Q. I have heard of TIPS, but someone mentioned I Bonds to me recently.  What is it and should I invest in I Bonds?

A. There are some government bonds that pay a rate of return that adjusts with inflation to ensure investors receive a fixed, real return have been around since the late 1990s. The most popular one is Treasury Inflation Protected Securities (TIPS), but few people know that shortly after the arrival of TIPS, the U.S. Treasury also began to issue "I bonds" directly to investors; these government savings bonds were an alternative to the historical Series E/EE and H/HH bonds, but like TIPS offered a rate of return that would float with inflation and ensure a specific fixed, real rate of return.

I Bonds Background
As real interest rates declined over the past decade, and the U.S. government experienced a sharp increase in debt issuance, TIPS have become increasingly popular as a way to hedge against the risk and fear of future inflation. Given the nature of their return, arguably I bonds can do so as well, but with one notable feature that makes them quite unique: the U.S. Treasury is always available to redeem Series I bonds at their full value, which eliminates any risk that their prices could decline if/when/as interest rates rise. In addition, unlike TIPS bonds, that have some very unfavorable tax treatment (which is why they're often held within IRAs), the I bond actually accrues and compounds its interest without paying it out, which allows the investor to both avoid reinvestment risk and enjoy automatic tax deferral as long as the savings bond is held!

Use of I Bonds
Given the unique features and benefits of I bonds, it is a potential way to hedge inflation and rising interest rates in an investor's portfolios, or simply to use as an alternative to cash or ultra-short-term fixed income at a more appealing yield. Unfortunately, dollar amount limitations on the purchase of I bonds restricts the extent to which they can be used, and the requirement that I bonds be held in a TreasuryDirect account (and not a standard brokerage/investment account) further limits the practicality of their use. Nonetheless, for anyone who is looking to manage exposure to inflation and rising rates, or would simply like a better return on emergency funds or short-term funds you don't plan to use for a few years anyway, perhaps it's time to give I bonds a closer look.

Key Features of I Bonds
I Bonds are a form of government (savings) bond issued by the US Treasury. Similar to TIPS (Treasury Inflation Protected Securities), they pay a rate of rate of return that is a combination of a fixed interest rate and a floating rate based on inflation (as measured by the non-seasonally-adjusted CPI-U). The effective result is that I Bonds pay a guaranteed "real" rate of return at or above inflation (the fixed rate in excess of the floating inflation rate). However, unlike TIPS - which technically pay their stated rate of interest as interest and apply their inflation adjustments to the bond principal (which provides the inflation component of the return by lifting the price of the bond itself and also therefore the base on which interest payments are calculated) - the I Bond actually accrues and compounds both its fixed and inflation returns on the bond itself. The fixed return is set at the time the I Bond is issued (updated by the Treasury twice per year, in May and November), and the inflation component of the return is changed every 6 months (which month is based on when the I Bond is issued).

Unlike TIPS (which are bought and sold in the open marketplace), I Bonds are not marketable and instead are issued directly from, and redeemed directly to, the US Treasury, through the online TreasuryDirect website. The Treasury will only redeem I Bonds after a 1-year holding period, and apply a penalty of 3 months' worth of interest if they are redeemed within the first 5 years. Because of the fact that the US Treasury is obligated to redeem I Bonds at any time (at least after the first year), the government does place a limit on how much an individual can purchase in I Bonds: up to $10,000 per calendar year for an individual (based on his/her Social Security number, so a couple can acquire $20,000 worth). Individuals are also allowed to purchase up to $5,000 worth of paper I Bonds in a calendar year, but such purchases of paper bonds can be done only via a tax refund; for those who don't want to purchase with a tax refund, and/or don't wish to buy I Bonds in paper form and wish to keep it all on TreasuryDirect, the limit remains at $10,000/year/person. Notably, the limits apply only to the purchase of I Bonds; there is no limit on I Bond redemptions (beyond the 1-year holding requirement and the 3-month interest penalty from 1-5 years).

For tax purposes, I Bonds are tax-deferred, and the interest is only reported when the bond is redeemed (unless an election is made to report the interest annually) or when it matures (I bonds can be held for up to 30 years). When the liquidation occurs, the interest is subject to Federal income taxes (reported by the Treasury on a Form 1099-INT), but as with all Federal government bonds, is exempt from state and local taxation.

Unique Features & Benefits Of I Bonds
Over the past 15 years that I Bonds have been issued, their real (fixed) rate of return has declined significantly, along with the overall environment for real returns on bonds. While in the early years (the late 1990s) I Bonds had a fixed rate as high as 3.6% (and the total return of the I bonds included the CPI-U on top of that amount!), because the bonds are always redeemed at their current value, I bonds have not enjoyed any price appreciation through the declining rate environment as TIPS and other bonds have. On the other hand, the fact that I bonds continue to accrue interest under the terms of the bond means those early I bond investors are enjoying not only a fixed rate of 3.6% (plus inflation!) on their principal, but their interest payments are automatically reinvesting at those rates, too! (Unlike TIPS bonds, where the fixed rate of interest is paid out and must be separately reinvested, subjecting the owner to both reinvestment risk and also potential additional transaction costs.)

On the other hand, I bonds cannot have a negative fixed rate, which means that in today's environment - where TIPS as long as 5 years still have a negative real return - the fixed rate on the I bond is "only" 0%. In addition, if/when/as interest rates ultimately rise from here - which can cause a decline in the price of a market-traded bond - the fact that I bonds can always be redeemed with the Treasury at their accrued value means that I bond owners effectively have a guaranteed put option on the value of the bond to ensure it won't experience a price decline in a rising rate environment.

Overall, returns on I bonds have grown more and more mediocre over the past 15 years, as inflation has generally been low, and the fixed rate on I bonds has declined as well. Given a 0% fixed rate, an I bond buyer who purchased 1 year ago would have generated a total return of only about 1.96% (which would be 0% fixed + 1.96% as the change in CPI-U {NSA} over that time period).

On the other hand, given what most investors anticipate (or at least hope!) is a trough in interest rates, I bonds function as a form of "floating rate" bond investment. If interest rates begin to rise due to rising inflation, the bonds will outright generate a higher nominal return as their interest rate rises to match a higher CPI-U. If real rates rise - such that the Treasury begins to issue future I bonds with higher fixed rates - the owner can simply redeem the bond and reinvest into a new one (albeit limit to the $10,000/person/year limitation on those new purchases). Conversely, if deflation actually sets in, the I bond is also protected; not only can the fixed rate never be negative, but if the CPI-U is negative it can never do more than offset the fixed rate (which would reduce the bond's total return to zero), which means unlike TIPS the I bond can only go up with higher inflation and cannot decline with deflation (while TIPS do have a guarantee that their principal value at maturity cannot be less than the original value of the bond, if deflation occurs for a TIPS bond that's already had positive inflation adjustments, deflation can result in a loss of those prior principal increases).

Integrating I Bonds Into Your Portfolio
The dollar amount restrictions on the purchase of I bonds will likely limit their appeal for high net worth individuals for whom a $10,000 allocation (or $20,000 for a married couple) is a fairly limited slice of their overall net worth (or even "just" their bond allocation). On the other hand, given that the dollar amount limitation is annual (based on the calendar year), a married couple could purchase as much as $40,000 of I bonds over the next few months (using both their 2013 and soon-to-be-2014 funding options) which suddenly makes the potential allocation enough to be relevant. Of course, those who wish to purchase so much in I bonds must also have liquid funds available to do the purchase in the first place, and the funds must be held in a taxable account, as I bonds cannot be purchased inside of an IRA or other retirement account (nor would there be any reason to do so, since the bonds are tax-deferred anyway).

Obviously, many people will not likely be "excited" to purchase bonds with a stated real return of 0% (plus the rate of CPI-U), but on the other hand for those who might be keeping a material amount of money in cash or ultra-short-term bonds anyway - perhaps fearing the risk of rising rates - the reality is that even "just" CPI is trending significantly higher than the yield on short-term fixed income. In other words, being assured of a 0% real return on a portion of the fixed income allocation might actually be better than the current alternative! And if/when rates rise and the funds can be reallocating into higher yielding options, the I bonds can be liquidated and reinvested accordingly; in essence, clients get a higher yield than short-term bonds, while still not facing any risk of price declines if rates rise (beyond the tiny 3 months of forfeited interest, which still only amounts to a fraction of 1% at today's rates).

An Emergency Fund Alternative
Another way to consider fitting I bonds onto your portfolio is to view them as an emergency fund alternative, given that I bonds maintain the principal stability of cash or a money market fund, but at a materially higher rate of return. Of course, clients considering a TreasuryDirect I bond holding as an emergency fund must remember that the funds will be illiquid for the first 12 months - so be certain there's an alternative to access needed funds in the meantime! - and also that checks cannot be written directly against a TreasuryDirect account (so realize that in a true emergency, it may still take a few days to liquidate and transfer money to another bank account to fund an emergency expense). Nonetheless, for those that can navigate these kinds of short-term cash flow timing concerns, I bonds arguably just represent a higher return money market alternative.

A TIPS Alternative
For other people, the best fit for I bonds may be not as an emergency fund alternative, but as a TIPS alternative for those who are concerned about rising rates. Given today's real yield curve for Treasuries, I bonds offer a better fixed rate than 5-year TIPS, have more favorable tax treatment (tax-deferral of all growth, which helps shelter both interest payments and the "phantom income" for TIPS principal adjustments), are less sensitive to rising rates (as I bonds effectively have a duration of 0, while 5-year TIPS have at least some exposure to rising rates), and can be cheaper to acquire and invest in (I bonds are purchased with no expenses or transaction charges, while TIPS not purchased at auction face potential bond trading costs, bid/ask spreads, and/or mutual fund or ETF expense ratios). On the other hand, for the true hold-to-maturity 30-year investor, it's notable that TIPS provide a far more appealing real yield of almost 1.5% (compared to the 0% on I bonds), and don't have the dollar amount purchase limitations.

For people who are especially interested in buying more I bonds, it's notable that the $10,000 limit is effectively increased to $15,000 given the rule allowing up to $5,000 of paper I bonds to be purchased with a tax refund. People who are especially eager to purchase I bonds may even wish to "overpay' on 4th quarter estimated taxes, just to get a tax refund to purchase TIPS (and may wish to file quickly if they do so, as this strategy also means clients will be without the use of their money or any interest it may generate during the intervening time period).

Conclusion
Ultimately, it's important to remember that I bonds are not true floating rate funds, as while the interest rate can rise with inflation, the fixed rate remains locked in (for 30 years!) at the time of purchase, unless redeemed and reinvested (which subjects the buyer to the dollar amount limitations again). Nonetheless, for people who fear the potential that inflation itself may drive interest rates higher, the I bond provides a unique alternative way to hedge the risk and allow the investor's rate of return to rise, and without the bond price risk of rising rates. Similarly, in the event that real yields rise, I bond buyers again are hedged against the risk of price declines thanks to the implied put option of being able to redeem the bond with the U.S. Treasury at any time for full value and reinvest in the future into new I bonds at higher rates (or simply other then-higher-yielding fixed income alternatives).

If you’re like most people, you’re missing out on valuable tax deductions or even free money because you’re not maximizing your company benefits.  

Remember that booklet that you were given when you were first hired a few years ago?  That’s your benefits package.  Try to find that or request a copy from the Human Resources department. (Many benefits packages are now available online).  Most companies offer some sort of health insurance, vacation time and a company retirement plan, but even figuring those out can be tricky.  Every employer offers different benefits which is why this process can be so confusing, so set aside an hour of time to read through everything.  If you’re still confused, make an appointment with someone in your H.R. department who can answer your questions.

Company Retirement Plan
Does your company offer a 401(k), 403(b) or SIMPLE IRA that you can contribute to?  If so, find out if your company offers an employer match and what you have to do to qualify.  Make sure that you’re contributing enough to receive your full company match.  For example: If your benefits package states that the employer will match 50% of the employee’s contribution up to 6% of his or her salary, this actually means: if you contribute 6%, your company will kick in 3%.  If you’re not contributing at least 6%, you’re leaving FREE MONEY on the table.  To save even more on your tax bill this year, increase your contributions so that you and your spouse are contributing the maximum each year towards your retirement accounts.

Health Savings Accounts (HSA)
Most companies just have one health insurance plan, but if you have multiple to choose from, you may want to see if your company offers a high deductible plan that includes a Health Savings Account (HSA).  An HSA allows you to contribute pre-tax dollars to an account to be used for out-of-pocket medical, dental, and vision expenses.  The best part is that any money you don’t use stays in the account to be used in the following years.  (This is a great way to save for more expensive health costs like pregnancy and delivery, or LASIK eye surgery).  You can even invest the assets in your HSA.  Some companies even contribute money towards your HSA because they’re saving money by you choosing a high-deductible plan over a traditional PPO plan.  You may even save $20 a month on your gym membership through your health insurance plan if you visit the gym a minimum number of times each month.  If you have a gym membership, find out if you qualify.

Flexible Spending Accounts (FSA)
If you don’t have an HSA to use for medical expenses, you may be able to sign up for a Flexible Spending Account (FSA) instead.  Again, this is money to pay for medical expenses with pre-tax dollars, but unlike the HSA, these dollars don’t carry over to the following years.  You either use or lose it, so make sure not to over contribute to your FSA.  There’s another type of FSA that is called the Dependent Care FSA.  Each spouse can contribute up to $2,500 per year in pre-tax dollars in a Dependent Care FSA to be used for childcare costs.  This means that a portion of your daycare costs can be paid with pre-tax dollars.  You cannot utilize both an HSA and FSA for medical expenses, but you can have an HSA for medical and a Dependent Care FSA for childcare.  (Technically, you can have an HSA for medical and a limited purpose FSA for dental and vision expenses, but that adds another layer of complexity).

Term Life Insurance
Many employers will include some group term life insurance as part of your benefits package (usually 1-2x your salary).  If you have children or a spouse that relies on your income, make sure that you sign up for additional term life insurance coverage or buy an individual term life insurance policy to ensure that your family would have the assets they need if something were to happen to you.  Don’t forget to name a beneficiary! 

Group Disability Insurance
Sign up for your group short-term and long-term disability plan.  It is much less expensive to purchase a group policy through your employer than it is through a private provider.  If you have two different policies to choose from, choose the one that provides the highest benefit amount.  Often disability insurance will cover 40-65% of your salary if you were out of work for a specific amount of time due to illness or injury.  Make sure you read the details of your policy because they can vary significantly and it may be worth it to buy a supplemental policy through another insurance company if your work benefits are not sufficient.  

Commuter Benefits
Do you take the metro or bus to work everyday?  Your employer might offer commuter benefits, which allow you to pay for your public transit costs through your paychecks using pre-tax dollars. This small change could save you money on costs that are already part of your monthly budget.  It all adds up!

Employee Stock Purchase Plan (ESPP)
Does your company offer an Employee Stock Purchase Plan (ESPP)?  If so, you may be eligible to buy company stock at a discounted price through your payroll deductions.  Sometimes you can buy shares up to 15% below market value, which is an even bigger incentive.  There are different tax implications depending on when you sell the shares so make sure you talk to your tax accountant or CPA before selling shares. 

Employee Stock Options
More and more employers are starting to offer employee stock options as an incentive to work at their company.  Often times you have to work at the company for a set amount of time before your stock options vest.  Once shares have vested, you can exercise your stock options at the strike price in your contract.  Stock options can be complicated but here’s a breakdown of definitions and key terms from Investopedia.

Vacation Time
Don’t be one of the 57% of Americans that has unused vacation time.  Whether you receive two weeks or four weeks, take some time away from the office and enjoy the time off.  If you’re not utilizing all of your vacation time, see if your work allows you to receive compensation for your unused time or ask about carrying over vacation days to the next year.

The Payoff: Save Money Now While Investing Money for Later
How does this impact your tax bill?  What about retirement?  Anything that you can pay for using pre-tax dollars such as health care costs, commuter benefits, or insurance will give you an up front tax break.  In addition, the more you can set aside in pre-tax retirement accounts the less you’ll pay in taxes, but also the more you’ll have for retirement!  Also, an ESPP can be a valuable tool to help you set aside even more money!

Every company offers a unique set of benefits.  Some companies offer store discounts, tuition reimbursement, sabbaticals, on site childcare centers, and much more.  The next time you’re wondering how to maximize your financial situation, start by reading your company benefits package.  You might be missing out on valuable perks!

Q. I understand if I purchase health care insurance from the marketplace, I could get government tax credit.  How will such healthcare tax credit impact my tax rate?

A. The premium assistance tax credit is intended to make health insurance purchased on an exchange more affordable for the "lower income" - which is actually broadly defined to include everyone up to 400% of the Federal Poverty Level.  As income rises, the premium assistance tax credit is slowly phased out, until eventually it provides no benefit at all.

However, the reality is that because the premium assistance tax credit phases out as income rises, it indirectly serves as a surtax that triggers higher marginal tax rates for those who are phasing the credit out. And the marginal impact is actually quite significant; at relatively modest levels of gross income from $25,000 to $50,000 of income, the premium assistance tax credit effectively doubles the marginal tax rate (to more than 30%) for those who are purchasing health insurance from the individual exchange. 

The end result doesn't mean that it's a good idea to avoid generating income - as long as the marginal tax rate is less than 100%, it is still a gain for you. Nonetheless, the introduction of the premium assistance tax credit may mean a whole new level of in-depth year-to-year tax planning for those with relatively modest incomes, who can be subject to surprisingly high marginal tax rates under the new rules.

The Federal Poverty Level thresholds are adjusted for inflation each year, and are determined based on the number of people in the household. For example, in 2013, the FPL was $11,490 for an individual and $23,550 for a family of four, which means at least some premium assistance credit is available for households with incomes up to $45,960 for individuals and $94,200 for a family of four.

“Income” for the purposes of the premium assistance tax credit and the FPL is based on modified Adjusted Gross Income (AGI), which means AGI increased by any income not reported due to the foreign earned income or housing cost assistance exclusions, any tax-exempt interest (i.e., municipal bond income), and any Social Security benefits that were excluded from income. In other words, household income for the purposes of the credit will include all bond interest (taxable or tax-exempt), and all Social Security benefits (taxable or tax-exempt).

For example:

Bill is a single 35-year-old non-smoker who earns $25,000 per year. His income is 218% of the $11,490 FPL (in 2013) for a household size of 1. Accordingly, this puts him roughly midway between the 6.3% and 8.05% threshold for maximum premium; his exact threshold is 18/50ths of the way from 200% to 250% of the FPL, so his maximum premium is 18/50th of the way between 6.3% and 8.05%, which means his maximum premium is 6.93% of his $25,000 income, or $1,733/year. If the actual premium for the second lowest cost Silver plan in his state is $300/month (or $3,600 per year), Bill’s premium assistance tax credit will be $1,867 (which brings his premium down to the maximum cap of $1,733/year). Accordingly, Bill will pay $144.42/month for his health insurance, with the remaining $155.58/month covered by the premium assistance tax credit. Notably, if Bill chooses to buy a different plan besides the Silver, which may cost more or less, his premium assistance tax credit will continue to be $155.58/month, but his share of the premium will be the remainder left over (whatever that comes out to be).

How The PATC Can Boost The Marginal Tax Rate?

The complication that arises with the PATC is that, because it is calculated based on income (or at least, the maximum premiums owed are calculated based on income, which indirectly means the credit is determined by income), generating more income not only creates the usual tax burden associated with income, but it can also trigger a phaseout of the PATC (at least up to 400% of the FPL, as beyond that point there is no PATC at all). 

For example:

Ted and Janet are a 45-year-old couple with two children, and their combined income is $50,000/year. With a $12,200 standard deduction and four $3,900 personal exemptions, their taxable income would be $22,200, putting them near the lower end of the 15% tax bracket. In addition, their income for a family of four would put them at 212% of the FPL, capping their health insurance premium at 6.72% of income, or $3,360; if the cost of a Silver plan for the family was actually $1,000/month ($12,000 per year), their premium assistance tax credit would amount to $8,640/year or $720/month, bringing their own out-of-pocket premium down to only $280/month for the family.

If the couple earned another $10,000 (rising from $50,000 to $60,000 for the year), their income would rise to 255% of the FPL, which would increase their maximum premium threshold to 8.19% x $60,000 = $4,913/year. As a result, they would be required to pay another $1,553 of health insurance premiums for the family, in addition to owing another $1,500 of taxes (at a 15% tax bracket on $10,000 of income), to a total burden of $3,053 for an extra $10,000 of income. Thus, the net effect of the changing income-related threshold for the premium assistance tax credit it to boost the couple’s marginal tax rate from 15% to a whopping 30.53%!

Marginal Tax Rate Increases At Varying Income Levels

Ultimately, the impact of the PATC on someone's marginal tax rate will depend on where exactly they fall on the income spectrum (and based on their family size as well, as the FPL thresholds vary depending on the number of family members in the household). The figure below shows how the marginal tax rate of a middle-aged married couple changes as their income rises, assuming they claim a standard deduction ($12,200 in 2013), two personal exemptions ($3,900 each in 2013), and have an annual health insurance premium of $7,000 for the two of them ($583/month before premium assistance tax credits).

What is a SIMPLE IRA?

A SIMPLE IRA, or Savings Incentive Match Plan for Employees, is a type of traditional IRA for small businesses and self-employed individuals. As with most traditional IRAs, your contributions are tax deductible, and your investments grow tax deferred until you are ready to make withdrawals in retirement.

Unlike SEP IRAs, SIMPLE IRAs allow employees to make contributions. What makes a SIMPLE IRA unique is that the employer is required to make a contribution on the employee's behalf - either a dollar-for-dollar match of up to 3% of salary or a flat 2% of pay - regardless of whether the employee contributes to the account.

SIMPLE IRAs have higher contribution limits than traditional and Roth IRAs, and it's cheaper to set up and run a SIMPLE IRA plan than it is to administer many other workplace retirement plans.

Who can contribute to a SIMPLE IRA?

To set up a SIMPLE IRA an employer must have 100 or fewer employees earning more than $5,000 each - including all employees who have worked at any point in the calendar year. And the employer cannot have any other retirement plan besides the SIMPLE IRA.

If your employer offers a SIMPLE IRA, you qualify to contribute if you earned at least $5,000 a year during any two years before the plan was set up, and if you expect to earn at least $5,000 this year.

How much can I put into a SIMPLE IRA?

There are two sets of contribution limits: one for the employee and one for the employer.  If you're an employee, you can contribute a percentage of your salary up to a limit of $12,000 for 2013.  If you're 50 or older, you can make an additional $2,500 "catch up" contribution.

Your employer must make a contribution every year it maintains the plan. The company can contribute either 2% of your compensation or a dollar-for-dollar matching contribution not to exceed 3% of pay. Your employer must make a contribution even if you choose not to, and all employees must receive the same type of contribution.

Finally, your company can lower the matching contribution to 1% or 2% of total compensation in any two out of five years that the plan is in effect. In the other three years, the company must make either a 3% match or the 2% flat contribution.

How do I know if a SIMPLE IRA is right for me?

If you are a small business owner or a self-employed person and you haven't set up any other type of work-related retirement plan, consider the SIMPLE IRA.  Unlike profit-sharing or 401(k) plans, SIMPLE IRAs are easy to set up and easy to administer.

This is especially true if you work alone but aspire to run a bigger business. Adding even one full-time employee to other plans, like a SEP IRA, can be a big hassle. Not so with a SIMPLE IRA. Keep in mind that the SIMPLE IRA's contribution limits are much lower than those for an SEP IRA ($12,000 for the SIMPLE in 2013, versus a maximum of $51,000 for the SEP), which can affect your ability to save enough for a comfortable retirement.

What is a SEP IRA?

A SEP IRA is a type of traditional IRA for self-employed individuals or small business owners. (SEP stands for Simplified Employee Pension.) Any business owner with one or more employees, or anyone with freelance income, can open a SEP IRA. Contributions, which are tax-deductible for the business or individual, go into a traditional IRA held in the employee's name. Employees of the business cannot contribute - the employer does. Like a traditional IRA, the money in a SEP IRA is not taxable until withdrawal.

One of the key advantages of a SEP IRA over a traditional or Roth IRA is the elevated contribution limit. For 2013, business owners can contribute up to 25% of income or $51,000, whichever is less.

Who can participate in a SEP IRA?

An employee is eligible to participate in a SEP IRA if he or she is at least 21 years old and has worked for the company in three of the last five years, and received at least $550 in compensation during the year.

As an employer, you don't have to fund contributions every year. But when you do choose to make contributions, you must contribute not only to your own SEP IRA, but the SEP IRA of every eligible employee. 

How do I know if a SEP IRA is right for me?

A SEP IRA may be your best bet if you are a one-person show and plan to keep it that way. You can open one at virtually any bank, mutual fund company or brokerage firm, and pay low or no annual account fees. Your contribution limit is based on a simple formula: You can put away as much as 25% of your net income, up to a cap that increases periodically to keep pace with inflation. In 2010, the cap is $49,000.

If you're a small business owner, SEP IRAs are appealing because they are easy and inexpensive to set up, and contributions are tax deductible. A SEP IRA's funding flexibility is also a draw. If you have a tough year financially, you can choose not to contribute to the plan. If you have a great year, you can fund the plan with a larger contribution than you'd originally intended.

What's a Keogh plan?

Before a tax law change in 2001, Keogh plans were a popular choice for high-income self-employed people. These days, they've been largely replaced by SEP IRAs, which have the same contribution limits but much less paperwork.

Keogh plans come in two varieties:

Defined-contribution. These plans have two variations: profit-sharing and money-purchase. The profit-sharing version of the Keogh is most like the SEP; there's a ceiling on contributions - 25% of compensation, up to a maximum contribution of $49,000 in 2010 - and below that limit you can put in whatever you can spare. You also can change your contribution each year. With the money-purchase plan, you pick a percentage of income you'll contribute every year, and stick with it. If you don't, you'll owe the IRS a penalty.

Defined-benefit. This type of Keogh acts as a traditional pension plan, but for one key fact: you fund it yourself. You pick the annual pension you want, then contribute (and deduct from your taxes) whatever amount is needed to reach that goal. If you're self employed and have a high income - say you're a doctor or lawyer - this type of plan may allow you to save more for retirement than many other plans.

Keoghs can be complicated to set up, and the paperwork required if you own one is considerable. If you're interested in establishing a Keogh, consult a financial adviser.

Who can contribute to one?

Keogh plans are designed for self-employed people, as well as small-business owners and their employees. To be eligible to establish a Keogh, a small business must be a sole proprietorship, partnership or limited liability company (LLC). If you have employees, they must be allowed to participate in the plan. However, employees don't contribute to the plan - the employer must kick in the entire contribution.

When can I get access to the money?

You can begin making penalty-free withdrawals at age 59 ½. And you must take withdrawals once you reach age 70 ½. If you are still working in your 70s, you can continue contributing to a Keogh plan, but you must still take the required distributions as well.

What if I need the money before retirement?

The Keogh allows you to make early withdrawals, but penalizes you heavily for that right. Typically you'll owe taxes plus a 10% early withdrawal penalty - and you might owe state tax penalties, too.

Some exceptions do apply: You may be able to take a penalty-free early withdrawal if you have certain disabilities or medical expenses. 

How should I invest the money?

Just as with an IRA, you can hold stocks, bonds, mutual funds and certificates of deposit in a Keogh plan.

When investing for a long-term goal such as retirement, you typically want to emphasize stocks, which have the best chance to generate returns that outpace inflation. Adding some bonds or cash to your mix can help reduce the overall volatility.

How do my withdrawals get taxed in retirement?

You pay regular income tax on your withdrawals in retirement. You can begin making penalty-free withdrawals at age 59 ½, although you don't have to start taking withdrawals until the year in which you turn 70 ½.

Does a Keogh plan make sense for me?

There are very few cases in which a Keogh is preferable to other types of retirement plans. If you don't have employees, for example, an individual 401(k) is likely a better choice, since it has higher contribution limits. 

6. Intentionally defective trust

The intentionally defective trust is a wealth-transferring device used by larger estates. It is an irrevocable trust that has been carefully drafted to cause the grantor to be taxed on trust income, yet have trust assets excluded from the grantor’s estate. Once established, it can offer multiple planning opportunities and benefits, particularly when combined with both gifts and installment sales.

TRUST ESTABLISHED. When establishing the trust, the grantor will typically retain a right to substitute assets of equivalent value. Retention of this right in a nonfiduciary capacity violates one of the grantor trust rules. The grantor is then considered the “owner” of the trust for income tax purposes, but not for estate, gift, and generation-skipping tax purposes. As to income taxes, the grantor and the trust are considered one and the same; trust income, deductions, and credits are passed through to the grantor.

Once established, the grantor then makes a gift of cash or other liquid assets to the trust, equal in value to 10 percent or more of the value of the property that will be sold to the trust in the subsequent installment sale.

INSTALLMENT SALE. Thereafter, the grantor and the trustee enter into a sales agreement providing for the purchase of additional assets from the grantor at fair market value. Under this agreement the trustee gives the grantor an installment note providing for payment of interest only for a number of years, followed by a balloon payment of principal at the end of the term. The assets sold will typically consist of property subject to a valuation discount (e.g., a non-controlling interest in a limited partnership, a limited liability company, or an S corporation). The amount of this valuation discount is immediately removed from the grantor’s estate.

SUBSEQUENT ADVANTAGES. Payment of taxes by the grantor upon the trust income enables the trust to grow income tax-free, and is a tax-free gift from the grantor to the trust beneficiaries. The interest and principal payments by the trust are “tax neutral,” meaning that they have no income tax consequences for either the grantor or the trust. Any growth of invested trust assets is excluded from the grantor’s estate.

If appropriate, the trustee could also use cash flow in excess of required interest payments to purchase life insurance on the grantor. Since the grantor/insured is not the “owner” of the trust for estate tax purposes, the death proceeds would be excluded from the grantor’s estate.

Information required for analysis & proposal

1. Names and ages of trust beneficiaries.

2. To who, in what amounts, and when trust income is to be paid?

3. To who, in what amounts, and when trust corpus is to be paid?

4. Trustee(s) of trust (both before and after grantor’s death).

5. Client’s: (a) Date of birth; (b) Sex; (c) Smoker/nonsmoker.

6. Client’s annual taxable income (to determine marginal tax bracket).

7. Approximate size of estates of both client and spouse (generally, gross estates less outstanding debts and liabilities).

8. Extent to which client and spouse have used their annual gift exclusion ($14,000 each in 2013).

9. Extent to which client and spouse have each used their available gift tax unified credit ($2,045,800 each in 2013, allowing them to each give $5,250,000 of property).

10. Property available for the initial gift.

11. Nature of income-property available for installment sale (preferably, an asset subject to valuation discount).

12. Client’s cost basis in income-property.

13. Anticipated annual income from income-property.

14. Length (term) of the installment note.

15. Minimum interest rate to be paid on installment note (applicable federal rate).

5. Grantor retained annuity trust (GRAT)

The grantor retained annuity trust (GRAT) is an estate planning technique that can be used to transferfuture appreciation to family members, or others, free of gift and estate taxes provided the grantor survives the trust term.

TRUST ESTABLISHED. In order to implement a GRAT, the grantor creates an irrevocable trust for a specified number of years, names his children as trust beneficiaries, and transfers to the trust property that has a potential for substantial appreciation. The grantor retains the right to receive, for the term of the GRAT, a “qualified annuity interest” based on either a specified sum or fixed percentage of the initial value of the property transferred to the trust. This annuity is mandatory and must be paid at least annually. The annual payment may be increased, provided the increase is not greater than 120 percent of the prior year’s payment. Additional contributions to the GRAT are not permitted.

Only the value of the remainder interest payable to the trust beneficiaries is subject to the gift tax. This value is determined by subtracting from the fair market value of the property transferred to the trust the present value of the annuity retained by the grantor. The value of this annuity is increased by a longer-term trust, larger annuity payments, and lower assumed interest rate used to make the present value calculation. To summarize, gift tax exposure is reduced if the present value of the retained annuity is increased and the value of the remainder interest is decreased:

                                                                           ↑                                                                      

             Exposure to Gift Tax                  Value of Retained Annuity            Value of Remainder Interest

                             ↓                                                                                          ↓

DURING TRUST TERM. Tax-free annuity payments are made to the grantor. Trust assets may be used to make these payments. For federal tax purposes the GRAT is considered a grantor trust, meaning that the grantor pays taxes on all trust income. Should the grantor die before the end of the trust term, the annuity payments continue to be made to the Grantor’s Estate and the property is subject to estate taxes.

AT END OF TRUST TERM. Any property remaining in the trust, including appreciation and earnings, is paid to the trust beneficiaries (i.e., the remainder interest). Provided the grantor lives to the end of the trust term (and does not die within 3 years of the transfer), this property is not subject to estate taxes.

Information required for analysis & proposal

1. Fair market value of property transferred to trust (provide appropriate appraisals).

2. Term of trust (in years).

3. Annuity to be paid (as dollar amount or percent of initial trust value).

4. Payment frequency (annually, semiannually, quarterly, or monthly).

5. Increase in annuity as a percent, if any (not to exceed 120 percent of prior year).

6. Age of grantor (if grantor retains reversion).

7. Date of transfer to trust (needed to set payment dates and determine Section 7520 interest rate as published monthly by IRS).

4. Charitable remainder trust

The charitable remainder trust enables an individual to make a substantial deferred gift to a favored charity while retaining a right to payments from the trust. Under the right circumstances use of such a trust offers multiple tax and nontax advantages, particularly to the individual who owns substantially appreciated property. These advantages include a charitable deduction resulting in reduced taxes, an increase in current cash flow, avoidance of capital gains upon a sale of the appreciated property, the eventual reduction or elimination of estate taxes, and the satisfaction of knowing that property placed in the trust will eventually pass to charity. When combined with a wealth replacement trust, the full value of the estate can still be preserved for heirs.

DURING LIFETIME the grantor, after establishing a charitable remainder trust, gives property to the trust while retaining a right to payments from the trust. A unitrust provides for the grantor to receive annually a fixed percentage of the trust value (valued annually), whereas an annuity trust provides for the grantor to receive annually a fixed amount. Either type of trust could require that payments be made for the joint lives of the grantor and another person, such as the grantor’s spouse.

At the time the property is given to the trust, the grantor can claim a current income tax deduction equal to the present value of the charity’s remainder interest. Upon receipt of the gift, the trustee will often sell the appreciated property and reinvest the proceeds in order to better provide the cash flow required to make the payments to the grantor. This sale by the trust is usually free of any capital gains tax.

The tax savings and increased cash flow offered by the use of a charitable remainder trust will often enable the grantor to use some or all of these savings to fund a wealth replacement trust for the benefit of his heirs, thereby providing for the tax effective replacement of the property transferred to the charitable remainder trust. If the wealth replacement trust is established as an irrevocable life insurance trustit is often possible to gain gift tax advantages during the grantor’s lifetime, while at death entirely avoiding inclusion of the life insurance proceeds in the estates of the grantor and the grantor’s spouse.

UPON DEATH the property placed in the charitable remainder trust passes to the designated charity. At the same time a tax-free death benefit is paid to the wealth replacement trust, which funds can then be held or distributed to the grantor’s heirs pursuant to the terms of this trust.

Information required for analysis & proposal

1. Fair market value of property transferred to trust.

2. Date of transfer to trust.

3. Payout rate (if unitrust) or amount (if annuity trust).

4. Payment frequency (annually, semiannually, quarterly, or monthly).

5. Age of person whose life determines length of payments.

6. Age of joint annuitant (if payout for two lives).

7. Discount rate (as published monthly by IRS).

3. Life insurance trust

This trust is one of the most basic tools of estate planning. When made irrevocable and funded with life insurance, it accomplishes multiple objectives. For example, it can:

• Provide Creditor Protection
• Provide Income for a Family
• Provide Liquidity for Estate Settlement Costs
• Reduce Estate Taxes
• Avoid Probate Costs
• Provide for Management of Assets
• Maintain Confidentiality
• Take Advantage of Gift Tax Laws

DURING LIFETIME, it is possible for a grantor to establish a trust that will accomplish all of these objectives. The beneficiaries of such a trust are normally members of the grantor’s family and likely to be estate beneficiaries.

Once the trust is created, policies on the life of the grantor can be given to the trust. If no such policies are available, then the trustee would obtain the needed life insurance. In either case, funds are given to the trust, which, in turn, pays the premiums to the insurance company.

In order to take full advantage of the gift tax annual exclusion, the beneficiaries must have a limited right to demand the value of any gifts made to the trust each year. However, in order not to defeat the purpose of the trust, the beneficiaries should not exercise this right to demand. In this way, each year up to $14,000 per beneficiary, as indexed for inflation in 2013, can be given gift tax-free to the trust.

UPON DEATH, the grantor’s property passes to his estate. At the same time, the insurance company also pays a death benefit to the trust. If the trustee was the original applicant for and owner of the policies, or if the grantor lived at least three years following the gift of existing policies  to the trust, the death benefit will be received free of federal estate taxes.

There are two ways the trustee can provide the liquidity to pay estate settlement costs. Either the trustmakes loans to the estate, or the estate sells assets to the trust. In any event, guided by specific will and trust provisions the beneficiaries can receive distributions of income and principal.

Information required for analysis & proposal

1. Name of individual to be insured (usually trust grantor).

2. Sex.

3. Date of birth.

4. Smoker/nonsmoker.

Attorney Drafting Trust Instrument Must Also Know

5. To whom, in what amounts, and when trust income is to be paid.

6. To whom, in what amounts, and when trust corpus is to be paid.

7. Trustee during insured’s lifetime.

8. Trustee after insured’s death.

9. Names of beneficiaries.

10. Ages of minor beneficiaries.

2. QTIP Trust

With large estates the QTIP trust provides a way to defer estate taxes by taking advantage of the marital deduction, yet “control from the grave” by directing who will eventually receive the property upon the death of the surviving spouse.

Under such a trust all income must be paid at least annually to the surviving spouse. The trust can be invaded only for the benefit of the surviving spouse, and no conditions can be placed upon the surviving spouse’s right to the income (e.g., it is not permitted to terminate payments of income should the spouse remarry). However, in order to qualify the executor must make an irrevocable election to have the marital deduction apply to property placed in the trust. This requirement not only gives the executor the power to determine how much, if any, of the estate will be taxed at the first death, it also provides great flexibility for post death planning based upon changing circumstances.

Our example assumes that in 2013 we have an estate of $11,500,000.

UPON THE FIRST DEATH, the estate is divided into two parts, with one part equal to $5,250,000 placed in a family or nonmarital trust (“B” trust in the chart). No taxes are paid on this amount since the trust takes full advantage of the $2,045,800 unified credit (i.e., the amount of credit in 2013 that allows each individual to pass $5,250,000 tax-free to the next generation). The remaining $6,250,000 is placed in the QTIP trust.

The executor may elect to have all, some, or none of this property treated as marital deduction property. Assume that in order to avoid appreciation of assets in the surviving spouse’s estate and obtain a stepped-up basis for additional assets taxed upon the first death the executor decides to make a partial election of $5,750,000 (i.e., of the $6,250,000 placed in the QTIP trust only $5,750,000 will be sheltered from estate taxes at the first death). This means that $500,000, the “nonelected” property, will be taxed at the first death. Although $200,000 of estate taxes must be paid, the remaining $300,000 will now be excluded from the taxable estate of the surviving spouse (any appreciation of this property after the first death will also be excluded). If authorized under the trust document or by state law, the executor can sever the QTIP trust into separate trusts.

UPON THE SECOND DEATH, the estate subject to taxation is limited to $5,750,000 (the amount remaining in the trust for which estate taxes were deferred). After paying taxes of $200,000, there remains $5,550,000. This amount, together with the $300,000 from the severed trust and the $5,250,000 from the “B” trust, are passed to the beneficiaries under the terms previously established in these trusts.

Information required for analysis & proposal

Attorney Drafting Will And Trust Must Know

1. Spouse’s name.

2. Children’s names.

3. Name of executor/executrix.

4. Ages of minor children.

5. Information regarding children of prior marriages.

6. Names and ages of other beneficiaries.

7. Trustee after testator’s death.

8. To whom, in what amounts, and when trust income is to be paid.

9. To whom, in what amounts, and when trust corpus is to be paid.

1. Revocable living trust

The revocable living trust (RLT) is a will substitute that can accomplish many estate planning objectives. It is an agreement established during the grantor’s lifetime that may be amended or revoked at any time prior to the grantor’s disability or death. 

The primary advantages of the RLT include: 
(1) providing for the management of grantor’s assets upon his mental or physical disability thus avoiding conservatorship proceeding; 
(2) reducing costs and time delays by avoiding probate; 
(3) reducing the chances of a successful challenge or election against a will; 
(4) maintaining confidentiality by not having to file a public will; and 
(5) avoiding ancillary administration of out-of-state assets.

Two additional documents are typically executed together with the RLT:

• The durable power of attorney authorizes the power-holder to act for the grantor when the grantor is disabled.
• The pour-over will functions as a “fail safe” device to transfer at death any remaining probate assets into the RLT, to undergo minimal probate as a means of clearing the estate of creditor claims, and to appoint guardians of any minor children.

DURING LIFETIME. The grantor establishes the RLT and typically names himself as the sole trustee. Following creation of the trust the grantor retitles and transfers his property to the trust. Because the grantor maintains full control over trust assets there are no income, gift, or estate tax consequences.

UPON DISABILITY. If the grantor becomes disabled due to legal incompetency or physical incapacity, a designated successor trustee steps in to manage the grantor’s financial affairs. Disability is determined under trust provisions providing a standard of incapacity (e.g., certification by two physicians that the grantor is unable to manage his financial affairs). Also, during the grantor’s disability, the holder of the durable power of attorney is authorized to transfer additional grantor-owned assets to the trust.

UPON DEATH.The RLT becomes irrevocable when the grantor dies. Under the grantor’s pour-over will, any probate assets not previously transferred to the RLT during lifetime are transferred to the RLT as part of the grantor’s residuary estate. Assets held in trust are then disposed of according to the terms of the trust. This can include an outright distribution to the trust beneficiaries, or the trust may contain provisions establishing separate tax-savings subtrusts similar to the marital and family trusts under the exemption trust will.

Although the RLT is not for everyone, it clearly offers substantial benefits for many individuals. The utility of a funded revocable trust increases with the grantor’s age, when there is an increased likelihood of incompetency or incapacity and the need for asset management.

Information required for analysis & proposal

Attorney Drafting Trust Instrument Must Know

1. Name of trust grantor.

2. Name of trust grantor’s spouse.

3. Name of individual who will be successor trustee.

4. Name of institution that will be alternate successor trustee.

5. Name of beneficiaries other than grantor.

6. Ages of minor beneficiaries.

7. Approximate size of grantor’s gross estate (i.e., will estate be subject to federal estate taxes or state death taxes).

8. To who, in what amounts, and when trust income is to be paid.

9. To who, in what amounts, and when trust corpus is to be paid.

Attorney Drafting Pour-Over Will Must Know

1. Name of testator.

2. Name of testator’s spouse.

3. Name of individual who will be personal representative or executor.

4. Name of individual or institution who will be successor personal representative or alternate executor.

Attorney Drafting Durable Power Of Attorney Must Know

1. Name of grantor.

2. Name of individual to be given the power.

3. Type of power to be given (e.g., general durable power of attorney or special durable power of attorney).