Frequent Social Security Questions

Answers to Social Security related questions can be found at www.socialsecurity.gov. Here are the most frequently asked questions that I have been asked recently.

Do I have to pay income tax on my Social Security benefits?

You will have to pay federal taxes on your benefits if you file a federal tax return as an "individual" and your total income is more than $25,000. If you file a joint return, you will have to pay taxes if you and your spouse have a total income that is more than $32,000.

How much will a widow or widower receive?

The amount you will get is a percentage of the deceased's basic Social Security benefit. The percentage depends on your age and the type of benefit you are eligible for. A widow or widower, full retirement age or older, will receive 100 percent of the deceased's basic Social Security benefit.
A widow or widower can receive full benefits at age 65 or older (if born before January 2, 1940) or reduced benefits as early as age 60. The age for receiving full benefits is increasing for widows and widowers born after 1939 until it reaches age 67 for people born in 1962 and later.

How are my retirement benefits calculated?

Social Security benefits are based on earnings averaged over most of a worker's lifetime. Your actual earnings are first adjusted or "indexed" to account for changes in average wages since the year the earnings were received. Then we calculate your average monthly indexed earnings during the 35 years in which you earned the most. We apply a formula to these earnings and arrive at your basic benefit, or "primary insurance amount" (PIA). This is the amount you would receive at your full retirement age, for most people, age 65. However, beginning with people born in 1938 or later, that age will gradually increase until it reaches 67 for people born after 1959.

I have worked as a stay at home parent and part time while my spouse has worked full time. What will my benefits be?

You can be entitled to as much as one-half of your spouse's benefit amount when you reach full retirement age. If you want to get Social Security retirement benefits before you reach full retirement age, the amount of your benefit is reduced permanently. The amount of reduction depends on when you will reach full retirement age.

Credit Card Offers for College Students

The topic of the previous blog was credit cards for undergraduate college students. My daughter who enters college this fall got 3 credit card offers: BB&T, Discover, and Capital One. From the offers it is apparent that she is considered a high financial risk by all 3 issuers, which is probably justified given her current level of income.

All 3 offers offer no annual fee and lots of other benefits.

Discover stated "Don't delay - start building your credit history today." Captital One stated "Keep in mind, we may increase your APR if you pay us late twice within 12 months."

These offers in the order of BB&T, Discover, & Capital One are presented below:

Annual Percentage Rate (APR) : It is a variable rate at the prime rate + ___% with a current rate of 17.9%, 16.99%, 19.8%.
Cash Advance APR: 24.15%, 23.99% with a default rate of 30.99%, 22.9% with a default rate of 24.9%.
Transaction fee for cash advance: 3% ($5 minimum), 3% ($5 minimum), 3% ($10 minimum).

Assuming a $500 credit limit here are the rest of the fees:

Late payment fee: $35, $39, $39
Over the credit limit fee: $35 and no overlimit paid, $39, $29.

For illustration sake lets use $35 for both the late payment fee and the over the credit limit fee.

Let's assume my daughter buys $350 worth of books and school supplies in a single transaction, probably a low amount. The first thing that happens is this amount is authorized and reserved by the issuer. Later the account is settled. The process of reserving and settling this account will essentially double book this account for a period and the credit card account will show a balance of $700.

For this $350 transaction and $35 fee will be assessed for the month. If the credit card is paid late another $35 fee is assessed. This single transaction can have $70 worth of fees. This is 20% of the transaction amount for a month and if this annualized by multiplying by 12 it becomes 240%. The account balance has now grown to $420+.

The largest potential problem with a credit card is with the fees, 240% annualized, not the APR of about 20%.

Just say NO to credit card offers for undergraduate college students.

Credit Cards and College Students

My daughter just graduated from high school and is preparing for college this fall where she will be a full time undergraduate student. Many are in this same situation.

The question we looked at was should she have a credit card? Here is the research we found in Volume 6 of the Journal of Personal Finance:

1. In 2003, credit cards are used by about 1/3rd of Americans age 18 and 19.
2. In 2004, one credit card is held by at least 70% of college students.
3. In 2001, 47% of undergraduate had 4 credit cards or more.
4. In 2001, 21% had balances between $3,0000 - $7,000.

I am sure these numbers have grown with time. Consequences for undergraduate students with credit card debt:

• Students feel forced to put jobs ahead of school to keep up with payments (notice not being able to pay off each month and having to make payments).
• Students who had an academic hearing often mentioned working multiple jobs to pay on debts as reasons for poor academic performance. The end result for some is dropping out of school, delaying graduate school, etc.
• This can lead to a poor credit rating and put the student in a more difficult financial position. The key justification given by a credit card issuer is "it is important for the student to establish a credit rating." Having a good credit rating is never stated.
• Having a poor credit rating leads to difficulty in obtaining future loans.

The bottom line is a credit card should be used by college student who has shown financial discipline. If financial discipline does not exist delay getting a credit card and use a debit card. A debit card is a good tool to teach financial discipline without having long term financial consequences.

My daughter went to a bank, with a branch in the town she is attending college, to open an account. The bank had a program for students that included a saving accounnt, checking account, debit card, and a credit card. She is now fully equipped to spend money.

What is she doing with this new found financial freedom? She is going to keep the debit card and cancel the credit card. The strategy is to use the debit card through undergraduate school and start using a credit card after graduation.

The next blog will show the 3 credit card offers and pitfalls of using any of these cards.

Estate Tax Charitable Deduction

This is the final blog in the series on reducing gift and estate taxes. If your estate is larger than the estate tax exemption limit another good strategy is to give a portion to your favorite charity.

Beside doing something good for others you also do something good for you. The strategy is to do a split interest transfer where both the charity and you benefit.

Seven requirements must be met for a gift to be tax deductible:

1. Contribution must be made to a qualified charity
2. Property must be the subject of the gift
3. Contribution must be in excess of any value received in return by the donor
4. Must be paid within the tax year
5. The value, if over $5,000, must be attained through a qualified appraisal. An appraisal is not required for publicly held securities.
6. Contribution effective at death is deductible and transfer must be made by the decedent.
7. A split interest must be in the form of a trust.

This split interest trust comes in 2 forms. The first form is the Charitable Remainder Trust where you derive an annual benefit and the charity gets what is left. Secondly, is the Charitiable Lead Trust where the charity derives an annual benefit and your beneficiary get what is left.

A Charitable Remainder Trust is an irrevocable trust designed to provide a fixed amount annually to a non-charitable beneficiary, usually you the donor, with the remainder left to the charity. The annual amount must be somewhere between 5 % & 50% of the initial fair market value. Future additions to the trust are not allowed.

This works really well when a person has assets and needs more money to live. Instead of selling the asset and paying capital gains tax reducing your income, you donate the asset, increase your income through a tax deduction and you get paid an annual income. You can do something good for a charity, get an income tax deduction, have more money to live each year, and you do not have the hassle associated with disposing of the asset. A good deal for you and the charity.

A Charitable Lead Trust is an irrevocable trust design to do just the reverse. You transfer an asset's income interest for a period of time, get a tax deduction, and retain ownership of the asset. This works well for a person who has sufficient income and wants to reduce the value of the estate.

An example of how this works is a person donates $10,000,000 worth of securities that likely will appreciate with time and the charity gets 8% ($80,000) for 24 years. The value of this is calculated to be worth $9,600,000. At the end of the 24 years the trust still has a value of $10,000,000 even after the annual payments. The value of the trust from an estate tax perspective is $400,000, below the exemption limit and free of any estate tax.

This is a relatively complicated topic and professional assistance is required. It is wonderful that both you and your favorite charity can benefit so that your life can continue to have an impact into the future.

Estate Tax Marital Deduction

A major issue for retirees is avoiding paying estate tax especially if the estate tax exemption limit is reduced back to a level of $1,000,000 - $1,500,000. It may be easier than you think to reach a $1,000,000 estate especially for a married couple. Consider the value of your home, personal property, life insurance proceeds when a spouse dies, IRAs, Annuities, 401(k)s, and future inheritance from your parents and other family members.

Once you reach the exemption limit, your estate will pay at least 41% in tax to the government. As the size of the estate grows so does the tax rate and tax burden.

Married couples have an option to reduce the amount of estate tax called the unlimited marital deduction. A spouse can give the entire estate to a spouse without paying estate tax if 3 requirements are met:

1. The property left to the surviving spouse must be included in the gross estate of the first spouse to die.
2. The property must actually pass to the surviving spouse.
3. The property must not constitute a terminable interest when ultimately received by the surviving spouse.

Even with the unlimited marital deduction, paying of estate tax can not be avoided. Once the surviving spouse passes the estate tax is calculated.

To minimize the amount of estate tax liability a dual approach is often used. The estate is divided into 2 parts, an amount of the estate equal to the exemption limit is given to the surviving spouse and the remainder is put into a trust. In this manner, the number of exemptions can be increased from 1 to 2. Saving 45% on $1,000,000 means that $450,000 is given to an entity you choose rather than the government.

Options exist with the design of the trust. This is a complicated topic and getting professional assistance may be extremely beneficial.

An option to reducing estate tax is to take advantage of the charitable deduction. This is the topic for the next blog.

Gift Tax Reduction Strategy

The previous blog showed that once the $1,000,000 gift exemption limit is reached for the giving of gifts a gift tax is imposed. This gift tax rate is at least 41%. For a transfer of wealth to be considered a gift, 4 conditions must be met: 1) a capable donor, 2) a capable donee, 3) delivery and acceptance, and 4) intent to make the gift by the donor. The tax is paid by the donor.

If you have accumulated wealth and do not want to give at least 41% to the government, you need a gift tax reduction strategy. Three other reasons exist to make gifts: 1) the appreciation of the property is transferred to the donee further reducing the tax liability, 2) reduces the donor's gross estate reducing estate tax liability and 3) shifting of income and overall reduction of income tax liability.

The easist strategy is to make gifts below the annual exclusion limit. For 2008, an individual can give up to $12,000 in a year per recipient. For couples, a gift splitting election can be used raising the limit to less than $24,000 in a year per recipient. Gifts are typically given to children and grand children and can be given for as many years as possible. For example if you are married and have a total of 10 children and grand childred about $240,000 can be gifted without impacting the gift exemption limit and reported on IRS Form 709.

An easy way to give a gift to a minor is through a Uniform Gift to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) account. The donor retains custody of the account and ownership transfers in the future to the minor at the age of majority typically age 18 or 21. You need to gift assets that give off little active or passive income due to the higher tax rate for the minor. Investing in assets that pay little or no dividends reduces the overall tax liability.

Charities are good entities to make gifts especially appreciated assets. I believe in tithing, giving 10%, of you income and this is typically done on a cash or check basis. Another acceptable alternative is the transfer of appreciated assets which transfers the capital gains to a tax exempt entity.

If you have a variety of assets which ones are the best to gift? The best assets to gift include: appreciated property to reduce tax on capital gains, fully depreciated property as the tax reduction has been eliminated, and out of state property to avoid probate. Gifts that are less desirable include: property with a value less than purchase as the individual wants to take the tax loss and property not fully depreciated to further reduce the tax.

Additional gift tax reduction strategies exist including various forms of trusts. This is a relatively complicated topic and it is good to get professional estate planning advice.

Gift and Estate Tax Planning

Congratulations you have been successful and have a large sum of assets. You have now entered the final stage in financial planning known as Estate Planning. It has 2 components, Gift Tax and Estate Tax reduction.

This is a very complicated topic that requires legal guidance. The blog will give an overview to get you on the road. You can avoid paying as much in taxes by taking a few steps.

TAX RATES

The Unified Federal Estate and Gift Tax Rates (1977 - 2009) for Taxable Transfers:

$1,000,000 - $1,250,000 = 41%
$1,250,000 - $1,500,000 = 43%
$1,500,000 - $2,000,000 = 45%

GIFT TAX EXEMPTION LIMIT

The gift tax exemption limit is $1,000,000. An amount less than $1,000,000 is not taxed. Gifts given to a recipient in a year worth less than $12,000 per person or $24,000 per couple are not reported and do not count toward this limit. Amounts above this limit must be reported and counted toward this exemption limit on IRS Form 709.

ESTATE TAX EXEMPTION LIMIT

For 2008, the estate tax exemption limit is $2,000,000. This limit increases to $3,500,000 for 2009. In 2010, the estate tax is repealed.

What happens to the exemption limit in 2011 and beyond? The answer is unknown. My belief is that given the current political environment that it could easily be reduced and could go back to the $1,000,000 level.

If the estate tax is repealed then no planning is required. If the exemption limit is reduced to $1,000,000, in an effort to raise taxes revenue and reduce the national debt, a considerable amount of planning may be requred. My strategy is to plan for the $1,000,000 limit and hope that the tax gets repealed.

Future blogs will discuss gift and estate tax reduction strategies.