Debits & Credits
by Doug Schultz & Rick Hillsbery
Many of us wonder if we will have the financial resources necessary to take that trek to Mount Everest, or lounge out on our private balcony overlooking a crystal blue sea. We wonder if we will have saved enough for our children’s college tuitions and, later, their weddings. We want to live comfortably and enjoy our beautiful community, maybe even give a little back, but how do we know we have enough financial resources to meet these goals? Better yet, how do we make these goals a reality?
Financial planning is the process of meeting our life goals through the proper management of our finances. A good financial plan can provide confidence and a measurable benchmark from which to monitor and make sure that our goals are on track. Working with the right team of professionals to build and track the plan will reduce anxiety and ensure that the right financial choices are made.
To understand the process, we have to look at the five major areas of
financial planning: investment, income tax, retirement, insurance and estate planning. All of these areas are important for different reasons and must be looked at individually, and as a whole.
Investment Planning
Investments are typically broken down into asset classes such as real estate, stocks, bonds and cash. Because you are reading this publication, it’s probably safe to assume that a large portion of your wealth is tied up in real estate. The key is to have your investment planning focus on asset allocation and diversification. Asset allocation is the practice of combining different asset classes in an appropriate mix for an individual’s risk tolerance to optimize the investment portfolio and meet financial planning goals. In other words: “Don’t put all your eggs in one basket.”
For those who have spent the time to be successful in apartment building ownership, the real-estate asset class has proven to be a great investment vehicle. Historically, real-estate appreciation, along with the income tax benefits from real-estate investment such as the interest expense deduction and depreciation deduction, have combined to make investing in real estate quite attractive.
However, those of us who owned property through the late 1980s and early 1990s remember that real-estate prices don’t always just go up. Over the long term, real estate has consistently increased in value and has been a great inflation hedge, even though, short term, there is price change volatility. This makes it important to look at diversifying among different major asset classes in your portfolio.
Diversification is important because we would like to plan for consistent returns over a long period of time. Historically, the stock market as a whole has outperformed inflation, just as real estate has. It is important to note, however, that from early 2000 through March 2003, the much-diversified S&P 500 index lost almost 50% of its value (excluding cash dividends). This was the worst downturn in the stock market since 1929. It wasn’t only those individuals who held individual stocks such as Enron and WorldCom who lost their nest eggs. If you had all your wealth diversified in the S&P 500 index, you also would have suffered.
Remember, any particular asset class, as a whole, can accumulate outstanding gains or suffer a downturn at any given time. Ownership in a good mix of real estate, stocks, bonds and an adequate cash reserve will improve your chances of surviving a deep trough in your overall portfolio.
Income Tax Planning
Income tax planning is an important part of overall financial planning. However, don’t let the income tax tail wag the economic dog. In the above example citing the recent bear market, many people did not sell their high-tech stocks for a profit early in the downtrend because they did not want to pay the tax. With hindsight, taking a profit and paying capital gains tax would have been better than losing.
You will make the best financial decisions when you understand the tax implications prior to the transaction. If you are contemplating a 1031 exchange of rental property, contact your accountant prior to the deal to make sure that the exchange will justify the additional transaction cost. If you are taking cash out of the deal, have a big cache of prior passive losses racked up or have capital-loss carry forwards, you may be better off not doing an exchange.
The alternative minimum tax is an evil byproduct of a well-intentioned idea invented by Congress to go after 155 wealthy individuals in the 1960s who were not paying any income tax. Unfortunately, because the internals of the AMT law were not indexed to inflation, millions of us may come under its clutches and that number is increasing every year. Therefore, the AMT makes tax planning more important than ever.
Retirement Planning
In retirement planning, a detailed cash flow analysis should be performed to determine your spending habits before retirement and your anticipated spending habits during retirement. For most people, spending will decrease in retirement because they will no longer have the cost of commuting, lunches out and paying for college. For a few of us, however, expenses can increase in retirement because of travel desires, increased medical costs or additional leisure time to shop. It’s important to self-analyze and determine where you fall in the post-retirement expense picture.
When thinking about retirement cash flow, consider that investment returns and inflation do not conveniently plot in an orderly straight line up and to the right. Inflation and your investment returns will fluctuate over time. There is a tool used by some financial planners called Monte Carlo analysis (no, we are not talking about gambling) that will tell you what the probability is of meeting your cash flow needs with a given set of goals and a given asset allocation. Obviously, the closer to retirement, the closer the probability number should be to 100%.
Insurance Planning
Insurance is a contract whereby premiums are paid to an insurance company in order to provide indemnification against loss. As a property owner, you are already aware of the importance of property and casualty insurance to protect your investment in case of property damage or ownership liability.
For those retiring early or for those ineligible for Medicare, health insurance can be a huge expense that needs to be considered. Even those eligible for Medicare need to consider the cost of premiums, co-pays and possible gap insurance. It might make sense to take a look at long-term care insurance to help defray the cost of nursing home care, especially if there is a history of Alzheimer’s disease in the family.
Insurance can also be used as an investment vehicle in the form of an annuity to provide a constant, known cash flow. For those people who find it difficult to control spending, an annuity might be a good tool to help regulate spending since it can be structured to provide a fixed payout on a regular basis.
Life insurance has different uses. If you haven’t yet achieved the level of wealth to provide living expenses for your family should you meet an untimely demise, life insurance is an important tool to replace income so that your loved ones can continue to meet basic needs without you.
Life insurance can also be used to provide liquidity to an estate. For example, if you own one large property that would be subject to estate tax and there are not sufficient liquid assets in the estate to pay the tax, a life insurance policy held by an irrevocable life insurance trust (see the estate planning section below) could be used by your heirs to pay the estate tax and allow them to keep the property.
It is more likely that a person will become disabled than die before age 65. Disability insurance can provide an income stream during disability. If you do not have employer-provided disability insurance and have family or other obligations, disability insurance may be right for you. Be careful to purchase the right policy because there are different definitions of disability, different payout rates and varying elimination periods.
Estate Planning
A good estate plan will allow you to leave your assets to whomever you wish with minimal estate taxes in a reasonable amount of time. Unfortunately, estate planning at this point in time is difficult because of political uncertainty. Will there be a $2 million exclusion limit like there is now, or will there be no estate tax in 2010? What an embarrassing state of affairs. Hopefully, Congress will enact reasonable legislation that is inflation indexed to give us a firmer footing for planning.
As discussed previously, life insurance can be used as a tool for a person with real-estate holdings to provide the liquidity for heirs to pay estate taxes. By default, life insurance proceeds would be included in the gross taxable estate. However, it may make sense to use an instrument such as an irrevocable life insurance trust to own a life insurance policy. If the rules are followed, the death benefit will not be subject to estate tax.
Another way to avoid estate tax is to take advantage of the annual gift exclusion. A married couple can give $24,000 (indexed for inflation) per year to anybody they want without having to pay a gift tax. In addition, there is no limit on the amount that can be given for education or medical expenses as long as the gift is given directly to the college, university, hospital or doctor, and not the student or patient. For example, if you have three children and seven grandchildren, you and your spouse can give up to $240,000 gift-tax free per year. If you desire to give more than the annual gift-tax exclusion amount to somebody in a given year, you still may be able to avoid the gift tax. You are given a lifetime exclusion of $1 million to be used to avoid a gift tax, but remember that the estate-tax exclusion is reduced by the amount of the gift-tax exclusion used.
Conclusion
Once you have constructed and implemented your financial plan integrating the five planning areas of investment, income tax, retirement, insurance and estate planning, the most important thing to do is to monitor the plan. As changes occur throughout your life, take the time to update the plan to meet your circumstances. A financial plan is a roadmap to the future of your financial wellbeing and will serve you well long into your retirement years.
The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of SFAA or SF Apartment Magazine. Doug Schultz is a certified public accountant and partner in the tax practice at Burr, Pilger & Mayer. Rick Hillsbery is a certified financial planner and a senior accountant in the tax and wealth management groups of Burr, Pilger & Mayer. Copyright © 2007 by SF Apartment Magazine. All rights reserved.