In the past couple months, the stock market has been like a roller coaster to me, and the volatile performance, the fear of market crash, the trade war seemed to extend the fears. .
But up to now, nothing has happened, still the fear is still haunting us. Why?
Because we are afraid of losing, losing our job, losing our investment and losing our retirement... The biggest secret of investing, like Warren Buffett said,
"Rule No.1: Never lose money. Rule No.2: Never forget rule No.1."
Speaking of investment, what are the common financial risks? What's the biggest risks? What's the impact of the risks, and how to avoid these risks?
Let me share with your some lessons that I lave learned, so you can avoid the same mistake that I made.
The common financial risks include market risk, investor behavior risk, longevity risk, withdraw risk, inflation, interest risk and taxation risk..., they are discussed in another blog of mine, How to consistently grow our investment with minimum risks.
If however, you have a comprehensive financial education session, click here to sign up, I will reach out to you within 24-48 hours. In addition, I will occasionally send you some emails, blogs and news covering from investment to retirement, from protection to Tax saving, from kids education to asset and estate planning etc...
Among the above risks, taxation is probably one of the biggest risks to our investment...
Let me share with you an example. Let's say we invested $10k on S&P500 in 1979. If the investment was placed in a taxable account, it will turn to ~$2.0M; but if it was placed in a tax-free account, it will become ~$5.0M.
We end up losing 61% of our investment due to taxation.
Then what can we do about the Taxation?
Think about it, how is it possible that Warren Buffett pays less tax than his secretary?
Only because of the US Tax structure, his assets are positioned among different TAX buckets, so as long as carefully planned, he is able to pay less tax.
US Tax Structures
So let's take a look at the 3 Taxation buckets, Tax Now, Tax Deferred and Tax Advantaged buckets...
- Tax Now category includes the money saved in the bank, the stocks and mutual fund.
The money we save in the bank cannot beat the inflation risk, so "saving money in the bank"="Losing Money"; stock and mutual fund are under the market risk, right?Enter your text here...
- Tax-deferred category includes 401k, 403b, IRA, Annuity and real estate investment.
While 401k, 403b, IRA are all under the market risk; if we are close to retirement age, can we still handle the fear of losing half of our retirement fund?
Real estate investment can be a little bit complicated; the real estate investment in California may worth considering, since the return is about 5 to 6% per year; but the real estate investment in NJ may not be a good idea, the investment cannot even beat the inflation risk.
In addition, even the real estate in California may also under the risk of economic down turns. Comparing to the other options, annuities seem to be a good idea, it captures the upside potential with downside protection, but it also has to follow IRS regulations, and the distribution may be taxable as regular income.
- Tax-advantaged category includes Roth IRA, municipal bonds, 529 and 7702.
Roth IRA has a salary requirement, and there is a limitation on how much we can put into the plan.
For municipal bonds, these are local government issued bond, although they are tax-free, we have to purchase it with after tax money, however, the return is very low, usually 2-3%.
The 529 plan is for educational purpose only, the money we put into the plan is strictly for educational use and this plan will significantly impact our kids' chance of getting tuition aids.
On the other hand, 7702 does not have much requirement on how much we can put away into the plan, nor are there any requirements on how we would like to use it. Some of these programs may include an investment component as well as an insurance component; the investment component will have upside potential with downside protections, however since it is an insurance program, it does involve some insurance cost.
Therefore, if this program is suitable for us, I would recommend to get one when we are young and healthy; since the cost will be lower when we are young, and if we are not healthy, the cost may be too high or even worse, we may not qualify.
So if we can properly allocate our assets into the right buckets, we will sure be able to maintain and grow our assets with minimum tax consequences, so we may be able to avoid a lot of headaches down the road.
However, I have to admit that many of these programs may be very good, but they may not be suitable for everyone; and there is not such "the best" program, since different individuals or families are different, have different needs, and different goals, so instead of "the best" program, we should look for the most suitable program for ourselves.
A good financial strategy should help us to reach a balance among the different Taxation buckets, so we can legally minimize our tax consequences and avoid a lot of headaches down the road.
Please note that the planning strategies I am going to talk about are not the same as our Tax filing, tax experts are specialized in filing tax returns, they file tax returns based on what happened in the previous year.
So the tax experts are familiar with tax laws and may have some ideas on how to reduce our tax consequences, but it is not their responsibility to inform the clients. Additionally, they are not financial planners, they may not have the knowledge to design an optimal financial plan.
Furthermore, there are a lot of good financial programs, but they may work better and achieve their optimal performance by leveraging programs from other tax buckets, especially different programs may have different risk control strategies.
Here are 7 common risk control strategies, Diversification, Asset Allocation, Asset Rebalancing, Dollar Cost Average, Value Investing, Professional Tactical Money Management and Leverage Financial Programs.
Again I have included extensive details in my other blog, if you want to read more about the financial risks, go ahead check out, How to consistently grow our investment with minimum risks.
If however, you want to obtain a comprehensive financial education or your are interested in any of these particular programs, click here to sign up, I will reach out to you within 24-48 hours. In addition, I will occasionally send you some emails, blogs and news covering from investment to retirement, from protection to Tax saving, from kids education to asset and estate planning etc...
As many believes, "history has the tendency to repeat itself"; in the U.S. history, economic crash occurs every 5 to 8 years, till now, the economy and stock market has been booming for 121 months already. Everybody knows it is going to happen, just a matter of when.
So it would be a good idea to get ourselves prepared before it occurs,
I am not going through all those risk control strategies, while I am going to share with you the pros and cons for each different options within each category. I will then share with you a few investment vehicles of my preference, and on how to leverage different programs to control the risks and achieve consistent growth of our asset with minimum risk and reduced tax consequences, still I may briefly cover the control strategies that are implemented in these programs.
Now, let's talk about Tax Now category...
Tax Now Category
There are many types of investment options, including bank savings, CDs, stocks, bonds and mutual fund.
Let's look at our saving account in the bank first, bank savings are free from most of the market risks, but how much interest can we get from the bank? About 0 - 2%, comparing to the inflation rate of 2.5% - 3%, we definitely losing due to inflation?
What about the tax, as we all know, the interest we earn from the bank are subject to Tax, income tax and it has the potential to raise our Tax-bracket...
While some of us believe, "money is safe in the bank", without knowing that Bank can also claim bankruptcy. The largest bankruptcy occurred in US history on Septeber 15, 2008, Lehman Brothers Holdings filed chapter 11; others, such as Washington Mutual, CIT Group, IndyMac Bancorp etc also filed bankruptcy. Banks are still a safe, since they are FDIC insured, although the standard insurance amount is $250,000 per depositor, per insured bank, for each account ownership category.
Plus, bank is probably still one of the most convenient place to hold our emergency money for short term needs, in case of losing a job, car accidents, sickness, any unexpected expenses..., but we should not save more than 6 months emergency money in the bank.
Money Market and CDs
Similar to our saving account, money market and CDs are also in the Tax-now category, so the interests earned from these options are subject to income tax, both are backed by FDIC insurance up to $250,000. The interest rate may be 2.1% to 2.2%, still lower than inflation. What kind of risks can you think about for these two options?
Stocks and Mutual Funds
Stocks and Mutual Funds are also under the tax now category, previously I have already shown the impact of the Tax to our investments. Other than the impact of Tax, it is also under the market risks, considering the market downturn may be just in the corner, no one can predict when it is going to happen.
My question to you, can you bear with the market risks?
If your answer is no, then what other options do we have? How can we catch partial gain from the market but avoid those market risks completely, while still be able lock the profit?
Tax Deferred Category
401k, 403b, SEP IRA, Traditional IRA are in the Tax deferred category, there are some slight differences, but the common features are the same.
Let's talk about the difference first; 401k and 403b are employer sponsored retirement plan, except that 403b is a retirement plan offered to certain employees of public schools and tax-exempt organizations. Both of these are employer sponsored plan; the limitation is $19,000 for 2018 for employee contributions, $6,000 catch-up contribution if age 50 or older; employer contributions (matching, profit sharing) up to 25% of compensation. Combined employee and employer contributions are limited to 100% of employee’s compensation up to $56,000 for 2019.
SEP IRA is a simplified employee pension plan; which is adopted by business owners to provide retirement benefits for themselves and their employees. There are also some contribution limitations for this plan.
For employees, the employer may contribute up to 25% of the employee's wages to the employee's SEP-IRA account. For example, if an employee earns $40,000 in wages, the employer could contribute up to $10,000 to the SEP-IRA account.
The total contribution to a SEP-IRA account should not exceed the lesser of 25% of income (20% for self-employed before self-employed tax deduction is included); or 55,000 (2018), 56,000 (2019).
A traditional IRA is another individual retirement plan offers tax-deferred benefit. To contribute to this plan, we need to have income from work; and the contribution also has limitations, the maximum contribution is $6,000 for 2019, plus $1,000 catch-up contribution if age 50 or older.
Since these plans are all in the Tax-deferred category, the money we put into these plans are tax-deductible. However, since our money are invested in the mutual funds, we have to bear with the market risks, and market downturns. Since we do not pay tax when we contribute to these plans, everything we took out from these accounts are taxable.
Some may argue, "By the time we retire, we don't have much income, so my tax bracket will be lower. "
Yes, our income will be lower, but out tax bracket may not be as low as we expect. By then, our mortgage are paid off, our kids are grown up, we will not have much tax deductibles; plus, do you think our Tax rate will stay the same? Our tax rate is about all time low right now, but our country has $23 trillion debt as of 2019, the social security is running out of money, our health care cost are still building up. What's the best way for our government to pay off the debt without going into bankruptcy?
On top of all the above, these are also under IRS regulations, we will be penalized for taking out the money before 59 1/2 rule and we will be penalized if we do not take the required minimum distribution before 70 1/2...
Annuity is another type of tax-deferred retirement plan. There are two types, variable and indexed.
Variable annuity, is similar to 401k, or IRA account, tax deductible when we contribute, but subject to income tax when we want to take out the money, we also have to follow the IRS 59 1/2 rule and RMD at 70 1/2 rule; plus, it is also under market risk; for some people between 25-35, who can bear with a little bit market risk, this can be a very good plan, because they still have time to grow, one or two market downturns can be recovered with no problem.
Indexed annuity too, is tax deductible when we contribute, but subject to income tax when we take out, we also need to follow the IRS 59 1/2 rule and 70 1/2 rule; since it is indexed, it is linked to the index fund, so it can catch the market gains without any market risks, and the gains are locked. This is a good plan for people who are ready to retire or some who do not want to take any market risks...
Real Estate investment is another type of tax-deferred vehicles, it needs big investment upfront; there are also risks associated with it; and the return really depends on the location. Like myself, I invested some real estates in New Jersey 12 years ago, I was only able to get an average of 0.5% returns; if however I had invested in CA, I should be able to get an average of 7% to 10% returns, although the returns are taxable.
Want to get some comprehensive financial education? Click here to sign up a FREE education session with me; I will share with you some basic financial knowledge about the US tax structures, how many works and how to make money work for you...
Tax Advantaged Category
The last bucket is the tax-advantaged category, which includes Roth IRA, Municipal bonds, 529 and 7702.
Similar to traditional IRA, we need to have income to contribute to this plan, except that we contribute with after-tax money, and the we don't pay tax when we take out the money. The maximum annual contribution in both 2020 and 2019 is $6,000 ($7,000 if you're age 50 or older). However, there is a salary limitation as well. If our family combined income is $203,000 or above, then we are not qualified. If we are single, and make $137,000 or above, then we are not qualified.
Municipal bonds are loans investors make to local governments. They are issued by cities, states, counties, or other local governments. For that reason, the interest from the bonds is tax-free. The return is about 3-4% per year.
Although municipal bonds is low-risk, they are not entirely without risk. If the issuer is unable to meet its financial obligations, it may fail to make scheduled interest payments or be unable to repay the principal upon maturity.
For example, Stockton, Calif., claimed bankruptcy in 2012, if anyone invested in any of municipal bonds offered by local government. The same happened to Detroit. So municipal bonds still have risks.
A 529 plan is a tax-advantaged savings plan designed to encourage saving for future education costs. It is a “qualified tuition plan,” sponsored by states, state agencies, or educational institutions and authorized by Section 529 of the Internal Revenue Code. It can be used for education purpose only. Sounds like a good plan if you have small kids, right?
But do you know the 529 plan will negatively impact your kids' chance of getting tuition aid. All the money in this plan has to be depleted before they qualify for the tuition aid.
So be careful!!!
Cash Value Life Insurance (7702)
Very few of us have heard about 7702, basically, it is cash value life insurance plan that has tax advantages under IRS code 7702. The cash value part has investment features and the insurance part has protection feature.
Personally, I have heard some good and bad things about financial vehicle; I am not going to argue whether it is good or bad, I will just share my thoughts.
I have many friends working on the trading floor in Wall street, who told me the best personal investment strategy is to invest in S&P500 index fund. I also have friends who heavily invest in the stock market. I am not going to say which is right and which is wrong. But on average, the friends who invested in the S&P500 index fund own at least one single family house outside of the city, in fact quite a few of them owns multiple condos in Manhattan; while the friends who heavily invested in the stocks market are still renting today.
I can't argue all the friends who own their own real estate are richer than the friends who rent, but on average, I think the friends who owns are generally in a better financial situation.
Although the main purpose of a cash value life insurance is for protection, the death benefit can be used to protect our family in case we cannot take care of them when something happens to us. Still the cash value portion has the benefit of investment feature.
It does not make any sense to purchase a cash value life insurance if we can only afford it for a few years, but if we have some extra money left in the bank that is more than enough for emergency use, then we can consider putting it into a cash value life insurance.
This plan is completely tax-free, including the death benefit if anything happens to us, the profit and policy loans are tax-free if we want to use it ourselves...
Specifically, I want to talk about IUL, because it is linked to the S&P500 index, it can capture the market gains, while protect against the market downturns.
One example, the FFIUL from TransAmerica, the interest grows with the market as high as 15% and it is also protected against market downturns with 0.75% returns. So if the market return is below 15%, we will get the full returns; if the market goes up 20%, we will get 15% return; but if the market is down -10%, we will still get 0.75% return. There is no worry about losing money.
Plus, there will not be any tax consequences for the profit we make out of the cash value from the life insurance. Upside potentials with downside protections and no tax, sounds too good to be true?
Let's look at the side-by-side return comparison between the S&P500 and the cash value in the FFIUL from TransAmerica.
From December 1973 to December 2015, the annualized return from S&P500 is 6.64%, while the annualized return from FFIUL is 7.94%. Considering investment return from S&P500 is taxable, but the return from life insurance is Tax-FREE, what one is better?
I understand some people only want to purchase a term, and invest the rest of their money into the stock market. I completely understand, if they are the luckiest investing expert with no emotions. But at least I am not one of them, and the friends of mine who believe they can do better than S&P500 but still renting are not.
I agree, the return of the cash value from a life insurance is not outrageous, but it still better than S&P500, right? For most of us, any investment better than S&P500 will be a perfect plan, plus it is Tax-FREE...
So if I can share with you a Tax-advantaged investment with better returns than S&P500, would you be interested? Click here to book FREE consultation session with me, I will share with you some basic financial knowledge, US Tax structure, how money works and how to make money work for you....
Leverage Different Tax Categories
Balance Among Tax Buckets
For an average American family, a healthy financial status is to achieve a balanced financial structure among these tax buckets.
Now, let's look at ourselves, are we balanced among the 3 tax buckets? If not, then how to reach the balance?
Since the Tax-Now category is really for emergency, it should have enough to cover 3 to 6 months of our income in case of emergency. Because the maximum return for this category is 2% to 2.5%, lower than inflation, this portion is losing money. So we want keep it to the minimum, just enough to cover the emergency.
Do we have enough or too much?
The Tax Deferred category is designed for our retirement, we need 80% of our final pre-retirement salary as our retirement income; the retirement income should consist of 3%-4% of our retirement savings or investment, assuming the return of the the saving or investment is 5%.
Let's assume we make $100,000 before retirement. Then we will need $80,000 as our retirement income, if we want to live the same lifestyle; after accounting for the $2000/month from social security, then we would need an annual retirement income of $56,000, then we need to have $56,000 / 0.03 or 0.04, we need to have a retirement saving of $1.4M - $1.9M.
Are we close? If not, how close are we?
If I can share with you some financial strategy or financial education to fast forward to your dream of freedom, that would be great, right? Click here to sign up a FREE consultation session with me, I will reach out to you within 24-48 hours, I will share with you some basic financial knowledge, some basic financial education, how money works and how to make money work for you...
For Tax Advantaged category, I will focus on cash value life insurance (7702), since all the other financial vehicles in this category have limitations.
The cash value life insurance include a cash value portion, which has investment features; any $ taken out of this plan is Tax-Free, if we need $60,000 for retirement income, then we probably only need $45,000 because we don't have to pay the income tax. Of course, the main purpose of this program is not for retirement, it is designed for protection, it is designated to help our family in case anything happens to us; however, the cash value portion does provide an extra benefit just in case we do need to use it ourselves, i.e., it can be used as a leverage for our retirement life, provide retirement income during market downturns...
Let me share with you how powerful it can be if we can leverage a cash value life insurance to complement our retirement plan.
Assuming we have $1M in our retirement savings, we need an annual of $70,000 to live a comfortable life; so after 16 years of withdrawal, we will have $383k left in our retirement saving if it following a hypothetical return from the S&P500 index fund.
Under the same scenario, if we do not withdraw the $70,000 for the 6 year of market downturns, after 16 years of withdrawal, we should be able to accumulate a total of $3.72M savings, under the same hypothetical return from the S&P500 index fund.
So the difference of $420k ($70,000 x 6) can cost us $3.3M, amazing, right?
Hypothetical Retirement Savings after 16 Years Withdrawal, with Annual Withdrawal of $70,000
Hypothetical Retirement Savings If Do Not Withdraw for the Down Market
Well, we still need some income for those 6 years of down market, right? If we don’t take it from our retirement saving, where do we get it then?
The answer is to take advantage of the cash value from our life insurance.
Assuming a 45 year old preferred non-tobacco male, purchased an IUL with $500,000 death benefit; he should have paid a premium of $6,967 annually for 20 years at the default return interest rate of 6.64% (assuming the annualized return of S&P500).
With strategically timed policy loans, he took out $50,000 from the cash value against his policy (which is equivalent to $70,000 Taxable income at the 28% tax bracket).
Note that loans from life insurance is completely Tax-FREE, as long as the life insurance is still in force; however if the policy is surrendered, the profit in addition to the premium will become taxable. (We have to be very careful to keep the policy in force.)
In the above scenario, a total of policy loan of $300k can save us an extra of $3.4M in our saving. Is this a good plan to you?
This is exactly how to leverage different financial vehicles to avoid the market risk, the inflation risk, the Tax risk; if you are interested in learning more financial knowledge? Or if you are interested in any of these financial programs, click here to sign up a FREE financial education session with me, I will reach out to you within 24-48 hours; I will share with you some basic financial knowledge, some basic financial education, how money works and how to make money work for you...
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