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Emergency Fund 3 to 6 mo of variable + fixed + taxes 3 mo for =double income household 6 mo for = single income household
PITI principal + interest taxes property insurance < or equal to 28% of gross income
Ideal savings 5-8% of gross income
Federal Bank under regulations from: FDIC Federal Reserve Comptroller of currency
State Banks under regulations from: FDIC Federal Reserve State
Mutual Funds Provide diversification & professional management
SEC 1933 Law Paper act for IPOs Need to register with the SEC: description of the company, management, security being offered, financial statements
SEC 1934 Law -Regulates the people in the business -Broker deals, SROs, registered reps -Creates SEC -finger printing requirement -qualification exam -Registration of principal (supervisor) -Prohibits SEC commissioners from buying or selling any securities, other than those issued by the U.S. government, in their personal accounts during their term of office -The use of credit to purchase new issues is prohibited for the first 30 days.
Investment Company Act of 1940 Identified investment companies: -Face amount certificate companies -UITs -Investment management companies -Shareholders have the right to vote on a company's change from a closed-end to an open-end investment company -A mutual fund may not use the term no-load if its 12b-1 fee exceeds .25% -An investment company must have more than $100,000 capitalization to be offered to the public -At least 40% of the board of directors must be noninterested persons.
Law of 1970 Creates SIPC, The SIPC fund, which constitutes an insurance program, is designed to protect the customers of brokers or dealers subject to the SIPA from loss in case of financial failure of the member
Fiscal Policy -Gov't budgets, spending, taxation
Monetary Policy Reserve requirements, interest rates, open market operations Controlled by the FOMC
Open Market Operations Repo = when the fed buys bonds (loosens credit) Reverse Repo = when the Fed sells bonds (tightens credit)
Fed Funds Rate The overnight bank to bank loan rate, not set by the Federal Reserve
Life Time Learning credit 2k maximum undergrad and grad school Cannot be used for room + board
American Opportunity Credit Max of $2,500 per student First 4 years of a secondary education Cannot be used for room + board
529 Plans -College Savings - Prepaid tuition - can front load with 5 years of gifts - can make one non reportable transfer each year - can designate a different beneficiary
Coverdell $2k maximum per child from all donors each year. Can be used for all sorts of levels of education Can be used until age 30 Cannot contribute once beneficiary reaches age 18
UGMA cash only age of majority parent's asset
UTMA includes real estate and LPs up to age 25 parent payes taxes, but it is an asset of the students for financial aid calculations
Series EE bonds Tax free only up to certain tax brackets. Have to be used & owned by parent for tuition / tax free withdrawals
Principle 1 - Integrity: Provide professional services with integrity. Integrity demands honesty and candor which must not be subordinated to personal gain and advantage. Certificants are placed in positions of trust by clients, and the ultimate source of that trust is the certificant's personal integrity. Allowance can be made for innocent error and legitimate differences of opinion, but integrity cannot co-exist with deceit or subordination of one's principles. Principle 4,7 Rule 1.1 , 1.2 , 1.3 , 2.2
Principle 2 - Objectivity: Provide professional services objectively. Objectivity requires intellectual honesty and impartiality. Regardless of the particular service rendered or the capacity in which a certificant functions, certificants should protect the integrity of their work, maintain objectivity and avoid subordination of their judgment. Principle 7 Rule 3.3, 4.4, 4.5
Principle 3 - Competence: Maintain the knowledge and skill necessary to provide professional services competently. Competence means attaining and maintaining an adequate level of knowledge and skill, and application of that knowledge and skill in providing services to clients. Competence also includes the wisdom to recognize the limitations of that knowledge and when consultation with other professionals is appropriate or referral to other professionals necessary. Certificants make a continuing commitment to learning and professional improvement. Principle 2,3,7 Rule 1.4, 4.1, 4.4, 4.5
Principle 4 - Fairness: Be fair and reasonable in all professional relationships. Disclose conflicts of interest. Fairness requires impartiality, intellectual honesty and disclosure of material conflicts of interest. It involves a subordination of one's own feelings, prejudices and desires so as to achieve a proper balance of conflicting interests. Fairness is treating others in the same fashion that you would want to be treated. 400-1 Principles 2,3,6,7 Rules 1.4, 4.1, 4.5 400-2 Principles 2,3,6,7 Rules 1.4, 4.1, 4.5 400-3 Principles 1,2,6 Rules 2.1, 4.1, 4.4, 4.5
Principle 5 - Confidentiality: Protect the confidentiality of all client information. Confidentiality means ensuring that information is accessible only to those authorized to have access. A relationship of trust and confidence with the client can only be built upon the understanding that the client's information will remain confidential. 500-1 Principles 3,4,6,7 Rules 1.2, 2.2, 4.1, 4.4 500-2 Principles 2,4,6,7 Rules 1.2, 2.2, 4.1, 4.4
Principle 6 - Professionalism: Act in a manner that demonstrates exemplary professional conduct. Professionalism requires behaving with dignity and courtesy to clients, fellow professionals, and others in business-related activities. Certificants cooperate with fellow certificants to enhance and maintain the profession's public image and improve the quality of services. 600 Principles 7 Rules 1.2, 3.3, 3.4, 4.1
Principle 7 - Diligence: Provide professional services diligently. Diligence is the provision of services in a reasonably prompt and thorough manner, including the proper planning for, and supervision of, the rendering of professional services
CFP Code of Ethics Integrity Objectivity Competency Fairness Confidentiality Professionalism Diligence
DEFINING THE RELATIONSHIP WITH THE PROSPECTIVE CLIENT OR CLIENT - Mutually agreed upon - Contract elements and responsibilities of each party - clients interest before your own 1.3 If the services include financial planning or material elements of financial planning, the certificant or the certificant's employer shall enter into a written agreement governing the financial planning services ("Agreement"). The Agreement shall specify:
The parties to the Agreement, The date of the Agreement and its duration, How and on what terms each party can terminate the Agreement, and The services to be provided as part of the Agreement. The Agreement may consist of multiple written documents. Written documentation that includes the items above and is used by a certificant or certificant's employer in compliance with state or federal law, or the rules or regulations of any applicable self-regulatory organization, such as the Securities and Exchange Commission's Form ADV or other disclosure documents, shall satisfy the requirements of this Rule.
INFORMATION DISCLOSED TO PROSPECTIVE CLIENTS AND CLIENTS - No false or misleading statements - Disclose compensation, possible conflicts of interest, written disclosures such as ADV
PROSPECTIVE CLIENT AND CLIENT INFORMATION AND PROPERTY - All information is confidential - Secure all documents & information - Keep records of assets under custody - Do not borrow / lend money to / from client - no commingling of your assets with client's - Return any property requested back
OBLIGATIONS TO PROSPECTIVE CLIENTS AND CLIENTS - Treat clients fairly, objectively, and with integrity - only offer advice if you are competent in the areas - compliant with regulatory bodies - only implement suitable recommendations - Advise clients of suspension from CFP Board
OBLIGATIONS TO EMPLOYERS 5.1 A certificant who is an employee/agent shall perform professional services with dedication to the lawful objectives of the employer/principal and in accordance with CFP Board's Code of Ethics.
5.2 A certificant who is an employee/agent shall advise his or her current employer/principal of any certification suspension or revocation he or she receives from CFP Board.
6. OBLIGATIONS TO CFP BOARD 6.1 A certificant shall abide by the terms of all agreements with CFP Board, including, but not limited to, using the CFP® marks properly and cooperating fully with CFP Board's trademark and professional review operations and requirements.
6.2 A certificant shall meet all CFP Board requirements, including continuing education requirements, to retain the right to use the CFP® marks.
6.3 A certificant shall notify CFP Board of changes to contact information, including, but not limited to, e-mail address, telephone number(s) and physical address, within forty five (45) days.
6.4 A certificant shall notify CFP Board in writing of any conviction of a crime, except misdemeanor traffic offenses or traffic ordinance violations unless such offense involves the use of alcohol or drugs, or of any professional suspension or bar within ten (10) calendar days after the date on which the certificant is notified of the conviction, suspension or bar.
6.5 A certificant shall not engage in conduct which reflects adversely on his or her integrity or fitness as a certificant, upon the CFP® marks, or upon the profession.
CFP Rules of Conduct 1.DEFINING THE RELATIONSHIP WITH THE PROSPECTIVE CLIENT OR CLIENT 2. INFORMATION DISCLOSED TO PROSPECTIVE CLIENTS AND CLIENTS 3. PROSPECTIVE CLIENT AND CLIENT INFORMATION AND PROPERTY 4.OBLIGATIONS TO PROSPECTIVE CLIENTS AND CLIENTS 5.OBLIGATIONS TO EMPLOYERS 6. OBLIGATIONS TO CFP BOARD
1. Establishing and defining the relationship with a client 100-1 Defining the Scope of the Engagement
-Identifying the service(s) to be provided; -Disclosing the practitioner's material conflict(s) of interest; -Disclosing the practitioner's compensation arrangement(s); -Determining the client's and the practitioner's responsibilities; -Establishing the duration of the engagement; -Providing any additional information necessary to define or limit the scope.
2. Gathering client data 200-1 Determining a Client's Personal and Financial Goals, Needs and Priorities -This Practice Standard addresses only the tasks of determining the client's personal and financial goals, needs and priorities; assessing the client's values, attitudes and expectations; and determining the client's time horizons. These areas are subjective and the practitioner's interpretation is limited by what the client reveals.
200-2 Obtaining Quantitative Information and Documents -The practitioner shall obtain sufficient and relevant quantitative information and documents pertaining to the client's financial resources, obligations and personal situation. This information may be obtained directly from the client or other sources such as interview(s), questionnaire(s), client records and documents.
3. Analyzing and evaluating the client's financial status 300-1 Analyzing and Evaluating the Client's Information -The practitioner will utilize client-specified, mutually agreed upon, and/or other reasonable assumptions. Both personal and economic assumptions must be considered in this step of the process. These assumptions may include, but are not limited to, the following:
-Personal assumptions, such as: retirement age(s), life expectancy(ies), income needs, risk factors, time horizon and special needs; and Economic assumptions, such as: inflation rates, tax rates and investment returns.
4. Developing and presenting financial planning recommendations 400-1 Identifying and Evaluating Financial Planning Alternative(s) -The financial planning practitioner shall consider sufficient and relevant alternatives to the client's current course of action in an effort to reasonably meet the client's goals, needs and priorities.
400-2 Developing the Financial Planning Recommendation(s) -After identifying and evaluating the alternative(s) and the client's current course of action, the practitioner shall develop the recommendation(s) expected to reasonably meet the client's goals, needs and priorities
400-3 Presenting the Financial Planning Recommendation(s) -When presenting a recommendation, the practitioner shall make a reasonable effort to assist the client in understanding the client's current situation, the recommendation itself, and its impact on the ability to meet the client's goals, needs and priorities. In doing so, the practitioner shall avoid presenting the practitioner's opinion as fact. -Personal and economic assumptions; Interdependence of recommendations; Advantages and disadvantages; Risks; and/or Time sensitivity.
5. Implementing the financial planning recommendations 500-1 Agreeing on Implementation Responsibilities -The client is responsible for accepting or rejecting recommendations and for retaining and/or delegating implementation responsibilities. The financial planning practitioner and the client shall mutually agree on the services, if any, to be provided by the practitioner. The scope of the engagement, as originally defined, may need to be modified. -The practitioner's responsibilities may include, but are not limited to the following:
Identifying activities necessary for implementation; Determining division of activities between the practitioner and the client; Referring to other professionals; Coordinating with other professionals; Sharing of information as authorized; and Selecting and securing products and/or services.
500-2 Selecting Products and Services for Implementation -The financial planning practitioner shall investigate products or services that reasonably address the client's needs. The products or services selected to implement the recommendation(s) must be suitable to the client's financial situation and consistent with the client's goals, needs and priorities.
6. Monitoring 600-1 Defining Monitoring Responsibilities -If engaged for monitoring services, the practitioner shall make a reasonable effort to define and communicate to the client those monitoring activities the practitioner is able and willing to provide. By explaining what is to be monitored, the frequency of monitoring and the communication method, the client is more likely to understand the monitoring service to be provided by the practitioner.
CFP Board Practice Standards 1. Establishing and defining the relationship with a client 2. Gathering client data 3. Analyzing and evaluating the client's financial status 4. Developing and presenting financial planning recommendations 5. Implementing the financial planning recommendations 6. Monitoring
How many hours are required of CE credits per year? 30
In a CFP hearing new evidence cannot be longer than ? pages and submitted less than ? days before the case? 100 pages 45 days
Presumed unacceptable conduct - fitness standards he/she can file a petition with the Disciplinary and ethics committee for reconsideration within 30 calendar days!
Unacceptable conduct - fitness standards individual is barred from being certified
Can you re-instate your CFP if you previously were certified? No
Code of Ethics Organized around the 7 principles: integrity objectivity competence fairness confidentiality professionalism diligence
Rules of Conduct Establish the high standards expected of certificants and describe the level of professionalism: Rule 1: defining the relationship Rule 2: info disclosed to clients Rule 3: Client information Rule 4: obligation to prospective clients Rule 5: obligation to employees Rule 6: obligation to CFP Board
Practice Standards Developed by CFP board for the ultimate benefit of consumers of financial planning services: 100 Establish & define relationship 200 Determine clients goals, needs 300 Analyze clients financial status 400-1 Identify and evaluate financial planning alternatives 400-2 Develop the plan recommendations 400-3 Present the recommended plan 500 Implement the plan 600 Define plan monitoring responsibilities
Articles Covers disciplinary rules and procedures
Maximum time a certificant can be suspended? 5 years
Days to notify the CFP board of a change of address 45 days
Can a certificant take custody of assets? Yes if clearly identified
FDIC Insurance A time deposit means a CD (federally insured) by FDIC. Bonds may be insured, but the question would have to say so. Variable annuities may provide some guaranteed rate of return and have some state guarantees. Treasury bills are guaranteed by the federal government.
SIPC Insurance The SIPC insures investors against losses arising from the failure of the brokerage firm.
UTMA v 529 Plans A gift to a QTP is considered a gift of a present interest; a gift to an UTMA is considered a gift of a present interest. The owner of a QTP retains the right to determine how and when to use the money in the account; the custodian of an UTMA loses control when the student reaches the age of majority. The owner of a QTP can change the beneficiary; the custodian of an UTMA cannot change the beneficiary. QTPs grow tax-deferred, and distributions are tax-free if used for qualified educational expenses; UTMA growth and income distributions can be subject to both regular tax and kiddie tax.
Can a 529 Plan or Coverdell ESA withdrawal be used to pay the tuition while taking a credit (American Opp or Lifetime Learning) for the tuition paid ? No.
Reverse Mortgage -The borrower or heirs can never owe more than the house is worth even if that value is less than the loan balance. -The home does not have to be owned free and clear to qualify for a reverse mortgage. -There are no monthly mortgage payments during the life of the loan. -There are no income qualifications. -A reverse mortgage is only available to homeowners 62 years and older living in condominiums and single family homes.
Registering with FINRA -When you are making commissions
Series 6 A Series 6 license allows a representative to sell an initial UIT offering.
Series 7 But, a mutual fund traded on a major exchange is a closed-end fund. To sell closed-end funds (NYSE, etc.), you need a Series 7 license
When to terminate a relationship? When the client is doing something illegal or asking you to do something illegal.
Investment Advisor Act 1940 -Requires registration of investment advisers with the U.S. Securities and Exchange Commission with more than $100 million of assets under management.
Bankruptcy Ch. 13 allows you to keep home Does not forgive federal loans, student loans, alimony. Ch. 7 is liquidation bankruptcy
Medicare Part A - Free - Hospital insurance -Age 65 -Under limited circumstances, services furnished in Canada, Mexico, or the Caribbean may be paid by hospital insurance. However, Europe is not covered. -Covers Diagnostic tests, home health services, skilled nursing home care for up to 100 days, hospice. Doesn't cover the first 3 pints of blood. -Medicare is always secondary payer -Patient can enter skilled care only if they have previously been treated in a hospital
Medicare Part B Medical Insurance -Benefits are subject to calendar-year deductible, and only 80% of the Medicare approved charges are paid. -The cost of doctor visits is covered both in and out of hospital. -Part B is a voluntary program of health insurance. -Outpatient services by a participating hospital are a covered expense. -Age 65 - Covered: diagnostic tests, radiology, metal health, blood transfusion, OT / PT, drugs that cannot be self administered, preventative health screenings. -Not covered: dentures, dental exam, eye glasses, hearing aids, most immunizations, Rx drugs, self administered drugs
COBRA -Available 60 days after the actual notice of the event to the qualified beneficiary by the plan administrator - Can get 18 months or 36 months -36 months for spouses and children not covered by another plan, or if insured dies -Have to offer COBRA if company has more than 20 full time employees -Disability COBRA can last 29 months - Costs about 3k per month -The COBRA plan must be identical.
HSAs - Tax free distributions for QUALIFIED expenses - Need to be part of a high deductible health plan -An HSA allows account owners to pay for current expenses and save for those in the future. Its first advantage is that contributions are tax deductible, or if made through a payroll deduction, they are pretax. Second, the interest earned is tax-free. Third, the account owners may make tax-free withdrawals for qualified medical expenses. -Minimum deductible $1,300 single, $2,600 married -Non medical HSA withdrawals face 20% penalty
Medigap -Cover approved expenses not paid by Medicare -Enroll within 6 mo of turning 65 and the policy is issued on a guaranteed issue basis -Policy cannot be cancelled unless of non-payment -Does not cover Rx drugs -Must be enrolled in A and B
Medicare part D - For Rx drug coverage - Must have part A and B
Medicare Enrollment - Enroll at 65 - initial enrollment period is 3 mo before - 3 mo after 65th birthday.
-Enroll for part B at either age 65 or when you stop working to avoid 10% penalty.
Own Occupation Disability Insurance - Inability to do his/ her job
Modified - Any Occupation Disability Insurance - Inability to do any job
Noncancellable Contract guarantees the individual can keep the policy in place by paying the premium (it does not increase) Normally renewable until age 65 or NRA
Guaranteed Renewable -Individual can keep the policy in force, but premiums can increase on a class basis (not individual basis)
Conditionally Renewable -Allows a noncancellable or guaranteed renewable policy to continue beyond age 65 -Only has a 2 year benefit and the premiums are adjusted for age & benefits -Can only be extended if the insured is an active employee -Is normally in all disability policies
Characteristics of Disability Insurance -Benefit period of 2-5 years -Elimination period (acts like a deductible) typically 90 days. -Riders: partial disability (benefits usually start after a period of total disability and last up to 6 mo. -Riders: residual disability benefit (benefits start immediately after a period of total disability) -Reduce cost by: Not buy the COLA rider, Purchase a guaranteed renewable policy, Increase elimination period
Total Disability -Loss of sight, hearing, speech, both hands/feet, 1 hand and 1 foot
Riders: residual disability benefit (benefits start immediately after a period of total disability) - Its own policy. Not a loss of income policy. - For total disability the monthly benefit will be equal to the social insurance substitute less any social insurance benefit. There is a 5 mo waiting period for social security, and a disabled person must wait 12 months. Ex. Disability base benefit $5,000 Social insurance substitute $1,200 Social security benefit received $600 Policy payout $5,600 (5000 + (1200-600)) Upon returning to work, the insured is unable to earn as much; benefits are proportional to the amount of income lost and are payable for the same duration as total disability benefits.
Taxation of disability benefits If employee owns plan & pays premiums = premiums are not deductible, but benefits are tax free
If employee owns the plan, but the employer pays the premiums (employer uses bonus money to pay premiums) = premiums are deductible to employer, and benefits are tax free
If employer owns plan, & pays the premiums= premiums are deductible to employer, but benefits are taxable to the employee
Partnership & S Corps: can deduct premiums paid for to cover a partner or >2% shareholder. Deduction is based on premium cost being included in the taxable income of the partner / shareholder. Proceeds are excludable from taxable income.
LTC Insurance -Guaranteed renewable, daily benefits -when a person cannot perform 2 or more ADLs (activities of daily living) -For chronically ill persons -Skilled, intermediate, custodial, home health care, adult day care -Elimination period: 30 to 365 days -Benefits lasting: 2 years to lifetime -Can elect an inflation protection rider to increase daily benefit - Premiums paid are tax deductible based on age, if over 10% AGI floor. Benefits received are not taxable. - A FSA cannot be used to reimburse premiums for LTC and expenses for LTC
Skilled Nursing Facility Coverage -Patient is covered under Medicare part A if they are sent to a skilled nursing facility after being in a hospital - Skilled care = the patient's condition will improve (so Alzheimer's isn't included) -First 20 days are paid by Medicare. Days 21-100 require a copayment ($164 per day) -After day 100, patient pays in full
FSAs for Health -Contribution limit $2,600 per year for health care -Can be used for medical expenses not covered by insurance -Can rollover $500 each year of unused funds for health accounts only -Cannot have a grace period (2.5 months) and a $500 rollover option -Cannot be used to pay for Medicare, COBRA, LTC insurance premiums. -Coverage ends at year end or separation of service (COBRA must be elected, other wise service ends) -Funded entirely through employee salary reductions, the salary reduction is not subject to FICA and FUTA. -Un-useable funds need to be taken as compensation or they will be forfeited -Not to be used toward cosmetic surgery
HSA + FSA An individual can only have both in the case they have a high deductible plan and a limited scope FSA which overs vision & dental expenses
FSAs for Dependent Care -Money can be deferred to his account for dependent care expenses such as, before/ after school care, child camps, expenses for a nanny who takes care of dependent -$5,000 limit for dependent care -Anyone under 13 that you claim as a dependent, or whom is mentally/physically incapable of caring for them self -Not eligible expenses: education/tuition, expenses for children over 13, late payment fees, overnight camps, advance payments, transportation to/from dependent care provider -Funded entirely through employee salary reductions, the salary reduction is not subject to FICA and FUTA.
Cafeteria Plans Choose from benefits including: -term life insurance -medical insurance -short/long term disability insurance -401k -An FSA is a cafeteria plan, set up by the company and costs can be shared by employees
Group Life Insurance -Employee doesn't pay tax, if their life insurance benefit is 50k or under. if total coverage exceeds 50k, then they are taxed on the amount of coverage over 50k minus the amount paid. -Employer can take deductions paid on premiums, as long as they are not the beneficiary. -Key employees do not get the 50k exclusion -Dependents of the insured can get insurance, but only 2k of that will be tax free -Employers usually own the LI policy and allow employees to change the beneficiaries. -If group life insurance is terminated, the client can convert to individual life, amount of insurance must remain the same.
Carved Out plans Employer removes a key / HCE from the group insurance. The company then takes out a separate policy on this employee. This is seen in split dollar, IRC section 162 bonus plans and DBO arrangements
Split Dollar Plan If the split dollar arrangement is entered into a group carved out plan, then it is taxed as group life insurance, premiums are deductible. If there is only 1 employee they cannot deduct the premiums
IRC Section 162 Employee purchases and owns the LI plan. The company then pays the premiums, so they can take the deduction. The premiums are like compensation to the employee, so they are taxable income. The employee has to pay the income tax on the premium with no cash, so a second bonus is paid to the employee to cover the tax.
Group Disability Plans -Short & Long term -Employer usually pays premiums, so benefits are taxable to the employee. -Typically covers 50-60% of earned income. -Short term (1 -365 days): benefits paid weekly -Long term (30 days-2 yrs): benefits paid monthly Usually limited to some cap such as 50% of compensation or 5,000 per month. -Typical definition is own occ for 2-5 years, then any occ after -Benefits can be reduced by social security -More liberal underwriting & wait periods
Social Security Disability Benefits Kick in on the 5th month, disability must have lasted 12 months or be expected to last at least 12 months
Fringe Benefits Tax Free: premiums for health, insurance premiums on group life up to 50k, value of qualifying day care, company car, commuter highway vehicle passes, employer provided parking spots, occasional overtime meal / transportation money, value of discounts on company products, up to 20% off services, group disability insurance up to 50% of salary
Taxable: Health insurance premiums paid for self employed individuals, partners, and >2% owners. Life insurance premiums paid in excess of 50k.
Annual Renewable Term -Must renew each year, but insured doesn't have to prove insurability each year. Premiums increase each year. The amount of insurance remains the same overtime, as premiums increase.
Level Term The premium is fixed for a certain amount of years. The longer the guarantee, the higher the premium. Renewal premiums can be much more than previous premiums.
Re-entry Provision When your level term policy ends, you can reapply with simplified underwriting & a low rate. If one doesn't qualify, they can keep their old level term policy, but have to pay a higher premium.
Decreasing Term Premiums stay level, but the amount of insurance decreases over time. Used to be used with mortgages.
First to Die / Joint Life Covers 2 people and will pay out when the first of those 2 dies. The money can be used to pay off mortgage or in a buy sell agreement or debt protection.
Renewability Guarantees the insured to renew the policy up until a specified age
Convertibility Allows insured to exchange a term insurance policy for a permanent insurance policy
Term Insurance -Used for long time periods 20+ years and for when funds for insurance are limited
Whole Life (ordinary life) Protects for the whole life. Assumes premiums will be paid for the entire life time. -permanent protection, level premium, combines savings with protection -Premiums are higher than term, generally not flexible
Universal Life Insurance Cash value isn't guaranteed, it's tied to interest rates (current and minimum) in a general account Cash value= interest + premiums Flexible premiums Adjustable death benefit Have to pay monthly deductions no guaranteed minimum death benefit, technically *Level death benefits: death benefit is constant, but the cash value increases. When the cash value exceeds certain benchmarks, the death benefit will increase
Variable Universal Life Insurance Part insurance/ part investment -prospectus required -cash value is tied to the performance of separate accounts (mutual funds) -flexible premiums -adjustable death benefit -monthly deductions, extra is invested in separate accounts -no guaranteed minimum death benefit, technically -must maintain positive account value - it is possible to have negative cash value
Variable Life Insurance -Cash value tied to performance of separate accounts -guaranteed death benefit, no guaranteed cash value -premiums are fixed for life of contract -suitability -prospectus -Part of premium goes to company's general assets, rest goes into separate accounts -minimum death benefit guaranteed -can be converted to whole life within first 2 years -45 day free look period from policy execution or delivery -Cash value calculated monthly -Death benefit calculated annually Unit values are computed daily and cash values are computed monthly.
Second to die policy Usually to provide liquidity to pay off estate taxes. Lower premiums than on 2 separate policies.
Endowments -Wrong/ not useable answers on the exam -Identical to whole life at age 100
LI contract Provisions 1. Automatic Premium Loan 2. Grace Period 3. Reinstatement Clause 4. Suicide Clause
Contract Provisions: automatic premium loan APL: if the policy holder doesn't pay the premiums during the grace period, APL kicks in and the premiums will be charged against the cash value as a loan Policy provision which would create a premium loan to pay a premium in default
Contract Provisions: Grace period 31 days after premiums due
Contract Provisions: Reinstatement Clause Gives the owner of a lapsed policy the right to reacquire the coverage with certain conditions (proof of insurability and payment of premiums in arrears)
Contract Provisions: Suicide Clause suicide can't occur within 2 years of contract, if this occurs insurer will only be liable for return of premium
Riders: Disability waiver of premiums Whole Life: company agrees to waive all premiums coming due after the insured has become totally diabled. The cash value is credited as if the insured had paid the premiums Universal & variable: the company either a) just waves the charges for mortality and administration expenses but doesn't include an increment to the policies cash value or b) the company waives the full premium that the client would normally pay
Riders: Double indemnity/ accidental death Normally doubles the death benefit
Riders: Guaranteed Purchase Option the insured may purchase additional insurance, regardless of their insurability at 3 yr intervals and up to a specified max age
LI Riders 1. Disability 2. Guaranteed Purchase option 3. Double indemnity
Dividend options: cash Paid to owner in cash
Dividend options: Reduction of premiums Dividends are paid toward the premium
Dividend options: Accumulated with interest Dividends remain with the insurance co. but are put in an interest bearing account. Interest is taxable. Dividends are added to the death benefit or paid out in cash if the policy is surrendered.
Dividend options: Purchase paid up additions Each dividend is used to purchase a small amount of additional fully paid up whole- life insurance
Dividend options: One year term insurance (5th dividend) All or a portion of the dividend is used to buy 1 yr term insurance equal to the policy's base cash value. This option increases the death benefit from year to year.
LI Dividend Options 1. Cash 2. Reduction of premiums 3. Accumulate with interest (interest would be taxable) 4. Purchase paid up insurance 5. One year term insurance (5th dividend)
nonforfeiture options: cash option Policy may be surrendered at any time for cash (minus debt, plus accumulated dividends) there is a 6 mo delay period.
nonforfeiture options: Reduced amount of paid up insurance The face amount of the policy will be reduced. the death benefit will be the amount the cash paid up whole life value would purchase as a new single premium. No additional premium is due. Company issues a policy worth the current cash value, no premiums must be paid and it is effective until death.
nonforfeiture options: Paid up term insurance (extended term) The policy may be continued in force for as long as the cash value will permit with no additional premium due. IF the insured outlives the term, then the policy is terminated. The cash value of the policy pays for the term insurance. At the end of the term, the cash value is 0. Current contract is kept in force until remaining cash value hits $0.
settlement option: cash option Owner / beneficiary takes lump sum
settlement option: interest option The proceeds are retained temporarily by the issuer, and interest is only paid. This is often considered the most flexible option.
settlement option: installments for a fixed period the proceeds + interest are paid out over some specific period of time
settlement option: installments of a fixed amount the proceeds are paid out in a fixed amount for as long as proceeds + interest last (spendthrift option)
settlement option: life income option setting up an annuity
Life insurance illustrations -name of issuer -name and address of producer -name, age, sex. address of producer - initial death benefit ./ underwriting & rating classification
Single premium policy Is a MEC, because it fails to meet the 7 pay test.
Modified Endowment Contract Must meet the requirements for classification as a life insurance contract under the 1984 act or 1. entered into on or after June 21 1988 and 2. fails to meet 7 pay test. Distributions are taxed under interest first rule Distributions subject to 10% penalty if policyowner is not over 59.5 or disabled Dividends paid by mutual life insurance companies under MECs are taxable as income if they are received in cash or to reduce premiums pd or if they are retained by the insurer in repayment of a policy loan Death benefit is excludable from income. Once a MEC, always a MEC Only problem is that withdrawals and loans are LIFO plus 59.5 penalty. Death benefits are tax free.
7 Pay test Too much premiums have been paid within the first 7 years
Material Change If a policy at first is not a MEC, but there is an increase in the death benefit under the contract it can then become a MEC.
Grandfathered Life Insurance Rules if the death benefit increases by more than 150k then the contract becomes subject to material change rules and may lose its grandfathered status
Transfer for Value Transferring a LI contract between parties can compromise the income tax exclusion of the benefits. Policy transfers are not jepoardized by the transfer for value rule when: -transfer to the insured -transfer to a partner of the insured -transfer to a corporation in which the insured is a shareholder or an officer -transfer to a spouse due to a divorce Typical violations: Corporation changes from a stock purchase to a cross purchase plan and transfers company insurance policies to stock holders
A gift of a policy to a family member can create a taxable gift, but it does not create a transfer of value. A sale of a policy to a family member is considered a transfer of value
Section 1035 Exchange Tax Free exchange of life insurance & annuity contracts - the exchange of a LI policy for another LI policy or annuity contract - Exchange of annuity contract for another annuity contract Must have same owner / insured / annuitant
Accelerated Benefit Rider This rider pays a portion of the policy's death benefit early, if the insured is terminally ill. Amounts are excluded from income tax. - coronary artery disease - neurological deficit thats permanent - end stage renal failure - AIDS - Can withdraw up to 50% death benefit
If insured is only chronically ill, they can withdraw benefits to pay for LTC, income tax free.
Viatical Settlement for terminally ill -When a certified terminally ill person sells their LI contract to a viatical company. The amount the insured receives for exchange of the contract is tax free. Viatical company will pay income tax on the death benefit (less amount paid to insured)
Life Settlements (viatical company) Transaction involving insured who is not terminally/ chronically ill and is generally over age 65. Taxed as follows: - tax free basis (premiums paid) - ordinary income from the basis to the policy's cash surrender value - LTCG from the higher of either the cash surrender value to the net settlement proceeds
When are MEC dividends taxable? They are received in cash. They are used to reduce premium. They are used to pay off a policy loan.
NOT when: They are used to purchase paid-up additions. They are kept with company and accumulate with interest.
Stock Redemption Plan The corporation purchases the stockholders interest using LI. Rights of creditors: LI can be attached No step up in basis Premiums paid are not deductible
Cross Purchase Plan One stockholder agrees to purchase a deceased stockholders share using LI Rights of creditors: LI can't be attached Beneficiary gets step up in basis Premiums paid are not deductible
Disability buy-sell agreements Premiums paid are not deductible Capital gains charged to insured. Gains above basis (purchase price - insured's basis)
Key employee LI Business should be owner and beneficiary Premiums paid are not deductible Death benefits are tax free to company
Split Dollar Plan: Endorsement Method Employer is owner Employee is not a shareholder Employer retains cash value of the policy (or premiums paid, if greater) Employee's beneficiary gets balance of any death benefit
Split Dollar Plan: Collateral Assignment Method Employee is owner Employee is a shareholder Employee assigns the policy Employer receives premiums paid Employee gets balance of cash value or beneficiary gets balance of death benefits Employer lends the employee the corporations share of annual premiums.
Variable Annuties -Two licenses -"attempts to keep up with inflation" -suitability -prospectus at time of solicitation -can provide lifetime income if you want it to -funded with after tax dollars -money grows tax deferred -only earnings are taxed at distributions -no maximum sales charge, must be "reasonable" -premiums placed in separately managed accounts -no guaranteed rate of return -customer picks SAs -mortality risk lies with insurance company -investment risk lies with customer -monthly check varies based on value of SAs
Annuities A periodic payment beginning at a specific or contingent date and continuing for a fixed period or for the duration of the designated life. 1. immediate, fixed, variable 2. accumulation & annuitization 3. payout methods: life, period certain, JWS
Pure Life Annuity - Provides periodic benefit payments as long as the annuitant lives, with the payments ceasing at death.
Fixed Annuity Pros: guaranteed stream of income no residual balance is left at death (which could be subject to estate tax) Fixed has the highest payout of all settlement options
Cons: fixed payment (no inflation hedge) Cant commute the remaining value (ask for money back if health changes) Annuitant may die before they have gotten all of their principle back & nothing will pass to heirs
Pension Max An application used when an individual is given a choice between picking a pure life annuity and a JT annuity. Ideally they should pick the pure life and use the excess over the JT amount to buy life insurance.
Period Certain The annuity will pay out for a specified period (as opposed to just "until death") if the annuity owner dies before the period is up, their beneficiary will get payout. The longer the guaranteed payment, the lower the payout.
Refund Annuity The contract will pay the different to the annuitants estate of any difference between the lump sum paid up front and monthly payouts.
Can be paid back in installments or in cash lump sum.
Favorable to younger people
Joint and survivor Annuity Annuity's payout is computed based on two lives. Under joint and last survivor annuity the insurance company promises to make payments until both annuitants die
Joint Life Annuity Annuity's payout is computed based on two lives. Under joint life annuity the insurance company stops making payments after the first person dies. There is no known useful application of JT life.
Single Premium Deferred Annuity SPDA Annuity is bought with a single premium. Earnings accumulate tax deferred until distributed.
Exclusion Ratio Used to calculate amount excludable from income tax
basis / expected return
Taxation of Annuity - Earnings accumulate tax deffered during accumulation stage - Once distributed some earnings are taxable based on exclusion ratio. - Corporations pay income tax on income received from the contract - Premiums are deductible when the annuity premiums are paid in the form of a bonus to the employee. (The employee owns the annuity.)
Annuity Withdrawals Contracts issued after Aug 13 1982 are LIFO. Withdrawal is taxable interest to the extent that the cash surrender value of the contract exceeds the investment. Also subject to the 10% below age 59.5
Homeowner's Insurance Section I coverage A. Dwelling B. Other Structures C. Personal Property D. Loss of Use
Section II Coverage E. Personal Liability F. Medical Payments
A. Dwelling Insures the dwelling and any connected structures including a garage, fence, deck and materials / supplies to be used for construction located on or next to the property. The land is excluded.
B. Other Structures Insures other structures that are apart from the dwelling by a clear space. Ex. pools, detached garages, fences, patios etc. Usually covered as a percentage of the dwelling limit. (10% of dwelling limit)
C. Personal Property Covers personal property anywhere in the world. Has internal limits ex. $1,000 for watercraft, jewelry, furs. $200 for cash money. $2,500 for silverware (theft only). Property excluded: animals, motor vehicles, aircraft, property of roomers/ boarders, property in an apartment rented to others 50% of dwelling coverage
D. Loss of Use Coverage for additional living expenses that arise if you cannot live in your dwelling due to covered damage. Practical normal standard of living. Insurance pays the difference between normal living expenses and the additional expenses. Not ALL expenses. 30% of dwelling coverage
E. Personal Liability Liability insurance to protect against damage for which the insured is legally liable arising out of bodily injury or property damage.
F. Medical Payments Provides up to $1,000 per person of coverage for necessary medical expenses of persons other than the insured who are injured while on the insured's location.
Basic Covered Perils WHARVES / FLT Wind Hail Aircraft Riot Vandalism Explosion Smoke Fire Lightening Theft
Broad Perils Everything in in basic plus RAF Rupture of a system Artificially generated electricity Falling objects Freezing of plumbing
Open Perils Covered everything except: A1 ordinace or law (loss caused by change of laws, construction, repair, demolition) A2 earth movement (earthquake, landslide, volcano eruption) A3 water damage (flood or if waterborne material backs up into house) but you can pay extra premium to have coverage "the water backup and sump discharge or overflow endorsement" A4 power failure A5 neglect (direct or indirect loss from neglect of the owner to use reasonable means to save the property after a loss) A6 war A7 nuclear hazard (exception is loss caused by fire even if fire is result of nuclear hazard) A8 intentional loss A9 Government action (destruction, seizure, confiscation of property by government authority)
Difference between HO2 & HO3 Difference between HO2 & HO3 is the dwelling, other structures and loss of use coverage they are on named broad peril in HO2 and open peril in HO3, personal property coverage is on a named peril basis under both forms with identical coverage for 16 named perils. HO3 is more comprehensive.
HO3 vs HO5 In HO5 the contents of the home are covered under the open peril form. HO3 is just broad peril coverage.
HO4 Renters policy. No structure coverage. Broad coverage on personal property.
HO6 Condo coverage. Is similar to HO4 with broad named peril coverage Unit owners building items: covers additions and alterations can get an endorsement to cover open peril basis on unit owner's building or personal property, both are available can add a rental unit coverage endorsement Loss assessment Loss of use coverage is broad 50%
HO8 Modified coverage form -obsolete types of construction, too large in relation to insureds needs, older homes -similar to HO2 but some limitations including -policy doesn't involve standard replacement cost provision contained in other homeowners forms but substitutes a unique functional replacement cost approach to building losses, theft is limited to $1000 each occurrence -contract agrees to make functionally equivalent repairs to avoid costly repair costs
Scheduled property endorsement floater To add insurance to things like jewelry, golf items, stamps, coins, art, antiques etc. On an open peril basis Items listed out and insured for a specific value
Property Loss Calc The coverage on dwellings and other buildings is on replacement cost basis if insurance is at least 80% of buildings replacement cost it will be replaced rather than cash value. personal property is replaced at cash value. 80% rule eliminates depreciation
((insurance carried / insurance required after coinsurance) x loss ) - deductible = amount paid by insurance
Auto Policy A. Liability per person/ per occurrence/ property damage B. Medical payments per person/ per occurrence C. Uninsured motorist per person/ per occurrence D. Damage to your auto collision loss, other than collision Can be written for husband & wife in same household Cannot be used for transportation of goods & materials Cannot be rented to others For private passenger use only
Covered Auto Vehicle listed in the declaration plus newly acquired vehicles, trailers, temporary substitute vehicles (due to breakdown, repair, loaner etc)
Newly Acquired Vehicles Replaces an existing auto, automatically has coverage A B & C. Part D is different, needs to be covered within 14 days.
Who is covered? -named insured + spouse (spouse can lose coverage if they leave the household) -a family member who is living in the same household -any one using the auto with your permission
PAP Part A: Liability Coverage -Protects the insured against loss arising from legal liability when his or her automobile injures someone or damages another person's property. Usually has a single limit but can be split limit 10000/20000/5000
PAP Part B: Medical Payments will pay for bodily injury caused by accident & sustained by insured within 3 years Who is the insured: the named person covered and any family member or if the named or family member is struck by a car. Persons other than the insured/ their family are covered for medical payments but only while occupying the insured's covered auto. Some exclusions- auto has less than 4 wheels, used as a public or livery conveyance, autos other than a covered auto used by named insurer or family member, autos operated without reasonable belief to do so, trucks being used in business, racing auto Limitations- no duplicate payments, payment is made on pro rata basis when coverage exists, subject to subrogation clause
PAP Part C: Uninsured Motorist Coverage promises to pay the amount that an injured insured could have collected from the insurer of an uninsured driver if such driver had carried auto liability insurance. Can apply yo medical expenses, lost wages, pain and suffering. But not punitive damages. ~standard limit is the minimum required under the state's financial responsibility law, but higher limits are available ~uninsured motor vehicle- doesn't have insurance, does have insurance but the company is insolvent, is in a hit and run
Covers named insured, spouse, family members, and anyone occupying the covered auto.
PAP Part D: Damage to Auto Coverage -Collision coverage -Other than collision (comprehensive coverage) Open Perils covered: -breakage of glass -loss caused by missles -falling objects -fire, theft, larceny -flood -earthquake -windstorm, hail -vandalism, riot -contact with animal -explosion
Umbrella Policy -Provides broader coverage then basic policies -The secondary payer to another insurance policy -It is always a good idea for a client to have an umbrella policy Excluded: intentional acts, damage to your own property, business pursuits, professional malpractice, directors / officers activities, worker's comp obligations
Business Owner's Policy -Is good for small to medium sized businesses. Comes with real property, content, medical payment coverage and liability protection. Does not included professional liability insurance. -The premium is deducible. - E & O errors and omission's policy is coverage for professional activities
Commercial Umbrella Policy Most exclude any error, omission, malpractice, or mistake of a professional. Premium is deductible.
Professional Liability - Premiums are deductible - Failure to use due care and the degree of skill expected from a person in the profession in which the insured is enagaged. Appropriate where the substandard conduct may result in bodily injury.
E & O errors and omission's policy Appropriate where the substandard conduct may result in property damage or loss of intangible property (money)Professional liability is covered only by errors and omissions. The personal umbrellas, the commercial umbrella, and the BOP all have exclusions for professional liability.
Occurrence Policy If the policy is in effect at the time of the occurrence, you are covered no matter when the suit is brought, even if the policy no longer exists.
Claims Made Policy covers you for any covered claim provided you meet: 1. insured when the claim is made 2. You have continually renewed the policy until the time the claim is made
The tail An extended reporting period. It takes effect when your policy is terminated. The tail endorsement allows you to report claims that come in after the policy is terminated for covered incidents that occurred when you were insured.
Workers Comp (absolute liability) Premiums are deductible by the employer, benefits are received income tax free. All employers have to have workers comp coverage under law Benefits: -medical expenses without limit on time or money, not subject to deductibles / coinsurance -disability income with very short waiting period, benefits are usually 66% of workers salary -death benefits payable to family -rehab benefits
Unemployment insurance Usually included in recipients gross income (taxable) Tax deductible to company
Cash / cash equivalents money market deposit accounts: offered by financial institutions and insured up to 250k money market mutual funds: open ended MFs and not insured
T bills short term securities with maturities of one year or less. issued at a discount from face value. weekly auctions.
Commercial Paper short term, unsecured, promissory notes issued by large corporations. Denominations start at 100k. Maturity is 270 days (9 mo) or less. Normally sold at a discount.
Eurodollar The deposit of a US dollar in any foreign bank
Yankee bonds Bonds issued by foreign banks and companies sold / held in the US. Registered with SEC.
Par bonds issued at par and included a stated coupon interest amount.
Discount bonds bonds trading below par
Bonds pay interest at the end of the period. are issued at par value. pay semiannual interest.
Rating agencies S&P and Moodys
Debenture a general debt obligation backed only by the full faith of the company.
Risks associated with bonds Credit risk: this is what the agencies rank on
Risks of corporate & munis: Default Reinvestment Interest Purchasing power
Risks of Government bonds: Reinvestment Interest Purchasing power
Risks of STRIPS & TIPS: Reinvestment Interest
Accrued interest interest is earned on the bonds daily
Original issue discount A bond issued at a discount will be accreted over the bond's life. Each year the portion of the discount that has been "earned"is included as taxable interest income, and the bonds basis increases. a zero coupon bond owner must report interest income although the bond pays no interest before mautrity.
Tbills Tnotes Tbonds Issued between $100-$1,000,000 3,6,12 months Issued between $1,000-$100,000 1-10 years Issued between $1,000-100,000 10-30 years
STRIPS The US government's 0 coupon bond. Direct obligation of the federal government. Usually purchased by pension plans because taxes are due on the interest, but no interest is paid until maturity (phantom income). STRIPS are zero coupon treasury bonds. They Not suitable for UTMAs.. would throw off phantom income
TIPS Inflation protected securities. The face value is adjusted semiannually. The amount of the semi annual interest rate will rise, as inflation rises. The higher the inflation, the higher the face value, the higher the interest rate. Sold in $1,000 demoninations. Investor is taxed annually on the appreciation of face value and on interest. Exempt from state and local taxes. Can be adjusted for delation as well. Interest rate is fixed, face value is variable.
Series EE bonds Nonmarketable, non transferrable, nonnegotiable, and cannot be pledged as collateral. Issued at face value. Have fixed rates of interest for 30 years. Demoninations as low as $50. Rates are adjusted for new bonds twice a year May 1 and Nov 1. Interest accures monthly and compounds semi annually. Interest is not subject to federal income tax until the bond is redeemed. Redemptions can be tax free if done by the the parent and used for education expenses. Used to be able to exchange EE bonds to HH bonds, but no longer.
I bonds Inflation indexed accrual securities of the US govt. Nonmarketable, non transferrable, nonnegotiable, and cannot be pledged as collateral. Issued at face value. Accumulate interest monthly. Interest is compounded every 6 mo, no guaranteed interest rate (different from EE bonds) The interest rate is compounded in 2 parts: fixed base rate and an inflation adjustment. The rate stays the same for the life of the bond.Inflation adjustment is adjusted every 6 months. The owner can choose to defer tax like series EE.
General Obligation Muni bonds Backed by full faith credit and taxing power for the company. They are considered the safest type of municipal credit
Revenue backed muni bonds Backed by a specific source of revenue to which the full faith and credit of the issuer has not pledged. They are more risky than GO bonds. Every issuer wants to be AAA by S&P.
High yield corporate bonds Rating of BB or lower, pays higher yield, to compensate for higher risk.
Convertible bonds Owner can convert bonds into a specific number of equity shares.
Bond investment value Present value of the bond (1000 par bond with 7% interest, 5 years to maturity if a compariable bond has 8% yield? 1000 FV 70/2 PMT 5*2 n 8 i PV = ?? = 959.45
Callable bond Callable is the right to redeem at a predetermined price at a date prior to maturity. Bond is likely to be called if interest rates drop. The cost to the issuer for early redemption is the call premium.
Put bond Allows the holder to sell the bond back to the issuer. investor would exercise the put bond if they bought the bond, then expected interest rates to rise
Ginnie Maes GNMA Safest corporate issues, as the bonds are backed by real property and are a direct guarantee of the US govt. Buys FHA, VA, farmers home admin insured mortgages. Pass through certificates. Minimum denomination is 25k. Interest rate risk & reinvestment rate risk. Each payment includes interest and return of capital.
CMOs The amount received by the investor changes each month. Less risky because they lump mortgages together. Multiclass pass through securities. A - Z tranches A= quick duration Z= longest duration
Preferred Stock Typically issued with a stated dividend, duration is often infinite. Price fluctuations in preferred stock exceed those of bonds. The typical purchaser of preferred stock is a corporate trustee with extra funds on hand. If a corporation buys these securities, then the dividends are excluded from taxation up to 70% Cumulative- must pay all dividenends in full before common stock dividends are paid noncumulative- missed dividends do not have to be made up Can be callable
Qualified Dividends Special tax treatment for qualified dividends (think LTCP rates for individuals) and 70% exclusion for regular C corps
ADRs Shares of foreign based companies held in the vault of a US bank and entitle shareholders to dividends and interest. Prices are in US dollars, and dividends are paid in US dollars, but they are quoted in foreign currency of origin. Most qualify as "qualified foreign corporation"and get the 15% qualified dividend rate.
ETFs Security representing a basket of stocks or bonds. They can be open or closed ended. They buy and sell throughout the day. Most are closed ended. They have low management fees and you can buy on margin. ETFs do not need to allocate taxable gains to investors until they redeem their shares. Trading orders can include stop-loss and limit orders Can be sold short
Unit investment trusts No day to day portfolio management. Passive investment, assets are frozen. No new securities can be purchased and securities originally purchased can rarely be sold. Can trade the unit investment trust on the secondary market. Payments can be income and/or return of principal.
Mutual Funds Open ended funds continue to sell shares to investors after the initial sale that starts the fund. The shares are nonnegotiable but redeemable.
Closed Ends funds No new shares are offered after once the fund's book is closed. Often holds illiquid securities.
Hedge Funds Aggressively managed using leveraged, long, short, derivative positions with the goal of generating high returns.
GICs Guaranteed investment contracts: are like CDs but issued by insurance companies. Terms range from 2-5 years and bear a guaranteed rate of interest. Value of GICs does not fluctuate with interest rates, but their value can depend on interest rates. Popular for defined benefit plans.
Real Estate Hedge against inflation Low correlation to the stock market Diversification in portfolio
Unimproved land Passive investment. Cannot generate income or depreciation. Primary return would be if it appreciates. Can provide negative return.
Improved Land typically generates income. Intrinsic value can be calculated using NOI
NOI (net operating income) Gross rental receipts +non rental income -vacancy -operating expenses =NOI
Cash expenses only NOI must be divided by cap rate to arrive at intrinsic value
REIT Real estate investment trusts are similar to closed end companies. But hold real estate, short term construction loans, mortgages. Diversification & marketability. Traded on an exchange or OTC. 75% of the REITs holdings has to be from real estate investments, the other 15% can be GNMAs or similar. If the REIT distributes 90% or more of its net investment income, it only pays tax on the undistributed portion. Assume REIT always pays out 90% of income.
Equity REITS invest in income producing properties such as office buildings, hotels, shopping centers, etc. Modest amount of leverage to finance the property purchases. Too much leverage and higher than expected vacancy can affect REITs cash flow resulting in decreased dividend payments and NAV Equity REITs can be leveraged. Equity REITs own the properties providing the investor with a hedge against inflation. An equity mutual fund or a Mortgage REIT is a poor hedge against inflation. In a truly inflationary time (1981), stocks did poorly. Inflation hit 21%. Inflation is the biggest factor in this question.
Mortgage REITs invest in loans to develop property or finance construction. Construction loans can earn high interest rates, but do carry high default risk rates. Vulnerable to purchasing power risk. Not liquid
Private REITs Reg D private placement, do not require a public registration filing. Shares can only be purchased by accredited investors and typically offer the possibility of larger than normal returns.
Derivatives A financial instrument whose value is based on a other asset, like an option 1 option = 100 contracts
Strike Price The minimum price a stock can be sold or bought.
Intrinsic value the minimum price an option will command, it is the difference between the market price of the underlying asset and the exercise price of the option
Premium the market price (cost) of an option. as the option approaches its expiration date, the market price of the option approaches its intrinsic value
Time Premium amount the market price of an option exceeds its intrinsic value
Put option gives the stockholder the right to sell and obligates the issuer to buy. It is used when investors are pessimistic on a stock (bearish). Writers (sellers) of the put want the premium. Buying a put is the best way to defend against loss.
Put - In the money Market price is below the exercise price intrinsic value is this
Put - Out of the money Market price is above the exercise price no intrinsic value, it is negative
What type of option offers the highest potential for loss? Writing a naked call
Call option Gives purchasers the right to buy and obligates the issuer to sell. Used in an optimistic bear market. Call writers can get premium. Covered call is a call written on a stock already owned by the call writer. They can keep the premium interest if it is called. Selling of a call without owning the stock is called a naked call. Writer seeks premium income. Buying a call can make you the most money, upside is unlimited.
Call - in the money Market price is above the exercise price
Call - out of the money Market price is below the exercise price intrinsic value is this, must be 0
Time value and speculative value If there is a long time expiration, then the premium is probably due to time value. if it has a short time to expire, the premium is probably due to volatility.
Protective Put buying a stock and a put for the same stock. this is a long position in both the stock and put, the put acts as insurance against decline in the underlying stock.
Straddle When someone buys a put and a call on the same stock, because they feel there will be volatility, but unsure in which direction it will go. Will make money as long as the stock moves in either direction by an amount greater than the combined premium.
Call options (9 mo or less) - taxability At the time of purchase: nondeductible capital expenditure To the writer: due to lapse: premium received is a short term gain due to exercise: premium received is added to sale price( would then be a LTCG or STCG depending on how long the security was held) To the holder: if the option is not exercised then the option is considered sold and produces a short term loss
Put options (9 mo or less) - taxability To the writer: due to lapse: premium received is a short term gain
Long term equity anticipation securities (LEAPS) - Expiration date can last form 9 mo to 3 years The buyer of a LEAPS option will be taxed at LTCG if they hold the contract for at least a year + 1 day. Other wise it is a STCG. An investor who exercises a LEAPS call option then sells the stock right away would be subject to STCG. Even if they had a LEAPS contract for 12 mo or more. Once LEAPS are exercised, then the investor must hold the shares of the stock for 12 or more months in order to pay LTCG
Warrant Option to purchase, within a specified time period, a stated number of shares of common stock at a specific price. Warrants are issued by corporations. (different from calls which are made by individuals) Warrants have maturities of a few years, calls generally expire in 9 mo Warrant terms are not standard, and call options are.
Futures contract an agreement between the buyer and seller, through a commodity exchange for future delivery of a commodity at a specified date for a specified price. Farmer wants to sell one (short position) or more contracts to lock in higher price, while buyer wants to protect against increase in price, so they buy a contract (long position)
Currency futures Futures contracts that are for future deliveries of currency. hedgers in foreign futures are multinational firms that make and receive payments in multiple currencies. Firms establish hedge positions to lock in the price of the currency and avoid risk associated with each currency.
Short Selling Used when an investor thinks the price of a security will decline. The short seller borrows the security, when the price declines the short seller instructs the broker to repurchases the security and cancel the short position by replacing the security. The investor profits on the difference between the price at which the borrow stock was sold and which it was repurchased. Short sellers must have margin Net proceeds from a short sale , plus required margin, are held at broker No funds are immediately received by the short seller There is no time limit on a short stock Dividends declared on any stock sold short must be converted by the short seller.
Can put the client at a lot of risk.
Collectibles Typically coins, stamps etc. They can rise sharply in price during inflationary periods. Limited markets for some of the products. There is market inefficiencies and little regulation of the market. The returns on collectibles may be negatively correlated with the return of financial assets, this suggests collectibles can provide diversity to a portfolio.
Reg D Private placement. It can be sold up to a maximum of 35 non accredited investors and an unlimited about of accredited investors. Exempt from registration, but full disclosure but be given to investors. Accredited investor: 1mm + net worth or annual income of 100k (individual) or 200k (couple) Doesn't include primary residence. Non accredited investors must be sophisticated. If they cannot evaluate the issue on their own, then they can hire a purchaser representative (lawyer or accountant) they can evaluate and sign letter in offering circle.
Systematic Risk Un diversifiable, measured by beta Purchasing power risk Reinvestment rate risk (investing short term) Interest rate risk Market risk aka systematic risk Exchange risk
Unsystematic Risk Diversifiable by diversification
Total risk Systematic + unsystematic risk. measured by standard deviation
Liquidity a security or commodity can be sold or purchased without delay and without a substantial change in price - absent new information. Both speed and stability of price. Closed end funds, ETFs and brokered CDs are generally not considered liquid (possible loss of princliple)
Marketability Refers to the speed of the transaction. Necessary, but not the only condition required for liquidity. -Savings/ checking / money market accounts and mutual funds are redeemed, not marketable. -REITs, ETFs, closed end funds, and brokered CDs are marketable. Marketability is the speed and ease with which a security may be bought/sold regardless of price fluctuation. They are not marketable if they must be redeemed through the issuer, rather than other investors.
Exchange rate Risk of uncertainty of the price at which one's country's currency can be converted to another's. All international investors face the uncertainty in the returns after they convert the foreign gains back to their own currency.
Devaluation The lowering of the value of a currency relative to the currencies of other nations. Devaluation can result from a rise in value of other country's currencies relative to the currency of a particular country.
Revaulation An increase in a country's value relative to the currency of a particular country.
Foreign currencies Reduced risk due to lower correlation with the US stock market. Taxed twice, first in foreign country, then in US. Also foreign markets are not as efficient as US markets. -Buy global mutual funds -buy ADRs -buy international mutual funds
Correlation Coefficient +1 (max risk) to -1 (no risk) measures how much 2 stocks are related to each other or how the price movements of one will affect the other. Need standard deviation and covariance to calculate correlation coefficient. co variance = correlation coefficient (standard dev1 standard dev2)
Correlation coefficient = covariance / (standard dev1 * standard dev2)
A negative correlation coefficient will make beta negative.
Covariance positive covariance = correlation is positive.
Coefficient of variation (CV) Measure of relative variability used to compare investments with widely varying rates of return and standard deviation. It is the standard deviation divided by the average. CE indicates risk per unit of expected return. Higher CV = more risky.
Standard Deviation Measures variability of returns used in a nondiversified portfolio and is a measure of total risk. Absolute measure of variability of results around the mean. 68% of results are in the first standard deviation, 95% within the second deviation, and 99% within the third deviation.
Beta measures volatility of returns used in a diversified portfolio and is a measure of systematic risk. The market as a whole has a beta of 1. Above 1 = more volatile than the market below 1 = less volatile than the market The greater the beta, the greater the systematic risk (nondiversifiable) associated with the stock. Beta = (correlation coefficient * standard deviation of security) / standard deviation of the market. Beta of the portfolio is equal to the weighted beta.
Geometric mean Superior method of measure of change of wealth over multiple periods. Compounds returns over more than one time period. Used to evaluate the performance of the portfolio manager. Multiply all returns together to get the FV, use of number of years, and PV as 1, calculate for i.
Time weighted return aka geometric return measures investment performance as a % of capital at work, effectively eliminating the effects of additions/ withdrawals and their timing that distort dollar weighted returns
Dollar Weighted return Measures changes in total dollar value, treating additions / withdrawals of capital as part of the return along with income, cap gains / losses. Same as IRR/ NPV. Manager to manager comparisons are not possible. Uses reinvestment rate.
Real Rate of return inflation adjusted rate of return (1+ rate of return - 1+ inflation rate ) - 1
nominal returns actual returns earned over a given period of time without accounting for the purchasing power of the dollar inflation.
Holding period return Total return (income plus price appreciation and dividends minus margin interest) from purchase to sale divided by cost of the investment. Fails to consider the timing of the cash flows. If the time period is over 1 year, then the HPR overstates the true annualized return. If it is less than one year, it under estimates.
Internal Rate of Return IRR The discount rate at which the present value of future cash flows equals the cost of the investment. When the NPV of the cash flows is 0 the discount rate being used is the IRR. When the IRR is greater than the required return, the investment is acceptable.
Yield to maturity Rate of return on bonds, defined as a promised compounded rate of return an investor will receive from a bond at current market price, if held to maturity. YTM takes into account both the market price of the bond as well as any cap gains or losses on the bond if held to maturity. Always use semiannual compounding. Assumes all coupons are invested at at least the YTM rate. 0 coupon bonds do not have reinvestment rate risk, because there is no coupon to be invested. Pv= amount bond is purchased for FV = 1,000 n = 2* number of years PMT = annual coupon /2
Yield to call Presumes the bond will be redeemed on the first call date. Same calculation as YTM, except FV is the call price maturity date is first call date
Current Yield Takes into account the current price of the bond. CY = annual interest in dollars/ current price
premium bond bond price is higher than par Lose money when bond matures
nominal yield -- Highest yield Current yield YTM YTC -- lowest yield
discount bond bond price is lower than par Makes money when bond matures
nominal yield -- lowest yield Current yield YTM YTC -- highest yield
Taxable equivelant yield TEY shoes the interest rate on a taxable bond necessary to provide the same after tax return as a muni. TEY= tax exempt yield / (1 - marginal tax rate) or Tax exempt Yield = taxable equivalent yield * (1 - marginal tax rate) No state / local tax on instate munis
Duration Measures the weighted average maturity of the bonds cash flow on a present value basis. Enables the investor to compare price volatility of bonds with equal coupons but different terms on the basis of time. Risk averse investors should prefer bonds with low durations. Aggressive investors should prefer bonds with high duration only when they anticipate rates will decline (bond prices then rise). -Most important measure of how risky bonds are because it measures their sensitivity to interest rate changes. Duration reveals how a bond will react to a particular change in interest rate. Ex. if a bond has a duration of 8 years & interest rates fall by 1%, then its value should rise by 8%. If interest rates rise by 1%, then its value should fall by 8%.
Interest / duration trade off High coupon (interest) = low duration small coupon (interest) = high duration
maturity / duration relationship long maturity = high duration short maturity = low duration.
Interest rate risk 2 parts: a. price risk b. reinvestment rate risk
immunization a passive bond strategy that seeks to safe guard a bond portfolio against interest rate volatility. A portfolio is immunized if the duration of the portfolio is equal to a preselected time horizon for the portfolio
Duration of 0 coupon bonds They have durations equal to their maturities. Because they have no coupons, their price fluctuate more than coupon bonds with the same maturity.
Duration to manage bond portfolios If interest rates are expected to rise, shorten duration. -- buy high coupon bonds with short maturities Interest rates going up, means bond prices and duration become lower. You want to shorten duration, you wither pay more (increase interest rates) or pay quicker (shorten maturity) If interest rates are expected to fall, lengthen duration. -- buy low coupon bonds with long maturities Interest rates are going down, meaning bond prices and duration go up. You want to decrease your interest, or lengthen the maturity.
0 growth model price = dividend / required rate of return Same as preferred stock valuation
Constant Growth Model Price = dividend * (1+growth rate of dividend) / required rate of return - growth rate of dividends. You should buy the stock if your calculated price is higher than the market price. -If the market lowers the required rate of return for the stock, the value of the common stock will rise -If investors expect that growth in dividends will be higher as a result of favorable developments for the firm, the value of the common stock will rise Compare predicted stock value with actual value. focuses solely on dividends and ignores other factors like competition, new products and investor setiment. Used for large stable companies in a mature market.
Yield Curves Shows the market rates of interest for bonds of different maturities with similar credit ratings.
Normal yield curves (positive) As maturities lengthen, yields increase. Investors demand a premium for the extra risk associated with longer term maturities Upward sloping
Inverted / negative yield curves If the Fed reserve tightens short term credit to slow the economy, then short term rates can rise above long term rates. This happens when the economy appears to be overheating, increasing inflation fears. Downward sloping
Price / earnings Many stocks pay no dividends/ have no growth. Current market price = earnings x p/e ratio The stock is over valued if its current price is higher than the p/e ratio Used to determine how much investors are willing to pay for a stock, relative to the company's earnings. Good to compare within the same industry. Tech companies have high P/E ratios Public utility companies have low P/E ratios Lower P/e ratio, better for investors looking to buy
Book Value Accounting value of equity shown on a balance sheet. Sum of common stock outstanding, capital in excess of par, and Retained earnings.
Return on equity determines profitability ROE = net income (EPS) / common stock equity (net worth or book value)
Dividend payout ratio percentage of earnings paid to the common shareholder as cash dividends DPR = common dividends paid/ EPS
Efficient Frontier (Markowitz) Shows the investor their expected return based on a given amount of risk. Also incl is covariance. Efficient frontier Below the efficient frontier = inefficient above the efficient frontier = unattainable
Risk tolerance: very risk adverse very steep indifference curve
Risk tolerance: less risk adverse Flatter indifference curve
CML: Capital Market Line Macro aspect of CAPM. The CML specifies the relationship between risk and return of the portfolio. Only used in financial markets in equilibrium, efficient.
SML: Security market line Can be used to value any asset whether an individual asset or a portfolio. Doesn't matter if the portfolio is diversified or not diversified. Securities above the SML are undervalued Securities below the SML are overvalued Assets on the SML have an expected rate of return equal to its required rate of return.
CAPM required rate of return= Rf + (Erm - Rf)B Rf= risk free rate Erm= market return B= beta
Market risk premium (Erm - Rf)
Stock Risk premium (Erm - Rf)B
Efficient Market Hypothesis -Investors cannot expect to outpreform the market on a consistent basis. Theory contends that all known information is reflected in the assets price. Day to day price changes will follow a random walk over time. Price changes are unpredictable and patterns are accidental. Passive investors believe in this strategy.
Strong Form Stock prices reflect public and private info. Not even access to inside info can produce superior results
Semi Strong Form All publicly known info & past prices is fully reflected in the stock prices. Neither technical or fundamental can produce superior results. Only private info could produce superior results.
Weak Form -Information everybody knows (historical data) -Price and volume -Use of fundamental analysis may produce superior results
Fundamental analysis book value dividend returns attempts to value stock by examining general economic conditions and the company's financial condition and growth prospects
Technical analysis market prices trends volumes of securities identify trends predict changes in the market
Anomalies p/e effect- stocks with low p/es perform better than those with high p/es small firm effect- stock of small firms out performs those of large firms January effect- stocks decline the last few days of the year and then rebound in Jan Neglected firm effect- stocks of firms not commonly studied by analysts outperform stocks of firms that receive considerable attention from analysts value line phenomenon- stocks rate 1 by value line investment survey outperform those rated 5 by the survey.
Top Down Method Investor looks at general trends in the economy, then select industries, then companies that should benefit from those trends
Bottom Up Method Searches for individual stocks with outstanding performance before considering the impact of economic trends
Ratio Analysis Ratios of one firm are compared with the same ratio of similar or all firms in a single industry.
Technical Analysis Use charts or computer programs to project price trends. Most examine the short or intermediate term. Dow Theory, Barron's confidence index, odd lot theory, investment advisor opinions, advance/decline line, moving average, mutual fund cash position.
Charting A type of technical analysis, believes in support and resistance levels Resistance: price ceiling Support: price floor
Sentiment Indicators Type of techincal analysis, measures the bullish or bearish mood of investors
Fundamental Analysis Looks at GDP, inflation, unemployment
Tax efficiency -turnover: number of times an asset is replaced during an accounting period -timing of cap gains: mutual fund returns are before tax, but income and cap gains affect return the investor retains
Mutual Fund Income Mutual funds have to distribute their earnings, to avoid paying corporate income taxes. So, they distribute net gains to shareholders at least once per year. This income can either be capital gains or dividends. -Unlike investing in individual stocks, the application of the capital gains tax rate has nothing to do with how long YOU have owned shares in a mutual fund but rather how long the FUND has held the assets in its portfolio. -One of the most effective ways for a mutual fund to increase its tax efficiency is to reduce its turnover ratio. -Purchases and sales take place directly between investors and the fund. The price of the fund is not determined until end of business day, when net asset value (NAV) is determined.
Stock Split To make ownership more affordable. 2:1 one share becomes 2 shares
Reverse Stock Split When shares consolidate, because the price is too low for institutional investors or because the company is about to be delisted
Wash Sale Rule No loss deduction is allowed for an loss of a stock or security if within a period beginning 30 days before and ending 30 days after the sale, the taxpayer acquires substantially identical stock or securities
Ex Dividend Date Date of record for the corporation is the second business day after the ex dividend date. On that record date , trades are settled and reflected on the corporations books. To be on the corporation's books as a holder of record and receive the dividend, the investor must purchase the stock before the ex dividend date.
Sharpe Ratio Measure expressed as the ratio of the excess returns of the portfolio to its standard deviation Higher is better! Measures total risk
Treynor Ratio Measure expressed as the ratio of the excess returns of the portfolio to its beta Higher is better!
Jensen ratio (alpha) This measure calculates the portfolio return actually attained and subtracts from it what should have been based on risk taken in the portfolio. Measures the contribution of the portfolio manager. Positive is good.
Jensen / Treynor Systematic Risk Beta High R^2 Diversified Look for highest alpha, then look for highest Treynor
Sharpe Unsystematic Risk Standard Deviation Low R^2 Not Diversified
Investment strategies Market Timing: purchase and sale of securities based on short term price patterns as well as asset values Passive investing (indexing): weighs portfolio to match a broad based index such as the S&P or the client buys an index fund Buy & Hold: a natural outcome of a belief in the EMH, buy securities and hold them until the investor needs them. Dollar Cost averaging: An equal amount of dollars is invested each period
Bond Ladder Bonds are purchased with different maturity dates. As a bond matures, a new long term bond is purchased.
Bond Barbell A barbell strategy is an investment in short term and long term bonds that requires periodic rebalancing of the portfolio. if the portfolio needs to be restructured due to a change in interest rates, only a group of bonds needs to be sold.
Margin Calculation The Fed's Reg T requires initial margin to be 50%. The second level of margin is applied by the exchanges and FINRA, which have their own margin requirements. (normally 25%) Called minimum maintenance margins and are ongoing margin requirements after initial Reg T requirements are met. (1 - inital margin %) / (1- maintenance margin %) x purchase price of stock
Strategic Asset Allocation Made once every few years, using simulation procedures to determine the likely range of outcomes associated with each mix. The investor is looking for a long run asset mix.
Rebalancing Done in response to changes in the economic environment or in the life cycle of the client
Tactical asset allocation Changes in asset mixes are driven by changes in predictions concerning asset returns. It is a market timing approach intended to increase exposure to a particular market when its performance is expected to be good and decrease when performance is expected to be bad.
Gross income inclusions Wages, salaries, tips IRA distributions Pension & annuities Alimony received unemployment income taxable social security ordianry dividends - sch B taxable interest - sch B business income and losses - Sch C Cap gains/ losses - Sch D Real estate - Sch E Punitive damages (minus wrongful death)
Gross income exclusions gifts inheritance child support muni bond income workers comp payments compensatory damages
Adjustments (above the line) IRA contributions student loan interest HSAs moving expenses self employment tax 100% self employment heath insurance Keogh or SEP penalty for early withdrawal of savings alimony paid Capital losses & business losses
standard / itemized deductions (below the line) AGI is reduced by the greater of your standard or itemized deduction
Standard Deduction -Single 6,350 -Married joint 12,700 -married sep 6,350 -head of household 9,350 -elderly (65+) 1,250 -blind 1,250 -child unearned 1,050
Itemized deductions -medical, dental, qualified LTC expenses (>10%)* -state and local taxes* -personal property tax* - charitable gifts* -home mortgage interest -real estate taxes* -investment interest -casualty and theft losses Overall reduction cannot be more than 80% of deductions. 3% AGI floor on * deductions
Investment interest margin debt interest. Maximum deduction is the amount earned in investment income. Can carry forward excess interest paid to the next year.
investment income interest, dividends, royalties, STCG.
Qualified dividends and LTCG have different tax treatment than above income.
Casualty and theft losses A sudden/ unexpected loss. The amount of the loss is reduced by any insurance paid. A timely insurance claim must be filed for the loss. There is a $100 floor, then that amount is reduced by 10% of AGI.
1. lesser of basis / FMV 2. minus insurance reimbursement 3. subtract $100 4. subtract 10% of AGI
Miscellaneous Deductions not subject to 2% AGI floor: gambling losses up to gambling winnings impairments related work expenses for handicapped employees
subject to 2% AGI floor: fees to investment counselors tax advice and prep fees hobby losses employee home office expenses un-reimbursed employee business expenses union dues work closes expense safety deposit box rentals education costs job agency expenses
Home office expense deduction The exclusive use of the home must be for the convenience of the employer. The expenses must be taken as a misc expense subject to the 2% AGI floor. You must prove you use the home area exclusively and on a regular basis. Home office must be used to conduct business activities and there must be no other fixed location of the business where the taxpayer conducts substantial activities of the business.
Entertainment Expenses 50% is deductible if the company / self employed pays for it deduct on Sch C.
If you are salaried, but do not get reimbursed, then you can deduct 50% minus 2% of AGI on Schedule A.
Schedule A itemized deductions form
Personal and dependency exemptions $4,050 for you, unless you are the dependent of another tax payer. Your spouse, unless they file sep. For someone under the age of 19 as of the end of the year For someone under age 24 and a full time student at the end of the year. Parents can be claimed as dependents, but they cannot have a taxable income of more than $4,050. It is subject to phaseout at 2% per 2,500 if income is over 313,800. no extra exemptions are given for blind/ elderly
Kiddie Tax 1986 provision attempts to discourage the shifting of income to lower bracket taxpayers as a tax avoidance technique. All net unearned income of a child who has not attained age 18 and who has at least 1 parent alive is taxed at the marginal tax rate of their parents. This applies to all unearned income regardless of the source of assets creating the income, or the date the income-producing property was transferred. Children under 18 are entitled to a standard deduction ($1,050) and an additional $1,050 will be taxed at the child's marginal rate of 10%. This means an unearned income in excess of $2,100 is the child's unearned net income, subject to the parent's tax rate. No matter who (aunt, uncle, grandparent, parents) transfers assets to the child, the unearned income is always taxed at the parents marginal tax rate!
Standard Deduction for a child with both earned income and unearned income They can take the higher of: a. $1,050 for unearned income or b. $350 + the amount of their earned income. But no more than the single person standard deduction ($6,350)
Self Employment Tax Pays SS and medicare taxes for themselves a part of their income tax. Based on net earnings from self employment, not on taxable income. Self employment income: net schedule C income, board of directors fees, general partnership income (K-1), part time earnings Self employment income does not include: dividends or interest on investments, gains from property, securities or commodities, real estate income or rents paid, distributive share of income or loss of a limited partner, wages from an S corp, distributions from an S corp self employment income *.1413 = self employment income tax due You can deduct 1/2 of this amount.
FICA Tax 6.2% up to 127,200 + 1.45% unlimited
Credits for child and dependent care (until age 13) The credit is a % of expenses paid for care of a dependent to allow the taxpayer to work and earn income. Qualifying expenses are limited to 3,000 for one dependent or 6,000 for 2 or more dependents. Depending on income a credit percentage of 20% to 35% applies. Use 20% for the exam. 20% of 6,000 = $1,200
Child tax credit Individuals can claim a child tax credit of $1,000 for each child under age 17. The credit is for a son, daughter, step child, or foster child. The amount of this credit is phased out with an MAGI 110,000 married & 75,000 single. It is reduced by $50 for each $1,000 above the phaseout (phased out at 130,000 married & 95,000 single)
Foreign Tax Credit Any foreign taxes paid can be deducted on the front of the 1040, or they can be credited dollar for dollar against an income tax liability.
Adoption Expenses You have to adopt the child and pay out of pocket for the adoption related expenses, then the amount of your tax credit is directly related to how much money was spent on any adoption related expenses. IF you adopt a special needs child, you can take the whole credit, even if expenses were less than the credit. Qualified adoption expenses: adoption fees, court costs, attorney fees, cost to adopt a foreign child. Non qualified adoption expenses: costs to adopt spouse's child, surrogate parenting arrangement The credit is taken in the year the adoption is finalized. If the child is a foreign national, then you can take the adoption credit only in the year the adoption is finalized.
credit for the elderly (65+) and the permanently and totally disabled Can take this credit once the individual turns 65, or is under 65 and retired with a permanent and total disability, and receives disability income.
Deduction Deductions are worth more to higher tax bracket tax payers.
Tax filing requirements Installment dates: April 15, June 15, Sept 15, Jan 15
Extension is good for 6 months (Oct 15th)
Amended tax returns are filed wit 1040X
The tax payer can be represented by an attorney, CPA, enrolled agent, enrolled actuary. CFP is the normal wrong answer.
Tax Penalties Negligence: the accuracy related penalty is imposed if any part of an underpayment of tax is due to either negligence or to disregard of rules / regulations but without attempt to defraud. The penalty is 20% of the underpayment.
Fraud: deliberately trying to cheat the government. The penalty is 75% of underpayment.
Failure to pay: .5% each month the tax is unpaid, up to 25%.
Failure to file: 5% of the tax due each month, up to 25%
Even if you don't have the money to pay the taxes, the best option is still to file.
Estimated Tax To avoid the penalty, pay the lesser of the following: 1. 90% of the current years tax liability 2. 100% of the prior years liability ( or 110% if the previous year's AGI is over 150,000)
Cash accounting Firms realize revenue from services performed in the year the payment was received, reguardless of when the services were performed. Businesses with average annual gross receipts of over 5mm for an prior 3 year period cannot use the cash method Can be used for consignment shops.
Accrual Method accounting Firms realize revenue when the earnings process with goods and services is complete, regardless of when payment for the goods and services is received. This method is mandatory for purchases and sales where there are inventories
Hybrid Uses accrual, cash and any other specifically permitted method
Changing accounting methods Cannot be done without advance permission from the IRS
Long term contracts A long term contract to manufacture, build, install property, if not completed in 1 tax year. They use the percentage of completion method.
Installment Sales When some or the entire amount on the sale of property consists of the buyers note the seller may be entitled to use a special method of accounting for the gain realized on the transaction. The installment method provides that the realized gain is not recognized in the year of the sale. instead the gain is spread over the lifetime of the note. Exceptions: if all payments are received in the year of the sale if the property is a publicly traded security if the property is sold at a loss if the property is sold to a related party, who sells the property within 2 years of the original purchase date
Net operating loss When business expenses are in excess of income. No taxable income, no tax cost. Can only be used by self employed, estates, trusts, and corporations. CANNOT be used by S corps and partnerships. NOLs can be carried back 2 years and forward 20 years. Important to be able to go back and amend past tax returns and get past taxes paid back.
Sole Proprietorship -Easy to start and terminate (no legal formalities) -100% of medical insurance premiums deductible by owner -availability of pension plans (SEP, Keogh) -conduit of income / losses to owner file on schedule C (on 1040)
-unlimited liability -business dies with owner -capital structure depends on resources of owner
Partnership (general partnership) An association of 2 or more owners to carry on the business for profit -Partnership can be oral (written preferable) -100% of medical insurance premiums deductible by owner -availability of pension plans (SEP, Keogh) -conduit of income / losses to owner -no double taxation -File 1065
-unlimited liability, joint and several liabiliy -capital structure depends on resources of partners -Partnership can dissolve upon death, bankruptcy, or incapacity of a partner -Losses up to basis -Risk free business -Sporadic Losses
Limited Partnership -General partner has unlimited liability, limited partners have limited liability -The limited partners are passive investors, if they are active, then they forefit their limited liability. -Limited partners are only liable for partnership debts up to their capital contributions.
LLC Can be classified as either a partnership or a corporation -Members -Limited liability -File 1065 -members receive K1 -Losses up to basis -LLC may operate like a partnership, but the members can be involved in daily operations without losing their limited liability status. All members have limited liability for all debts / claims against the business.
LLP A partnership in which the general partners are not personally liable for malpractice related claims arising from the professional misconduct of another general partner. Useful for a partnership that wants to convert from an entity where one or more partners have unlimited liability.
C Corp A separate tax entity -Can have more than 100 shareholders -Limited liability -No income / loss flow through. Business pays the taxes form 1120 -Continuity of life -Dividend received deduction (70% rule) -Transferability of ownership (stock) Minimum corporate tax rate: 15% Maximum corporate tax rate: 35% -Double taxation (after tax earnings from the Corp, distributed income is again taxed to owners) -Accumulated earnings beyond a certain limit are subject to double taxation -Dividends paid after tax Corporate formalities
Corporate Received Deduction Corporate shareholders are allowed a deduction for dividends received. 70% of dividends received from qualifying corporation may be excluded from income of recipient corporation if recipient corporation owns 20% of less of distributing corporation 80% exclusion if ownership is between 20-80% 100% exclusion if ownership is over 80%
Which of the following forms of business organization can pass losses through to the owner(s)? S corporation Sole proprietorship General partnership Limited partnership
How can a business owner reduce his/her taxes? File as a regular corporation (1120). A regular corporation will provide the owner with a separate tax entity. Money left in a corporation is taxed at 15% for the first $50,000.
Section 1244 qualified small business stock - First million dollars of stock ( C or S ) issued after incorporation - Loss of 100,000 per year on a joint return considered ordinary not capital loss -Up to $100,000 of loss is treated as an ordinary loss. -Any loss in excess of the maximum annual ordinary loss is treated as a capital loss.
Personal Service Corp (PSC) A closely held C corp that is owned by certain individuals who perform services is denied the progressivity of the corporate rate schedule. Any income retained by the PSC is taxed at 35% flat. Businesses that should avoid operating as a corporation and becoming a PSC are: Health (doctors, dentists) Accountants, architectural Law Engineering A PSC occurs when the principal activity is the performance of personal services by the employee owner.
S Corp -Passthrough of income, deductions, and tax credits to investors. Limited losses up to basis. (basis is cash plus direct loans made by the shareholder to the corporation) - no double taxation -Shareholders -Limited liability -1120S Form -partners get K1 -No more than 100 shareholders (none of whom may be a non-resident alien, all of whom must be individuals, estates or certain trusts) -Can only issue a single class of outstanding common stock. Can be voting / nonvoting. -Must be a domestic corporation -Pension plan -100% of medical and dental expenses are deductible for 2% owner -Losses up to basis -S corporations are separate entities, not separate "tax"entities. -Basis for an S corporation is limited to capital and direct loans.
Disadvantages: -corporate formalities -sale of stock limited by eligibility
Conduit Entity - Sole Proprietorship Can use NOL for two years in the past or 20 years in the future. If an individual borrows money for business purposes, then the interest paid on the debt is deductible on Sch C WITHOUT LIMIT!
Conduit Entity - Partnerships Have to file 1065, but it is for information purposes only. Each partner includes in his/her return the distributed share of the partnership income or loss items. Losses up to basis (basis equals cash contributed by the partner, direct loans made to the partnership by the partner, and loans made to the partnership
Conduit Entity - S Corp Losses up to basis (basis equals cash contributed by the shareholder plus direct loans made by the share holder to the S corp)
When an S corp incurs debt, the shareholders don't typically have personal liability for the debt. Therefore the S corp debt is not included in the shareholder's basis.
Conduit Entity - Limited Liability Corporations Regardless of the number of members, if the entity is treated as a partnership, only an information return is filed. The income subject to tax will pass thru to the individual members. IF the entity makes a corporate election, the business itself is a taxable entity and normally files using a form 1120 or 1120s
Conduit Entity - LLCs and LLPs Has limited liability like an S corp, but offers losses up to risk basis like a partnership. Can claim NOL. If there is two or more members, it is classified as an LLP. This means LLC/LLPs offer conduit taxes and losses up to risk basis.
Distributions Corporate stockholders may receive a return on their investment in the form of a dividend. Corporations cannot deduct a dividend payment. The business profit flowing thru to investors as dividends is taxed twice.
Original Basis A taxpayer's investment in any asset or property right. It's a measure of unrecoverable dollars represented by the asset. Increases basis: legal fees, improvements, commissions, sales tax, freight Does not increase basis: repairs, real estate taxes, normal business expenses When basis is increased by these incidental costs, it becomes cost basis
Adjusted Basis Cost basis less recovery. Cost recovery is a deduction for depreciation. The deduction generates a tax savings and reduces the basis of the asset.
Ammoritization A business may own a variety of assets with no physical substance, however the assets represent vauable property right or economic attribute (goodwill). The tax basis in such intangible objects must be recoverable in some type of ammoritization method. Intangibles are amortized under a tax section called 197 intangibles. The recovery method is similar to straight line.
Depreciation / Cost Recovery Concepts Cost Recovery deductions are an allowance for the exhaustion and wear and tear of property used in a business.
Modified Accelerated Cost Recovery System (MACRS) Used for fixed assets, but not land or intangibles! Applies to all property (nonresidential real property) placed in service after 1986. Straight line is an option, but the half year conversion must be used. If more than 40% of depreciable property is placed in service during the last 3 mo of the year, the firm must use a mid quarter convention.
Property Classes & depreciation time 5 years -- autos, light duty trucks, computers (1245 property) 7 years -- office furniture and fixtures (1245 property) 27.5 years -- residential rental property (1250 property) 39 years -- nonresidential (buildings) real property (1250 property)
MARCS Table MARCS: 5 year-- 20%, 32%, 19.2% 7 year-- 14.29%, 24.49%, 17.49%
Straight line 5 year -- 10%, 20%, 20% 7 year-- 7.14%, 14.29%, 14.29%
Expensing Policy Allows businesses to expense (rather than capitalize) a limited dollar amount of tangible property during a taxable year under section 179
Section 179 Deduction For 1245 property only Can expense up to $510,000 of qualifying property in the year of acquisition. Qualifying property is tangible business property purchased for use in the active conduct of a trade/business. The maximum cost that can be expensed is reduced dollar for dollar by the cost of qualifying property (placed in service during the year) that exceeds $2,030,000. the amount of expense deduction is limited to taxable income. You cannot create a loss with a 179 deduction. Any deduction not allowed because of a lack of income be carried forward next year.
In terms of its accounting treatment, an expense is recorded immediately and impacts directly the income statement of the company, reducing its net profit. In contrast, a capital expenditure is capitalized, recorded as an asset and depreciated over time.
Adjusting for Basis S Corp shareholders increase their basis by their portion of income / gain for the year. On the other hand, shareholders reduce their basis by their share of corporate losses. Cash distributed by an S corp is a nontaxable return of investment that reduces basis. This is why it is not subject to FICA or self employment taxes. S corps usually pay the owners a salary, subject to FICA and FUTA. The unearned income and losses adjust their basis.
1031 Exchange Like kind exchanges, no gain or loss will be recognized on the exchange of certain properties held either for an investment or for productive use in a trade or business 1. the exchange must be like kinded 2. The taxpayer must have used the property for business use and must acquire the property for business use Must identify the like kind exchange within 45 days after the transfer and the transfer must be received within 180 days of the transfer
1035 Qualifying property Real estate, machinery, equipment, office furniture, computers, most other real & personal property. IRS: properties are of like kind if they are of the same nature or character. Livestock exchanged for other live stock of a different sex is not a like kind exchange. Property used in the US is not a like kind exchange for property used outside the US Real properties generally are of like kind, regardless of whether the properties are improved or not. However, real property in the US and real property outside the US are not like kind properties.
Boot In a like kind exchange, any cash or other (not like kind) property involved in the exchange to make the property of equal exchange is called the boot. The presence of the boot does not disqualify the exchange. Instead the party receiving the boot must recognize a portion of the realized gain equal to the lesser of the boot or realized gain.
Calculating boot 1. Add together FMV of property to be acquired + boot 2. Subtract basis in currently owned property (this is the realized gain) 3. Subtract the lesser or a. the boot received or b. the realized gain (#2) from the realized gain 4. FMV of property to be acquired minus #3 5. Arrived at adjusted basis in new property
Cap Gains & losses Sum LTCG/L & STCG/L If any gains and losses are left net them together If a loss remains after netting capital gains and losses, only $3000 of losses can be used to offset ordinary income in a single year. Unused carry forward losses are lost after the year of death.
LTCG rates 0% 10%-15% bracket 15% 25-35% bracket 20% 39.6% bracket
STCG rates ordinary income rates
Long term collectible gains rate 28%
Sale of residence The max gain from the sale of a residence that can be excluded from gross income is $500,000 for married couples, and $250,000 for single. To claim this the house needed to be used as the primary principal residence for 2 of the 5 past years preceding the sale. If the home sale gain is entirely excluded, then the transaction is not reported on the taxpayer's return at all. Unforeseen circumstances for not meeting the 2 /5 years residency requirement: -divorce, separation, death of spouse -becoming eligible for unemployment comp -a change in employment that makes it impossible to pay the mortgage -multiple births from 1 pregnancy -condemnation, seizure, or involuntary conversion of the property such as foreclosure -a job related move if the new job is more than 50 miles from the old home / work place. Deduction: 1 year of 2 year requirement =50% deduction
AMT Separate method of calculating income tax liability. Applies when the AMT calculation is higher than the regular income tax liability. 1. Post deduction 1040 income 2. add back any item that was deductible for the 1040 but not for AMT 3. add preference items 4. Result is AMT base 5. subtract exemptions (subject to phaseout) 6. Result is AMTI 7. Calculate AMT 26 & 28%
If AMT tax is higher than regular tax, you pay AMT. AMT payable is the difference between AMT and regular tax.
AMT Preference Items IPOD private activity municipal bonds oil & gas % depletion / excess intangible drilling costs Depreciation (ACRS & MACRS but not straight line)
Add back items Property, state, local, sales tax misc deductions (advisor fees) incentive stock option bargain element
Strategies to defer AMT -Accelertating receipt of taxable income or deferring payment of the property taxes, state income taxes, deductible medical expenses, or charitable giving -Deferring the exercise of an incentive stock option plan (add back item) to a later date, or disqualifying the ISO so it becomes a nonqualified stock option (income taxable) -By purchasing public purpose muni bonds, instead of private -renting will eliminate the property tax deduction -Selling his home and paying off his mortgage increase his regular taxes
Passive Activity A trade or business in which the tax payer doesn't materially participate. The limit is designed to minimize the extent to which certain tax payers may take advantage of otherwise deductible losses.
RELPs real estate limited partnerships: a passive activity loss may generally not be used by a taxpayer to reduce portfolio income, compensation, or business income. Losses from Non Public limited partnerships can only be offset with gains from Non Public limited partnerships. Losses can be netted with passive income.
2 kinds of passive activities 1. Rentals, including equiptment & real estate and royalty income like oil royalties 2. business in which the tax payer does not materially participate. (LPs, partnerships, S corps and limited liability companies in which the taxpayer does not materially participate)
PTP (publicly traded partnership) rules AKA Master limited Partnerships -interest must be traded on a securities market or on a secondary market -Income from a PTP may not be sheltered by passive losses from any source. PTP income is portfolio income like dividends. -Losses may not be used to offest passive income from other sources. -Net loss from PTP must be carried forward and can only be used against future income from the same partnership.
Disallowed losses Carried forward until the tax payer can dispose of the interest. There is NO $3,000 per year loss allowed here.
Disposition of passive activities The passive activity loss limitation is not a permanent disallowance. The partnership can make income to go against the loss. When the investor disposes of their entire interest in a passive activity in a taxable transaction, any suspended losses with respect to the interest is fully deductible in the year of disposition. The partnership can be sold as a loss.
Real Estate passive activity exceptions -A taxpayer will be treated as materially participating in an activity only if the taxpayer is involved in the operation of the activity on a regular, continuous, substantial basis. Generally no limited partners are materially participating. - Active participation is a lesser standard than material participation. Although passive, it is an exception to the passive loss rules. It requires bona fide involvement. A limited partner may NEVER be an active participant. To qualify tax payer must own at least 10% interest in the property. Active participation can produce income or loss.
Real estate Loss -can deduct 25,000 per year of net losses from real estate activity -Deduction is phased out for investors with AGI between 100,000-150,000 on a 2 for 1 basis. -Deduction will offest active or portfolio income.
Rental of principal residence If the home is rented for 14 or less days out of the year, then the rental income is excluded from gross income, but no deductions attributable to the rental use are allowed.
Vacation homes are considered a residence if the unit for personal property exceeds the longer of 14 days or or 10% of the period of rental use.
Real estate phantom income a result of real estate property declining in value, then is refinanced or the debt is forgiven.
Low income housing tax credits Passive activity that generates up to 25,000 in tax credit. Tax credit calculation: 25,000 * tax bracket
Oil and gas working interests Exempt from PAL rules Losses for which the taxpayer is personally liable are deductible against active or portfolio income without limits and without respect to the tax payers AGI. To qualify as a working interest, the form of ownership may not limit the taxpayer's personal liability. If you are a limited partner, you cannot take the loss. The loss becomes a passive loss. Percentage depletion triggers AMT. Cost depletion is not an AMT preference item.
Married / widowed filing status -surviving spouse files with deceased spouse in the year the spouse dies. -If the widow maintains a home for a dependent child, then he / she qualifies as a surviving spouse for 2 years (files as MFJ)
Alimony Deductible to payor and taxable to payee if: -the taxpayers cannot file a joint tax return or live together -payments made in cash -payments must be received by or for the benefit of the payee spouse (not child support) -the payments cannot exceed beyond the death of the recipient spouse -If the payee spouse owns the life insurance policy on the life of the payor, the policy payments made by the payor will qualify as alimony if the payments are made under the divorce instrument. -Cash payments to 3rd parties can qualify if pursuant to the divorce instrument for an obligation of the spouse (rent, mortgage, tax, tuition) -Payment of the payee spouse's rent by payor spouse -Payment of the payee spouse's tuition to State University to become eligible to take the CFP® Certification Examination
Alimony Recapture rules If the alimony payments decrease too fast (they were frontloaded) then the IRS says the payments were really a property settlement. As a result, alimony paid will be recaptured as ordinary income. When there is no alimony paid in year 3: Year 1 alimony + year 2 alimony - 37,500 = recapture
Child Support Nontaxable to payee and nondeductible to payor. Any amount tied to a contingency or occurrence of an event relating to a child is considered to be child support not alimony -Custodial parent gets the exemption
Divorce property settlements Any property exchanged as part of a divorce is tax free. Basis is carried over. Transfer of a life insurance policy, is not a taxable event / does not have tax consequences.
Public Charities 50% -churches, schools, hospitals -All organizations organized and operated for charitable, religious, educational, or literacy purpose, or prevention of cruelty to children / animals.
Private Charities 30% Private nonoperating foundations fraternal orders war veterans organizations
Charitable Deduction limit can only deduct 50% of AGI *must use the public charity deduction before the private Any excess deductions can be carried forward for 5 years,or until death if sooner
Gift of Life Insurance Charitable contribution is the value of the policy or cost basis, which ever is lower. Then limited to 50% or 30% of AGI. Treated like ordinary income.
Appreciated Property Gift An individual's deduction ceiling for gifts of appreciated LTCG property to a 50% charity, is 30% of AGI unless they elect to use basis rather than fair market value. If the individual uses basis they can deduct 50% of AGI.
Gift of property that generates ordinary income Deduction is limited to basis -If sold the property would produce ordinary income, not cap gains. Examples: inventory, copyright, use unrelated property, work of art created by the tax payer, antiques, short term cap gains property. Art is deducted at basis, unless the charity can use it in its charitable purposes
Calculating Charitable Gifts 1. Calculate max deductible amount (50% of AGI) 2. Calculate the amount given to 50% organizations -50% of AGI for cash donations -30% of AGI for LTCG FMV property -50% of AGI for short term gains, inventory / works of art using BASIS 3. Calculate the amount given to 30% organizations -30% of AGI for cash donations
Can a nonitemized take a charitable deduction? No! You must itemize.
Proof of charitable donations If it is a donation of more than $250, the donee organization must provide written acknowledgement.
Proof of donation of a car over $500 must be in written acknowledgement as well. Deduction is limited to the gross proceeds from the sale of the car.
QCDs (qualified charitable distributions) -Owner of IRA needs to be at least 70.5 -Applies to IRA and roth IRAs -Do not apply to employer plans -Capped at 100k per year per person -Apply only to taxable amounts (no basis transfer) or after tax roth IRAs (ie distributions before the 5 years or distributions of the growth portion)
Social Security OASDI, medicare, unemployment insurance, supplemental security insurance (SSI)
Fully insured = 40 quarters of coverage Members of the armed forces are covered
Non qualifiers for Social Security -Federal employees continuously employed since before 1984 -some Americans working abroad -Student nurses or students working for a college -railroad employees (eligible for medicare, but excluded from social security) -a child, under age 18, who is employed by a parent in an unincorporated business -ministers, members of religious orders -members of tribal councils
Disability Benefits (worker) -Worker is entitled to benefits is he/she is under age 65 and: has been disabled for 12 months is expected to be disabled for at least 12 months has a disability which is expected to result in death and has completed the 5 mo waiting period
Disability Benefits (spouse) Spouse of a disabled worker qualifies if: -over age 62 -has a child in care under age 16 -has a child over 16 that is disabled
Benefits for Spouse (insured is deceased) Qualifies for SS payments, regardless of age if caring for a child of the deceased who is either under age 16 or over 16 & disabled
Benefits for dependent (insured is deceased, disabled, or retired) -Must be unmarried -Under age 19 and a full time elementary / secondary student or age 18 or over but has a disability which began before age 22.
Social security strategies -One time right to withdrawal: client has one time right to withdraw their application for retirement within 12 months after benefits begin.
Currently insured worker is entitled to: 1. Lump sum death benefit $255 (will be given to spouse OR a dependent child) 2. Surviving spouse benefit 3. A dependent benefit
Primary insurance amount (PIA) Basic Unit to determine amount of each monthly benefit payable under social security
*A spouse/divorced spouse may be entitled to a PIA that is 50% or more than the workers PIA
Social Security and divorce Divorced spouse can claim spousal benefits if they were married for at least 10 years and are not remarried. They can usually get 50% of PIA.
Taking Social security before you reach full retirement age & still working Under full retirement age: government deducts $1 for every $2 from your SS benefit if you earn above $16,920.
Taking social security the year you reach full retirement age In the year you will reach full retirement age, the period for which you worked, the government will with hold $1 for every $3 earned above the 44,880 limit until you reach the month you reach FRA.
Provisional income Provisional income is AGI plus tax exempt interest + 1/2 SS income
Taxation of SS If a person's "provisonal"income plus half of his/her SS benefits are more than the following base amounts, then 50% of his / her benefits will be taxable income: 25,000 MAGI for single taxpayer 32,000 married filing joint
If a person's "provisonal"income plus half of his/her SS benefits are more than the following base amounts, then 85% of his / her benefits will be taxable income: 34,000 MAGI for single taxpayer 44,000 married filing joint
Disability Benefits Worker is entitled if: -is insured for disability benefits, is under age 65 -has been disabled for 12 months, or is expected to be disabled for at least 12 months -has filed for disability and has completed the 5 mo waiting period
Reduced benefit before NRA Fully insured can start receiving benefits the month after they reach age 62. PIA is reduced by 1/180 for each of the first 36 months the worker is under NRA when benefits commence. Benefit Reduction = (1/180) # of months before NRA PIA
Defined Benefit Vesting schedule, administrative costs, exempt from creditors, integrate with SS 1. favors older employees 50+ 2. certain retirement benefit 3. must have very stable cash flow (they have to make contribution each year) 4.past service credits allowed -Subject to PBGC. -Section 415 limit: max limit on the projected annual benefit that a defined benefit plan can provide. Beginning at 65, max is the lesser of $215,000 or 100% of participant's comp averaged over highest 3 earnings years -Forfeitures must be paid to reduce employer contributions
Ex. cash balance pension plan
cash balance pension plan Provides for annual employer contributions at a specified rate to a hypothetical individual accounts that are set up for each plan participant. Employer guarantees contribution level & minimum rate of return (interest credited to the account is guaranteed. (similar to money purchase plan, but here there is a minimum rate of return)
Good for a company who needs cost savings and simple defined contribution make more sense for the company. Mid-large size company that has a well funded DB plan and is looking to save on benefit costs, but avoid new PPA rules. This conversion hurts older, long service employees because the lump sum payout at termination is smaller & because of the fixed contribution & fewer years of compounding guaranteed interest.
-Forfeitures must be paid to reduce employer contributions
Defined Benefit Formulas -Unit benefit formula (percentage of earnings per year of service formula) : most frequently used to calculate defined benefit. Factors both service & salary. (% years annual comp) = annual pension. Only first 270k is taken into consideration, and the amount is capped at 215k.
-Final Average method: earnings averaged 3-5 years prior to retirement. Final average method usually produces a retirement benefit better matched to the employees income at retirement. Only first 270k is taken into consideration, and the amount is capped at 215k.
-Past service: Service with the employer prior to the inception of the plan. It is important to employers who are setting up a new plan for the benefit of long service employees.
412(i) -DB plan funded with only insurance products. -The insurance company actuary's assumption becomes the actual contribution due. -Plan is exempt from min funding standard. -Company must have some need for life insurance. -Allows for large contribution, but the plan return in diminished.
Defined Contribution Vesting schedule, administrative costs, exempt from creditors, integrate with SS 1. favors younger employees 2. uncertain retirement benefits
Defined Contribution: Money Purchase Pension Plan 1. Up to 25% employer deductions 2. fixed contributions 3. stable cash flow
Benefit formula requiring the employer contribution that is a flat % of each employee's comp. Can use up to 100% or as low as 3%. Only the first 270k of employee's comp can be taken into account!!
Max contribution 2017: lesser of 54k or 100% of salary
- Good for stable work force, simple to administer & explain, young & well paid employees -A money purchase plan can allow for a $54,000 contribution and is subject to the minimum funding standard (mandatory contribution).
Defined Contribution: Target Benefit Pension 1. Up to 25% (of the aggregate eligible compensation of all covered participants) for employer deductions 2. fixed contributions by employer 3. stable cash flow 4. Favors older employees Alternative to a defined benefit plan that provides adequate retirement benefits to older employees but has lower costs & simplicity of a defined contribution plan.
-Uses features from both defined contribution & benefit. -Max contribution 2017: lesser of 54k or 100% of salary -Retirement benefit is determined by account balance -Employee assumes investment risk. -No annual actuarial determination is required -Forfeitures can be used to reduce plan costs or reallocate to other participants -The maximum retirement benefit for a participant is the value of the participant's account at retirement
-Benefits older employees -Actuary determines initial contribution level -Fixed mandatory contributions -Plan is established to provide a specific benefit (target) at retirement, but it is not guaranteed.
Defined Contribution: Profit Sharing 1. Up to 25% employer deductions 2. flexible contributions up to 25% (must be reoccuring and substantial) 3. 401k provisions (FICA / hardship provision) 4. SIMPLE 401k is exempt from creditors
-Employers contribution to each plan year can be a purely discretionary amount of nothing at all. IRS does not specify "reoccuring"or "substantion" -Each participant has an individual account. -Account has employer contributions, investment returns, and forfeitures (normally reallocated to active participants)
Good for employers whose: -profit margin varies year to year -when an employer wants to adopt a qualified plan with an incentive feature to make the company profitable -employees are young, well paid, and have TIME to accumulate earnings
Defined Contribution: Stock Bonus Plans (aka 401k, CODA) 1. Up to 25% employer deductions 2. flexible contributions 3. 100% of the contribution can be invested in company stock 4. ESOP cannot be integrated with SS or cross tested Looked at as a way to finance company operations
-Plan with maximum contribution and the maximum deductible contribution flexibility -Employees have an option to put money into the plan or to receive the same amount as taxable cash compensation. If an employee elects to defer, the deferral is still subject to FICA. Limit on deferral amount is 18k. -when an employer wants to provide a qualified retirement plan, but can only afford minimal extra expense -good for employees who want to increase their savings on a tax deferred basis -Forfeitures increase account balances of plan participants
Defined Contribution: Stock Bonus Plans - ESOP (cannot be established by partnerships (Keogh)) Stock bonus plan that the employer can use as a conduit for borrowing money from a bank or other financial institution. When an ESOP is used to borrow money, it is known as a leveraged ESOP or LESOP. -Must invest plan assets primarily in employer stock. -Participants accounts are stated in terms of shares of employer stock. - Benefits are generally distributable in the form of employer stock -Employers may deduct dividends with respect to stock held in the ESOP
The deductible dividends must be: -paid in cash directly to participants / beneficiary -paid to the plan and subsequently distributed in cash to participants / beneficiary no later than 90 days after the close of plan year -used to make payments on loans used to acquire employer securities -paid to the plan and reinvested in qualifying employer securities
-Company broadens ownership of the stock, creates market, provide liquidity, provide for business continuity planning -When a company wants to provide its employees with tax advantaged means to acquire company stock. -Looked at as a way to finance company operations: the company uses cash to buy company stock , funding company operations.
Rollover of an ESOP Basis of employer stock is treated as ordinary income at time of distribution regardless of whether the stock is sold or not. NUA is always treated as long-term capital gain regardless of holding period. There are two assets in the plan, the company stock and cash. He takes a lump sum of the company stock, then that qualifies for NUA treatment. The noncompany stock portion which in this case was cash can be rolled over into the IRA. If he rolls the company stock into the IRA, then it losses its NUA.
Solo 401k aka uni 401k - not subject to testing and nondiscrimination rules. -Allows for 2 different contributions, elective deferral up to 18k, plus the employer contribution up to 54k. Catch up is 6k for those 50 or older. -Solo is you and your spouse / you and your partner. Part time employees under 1000 hours per year do not count. -the deferral / contribution could be 60k (54000+6000) . This is a larger amount then Keogh/SEP -uncomplicated retirement plan to put away the maximum allowable per year.
Other retirement plans No vesting schedule, limited admin costs Simple IRA SEP IRA SARSEP 403b
SIMPLE IRA savings incentive match plan for employees 1. Simple 401k is exempt from creditors 2. for small employers (100 employees or less). Easy to set up (IRS for 5304 or 5305) 3. REQUIRED employer match up to 3% of the employee's comp. Nonelective contribution of 2% of employee comp for all eligible employees (employee gets 2% even if they are not deferring) 4. salary reduction limit up to 12,500 + catch up for those over 50 5. Company cannot have another plan 6. immediate vesting 7. Plan can be terminated, but only prospectively, terminating no earlier than the next calendar year. Contributions have to be made up until then. 8. Employer cannot have any other qualified plan (SEP, 403b etc) when it has SIMPLE 9. Plan has to cover anyone who earned 5k in any 2 previous years and is reasonably expected to earn 5k in the current year. Employer must notify participants that they have a 60 day election period to elect a salary deferral / modify existing. 10. Distributions taxed the same way as traditional IRAs, but there is a 25% tax penalty for withdrawals made in the first 2 yrs
Simple 401k Traditional 401k adopts simple provisions. Exempt from ADP & ACP tests. Exempt from top heavy requirements. Rigid plan design.
Still subject to 270k compensation cap. Exempt from creditors. The deferral is $12,500 but the match is limited to $8,100.
SEP IRA 1. Contributions limited to the lesser of 25% of compensation (270k max) or 54,000. Contributions for self employed owners have limits of 20% of net income less self employment tax = 18.59%. 2. Account immediately vested 3. can be integrated with SS 4. special eligibility: 21+ years old, paid at least $600/ yr and worked 3 of 5 past years.
-Plan contributions are not subject to FICA and FUTA -An employer sponsored plan in which contributions are made to the participating employees IRA. -Employer contributions only. -Employer contributions are flexible & not required -Very simple & inexpensive to install, but lose flexibility with regard to participation requirements -contributions must be the same % for all employees and owners. -Recurring and substantial contributions does not apply to SEP -Form 5305 SEP
SARSEP Can no longer be established, but new employees can be added to existing plans 1. May have up to 25 employees and 50% of employees must participate by deferring 2. must have been in existence before 12/31/1996 (grandfathered in) 3. salary deduction limit of 18k. 6k catch up for age 50 & over. -The 415 limits apply (total additions equal to the lesser of $54,000 or 25% of compensation) -Old plans can be rolled into IRAs or another qualified plan. -All contributions are 100% vested
403b 1. for 501c3 organizations & public schools (private universities, non profit hospitals, churches) 2. subject to ERISA only if employer contributes 3. salary reduction limit up to 18k, subject to FICA 4. Employer contributions must be subject to vesting schedule 5. $6000 catch up provision, age 50 + 6. Extra catch up provision: 15 years of service with the same employer can exclude an extra $3,000. If both these catch ups apply, you can take both. 7. Investments are limited to annuity contracts or mutual funds. incidental life insurance protection under annuity contracts is also allowed (cash value LI) No UITs, individual securities or closed ends funds. 8. "State of X"is not a sponsor to a 403b plan
Maximum excludable amount: 1. Salary deferrals only: for salary reduction contributions, determine whether the intended contribution exceeds the elective deferral limit for the year (18k) 2. Salary deferrals + employer contributions: Determine whether the intended contribution amount exceeds the section 415c limit (54,000 or 100% of comp which ever is less)
Factors affecting employees retirement benefits (defined benefit plans) -Proximity to retirement age -Past service (service prior to inception of plan) -Forfeitures must be paid to reduce employer contributions -Investment return assumptions -Salary scale assumptions (older employees paid more than younger ones) -If inflation is lower / higher than expected the company's contributions will change
Factors affecting employees retirement benefits (defined contrib plans) -Years to retirement -Investment returns -Salary Levels -Employer contributions -Forfeitures (can be used to reduce plan costs or reallocate to other participants) -Inflation
Not: -life expectancy
Section 457 Plan Rules governing all nonqualified deferred comp plans of government units, agencies and non church controlled tax exempt organizations., non profit organizations. Limited to highly compensated employees. Top hat plans. -Deferral limit: lesser of 18k or 100% of comp -Special catch up provision: final 3 years before NRA. Cannot be used in final year of employment. Limit is lesser of a. 2x the normal limit (18,000 * 2) or the sum of the otherwise applicable limit for the year plus the amount by which the applicable limit in preceding years exceeds the participants actual deferral for those years. -Catch up: Age 50+ catch up is $6,000 ONLY for government employees -The rules stating that the contribution limits under 457 must be coordinated with the limits under 401k, 403b and SARSEP were repealed. -The elective deferrals are required to be taken as wages at the time of deferral. They are subject to FICA tax at the time of contribution. The states non elective contribution is also required to be taken into account as wages. -Subject to RMD and can be rolled into Roth -Subject to QDROs
Qualified Plan Rule #1 Nondiscriminatory Must cover a broad group of employees Must satisfy age & service 1. Need to be age 21 and have 1 year of service. There is a special provision for a two year service requirement, but the employee is fully vested after the 2 years 2. Has to work 1,000 hrs during the initial 12 mo period after being employed will earn a yr of service.
Qualified Plan Rule #2 coverage requirements. In addition to rules restricting age & service, qualified plan coverage is further regulated through 2 alt overall coverage tests: 1. Ratio % test: the plan must cover a % of non highly compensated employees (NHCEs) that is at least 70% of the percentage of highly compensated employees covered. If this test fails, the following must be passed. 70% * % of HCE covered = % of NHCE that can be excluded 2. Average benefits for non highly compensated employees must be at least 70% of that for HCEs.
Qualified Plan Rule #3 Highly Compensated Employee Affects ADP / ACP tests - a greater than 5% owner (if you are an employee and the spouse, parent, child, or grandchild of an individual who is a >5% owner, then you are deemed to be a >5% owner. Not siblings) -an employee earning in excess of $120,000 in the preceding year.
Qualified Plan Rule #3 part 2 Key Employee Affects top heavy plans During the year this person has been: -greater than 5% owner (if you are an employee and the spouse, parent, child, or grandchild of an individual who is a >5% owner, then you are deemed to be a >5% owner. Not siblings) -an officer & compensation greater than 175k -greater than 1% ownership & compensation greater than 150k
270k salary cap for includable comp
Qualified Plan Rule #4 Vesting Schedules A plan is top heavy if more than 60% of its aggregate accrued benefits or account balances are allocated to KEY employees. Top heavy plans use a faster vesting schedule.
Salary deferrals are always 100% vested
Top Heavy DB Vesting Schedule Faster 1. 100% vested with 2 yr eligibility 2. 2 to 6 yr graded (used to retain employees) 3. 3 year cliff
Non Top Heavy DB Plan Vesting Schedules Slower 1. 5 year cliff 2. 3 to 7 yr graded (used to retain employees) 3. 100% vested with 2 yr eligibility
Qualified Plan Rule #5 ADP / ACP Tests ADP: actual deferral percentage ADP test of the HCE must not exceed the greater of: 1. 125% of the NCHCE rate (ADP is 8% or more) 2. 200% of the NCHCE rate and not more than 2% greater than the NHCE rate (ADP between 1% and 8%) Times 2 for 0-2% Plus 2 for 2-8%
Catch up provision: Age 50 by end of year. Elective deferral limit is increased by lesser of 6,000 or the amount of the participants comp reduced by any other elective deferrals by the participant for the yr
Qualified Plan Rule #6 Common Control Common control must be taken into account in identifying the "employer" -Parent subsidiary: one entity (parent) owns at least 80% of one or more entities -Brother/sister: 5 or less owners of two or more entities own 80% or more of each entity -Affiliated Service Group: rules apply primarily to service organizations that provide professional services in the field of law, health, accounting, engineering -Employee leasing: provisions were adopted to reduce the discrimination potential from an employers choosing to lease employees from an independent employee leasing organization rather than employ them directly
Annual additions are limited to the lesser of 100% of comp or $54,000. For purposes of this limit, an individual with multiple accounts applies the limit in the following ways: -in the aggregate to all accounts when the plans are offered by a single employer or 2 or more related employees -separately to each account in unrelated employer plans Deferrals are always in aggregate, no matter how many companies you work for ($18k) Related employers are controlled groups and may limit annual additions to 54,000.
Qualified Plan Rule #7 Integration with Social Security Equalize the employer's contributions to retirement plans for higher and lower paid employees. Without integration, the employer contributes a higher % of compensation for lower paid employees. Net result is to lower the cost for rank-and-file employees while maintaining the same level of contribution (cost) for more highly paid employees. Can integrate: DB, cash balance, money purchase, target benefit, profit sharing, stock bonus, SEP
Cannot integrate: safe harbor 401k and 401k match only, difficult profit sharing contribution, ESOP, SIMPLE (IRA & 401k)
Qualified Plan Rule #7 Deduction Limits -Employers can deduct a maximum of 25% of all eligible employee's compensation. Some individual plan participants may have contributions in excess of 25% but as along as the company as a whole does not contribute more than 25%, the rules of discrimination aren't violated.
Qualified Plan Rule #7 Defined contribution limits Section 415 limits applies to all defined contribution plans. Restricts annual additions (employer contributions, employee salary reductions, and plan forfeitures) to each participants account to the lesser of 100% comp or 54,000.
Excess contributions: -May be reallocated to another employee -May be applied in a later year to the same employee -May be used to reduce future plan contributions
Qualified Plan Rule #8 Annual Compensation limit Only the first 270k of an employee's comp is taken into account. Employee can defer 18k Company can match using the difference between (54,000-18,000). Max total account is 54,000
Qualified Plan Rule #9 Compensation Only taxable compensation paid or accured during the year. Includes elective deferrals (401k and section 457) and salary reduction contributions (under sec 125 cafeteria plans FSA/ HSA) Profit sharing contributions calculated based on gross salary (before deferrals & FSA contributions) Compensation over 270k is not included
Qualified Plan Rule #10 Multiple Plans Elective deferrals: for more than 1 employer. Elective deferrals to multiple plans are always aggregated if there is more than one employer. -401k/403b/simple 401k/sarsep -- 18,000 max & 6,000 catchup -Simple IRA/ -- $12,500 & 3,000 catchup -Deferrals are always in aggregate, no matter how many companies you work for ($18k)
Annual additions: limited to the lesser of 54,000 or 100% comp. For an individual with multiple accounts: -in the aggregate to all accounts when the plans are offered by a single employer or 2 or more related employees -separately to each account in unrelated employer plans
Self Employed (Keogh) A qualified retirement plan that covers sole proprietors and partnerships. Keogh is a type of defined benefit /money purchase/ profit sharing plan for sole proprietors & partnerships. -The owner/employee contribution or benefit is based on net earnings ahead of salary.Net earned income is defined as the owner-employee's net income from the business after all deductions, including the deduction for employee only plan contributions. -The IRA ruled that the self employment tax must be computed and a deduction of 1/2 of the self employment tax must be taken before determining the deductible contribution. -If the employee contribution is 15% then the self employed contribution is 13.03% -If the employee contribution is 25% then the self employed contribution is 20%
Shortcut: Take net Sch C income * 12.12% for 15% contribution Take net Sch C income * 18.59 % for 25% contribution For SEP: 15% plan, multiply business profit by 12.12%
Qualified Plan Rule #11 Loans from qualified plans Loans are allowed under the following: -made under an enforceable agreement requiring repayment -Total loan does not exceed the lesser of 50% of the vested balance or 50,000. Special rule allows participants will small accounts to borrow up to 10k without regard to the percentage limitation. -Loan is repaid in 5 years or less. Unless loan is used to buy a dwelling to be the place of primary residence. -Loan payments are level made at least quarterly. -If a loan payment isn't made, it is deemed a taxable distribution. -the vested amount may be used to back the loan to satisfy the participants obligation in the event of default. Loans not allowed: -SEP, Simple, IRA, SAR SEP -Interest deductions are not allowed, if the loan is on a plan funded by salary reductions -Loan is secured by plan assets or a home which was bought with the loan
Distribution Rules 1. attainment of specific age/ years of service 2. Hardship: allowed at any age in any type of profit sharing plan. -financial needs test (immediate & heavy financial need) -resources test (cannot exceed amount needed to satisfy need & participant has no other sources to satisfy need 3. PPA is allowing for inservice distributions as early as age 62 for DB plans. PPA also clarifies that distributions will be treated as retirement income.
Exceptions to the 10% early withdrawal penalty (before age 59 1/2) -Death -Disability -Substantially equal periodic payments after separation from service -Distribution follow separation of service at age 55 or later -Distribution in accordance with QDRO -Medical expenses in excess of 10% AGI or health insurance costs while unemployed (must file for unemployment)
72t -Substantially equal periodic payments after separation from service 1. paid not less frequently than annually 2. paid without changing the amount for the longer of 5 years or until the payee reaches 59.5 (if payment amount changes, the 10% penalty will be retroactively charged against all past distributions) 3. based upon the life expectancy of the recipient 4. based upon reasonable rate of interest 5. if applicable, based upon reasonable mortality assumptions -Only exception is a one time election to switch from the annuity/amortization method to the RMD method. This will reduce 72t payout amounts. No penalty for making this switch.
QJSA qualified joint survivor annuity -post retirement death benefit for the plan participant's spouse. -Qualified pension plans are required to provide a QJSA. -Currently, survivorship annuity must not be less than 50% or more than 100% of the annuity payable during the joint lives of the participant & spouse
QPSA qualified survivor annuity -preretirement death benefit for the plan participant's spouse upon the death of the participant who dies before the starting date of the QJSA. -Survivorship annuity cant be less than what would be payable under the plans QJSA.
QPSA & QJSA - Provided by: money purchase pension plan, target benefit pension plan, money purchase pension plan that merged into a profit sharing plan. -money purchase pension plan that merged into a profit sharing plans have to keep the QPSA & QJSA provisions on the merged monies only.
Rollovers -Purpose is to defer taxation & avoid early 10% distribution penalty -Almost all plans can be rolled into one another -Transfers to another 457 plan remain the only option for nongovermental tax exempt organizations -Hardship distributions from any retirement plan cannot be rolled into another qualified plan -RMDs from any retirement plan cannot be rolled into another qualified plan
IRA 60 day rollover -Anyone can withdraw all or part of their IRA balance, then reinvest it within 60 days in another IRA. Can only occur 1x per year, allows the person to continue to defer any income tax due.
Direct Transfer If a participant receives a direct distribution from a qualified plan (any plan other than IRAs), the plan must withold 20% for taxes. The transfer to another qualified plan / IRA must be done within 60 days.
To avoid the 20% witholding, you can do a direct transfer from one plan to the other (you never have control of the funds)
RMDs - IRAs,SEP IRA, SARSEP, SIMPLE -Have to be taken by April 1, the year following your 70 1/2 birthday -Take distributions by Dec 31 every year after -A more than 5% owner must take RMDs like IRA owners, but can still contribute to the plan -50% penalty on the amount by which a distribution falls short of the RMD -RMD Calculation: previous year ending balance / life expectancy factor *if both the 70th & 70 1/2 birthday occur in the same year, use the age 70 life expectancy number. if the 70 1/2 and 71st birthday are in different years, use the age 70 life expectancy number -If the spouses are more than 10 years apart in age, then you can use the longer distribution period, measure by the joint life and last survivor life expectancy table -Stretch IRA refers to making the beneficiaries on a traditional IRA that extend payment of assets and allows succeeding generations to enjoy tax deferred growth for that time.
RMD: Owner dies while taking RMDs (spousal bene) In the year of death, the RMD is $0 In the year after, the spouse takes an RMD based on their own life expectancy.
RMD: owner dies before taking RMDs (spousal bene) The spouse doesn't have to start taking RMDs until their required date -Roll into beneficiary's IRA; take distributions based on beneficiary's RBD (new uniform lifetime table) -Take distributions over the beneficiary's life expectancy by December 31st of the year after the owner's death
RMD: owner dies before taking RMDs (nonspousal benes) In the year of death, the RMD is $0 In the year after, the bene takes an RMD based on their own life expectancy in the first year, then the use the divisor from the year before minus 1. -Take distributions over the beneficiary's life expectancy by December 31st of the year after the owner's death
QLAC Qualified longevity annuity contract -An annuity contract that is purchased within a traditional retirement plan (401k, 403b, IRA) under which the annuity payments are deferred until the client reaches old age in order to provide retirement income late in life. Payments must begin the months following 85th bday. -Once the client reaches age 70.5 they can only buy a QLAC if the annuity premium value equal to the lesser of 25% of the account value or 125k Pros: -Value of QLAC is excluded from the RMD amount, which reduces tax liability -Remove the responsibility of investing later in life, less fear of running out of money -allow client to claim SS benefits earlier with the expectation that later in life they will use the QLAC proceeds to fund a reduced SS benefit later on -If a client claims SS early, then they don't have to withdraw as much, allowing the assets to grow longer
Cons: -Loss of control of their retirement assets (what if they don't live long enough to use the QLAC?) -Inflation concerns (it pays a fixed rate) -concerns about the rate of return (espc in the low interest rate we are experiencing now)
401k Inheritance All non spousal beneficiaries can transfer the 401k proceeds into a bene IRA and take the sum within 5 years, or over their life expectancy. This applies to inherited 403bs &457s -Set up an inherited IRA, do not transfer the funds to an existing IRA -Arrange for a direct transfer of the money
Beneficiary has to be a spouse if the plan is: This applies to pension plans only (DB, CB, MP, and TB), not profit-sharing.
QDRO Qualified Domestic Relations Order A qualified plan must provide that retirement benefits not be assigned, alienaed, or subject to garnishment. The two exceptions are: -may not prevent collection of federal taxes -may not be attached by a spouse / former spouse through QDRO -The amount the ex spouse gets doesn't change -QDROs only apply to qualified plans, 403(b)s, and governmental 457s - not IRAs.
A QDRO is necessary to avoid the 10% early withdrawal penalty. But you still have to withold the 20% for taxes.
If the plan participant has no immediate right to the funds, then the QDRO cannot require the trustees to make such cash payment. If cash payments cannot be made, then a sub trust must be created, with cash distributions made at the earliest time permitted under the plan.
Tax management strategies for distributions 1. avoid 10% penalty by taking distributions according to 72t 2. spread distributions out and take distributions in years you are in a lower tax bracket 3. use after tax investments for retirement needs
Net unrealized appreciation (difference between employer cost basis and market value upon lump sum distribution to employee) always taxed at LTCG rate, no matter the holding period. Not taxable until sold. The basis is taxed as ordinary income. Any gains accrued after the distribution are taxed at STCG / LTCG depending on the holding period.
ERISA -- Employee Retirement Income Security Act Imposes duties, standards on the plan fiduciaries. Enforced by DOL. -Solely in the interest of the plan participants & benes -exclusive purpose of providing benefits to the participants & their beneficiaries and defraying reasonable plan expenses -by diversifying investments of the plan to minimize risk of loosing large amounts
prohibited transactions: a fiduciary should not engage in a transaction if it knows there will be a conflict of interest: -furnishing of goods/services between the plan and party of interest -transfer to or use for the benefit of a party in interest, of any assets of the plan
ERISA prohibits a plan fiduciary from dealing with the assets of the plan in its own interest or for its own account (anti self dealing) or from receiving any consideration for its own account (anti kick back rule)
PBGC -- Pension Benefit Guarantee Corp Along with the IRS, helps control the operation of qualified plans (only defined benefit & cash balance) Ensures payment of guaranteed benefits. Funded with annual premiums from defined benefit plan sponsors. Guarantees a monthly benefit that is adjusted annually based on PBGC & ERISA formulas. Only covers non forfeitable benefits and pension benefits. Have to be vested. Only PBGC can initiate an involuntary termination of a DB plan.
IRC -- Internal Revenue Code Dispenses favorable tax treatment to those plans that are qualified and punishes those that have lost qualified status.
Fiduciary A person who controls plan assets or administration, or who renders investment advice for a fee or other compensation. This can also include: corporate officers, directors, plan admins, trustees, members of the investment committee and investment advisors. Under ERISA can be liable for all losses.
Form 5500 Plan administrators for Keoghs, defined benefit plans, corporate pension, and profit sharing, certain 401k and 403b must file form 5500, each year: 5500 EZ for one plan participant only 5500 SF for less than 100 participants 5500 for more than 100 participants The DOL gets the form and its a disclosure document for plan participants & beneficiaries
Establishing new qualified plans Plan doc must be established within the same tax year for which the employer wishes to take the tax deduction. Safe harbor 401ks need to be adopted before the beginning of the year. Standard 401k plans have to be established before the first deferral is made. Simple 401k plans may be adopted anytime between Jan 1 and Oct 1.
Investments in qualified plans: Unrelated business taxable income (UBTI) If UBTI exceeds $1000 then the qualified plan is subject to income tax. Income from a limited partnership (except real estate) or dividends from a margined account are considered UBTI,
Investments in qualified plans: Life insurance LI benefits must be merely incidental to the primary purpose of the plan. If the amount meets the below tests, it is incidental: 1. the aggregate of the premiums paid for a participant's insured death benefit are at all times less than the following % of the plan benefit for that participant: Whole life -- 50% Term or universal -- 25% 2. The participants insured death benefit must be no more than 100x the expected monthly benefit. DC plans usually use rule #1 DB plans usually use rule #2
LI satisfies the need and gives the business a tax deduciton. The amount subject to income tax is the cash value. The pure benefit (face amount minus cash value) is tax free.
Traditional IRAs Can contribute the lesser of total earned income or $5,500 (indexed for inflation). Catch up $1,000 at age 50 Compensation: wages, salary, tips, professional fees, bonuses, alimony, separate maintenance payments. Can contribute up to age 70.5 Contributions may or may not be deductible
Deductible IRA contributions - If neither spouse is part of a qualified plan, then the IRA contributions are deductible - If a single person is not an active participant in a qualified plan, then the IRA contribution is deductible -457 plans don't count as active participant plans. -If one spouse is an active participant & the other isn't then they can deduct up to the phaseout limits (186,000 -196,000) -Phaseout limits for those who are active participants single (62,000 -72,000) and married (99,000-119,000) -Active participant means you have made annual additions to a DB or DC plan, or received forfeitures / deferrals from the employer - You can still contribute if over AGI phaseout limit, the contribution just won't be deductible
Spousal IRA Spouse can make contribution for their spouse who doesn't work / makes minimal amounts, as long as the spouse's compensation equals or exceeds the contributions made for both people.
IRA withdrawals 10% early withdrawal penalty under age 59.5 unless: -death -disability -first home expense up to 10k -substantially equal payments -qualified education expense -medical expenses >10% AGI -distribution used to pay medical premiums after separation of service subject to 10% AGI floor
IRA Loans Not permitted. If you borrow from your IRA or use it as security from your loan it is going to be considered a distribution.
Roth IRA Contribution based on earned income: Single $118,000 - $133,000 Married J $186,000 - $196,000 Married S $0 -$10,000
Can make contributions after age 70.5, if you have earned income. Contributions limited to lesser of earned income or $5,500 ($1000 catch up age 50+) $5,500 / $6,500 is a combined limit for both Roth and traditional contributions Can do a spousal roth IRA Regular contributions can be withdrawan at any time. Any excess withdrawals can be withdrawan tax free if account has been open 5+ years, if there is a special purpose for the withdrawal, or you pay 10% penalty
Withdrawal order: 1. contributions -- never taxable 2. conversions 3. earnings
Withdrawal of earnings from a conversion Roth IRA -Meets 5 year holding period, withdrawal due to: age 59.5, death, disability, first home purchase $10k = no income tax or 10% penalty -Meets 5 year holding period, withdrawal due to: medical expenses, medical premiums while unemployed, substantially equal periodic payments, higher edu expenses = no 10% penalty, but income tax -Meets 5 year holding period, but no event/ triggering purpose: 10% penalty + income tax -Fails to meets 5 year holding period, withdrawal due to: age 59.5, death, disability, first home purchase $10k, medical expenses, medical premiums while unemployed, substantially equal periodic payments, higher edu expenses = no 10% penalty, but income tax -Fails to meets 5 year holding period, but no event/ triggering purpose: 10% penalty + income tax
Roth IRA death distribution rules -Distribute within 5 years of owners death or over the life expectancy of the bene or if the beneficiary is the spouse they can delay distributions until the spouse would have been 70.5 or treat the Roth as their own (no distributions required)
Roth 401k -Only current 401(k), 403(b), and 457(b) sponsors may offer a "qualified Roth contribution program". You can only roll a Roth IRA into one of the above sponsored Roth accounts. -There are no income restrictions like with Roth 401(k) phaseouts -Employers can only contribute pre-tax money. -Max deferral is 18k +6k catch up at age 50 -Can still contribute to a Roth outside of work. -Will require minimum withdrawals when the account holder reaches the RBD
Nonqualified Plans -Not subject to ERISA -May discriminate -No tax deductions for employers until employee is taxed -Fund's earnings may be payable to the employer (depending on the investment held) -Distributions are taxed at ordinary income rates (except ISOs) -Used when an employer wants to provide more benefits to an executive who is already receiving the max benefits or contributions under the employer's qualified plan
Qualified Plan -Can't discriminate -Subject to ERISA -Immediate tax deduction for contribution -Earnings accrue tax deferred until distribution -Distributions are taxed at ordinary income rates (exception 10 year averaging and NUA under stock bonus / ESOP)
Nonqualified: Salary reduction plans (AKA pure deferred comp arrangement) Uses some portion of the employee's current compensation to fund the ultimate compensation benefit
Nonqualified: Salary continuation plans Plan uses employer contributions to fund the ultimate compensation benefit
Unfunded: Deferred Comp The plan can consist of a mere promise to pay or be informally funded with life insurance, annuities, mutual funds, or general investments. Assets are owned by the company, making them subject to creditors. No tax deduction for the employer until employee receives the benefit.
Life Insurance -Used because the cash build up is not taxable. -Premiums are not currently deductible -Death proceeds to employees are nontaxable, because the employer didn't use a tax deduction on the premiums paid -Benefits paid to the beneficiary are tax deductible because the benefits are an expense to the employer. These benefits are deferred compensation & subject to income tax -The present value of payments by the surviving beneficiaries is included in the insured's gross estate
Rabbi Trust -Assets must be available to all general creditors if they file for bankruptcy or become insolvent. -Participant must not have greater rights then unsecured creditors -Plan has clear rules for when the benefits are paid -Company must notify trustee if they are having financial hardships, trustee holds assets for general creditors.
Use a rabbi trust when: -there is fear ownership / management may change before the deferred comp benefits are paid -A situation where new management may be hostile to the key employee in the future and fail to honor a compensation agreement -A situation where litigation to enforce payment of deferred comp in the future would be likely too costly (hostile takeover, merger, acquisition, NOT bankruptcy)
Income Tax for Informal Plans Creates taxation in 2 ways for the employer 1. Funds set aside for the plan are taxed at the corporate level 2. Earnings set aside can earn additional income. Annuities create additional tax.
Only corporations can effectively implement a deferred comp plan, because they are separate tax entities.
Unqualified Funded Plan -Free transferability of the employee's interest -presence of a "substantial risk of forfeiture"at the time the contribution to the plan by the employer is made. Exists if the employee's right to the enjoyment of the property are conditioned upon performance of services for a period of time.
Substantial risk tests (there is no risk if one of the following is a close relationship) : -the employee's relationship to the other stock holders and degree of potential control -employee's relationship to corporate officers
ISO -- incentive stock options (meet IRS conditions) Tax favored plan for compensating executives by granting options to buy company stock. Only the first 100k worth of ISOs granted to any employee that vest in one calendar year is entitled to favorable ISO treatment. ISO tax treatment is when employees are only taxed at cap gains rates if they have held the stock long term. Excess is treated as a non qualified stock option. Usually 1 year vesting. Plus 1 year from exercise date. Violation of the rule will make the ISO an NSO No tax at exercise. Corporation does not receive any tax deduction at any time. Subject to AMT add back ISOs can become worthless if the stock price declines
Disqualifying Disposition If ISOs are sold & exercised in the same calendar year then the bargain element is subject to FICA (because it is considered wages)
If ISOs are sold & exercised in the different calendar years, but still not a year apart, then the bargain element is subject to ordinary income (not FICA).
If the the 2 year rule is violated in different calendar years, the bargain element is subject to ordinary income
If the 1 & 2 year rules are broken then the bargain element is taxable compensation (subject to FICA)
Gifting of ISOs will disqualify them. All gains will be treated as ordinary income to the optionee
Nonqualified Stock Option (do not meet IRS conditions) The right to buy a specified number of shares of the employers stock at a given time and price. As soon as they are sold income tax is due on any gains (difference between strike price and market price) Taxed again if you sell the stock (difference between share price and acquisition price) No vesting
ISO / NSO time line 1. Grant date (no tax event) 2. Vesting period (1 yr ISO // none NSO) 3. Exercise date (no regular tax (but is an AMT add back) ISO // difference between grant & exercise is taxable at ordinary income rate NSO) 4. Holding period (1 year ISO // >1 yr for LTCG treatment NSO) 5.Sale Date (excess above basis (grant price) is cap gain ISO // excess above basis (exercise price) is cap gain NSO)
Restricted Stock Units (RSUs) - Will always be worth something, unless the company is insolvent. -No limiting factor in the number of grants or who they are to -Treated as compensation and subject to FICA. -Also subject to cap gains when sold, but can be sold for a loss if the price falls, too. -Regular tax + FICA is paid at time of exercise -If an employee holds the shares for future appreciation, they not only have to pay tax at exercise, but they have to have cash to purchase the necessary shares
Community property (an equalizer) -Each spouse owns an undivided, equal part in all property. Each spouse owns one half of all property, but there is no survivorship rights, so a will is needed, and the property will be subject to probate. Included as community property: income earned by one or both spouses during marriage, appreciation on solely owned property that is attributable to the contributions of the nonowner spouse, separate assets that have been commingled with community property so it is no longer determined which are separate Not included as community property: income earned by the spouse before marriage Gift or inheritance received by one spouse interest earned on separate assets held by one spouse as the sole owner Advantage: survivor gets full step up in basis (on appreciated property ie homes, LI) if the property is includible in the deceased spouse's gross estate
Quasi Community Property Property moved from a common law state to a community property state
Sole Ownership Outright ownership / separately owned property included in your gross estate
JTWROS Property that can be held by husband & wife, parent & child, siblings, business partners -The owners have an equal amount of ownership, control, and enjoyment of the property. -Income from the property is split equally between owners -Survivorship feature, if one owner dies, the property immediately passes to the other owners -Property is not controlled by will, and is excluded from probate. (passes by law) -Non spousal ownership: Full value of the property is included in the first to die's gross estate -Spousal ownership: only 1/2 of property's FMV is included in gross estate at death 1/2 step up in basis.
Joint Tenancy in entirely Can only be used by spouses Can only occur with mutual consent Property can be divided equally Used to protect claims of one another's individual creditors, but not protected from joint creditors. Not allowed in community property states Terminated by: mutual consent, death, or divorce settlement
Tenancy in Common - a way to own property with others - Each own undivided interest in the property - Owners are entitled to a division of income from the income producing property with respect to the interest they own -Free to transfer their share of the property to other individuals (who may / may not be owners) - No survivorship rights. Upon death the holder's share will go through probate and is included in the gross estate.
Methods of property transfer at death 1. Probate 2. Transfer by operation of Law
Probate Process Process used to make an orderly distribution of property from the decedent to the beneficiaries. Supervised by the court Creditors can file claims against the estate Public publication of will
Use a trust to avoid probate
Wills Testator is the person making a will. The transfer of property directed by the will is via the process called probate.
Dying without a will Intestate
Probate pros and cons Pros: administration of estate by court supervision marshal all the assets pay bills / resolve credit issues oversee distribution of estate as directed
Cons: loss of privacy possibility of a will contest court costs & delays possible multi state proceedings
Ancillary Probate The separate probate process for property outside the state of the decedent's residence. Can't avoid. Double probate process.
Assets subject to probate -singly owned assets -TIC property -community property -assets where the beneficiary is designated as the estate of the insured
* use a trust to avoid probate
Transfer by operation of Law Property is transferred by law. Ex. JTWROS
Election against the will In some states, if the survivng spouse hasn't inherited a minimum amount of assets, they have a right to a share of the deceased estate. Usually 1/3 or 1/2 of the estate.
Estate Tax Form Form 706 must be filed for for all citizens who are deceased and had a gross estate plus Adjustable taxable gifts equal to or exceeding the exclusion in the year of death. The executor is responsible for paying the tax.
Calculating the estate tax 1. Gross estate (probate and non probate assets) subtract: funeral expenses, admin costs, debts. taxes 2. Adjusted Gross estate subtract: marital & charitable deduction 3. Taxable estate plus taxable gifts 4. Tax Base subtract: $5,490,000 exemption Remainder taxed at 40% 5. Tentative Tax subtract: gift tax paid 6. Net estate tax
Gross Estate Total FMV of all property and interest owned or held by the deceased at the time of death. Subtracting deductions, debts, admin fees and expenses, credits.
inclusions: home, furniture, personal interests, assets, intangible rights (patents). 1/2 of Joint tenancy with spouse. Life insurance can be included.
Transfers made out of the deceased's ownership within 3 years are included in the estate (doesn't include cash or buildings)
Survivorship annuity lump sum & PV of future payments are included in gross estate
Property transferred but with a retained interest is included in gross estate (except 529 plans)
Life Insurance (estate tax) 3 reasons LI proceeds can be included in the deceased estate: 1. proceeds were paid to the executor of the decedent's estate 2. decedent at death possessed an incident of ownership in the policy 3. decedent gifted their policy within 3 years of death (only applies if they were the owner& insured on the policy)
If LI is taken out on someone to pay taxes for the estate, then it is includable in the gross estate
Gift Tax Paid Any gift tax paid within 3 years of death is included in the estate of the transferor, because a large deathbed gift could reduce estate taxes. 2017 gift exlusions: Lifetime $5,490,000 annual 14k
Exclusions from Gross Estate -life insurance owned by others -completed gifts -Life estate for their life only (life estate gives the owner the right to posess, enjoy, derive income from property until they die, then the interest terminates.)
Adjusted Gross Estate Excludes: funeral expenses, admin expenses, debts, taxes, income taxes, state death taxes, & casualty losses.
Deductions from Adjusted Gross estate Marital deduction: unlimited amount of property can pass to a surviving spouse estate tax free if: -the property is included in the deceased gross estate -the property must actually pass to the spouse
charitable deduction: outright gifts to qualified charities are 100% deductible
Taxable Estate Adjusted gross estate minus martial and charitable deductions
Adjusted Taxable Gifts Gifts made after 1976 that are not included in the decedents gross estate. They are added to the taxable estate to get tentative tax basis
Estate Tax Calculation Once tax base is calculated, subtract $5,490,000 exemption and multiply it by 40%. Credits are subtracted from this.
Common to lifetime gifts and testamentary transfers -use same tax rate schedule, calculation is cumulative - single, shared exemption amount that offsets exclusions amount up to $5,490,000 -unlimited marital deduction -unlimited charitable deduction
-Exemption may be used in full while living and again in full at death, this is because taxable gifts are added back to the taxable estate. -Taxable gifts are created to get appreciation out of the estate, even though the decedent knows they will be added back
Zero Basis Rule / Form 8971 Form 8971 is only required if form 706 is. An asset not reported on form 708 and later sold by the beneficiary does not get a step up in basis, instead has 0 basis.
Inter vivos gift Gift while the transferor is alive. Ex. a transfer to an irrevocable trust a transfer to a revocable trust is not a completed gift because the donor has retained power.
A gift can be broadly defined to include sale, exchange, or other transfer of property from one other person (the donor) to another (the donee) without adequate and full consideration in money or money's worth
What is the gift tax exemption amount in 2017? $5,490,000
What is the gift tax exclusion amount in 2017? $14,000
Gifting to an irrevocable Trust An irrevocable trust must have Crummey provisions in order to qualify for the gift tax annual exclusion. If Crummey is not stated, the gift is a future interest.
Crummey Powers The Crummey clause provides a right of withdrawal equal to the lesser of the amount of annual exclusion or the value of the gift transferred.
How much can one person gift to one person and pay no gift tax in 2017? The annual exclusion ($14,000) plus the gift exemption ($5,490,000) = $5,504,000
Appropriate gift property 1. highly appreciated property to a charity or a donee in a lower tax bracket 2. property likely to appreciate. Good to gift to remove future value from donor's estate 3. Income producing property. Good to gift only if donee is in a lower tax bracket. 4. Loss property. Always sell to take the loss then gift cash from the loss. 5. Out of state property. Always gift to avoid ancillary probate 6. Property subject to depreciation. Keep to get full depreciation 7. Life insurance. Excellent to gift
Strategies for closely held business owners Gift business interest to family members using FLPS and LLCs or by gifting closely held stock. This will reduce the value of the business interest in the estate. Care must be used so the estate isn't disqualifiede from using section 303 or 6166. Can also gift fully depreciated property to family members.
Gifts of present interest Present enjoyment from the gift 14k gift exclusion to each donee, excluded from the donor's taxable gift. Exceptions: Gifts in trusts of future interests for minors 2503c
Gifts of future interest Do not qualify for annual exclusion
Net Gift Technique Gift is made, on the condition the donee pays the gift tax. Discounted gift that benefits the donor and donee. Limitations: -$5,490,000 exemption must first be exhausted before there is any gift tax payable by the donee -The decedents gross estate includes the amount of gift tax paid by the donees on net gifts made by the decedent in the past 3 years -The amount paid by the donee in tax can be used as a credit to the donor's estate -Used when the donor has a liquidity problem and cannot afford the gift tax. Ex. Amount gifted * 40% = X X / 1.4 = amount of gift tax donee pays
Tax implications of gift The value of the gift for gift tax purposes is the FMV at the date of the gift. The basis for income tax purposes is: if the FMV of the gift is greater than the donor's adjusted basis, then use donor's adjusted basis
Valuation of a gift If the FMV on the date of the gift is less than the donor's adjusted basis in the gift then you determine the following based on sale price: - a loss is measured using the FMV on the date of the gift - a gain is measured using the donor's basis If the gift is sold for an amount between the basis and FMV there is no gain or loss
Life Insurance for gifting If the gift is of LI with future premiums due, then the value is established by adding the "interploated terminal reserve"and the value of the unearned portion of the last premium 1. (future reserve - last reserve) * (number of months between last reserve and death) 2. Plus amount of last reserve 3. Plus (1 - number of months between last reserve and death) * unearned premium
Crummy trust Trust with a demand right. Demand rights can be given to children by guardians. Beneficiary has the right to withdrawal from the trust within 30 days. IF the demand is not made within 30 days, then the funds stay in to be managed by the trustee, if the demand is made, then the trustee has to give the funds to the beneficiary. Most often used with ILITs. Might have 5% / $5000 rule
Summary of gift taxes and the donors estate -Generally gifts are simply "adjusted taxable gifts"to the extent such gifts exceed the annual exclusion -adjusted taxable gifts are added to the taxable estate -Gift taxes paid are generally allowed as credit against the tentative tax -gift taxes paid on any gifts within 3 years are added to the gross estate
Gift Tax filing requirements Form 709 must be filed by the donor in the year who gives: -more than 14k -a gift of a future interest in any amount -a gift for which the spouse wants to gift split
Annual Exclusion: 14k Gift tax exclusion: 5,490,000
Gift Splitting -Both spouses give one half of the gift. -Both spouses must consent -Both spouses must file gift returns, if after the split the values exceed the annual exclusion rate. -Only one form must be filed if it is under the exclusion, both spouses must sign off on the form though. -No tax form would have to be filed if the gift was made in a community property state or if the interest was jointly held.
Gifting property to joint tenancy ownership -Gift tax depends on the nature of the property -Most gifts are considered transferred once the title transfer is executed
Deductible gifts -Gifts made directly to an education institute for tuition -Gifts made directly to a medical institute -Gifts to a spouse -Gifts to a qualified charity -Gifts to political organization -Gifts to the President of the US
Gift of a future interest to minors: 2503b 2503b Trust (bad boy) -interest only distributions (Provides minor with a stream of income) -must use applicable credit to fund -income payout subject to kiddie tax -interest is a present interest gift, while the remainder is a future interest gift -More suitable for an adult child -Interest may not be subject to gift tax, if under 14k, but is likely subject to income tax
Gift of present interest to minors: 2503c Trust Rate 39.6% @ 12,500 -can be funded with any type of asset -normally distributed at age 21 -cost to set up and maintain (legal and accounting) -can be included in grantor/ trustee's estate -Grantor can make a gift to a minor and still obtain the annual gift exclusion. The gift will not be considered of future interest if the following are met: -the trust must provide that the property and income may be expended by or for the benefit of the donee before the donee attains age 21 -any property not expended by age 21 will be passed to the donee at age 21 -if donee dies before age 21, the property must be payable to their state or the donee must hold a general power of appointment over the property
2503b v 2503c Investment type- 2503b: income producing. Mandatory income distributions 2503c: any kind of investment. Paid at age 21 or sooner
Gift Tax- 2503b: Gift of future interest, donor must use applicable credit. Income is present interest. 2503c: gift of present interest, so exclusion applies
Taxation- 2503b: subject to kiddie tax 2503c: subject to trust tax rules
UTMA is preferrable to 2503c because: simplicity, cost, earnings taxable to child
Gift of present interest to minors: 529 plans College savings plans -funded with specific funds -flexible distributions -lump sum gift of 70k (completed gift) -donor retains control
Gift of present interest to minors: UTMA -Can be funded with any type of asset including real estate, partnerships, patents, royalties -normally distributed at age 21 -can be included in custodians estate -Allows custodian gifts at death -income taxable to the minor (kiddie tax) -if the donor is the custodian and pre deceased the minor, the account balance is included in the donor/custodian's gross estate, otherwise it is included in the minor's estate -May not be used to satisfy any obligations to support the minor -any adult can be the custodian, state law determines UTMA v UGMA
Gift of present interest to minors: UGMA -must be funded with cash type assets (securities, LI, cash, annuities) -normally distributed at age 18 -can be included in custodians estate -income taxable to the minor (kiddie tax) -if the donor is the custodian and pre deceased the minor, the account balance is included in the donor/custodian's gross estate, otherwise it is included in the minor's estate -May not be used to satisfy any obligations to support the minor -any adult can be the custodian, state law determines UTMA v UGMA
529 ABLE -operated by individual states -nonresidents can open them in most cases -details, fees, investment types vary from state to state -Anyone can contribute to ABLE, but there are financial limits of $14,000 from each contributor per year. -Total limit of contributions will vary by state -One of the primary purposes ABLE was established was to provide savings for family's with disabled individuals without losing their SS eligibility. First 100k saved is exempt from SSI income eligibility tests -Can be used tax free to cover expenses related to living with a disability ex. basic living expenses, education, heath care, transportation -Account eligibility limited to those with severe diasabilities that began prior to age 26.
Incapacity -lack of physical or intellectual power of legal qualifications -the quality or state of being incapable
Incompetent -not legally qualified -lacking the qualities needed for effective action -unable to function properly
POAs a written doc which one person (principal) uses to empower another person (attorney in fact) to act on their behalf
Durable POA for Heath Care -only medical decisions -always a springing power
Durable POA for asset management -not affected by the principal's later incompetency -Document can be drafted so as to empower the holder currently or to become effective only in the even the principal becomes incompetent -death of the principal terminates the POA
Powers which cannot be given to another -execute or revoke a will -power to execute a living will
Durable authority of agent continues when principal becomes incompetent
Nondurable power ceases when the principal is no longer legally competent
springing power Agent has no power over the principal's assets until incompetency
Living Will (advance medical directive) Legal document which directs the physician to discontinue life sustaining procedures if the client is terminally ill or permanently unconscious. Relays wishes regarding live sustaining issues.
Guardianship "guardian of the person" Health care and other personal decisions Court appointed and subject to court supervision
Conservator "guardian of the property" Can make financial decisions Court appointed and subject to court supervision
Revocable Trust Funded either before incompetency or by the attorney in fact, the grantor can also write provisions that specify management by the trustee in the even of the grantor's incometency. The 2 advantages of the trust are that the trustee's authority to act in managing assets may be recognized and can be enforced, while a durable POA may not be. Revocable trust continues after death, durable POA dies at death.
Medicaid Planning -Both income and assets below certain limits, which vary from state to state. -Usually less than $2,000 in countable assets -New act will prohibit those from getting coverage if they have gave money or assets away in the last 5 years to get coverage. -Ineligible if they have more than 500k in home equity -If you have an annuity, you must name the state as your beneficiary to cover expenses
Special Needs Trust Can protect a disabled person from being exploited for people looking for money, because the trust has a feature where expenditures need to be approved by trustee. Use private funding to preserve public benefits.
Allows beneficiary to continue receiving public benefits (medicaid, section 8 housing assistance, SS)
Trust can only pay for supplemental needs not covered by those programs. Ex. private nursing care, furniture & supplemental housing expenses, vacations
Can be used in litigation where a person is diabled in result of an accident. Money from settlement will fund the trust.
Trust - in order for it to exist there must be trust property (aka the corpus) - must be a grantor (trustor) the person who transfers the property & dictates rules of the trust - Must be a trustee. This is the party to whom the property is transferred. They receive legal title to the property in the trust and they will manage / distribute the trust/ any income according to the terms of a formal written agreement. Has legal title. -There must be a beneficiary. This is the party who benefits from the trust. They will receive direct or indirect benefits in the form of income or property. Holds the equitable title -The grantor and trustee must be legally competent
Simple Trust (uses conduit principle for distributions) A trust (or estate) is considered merely a conduit for forwarding income to the beneficiaries. Income and deductions are passed on to the beneficiaries, who pay tax on their own marginal tax bracket.
Distributable net income (DNI) The accounting principle that limits the amount that trust beneficiaries must report as gross income for income tax purposes. Attempts to do the following: -provide the trust (estate) with a deduction for the amount being distributed -limit the portion of the distribution that is taxable to the beneficiaries -ensure the character of the distributions remains the same in the hands of the beneficiary as it was in the trust No double taxation of trust income because the trust receives a deduction ("distribution deduction") on the income that is distributed to the benes. Deduction is equal to the lesser of the amount distributed to the benes or DNI
Trust (complex) - A separate tax entity - if it is an irrevocable and the grantor has not retained any control - income is accumulated (either because the trust document requires it or because the trustee has discretion to accumulate it)
Differences between simple & complex Income: simple- distributed complex- must or may be accumulated
Tax: simple-income distributed is taxed to the beneficiary complex- income accumulated is taxed to the trust. Income distributed taxed to the beneficiary.
Corpus Distribution: simple- normally no distribution of corpus complex-corpus can be distributed
Charitable gifts: simple- no complex- can make charitable gifts
Revocable Created when the grantor transfers the trust property to the trustee but reserves the power to alter or terminate the trust. Grantor can also be the trustee. Usually becomes irrevocable at death. Aka Grantor trusts.
Inter vivos (revocable living trust) Avoids probate Grantors are usually trustees Becomes irrevocable at death or terminates with the corpus distributed to the remainderman or continues in existence to a later date. Usually has no gift tax during grantor's lifetime. Transfer doesn't constitute gift tax, because the gift is not complete. All income earned by the trust is taxable to the grantor.
Pros and Cons of Revocable living Trust Pros: organization of property during lifetime greater privacy potentially lower cost than probate alt to guardianship or conservatorship speed of disposal of property avoidance of probate &ancillary probate Avoid will contests
Cons legal fees to create / prepare funding burden longer creditor period Doesn't save on estate taxes
Testamentary trusts May be created in accordance with someone's will. The trust can protect trust property form successive estate tax liability as it passes from one beneficiary to another
Irrevocable Can't be altered or amended without approval of the court. Rarely included in the grantor's estate (for estate tax purposes). Grantor cannot terminate the trust and reclaim the property.
Spendthrift trust A provision that prohibits the transfer of the beneficiary;s interest and stipulates that it is not subject to the claims of the beneficiary's creditors.
Bypass Trust // "B trust" Bypass, nonmarital, B, family, applicable credit amount. Consists of property transferred to the trust at the time of the decedent's death. Gives the decedent postmortem control over the property. The amount of property transferred to the trust is usually an amount equal to the exemption. Can be structured to provide income stream to surviving spouse. Income can be split among the spouse and other individuals Surviving spouse may be given limited withdrawal rights (5 and 5 or HEMS) if this is the case it will not be included in the surviving spouse's estate At the surviving spouse's death the assets pass to the beneficiary, estate tax free. Always fully fund the bypass trust using the available exemption. The Bypass trust does not use the marital deduction. It normally uses the applicable exemption amount ($5,490,000).
Portability of un-used exemption The surviving spouse can use any remaining / unused exemption of the deceased spouse.
Marital Trust AKA Power of appointment trust, A trust, marital A trust Consists of property transferred to the surviving spouse at the decedent's death. Surviving spouse either has a lifetime or testamentary general power of appointment over this property and can transfer it to whomever they wish. Gives the surviving spouse postmortem control over the property. Surviving spouse has a right to all the income and can invade the corpus. Property placed in this trust qualifies for the marital deduciton. Not subject to estate tax, but included in gross estate of the decedent.
QTIP (qualified terminal interest property) current income interest or C trust Used for the decedent who wishes to provide the surviving spouse with a stream of income that will be paid for life yet also wishes to get the marital deduciton. L lifetime income interest for spouse A annual payment for spouse M mandatory payments to spouse E exclusively for the spouse Gives the decedent spouse postmortem control over the property when the surviving spouse dies. Property can qualify for the marital deduction, but must be included in the gross estate. Executor must make an election on the decedent's tax return to have the property be treated as a QTIP. Can add a provision to make any estate tax attributable to the QTIP must be bourne by the surviving spouse's estate (the surviving spouse's estate will receive reimbursements from the QTIP for any tax that needed to be paid) QTIP property need not be in the form of a trust. This is the only exception known.
Dynasty Trust (aka GST) Can last for the lives in being plus 21 years and 9 months or as long as local law allows. Beneficiary interests are limited to life estates. The rule of perpituities would be violated if a number of years is stated.
QDOT (Qualified Domestic Trust) When one spouse is not a US citizen: -there is no unlimited marital deduction -jointly held property between the spouses is not considered one half owned -limited gift amount between spouses ($175k) -The tax exemption (5.49 million) is available unless the spouse is a non resident alien -Use the QDOT to get the marital deduciton to the non US citizen spouse
Powers of appointment is an interest held by a person which gives the holder the ability to determine who shall enjoy use and possess the property subject to power
General power The holder can exercise the power without any conditions or restrictions placed on the ability to exercise the power. There are no required words or phrases to set it up.
Special Power The holder can exercise the power only with certain conditions / restrictions placed on the ability to exercise the power (ie can only have the power for a certain period of time, or can only act for certain beneficiaries)
Five or Five Power Flexibility with little / no tax consequence. Property subject to a general power will be included in the donee-decedents estate only to the extent of the greater of $5,000 or 5% of the total value of the property / trust If the 5 and 5 is exercised during the life time, then the amount withdrawan will be included in the gross estate
Distributions for an ascertainable standard ascertainable standard is a power limited by some unit of measurement. If power is limited by HEMS it is not a general power. Heath, education, maintenance, support "support in reasonable comfort" If is has "support"then it is not a general power
CRAT -used in situations where the donor wants to provide a nonchariable beneficiary with a stream of income to last a period of years or for the rest of their lifetime. Period of years cannot be more than 20. -Once the beneficiary receives all income, the property passes to the qualified charity. -Remainder interest is required to be at least 10% of the contributed amount -Donor can only make 1 contribution -Once established, the corpus must pay out a specific amount of income each year (must be at least 5%) this amount remains fixed gauranteed fixed income for life
CRUT -charitable deduction is the PV of the gift (not basis!) -used in situations where the donor wants to provide a nonchariable beneficiary with a stream of income to last a period of years or for the rest of their lifetime. Period of years cannot be more than 20. -Once the beneficiary receives all income, the property passes to the qualified charity. -Remainder interest is required to be at least 10% of the contributed amount -Donor can make more than 1 contribution -Once established, the corpus must pay out a specific percentage of income each year (must be at least 5%) this amount remains fixed -Income can rise with inflation
Charitable lead trust -Can take an upfront income tax deduction for the current value of the payment stream distributed to charities, however future income & gains are taxable to you and you will not be entitled to anymore any additional charitable deductions or the annual deduction.
Non Grantor lead trust: annual income tax liability is reduced through its deductible charitable contributions. You will receive a gift tax deduction for the upfront PV of the gift. Appreciation of assets os free of estate &gift taxes
If trust is established at your death, your estate can take the PV of the payment stream as an estate tax deduction. Annuity payout creates an estate tax deduction, because its a chaitable gift.
Charitable Gift Annuity Donor transfers property directly to the charity and the charity pays the donor a specific amount each year during remainder of the donor's life. -money is NOT transferred to a trust, instead just to the charity directly -charity gets the money now. -the value of the property transferred to the charity exceeds the value of the annuity guaranteed by the charity. The amount contributed is the allowable deduction. The transition is an aquisition of an annuity and a charitable contribution so no 5 and 5 rule
Pooled income fund Donor places property into a common trust fund, the assets are commingled with other donor's property. The assets are controlled by the public charity. After the income distributions terminate, the charity gets the remainder. Donor cant change their mind on who gets the remainder. -commingled -cant invest in tax exempt securities -upon death, the remainder interest vests with the charity -donor receives an income tax deduction for the PV of the remainder interest. Additionally, the donor receives a gift tax deduction for the property gifted. -donor cant be a trustee of the funds -kind of like a mutual fund ran by a public charity -no 5% rule
Wealth replacement trust AKA IILT. Face amount of policy in ILIT can be less than or equal to the value of the property tranferred to charity.
Used when a donor has concerns about not having money once they have donated so much to charity.
Private Foundations a trust or nonprofit organization, that may be created or controlled by a family to contribute charitable causes. Seperate, legal entity that holds investments and uses 5% of its assets each year for charitable activities. Has to follow specific state and federal laws to get the tax deductible status.
Private foundation creater will have complete control over the amounts and recipients of the gifts. 5% must be distributed annually Control of the foundation may remain the family over generations Foundation can distribute gifts to noncharitable beneficiaries if the purpose is for: study, travel, scholarship, award, prize, or intended to improve literacy, art, skill talent etc
-subject to excise taxes (2% of net income), but exempt from federal income tax -15% penalty if they dont distribute 5%
Donor Advised Funds Can establish at a community/ public foundation. The donor may recommend eligible charitable recipients for grants from the fund. The public charity's governing body must be free to accept or reject the recommendations. 1. Separately identified with reference to the contribution of a donor(s) ex. the fund is named after a donor. Organization tracks contributions with respect to specific donors 2. It is owned and controlled by a sponsoring organization 3. the donor or a person appointed by the donor has, or expects to have the privilege of providing advice with respect to the funds investments / distributions
Bargain Sales The property is sold to the charity for less than FMV. The sale must be allocated between the portion of the property "sold"and the portion "gifted"to charity, based on the FMV of each portion. Sale price / FMV price * basis = adj. basis sale price - adj basis = taxable gain
Installment Sale -property owner needs income -sale of property at FMV in exchange for payments -PV of remaining payments is included in owner's estate -property is secured -gain is a capital gain. Do not use if property is subject to recapture -if property is sold by a related party, then sold again within 2 years, the seller is deemed to have paid in full for income tax purposes -if debt is cancelled or forgiven (at death or not) then the seller must recognize gain to the extent that the FMV on the date of cancellation exceeds the seller's basis in the obligation. Gain: FMV - basis and the FMV will be considered a gift.
Self Canceling Installment Note -property owner needs income that will not continue past their death. -no value is included in the owners estate -gain is a capital gain -assets can be depreciated -interest can be deducted -higher payout than installment sale -Balance of any payments due at death, are automatically cancelled. -Can depreciate assets based on purchase price paid and to deduct the portion of payments attributable to the interest expense. -Higher tax payments while living. -Buyer pays a premium for the cancellation feature - Cancellation of payments will trigger recognition of the entire remaining gain on the decedent's estate income tax return.
Private Annuity -property owner needs income -private sale in exchange for periodic payments -no value is included in the owners estate -property is transferred for a promise -taxation to the seller -all the gain which would have been recognized over the life of the annuity will now be taxed in the year in which the private annuity is established. -Doesnt work because it creates phantom income.
GRAT -property owner needs income -Irrevocable trusts that allow the grantor to make gifts of property while retaining an income interest and in return they receive a fixed annuity for a number of years. -at the end of the term, assets are distributed to a remainder person -the value of the gift is discounted -owner must outlive term, or the asset is brought back into the estate at the date of death value -Gift of future interest, no 14k annual exclusion -More useful than GRUT, asset only has to be valued once. -For assets likely to appreciate
Partnership / S corp Gifting shares -property owner wants to gift assets/ income to family members -family member receives conduit income. don't use if child is under 24 (kiddie tax) -Gift shares to other family members to take advantage of the exclusion. -business entity must be capital sensitive (warehouse). do not use if business is service related (CPA, CFP businesses)
Family Limited Partnership -property owner wants to gift assets/ income to family members. shift income to children -Gift interest to limited partners to reduce size of the estate -qualifies for various valuation discounts allowing for greater reduction of the size of an estate -general partner maintains control -business is not service related -income and tax benefits must be allocated according to each owners percentage in the partnership. -general partners must be paid for their personal service to the partnership -capital must be "a material income producing factor"income cannot come from personal services of the general partner -two types of valuation discounts: lack of control and marketability, allow for gifting discounts. -donor retains control over the general partnership assets, determines when to make distributions etc -No step up in basis for transferred property. -FLP has some asset protection against creditors of the general partners. Assets of the FLP generally cannot be attached to satisfy personal debts of the parent/partners -General partner is responsible for all partnership debt -Partnership interest is considered personal property, so an owner could avoid ancillary probate.
Gift leaseback -property owner wants to gift assets but is held back by lack of available assets (except for business assets) -gift of fully depreciated property to a family member in a lower tax bracket, who then leases the property back to the business owner. -lease payments are a business deduction for the parent as long as there is a legit business purpose. -The lease is treated as income to family member -Dont use if child is under age 24
Qualified Personal Residence Trust -irrevocable transfer of a personal residence -at the end of the term, the residence is elimiated from the estate, and passed to the beneficiaries of the trust -value of the gift is discounted -owner must outlive term, or the asset is brought back into the estate valued at FMV date of death. Used when; -residence is worth more than 1mm -when the life expectancy is reasonable -when the donor continues to live in the residence -when the estate is large (over 5.49mm) -Can put a vacation home in the QPRT -Residence can be sold during the initial term. Replacement home needs to be purchased within 2 years. -Residence can still have a mortgage
GRUTs Grantor retains a qualified unitrust interest consisting of an irrevocable right to receive a fixed percentage each year of the net FMV of the trust assets which is determined annually. -Best asset to transfer is an asset subject to appreciation, not an income producing asset -Asset needs to be valued annually.
GRIT -Property transferred into an irrevocable trust, retaining the right to income for a period of years. -At the creation of the trust, the value of the property transferred into the trust is reduced by the retained interest (normally 0) -gift of future interest -Gift FMV - retained interest ($0) = taxable gift. this is a larger taxable gift than the GRAT's.
GSTT Generation skipping transfer tax Tax all individual wealth in excess of certain amount each time it passes to the next generation. Only a tax that explicitly address the generational relationship between the transferor and transferee can consistently tax wealth as it passes to succeeding generations
Skip persons: -someone who is at least 2 generations younger than the donor. -unrelated persons who are more than 37.5 years younger -if an individual whose parents are deceased, then the individual and all succeeding generations move up one.
The first 5.49 mm transferred is exempt from GSTT. $14k annual exclusion. A spouse can elect to gift split. Flat tax of 40% A GSTT gift is also subject to gift tax Estate tax and GSTT tax can both be due. Gift taxes paid within 3 years will be brought back into the estate, but not the GSTT paid.
GSTT transfer to skip person #1: Direct Skips GSTT is imposed at the time of the direct skip. Transferor is liable for the GSTT on direct skips. Allocation of the exemption is automatic with direct skips, but transferor can elect to not have it apply. Can use exclusion and exemption to make a total gift of $5,504,000
GSTT transfer to skip person #2: taxable terminations a termination of a nonskip person's interest in income or principal of a trust with the result that skip persons become the only remaining trust beneficiaries. Allocation is elective here.
GSTT transfer to skip person #3: taxable distributions Any distribution of property out of a trust to a skip person (other than a direct skip or a taxable termination). When a trust has beneficiaries in 2 or more generations and the trustee makes a distribution to a skip person, it is a taxable distribution. The skip person pays the tax after the exemption is used up.
GST Summary of payments -If the transfer is a direct skip, the transferor pays the GST tax -If the transfer is a taxable termination, the GST tax is paid by the trustee -If the transfer is a taxable distribution, the GST tax is paid by the transferee
Trust Fiduciary Person or entity that occupies a position of special trust in relation to the other person. This involves holding legal title to the property that must be handled for the sole benefit of the other person (beneficial owner). It may also involve making personal decisions for the person, just as a guardian does. Trustees, guardians, agents, personal representatives
Duties: -loyal to beneficiaries, does not self deal, preserves property & makes it productive, impartial to all beneficiaries
Beneficiaries can take civil and criminal action against the fiduciary if they breach their duties
Executor/ Personal Representative The person nominated in the will to be the personal representative. Female= executrix The court appoints a personal rep to act as a fiduciary to represent and manage probate cost.
Trustee The trust, court decisions over the years and current laws have provided rules that spell out the trustee's duties. When the trustee controls trust assets they must be faithful to the beneficiaries by acting in the beneficiaries best interest.
Guardian Guardian - for minors Conservator- for adults (usually disable)
Must make annual reports to the court Must also have court approval for certain expenitures or to sell certain assets
income tax treatment of distributions to beneficiaries -Beneficiaries are taxed on the part of the income currently distributed and the estate or trust on the portion that it has accumulated. -If the estate has to distribute all of its income, the beneficiary must report their share of DNI, whether or not they actually receive it.
If the trustee has a choice not to distribute all or part of the current income, then the beneficary must report the following: -all income that is required to be distributed, whether or not it is actually distributed -all amounts actually paid or credited up to the amount of the beneficiaries distributed net income. Tax rates are more generous than individual rates.
Grantor trusts (defective or tainted trusts) In a grantor trust, the maker holds too much control or "strings"over the property for tax purposes. Income tax liability. The grantor will be taxed on the income produced by the trust
Defective Trust Examples -Trust income is or may be distributed or accumulated for later distribution to either the grantor or their spouse -trust income is or may be used to discharge any legal obligation of the grantor -trust income actually used to discharge a legal support obligation of the grantor -the power to control the beneficial enjoyment of trust principal or income is held by either the grantor or grantors spouse -trust income is or may be used to pay premiums on LI. In the funded scenario, the amount of the LI premium is income taxable to the grantor. - A reversionary interest that exceeds 5% of the trust value at the time of creation is retained by the grantor
Estate tax purposes: -grantor retains a right to income or use/enjoy the property -a reversionary interest that exceeds 5% at the time of death
Should never taint for income & estate tax purposes.
Administrative Power Held by either the grantor or their spouse to deal with the trust property for less than full consideration, to borrow from the trust without aqeduate interest or security or the right to vote the stock held in the trust corpus.
Alternative Valuation Date May elect to have the the assets included in the decedent's gross estate valued at an alternative valuation date, which is 6 months after the decedent's death. The following conditions must be met in order to use the alt date: -creates a reduction in total value of gross estate -must be applied to all properties included in gross estate -cannot be used on assets that have a value that decreases with the mere passing of time
Cannot step up in value: -assets passing to the spouse using marital deduction -assets passing to children that are equal or less than 5.49 mm
Exceptions to 6 mo valuation date: waiting assets: some assets experience a reduction in value by a lapse in time (mortgage payouts, annuity payouts, notes receivable) Can use valuation date on these as date of death and still use 6 mo valuation for all other assets. Assets sold: assets sold or distributed before the AVD are valued at the date of sale.
Disclaimer An unqualified refusal by a potential beneficiary to accept benefits given through a transfer of property. For federal tax purposes, the disclaimer is regarded to never have received the property. No transfer is consdiered to have been taken place. In order to disclaim and have a favorable result the following requirements must be met: -disclaimer must be an irrevocable refusal to accept the interest -the refusal must be in writing -the refusal must be received within 9 months after the later of a. the date on which the transfer creating the interest was made or b. the day on which the person disclaiming reaches age 21 -the intended donee cannot have accepted ANY interest in the benefits -as a result of refusal, the interest will pass, without the disclaimer's direction, to someone else.
Disclaimer Trust Possible for the spouse to disclaim the property, yet receive a stream of income from the disclaimed bequest. This can be accomplished through a disclaimer trust. The trust is part of a clause in the decedent's will. If the surviving spouse disclaims the assets, then those assets are transferred to an irrevocable trust, and income is paid to the surviving spouse. Spouse cannot have any power to invade corpus in the irrevocable trust (exepct with ascertainable standard)
Estate Liquidity: Stock 303 Plan: Stock Redemption -Business must be incorporated (closely held stock) -Business can distribute a portion of the stock of a decedent without it being taxed as a dividend. -Value of stock must exceed 35% of decedents adjusted gross estate -amount of stock redeemed cannot exceed the sum of the estate taxes plus admin expenses
Estate Liquidity: Installment Payment of estate taxes 6166 Used to pay the estate tax attributable to the closely held business interest in 10 equal installments beginning 4 years after the decedent's death. 1. property must be in a sole proprietorship, partnership, or corporation. Aggregation is allowed if more than 20% interest in each business 2. interest must be carried on as of the day of death 3. Value of the business must exceed 35% of decedent's adjusted gross income 4. During the first 4 years (of 14 years) can pay interest only on taxes due 5. the interest rate will be 2% on the first 1.49mm. 6. the 2% is not deductible
Post Mortum: Estate tax reduction Special Valuation 2032A 1. Real estate used for farming or in a closely held business 2.must meet 2 rules to qualify: -50% of gross estate must consist of real and personal property -25% of the gross estate must consist of real property 3. 1,120,000 reduction in the gross estate 4.Must be in qualified use; 5 out of 8 rule before death / 10 years after death
whenever 2032A is available, so is the installment sale 6166
Estate planning for nontraditional relationships: children of another relationship cohabitation adoptions same sex relationships - A revocable trust or tennancy in common is usually a good answer -Theres no marital deduction -guardianship for children not in common can be an issue
Not good options: wills (likely to be contested) JTWROS has problems (one partner can sever the joint tenancy, noncontributing partner can make withdrawals which could be taxable gifts, unwanted withdrawals & reachable by creditors)
Nontraditional family members can use GRITs
What are the types of systematic risks? P.R.I.M.E
Purchasing Power Risk Reinvestment Rate Risk Interest Rate Risk Market Risk Exchange Rate Risk
What are the unsystematic risks? ABCDEFG
Accounting Risk Business Risk Country Risk Default Risk Executive Risk Financial Risk Government/Regulation Risk
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