For all of our existence, one common misconception among the general public was that estate planning was only for rich people and “Trust Fund Babies”. However, this notion could not be further away from the truth, especially when considering the recent changes we have seen in family dynamics and financial opportunities.

The three major financial institutions of the United States consist of the banking industry, stock brokerage industry, and insurance industry. Under the Glass-Steagall Act, each major industry could not engage in activities that fell within the scope of the other two industries. In 1999, the Glass-Steagall Act was repealed and the door was left open for each major industry to conduct activities and transactions that fell within the scope of the other two industries. This in turn increased the probability for both unlimited prosperity and financial collapse.

The second part of this two-part article (View Part 1)analyzes financial planning from an estate planning standpoint. Financial planning is an essential component of estate planning. The amount of wealth you generate prior to retiring will generally determine whether you will have a comfortable retirement and have anything left over to pass on to your descendants after your death. When choosing a retirement plan, you ideally want some combination of the following tax efficient strategies: for the contributions to be tax deductible, the appreciation to be tax deferred, and the distributions to be tax-free.

Longevity

Life expectancy for both males and females in the United States has been on a consistent rise since the 1900s. At the turn of the 20^th century, the average man and woman did not live past the age of 50. At the turn of the 21^st century, the average man lived up to the age of 75, while the average woman lived up to the age of 80.

This data is significant for several reasons. First, since the age of retirement is currently at 65, the average man has to live at least ten more years after retiring without earning any income, while the average woman must live for an additional 15 years without earning any income. Second, living longer may inevitably cause for more people to opt out to work beyond the age of 65, since it is likely that most people would not have secured enough financial resources for a comfortable retirement when they reached the age of 65. Third, federal programs for retirees, such as Social Security and Medicare would now have to presumably be subjected to cuts, since there would now be significantly more people utilizing the resources of these federal programs due to the spike in life expectancy.

Living comfortably during retirement does not include only the necessities one needs to survive, but also includes engaging in activities that derive pleasure. However, the necessities alone can have a hefty price. If you think about the expenses you will have for your housing needs that may include rent, mortgage, insurance, or property tax, then add those expenses to groceries and hygiene products, these expenses alone can be costly. In addition, you will probably need to get from your home to a supermarket or another point of destination by car, train, bus, or other form of transportation. Since most people in California use vehicles as their preferred method of transportation, the fluctuating price of gas, insurance, and car payments may add on yet another set of expenses that may be unsustainable at the time of retirement.

The expenses don’t just end there. One of biggest expenditures during retirement pertains to health care. While Medicare covers some of those expenses, it may not cover them all. Thus, regular checkups even for the healthiest individuals, combined with pharmaceutical drugs and other related products can also be very expensive. If you also add outstanding loans in the mix, such as credit card and student loan debt, the monthly expenses may not even be sustainable for a middle-income earner, let alone a retiree who no longer earns income.

Besides the necessary expenses, there are also expenses associated with leisure. When people are asked about their vision for retirement, some say they plan on traveling at least once a year, some say playing golf and tennis several times a month, others say dining with their spouses at a local restaurant every weekend. Needless to say, all of these activities may cost a considerable amount of money, and in some cases, a significant amount of money.

From the retirees’ standpoint, many of them have been looking forward to retirement by working hard in their prime years. Thus, their aspirations for retirement are warranted in many instances. However, when they approach retirement, many of them realize that they do not have sufficient funds to comfortably enjoy their retirement years.

Foundational Financial Concepts

There are two foundational concepts related to finance to keep in mind as you are going through this article. The first concept is whether the income you are generating comes from an active or a passive source. The second concept is whether your money will grow or diminish in value as you approach retirement.

Active income pertains to any source of income where your active involvement will be required in order for the income to be generated. One such example of active income is your salary. Passive income pertains to any source of income where your active involvement will not be required in order for the income to be generated. One such example of passive income is investment income from real estate. The fundamental issue upon retirement is that nearly all of the income you receive must be predominantly derived from a passive source since you will no longer be working to earn a living.

Passive income will be a significant factor in determining the quality of life you will have when you retire. It follows that it is critical to invest in places that will provide an adequate return on your investment. Hence, how much return you will have on your money is a necessary element in determining to what extent your money will grow before you retire. One of the essential indicators that will determine to what extent your money will grow or diminish in value is inflation.

The underlying concept behind inflation is that every time new money is printed by the government, the value of your existing dollar diminishes. No retirement plan is complete unless it factors in inflation. The rate of inflation averages at approximately 3% per year. Thus, if you have $5,000 in your retirement portfolio today and you retire in 20 years, you will need $9,030 to match the purchasing power of today’s value of $5,000.

Money Havens

Depending on your financial goals, there are various avenues available for stockpiling your money. The primary considerations in picking the avenue that is best for you will depend on how much of a return you want on your money and how much control you want to have over your money. Generally, the more control you have over your money, the less of a return you will have on your money. The opposite is also generally true.

Between the three major financial institutions (Banking, Stock Brokerage, and Insurance), there is no shortage of places for putting your money. Some examples include Bank Accounts, Certificate of Deposits (“CD”), Money Market Accounts (“MMA”), Savings and Loans, Credit Unions, Stocks, Bonds, Mutual Funds, Exchange Traded Funds, Annuities, and Life Insurance. A retirement portfolio should generally be diversified to include a combination of several avenues with a special outlook for inflation, taxes, and fees that may be associated with the maintenance and withdrawal of your money.

When you put your money in an Individual Retirement Account (“IRA”), you will generally pay a 10% penalty if you withdraw your money before you are 59½ years old. On the contrary, when you put your money in a Bank Account, you generally have unfettered access to your money. As such, Bank Accounts provide the lowest return on your investment, generally at 0.01 percent. CDs and MMAs generally provide less than a one percent return on your investment. Stocks and Bonds may provide significantly larger returns, but they are subject to volatility and other market risks.

Economic Conditions

Economic conditions determine not only the overall strength of the economy, but they also have a significant impact on inflation (or deflation), interest rates, and volatility. One of the primary methods for measuring the strength of the economy is the stock market. While the stock market has historically performed well, it has also crashed many times in the last 100 years, most notably in 1929 and 2008. In both instances, the U.S. economy went into a severe recessionary period.

In 2008, the stock market crashed primarily due to the collapse of the housing market. Millions of people lost their jobs and witnessed their 401(k) accounts plummet. The government paid trillions of dollars to businesses and banks. In order to prevent a complete collapse of the economy to the point where ATMs were at the verge of becoming inoperative, the Bush administration paid $700 billion to the major banks. Needless to say, the financial crisis of 2008 caused a severe panic on Wall Street, Main Street, and virtually everywhere else in the United States.

The viability of the stock market is an important consideration for an investor since it generally determines how much activity there is in the economy. During a recessionary period, people generally do not invest in the stock market. In addition, as we saw in 2008, the government printed a significant amount of extra money in case the recession led to a depression. When the recession was over, all of the extra money started circulating in the economy, thereby causing inflation. Thus, not only did many people lose a significant amount of money, but any money they had left was now worth less in value than before the crisis began.

Social Security

In 1935, the social security program was authorized with the passage of the Social Security Act of 1935. The social security program grants benefits to people who reach the age of 65. The program is contributory, where both the employee and employer contribute to the program. Pursuant to the Federal Insurance Contributions Act (“FICA”), the social security program requires for 6.2% of the employee’s income to be paid by the employee and 6.2% to be paid by the employer (capped at $110,000 per year or $2,500 per month).

At the time the law was passed in 1935, the average life expectancy was at age 63. Today, the average life expectancy is nearly at 80. In all likelihood, there will come a point within the next decade where the age of retirement will be raised by at least two to three years to as much as five years. Another likely outcome is that the amount of the benefits received will also be reduced due to longevity and an increase in the population size. In 1935, the U.S. population size was 127.3 million, today it has 325.7 million inhabitants. Therefore, it is not realistic to expect that the social security benefits we will be receiving in the near future will remain at their current form.

Defined Benefit Plans

In addition to the federal social security program, the retiree may also be entitled to receive income from state-funded programs such as public pension plans. Similar to social security, pension plans provide for guaranteed income for life. Pension plans for both public and private employees are Defined Benefit Plans. The income that will be derived from a pension plan is known in advance, hence, the amount is defined.

Most public pension plans across the United States require for the employee to contribute generally between seven to nine percent of his or her gross salary. The same percentage is generally also matched by the employer. Today, pension plans are predominantly available to only government employees. California has over $333 billion in unfunded pension liabilities according to some estimates. California has also seen a significant increase in its population size, which also suggests that California is likely going to implement severe cuts in its pension programs in the near future.

In the private sector, there are significantly less employers who provide pension plans to their employees primarily because of the employers’ exposure to potential liability. The employers have complete oversight over the plans, including funding future benefits and paying fees and expenses associated with the plans. The funding of future benefits became especially burdensome when Congress passed the Employee Retirement Income Security Act of 1974 (“ERISA”), which required for the employers to maintain enough money in a trust to pay for their employees’ future retirement benefits.

Defined Contribution Plans

As opposed to a Defined Benefit Plan where the amount that will be received upon retirement is defined, the money that is put in a Defined Contribution Plan is defined. One of the most famous and infamous types of Defined Contribution Plans are 401(k) plans. The 401(k) plans generally allow for the employee to contribute approximately seven percent of his or her gross salary and for the employer to match the first 3 percent of the contributed amount. The 401(k) plans are popular because they allow for the amount of the contribution to be tax deferred until the withdrawal period. However, as illustrated below, one major downside to a 401(k) plan is its dependence on market volatility since most 401(k) plans invest in a spread of mutual funds, including stocks, bonds, and money market investments.

Let’s assume that a particular 401(k) plan has $1 million. In the first year, the market had a 30 percent increase, which brought the total amount in the account to $1,300,000. In the second year, the market has a 30 percent loss and the plan is now worth $910,000. Even though in both years there was either a 30 percent gain or a 30 percent loss, the net amount is $90,000 less than the initial amount of the investment. During the 2008 recession, it is estimated that 401(k) plans lost between 25 to 50 percent of their value due to their dependence on market risks and volatility.

Combination Plans

Under Treas. Reg. §1.401(a)(4)-(9)(a), a person is permitted to combine one or more Defined Benefit Plans with one or more Defined Contribution Plans. The combination plans are popular particularly among small business owners, especially where the business owner is also an employee of the business. In addition to providing for financial security in retirement, these plans provide for an opportunity to shift large amounts of income thereby reducing the tax liability of the taxpayer.

Annuities

Similar to social security and pension plans, annuities may also provide guaranteed income for life. Annuities are based on mortality credits. In other words, the longer you live, the more benefit you may receive. There are two overarching categories of annuities: Immediate Annuities and Deferred Annuities.

Immediate Annuities can either be for a specified period of time or for a lifetime. The way it generally works is that a person pays a lump sum to an insurance company and in return receives income for either a specified period of time or for life. If you enter a contract for a Deferred Annuity, you may pay a lump sum or make a series of payments to the insurance company and your money will start earning interest without any tax obligations until distributions are made.

There are two types of Deferred Annuities: Fixed Deferred Annuities (“Fixed Annuities”) and Variable Deferred Annuities (“Variable Annuities”). Fixed Annuities provide a fixed return on earned interest, thus it operates like a CD, but generally provides a larger return on your investment. However, unlike a CD where taxes are due on the interest earned each year, taxes are not due for Fixed Annuities until withdrawals are made. Variable Annuities also allow for the taxes earned on the interest to be deferred, but they are subject to market risk and volatility. On the other hand, Fixed Annuities are not subject to market volatility.

Variable Annuities provide guaranteed death benefits, which adds a layer of protection in the event that the value of your annuity is less than your initial investment. However, unlike a death benefit in a life insurance policy, the death benefit under an annuity may not be entirely tax-free. Fixed Annuities also provide significant benefits, such as allowing a family member to be a recipient of the annuity in case the annuitant dies before exhausting the period of the annuity. For example, you are guaranteed to receive $50,000 annually for 25 years. If you die before the 25-year period, your spouse will receive $50,000 until the end of the 25-year period.

Life Insurance 

When the insurance company writes a life insurance policy, the risk is that the insured will die soon, thereby causing a payout that is much larger than the investment. On the other hand, the risk with an annuity is that the annuitant may live long, thereby granting lifetime income in an amount that is much larger than the initial investment. There are two overarching categories of life insurance policies: Term and Permanent.

Term policies are usually between one to twenty years. The premiums for Term policies are generally lower in the beginning, but they tend to rise quickly to the point that it becomes unaffordable to maintain the policies. Permanent policies are generally in two forms: Whole Life and Universal Life.

Whole Life policies generally guarantee that the premium will stay the same and that it will never increase in addition to guaranteeing a death benefit and cash value. Universal Life policies are permanent policies that consist of a combination of low premiums that are available in term policies and tax deferred guaranteed interest fixed accounts.

Long-Term Care

Prior to purchasing an annuity or life insurance policy, it is important to consider whether Long-Term Care (“LTC”) can be included as a hybrid policy or whether a separate LTC policy should be purchased altogether. LTC is a type of care that a person requires as a result of his or her physical condition in order to engage in basic daily activities.

The activities that fall within the scope of LTC include dressing, bathing, and going to the bathroom. Since such care may be required for the entire duration of all waking hours, these services can be very expensive. Even though Medicare and Medicaid may provide for as much as 50 percent of the cost of those services, there should also be other funding sources since the annual expenses for LTC can be as much as $100,000. An LTC policy may pay for home care, hospice care, nursing facility, or assisted living facility. The policy may potentially apply to a family member if the policy is never exercised by the insured.

Have questions?

Contact Tax And Business Lawyer Haik Chilingaryan