What Is An Inverted Yield Curve?

Today, August 14, 2019, the main part of the yield curveinverted. This is an important event because an inverted yield curve hashistorically been a very good predictor of a coming recession. In this articlewe will review

1. What the yield curve is

2. What it means when the yield curve inverts

3. Historical data showing why it’s been a goodpredictor of recessions

4. What it means for investors today

Understanding the Yield Curve

The yield curve is an economic indicator that originates from the bond market. It’s basically a chart that shows the yield of government bonds at different durations. For example, the yield on a two-year treasury note versus a 10 year government bond.  In a healthy economic environment, the curve is positively sloped as is illustrated by the chart below.

In a positively sloped yield curve, longer-term bonds have higher yields.  Here’s a hypothetical example using CDs. Let’s say you go into that bank and you are trying to decide between buying a 1 year CD or a 5 year CD.  In most cases you would naturally expect the 5 year CD to give you a higher level of interest because the bank is locking up your money for 5 years instead of 1 year.  If a 1 year CD gives you 1% interest, you might expect a five-year CD to give you 3% interest in a bond market that has a positively sloped yield curve, because the further you go out in duration, the higher the current yield.

However, sticking to our hypothetical example using CD's, there are periods of time when you go into the bank and the 1 year CD has a higher interest rate than a 5 year CD. That would make you ask the obvious question, “Why would anyone to buy a 5 year CD at a lower interest-rate than a 1 year CD? You get a higher investment return on your money for the next year and you get your money back faster?”.

The answer is as such, in the bond market, investors willsometimes buy bonds for a longer duration at a lower current yield because theyexpect a recession to come.  When arecession hits, typically the Federal Reserve will start lowering interestrates to help stimulate the economy. When that happens, interest ratestypically drop. Anticipating this drop in interest rates, bond investors are willingto buy bonds today that lock up their money for a longer period of time with alower yield because they expect interest rates to drop in the near future. 

So, let’s use the hypothetical CD example again.  You go into the bank and the 1 year CD rate is 3% and the 5 year CD rate is 2.5%. In an inverted yield curve situation, investors are buying those 5 year CD’s even though they have a lower interest-rate, because when the recession hits and the Fed starts lowering interest rates when that 1 year CD matures a year from now,  the new rate on CD’s may be a 1 year CD at 1% and 1.5% on a 5 year CD.  So from an investment standpoint today, it’s a better move to lock in your 2.5% interest rate for 5 years even though the yield is lower than the 1 year CD today.  You can see in this example why an inverted yield curve is such a bearish signal for the markets.

Below is an illustration of an inverted yield curve:

It’s a Very Good Predicator of Recessions

When you look at the historical data, it shows how frequently an inverted yield curve has preceded a coming recession. Below is a chart that shows the spread between a 2 year government bond and a 10 year government bond.  The yield curve is positively sloped when the blue line is above the dark black line.  When the blue line falls below the dark black line, that means that the yield curve is inverted. The grey areas in the chart indicate recessions. 

Today, the main part of the yield curve which means the 2year vs the 10 year bonds inverted. However, it’s important to point out that earlier in 2019, the yield onthe 10 year treasury bond dropped below the yield on the 3 month treasury note,so technically this is the second time the yield curve is inverted in 2019.

What Does That Mean for Investors?

If we use history as our guide, the inverted yield curve is a caution light for investors.  Historically, the main question people ask next is, “How long after the yield curve inverts does the recession usually begin?”.  Here is the chart:

As you can see, the problem with using this data to build an estimates timeline until the next recession is the variance in the data. Even though, in the past 5 recessions,  the “average” period of time between the inversion of the yield curve and the subsequent recession was about 12 months, in 2 out of the 5  recessions, the inversion happened within 2 months of the beginning of the next recession.   Timing the markets is very difficult and as we get into the later innings of this long economic expansion, the risks begin to mount.  For this reason, it very important for investors to revisit their exposure to risk asset to make sure they are properly diversified.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Should I Payoff My Mortgage Early?

As a financial planner, clients will frequently ask me the following question, “Should I apply extra money toward my mortgage and pay it off early?”. The answer depends on several factors such as: 

• The status of your other financial goals

• Interest rate

• How long you plan to live in the house

• How close you are to retirement

• The rate of return for other available investment options

Status of your other financial goals

Before you start applying additional payments toward your mortgage, you should first conduct an assessment of the status of your various financial goals.

For clients that have children, we usually start with the following questions:

“What are your plans for paying for college for your kids?  Are the college savings accounts appropriately funded?”

The cost of college keeps rising which requires more advanced planning on behalf of parents that have children that are college bound, but before committing more money toward the mortgage, you should have an idea as to what your financial aid package might look like, so you have a ballpark idea of what you will have to pay out of pocket each year for college.

If you have an extra $5,000 sitting in your savings account, you can either apply that toward the mortgage, which is a one-time benefit, or you can put that money into a college 529 account when your child is 5 years old, and let it accumulate for 13 the next years.  Assuming you get a 6% rate of return within that 529 account, you will be able to withdrawal $10,665 all tax free when it comes time to pay for college.

Here is the list of other questions that we typically ask clients before we give them the green light to escalate the payments on their mortgage:

• Is there enough money in your retirement accounts to fulfill your plans for retirement?

• Do you have any other debt? Student loan debt, credit card debt, HELOC?

• How many months of living expense have you put aside in an emergency fund?

• Are there any big one-time expenses coming up?

• Do you have the appropriate amount of life insurance?

• Do you foresee any career changes in the near future?

If there are financial shortfalls in some of these other areas, it may be better to shore up some of the weaknesses in your overall financial plan before applying additional cash toward the mortgage. 

What is the interest rate on your mortgage?

The interest rate that the bank or credit union is charging you on your mortgage has a significant weight in the decision as to whether or not you should pay off your mortgage early.  We tell clients that you should look at the interest rate on debt as a “risk free rate of return”.  If you have a mortgage with a 4% interest rate and you have $5,000 in cash sitting in your savings account, by applying that $5,000 toward your mortgage you are technically earning a 4% rate of return on that money because you are not paying it to the bank. The reason it is “risk free” is because you would have paid that money to the bank otherwise. 

It’s important to understand the risk-free concept of paying off debt.  Clients will sometimes ask me “Why would I put more money toward my mortgage with an interest rate of 4% when I can invest it in the stock market and get an 8% rate of return?”

My answer is, “It’s not an apple to apple comparison because you are comparing two different risk classes.” You have to take risk in the stock market to obtain that possible 8% rate of return, as compared to applying the money toward your mortgage which is guaranteed because you are guaranteed to not pay the bank that interest.  It would be more appropriate to compare the interest rate on your mortgage to a CD rate at a bank, or the interest rate for a money market account.

After this exchange, the client will frequently comment, “Well, I can’t get 4% in a CD at a bank these days”.  In those cases, if they have idle cash, it may be advantageous to apply the cash toward the mortgage instead of letting it sit in their savings account or a CD with a lower interest rate.

Interest rate below 5%

When the interest rate on your mortgage is below 5%, it makes the decision more difficult.  Depending on the interest rate environment, there may be lower risk investments other than stocks that could earn a higher rate of return compared to the interest rate on your mortgage.  You may also have some long term financial goal like retirement that allows you to comfortably take more risk and assume a higher long term annualized rate of return in those higher risk asset classes. When you have a lower interest rate on your mortgage, applying additional cash toward the mortgage may still be the prudent decision, but it requires more analysis. 

Interest rate above 5%

When we see the interest rates on a mortgage above 5% the decision to pay off the mortgage early gets easier. Based on the examples that we have already covered, if the interest rate on your mortgage is 6%, by applying more cash toward the mortgage you are earning a risk-free rate of return of 6%, that’s a pretty good risk-free rate of return in most market environments. For our readers that had mortgages in the early 80’s, they saw mortgage rates north of 15%.  That’s a nice risk-free rate of return, but hopefully we never see the interest rate on mortgages that high ever again. 

How long do you plan to live in the house?

If you plan to sell your house within the next 5 years, applying additional payments toward the mortgage has a positive financial impact, but it’s typically not as strong as when you compare it to someone that has 20 years left on mortgage and they plan to be living in the house for the next 20+ years. 

It’s a lesson in compounding interest.  Example, you have the following mortgage: 

Outstanding balance: $200,000

Interest rate: 4%

Years left on the mortgage: 20 Years 

You have $20,000 sitting in your savings account that you are considering applying toward the mortgage.  If you plan to sell the house a year from now, applying $20,000 toward the mortgage would save you $800 in interest. 

If you plan to stay in the house for the full 20 years, applying the $20,000 toward your mortgage today would save you $9,086 in interest over the remaining life of the mortgage. 

Should I payoff my mortgage before I retire?

When we are helping clients prepare for retirement, we remind them that with all of the unknowns that the future holds, the one thing that you have 100% control over both now and in the future are your annual expenses.  You don’t have control over market returns, inflation, tax rates, etc, so the goal is to give you the most flexibility in retirement and minimize your expenses. It not uncommon for the mortgage to be your largest monthly expense.

It is for this reason that retirement serves as kind of a wild card in this rate of return analysis. During the accumulation years, you may be assuming an 8% rate of return on your retirement account because you had an overweight to stocks in your portfolio.  Now that you are transitioning over to the distribution phase, it’s common for investors to decrease the risk level in their retirement accounts, which is often accompanied by a lower assumed rate of return over longer time periods.  It makes that gap between the interest rate on your mortgage and the assumed rate on your investment accounts smaller, thus giving more weight to escalating the payoff of the mortgage.

Additionally, no mortgage means less money coming out of your retirement accounts each year, which helps investors manage the risk of outliving their retirement savings.

While we like our clients to retire with as little debt as possible, there are scenarios that arise where it does make sense to have a mortgage in retirement.  Both of these scenarios stem from the situation where 100% of the client’s assets are tied up in pre-tax retirement accounts.

If they have $50,000 left on the mortgage and they are about to retire, we typically would not advise them to distribute $50,000 from their retirement account to pay off the mortgage because they will take a big income tax hit by realizing all of that additional taxable income in a single tax year.   In these cases, it may make sense to continue to make the regular monthly mortgage payments until the mortgage is paid in full.

In a similar situation when clients want to buy a second house in retirement, but most of their money is tied up in pre-tax retirement, instead of incurring a big tax hit by taking a large distribution from their retirement accounts, it may make sense for them to just take the mortgage and make regular monthly payments. This strategy spreads the distributions from the retirement accounts over multiple tax years which could more than offset the interest that you are paying to the bank over the life of the loan. In addition, the money in your retirement accounts is allowed to accumulate tax deferred for a longer period of time. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Understanding Required Minimum Distributions & Advanced Tax Strategies For RMD's

Understanding Required Minimum Distributions & Advanced Tax Strategies For RMD’s

A required minimum distribution (RMD) is the amount that the IRS requires you to take out of your retirement account each year when you hit a certain age or when you inherit a retirement account from someone else. It’s important to plan tax-wise for these distributions because they can substantially increase your tax liability in a given year; consequentially, not distributing the correct amount from your retirement accounts will invite huge tax penalties from the IRS. Luckily, there are advanced tax strategies that can be implemented to help reduce the tax impact of these distributions, as well as special situations that exempt you from having to take an RMD. 

Age 72

LAW CHANGE: There were changes to the RMD age when the SECURE Act was passed into law on December 19, 2019.  Prior to the law change, you were required to start taking RMD’s in the calendar year that you turned age 70 1/2.  For anyone turning age 70 1/2 after December 31, 2019, their RMD start age is now delayed to age 72.

The most common form of required minimum distribution is age 72.  In the calendar year that you turn 72, you are required to take your first distribution from your pretax retirement accounts.

The IRS has a special table called the “Uniform Lifetime Table”.  There is one column for your age and another column titled “distribution period”. The way the table works is you find your age and then identify what your distribution period is. Below is the calculation step by step:

1) Determine your December 31 balance in your pre-tax retirement accounts for the previous year end

2) Find the distribution period on the IRS uniform lifetime table

3) Take your 12/31 balance and divide that by the distribution period

4) The previous step will result in the amount that you are required to take out of your retirement account by 12/31 of that year

Example: If you turn age 72 in March of 2023, you would be required to take your first RMD in that calednar year unless you elect the April 1st delay in the first year.  After you find your age on the IRS uniform lifetime table, next to it you will see a distribution period of 25.6. The balance in your traditional IRA account on December 31, 2018 was $400,000, so your RMD would be calculated as follows:

$400,000 / 25.6 = $15,625

Your required minimum distribution amount for the 2023 tax year is $15,625.  The first RMD will represent about 3.9% of the account balance, and that percentage will increase by a small amount each year.

RMD Deadline

There are very important dates that you need to be aware of once you reach age 72. In most years, you have to make your required minimum distribution prior to December 31 of that tax year. However, there is an exception for the year that you turn age 72. In the year that you turn 72, you have the option of taking your first RMD either prior to December 31 or April 1 of the following year.  The April 1 exception only applies to the year that you turn 72.  Every year after that first year, you are required to take your distribution by December 31st. 

Delay to April 1st

So why would someone want to delay their first required minimum distribution to April 1? Since the distribution results in additional taxable income, it’s about determining which tax year is more favorable to realize the additional income.

For example, you may have worked for part of the year that you turned age 72 so you’re showing earned income for the year.  If you take the distribution from your IRA prior to 12/31 that represents more income that you have to pay tax on which is stacked up on top of your earned income. It may be better from a tax standpoint to take the distribution in the following January because the amount distributed from your retirement account will be taxed in a year when you have less income.

Very important rule:

If you decide to delay your first required minimum distribution past 12/31, you will be required to take two RMD‘s in that following year.

Example: I retire from my company in September 2023 and I also turned 72 that same year. If I elect to take my first RMD on February 1, 2024, prior to the April 1 deadline, I will then be required to take a second distribution from my IRA prior to December 31, 2024.

If you are already retired in the year that you turn age 72 and your income level is going to be relatively the same between the current year and the following year, it often makes sense to take your first RMD prior to December 31st, so are not required to take two RMD‘s the following year which can subject those distributions to a higher tax rate and create other negative tax events.

IRS Penalty

If you fail to distribute the required amount by the given deadline, the IRS will be kind enough to assess a 50% penalty on the amount that you should have taken for your required minimum distribution. If you were required to take a $14,000 distribution and you failed to do so by the applicable deadline, the IRS will hit you with a $7,000 penalty. If you make the distribution, but the amount is not sufficient enough to meet the required minimum distribution amount, they will assess the 50% penalty on the shortfall instead. Bottom line, don’t miss the deadline. 

Exceptions If You Are Still Working

There is an exception to the 72 RMD rule.  If your only retirement asset is an employer sponsored retirement plan, such as a 401(k), 403(b), or 457,  as long as you are still working for that employer, you are not required to take an RMD from that retirement account until after you have terminated from employment regardless of your age.

Example:  You are age 73 and your only retirement asset is a 401(k) account with your current employer with a $100,000 balance, you will not be required to take an RMD from your 401(k) account in that year even though you are over the age of 72.

In the year that you terminate employment, however, you will be required to take an RMD for that year. For this reason, be very careful if you’re working over the age of 72 and leave employment in late December. Your retirement plan provider will have a very narrow window of time to process your required minimum distribution prior to the December 31st deadline.

This employer sponsored retirement plan exception only applies to balances in your current employer’s retirement plan. You do not receive this exception for retirement plan balances with previous employers.

If you have retirement account such as IRA’s or other retirement plan outside of your current employer’s plan, you will still be required to take RMD’s from those accounts, even though you are still working.

Advanced Tax Strategies

There are two advanced tax strategies that we use when individuals are age 72 and still working for a company that sponsors are qualified retirement plan.

It’s not uncommon for employees to have a retirement plans with their current employer, a rollover IRA, and some miscellaneous balance in retirement plans from former employers.  Since you only have the exception to the RMD within your current employers plan, and most 401(k), 403(b), and 457 plans accept rollovers from IRAs and other qualified plans, it may be advantageous to complete rollovers of all those retirement accounts into your current employer’s plan so you can completely avoid the RMD requirement.

Strategy number two. If you are still working and you have access to an employer sponsored plan, you are usually able to make employee contributions pre-tax to the plan.  If you are required to take a distribution from your IRA which results in taxable income, as long as you are not already maxing out your employee deferrals in your current employer’s plan, you can instruct payroll to increase your contributions to the plan to reduce your earned income by the amount of the required minimum distribution coming from your other retirement accounts.

Example:  You are age 72 and working part time for an employer that gives you access to a 401(k) plan. Your 401(k) has a balance of $20,000 with that employer, but you also have a Rollover IRA with a balance of $200,000. In this case, you would not be required to take an RMD from your 401(k) balance, but you would be required to take an RMD from your IRA which would total approximately $7,500.  Since the $7,500 will represent additional income to you in that tax year, you could turn around and instruct the payroll company to take 100% of your paychecks and put it pre-tax into your 401(k) account until you reach $7,500 which would wipe out the tax liability from the distribution that occurred from the IRA.

Or, if you have a spouse that still working and they have access to a qualified retirement plan, the same strategy can be implemented. Additionally, if you file a joint tax return, it doesn’t matter whose retirement plan it goes into because it’s all pre-tax at the end of the day. 

5% or More Owner

Unfortunately, I have some bad news for business owners.  If you are a 5% or more owner of the company, it does not matter whether or not you are still working for the company, you are required to take an RMD from the company’s employer sponsored retirement plan regardless.  The IRS is well aware that the owner of the business could decide to work for two hours a week just to avoid required minimum distributions. Sorry entrepreneurs. 

A Spouse That Is More Than 10 Years Younger

I mentioned above that the IRS has a uniform lifetime table for calculating the RMD amount.  If your spouse is more than 10 years younger than you are, there is a special RMD table that you will need to use called the “joint life table” with a completely different set of distribution periods, so make sure you’re using the correct table when calculating the RMD amount. 

Charitable contributions

There is also an advanced tax strategy that allows you to make contributions to charity directly from your IRA and you do not have to pay tax on those disbursements.  The special charitable distributions from IRA’s are only allowed for individuals that are age 72 or older.  If you regularly make contributions to a charity, church, or not for profit, or if you do not need the income from the RMD, this may be a great strategy to shelter what otherwise would have been more taxable income. There are a lot of special rules surrounding how these charitable contributions work. For more information on this strategy see the following article:

Lower Your Tax Bill By Directing Your Mandatory IRA Distributions To Charity

Roth IRA’s

You are not required to take RMD‘s from Roth IRA accounts at age 72, this is one of the biggest tax advantages of Roth IRAs. 

Inherited IRA

When you inherit an IRA from someone else, those IRAs have their own set of required minimum distribution rules which vary from the rules at the age 72.  The SECURE Act that was passed in 2019 split non-spouse beneficiaries of IRA into two categories.  For individuals that inherited retirement accounts prior to December 31, 2019, they are still able to stretch the RMD over their lifetime and the required minimum distributions must begin by December 31st of the year following the decedent date of death. For individuals that inherited a retirement account after December 31, 2019, the New 10 Rule replaced the stretch option and no RMDs are required for non-spouse beneficiaries.  For the full list of rule, deadlines, and tax strategies surrounding inherited IRA’s see the articles listed below:

Spouse Inherited IRA Options

How Do Inherited IRA’s Work For Non-Spouse Beneficiaries

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Potential Consequences of Taking IRA Distributions to Pay Off Debt

Potential Consequences of Taking IRA Distributions to Pay Off Debt

Once there is no longer a paycheck, retirees will typically meet expenses with a combination of social security, withdrawals from retirement accounts, annuities, and pensions.  Social security, pensions, and annuities are usually fixed amounts, while withdrawals from retirement accounts could fluctuate based on need.  This flexibility presents opportunities to use retirement savings to pay off debt; but before doing so, it is important to consider the possible consequences.

Clients often come to us saying they have some amount left on a mortgage and they would feel great if they could just pay it off.  Lower monthly bills and less debt when living on a fixed income is certainly good, both from a financial and psychological point of view, but taking large distributions from retirement accounts just to pay off debt may lead to tax consequences that can make you worse off financially.

Below are three items I typically consider before making a recommendation for clients.  Every retiree is different so consulting with a professional such as a financial planner or accountant is recommended if you’d like further guidance.

Impact on State Income and Property Taxes

Depending on what state you are in, withdrawals from IRA’s could be taxed very differently.  It is important to know how they are taxed in your state before making any big decision like this.  For example, New York State allows for tax free withdrawals of IRA accounts up to a maximum of $20,000 per recipient receiving the funds.  Once the $20,000 limit is met in a certain year, any distribution you take above that will be taxed.

If someone normally pulls $15,000 a year from a retirement account to meet expenses and then wanted to pull another $50,000 to pay off a mortgage, they have created $45,000 of additional taxable income to New York State. This is typically not a good thing, especially if in the future you never have to pull more than $20,000 in a year, as you would have never paid New York State taxes on the distributions.

Note:  Another item to consider regarding states is the impact on property taxes.  For example, New York State offers an “Enhanced STAR” credit if you are over the age of 65, but it is dependent on income.  Here is an article that discusses this in more detail STAR Property Tax Credit: Make Sure You Know The New Income Limits.

What Tax Bracket Are You in at the Federal Level?

Federal income taxes are determined using a “Progressive Tax” calculation.  For example, if you are filing single, the first $9,700 of taxable income you have is taxed at a lower rate than any income you earn above that.  Below are charts of the 2019 tax tables so you can review the different tax rates at certain income levels for single and married filing joint ( Source: Nerd Wallet ).

There isn’t much of a difference between the first two brackets of 10% and 12%, but the next jump is to 22%.  This means that, if you are filing single, you are paying the government 10% more on any additional taxable income from $39,475 – $84,200.  Below is a basic example of how taking a large distribution from the IRA could impact your federal tax liability.

How Will it Impact the Amount of Social Security You Pay Tax on?

This is usually the most complicated to calculate.  Here is a link to the 2018 instructions and worksheets for calculating how much of your Social Security benefit will be taxed ( IRS Publication 915 ).  Basically, by showing more income, you may have to pay tax on more of your Social Security benefit.  Below is a chart put together with information from the IRS to show how much of your benefit may be taxed.

To calculate “Combined Income”, you take your Adjusted Gross Income + Nontaxable Interest + Half of your Social Security benefit.  For the purpose of this discussion, remember that any amount you withdraw from your IRA is counted in your Combined Income and therefore could make more of your social security benefit subject to tax.

Peace of mind is key and usually having less bills or debt can provide that, but it is important to look at the cost you are paying for it.  There are times that this strategy could make sense, but if you have questions about a personal situation please consult with a professional to put together the correct strategy.

About Rob……...

Hi, I’m Rob Mangold. I’m the Chief Operating Officer at Greenbush Financial Group and a contributor to the Money Smart Board blog. We created the blog to provide strategies that will help our readers personally, professionally, and financially. Our blog is meant to be a resource. If there are questions that you need answered, please feel free to join in on the discussion or contact me directly.

Do I Have To Pay Tax On A House That I Inherited?

Do I Have To Pay Tax On A House That I Inherited?

The tax rules are different depending on the type of assets that you inherit. If you inherit a house, you may or may not have a tax liability when you go to sell it. This will largely depend on whose name was on the deed when the house was passed to you.  There are also special exceptions that come into play if the house is owned by a trust, or if it was gifted with the kids prior to their parents passing away. On the bright side, with some advanced planning, heirs can often times avoid having to pay tax on real estate assets when they pass to them as an inheritance. 

Step-up In Basis

Many assets that are included in the decedent’s estate receive what’s called a step-up in basis. As with any asset that is not held in a retirement account, you must be able to identify the “cost basis”, or in other words, what you originally paid for it. Then when you eventually sell that asset, you don’t pay tax on the cost basis, but you pay tax on the gain.

Example:  You buy a rental property for $200,000 and 10 years later you sell that rental property for $300,000.  When you sell it, $200,000 is returned to you tax free and you pay long-term capital gains tax on the $100,000 gain.

Inheritance Example: Now let’s look at how the step-up works. Your parents bought their house 30 years ago for $100,000 and the house is now worth $300,000.  When your parents pass away and you inherit the house, the house receives a step-up in basis to the fair market value of the house as of the date of death. This means that when you inherit the house, your cost basis will be $300,000 and not the $100,000 that they paid for it. Therefore, if you sell the house the next day for $300,000, you receive that money 100% tax-free due to the step-up in basis.

Appreciation After Date of Death

Let’s build on the example above.  There are additional tax considerations if you inherit a house and continue to hold it as an investment and then sell it at a later date.  While you receive the step-up in basis as of the date of death, the appreciation that occurs on that asset between the date of death and when you sell it is going to be taxable to you.

Example: Your parents passed away June 2019 and at that time their house is worth $300,000. The house receives the step-up in basis to $300,000. However, lets say this time you rent the house or don’t sell it until September 2020. When you sell the house in September 2020 for $350,000, you will receive the $300,000 tax-free due to the step-up in basis, but you’ll have to pay capital gains tax on the $50,000 gain that occurred between date of death and when you sold house.

Caution: Gifting The House To The Kids

In an effort to protect the house from the risk of a long-term event, sometimes individuals will gift their house to their kids while they are still alive. Some see this as a way to remove themselves from the ownership of their house to start the five-year Medicaid look back period, however, there is a tax disaster waiting for you with the strategy.

When you gift an asset to someone, they inherit your cost basis in that asset, so when you pass away, that asset does not receive a step-up in basis because you don’t own it and it’s not part of your estate.

Example:  Your parents change the deed on the house to you and your siblings while they’re still alive to protect assets from a possible nursing home event.  They bought the house 30 years ago for $100,000, and when they pass away it’s worth $300,000. Since they gifted the assets to the kids while they were still alive, the house does not receive a step-up in basis when they pass away, and the cost basis on the house when the kids sell it is $100,000; in other words, the kids will have to pay tax on the $200,000 gain in the property.  Based on the long-term capital gains rates and possible state income tax, when the children sell the house, they may have a tax bill of $44,000 or more which could have been completely avoided with better advanced planning.

How To Avoid Paying Capital Gains Tax On Inherited Property

There are ways to both protect the house from a long-term event and still receive the step-up in basis when the current owners pass away. This process involves setting up an irrevocable trust to own the house which then protects the house from a long-term event as long as it’s held in the trust for at least five years.

Now, we do have to get technical for a second. When an asset is owned by an irrevocable trust, it is technically removed from your estate. Most assets that are not included in your estate when you pass do not receive a step-up in basis; however, if the estate attorney that drafts the trust document puts the correct language within the trust, it allows you to protect the assets from a long-term event and receive a step-up in basis when the owners of the house pass away.

For this reason, it’s very important to work with an attorney that is experienced in handling trusts and estates, not a generalist. It only takes a few missing sentences from that document that can make the difference between getting that asset tax free or having a huge tax bill when you go to sell the house.

Establishing this trust can sometimes cost between $3,000 and $6,000. But by paying this amount upfront and doing the advance planning, you could save your heirs 10 times that amount by avoiding a big tax bill when they inherit the house.

Making The House Your Primary

In the case that the house is gifted to the children prior to the parents passing away and the house is not awarded the step-up in basis, there is an advance tax planning strategy if the conditions are right to avoid the big tax bill.  If one of the children would be interested in making their parent’s house their primary residence for two years, then they are then eligible for either the $250,000 or $500,000 capital gains exclusion.

According to current tax law, if the house you live in has been your primary residence for two of the previous five years, when you go to sell the house you are allowed to exclude $250,000 worth of gain for single filers and $500,000 worth of gain for married filing joint.  This advanced tax strategy is more easily executed when there is a single heir and can get a little more complex when there are multiple heirs.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

How To Use Your Retirement Accounts To Start A Business

One of the most challenging aspects of starting a new business is finding the capital that is needed to support your expenses as you begin to build up a revenue stream since it’s not always easy to ask friends and family for money to invest in a startup business.  Luckily, for new entrepreneurs, there are some little-known ways on how you can use retirement accounts as a funding source for your new business. However, before you cash out your 401(k) account to start a business, you have to fully understand the pros and cons of each option. 

ROBS Plans

ROBS stands for “Rollover for Business Startups”.   ROBS is a special program that allows you to use the balance in your 401(k) or IRA account to fund your new business while avoiding having to pay taxes and the 10% early withdrawal penalty for business owners under age 59.5.  Unlike a 401(k) loan that has limits, loan payments, and interest, ROBS plans allow you to use your full retirement account balance without having to enter into a repayment plan. 

Why do business owners use ROBS plans?

The benefits are fairly obvious.  First off, by using your own retirement assets to fund your new business, you don’t have to ask friends and family for money.  Secondly, if you were to embark on the traditional lending route from a bank for your start-up, most would require you to pledge personal assets, such as your house, as collateral for the loan. Doing this puts an added pressure on the new entrepreneur because if the business fails you not only lose the business, but potentially your house as well.  By using the ROBS plan, you are only risking your own assets, you have quick and easy access to those funds, and if the business fails, worst case scenario, you just have to work longer than you expected. 

Is this too good to be true?

When I explain this funding strategy to new business owners, the question I usually get is, “Why haven’t I heard of these plans before?”, and here are a few reasons why.  To begin, you are using retirement plan dollars and accessing the tax benefits, and in doing so there are a lot of complex rules surrounding these types of plans. It’s not uncommon for accountants, third-party administrators, and financial advisors to not know what a ROBS plan is, let alone understand the compliance rules surrounding these plans; thus, it’s rarely presented as a viable option. Over the course of this article we will cover the pros and cons of this funding mechanism. 

How do ROBS plans work?

The concept is fairly simple, your retirement account essentially buys shares of stock in your new business which provides the business with the cash needed to grow. You do not have to be a publicly traded company for your retirement account to buy shares, however, you are required to establish your new company as a C-Corp in order for this plan to work.

This process entails incorporating your new business, as well as establishing a new 401(k) plan within that business, that contains the special ROBS features. Then, you can transfer assets from your various retirement accounts into the new 401(k) plan allowing the 401(k) plan to then buy shares in your new company.  While this sounds easy, I cannot stress enough that you must work with a firm that fully understands these types of plans and the funding strategy.   These plans are perfectly legal, but there are a lot of rules to follow. Since this funding strategy allows you to access retirement account dollars without having to pay tax to the IRS, the IRS will sometimes audit these plans hoping that you did not fully understand or comply with the rules surrounding the establishment and operations of these ROBS plans.

The steps to set up a ROBS plan

Here are the steps for setting up the plan:

1) Establish your new business as a C-Corp.

2) Establish a new 401(k) plan for your new business

3) Process direct rollovers from your 401(k) accounts and IRA accounts into your new 401(k) plan

4) Use the balance in your 401(k) account to purchase shares of the corporation

5) Now you have cash in your business checking account to pay expenses

You must be a C-Corp

The only type of corporate structure that works for a ROBS plan is a C-Corp because only a C-Corp can sell shares of the business to a retirement account legally.  That means that LLCs, sole proprietorships, partnerships or even S-Corps will not work for this funding option. 

Establishing the new 401(k) plan

ROBS plans have all the same features and benefits of a traditional 401(k) plan, profit-sharing plan, or defined benefit plan, except they also have special features that allow the plan to invest plan assets in the privately held C-Corp.

You need to work with a firm that knows these plans well because not all custodians will allow you to hold shares of a privately held corporation in a qualified retirement account. For many investment firms and custodians, this is considered either a “private placement” or an “alternative investment”.  There is typically a special approval process that you must go through with the custodian before they allow your 401(k) account to purchase the shares of stock in your new company. Be ready, there are a lot of mainstream 401(k) providers that will not only not know what a ROBS plan is, but they often times limit the plan investment options to mutual funds; to avoid this, make sure you are aligning yourself with the right provider. 

Transferring funds from your retirement accounts to your new 401(k) plan

Your new investment provider should assist you with coordinating the rollovers into your 401(k) account to avoid paying taxes and penalties.  Also, if you have 401(K) Roth or after-tax money in your retirement accounts, special preparations need to be made prior to the rollover occurring for those sources. 

Purchasing stock in the business

It’s not as easy as simply transferring money into the business checking account since you have to go through the process of issuing shares to the 401(k) account. In most cases, the percentage of ownership attributed to the 401(k) plan is based upon your total funding picture to start up the company. If your retirement accounts are the sole resource to fund the business, then technically your 401(k) plan owns 100% of the company. It’s not uncommon for new business owners to use multiple funding sources including personal savings, funding from friends and family, or a home-equity loan.  In these instances, a ROBS plan is still allowed but the plan will own less than 100% of the business.

I don’t want to get too deep in the weeds with this point, but it’s usually advisable not to issue 100% of the shares of the business to your 401(k) plan. This could limit your ability to raise additional capital down the road because you don’t have any additional shares to issue to new investors or to share equity with a new partner.

Using the capital to grow your business

Once the share purchase is complete, the cash will be transferred from your retirement account into the business checking account allowing use those funds to start growing the business.

There is a very important rule when it comes to what you can use these funds for within the new business. First and foremost, you cannot use these funds to pay yourself compensation as the business owner. This is probably the biggest ‘no-no’ associated with these types of plans. The IRS does not want you circumnavigating income taxes and penalties just to pay yourself under a ROBS plan.  In order to pay yourself as the business owner, you have to be able to generate revenue from the business.  The assets from the stock purchase can be used to pay all of your expenses but before you’re able to take any money out of the business to pay yourself compensation you have to be showing revenue.

Once new business owners hear this, it’s often disheartening. It’s great that they have access to capital to build their business, but how do they pay their bills while they’re building up the revenue stream? Luckily, I have good news on this front. We have additional strategies that we can implement using your retirement accounts outside of the ROBS plan that will allow you to pay yourself compensation as the owner and it can work out better tax wise than paying yourself as a W2 income through the C-corp.

Requirements for ROBS plans

There are a few requirements you have to meet for this funding strategy to work.

1) The funds have to be held in a pre-tax retirement account. This means that money in Roth IRA’s and Roth 401(k)’s are not eligible for this funding strategy.

2) You typically need at least $50,000 in your new 401(k) account for the ROBS plan to make sense since there are special costs associated with establishing and maintaining a ROBS 401(k) plan.  If your balance is less than $50,000, the cost to establish and maintain the plan begins to outweigh the benefit of executing this funding strategy.

3) If you’re rolling over a 401(k) plan to fund your ROBS 401(k) plan, it cannot be from a current employer. In other words, if you are still working for a company and you’re running this new business on the side, you are not able to rollover your 401(k) balance into your newly established 401(k) plan and implement this ROBS strategy. The 401(k) account must be coming from a former employer that you no longer work for.

4) You have to be an active employee in the business

There are special IRS rules that define if an employee is actively or materially participating in a business. Since ROBS plans do not work for passive business owners, it is difficult to use these plans for real estate investments unless you can prove that you are an active employee of that real estate corporation. If your new business is your only employer, you work over 1000 hours per year, and it’s your primary source of revenue, then you should not have a problem qualifying as an active employee.  If you have multiple businesses however, you really need to consult your accountant and ROBS provider to make sure you satisfy the IRS definition of materially participating.

A ROBS plan can be used for more than just start-ups

While we have talked a lot about using ROBS plans to start up a business, they can also be used for other purposes. These plans can be a funding source to:

1) Buy an existing business

2) Recapitalize a business

3) Build a franchise

These plans can offer fast access to large amounts of capital without having to go through the traditional lending channels.

Cost of setting up and maintaining a ROBS plan

It typically costs $4,000 – $5,000 to set up a ROBS plan and you cannot use the balance in your retirement account to pay this fee. It must be paid with outside funds.

As for ongoing fees, you will have the regular administrative, recordkeeping, and investment advisory fees associated with sponsoring a 401(k) plan which vary from provider to provider. You may also have additional fees charged each year by the custodian for holding the privately held C-Corp shares in your retirement account.  Make sure you clearly understand what the custodian will require from you each year to value those shares.  If you wind up with a custodian that requires audited financial statements, this could easily run you an additional $8,000+ per year to obtain those audited financial statements from an accounting firm.  If you are sponsoring one of these plans, you probably want to try to avoid this large additional cost.

Complications if you have employees

For start-up companies or established companies that have employees that would otherwise be eligible for the 401(k) plan, there are special issues that need to be addressed. The rules within the 401(k) world state that all investment options available within the plan must be made available to all eligible employees.  That means if the business owner is able to purchase shares of the company within the retirement plan, the other eligible employees must also be given the same investment opportunity. You can see immediately where this would pose a challenge to the ROBS plan if you have eligible employees.

However, investment options can be changed which is why ROBS plans are the most common in start-ups where there are no employees yet, allowing the 401(k) plan to setup the only eligible plan participant, the business owner, allowing them to buy shares of the company.  Once the share purchases are complete, the business owner can then remove those shares as an investment option in the plan going forward.

The Cons of a ROBS plan

Up until now we have presented the advantages of the ROBS plan but there are some disadvantages.

1)  The first one is pretty obvious. You are risking your retirement account dollars in a start-up business. If the business fails, not only will you be looking for a new job, but you’ve depleted your retirement assets.

2)  You are required to sponsor a C-Corp which may not be the most advantageous corporate structure.

3) You are required to sponsor a 401(k) plan.  When running a start-up business, it’s sometimes more advantageous to sponsor a Simple IRA or SEP IRA which requires less cost and time to maintain, but you don’t have that option using this funding strategy.

4)  The business owners can’t pay themselves compensation from the stock purchase

5) The cost to setup and maintain the plan. Paying $5,000 just to establish the plan isn’t exactly cheap.  Plus, you’re looking at $2,000+ in annual maintenance costs for the plan.  Other options like taking a home-equity loan or establishing a Solo 401(K) plan and taking a $50,000 401(k) loan from the plan may be the better funding option.

6) Audit risk.  While it’s not the case that all these plans are audited, they do present an audit opportunity for the IRS given the compliance rules surrounding the operation of these plans. However, this risk can be managed with knowledgeable providers.

7) Asset sale of the business becomes complex.  If 10 years from now you sell your company, there are two ways to sell it. An asset sale or a stock sale. While a stock sale jives very easily with this ROBS funding strategy, an asset sale becomes more complex.

Summary

Finding the capital to start up a business is never easy.  Each funding option comes with its own set of pros and cons.  The ROBS plan is just another option for consideration. While I have greatly simplified how these plans work and how they operate, if you are strongly considering using this plan as a funding vehicle for your new business, please reach out to us so we can have an open discussion about what you are trying to accomplish, and how the ROBS plan stacks up against other funding options that you may have available. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

The Top 4 Things That You Need To Know About The Trade War With China

The trade negotiations between the U.S. and China have been the center of the stock market’s attention for the past 6 months. One day it seems like they are close to a deal and then the next day both countries are launching new tariffs against each other.  While many investors in the U.S. understand the trade wars from the vantage point of the United States, very few people understand China’s side of the equation.   The more we learn about China’s motivation and viewpoint, the more we realize that this could be a very long, ugly, and drawn out battle. The main risk is if this battle is not resolved soon it could lead to a recession in the U.S. sooner than expected. 

1:  China Is Tired Of Being On The Losing End Of Trade Deals

When you look back through history, going as far back as the mid 1800’s, China has been on the losing end of many of it’s trade deals.  To summarize that history, when you are a very poor country, and your economy is based primarily on exporting goods to other countries, those countries that are buying your goods have a lot of power over you.  If you don’t agree to their terms, they stop buying from you, and your economy collapses.  China’s history is filled with trade deals where terms were dictated to them so they feel like they have been taken advantage of.

Now that China has the fastest growing middle class in the world, they are less reliant on trade to fuel their economy.   Also, the size of China’s economy is growing extremely fast. The size of a country’s economy is measured by their GDP (Gross Domestic Product). A country’s annual GDP is the dollar value of all the goods and services that are produced in that country in a single year.   It’s fascinating to see how quickly China has grown over the past 20 years compared to the U.S.

The numbers speak for themselves.  In 2000, the size of China’s economy was only 9% of the U.S. economy.  In only a 17-year period, China’s economy is now 67% the size of the U.S. economy and based on current GDP data from both countries, they are still growing at a pace that is about three times faster than the U.S. economy.

China seems to be making a statement to the world in these negotiations that terms will no longer be dictated to them.  China now has the economic firepower to negotiate terms as an equal which could drag out the trade negotiations longer than investors expect.

2: Tariff Impact On China vs U.S.

In May, the U.S. raised the tariffs on select goods imported from China from 10% to 25%.  China then retaliated by raising their tariffs on US imports from 10% to 25%.  We have heard in the news that these tariffs hurt China more than they hurt the U.S.    In the short term this would seem to be true. The U.S. imports about $500 Billion in goods from China compared to the $100 Billion in goods that China imports from the U.S.

But the next question is, “if it hurts China more, does it hurt them a lot or a little from the standpoint of their overall economy?”   The answer; not as much as you would think.  The chart below shows China’s total exports as a percentage of their GDP.

Back in 2007, exports contributed to over 35% of China’s total GDP.  As of 2018, exports represent less than 20% of China’s annual GDP.  Of their total exports about 18% go to the U.S.  So if you do the math, exports to the U.S. equal about 3.6% of China’s total annual GDP.   Personally, I was surprised how low that number was.   Based on what we have been hearing about the negotiations and how the U.S. is in such a strong position to negotiate, I would have expected the export number to be much larger, but it’s less than 4% of their total GDP.  This again may lead investors to conclude that the volatility we are seeing in the markets surrounding the trade negotiations may be an unwelcomed guest that is here to stay for longer than expected.

3: The Impact of Tariffs On The US Economy

While the U.S. is using tariffs as a negotiating tool,  it may be the U.S. consumer that ends up paying the price. That washing machine that was $500 in April may end up costing $625 in June.  Companies that are importing goods from China and selling them to the U.S. consumer will have to decide whether to absorb the cost of the tariffs which would decrease their net profits or pass those costs onto the consumer in the form of higher prices.

The other problem that you can see in this example is tariffs are inflationary.  Meaning they push prices higher. The Fed announced at their last meeting that they were content with keeping interest rates where they are for the remainder of 2019 given the slowing economic growth rate and tame inflation.  But if tariffs spark inflation, they may have to reverse course and raise rates unexpectedly to keep the inflation rate under control which would be bad news for the stock market.

4: Global uncertainty

Companies typically do not invest or make plans for growth if the global economy is filled with uncertainty, they pause and wait for the smoke to clear.   The longer the trade uncertainty between the U.S. and China persists, the more downward pressure there will be on global economic growth around the world. 

Summary

It’s unclear how this situation between the U.S. and China will play out and how long it will be before there is a resolution. In times of uncertainty, investors need to be very aware of how these trends could potentially impact their investment portfolio and it may be the appropriate time to begin building some defensive positions if you have not done so already. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

How Much Emergency Fund Should You Have And How To Get There

How Much Emergency Fund Should You Have And How To Get There

If you watched the nightly news during the latest government shutdown you would have seen stories about how people struggle when they aren’t getting a paycheck.  Most Americans are not immune to having a set back at a job and it is a scary feeling to not know when the next paycheck will come.  The emergency fund is what will help you bridge the gap in these hard times.  This article should help determine how much emergency fund you should have and strategies on how you can get there.

We make a point of this in every financial plan we put together because of its importance.  A lot of people will say their job is secure so they don’t need to worry about having an emergency fund.  This may be true, nevertheless the emergency fund is not only for the most extreme circumstances but any unexpected expense.  Anyone can have an unforeseen cost of $1,000 to $5,000 and most people would have to pay for this expense on a credit card that will accrue interest and take time to payoff.

Another common thought is, “I have disability insurance, so I don’t need an emergency fund”.  Most disability insurance will not start until a 90-day elimination period has been met.  This means you will be out of a check for that period but still have all the expenses you normally would.

Current Savings In The United States

“Smartasset” came out with a study in November 2018 that stated; of those Americans with savings accounts, the average savings account balance was $33,766.49.  This seems like an amount that would be enough for most people to have in a “rainy day fund”.  But that is the average.  Super Savers with very large balances will skew this calculation so we use the median which more accurately reflects the state of most Americans.  The median balance is only approximately $5,200 per “Smartasset”.

With a median balance of only $5,200, it doesn’t take much misfortune for that to be spent down to $0.  At $5,200, it is safe to assume that most Americans are living paycheck to paycheck.

If your income only meets your normal expenses, you need to ask yourself the question “where am I coming up with the money for an unexpected cost?”.  For a lot of people, it is a credit card, another type of loan, or dipping into their retirement assets.  By taking care of the immediate need, you shift the burden to another part of your financial wellbeing.

Emergency Fund Calculator

There is no exact dollar amount but a consensus in the planning industry is between 4-6 months of living expenses.  This is usually enough to cover expenses while you are searching for the next paycheck or to have other assistance kick in.

It is important for everyone to put together a budget.  How do you know what 4-6 months of living expenses is if you don’t know what you spend?  Putting together a budget takes time but you need to know where your money is going in order to make the adjustments necessary to save.  If you are in a position that you don’t see your savings account increasing, or at least remaining the same, you are likely just meeting expenses with your current income.

Resource:  EXPENSE PLANNER to help you focus on your spending.

I Know My Number, How Do I get There?

Determining the amount is the easy part, now it is getting there.  The less likely option would be going to your boss asking, “I need to replenish my emergency fund, can you increase my pay?”.  Winning the lottery would also be nice but not something you can count on.Changing spending habits is an extremely difficult thing to do.  Especially if you don’t know what you’re spending money on.  Once you have an accurate budget, you should take a hard look at it and make cuts to some of the discretionary items on the list.  It will likely take a combination of savings strategies that will get you to an appropriate emergency fund level.  Below is a list of some ideas;

• Skip a vacation one year

• Put any potential tax refund in savings

• Put a bonus check into savings

• Increase the amount of your paycheck that goes to savings when you get a raise

• Side work

• Don’t upgrade a phone every time your due

• Downgrade a vehicle or use the vehicle longer once paid off

Reward Yourself

There is no doubt some pain will be felt if you are trying to save more and it also takes time.  Set a goal and stick to it but work in some rewards to yourself.  If you are making good progress after say 3 months, splurge on something to keep your sanity but won’t impact the main objective. 

Where To Keep Your Emergency Fund?

This account is meant to be liquid and accessible.  So locking it up in some sort of long term investment that may have penalties for early withdrawal would not be ideal.  We typically suggest using an institution you are familiar with and putting it in a savings account that can earn some interest. 

About Rob……...

Hi, I’m Rob Mangold. I’m the Chief Operating Officer at Greenbush Financial Group and a contributor to the Money Smart Board blog. We created the blog to provide strategies that will help our readers personally, professionally, and financially. Our blog is meant to be a resource. If there are questions that you need answered, please feel free to join in on the discussion or contact me directly.

STAR Property Tax Credit: Make Sure You Know The New Income Limits

The STAR Credit is a great way to reduce your property taxes in New York.  If you are over the age of 65, it gets even better with the Enhanced STAR Credit.  But you have to know the income limits associated with the credit otherwise you could unexpectedly lose the credit which could cost you thousands of dollars in additional property taxes.  They made some big changes to the credit that a lot of homeowners are not aware of. In this article we will review: 

• The income limits for the STAR Credit

• Eligibility requirements for the Enhanced STAR Credit

• How much money the STAR credit saves you

• The most common mistakes that people make that disqualify them from the credit

• The changes that were made to the property tax credit

STAR Property Tax Exemption

Let’s start with the basics. STAR stands for School Tax Relief.  It’s a partial exemption from school taxes for your primary residence.  There are two different STAR programs: 

Basic STAR

Enhanced STAR 

You Have To Apply For The Credit

You have to apply for the credit to receive it. It’s not automatic. Also, if you turn 65 this year and you want to further reduce your property taxes, there is a special application process for the Enhanced STAR Credit which requires you to enroll in the annual Income Verification Program (IVP).  We will cover this in more detail later on in the article. 

How Does The STAR Credit Work

The STAR credit exempts a specified dollar amount from the assessed value of your house prior to the calculation of your school tax bill.  Here are the current exemption amounts: 

Basic STAR:           $30,000

Enhanced STAR:  $65,000 

The actual dollar amount that you save in school taxes will vary based on where you live in New York State.  But if you live in a $300,000 house, you qualify for Basic STAR, and your school taxes before the STAR’s credit are $7,000.  It could save you around $700 per year in school taxes. If you qualify for the enhanced STAR, you can more than double that savings number.  In a high property tax state like New York, every little bit helps. 

Income Limits For The STAR Credit

Here is a table from NYS Department of Taxation and Finance that summarizes the eligibility requirements for the Basic STAR and Enhanced STAR credit: 

Requirement #1: It must be your primary residence. The credit does not apply for rental properties or second homes.

Requirement #2:  To qualify for the Enhanced STAR, one of the homeowners must be age 65

Requirement #3: The income limitations.  We see fewer issues with the Basic STAR since the income limit is $500,000.  We see a lot more issues with the Enhanced STAR credit with the income limit at $86,300.  Mainly because when you add up social security, pension payments, and required minimum distributions from IRA’s, you have homeowners that flirt with that income limit on a year by year basis. Crossing the income line would drop you back into the Basic STAR program which will most likely result in an unfriendly property tax surprise.

Income Calculation

The eligibility for the 2019 STAR credit is actually based on your income from 2017.  You can reference your 2017 federal and state tax returns against the table listed below: 

Enhanced STAR Credit

Once you or your spouse turn age 65, you are then eligible to apply for the Enhanced STAR program.

Unlike the basic STAR program, the Enhanced STAR program required homeowners to file renewal applications with their local assessor each year to remain in the program. Under the new rules, new applicants are required to enroll in the Enhanced STAR Income Verification Process.

The application deadline is typically March 1st if you are filing at the county level but it can vary from county to county.   You should contact your assessor to verify the application deadline in your area.  The good news about enrolling in the Enhance STAR Income Verification Program is you only have to do it once.  Once enrolled you will receive the Enhanced STAR credit each year as long as your income is below the required threshold.

Common Mistakes With The Enhanced STAR Credit

Since the income threshold for the Enhanced STAR program is much lower than the Basic STAR program this is where we see homeowners get into trouble.  For most retirees, their income is relatively the same from year to year. However, there are frequently one-time events that occur that can push a retiree’s income higher for a given year.  Not only do they end up with a large tax bill when they file their taxes but they also find out that they lost the Enhanced STAR Credit for that year. Double ouch!! 

Here are the most common income events that retirees have to watch out for: 

• Capital gains and dividends from taxable investment accounts

• Taking larger distributions from IRA’s or pre-tax retirement plans

• Age 70 ½ - Required minimum distributions start from IRA’s

• Receive an inheritance (some sources can be taxable)

• Sell real estate or land other than the primary residence

• Surrendering a life insurance policy

• Part-time income

• The year you turn on social security benefits

If you experience financial events that are expected to increase your taxable income for a given year, you should work closely with you financial advisor or accountant during those years because there may be ways to reduce your income to maintain the Enhanced STAR credit with some advanced planning. 

Changes To The STAR Credit

New York made some significant changes to both the Basic STAR and the Enhanced STAR credit that not many homeowners are aware of.  The amount of the credit did not change but the methods for applying for and receiving the credit did change.

If you were receiving the Basic STAR credit before and you have not moved since 2016, there is nothing that you have to do.  Everything will continue to operate the same.  However, if you move or if you are new homeowner, the STAR process will be different.  Under the old method, you would simply see a deduction for your STAR credit on your school tax bill.   Going forward, when you buy a new house, you will have to pay your full school tax bill, and then New York will mail you a physical check for your STAR credit.  In order to receive your check in September, you must register for the Basic STAR program through the state Department of Taxation and Finance by July 1st.

After July 1st, you can still apply for the STAR credit, and the state will provide you with a check, but you may receive the check after September.   The same manual check process is applicable with the Enhanced STAR program as well.

If you were receiving the Enhanced STAR and you have not moved, New York is allowing those homeowners to continue to file their renewal applications with their local assessor each year without having to enroll in the new Enhanced STAR Income Verification Program.  However, if you move, you will have to enroll in the Income Verification Program in order to remain in the Enhanced STAR Program.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Why Do You Owe More In Taxes This Year?

“I thought there was a tax break.  Last year I got a refund. This year, I owe money to the IRS.  How did this happen and what do I need to change to fix this?”

As more and more people file their taxes for 2018, the situation described above seems to be the norm instead of the exception to the rule. Taxpayers are realizing that either their tax refund is lower, they owe money for the first time, or their tax bill is larger than it normally is.  While this is a shock to many families and individuals, we saw this issue coming in February of 2018.  We even wrote an article at that time titled “Warning To All Employees: Review The Tax Withholding In Your Paycheck Otherwise A Big Tax Bill May Be Waiting For You”.

Below we will highlight some of the catalysts of this issue and provide you with some strategies on how to better prepare for the coming tax year.

New Tax Withholding Tables

When tax reform was passed, the government issued new federal income tax withholding tables to your employer in February which provides them with the amount that they should withhold from your paycheck for tax purposes.  Since the federal tax brackets dropped, so did the withholding tables.  In February 2018, this seemed like a great thing because most taxpayers saw an increase in their take home pay.   However, it simultaneously created a big tax problem for a lot of employees. 

Gross Income vs. Taxable Income

There is a difference between your “gross income” and your “taxable income”.  If your salary is $80,000 per year, that is your gross income.  At tax time, you get to take deductions against your gross income, to reach your total “taxable income” which is a lower amount. Your taxable income is the amount that you actually have to pay taxes on.

For example, you have a married couple, husband has a W2 for $60,000 and his wife has a W2 for $70,000.  Their combined gross income is $130,000.  Let’s assume they take the standard deduction in 2018 which is a $24,000 deduction.  Their total taxable income for 2018 is $106,000.

Impact of Tax Reform

While tax forms did bring lower federal income tax brackets, it also made a lot of changes to the deduction side of the equation.  For those of us living in New York, California, and other high tax states, the biggest change was probably the $10,000 cap that they placed on property taxes and state income taxes.  The other big change for taxpayers with children was the elimination of the personal exemption deduction which was replaced with a credit. The personal exemption change works for some taxpayers and against others.  For more on this topic reference: More Taxpayers Will Qualify For The Child Tax Credit In 2018

For that married couple above that made $130,000 in 2018, under the new tax rules their total taxable income may be $106,000 but if they applied the old tax rules it may have only been $95,000.  People are finding out that while the federal tax rates dropped, their total taxable income for the year increased because the higher standard deduction did not make up for all of the itemized deductions that were lost under the new tax rules.

To further aggravate that wound, at the beginning of 2018, the federal government instructed your employer to withhold less federal income tax from your paycheck which put some taxpayers further behind on their withholdings.  If you were used to getting a refund when you filed your taxes, technically you may have already received it throughout the year in your paycheck but you just didn’t know it.  There are of course taxpayers in the even more difficult camp that were banking on getting a refund only to find out that they actually owe money to the IRS.

How Do You Fix This?

If you unexpectedly owed money to the IRS this year or if you want to restore that refund that you typically receive when you file your taxes, you are going to have to change your tax withholding amount with your employer.  You have to request a Form W-4 from your employer. I looks like this…… 

Form W-4

You can reduce the number of allowances that you are claiming on line 5 or you can instruct your employer to withhold an additional flat dollar amount each pay period on line 6.

There are also other options beside increasing your tax withholdings like increasing your contributions to your 401(k) account or contributing money to a Health Savings Account for your health expenses.  These moves may assist you in reducing your taxable income which could lead to a lower tax liability.

Consult With Your Accountant

While I have highlighted the more common catalysts leading to this under withholding issue, there were a lot of changes made to the tax rules so there could have been other factors that led to your higher tax liability this year.  Your gross income could have been higher, maybe you took a distribution from an IRA account, or you have realized gains from an investment that you sold during the year.  You really have to work with your tax professional to identify what triggered the additional tax liability and determine what action should be taken to reduce your tax liability going forward.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future