Blog Archives - PFwise.com

6 Benefits of Permanent Life Insurance - 2. A Good Asset

2/29/2016

In our last blog post, we introduced the most important benefit of life insurance - income tax exemption. Now the second benefit of life insurance.

2. Life Insurance As a Good Asset
Most people have their retirement savings in IRAs and 401(k)s. But these are "bad" assets because they are tax-deferred rather than tax-exempt. The tax will have to be paid one day, usually at the time you need the money the most, creating a growing debt on these retirement savings. Also, the unknown, probably higher tax rate, makes long term financial planning difficult.

Replacing these "bad" assets over time with permanent life insurance turns these tax-deferred funds into tax-free savings. Anyone who plans retirement should begin a program of systematic IRA withdrawals to decrease their IRA balances and plow those funds into permanent life insurance. In this way, the increasing and uncertain tax debt will be paid off by paying the tax now at known tax rates, which are at historic lows right now, while income tax-free savings are growing in the permanent insurance policy.

In our next blog post, we will discuss life insurance as an investment, rather than an expense.

6 Benefits of Permanent Life Insurance - 1. Income Tax Exemption

2/28/2016

Q. What are the benefits of a permanent life insurance (other than death benefit)?

A. There are 6 important benefits of a permanent life insurance policy, we will discuss each of them in this mini-blog series.

1. Income Tax Exemption Benefit
The single biggest benefit in the Federal tax code is the income tax exemption for life insurance.

When an insurance company sends out the check with a large amount to the beneficiary of a policy when the insured passed away, there is no income tax to pay for the receiver when receiving such a large amount of money, you can't find such a benefit anywhere else!

Because of this huge benefit, life insurance, especially permanent life insurance, should be a bedrock of any serious financial, retirement or estate plan.

Besides the death benefit, there are other important benefits of permanent life insurance. In our next blog post, we will discuss why Life Insurance is a good asset, while the other retirement products are "bad" assets.

Why Fund Rankings Might Not Work For You

2/27/2016

In our last blogpost, we introduced the concept of risk aversion, now we will discuss why fund rankings might not work for some investors.

Let's say you are extremely risk averse, with a measure of five (you need a gain of $500 in order to play the game with the potential of losing $100), even a high rated fund might be too risky for you. Or your risk aversion measure is only 1.5, then again the fund rating system might not suit you well. The reason is those popular fund rating systems assume all investors have the same and typical risk aversion (around 2 if you want to quantify it), but if your risk tolerance level is outside of the norm, such fund rating guides could potentially mislead you to funds that don't fit your investment style.

Once you have learned your risk tolerance level through the tool we introduced in the last blogpost, the ideal situation is to develop a fund ranking system that is based on your risk tolerance level. Unfortunately such a customized fund ranking system does not exist today.

The Bottom Line? Use caution when you rely on the fund rankings to pick your fund choices.

Are Fund Ratings Reliable?

2/26/2016

Q. I plan to use Morningstar's fund rankings to guide my fund investment decisions, are fund ratings reliable?

A. It depends on what kind of investor you are, for some, the simple fund ratings might not be helpful at all, here is why -

Fund rating systems from Morningstar or S&P Capital IQ don't take into account the investors' risk aversion levels, which could vary significantly from person to person.

What is Risk Aversion?
The best example to illustrate what is risk aversion is probably the following coin-flip game -

For head you gain $200, for tail you lose $100, will you play this game?

Surprisingly, most people won't play this game because of the potential loss of $100, even mathematically you could gain from this game.

By adjusting the different payoff figures in order to attract you to the game, you could measure your level of risk aversion. Use the following tool to check your level of risk aversion - digitai.org/#lab.

In our next blogpost, we will discuss why different people's risk aversion leads to ineffectiveness of the fund ranking guides.

Why ETFs Are More Tax Efficient? Part B. Structural Setup

2/25/2016

In our last blog post, we discussed the first main reason why ETFs are more tax efficient - passive investment. Now we will look at the second key reason that makes ETFs are more tax efficient.

2. Unique Structural Set Ups
ETF's structure is the second source of ETFs’ tax efficiency - ETF companies work with specialized dealers (aka Authorized Participants) to create and destroy shares based on supply and demand.

When an ETF investors pull money out, the ETF manager can deliver a basket of shares to the specialized dealer, who then sells them. This is referred to as “in-kind” redemption. That doesn’t qualify as a taxable event for shareholders, hence the greater tax efficiency.
On the other hand, mutual funds must meet investor withdrawals by unloading shares in the open market, creating taxable events.

Why ETFs are Tax Efficient? Part A. Passive Investments

2/24/2016

Q. Why ETFs are tax efficient?

A. There are two main reasons why ETFs are more tax efficient.

1. More Passive Investments
Index-tracking ETFs are more tax efficient than actively managed mutual funds because churn within the ETF portfolio is inherently lower than in stock-picking investment strategies. This is true of index funds in general, including index-tracking mutual funds, not just ETFs. In other words, index funds are more efficient in part because they usually hold the same stocks over weeks and months, until a re-balance.

Capital gains are generated inside a fund when a manager sells winning positions. Funds are required to distribute those gains to their shareholders, who in turn are required to pay taxes on them. Most index-tracking ETFs don’t pay out capital gains, except for in rare cases.

In our next blog post, we will discuss the second reason why ETFs are more tax efficient - structural reason.

Is Smart Beta Strategy Truly Smart?

2/23/2016

Q. Should I invest in smart beta strategy-driven funds in order to generate higher returns?

A. Ever since the financial crisis of 2008, investors have embraced "smart beta" funds - funds that are neither passive index funds nor actively managed funds, but using other tactics, such as fundamental, high-dividend, low volatility, high-momentum, low-beta, etc. to determine fund investments, and many smart beta funds have generated great returns in the past several years.

Amid stock market turmoils lately, investors are turning to smart beta funds as a refuge. But should you expect the smart beta funds continue to generate stellar returns in the future?

In one of our previous blog posts, we have pointed out one of the reasons smart beta did well, here we will give investors another alert -

A recent academic study has found that many of the smart beta funds had low valuations a few years ago when they started, but now they are dangerously expensive.

For example, funds that invest in low-volatility stocks - the low-volatility stocks used to be half as expensive as the overall stockmarket, but now they are 20% more expensive! If you invest in them now, you are paying a higher price, which could mean less stellar return going forward.

What should you do before investing in a smart beta fund?

Checking its history - if it used to have low PE or low price to book ratios, but not anymore, it's a good indication you are buying high, can you sell higher, that's a question only future can tell.

Life Insurance's Non-death Lifetime Benefits

2/22/2016

Q. What are the lifetime benefits for life insurance?

A. Life insurance is known for its death benefit, but most people don’t realize life insurance also provides powerful lifetime retirement and tax benefits.

Life Insurance's Retirement Benefits
A permanent life insurance policy can double as a retirement savings account, because funds in a permanent life insurance product can be accessed for retirement use, but without the worry about what future tax rates will be.

This is a big deal, because if the funds were in an IRA, distributions would not only be taxable (in a traditional IRA), but that increased income could trigger other so called “stealth taxes.”

Life Insurance's Tax Benefits
If set up properly, there is no tax impact when accessing funds in a permanent life insurance policy. But if funds were in an IRA and accessed, there would be hidden tax increases in the form of phased-out deductions, tax credits, exemptions and other benefits as income increases. For example, an income increase from an IRA distribution could cause more Social Security benefits to be taxable or the trigger the 3.8 percent additional tax on net investment income from capital gains, interest and dividends.

In Summary
Accessing funds from a life insurance policy are tax-free, they keep taxable income and taxes lower in retirement. These are valuable lifetime benefits, in addition to the death benefit.

Two Great Tax Saving Benefits Uncle Sam Might Take Away Soon

2/21/2016

President Obama's fiscal 2017 budget includes the following two proposals that if approved could take away two major Roth IRA related tax saving strategies:

1. End of Backdoor Contribution to Roth IRA
We have discussed backdoor contribution to Roth IRA several times in the past, here, and here, it's a great tax saving strategy for high earners to sidestep the income limitation on Roth IRA contributions. But a a provision in the fiscal 2017 budget would shut this door.

2. Mandatory Roth IRA Contribution
Unlike traditional IRAs, there is required minimum distribution for Roth IRA savings. But a provision in the fiscal 2017 budget would require the RMD from Roth IRA after age 70.5.

At this time, we don't know if these two provisions would pass. While the benefits are still available, grab them as you could.

How to Evaluate REITs?

2/20/2016

Q. Are REITs attractive investments at this time?

A. REITs are companies that own and manage properties, such as apartments, office buildings, hospitals, self-storage facilities, farmland, etc. they collect rents and pass as profits to investors.

REITs have generated very impressive returns, for example, Vanguard REIT Index fund (VGSIX), had cumulative total return of 188% between 2009 and 2015 (16% annualized return). But do REITs offer attractive valuation at this time? How to evaluate REITs?

REITs vs. Bonds
First, REITs are not bonds that have promised returns. REITs are stocks, if the managers or REITs overpay properties or fail to collect expected rents, REITs investors could suffer significant losses.

Yield Spread
An important metric an investor should check a REIT is its yield spread. A REIT's yield is the payout as a percentage of share price. Yield spread refers to the difference between the REIT's yield and 10-year Treasury notes. Historically, the average yield spread is about 1%. The higher the yield spread, the better.

Price to FFO Ratio
FFO stands for funds from operations, it's an important metric to evaluate REITs because REIT income statements are distorted by an often unrealistic depreciation charge and by property sales, both make evaluating how the company's properties perform difficult. FFO takes a company's reported profits and eliminates the depreciation and property sales to arrive at a standardized measure of cash flow that can be used to compare different REITs.

The historical Price-to-FFO ratio is around 16 and 17, if you are buying a REIT with higher Price-to-FFO ratio, you might be overpaying for the REIT.

The Bottom Line
REITs should be part of a investor's investment portfolio, but not too much. If the REITs you plan to invest have had a great run, it might be wise wait until valuations are not over stretched.

Key Advantages of ETFs and Mutual Funds

2/19/2016

Q. What are the key advantages of ETFs over mutual funds and vice versa?

A. There are pros and cons associated with ETFs and Mutual Funds. Below we will discuss the key advantages of one category over another:

Advantages of ETFs over Mutual Funds
1. Tax-efficient
ETFs often are more tax-efficient, giving investors more control over when to book gains or losses.

2. Transparency
Because ETF portfolios are readily available online or in fund literature, investors can easily tell what they own.

Advantages of Mutual Funds over ETFs
1. Research capability
Active fund managers usually are supported by analysts who follow individual stocks and market sectors, something that individual investors may find hard to do.

2. Skills of fund manager
Also, a skilled manager could try to enhance returns by taking advantage of attractively priced stocks, especially when the market is falling.

Use ETFs or Mutual Funds to Invest in Bonds?

2/18/2016

Q. I want to add bonds to my investment portfolio, I am also concerned about the interest rate risk. Should I use ETFs or Mutual Funds to invest in bonds?

A. The answer is it depends on your strategy, either ETFs or Mutual Funds could work.

For ETFs, certain types of index funds might pose significant rate risk because they closely track the benchmark Barclays Aggregate Index, and this index includes a large portion of high-quality, rate-sensitive bonds, such as U.S. Treasuries. But ETFs that own larger portions of lower-rated bonds, such as U.S. high-yield (or junk) securities, would be less sensitive to broad moves in rates.

Managed bond funds typically do things to damp rate risk, such as owning shorter maturities or using derivatives to hedge against rate moves.

The bottom line? You could find either bond ETFs or bond funds that give you exposure to bonds and with less interest rate risks.

Use ETFs or Mutual Funds for Automatic Monthly Investment?

2/17/2016

Q. I just started investment and plan to set up monthly automatic purchases, should I use ETFs or Mutual Funds?

A. If you are just starting out and want to put a little money into the market each month, then mutual funds with no or low minimum investment requirements are probably your best choices, such funds typically allow you to add to your holdings regularly at no charge.

On the contrary, many ETFs can only be purchased through a broker, who will charge a commission on each purchase. But if your broker offer commission-free ETFs and you find those ETFs meet your investment objectives, then such ETFs are good options too.

What Happens If I Die Without a Will?

2/16/2016

Q. What will happen if I die without a will?

A. For parents with young children, if you die without a will, the following decisions will be made by some strangers - who to raise your children? Who to manage your assets for your children's care?

Basically, if you die without a will, the state in which you live will provide one for you. This means you give up the opportunity to distribute your assets as you want; you just hired the state to figure it out for you, and chances are all your assets may not pass to your spouse and children.

It doesn't have to be hard to develop an estate plan, just get these three things done and you will be in good shape.

A Customer or A Client?

2/15/2016

What’s the difference between a customer and a client?

A customer is someone who buys what you make.

A client is someone who asks you to make something.

Both have the power to choose, but the client has the power to define.

There is a large number of potential customers, and you make for them before you know precisely who they are.

There are just a relative handful of clients you could handle, though, and your work happens after you find them or they find you.

You can do great work for either.

But don't confuse them.

Saturday Summary for February 14 2016 - Perspective on Market

2/14/2016

Is There State Income Tax on Life Insurance Death Benefit Payout?

2/13/2016

Q. Is there state income tax on life insurance benefits payout?

A. Generally speaking, there is neither Federal income tax nor State income tax levied on life insurance death benefits payouts.

There might be exceptions, for example, if the beneficiary doesn't receive all of the payouts at once and the remaining balance held by the insurance companies pay interest, then there will be income tax on that interest gains.

Issues with QLAC and the Answers

2/12/2016

Q. What are the issues with QLAC and potential solutions?

A. QLAC, or qualified longevity annuity contract, is a government approved annuity product designed to solve the problem of running out of money while you are still living.

It's different from the traditional annuity – with traditional annuities, you have to start making annual withdrawals at age 70 and half; with QLAC, you can defer withdrawals until age 85, so your money can continue growing on a tax-deferred basis for another 15 years.

Some problems with QLAC and potential solutions:

1. Interest rate on QLAC tend to be low when compared with a well-diversified portfolio.
However, that's the price you pay for stability, because even a well-diversified portfolio could suffer a big loss in some dramatic market situations.

2. Fees tend to be higher on these products.
However, if your goal is to solve longevity problem (money is still available while you live a very long time), fees matter little because your annuity payments not tied to the actual investment growth (which hurt by the higher fees).

3. Tax rates could be higher as the gains will be taxed at income tax rate, rather than capital gain tax rate, level.
However, if your income is not very high during your older years, this should not be a problem.

4. Lack of liquidity with the annuity products.
While some annuity products allow you for some partial withdrawals without penalty, this could be a serious issue for most annuity investors, and is the reason why you shouldn’t put all your money into an annuity contract.

What Is a House's Stepped Up Cost Basis and Why It Matters?

2/11/2016

Q. I inherited a house my parents bought at $100,000. Its value is $700,000 now. I am married. If I sell the house, do I have to pay tax on $100,000 ($700,000 - $100,000 cost - $500,000 home sale tax exclusion)?

A. If you sell the house for $700,000, you will not owe any tax, thanks to your stepped up cost basis, which is the value of the house you inherited from your parents. Your parents' cost basis does not matter to you.

You will owe capital gain tax if you sell the house for more than $700,000.

Should I Withdraw Roth IRA or 401(k) First?

2/10/2016

Q. I plan to retire soon. Should I withdraw money from Roth IRA or 401(k) first?

A. The best way to answer this question is to actually run the number.

Here is a website you can use to run different scenarios -

www.i-orp.com

It even suggests how much of a 401(k) or rollover IRA to convert to a Roth IRA each year while staying in a low tax bracket. Conversions may be very beneficial, especially if you have a taxable account to pay the taxes.

529 ABLE Account 101 - Part C

2/9/2016

In our last two blogposts, we discussed the similarities and differences between a 529 ABLE account and a 529 college-savings account.

For families with a special needs child, the familiar option is special-needs trust. How to choose between the special-needs trust and 529 ABLE options?

The first consideration is cost, a special-needs trust is costly (it costs anywhere between $2,000 and $5,000 to set up), but the benefit is you can put in as much assets as you could, and the special needs child could still benefit from government assistance programs.

However, the investment gains in the special-needs trust is taxable. Here is 529 ABLE accounts shine, since it's tax free if used for eligible uses, such as education, housing, transportation, and employment training. If used for other purposes, investment gains are subject to income tax and 10% penalty.

The Bottom Line
If your available funds are limited, such as less than $50,000, it makes sense to set up the 529 ABLE account (note not to put more than $100,000 into it in order not to affect a beneficiary's eligibility for government benefits).

If you have far more money to invest, consider a special-needs trust.

529 ABLE Account 101 - Part B

2/8/2016

In our last blog post, we discussed the similarities between 529 ABLE and 529 College Savings accounts. Now the differences between the two.

In a 529 ABLE account, a disabled individual can have as much as $100,000 in it and still benefit from Medicaid and Supplemental Security Income (SSI). Previously, to qualify for SSI, one's assets cannot exceed $2,000. Medicaid has a similar asset cap.

Each beneficiary is limited to only one 529 ABLE account (note: one beneficiary theoretically could have unlimited number 529 college savings accounts).

Because of the limitation of only one 529 ABLE account and annual $14,000 contribution limit, it means a family needs to start as soon as possible in order to save enough money in a 529 ABLE account.

In our next blog post, we will discuss if 529 ABLE account is still needed if you already have a special-needs trust, or how do you decide between the two options.

529 ABLE Account 101 - Part A

2/7/2016

Q. What is 529 ABLE account?

A. 529 ABLE account is a very new (just passed by Congress one year ago) savings vehicle for disabled people that offers the same tax-free growth and tax-free use just like 529 college-savings plans.

Similarities Between 529 ABLE and 529 College Savings Account
Like 529 college savings accounts, you can open a 529 ABLE account at any state that offers it (currently 35 states offer it), make sure you compare costs and investment options. If you live in a state that offers tax incentives (Oregon, Iowa, Missouri, Montana, Nebraska, New York, and Wisconsin), it's advantageous to open in your own state.

Also like 529 college savings accounts, a disabled person or friends or relatives can make one-time or regular contributions to 529 ABLE accounts. The account owner can make decisions on behalf of the disabled individual.

Annual contribution to 529 ABLE is capped at $14,000.

Just like 529 college savings accounts, if 529 ABLE money is not used for qualified expenses, such as education, housing, transportation and employment training, there will be income tax and 10% penalty on the investment gains.

In our next two blog posts, we will discuss differences between 529 ABLE and 529 college saving accounts and differences between 529 ABLE and special-needs trusts.

10 Reasons Why Life Insurance Is A Viable Asset Class

2/6/2016

Q. Why I should consider including Life Insurance in my investment portfolio?

A. Portfolios, regardless of the size, should be as diversified as possible. While most portfolios have real estate, stocks, and bonds, cash life insurance is often overlooked. If you believe in IRR mathematics, you should add the tax-free asset of life insurance to the mix as well.

Below are 10 reasons why life insurance is an attractive asset class and should be an part of your portfolio:

1. Superior, Safe Results
The average. life expectancy (84-87) typically provides a tax-free IRR of 6% to 8%, which would require an equivalent yield of 9.23% to 12.31% in a taxable investment just to compete.
2. Predictable Value
No other asset comes with a lifetime annual internal rate of return (IRR) illustration.
3. It Ensures Your Legacy
A policy can be set up to pay a known death benefit amount at the time of the insured’s death.
4. Value Not Directly Linked to Market Performance
A life insurance policy can be designed in such a manner that the death benefit may not directly depend on market performance.
5. Liquidity
The life insurance policy is easily converted into cash at death and is not reduced by commissions, taxes, transfer cost or fees. In addition, your client has access to their policy cash surrender value at all times.
6. Growth / Leverage
The death benefit amount is likely to exceed the costs of acquiring and maintaining it. Premiums paid for death benefit protection may provide a competitive rate of return through life expectancy.
7. Income Tax Free Features
Asset growth is income tax free when distributed at death. When established properly, life insurance can be purchased inside your pension plan with tax-free dollars.
8. May Avoid Estate Taxes
Life insurance is frequently purchased to avoid estate taxes. No other asset offers this immediate estate tax advantage.
9. Avoids Probate
Forget about the costs and delays associated with passing assets through probate; life insurance be immediately delivered to beneficiaries without any financial burden.
10. Versatility
By leveraging life insurance to shore up their financial security, many investors become more comfortable taking added investment risks with other assets.
If you are ready to diversify your portfolio with life insurance, please contact us so we can work together to find out the best product for you.

May a Life Insurance Beneficiary be Required to Pay Estate Tax?

2/5/2016

Q: May a life insurance beneficiary be required to pay estate tax attributable to death proceeds?

A: Yes, under either of two circumstances:

1) Where the decedent/insured has directed in his or her will that the life insurance beneficiary pay the share of death taxes attributable to the proceeds; and

2) where the state of the decedent’s domicile has a statute that apportions the burden of death taxes among probate and nonprobate beneficiaries in absence of any direction from the decedent regarding where the burden of death taxes should fall.
Most states have statutes that apportion death taxes (federal, state, or both) among the beneficiaries of an estate, probate and nonprobate, under circumstances where the decedent has not directed otherwise. A few states place the death tax burden on the probate estate (technically, the residuary estate).
A federal apportionment statute provides in pertinent part as follows: “Unless the decedent directs otherwise in his will, if any part of the gross estate on which tax has been paid consists of proceeds of policies of insurance on the life of the decedent receivable by a beneficiary other than the executor, the executor shall be entitled to recover from such beneficiary such portion of the total tax paid as the proceeds of such policies bear to the taxable estate.”