The NAPFA Board of Directors has elected Stephen C. Craffen to the position of 2018-19 NAPFA National Chair. Steve will serve as Chair-elect until his term begins on September 1, 2018. He was first elected to the Northeast/Mid-Atlantic Region Board (NEMA) in 2008, and was elected 2013-14 NEMA Board Chair. In 2015, Steve was elected to the NAPFA Board of Directors. His election to the 2018-19 Chair position will allow him the opportunity to guide NAPFA into the future, and influence the financial planning profession as a whole.
It is important to manage a portfolio in a tax-wise fashion to help maximize your return in the long run. There are several strategies that can be used to do that, here we discuss them.
- Asset Placement: different asset classes produce different amounts of recurring taxable income with different classifications under the tax code. Common stock dividends are usually treated as “qualifying dividends” if you hold the stock for a certain time (typically 60 days for common stock). They are taxed at the same rate as the capital gains rate that is applicable to your marginal tax bracket (0%, 15% or 20%). Income from REIT’s and bonds is taxed as ordinary income so it may be taxed at a rate as high as 37% (the top bracket in 2018). You can increase tax efficiency by holding those types of asset classes in your tax-deferred or tax-free accounts. Some assets also generate a lot of recurring income in particular natural resources, and alternative investments. Typically, we recommend the following holding order for different asset classes:
|Preferred Account Type||Note|
|Natural Resources||Tax Deferred||High recurring ordinary income|
|Alternatives||Tax Deferred||Frequent tax events|
|International Bonds||Tax-Deferred||High Income tax free not available|
|Real Estate||Tax-Deferred||High income does not qualify for special dividend rate|
|Bonds||Either||Can purchase tax-free municipals in a taxable account|
|International Stock||Taxable||Dividends not qualified but not as high as other asset-classes|
|Domestic Large||Taxable||Dividends taxed as qualified|
|Domestic Small||Taxable||Dividend rate low, taxed as qualified.|
- Choosing more efficient vehicles: Mutual funds are not generally tax efficient, they must distribute all, or substantially all (90% or more) of net investment income and at least 98% of capital gain net income to the shareholders annually. Sometimes because of this it might make sense to hold off from investing in a mutual fund during the last 2-3 months of the year. Buying a fund late in the may lead to receiving part of your investment back as a capital gain distribution creating a taxable event. That can happen even if you really have no gain in the fund. Another disadvantage for the mutual fund type investment vehicle is that amounts a mutual fund distributes can be dramatically increased if it suffers a round of shareholder redemptions. When that happens fund, managers may have to sell highly appreciated stock to fund the redemptions with the resulting capital gains that are realized distributed to the existing shareholders that are left behind. Exchange Traded Funds (ETF’s) do not have to distribute their gains to shareholders, they can be retained, reinvested with the gains reflected in increased share price for the ETF. ETF shares are also do not have the disadvantage that mutual funds have with redemptions; ETF shares are not redeemed instead they are sold on markets like a stock instead of the shares being wiped out by a mutual fund company they are purchased by someone else. If you are in a higher marginal tax bracket, ETF’s may be the preferred investment vehicle.
- Proper bond selection: Bonds can be held in either taxable or tax deferred accounts. If they are held in a taxable account and you are in a high marginal bracket you can purchase municipal bonds therefore we are relatively indifferent to which account should hold them. It is important to know what your marginal bracket is to determine if the tax equivalent yield for a municipal bond is at least as high as the yield on taxable bonds.
- Capturing losses: Capturing losses may not always provide the benefit one imagines. When you sell an investment that has declined from it’s purchase price to a lower value, if you sell at the lower value and use the proceeds to purchase another investment that investment will have a cost basis that equals the value at which you sold the losing stock or fund. If the new investment appreciates back to the original value of the first investment and you sell you have now paid tax on a gain that equaled the prior loss. Therefore, capturing losses is really only a deferral of taxation. In effect your real gain from the transaction is only on the earnings you received on the money you did not pay in taxes. Capturing losses does make sense in some circumstance thought for example if you want to offset gains in the same year and there is a good chance you might be in a lower tax bracket in the future possibly due to retirement or a reduction in tax rates (as we just experienced).
Knowing what tax bracket, you are in and in particular what marginal bracket you are in is important in determining which strategies are most useful to improve the net after tax return for your portfolio. Proper tax management of a portfolio can improve your net return (after expenses and taxes). Some estimate that your realized return can be as much as .25% higher annually.
Stephen C. Craffen
Steve was interviewed by a couple of his NAPFA friends at “Zebra Smash”, the discussion was focused on Modern Portfolio Theory and the advancements that have been made over the years. You can listen to the interview here:
Estate planning for families that include children from parents who have been married a couple of times can be complex. Sometimes ensuring that all the children are treated fairly means you may need to take measures to protect their inheritance if you die prematurely. Your current spouse may not have any emotional tie to them so they could disinherit them either innocently or with malice.
Consider the following example of a husband and wife who both have children from prior marriages and have a child together:
Consider the following:
- If John predeceases Mary: Assume Mary has no affection for or relationship with John’s children from his prior marriage. At her death, she leaves them out of her will, and they are left with nothing from John, (who had a simple “I love you” will that left everything to Mary). They are effectively disinherited through a bad sequence of events and poor planning unless their mother Sue (who may or may not have much of an estate) leaves them something. Or if Sue is married and leaves everything to her new husband he could leave everything to someone else effectively leaving no inheritance for John and Sue’s children. This means that things John (and possibly Sue) might have worked hard for never benefit their own children from their marriage.
- If Mary predeceases John: John remarries, he marries a much younger woman who outlives him; since Mary left everything to John, her child from her first marriage could be disinherited if John leaves everything to his new wife who will most likely out live him. Or his younger wife could still care enough about Mary’s son that she does leave him something but John’s young wife may live for many more years meaning any inheritance Mary’s son would have received may be delayed for 20-30 years.
Those are just two of many possible sequences of events. While every scenario cannot be anticipated some estate planning techniques can reduce the risk that someone’s children are not left out in the cold. Here are two.
QTIP Trust (Qualified Terminal Interest Property) – Is a testamentary (created through a will at someone’s death) trust used by married couples to control the disposition of assets in their estate after the death of their spouse. John’s will would create the trust and specify which assets that he owns individually will be in the trust. Assets he leaves to the trust will qualify for the unlimited marital deduction if his executor makes a QTIP election on his estate tax return. A requirement for those assets to qualify for the unlimited marital deduction is that his wife Mary must receive all the income generated by the assets for the remainder of her life. The assets in the trust will also be counted as part of her gross estate at her death. John though has designated who will receive the assets at his wife Mary’s death and that choice is irrevocable. Using this estate planning technique, he can make sure that his children are never disinherited.
Mary can also include this type of trust in her will to protect her the legacy of her son from her first marriage.
Unfortunately, a QTIP trust is not the most appropriate technique if a person has the bulk of their assets in IRA’s, 401K’s, or other qualified types of accounts that will become subject to the Required Minimum Distribution rule. The reason is complex and related to the requirements that all income from the assets in a QTIP trust be distributed to the remaining spouse every year. The definition of income for an IRA may clash with the definition of income under some state’s rules regarding trusts.
Irrevocable Life Insurance Trust (ILIT) – Another and perhaps more appropriate method of protecting children in a mixed family circumstance is life insurance combined with an Irrevocable Life Insurance Trust (ILIT). Here a trust is created while the spouse is living (unlike a QTIP which is typically created at death through a will). The trustee of the ILIT applies for life insurance on the life of the spouse and the trust owns the policy, the spouse pays the policy premium each year by gifting funds to the trust. The trust is created for the benefit of whomever the spouse selects, in this case possibly a child. At the death of the spouse the life insurance is paid to the trust which may then invest the proceeds and pay the income to the child, provide them with rights to the principle under certain conditions (maintenance, education, support, or health) and perhaps gradually pay the corpus out to them at specific ages (25, 30, 35, for example). This type of trust has other benefits including protection of the assets from the child’s creditors. This is a short and simple summary of this type of trust which could accomplish many of a parent’s goals for the protection or creation of a legacy for their children, one not affected by remarriages. It does come at a cost though, the cost of life insurance and the requirement that the spouse be insurable. It is also recommended that the spouse consider setting this trust up when they are younger and the cost of life insurance is less.
Here is a summary of the 2 approaches:
|QTIP Trust||ILIT Trust|
|When Created||At First Spouse’s Death||During Lifetime|
|How Funded||Assets that qualify for marital deduction||Life insurance purchased by trustee|
|Duration||Does not benefit child until second death||Benefits children at the death of their parent (first death)|
|Income Beneficiary||Must be spouse to qualify||Child(ren) or anyone chosen|
|Restrictions||IRA’s are not appropriate to fund the trust||Can be life insurance but may also gift other assets (not IRA’s)|
|Cost||Typical costs for trust management||Life insurance premium and typical trust management costs.|
|Advantage||Spouse controls disposition of assets after their death||Benefits children at their parent’s death (no wait for the second death of a step-parent).|
|Disadvantage||Child may not receive inheritance for years. Asset may be depleted by remaining spouse||Cost of life insurance.|
This is a brief non-technical summary of a couple of approaches to consider if you do have children from prior marriages.
Stephen Craffen MS, CFA, ChFC
Steve was asked by reporter Karin Price Mueller (Star Ledger) to respond to some questions about current market conditions:
Retirement should be the time when you are less stressed and should have fewer worries, after all you no longer have the stress of the commute or your job. Many find those worries replaced with others including fears they might run out of money or be forced into a diminished lifestyle. Those fears are justified; inflation increases your expenses and diminishes the value of any fixed income you receive, health care costs are a great unknown, or you may live much longer than predicted increasing the chance you could outlive your resources. Guarding against some of those dangers by having the correct mix of assets to provide enough growth without taking on excessive risk may be challenging.
The risk that you might outlive your assets may be dramatically increased if you happen to retire at the “wrong” time. What happens for example if your timing is poor and you just happen to retire before a market decline? What does that mean for your portfolio? A declining market combined with the withdrawals you may need to make to create that “retirement paycheck” will put a severe strain on your portfolio and dramatically increase the odds that you may run out of money especially if you live for 20 or more years in retirement.
This risk, commonly called “Sequence Risk” or order of return risk (bad timing combined with withdrawals), is a risk that can devastate the portfolio of retirees.
An example will make it much clearer:
If you retired in 1996 and had a portfolio of $100,000 all invested in an S&P 500 index you would have experienced the following sequence of returns.
- 1996 – 23.10%
- 1997 – 33.40%
- 1998 – 28.60%
- 1999 – 21.00%
- 2000 – (9.10%)
- 2001 – (11.90%)
- 2002 – (22.10%)
- 2003 – 28.70%
- 2004 – 10.90%
- 2005 – 4.90%
If you were withdrawing $6,000 per year to meet your income needs in retirement your portfolio would have grown to $162,548 and your withdrawals would have been $60,000 for a total of $222,548.
Now consider an alternative universe where the order of returns is reversed as follows:
- 1996 – 4.90%
- 1997 – 10.90%
- 1998 – 28.70%
- 1999 – (22.10%)
- 2000 – (11.90%)
- 2001 – (9.10%)
- 2002 – 21.00%
- 2003 – 28.60%
- 2004 – 33.4%%
- 2005 – 23.10%
With the same $100,000 portfolio and annual withdrawal of $6,000 your portfolio would be worth $125,691, combined with the $60,000 in annual withdrawals it totals only $185,691. Now the $6,000 withdrawal represents 4.8% of your portfolio instead of 3.7% in the original scenario. If you were not making withdrawals the sequence would not have mattered, your portfolio would be worth the same with either pattern of returns, $238,673. There is no impact if you are not making withdrawals. (People in the “accumulation” phase of their life may benefit from dollar cost averaging.) It is the timing of the withdrawals that particularly impacts prospects for your invested assets. Selling an asset that has declined in price dramatically limits your ability to capture the upside during market recoveries. Managing sequence risk means you need to try to avoid the sale of asset classes that are in the throes of a bear market. Here are some suggestions:
Have enough in fixed income (bonds) – If you have a portfolio of $1,000,000 and need to withdraw $40,000 each year, have enough in bonds to guarantee the $40,000 is available for 7-8 years in case a bear market is very severe. That means having no more than 70% of your portfolio in riskier, growth assets.
Reduce your withdrawal rate – Manage your discretionary expenses so you can reduce the demands on your portfolio until the market recovers. There are various rules based approaches we’ve studied.
Have more recurring income through your Social Security claiming strategy or by buying immediate income annuities – Delaying Social Security till age 70 may dramatically increase your monthly income. Turning some of your portfolio into a steady income stream by annuitizing it can enable you to invest differently since you know you have a safe income floor.
Consider a Reverse Mortgage – Establish a Home Equity Conversion Mortgage (HECM) early on in retirement to act as a backup source of funds to tap during market declines.
We will discuss these strategies in future blogs.
Understanding your exposure to “Sequence Risk” and having a strategy to overcome it may be critical to your retirement.
Stephen C. Craffen, CFA
Interest rates have been low for years, dramatically impacting anyone who must hold a large position in cash. There may be several reasons why you need to hold a large cash position, perhaps you have some anticipated large expense looming, or you need to have a large cash reserve for an emergency. You might have thousands of dollars in cash, earning .25% in a money market account. Can you earn more?
Here are some of the investments you might consider and why they may not be good choices.
Floating Rate Loan funds – are funds that invest in bank loans, very often those that are below investment grade. Right now, some of these funds have yields that range from 4-6%, a huge improvement over a money market fund. Unfortunately, these types of funds are subject to more risk than one would expect. In 2008 when markets were crashing some of these funds also declined in value by 25-30%. During a financial crisis, the default rate for the loans these funds hold can also skyrocket and impact return. Exposure to that amount of risk is not what you want for your cash reserves.
High Yield Bond funds – High yield bonds are generally considered to be bonds that are rated BB or lower by S&P or Ba by Moody’s. They have historically provided high income over the years. Like every other class of bond, yields are now low when compared to their historical yield; yet their risk has not decreased. Like floating rate loan funds, in 2008 high yield bond’s return was -28%, illustrating how risky this asset class is during economic slowdowns or financial crises. Like floating rate loans their default rate also tends to rise dramatically during recessions.
Longer Term Bond ETF’s – May have a much higher yield than a money market account but they come with much greater risk not from defaults (for government bond funds or high-quality corporate’s) but instead from increasing interest rates. The market value of the bonds they hold can be quite sensitive to interest rate changes. For example, Vanguard’s Long-Term Government Bond ETF (VGLT) lost 1.8% for the prior year ending 5/31/2017. That includes it’s yield which is around 2.7% right now. If interest rates rise long term bond funds can easily have negative returns as high as 6% in one year, since the bonds they buy may decline in value that much or more for each 1% increase in interest rates.
Preferred Stock Funds – Companies may issue several classes of stock including common stock and preferred stock. Preferred stock is issued with a fixed and typically high dividend, right now yields are in the 4-6% range. If a company is liquidated preferred shareholders receive whatever is left after bond holders are reimbursed but before common stockholders. Preferred stock has much of the risk of common stock since it is effectively an unsecured debt (unlike a bond) but it lacks the potential for growth since the dividend is fixed and the preferred stock may also be callable. Because of these features we do not believe it is a good investment for most people. In a bad market, preferred stock acts like common stock. In one case, an ETF that invests in preferred stock dropped 61% from May 2007 to March 2009.
While this list is not complete, we hope we’ve given you a feel for the risks you may encounter in trying to get more yield. You increase your exposure to types of risk that generally do not exist with a money market account. Those risks in summary include, market risk, interest rate risk, and default risk. When we consider these options, I recall something a professor wrote on the black board when I was getting my Masters in Finance: TINSTAAFL. None of us could guess what the heck that meant until he told us: There Is No Such Thing as A Free Lunch.
Stephen Craffen & Laura Mattia
Title: Voices: On the need to better understand risk
Quote: “Advisers are using the wrong software along with bad assumptions. I’ve also seen a lot of advisers throw up their hands at asset allocation software and decide not use any. I can see why they get frustrated, but I think abandoning the programs altogether is a bad idea. Finding better software that imposes realistic views on asset class returns or that uses a statistically viable method of incorporating the adviser’s views is still an improvement over the “seat of the pants” approach.”
Click here to view the article.
Title: Seeking Safe Investment Alternatives by Kevin DeMarrias
Quote: “We strongly caution people about taking on too much risk in attempting to increase their yield”, said Stephen Craffen, a Partner in Stonegate Wealth Management LLC in Fair Lawn. “They need to fully understand the additional risk they may be taking by investing in high yield bonds, preferred stock, etc.”
Stonegate Wealth Management, LLC is pleased to announce that Firm Founder and Partner, Stephen Craffen has been appointed by the National Association of Personal Financial Advisors (NAPFA), to act as the President of the North East/Mid-Atlantic Region for the 2012/2013 fiscal year. In accepting this honor, Mr. Craffen will be leading the region of the United States with the largest NAPFA membership.
Mr. Craffen has been a member of NAPFA since 1998. He has served as a volunteer for NAPFA in many capacities over the years. Mr. Craffen has served as a member of NAPFA’s new Leadership and Development Committee for the National Board, helping to establish the procedures that will be used to select future National Board members and he has served on the Eastern Region Conference Committee for several years. He has also organized and helped to run a series of educational symposiums on the East Coast for the past three years. Additionally, Mr. Craffen was a study group director for NAPFA’s Eastern Region.
NAPFA is the nation’s premier organization of fee-only financial advisors. As a member of NAPFA, Mr. Craffen adheres to a strict code of ethics and has signed an oath stating that he will not accept commissions of any kind.
Mr. Craffen is looking forward to leading the North East/ Mid-Atlantic Division of NAPFA stating,
“I look forward to continuing my service to NAPFA and helping it maintain its role as leaders in the financial planning field.”
Craffen founded Stonegate Wealth Management in 1993. The firm became a fee-only firm in 1998 to provide its clients with the highest levels of financial planning and investment advisory services on a cost-effective basis and without product bias. The firm has $210 million in assets under management. Steve is a Chartered Financial Analyst (CFA) charter holder, recognized as a hallmark of excellence in securities analysis. A graduate of Stevens Institute of Technology (1977 BE), he also earned a Master of Business Administration from Rutgers University in 1983, and a Masters in Financial Planning in 1998 from the College for Financial Planning in Denver Colorado.
Partners in the firm include Craffen, Thomas J. Geraghty, CPA, CFP, and Craig R. Marson, CPA, J.D.
For Release 9 a.m. EDT, May 18, 2012