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The Long Term Times September 2014
Volume 14, No. 3
(Download PDF Version)

Articles:

Social Security Update

Every year, the Trustees of the Social Security Trust Funds release a report to Congress on the current financial condition and projected financial outlook of the program. This year’s report, released on July 28, contains valuable information about the health of Social Security that may help you understand how your Social Security benefits might be affected.

Opposing Court Rulings Lead to Confusion over Health Insurance Subsidies

A goal of the Affordable Care Act (ACA) is to provide more Americans with access to affordable health care. One of the ways the ACA attempts to make health care affordable is through federal subsidies that reduce insurance premiums and out-of-pocket costs for eligible consumers who purchase health insurance through either statebased or federal exchanges. Two opposing federal appeals court rulings have called the legality of these subsidies into question. How might these court decisions affect you?

IRA Strategies

When it comes to retirement savings, the IRA and its first cousins, the 401(k) and the 403(b), are the most commonly used types of accounts. The rules for using these sorts of plans seem simple on the face of it: figure out how much you can contribute for the year, make arrangements to have that amount contributed, and in the beginning name a beneficiary to receive your IRA should you fail to live until your retirement years. But dig down into the “fine print,” and these plans are not as simple as they seem.

Social Security Update

Every year, the Trustees of the Social Security Trust Funds release a report to Congress on the current financial condition and projected financial outlook of the program. This year’s report, released on July 28, contains valuable information about the health of Social Security that may help you understand how your Social Security benefits might be affected.

What are the Social Security Trust Funds?
The Social Security program consists of two parts. Retired workers, their families, and survivors of workers receive monthly benefits under the Old-Age and Survivors Insurance (OASI) program; disabled workers and their families receive monthly benefits under the Disability Insurance (DI) program. The combined programs are referred to as OASDI. Each program has a financial account (a trust fund) that holds the Social Security payroll taxes that are collected to pay Social Security benefits. Other income (reimbursements from the General Fund of the Treasury and income tax revenue from benefit taxation) is also deposited in these accounts. Money that is not needed in the current year to pay benefits and administrative costs is invested (by law) in special Treasury bonds that are guaranteed by the U.S. government and earn interest. As a result, the Social Security Trust Funds have built up reserves that can be used to cover benefit obligations if payroll tax income is insufficient to pay full benefits.

What are some highlights from this year’s report?
This year’s Trustees report projects that the OASI Trust Fund and the DI Trust Fund will have sufficient reserves to pay full benefits on a timely basis until 2034 and 2016, respectively. The combined trust fund reserves (OASDI) are still increasing and will continue to do so through 2019. Beginning in 2020, annual costs will exceed total income, and the U.S. Treasury will need to redeem trust fund asset reserves. The combined trust fund reserves will be depleted in 2033 if Congress does not act before then. This is the same year projected in last year’s report.

Once the combined trust fund reserves are depleted, payroll tax revenue alone should still be sufficient to pay about 77% of scheduled benefits. This means that 20 years from now, if no changes are made, beneficiaries may receive a benefit that is about 23% less than expected.

However, because the DI Trust Fund reserve is projected to be depleted in two years, legislative action is needed as soon as possible. Once the reserve is depleted, income to the fund will be sufficient to pay only 81% of DI benefits.

You can view the 2014 OASDI Trustees Report at www.ssa.gov.

Why is Social Security facing financial challenges? Fewer workers are paying into the system, so payroll tax income is decreasing. When there are fewer payroll taxes coming into the system each year than benefits paid out, trust fund reserve assets have to be spent to make up the difference. The strain on the trust funds is worsening as large numbers of Baby Boomers reach retirement age and because Americans live longer.

What is being done to address the financial challenges Social Security faces? For years, the Trustees have been urging Congress to address the financial challenges in the near future, so that solutions will be less drastic and may be implemented gradually, lessening the impact on the public. As the conclusion to this year’s report states, “The Trustees recommend that lawmakers address the projected trust fund shortfalls in a timely way in order to phase in necessary changes gradually and give workers and beneficiaries time to adjust to them. Implementing changes soon would allow more generations to share in the needed revenue increases or reductions in scheduled benefits. Social Security will play a critical role in the lives of 59 million beneficiaries and 165 million covered workers and their families in 2014. With informed discussion, creative thinking, and timely legislative action, Social Security can continue to protect future generations.”

Action needs to be taken very soon to address the DI program’s reserve depletion. According to this year’s report, in the short term, lawmakers may reallocate the payroll tax rate between OASI and DI (as they did in 1994). However, this may only serve to delay DI and OASI reforms. Members of Congress and the President support longer-term efforts to reform Social Security, but progress on the issue has been slow.

Some long-term reform proposals on the table are:

  • Raising the current Social Security payroll tax rate (according to this year’s report, an immediate and permanent payroll tax increase of 2.83 percentage points would be necessary to address the revenue shortfall).
  • Raising the ceiling on wages currently subject to Social Security payroll taxes ($117,000 in 2014).
  • Raising the full retirement age beyond the currently scheduled age of 67 (for anyone born in 1960 or later).
  • Reducing future benefits, especially for wealthier beneficiaries.
  • Changing the benefit formula that is used to calculate benefits.
  • Changing how the annual cost-of-living adjustment for benefits is calculated.

Thanks to Broadridge for the above article. This article copyright Forefield Inc.

Opposing Court Rulings Lead to Confusion over Health Insurance Subsidies

A goal of the Affordable Care Act (ACA) is to provide more Americans with access to affordable health care. One of the ways the ACA attempts to make health care affordable is through federal subsidies that reduce insurance premiums and out-of-pocket costs for eligible consumers who purchase health insurance through either statebased or federal exchanges. Two opposing federal appeals court rulings have called the legality of these subsidies into question. How might these court decisions affect you?

What is the issue?
At issue is a provision in the ACA authorizing subsidies “through an exchange established by the State.” The IRS has interpreted the law to include subsidies for health insurance purchased through either state-based exchanges or federal exchanges. However, the plaintiffs in both cases allege that the IRS interpretation is wrong and that these subsidies should be available only to eligible consumers who purchase insurance through state-based exchanges and not for consumers who purchase insurance through federal exchanges.

What did the courts decide? In a 2-1 decision, the U.S. Court of Appeals for the District of Columbia Circuit, in Halbig v. Burwell, held that subsidies are available only to consumers who purchase health insurance through state-based exchanges and not through federal exchanges.

However, within a few hours of the Halbig decision, a three-judge panel of the U.S. Court of Appeals for the Fourth Circuit in Virginia ruled, in the case King v. Burwell, that subsidies are available to eligible consumers who purchase insurance through either state-based exchanges or federal exchanges.

Which states have their own exchanges?
According to the Kaiser Family Foundation, 16 states and the District of Columbia operate their own state-based exchanges. These states include California, Colorado, Connecticut, Hawaii, Idaho, Kentucky, Maryland, Massachusetts, Minnesota, Nevada, New Mexico, New York, Oregon, Rhode Island, Vermont, and Washington.

The federal government operates exchanges in the remaining states. Most consumers access federal exchanges through the federal government website, www.healthcare.gov.

Will I lose my subsidies?
It appears that nothing will change in the short term. The D.C. Circuit court has suspended its ruling pending an appeal by the federal government, which said it intends to appeal to the full D.C. Circuit court (11 presiding justices). In addition, the White House has said subsidies will continue to be offered to those who are eligible through both state-based exchanges and federal exchanges.

What might happen next?
Aside from a presumed federal government appeal to the full D.C. court, the issue may ultimately be decided by the U.S. Supreme Court, which has already ruled twice on other issues relating to the ACA. Also, two federal lawsuits on the same issue are currently pending in Indiana and Oklahoma.

Thanks to Broadridge for the above article. This article copyright Forefield Inc.

IRA Strategies

When it comes to retirement savings, the IRA and its first cousins, the 401(k) and the 403(b), are the most commonly used types of accounts. The rules for using these sorts of plans seem simple on the face of it: figure out how much you can contribute for the year, make arrangements to have that amount contributed, and in the beginning name a beneficiary to receive your IRA should you fail to live until your retirement years. But dig down into the “fine print,” and these plans are not as simple as they seem. Beneficiary designations, early withdrawals, retirement distribution strategies, bankruptcies, mandatory distributions and the choice of custodians are all areas that contain traps for the unsuspecting participant. The rules regarding these plans have been created over many years, with layer upon layer of complexity formed by Congress’ attempt to “simplify” the tax code in order to create economic fairness among different groups of constituents. There is a lot to know about IRAs and company plans. But today let’s just look at two areas that involve IRAs and other sorts of retirement plans - beneficiary designations and early withdrawals.

Beneficiaries
Selecting beneficiaries for retirement benefits is different from choosing beneficiaries for other assets such as life insurance. With retirement benefits, you need to know the impact of income tax and estate tax laws in order to select the right beneficiaries. Although taxes shouldn't be the sole determining factor in naming your beneficiaries, ignoring the impact of taxes could lead you to make a less than ideal choice.

Most inherited assets, such as bank accounts, stocks, and real estate, pass to your beneficiaries without income tax being due. However, that's not usually the case with 401(k) plans and IRAs.

Beneficiaries pay ordinary income tax on distributions from 401(k) plans and traditional IRAs. With Roth IRAs, however, your beneficiaries can receive the benefits free from income tax if all of the tax requirements are met. That means you need to consider the impact of income taxes when designating beneficiaries for your 401(k) and IRA assets. For example, if one of your children inherits your house from you and another child receives your 401(k) benefits of equal value, they aren't receiving the same amount. The reason is that all distributions from the 401(k) plan will be subject to income tax at ordinary income tax rates, while the value of your house on the date of your death is not subject to income tax at ordinary income tax rates. Similarly, if one of your children inherits your taxable traditional IRA and another child receives your income-tax-free Roth IRA, the bottom line is different for each of them.

It is important to note that the rules regarding beneficiary designations (and other aspects of your qualified retirement plan) are controlled not only by tax law, but also by the PLAN DOCUMENT. The plan document is the document that governs your retirement plan, and while it must conform to federal law, it can also impose other sorts of rules that can have more restrictive options than tax law allows. Just because Uncle George’s 401(k) from XYZ Widgetworks allows his beneficiaries to take their distributions over their lifetime doesn’t mean that your 401(k) does. The flexibility of the plan in regards to beneficiary designations and methods of distribution are important areas to review in light of retirement or termination of employment with a particular company, and may be one of the first things to consider when evaluating whether to leave funds in your 401(k) or company plan or rolling them into an IRA. This seemingly small detail can be the difference between a 30-year old non-spouse beneficiary taking the 401(k) as a lump sum (and paying the tax that year) or stretching IRA distributions over their lifetime (keeping the tax deferral working for many years).

Early Withdrawals
So, you are 55 and have almost all of your investments inside your 401(k) or IRA. You’ve decided you want to take 5 years off (or just plain retire), but to do it you’ll need to tap into your IRA/401(k).

If you receive a distribution from your traditional IRA (401(k)s can be different) before you reach the age of 59½, the federal government considers this a premature distribution. Like all distributions from traditional IRAs, premature distributions are generally taxable. You will pay federal (and possibly state) income tax on the portion of the distribution that represents tax-deductible contributions, any pre-tax funds that were rolled over into the IRA from an employer-sponsored retirement plan, and investment earnings. In addition to regular income tax, distributions taken prior to age 59½ may be subject to a 10-percent federal penalty tax (and possibly a state penalty) on the taxable portion of the distribution. You can avoid this federal penalty (known as the premature distribution tax) only if you are age 59½ or older at the time of the distribution, or if you meet one of the exceptions allowed by the IRS.

There are a number of exceptions that may allow your distribution to escape the 10% penalty, such as distributions made to pay for medical expenses and first homes, education and disability. An additional exception to the penalty, potentially a bit broader than those above, can be had if the distribution in question is calculated as if it is one of a series of equal payments designed to last your lifetime. Once these sort of payments, called Substantially Equal Periodic Payments, or SEPPs, are started, they must go at least until you’re age 59 ½ or 5 years has passed, whichever is longer.

If you choose to take a SEPP withdrawal, you get to choose from 3 different methods of calculating what the amount will be. To meet the substantially equal periodic payments exception, you must use an IRSapproved distribution method and take at least one distribution annually. There are three IRS-approved methods for calculating substantially equal periodic payments, each of which uses a factor representing your life expectancy (or the joint life expectancies of you and your beneficiary). It's important to understand how these methods work and how recent tax law changes may affect your choice of method.

The payments from your IRA or retirement account must continue for at least five years, or until you reach age 59½, whichever is later. If you modify the payments (e.g., by taking a smaller distribution than you should have), you generally will be subject to the 10 percent premature distribution tax on the taxable part of all payments made to you before you reach age 59½ (unless the modification was due to death or disability). There is one exception to this rule, and it involves a switch from one method of distribution to another.

“You generally will be subject to the 10 percent premature distribution tax on the taxable part of all payments made to you before you reach age 59½.”

Get Advice
Today we have touched on two very sensitive aspects of tax qualified savings plans. The rules governing these instruments are anything but simple, and the traps and pitfalls for the unwary are liberally sprinkled throughout the tax code and the plan documents that govern them. The overarching piece of advice that we can give to participants in these types of plans is to get advice from an expert in IRA/401(k)s when considering the implications of your decisions regarding them.

Team Update

The days are starting to shorten and the evenings feel a bit cooler. Could summer really be coming to an end? We’ve had a most beautiful summer season here in the NW and everyone has taken some time to enjoy the bounty that our lovely region affords.

Mike reports that patience has been rewarded at Astoria’s buoy 10 during his recent fishing excursion there. Beautiful weather and fish caught, some good days indeed. On the car front, the judging at the Forest Grove Concourse was a delight as were the Italian Sports Cars featured this year. Soon he’s off to Tacoma for the Northwest Corvette Restorers meet. Great Cars and good friends!

Fred and Amy continue to have good changes in their family life. Their daughter, Taylor, is two months into her 6-month Ugandan odyssey, and has been helping some local organizations as well as teaching a kindergarten class. Their son, Peyton, is entering his senior year in high school and is excited about quarterbacking in the upcoming football season. They also just added a new family member, of the four-legged variety! “Chance” is an 8 week old part-French Bulldog and part-Boston Terrier.

Scott has been busy on a couple of fronts. First and foremost, when not engaged here at the office he has been working his way up and down the Puget Sound in pursuit of the perfect sailing breeze (he reports that some have been pretty close!). He also had some good summer visits with his son and daughter, sadly a less regular occurrence as they speed ahead in their own lives. Finally, always the capitalist, he has been helping some non-profits involved in building political will for a market-based solution to global warming based around a revenue-neutral carbon tax.

Jennifer and Ron continue to explore Oregon every chance they get. This Labor Day week, they headed south to Crater Lake, enjoyed the optical illusions of the Vortex House, visited the Oregon Caves, dipped into California to see some redwoods, then spent a lazy time driving back up the coast highway.

The information and opinions expressed in this newsletter are those of Scott Maxwell and Fred King, advisor affiliates under The H Group, Inc., a Registered Investment Advisory firm.