isn’t necessary for your heirs so you take the steps on the front-end to reduce the costs and headache.  Either way, it is good to understand the costs and the options for making things pass as smoothly as possible.  

What does "Chained CPI" Mean?

A popular way to reduce expenses and raise revenue in DC is to pass legislation that isn't felt today, but felt in the future.  It's a convenient way for policy makers to have a meaningful impact on the trajectory of the Federal debt (not the deficit) without having their constituents understand what they have done until it is too late.  One idea that has been around for a long time is changing the way that we measure our Cost of Living Index (COLI) to "chained" price increases and attempting to measure a substitution effect as a result of price changes.  Huh is a perfectly reasonable response.  

There is a very simple way to think about this.  Let's assume that you go to the grocery store one day and the price of four boneless skinless chicken breasts is $10 and the price of four pork chops is $10.  Four weeks later you go back to the same grocery store and the price of the chicken breasts has doubled to $20 but the price of the pork chops has remained the same.  Are you still going to buy the chicken breasts or are you going to double up on the pork chops?  Economists argue that most consumers will double up on the pork chops.  But that isn't the way that the current consumer price index calculates it.  It assumes that you have a fixed basket of goods and you don't change your spending habits no matter what happens.  

The Chained CPI tries to take a different angle.  The Chained CPI takes into account the historical price of a item relative to its current price and substitute items and assumes that consumers will make changes based on the current prices relationship to its historical price and other similar items.  Huh?  It assumes you buy the pork chops rather than the chicken.  In essence, it allows you to change your basket of goods based on prices in the market place.  

In other words, the historical index doesn't allow you to change your spending habits based on higher or lower prices but the Chained CPI does.  

Believe it or not, the Chained CPI (technically referred to as the C-CPI-U) has only been around since 2002 but because it has a two year lag it has been measuring prices since 2000.  Over that time period, the Chained CPI has averaged about 0.2% less than the traditional CPI which doesn't seem like much until we think of the impacts that it could have on the two places it is being talked about: Social Security benefits and tax brackets.

Details:

Social Security benefits 

If you start taking your Social Security benefits at age 65, receive $18,000/year (or $1,500/month) in the first year and live to age 90 a pretty large disparity will show up with "just" a 0.2% reduction in the annual increase.  

Assume two cases.  In one case you will receive a 3% increase every single year and in the other case you will receive a 2.8% increase every year.  At the end of the first year, the difference between a 3% increase and a 2.8% increase is just $36/year.  However, after 25 years that annual difference is now almost $1,800 (10% of your initial annual benefiti) and at the end of 30 years the difference is almost $2,500 per year.  That doesn’t sound that large, but the difference is between receiving $37,688/year and $35,900/year.  For Bill Gates, that isn’t a big difference but for someone who is just receiving Social Security benefits – with no other assets or income to support them - it is a large difference. 

Most politicians understand the impact that this has on those seniors who live an extended life (mostly recognized as living either to age 80 or 85).  Therefore, most proposals that adjust the way we increase Social Security benefits incorporate a one-time large increase in the benefit at 80 or 85 to get the recipient back to or near where they would have been under the current formula. 

Tax brackets 

The other case is in tax bracket adjustments.  If tax brackets are allowed to increase annually for inflation and the way inflation is calculated is held to a lower rate of increase then your future taxes will increase as well.  

If we apply the same 3% increase and 2.8% increase to the top end of the current 15% tax bracket then we come out with a similar result.  For reference point, the top of the 15% tax bracket is represented by taxable income of $72,500.  After one year, the difference is $145 – meaning that the last $145 is taxed at the 25% rate rather than the 15% rate.  This results in an anticipated higher tax bill of just $14.50.  However, at the end of 25 years the difference is $7,200 with a higher tax bill of approximately $720 and at the end of 10 years the difference is approximately $10,000 for a higher tax bill of about $1,000 annually. 

It may sound like a small tax increase and it is.  However, if you start doing the math at higher income levels you are having a much larger increase in the overall tax liability.  Therefore it should be welcomed by those who favor a more progressive tax code as it does have a small impact on lower and middle class families while having a larger impact on those taxpayers earning higher income. 

Applying the Social Security adjustment against millions of future recipients will significantly reduce future government expenses.  In addition, changing the way that the government collects revenue through tax bracket adjustments will raise an enormous amount of new revenue to the table. 

ATRA – Roth Conversion and the 401(k)

Congress passed an important tax relief package earlier this month called the American Taxpayer Relief Act (forever known now as ATRA) – in case you hadn’t heard – and one of the more interesting provisions is the ability to do a Roth conversion within a 401(k) plan. 

What

Before January 2^nd, employees were mostly prevented from moving assets from the traditional, pre-tax portion of their 401(k) to a Roth component of the same 401(k) plan.  Yes, it was available to those employees who otherwise were eligible to take a distribution from the plan but that was rather limited. With the passage of ATRA, though, Congress has now opened up the opportunity for anyone to move assets from the traditional, pre-tax portion of the 401(k) plan to the tax-free , Roth portion of their 401(k).  In the financial community, the process of moving assets from a traditional account to a Roth account is called converting (aka, a Roth conversion).  

To be clear, it is not as simple as simply moving assets from the traditional 401(k) account to the Roth account.  In order to do this, you have to pay taxes – at your current income tax rate – on however much you convert.  But the end result is that the assets will now grow tax-free and will be distributed income tax-free (under most circumstances). 

Impact

The impact on this is probably fairly limited to most people – or at least it should be.  However, the obvious segment of the population that this benefits are those young people – likely still in their 20s or early 30s – who are still on an upward trajectory in their career paths , have some savings in the traditional 401(k) plan and also aren’t already in a high tax bracket that they anticipate will fall in retirement.   

In other words, it makes sense for people who expect to be in a higher tax bracket in the future when they start taking distributions from the account. 

Planning

So ATRA opened up the possibility for people to move assets from the traditional 401(k) to the Roth 401(k), should you do it?  It depends really on two factors one of which is a complete unknown for most:

      

      1)      Do you expect to be in a higher tax bracket in retirement than you are now?  If the answer is yes, then you should convert assets now as long as you can answer yes to the next question.

      2)      Do you have the cash to pay the taxes today – or technically next year on April 15^th?  You see in order to convert the assets from the traditional account to the Roth account you have to pay income taxes on it today. 

For parents of young adults who see the value in the Roth account and have the cash available to help their children, this may be a very good opportunity. Talk to your adult children about the opportunity, get an understanding of their current tax picture, and know how much they may have in their 401(k).  If they have a lot – or more than you are willing to gift them to pay the taxes – then consider advising them to do a partial conversion.  In other words, if they have $25,000 in the traditional IRA and you only wanted to give them $2,000 to pay the taxes then figure out how much $2,000 will convert – or ask your financial professional to assist you.