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Wrong Number

Adam M. Grossman

AS I NOTED LAST WEEK, investing can be maddening. But it isn’t just investing. Many other personal-finance questions can also drive us crazy. Why is that?

One reason: The stakes are often high, so mistakes can be costly. A second reason: By definition, all data are historical, but all decisions are about the future. To the extent that the future doesn’t look like the past, we have a problem.

Those two factors are very real. But there’s a third reason financial decisions can be frustrating: Many of the numbers that we rely on to guide our decisions can be confusing, inconsistent and sometimes downright misleading. Below are the five instances I’ve encountered most often.

1. IRA distributions (Part I). I remember speaking with a fellow who had recently turned age 70. His plan, he said, was to delay collecting Social Security until age 72 so he could maximize his benefit. This revealed a key source of confusion for retirees. Until a few years ago, investors were required to begin taking distributions from tax-deferred retirement accounts at age 70½. That aligned, more or less, with the age at which Social Security benefits hit their maximum, which is age 70.

But under new rules, required minimum distributions (RMDs) from retirement accounts don’t need to begin until age 72. Meanwhile, the Social Security rules are unchanged. Benefits still hit their maximum at 70. While the change to the RMD starting age benefited many investors, it also introduced confusion. And the rules may change yet again: Congress is now considering moving the RMD starting age to 75. If you’re in your late 60s or early 70s, you’ll want to keep an eye on these rules.

2. IRA distributions (Part II). For investors who dread RMDs, there’s a handful of solutions. One is a qualified charitable distribution (QCD). This allows you to make a contribution to a charity directly from you IRA. You don’t receive a tax deduction for your generosity. But it counts toward your RMD—up to $100,000 per year—without registering as income on your tax return.

Those features all make QCDs a great strategy for investors with sizable IRAs. But there’s a quirk in the rules: As noted above, RMDs don’t need to begin until age 72. But you can start QCDs, if you wish, at age 70½. You don’t have to wait until 72. Why would you make a QCD earlier? One reason: If you have significant tax-deferred IRA balances and charitable intentions, this would trim the size of your IRA, thus reducing future RMDs.

3. Life insurance premiums. If you’re like most people, when you receive a bill, you pay it. There can be a wrinkle, though, with whole-life insurance policies. It may be that the premium shown on the invoice is not the actual amount due. This could be for one of two reasons.

First, the amount on the invoice might be an artificial number chosen by the insurance agent, at the inception of the policy, to help build up the policy’s cash value. If that’s the case, you might be able to pay less than the amount shown on your invoice.

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A second possibility: If you’ve been making extra payments like that for a period of years, it may be that your policy is now at a point where it’s self-sustaining. In other words, the dividends from your accumulated cash value might be sufficient to cover all of your future premiums. That would allow you to stop making payments entirely. Every policy differs, of course, so you’ll want to consult your agent and check the numbers carefully. But it’s important to keep in mind this possibility—that the amount “due” may not actually be due.

4. Marginal tax brackets. Some financial decisions hinge on an evaluation of your marginal tax bracket—if, say, you’re considering making a large charitable contribution or a Roth conversion. But unfortunately, our tax code is so immensely complex that a taxpayer’s marginal tax bracket isn’t necessarily the income-tax rate that applies to the last dollar of income. This is an inconsistency that can bedevil both working people and retirees.

For retirees, the key drivers are Social Security and Medicare. Social Security benefits are only taxed above certain income thresholds. Similarly, Medicare’s income-related monthly adjustment amount (IRMAA) surcharges only apply above certain income thresholds. But the effect is the same: As your income approaches various levels, the next dollar of income can cause a very significant jump in a retiree’s overall tax rate. In certain cases, just an extra penny of income can cost you far more than that in taxes.

For those in their working years, the tax thicket is even worse, thanks to the mix of tax credits and deductions that phase out as income rises. As a taxpayer’s income hits those phaseout levels, the effective marginal rate can jump significantly—far in excess of what a simple tax bracket analysis would suggest. The solution: If you’re doing tax planning, I suggest using a comprehensive tax calculator or a tool like TurboTax that will factor in the myriad variables. If you’d like to learn more about this topic, CPA and author Mike Piper provides more detail in this article.

5. Bond rates. Suppose you were choosing between two bonds from the same issuer—identical in every way except that one carried an interest rate of 5% and the other 3%. Which would you choose? The answer: It depends. At issue is the distinction between a bond’s coupon rate and its yield.

A bond’s coupon is the amount that it will pay in reference to its par value. In general, a bond’s par value is $1,000, so a bond with a 5% coupon rate would pay a bondholder $50 of interest each year. By contrast, yield describes the total investment return that an investor would realize if the bond were held to maturity. In addition to the coupon payments, yield also takes into account the price at which a bond is purchased.

To understand yield, let’s look at two examples. In the first case, suppose you paid $1,000 for a bond with a 5% coupon. In that case, since the value of the bond at maturity—$1,000—will be the same as the purchase price, the investment return will consist of only the 5% coupons. The yield on this bond will thus be 5%.

But suppose you got a bargain and only paid $950 for this same bond. This can easily happen. Bonds don’t always sell at par. For simplicity, let’s assume the bond matures in one year. In that case, you’d still receive your 5% coupon payments. But in addition, you’d realize a gain on the price of the bond itself. At maturity, the bond’s issuer will pay you $1,000. Since you only paid $950, you’ll enjoy an additional gain of 5.3% ($1,000 divided by $950). In total, then, this bond would end up yielding more than 10%, even though its coupon was just 5%.

The lesson: When evaluating bonds, don’t dismiss bonds with low coupons and don’t be deceived by bonds with high coupons. Always look at yield. That’s the more important measure.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.

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David Lamb
David Lamb
7 months ago

The potential changes to RMD intrigued me, and here are some further details:

“Secure 2.0 lifts the minimum age at which enrollees must begin withdrawing money from their accounts each year to 75 from 72. That allows for three additional years of tax-free growth on their retirement investments.”
“The Secure Act changed the age for RMDs from 70 ½ to 72, and now that age may be raised even further, to 73 next year, 74 by 2030, and 75 in 2033.”

So the 2030 and 2033 potential changes won’t help me at my current age of 68 but younger readers may benefit, of course all subject to the actual legislation passed, if any.

Steve Spinella
Steve Spinella
7 months ago

Thank you, Adam. At a certain level all of these situations remind me of those word problems in math classes long ago. It’s not just making the calculations, but understanding which numbers should go into those calculations. The real world is worse, as the options for selecting numbers go up exponentially (right, another math word!)
In my own, admittedly limited, experience advising others I find the bigger problem is that most people I advise neither think quantitatively nor do they estimate well. I could use help understanding how to communicate better with people like this. A few just trust me and my math skills, but most are drawn to more persuasive communicators, who may have much worse math skills or perhaps even occasionally the intent to deceive.

Neil Imus
Neil Imus
7 months ago

Thanks so much for your your articles; they are always very informative. I did, however, have a question about the qualified charitable distribution (QCD) strategy you outline.

If you can itemize deduction on your taxes (i.e. don’t take the standard deduction), and therefore can deduct a charitable contribution, I can’t see how making a QCD ever makes sense before your are required to take a required minimum distribution (RMD).

Assume I want to contribute $10K to a charity, am in the 20% tax bracket, and am at least 70 1/2 but not 72 so don’t have to take an RMD.

Scenario 1: I just contribute to the charity from my existing income. I will realize a $2K tax savings when I deduct the $10K on my taxes. (And if I contribute $10K worth of appreciated stock rather than cash, I’ll save even more tax because I won’t have to pay any capital gains on the stock contributed.)

Scenario 2: I make the $10K contribution with a QCD from my IRA. I don’t pay tax on the $10K but I don’t get to deduct the contribution so don’t save $2K in taxes this year. The only benefit is reducing my IRA by $10K, but that only reduces my RMD when I turn 72 by about $400 (the RMD at age 72 is slightly less than 4%) and the tax on that $400 would be $80. So I would forgo saving $2,000+ in taxes this year to save $80 in taxes the year I turn 72 (and, of course for each year after that).

Am I figuring this incorrectly?

wtfwjtd
wtfwjtd
7 months ago
Reply to  Neil Imus

“Am I figuring this incorrectly?”

Yep. Point 1: Itemizing deductions only makes sense if you have more than the standard deduction, which this year (for those over 65) is $14,250 Single and $27,800 MFJ. So your $10k charitable donation by itself benefits you not at all as it is well below the standard deduction amount that you already receive.
Point 2: A $10k QCD reduces your taxable income by $10k, as well as satisfying at least part of your RMD requirement (if any). So you have avoided paying income tax on the $10k (your tax “savings”), as well as avoiding income tax on that part of your Social Security that would otherwise become taxable. As for not getting to deduct it, see point 1 above.

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