Dear Clients and Friends,
The purpose of The Financierge is to discuss some of the latest topics reflective of the diverse planning and thought leadership we provide our clients. In this month’s issue of The Financierge, we start by covering the benefits of Health Savings Accounts and some basics on rental property taxation. Next, we share some ideas on why disability insurance may be a good idea. Then, for clients looking for liquidity with unrealized gains, we discuss the benefits of using a charitable remainder trust. We also share some thoughts on creating a family legacy plan for donor-advised funds and discuss how business owners can leverage retirement plans to accumulate wealth while managing taxes. We conclude with some thoughts on health & longevity, days to celebrate in July, and share some wisdom from our nation’s Founding Fathers. Let’s dive in . . .
Health Savings Account Benefits
Health Savings Accounts (HSAs) are a great tax-advantaged tool to save for health care expenses if you have a high-deductible health plan (HDHP). With an HDHP you pay a lower premium per month but a higher annual deductible for medical care. In 2022, the deductible is at least $2,800 for a family and $1,400 if you’re single.
One advantage to a high-deductible health plan is that it comes with the option to save money in an HSA. An HSA is a triple tax-advantaged account where you contribute money pre-tax, allow it to grow tax-free, and then take it out tax-free as long as you’re using it for a qualified medical expense. Don’t forget to save your receipts because the IRS determines qualified medical expenses, and if your withdrawal amount doesn’t qualify, you’ll be hit with a 20% tax penalty. The IRS does have an exception on distributions from an HSA after you are disabled, age 65, or die. Also, HSA distribution for medical expenses can’t be taken as an itemized deduction.
Another major advantage of the health savings account is that you’re putting money in pre-tax, allowing it to grow tax-free, and then withdrawing it tax-free if you have a qualifying medical expense. These tax savings, combined with the investment potential of the account, can add up over the years. One investment strategy for your HSA is to max out the amount you can contribute each year. In 2022, the current limits are $3,650 for individuals and $7,300 for family coverage. If you are age 55 or older, you are eligible for a “catch-up” contribution of $1,000 per year. Another investment strategy is to invest in assets with the highest return long-term but as with any investment you must be aware of risk, so it is a good idea to talk to your private wealth advisor.
Vacation Property Taxation
The tax treatment of renting your vacation property depends on how many days you rent it for and your level of personal use. Personal use includes vacation use by your relatives (even if you charge them market rate rent) and use by non-relatives if a market rate rent isn’t charged. If you rent the property out for less than 15 days during the year, it’s not treated as “rental property” at all. In the right circumstances, this can produce significant tax benefits. Any rent you receive isn’t included in your income for tax purposes (no matter how substantial), but you can deduct property taxes and mortgage interest but no other operating costs or depreciation. Remember, mortgage interest is deductible on your principal residence and one other home, subject to certain limits.
If you rent the property out for more than 14 days, you must include the rent you receive in income. However, you can deduct part of your operating expenses and depreciation, subject to several rules. First, you must allocate your expenses between the personal use days and the rental days. For example, if the house is rented for 90 days and used personally for 30 days, then 75% of the use is rental (90 days out of 120 total days). You would allocate 75% of your maintenance, utilities, insurance, etc., costs to rental. You would allocate 75% of your depreciation allowance, interest, and taxes for the property to rent as well. The personal use portion of taxes is separately deductible. The personal use portion of interest on a second home is also deductible if the personal use exceeds the greater of 14 days or 10% of the rental days. However, depreciation on the personal use portion isn’t allowed.
If the rental income exceeds these allocable deductions, you report the rent and deductions to determine the amount of rental income to add to your other income. If the expenses exceed the income, you may be able to claim a rental loss. This depends on how many days you use the house personally. Here’s the test: if you use your house personally for more than the greater of 14 days or 10% of the rental days, you’re using it “too much,” and you can’t claim your loss. In this case, you can still use your deductions to wipe out rental income, but you can’t go beyond that to create a loss. Any unused deductions are carried forward and may be usable in future years. If you’re limited to using deductions only up to the amount of rental income, you must use the deductions allocated to the rental portion in the following order: interest and taxes, operating costs, and depreciation.
If you “pass” the personal use test (i.e., you don’t use the property personally more than the greater of the figures listed above), you must still allocate your expenses between the personal and rental portions. In this case, however, if your rental deductions exceed rental income, you can claim the loss. (The loss is “passive,” however, and may be limited under the passive loss rules.)
Why Disability Insurance is Important
Insurance is a good risk management tool to financially protect yourself against unexpected events. But when most people think about financial risk, they think about their car, home, or investments. But perhaps the most valuable assets you have is yourself and your income earning potential. This is where disability insurance comes in.
According to the Centers for Disease Control and Prevention (CDC), one in four adults will be out of work for at least a year due to a disability. Disability insurance can help in these situations. The most common disability insurance claims are for work-induced musculoskeletal disorders, like back pain or tendonitis, cancer, pregnancy, and mental health issues.
There are two types of disability insurance: long-term and short-term. Short-term disability covers you for a shorter amount of time, typically under three months, while long-term disability insurance can cover your lost income for years, depending on the policy. Many people have short-term disability insurance through their employer, but that only covers you for a short amount of time, typically only covers a portion of your salary, and is taxable because your employer is paying the premium. Keep in mind that workers’ compensation will cover your injury or illness unless you get injured on the job or your injury was directly related to work. Also, according to the Center on budget and Policy Priorities, Social Security does offer some disability insurance coverage, but the application process is often very time-consuming, has a 70% denial rate, and the average monthly benefit is $1,279 a month.
Purchasing a long-term disability insurance policy is a good way to help cover some of these income gaps with tax-free income if the unexpected happens. The average cost of a long-term disability insurance policy is 1% to 3% of your annual salary, depending on your job, salary, and level of health. The type of policy also affects the cost – whether it’s an any-occupation or own-occupation policy. Any-occupation disability insurance will cover you if you’re unable to generally work in your line of work, and own-occupation covers you if you’re unable to perform your specific job. Own-occupation policies cover your income better but are often more expensive.
When considering how much disability insurance to get (or if you even need it), think about your job, how much you make, and who would cover your bills if you were to become sick or injured. Short-term policies last a maximum of 26 weeks and cover around 40-60% of your income. Long-term policies can last the rest of your life and typically replace 40%-60% of your income. You should take a closer look at your current financial situation to decide how much coverage you need. Even if your employer offers disability insurance (and especially if they don’t) you should consider purchasing an individual plan. It will travel with you if you leave your job, so you’ll always be covered.
One strategy may be to ladder your disability insurance policies, which basically involves holding both long-term and short-term disability insurance policies. Short-term disability policies have a short elimination period before paying out benefits, while long-term disability insurance policies have longer waiting periods, typically around 90 days. Laddering your policies ensure you start getting paid right after an illness or injury.
Gain Liquidity, Reduce Taxes, and Help Your Favorite Charities
If you need liquidity but have unrealized capital gains, it may be worth investigating the benefits of a Charitable Remainder Trust (CRT). First, if you sold an asset with unrealized capital gains, you would most likely have to federal capital gains taxes of at least 23.8% for stocks (31.8% for artwork and collectibles), plus state income taxes (CA 13.30%, HI 11.00%, NJ 10.75%, OR 9.90%, MN 9.85%, VT 9.75%, NY 8.82%, IA 8.53%, WI 7.65% ME 7.15%, and 0% for AK, FL, NH, NV, SD, TN, TX, WA, and WY). The result is that either they sell now at a lower value, and pay the tax, or hold the investment with hopes that it will recover before their costs outpace their income. In times like these, consider using a Charitable Remainder Trust.
A Charitable Remainder Trust (or CRT) is a “split interest” trust – you have an interest, and one or more charities you designate have an interest in the trust. You get the right to an annuity from the trust for either their lifetime or a term of years, and the charities have a right to the remainder of the trust assets when the trust ends. There are two basic types of Charitable Remainder Trusts, one with a fixed annuity (a Charitable Remainder Annuity Trust or CRAT) and one with a variable annuity (a Charitable Remainder Unitrust, or CRUT).
The advantages of a CRT are numerous. First off, if assets are placed into the CRT before they are sold, then no capital gains tax is due at the time of the sale. Second, you get an immediate charitable income tax deduction of at least 10% of the value of the assets transferred to the trust. Third, the annuity can be set for either a term of years or for a single or joint life expectancy (with a maximum of 20 years). Fourth, like a Qualified Retirement Account, the investments that remain in the CRT accumulate income tax-free, which encourages a higher rate of appreciation than in taxable accounts. Fifth, you can, during the term of the trust, change which charities the remainder goes to in the end.
A further advantage of the CRUT is that, as a variable annuity, if the value of the assets in the trust rises, the amount of the annuity paid out also rises, providing some protection against inflation. Though, if the value of the assets falls, then the amount of the annuity also falls. This variability allows the actual payout rate to be set much higher than a similar CRAT can be set.
There are relatively few disadvantages to the CRT. One is that gifting the annuity to someone else (other than to a spouse) is a currently taxable gift, but against which applies both the annual exclusion (now $16,000) and the Unified Credit (now $13 million). Second, the CRT must be drafted precisely to comply with all statutory and regulatory requirements. Third, the CRT is subject to the same investment restrictions that Charities and Private Foundations are subject to, so investing in anything other than publicly traded stocks and bonds may result in a large excise tax.
The basic requirements for a CRT are that the trust is in writing; the trust functions only as a Charitable Remainder Trust; that the assets transferred to the CRT qualified as a charitable deduction; that at least one income beneficiary is not a charity; that the remainder beneficiaries are, and remain, qualified as a charity; and the annuity interest is calculated according to the regulations.
When the annuity is paid out each year to you, the payment is taxable. Unlike a regular annuity, however, the income is not just ordinary income, it can be, depending on what the nature of the trust assets are, dividend, interest, capital gains, and even tax-free return of principal.
Here is an example of how the CRAT and the CRUT work:
Kenny, age 65, and Ericca, age 64, inherited a work of art 20 years ago that, at the time, was valued at $20,000. Today the art will net $1,500,000 at a sale. Kenny and Ericca plan on retiring but, with the rise in inflation and the rise in the cost to insure the artwork, they feel that they will need to sell the artwork to raise the needed cash to supplement their retirement income.
If Kenny and Ericca sold the artwork, they would have $1,480,000 worth of long-term capital gains taxed at a rate of 28%, plus the Investment Income Tax of 3.8%, for a total tax rate of 31.8%, or $470,640 in taxes due that year. The net available for investment is $1,029,360 which, we will assume, earns 5% or $51,468, a year.
Now, if Kenny and Ericca placed the artwork into a CRAT before it is sold, with an art museum as the remainder charity to make the donation deductible, then they would have the full $1,500,000 after the sale and take a $77,195 annual annuity for their joint lifetimes. They would pay taxes on only the $77,195 distributed each year, and they would have an immediate income tax deduction of $223,000.
Finally, if Kenny and Ericca place the artwork into a CRUT before it is sold, again with the art museum as the remainder charity, they would have the full $1,500,000 after the sale. They would receive a variable annuity at a rate of 11.07% of the fair market value of the trust assets each year, beginning in the first year with a payout of $166,065, and would receive an immediate income tax deduction of $150,000.
So, if you are looking at how to raise the needed cash to retire, or if you have met your goal for appreciation of the stock or artwork, then now might be a good time to consider a charitable remainder trust.
Creating a Family Giving Legacy for Your Donor Advised Fund
Many families establish a Donor Advised Fund (DAF) to manage charitable contributions and reduce taxes. One of my favorite benefits is that it helps create a family-giving legacy by engaging your loved ones and using your philanthropy as a tool to create better communication and understanding in your family. You can simply start by creating an annual giving budget, a process, and perhaps a Family Philanthropy Board. Your annual giving budget might include separate amounts for you, your spouse, both you and your spouse, children, grandchildren, and/or your collective family. Once that is established you can meet to discuss how to establish your giving mission, how the funds will be approved, when you will have meetings, etc. I often recommend that clients take a few hours during their family events or vacations to discuss. If you so choose, there are several benefits to giving through a Family Philanthropy Board where you can engage family members, model philanthropic values, and establish traditions around charitable giving. This is a great way to prepare future generations to continue the family’s legacy. Specifically, a Family Philanthropy Board can help create greater group decision-making, improve investment knowledge, perform due diligence on charities, promote family virtues and values, and a focus on generosity. We can help you create a family-giving legacy and make sure it complements your family’s financial goals.
Optimizing Retirement Savings
Business owners can increase retirement savings, manage tax, and optimize cash flow in retirement by using a qualified retirement plan. A qualified retirement plan helps accumulate wealth and reduce taxes. I can also help retain employees. As a business owner, you can maximize individual 401(k) contributions by deferring up to $20,500 in salary in either a pre-tax 401(k) or post-tax Roth 401(k). If you are over age 50, you can add an annual “catch-up” contribution of $6,500. To get these benefits, employers are required to make a contribution for their employees.
A Safe Harbor 401(k) is a type of retirement plan that allows employers to maximize their annual salary deferral. Employer Safe Harbor contribution costs generally average 3-4% of gross eligible salaries and are deductible. For business owners looking to save $61,000 per year (or $67,500 if over age 50), there is a 401(k) Plan that also utilizes Cross Tested/New Comparability functionality. This is a type of calculation method that combines the 401(k) and most often 3% Non-Elective Safe Harbor with profit sharing. What makes these plans unique is that business owners can select certain groups of employees to participate in the profit-sharing portion of the plan, but the plan will need to be tested so that benefits do not discriminate in favor of highly compensated employees. Also, profit-sharing contributions are flexible year to year and are often subject to a vesting schedule of up to 6 years using a graded vesting schedule.
Another retirement savings strategy is a Cash Balance Defined Benefit Plan that can allow for $200,000 in Retirement Savings. This is best for someone looking for a large tax deductions and rapid retirement plan savings. The pre-tax account is an above-the-line tax deduction. Cash Balance plans are best for owners that have a consistent revenue that projects at least 3-5 years into the future, already contribute 5% or more towards employee retirement benefits through a Safe Harbor and Profit-Sharing Plan, and are comfortable with advanced plan design requiring regular and recurring annual contributions.
Health & Longevity – The Benefits of a HIIT
The U.S. Department of Health and Human Services recommends that adults get between 150 and 300 minutes of moderate-intensity exercise per week. However, you can cut that time commitment in half and increase physiological benefits by using High-Intensity Interval Training (HIIT). According to the Cleveland Clinic Journal of Medicine, and many other sources, HIIT has been shown to aid in weight loss, cardiovascular health, age reduction, mental health, diabetes prevention and management, and respiratory health. Essentially, HIIT alternates short periods of explosive bursts of exercise with less intense recovery periods. Workouts can last from less than 10 minutes to 30 minutes total, including the warm-up, recovery time between exercise intervals, and cool-down. According to the American College of Sports Medicine, the intense bursts of activity are performed at 80% to 95% of your maximal heart rate (the number of times your heart beats in a minute) and are alternated with the less intense activity performed at 40 to 50% of your maximal heart rate. This combined work/rest interval is commonly repeated six to ten times and can be done with any exercise two to three times per week. Please check with your healthcare practitioner before starting HIIT, especially if you have an existing medical condition.
Talk with your family about getting the little ones vaccinated. In case you missed it, CDC now recommends COVID-19 vaccines for everyone 6 months and older, and boosters for everyone 5 years and older. The CDC says COVID-19 vaccines are safe and effective at preventing children from getting seriously sick. If children have already had COVID-19 they should still get vaccinated and can also receive other vaccines. Please check with your healthcare practitioner, especially if you have an existing medical condition.
Here are some fun days to celebrate in July:
- July 1 – National Postal Worker Day – hug your mailperson?
- July 2 – Civil Rights Act Day/World UFO Day – hire a competent and trustworthy alien?
- July 4 – Independence Day!!
- July 5 – National Bikini and National Workaholics Day – wear your bikini to workday?
- July 7 – Global Forgiveness Day/National Chocolate Day – buy your frenemy some M&Ms!
- July 11 – United Nations’ World Population Day – one 7.8 billion human group hug!
- July 12 – National Cow Day – no cow tipping allowed!
- July 13 – National French Fry Day
- July 12/13 – Amazon Prime Day – 175 more shopping days until Christmas!
- July 17 – World Emoji Day/National Ice Cream Day
- July 20 – National Moon Day – in ‘69, one small step for man, one giant leap for mankind!
- July 21 – National Junk Food Day! Writer Ernest Hemingway was born (1899).
- July 24 – Parent’s Day! Pilot Amelia Earhart (1st woman to fly Atlantic) was born (1898).
- July 26 – Aunt and Uncle Day! Irish playwright George Bernard Shaw was born (1856).
- July 28 – First Lady Jackie Kennedy was born (1929).
- July 30 – Automotive pioneer Henry Ford was born (1863).
- July 31 – National Avocado Day! – they help to prevent disease and promote health!
Here are some inspirational quotes from our Nation’s Founding Fathers:
“He that would live in peace and at ease, must not speak all he knows or judge all he sees.” – Benjamin Franklin
“Well done is better than well said.” – Benjamin Franklin
“People sometimes attribute my success to my genius; all the genius I know anything about is hard work.” – Alexander Hamilton
“Always stand on principle…even if you stand alone.” – John Adams
“If you want something you’ve never had, you must be willing to do something you’ve never done.” – Thomas Jefferson
“The circulation of confidence is better than the circulation of money.” – James Madison
“It is better to offer no excuse than a bad one.” – George Washington
“Distrust naturally creates distrust, and by nothing is good will and kind conduct more speedily changed.” – John Jay
“To succeed, jump as quickly at opportunities as you do at conclusions.” – Benjamin Franklin
“Do you want to know who you are? Don’t ask. Act! Action will delineate and define you.” – Thomas Jefferson
“Let us by wise and constitutional measures promote intelligence among the people as the best means of preserving our liberties.” – James Monroe
“The advancement and diffusion of knowledge is the only guardian of true liberty.” – James Madison
“Learn to think continentally.” – Alexander Hamilton
“Dost thou love life? Then do not squander time, for that is the stuff life is made of.” – Benjamin Franklin
“Nothing can stop the man with the right mental attitude from achieving his goal; nothing on earth can help the man with the wrong mental attitude.” – Thomas Jefferson
“Ambition must be made to counteract ambition.” – James Madison
“Without continual growth and progress, such words as improvement, achievement, and success have no meaning.” – Benjamin Franklin
“Whenever you do something, act as if all the world were watching.” – Thomas Jefferson
“The advancement and diffusion of knowledge is the only guardian of true liberty.” – James Madison
“Tell me and I forget. Teach me and I remember. Involve me and I learn.” – Benjamin Franklin
“The people are the only legitimate fountain of power.” – James Madison
“Those who own the country ought to govern it.” – John Jay
“Either write something worth reading or do something worth writing.” – Benjamin Franklin
“Truth will ultimately prevail where there is pains to bring it to light.” – George Washington
“Never leave that till tomorrow which you can do today.” – Benjamin Franklin
“Real firmness is good for anything; strut is good for nothing.” – Alexander Hamilton
“Energy and persistence conquer all things.” – Benjamin Franklin
“Liberty, when it begins to take root, is a plant of rapid growth.” – George Washington
“Happiness depends more upon the internal frame of a person’s own mind than on the externals in the world.” – George Washington
At The Bahnsen Group, our mission is to help you successfully plan and achieve your lifetime family goals. Please reach out to me or your Private Wealth Advisor if you have any questions or if there is anything we can do for you.
Have a prosperous, healthy, and blessed month ahead!
Warm and best regards,
Don B. Saulic, CFP® CPA
Managing Director, Partner
Internal Revenue Service (IRS) is the source of all tax data