When it comes to saving and investing, most people's first priorities relate to financing the lives they want for themselves. Their top goals may be things like buying a home, raising kids -- and educating the little darlings -- and eventually retiring in a situation that allows them to enjoy those golden years. But in the March mailbag, a fair number of questions came from listeners looking to make the best decisions around financially aiding children, grandchildren, and sometimes their own parents.
In this Motley Fool Answers episode, hosts Alison Southwick and Robert Brokamp -- with help from Megan Brinsfield, director of Foolish Planning with our sister company, Motley Fool Wealth Management -- answer a raft of questions on subjects such as transferring funds from retirement accounts to your heirs, giving stocks to grandchildren, helping parents who are unprepared for retirement to catch up fast, tax optimization, asset location, and more.
A full transcript follows the video.
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This video was recorded on March 26, 2019.
Alison Southwick: This is Motley Fool Answers! I'm Alison Southwick, and I'm joined, as always, by Robert Brokamp, personal finance expert here at The Motley Fool.
Robert Brokamp: Well, hello!
Southwick: People are talking passionately about brackets, the trees have commenced their assault on my sinuses, and I saw the sun for five minutes today, so it must be time for our March Mailbag. Joining us this month is Megan Brinsfield, director of Foolish Planning with Motley Fool Wealth Management.
Megan Brinsfield: Hey!
Brokamp: A sister company of The Motley Fool.
Southwick: We're going to tackle your questions about setting up retirement accounts for your kids, how to help your parents if they aren't prepared for retirement, when to take Social Security, and tax optimization in your portfolio. All that and more on this week's episode of Motley Fool Answers.
Southwick: Hey, Megan! Welcome back!
Brinsfield: Hi, thank you! Excited! Shall we start over again?
Southwick: No, that's perfect! No, you nailed it! The level of incitement...excitement really matches, really matches what we're going for.
Southwick: Hello! Well, I guess we should just get into it before things get a little too crazy. The first question. Are you ready?
Brokamp: We're ready!
Southwick: Try to contain yourself. It comes from Emory. "I have a 401(k), a Roth, and am just getting ready to open my first investment account outside of retirement savings." Yay! "I was thinking about making this a more dividend-focused account, but then thought that this might be more complicated as there may be tax implications with capital gains. Do you have any recommendations for tax optimization? Should I just keep a Foolish mixture in each account, or is there a benefit to focusing investment categories [growth, value, dividend, ETF] into specific types of accounts?"
Brinsfield: In general, when you're thinking about asset location, which is what this question is about, there are two variables that tend to matter more than others. One is the length of time that you have to invest. If you're investing as a young person for multiple decades, the more it matters to get the right assets in the right buckets.
And then the other thing that is a big variable is the turnover in your account. How often are you selling stocks or collecting a dividend off of those stocks? And the more frequent that is, it erodes that tax location strategy.
If you have a long time to invest and low turnover, then having dividend payers inside a retirement account is going to be better for you. But in general, you want to have stocks that don't pay a dividend -- that are just growing because you're holding them and they're appreciating -- in a taxable account where you're not incurring any tax at all until you sell those investments ultimately.
Southwick: Let's build off that question with one from Patrick. "I listened to your recent episode featuring Larry Swedroe and immediately bought and read his book." Wow! Way to sell, Bro!
Brokamp: Good job! And Larry!
Southwick: The book is called Your Complete Guide to a Successful and Secure Retirement. "Among other things, he asserts it is generally better to hold fixed-income investments in tax-advantaged accounts [and] IRAs, 401(k)s, and equities in taxable brokerage accounts. What are your thoughts on this? My employer offers 12 or so funds in our 401(k) plan, but only one is a bond fund. What's a boy to do?"
Brokamp: Yes, this is another asset-location question, and as Megan suggested, the longer you have, the more this matters. Back when I first started writing about this -- and it was more than 10 years ago -- people would often cite the study -- I think it was from USAA -- that found that good asset location could increase your after-tax wealth by 15%. So it definitely matters, but the longer you have to invest, the more important it is.
What Larry was citing in his book is some general advice that many studies have found, which is if you have fixed income -- a bond, for example -- they're very tax inefficient because they pay income every year and it's taxed at an ordinary income tax rate, so it would make sense to have those in tax-advantaged accounts.
Compare that to, let's say, a stock that doesn't pay a dividend, like Berkshire Hathaway, which I own. If you bought that and you held it for 30 years, you'd never pay taxes on it until you sell, so it has its built-in tax advantages. That's the basic idea behind this general advice.
That said, some bonds are more tax efficient than others. For example, a municipal bond is tax-free if you live in the state or locale that it operates. You should have that outside of your tax-advantaged accounts. And then some stock strategies are very tax inefficient if you're a frequent trader. If you own an actively managed stock fund that has high turnover and lots of dividends, those would be better inside the retirement account.
So it gets a little complicated. I think the best thing for you to do is just Google "asset location" and you'll find some good articles that rank investments according to tax inefficiency. It's basically you start at the top, put those things in your tax-advantaged accounts until you fill them up, and then whatever you have left over, you keep outside of those.
Southwick: Let's move on to our next question from Joe. "What are the tax benefits, limits, or ramifications of transferring stocks to my granddaughter?"
Brinsfield: Great question from Joe! And a generous one. He sounds like a nice grandpa. I think one of the main misconceptions that people have when they transfer stock to someone else is that maybe they'll get a better tax rate if they do that. When he mentioned "granddaughter" that stuck out to me as potentially someone who is not yet a full adult. You think of children having better tax rates because they're not earning any money and they get the benefit of a deduction and all of that good stuff.
But then you've got the Kiddie Tax that comes in and it's like a dark cloud over that situation because if you have unearned income as a minor -- so if you're under 18 or if you're a full-time student and under 24 -- that unearned income is taxed at a beneficial rate only so much. So the first $1,050 is not taxed, the next $1,050 is at the student's or child's tax rate, and then anything beyond that is treated as if it was taxed inside a trust. That used to be it will get taxes at the parents' rate.
With this latest tax reform, the Kiddie Tax actually takes on the trust tax brackets, which are much lower, so any unearned income over those initial thresholds is going to be taxed at pretty much the highest capital gains tax rate when that person sells.
Brokamp: Right. When you say tax rates on trusts are lower, what you really mean is it does not take much income to get to those higher brackets.
Brokamp: It's surprising, really. Trusts can be, actually, very tax inefficient.
Brinsfield: Exactly. The highest rate for an individual is in the hundreds of thousands of dollars. The highest tax rate for a trust -- you'd get there over $12,500 income.
Southwick: Oh, goodness! Wow!
Brokamp: Yeah. Another consideration people often think of when it comes to gifting is the annual gift tax exclusion, which for this year is $15,000. A lot of people think, "If I give more than that, I owe taxes." That's not true. It means you have to file the gift tax form, which is Form 709, and that just eats into your lifetime unified gift estate exemption, which is $11.4 million per person. Am I getting this right? I always have to look at Megan to make sure I get all this right.
Basically it just lowers that. Instead of being able to give $11.4 million when you die, it's $11.3 million something, something, something.
Southwick: $11.399999 million...
Brokamp: So people don't have to worry about that. You just have to make sure you file that form.
Southwick: Do you have any recommendations for Joe? What should he do if he wants to give stock to his granddaughter?
Brinsfield: If the granddaughter receives the stock, she can hang on to it until [her age is] beyond those Kiddie Tax rules and sell it when she's a young adult, probably still in a very beneficial tax bracket. The other thing he could do, -- which is a little morbid -- is to hang on to that stock until he passes away, and then there's a step-up in basis and his granddaughter -- or whoever he chooses -- would receive that stock with no gains built in at all. It would be tax-free if they received it and immediately sold it.
Southwick: Isn't it a pain in the patoot to transfer stocks to someone?
Brokamp: Generally, no.
Southwick: You just go to your broker and you're like, "I want to give these five shares of Google to this person's brokerage account"?
Brokamp: Generally speaking.
Southwick: Oh! Can I do that with anyone?
Brokamp: Sure, you can give me some if you'd like.
Southwick: No, seriously. Can I just be like, "I want to give you some of my stock"? I could just do that?
Brokamp: Sure. You'd have to open an account.
Southwick: Oh, OK. Next question comes from William. "I'm almost 69 and between my wife and me we receive $21,000 from a pension and $28,000 from Social Security each year. Our IRA is valued at $130,000 and we have other investments also worth $130,000.
"As we draw down the IRA account we will move the net amount, after taxes, to a taxable account. The long-term gains and qualified dividends from this account won't be taxed, though it may increase the amount of Social Security that is taxable. Should we draw out large amounts from the IRA but keep our income below $100,000 to stay in the 12% tax bracket, or pull out minimum amounts and leave the taxes to the ones who later inherit this account? They are in a higher tax bracket at this time."
Brokamp: Well, William, a couple of things. The general rule for when to withdraw money from your accounts in retirement if you have different accounts of different types is to withdraw money from the taxable account first and leave your retirement accounts alone. Unfortunately at some point you do have to take money out of your traditional accounts at 70 and a half [years old], and it sounds like that's what William is thinking about because he's getting close to that age.
It also sounds like he doesn't need the money, because he plans to just take that money out and then put it in a taxable account. He's saying that the dividends and capital gains will be free of taxes. That's because below a certain threshold and a certain tax bracket, you actually pay no taxes on dividends and capital gains as long as they're qualified dividends and long-term capital gains.
So it sounds to me like what he's thinking is maybe he should take advantage of that as much as possible to get money out of the IRAs and set that new cost basis, because it's eventually going to be left to his kids so it's essentially saving his kids some taxes. If he leaves it in the IRA, when you inherit an IRA and take the money out, it's all taxable. Megan, I don't know if you agree, but it sounds like what he's trying to do is to lower the tax burden of the people who are eventually going to inherit this money.
Brinsfield: Yes, it sounds like that's what he's trying to do and it's especially nice of him, I thought, when I first saw this question. I was like, "You're already leaving them money. You want to make it tax efficient for them, too?"
Southwick: They'll never appreciate it.
Southwick: They don't know what you went through.
Brinsfield: Exactly. The troubles you've seen.
Southwick: The taxes you've avoided.
Brinsfield: Yes, all for them. One thing to consider, here, is that they seem to be in a place where they can afford to take on a little bit more tax burden each year. Just referencing my handy-dandy tax bracket sheet -- the other bracket in March...
Brokamp: Which we all have, by the way.
Southwick: Pull it out.
Brokamp: That's right! The other March bracket.
Brinsfield: As a married couple filing jointly, you can have $77,400 of income before you're taxed at the 22% rate. Everything under that is 12%. So if you consider the fact that you have to subtract a $24,000 standard deduction to get there in the first place, you could have a gross income of almost $100,000 and pay 12% on that, and that's going to be extremely attractive compared to almost any recipient's tax rate. So I think that's really wise of them to do, basically year-to-year. Because they're getting to that 70 range, they're going to have a minimum that they have to withdraw, but they could withdraw extra up to that roughly $100,000 threshold in order to increase the tax efficiency even further.
Brokamp: I would say to answer his question on whether I would do that or not, clearly they're able to live off the Social Security and the pension. But when you look at their actual savings -- a total of $260,000 -- for a retiree that's not actually a whole lot and it may not be enough of a cushion if later on they have higher health expenses or long-term care. I would say just make sure that you're taking care of yourself. I like the fact that you're trying to be more generous to your heirs, but just looking at the number of assets that you have, I would still do everything you can to maximize your situation first.
Brinsfield: I think that's fair, because the other thing is they're not going to die at the same time, so there might be some loss of either Social Security and/ or pension that then requires a higher reliance on those savings.
Brokamp: With every retirement plan with a married couple you always have to analyze what's going to happen if one's spouse dies -- what's going to happen if another spouse dies -- and see how that affects both income as well as expenses.
Southwick: The bottom line, William, is that's really sweet of you, but we're giving you permission to look out for yourself, first.
Brokamp: Yes, that's it.
Southwick: Be selfish. The next question comes from Ian. "I'm in a fortunate situation with my parents being able to help my wife and me with a down payment on a home that we plan to purchase in the next two to three years once we get out of the ridiculously priced Silicon Valley. For their own tax financial purposes, my parents gifted us some equities. I have had these stocks for about a month and they've taken quite a hit as the market has dropped.
"I'm interested in the tax implications if I were to wait to remove them from the brokerage and into our savings once they've gotten back up to the original amount gifted to us or hopefully a bit more. If I sell the equity when it is more than the amount of the gift, am I taxed at any amount greater than the initial gift? I'm under the impression that I would not be taxed on the initial gift as it is under the taxable gift amount allowed between family members."
Southwick: Hooray for parents and grandparents, huh?
Brokamp: Yes, a lot of gifting!
Southwick: They're so generous on this show today!
Brinsfield: Exactly! Ian received some stock from his parents. I think the first misconception that he has in the question is that when he received that stock that it was valued at its market rate, which is not the case. In fact, when he received that stock, he received the same basis as his parents had.
Southwick: So if they bought it at $10,000 and it's now at $12,000 it's as if he bought it at $10,000.
Brinsfield: Correct. And then the second thing that he sort of misunderstood is that when you receive a gift there's no tax implication as the recipient of a gift. It's just the person transferring that has to pay attention to those annual limits every year. That's one thing to keep in mind. If you're the recipient of a gift you don't have to worry about the amount that it is.
Brokamp: He's received this gift so he needs to, first of all, know what his parents' basis on the stock was. He says it's gone down since he's gotten it. If it is below their cost basis, he can sell it, take the loss, and write that off on his taxes.
Another issue, though, is that he wants to spend the money in two to three years from his inherited stock, and our general rule is any money you need in the next two to three years probably shouldn't be in the stock market anyhow. He's talking about waiting until the stocks recover and then selling and that's always a very difficult short-term thing to time. My general advice to him would be, I would just sell that and keep it in cash and then when tax time comes around he just has to ask his parents what the cost basis on those stocks were.
Brinsfield: I thought you were going to say to just ask his parents for more money.
Brokamp: That's true, too! If that works...
Southwick: Go for it! The next question comes to us from someone who wants to stay anonymous. "My question is about how to best prepare my parents for retirement who are 50 and 60 years old and have little to no savings. My suggestion was to invest in a solo 401(k) and a Roth IRA and try to contribute 30% of their household income for the next 10 years with about 60% stocks and 40% bonds. Is there a faster but still relatively safe way for them to maximize savings for retirement?"
Brokamp: First of all, Anonymous, good for you for trying to help your parents! They're definitely going to be in a tough situation. You don't say whether they have a pension or not. I'm going to assume that they don't, but hopefully they do. I've talked on this show, before, how as a country we need to start thinking that 70 is the new 65.
More and more people just really have to look at 70 as their retirement age so you're right to suggest to your parents they should do this for at least 10 years, but I would say that's really only true for the 60-year-old. I'm going to assume that's the dad, since with most couples the husband is older. The 50-year-old is probably the wife. I'm assuming, here, the wife is only 50, so I would think that she also would have to work longer and should shoot for 70, as well. If they're at this age and they don't have anything saved, they just need to look at working longer.
I think a 60% stocks, 40% bonds portfolio is fine for the 60-year-old who's going to retire in 10 years, but if the 50-year-old ends up working for 20 years, I think you could go all stocks at this point, especially if you're just starting to save. You're just putting in a few hundred dollars a month. Whatever happens to the stock market in the next few years is actually not going to be that big of a deal because you're just starting out. You've got 20 years ahead of you and you're trying to catch up. I think an all-stock portfolio is perfectly fine for the next five years or so.
Another thing I would just say to them -- I don't know if they own a home or not, but home equity is probably going to play a big role in their situation if they do, whether they downsize or they get a reverse mortgage. Another somewhat safe way to improve their prospects is to pay down the mortgage sooner. That way they own the home outright so that when they sell it they either get more equity or if they do a reverse mortgage they'll get more from it.
Southwick: The next question comes from Matt. "When my grandfather needed nursing home care several years ago, it quickly became apparent why he was such an advocate for long-term care insurance. He and my grandmother gave me many gifts over the years, few more important than financial literacy and no small amount of security. However, apparently they also gave me a genetic disposition for worrying -- let's call it 'prudent preparedness.'"
Brokamp: I like it.
Brokamp: I like that.
Southwick: Let me just call it awfulizing here. "Prudent preparedness." "Now my wife and I are in our late thirties and I'm wondering if it's too soon to start thinking about long-term care policies of our own. The conventional wisdom seems to be to start that process in your early 50s, but I'm curious if there's any hidden disadvantages to beginning sooner."
Brinsfield: When it comes to [being worrisome], you are like the dream client of insurance salesmen everywhere, so I just want to caution that you should go into any insurance situation with prudence.
Now in your thirties, I would argue that long-term care is not your biggest risk. You mentioned being married. I don't know if you have children, but if you do have children you should be thinking about if something happens to you that is not long-term care. Long-term care typically happens to people toward the end of their lives. What if you were to pass suddenly or if you became disabled? Those are two really big risks in your thirties because most of your financial plan is relying on your future earning potential. If that is lost, then you have suddenly chopped yourself off at the kneecaps.
I would argue that starting with a long-term care policy in your thirties -- one of the downsides to that is you're going to be paying premiums for a really long time. Thirty or 40 years before you may ever get the benefit of that policy. I was talking to an insurance agent, recently, who said they price policies based on the fact that they want to get 10 good years of premiums out of somebody before a benefit is collected. So again, you're just setting yourself up for forking over a lot of money if you're starting in your thirties with this type of policy.
Brokamp: We talked before on this show about how the long-term care insurance industry has really struggled. It used to be over 100 providers and now it's down to about one half dozen. GE, because it bought an insurance company, is on the hook for a lot of long-term care and they just announced that they're going to have to increase premiums for a total of around $1.5 billion or something like that.
So often when you buy a policy you'll be told by the agent that the premiums probably won't go up, but that's not true. They generally do. The biggest provider of long-term care insurance is Genworth, and they have just decided to stop selling policies through agents and only directly through Genworth itself. They're trying to cut costs by cutting out the intermediaries. It's just always struggled.
So you're looking at a situation of jumping into a type of insurance that you're going to hold on to for 40 or 50 years in an industry that has really struggled over just the last 20, so you're taking on a lot of risk by taking on something like that now.
What you do if you don't have the insurance is just make sure that you save a lot of money. Just by reading your note I can tell you're probably already doing that, and if you have a sizable portfolio by the time you're in your 70s and 80s, and need long-term care, you're going to be OK.
Southwick: The next question comes from Vic. "I'm 27 and have three major life events all at once. The first two are one, I'm getting married later this year and two, I'm buying a house. I saved up quite a bit for both transactions, but afterwards I only have a 401(k) worth $80,000 and an emergency fund of three months of living expenses. The third major event is my parents, both elderly and sick, will move in with me and I'll have to take care of them.
"My questions are how much should I have in emergency funds as I will have a mortgage plus two dependents, should my wife and I have a joint emergency fund or should we have separate emergency funds? After building up an emergency fund, what should I prioritize with any extra income? Paying down the mortgage or building up a brokerage account?"
Brokamp: Well, congrats, Vic, on getting married and the new house!
Southwick: Yeah! And what a great son taking care of your parents!
Brokamp: Yes. And also congrats on having $80,000 in your 401(k) at age 27! You have way more than the average 27-year-old and actually more than the average American.
Southwick: More than the average anything.
Brokamp: That's great! To answer your questions specifically, how much should you have in emergency funds? I would say this is the type of situation where a bigger one is probably better because you're now on the hook for the mortgage. You don't know what the medical costs for your parents are going to be, so yes, having more cash on the side is a good idea.
Your second question was whether you should have it jointly with your wife or separate? For most couples I'd say joint is fine. It depends, a little bit, on how your wife feels about this whole situation about the parents moving in and how much of the family resources you're going to devote toward helping them. If there is going to be any conflict about that, maybe it is better to have somewhat separate finances so that you know you have this amount to devote to your parents and it's just not an issue with your wife.
And then after building up the emergency fund, what should you do? The first thing I recommend to everyone is get the match from your 401(k). Make sure you're doing that. After that, maybe consider a Roth IRA if you're not earning too much. The great thing about the Roth, besides the fact that you get the tax-free growth, is that you can access the money you contribute to the Roth before age 59 and a half tax- and penalty-free if you need it. Again, you're in this situation where you might have some unexpected expenses, so I think a Roth is a great place to keep money that you may need to tap before you're 59 and a half.
And the other thing I'll say about this is you're taking on a lot of responsibility. Chances are your city, county, or state will have resources to help elderly folks, so I would see what's available to them. Resources or services your parents are eligible for. And we talked about this last year in a couple of episodes that I recommend. We had a couple of folks in from AARP -- Amy Goyer on September 4th talking about how to be a caregiver and then Dr. Jean Accius on October 23rd about long-term care and community long-term care. Just listen to those, because I think they had some other good tips about taking care of older relatives.
Southwick: The next question comes from Tom. "How should I think about asset allocation when dollar-cost averaging into a 529 plan for a newborn grandchild?" Oh, these grandparents!
Brokamp: I'll tell ya!
Southwick: "One option I'm considering is a U.S. Total Market Index Fund. The other option combines international, emerging market, and real estate indexes with a U.S. index fund. It seems the 'experts' on financial shows favor diversification internationally, but the U.S. market seems to have outperformed all others over the past five to 10 years. Of course, past performance does not guarantee future results and reversion to the mean is likely, but it seems that the U.S. economy is forecast to grow faster than Europe and China, at least in the near future."
Brinsfield: I'm going to agree with the "experts," mainly because I think when you're looking at diversification, you can't make bets on what's going to grow faster or slower, unless you want to just make bets. If you are looking at hedging your bets against all the different asset classes, you're going to diversify and make sure that you're taking gains from anyplace that offers it and not thinking, "Well, China didn't do as well last year, so I'm going to maybe think they're doing better this year."
This leads to a lot of gamesmanship each year in your asset allocation and overall, at a newborn's age, you have almost 20 years for these assets to grow, so looking at the last five or 10 is probably not really relevant for making that sort of long-term decision.
Southwick: The next question comes from Mike. "I know that taking Social Security at age 62 means that my monthly amount will be 70% of what it would be if I waited until age 67, but if I was heavily invested in good stocks and market funds, my portfolio could grow in retirement more than it would if I had to withdraw more because I deferred taking Social Security until later. What do you think?"
Brokamp: Well, Mike, everyone in America has a full retirement age. For anyone born in 1960 or later, it is 67, so I assume that's what Mike's situation is. Full retirement age is an important concept with various planning strategies, but the first thing I want to make sure Mike knows is that you can actually delay up to 70 to have your benefit grow, so that's something to consider.
My bottom line, these days, with determining when to take Social Security is go and use a good tool. There are some free good ones on the internet. There's one from AARP. One from FinancialEngines.com. You'll find a good one at OpenSocialSecurity.com. There's one called Maximize My Social Security that you have to pay $40 for, but it's highly recommended by many people that I respect, so I would recommend you do that.
Especially when you're married, you need to look at the numbers. You need to put in your specific benefits. It runs the analysis and it says, "Well, you should take it at this age. Your spouse should take it at this age." I highly recommend that.
Really over the last 10 or so years, the advice has been to delay as much as possible, but it depends on a lot of factors and I think Mike brings up a good one in that if he delays it, that means he has to take more money out of his portfolio, which means he's selling stocks that might have great returns.
I think in the end it's very individual. I think it's a worthwhile point, but you have to be pretty confident that your stocks are going to do well with solid, double-digit returns because if instead you take Social Security early hoping your portfolio will grow, but instead it doesn't, taking it early would have been a mistake. There's a certain amount of what your risk tolerance is, too.
Southwick: The next question comes from Raj. "My parents bought a house for $189,000 and borrowed against the equity when it increased in value. When they were having trouble making payments I helped out my parents by refinancing the loan. The property was worth $215,000 at the time. I put $28,000 down and there was a loan of $166,000. My dad did a quitclaim giving the title to my mom and me. A few years later we refinanced again and my mom did a quitclaim deed giving title to my wife and me. What is my cost basis since I kind of inherited it?
"Second, I have a second primary residence. Up until last year's tax filing, I have treated my parents' house as a second property as a way to increase my itemized deductions. The new tax code, however, has a $24,000 standard deduction and my itemized deductions are falling well short of it; therefore, I am considering converting the house my parents live in to a rental property. This will result in passive losses and will help reduce my taxable income. Does this strategy make sense?"
Brinsfield: First we're going to tackle the "What is my cost basis?" question, because there were a couple of terms thrown around in Raj's original communication around whether this is a gift. Is it inherited? Did I buy it?
I think it breaks down into two transactions. The first one is when he refinanced the house for his parents, he gave up $28,000 and in return received half of a house. Most people would call that a sale. You exchanged some property for things received in return. At that time he received half the house which was valued at $215,000 in total, so his half would be $107,500.
Now that's a little bit off, so if you look at what he put in, he put in $28,000 and he's taking on, in theory, half the mortgage, as well, and that gets him to $111,000. But let's just call it $107,500 for now. And then the second transaction is on the second refinance when his mom gives him the second half of the property. He didn't put anything into it at that point. He was just receiving this gift.
Again, stepping into the shoes of the parents, you're taking on their cost basis in the house, which regardless of what it was worth, they paid $189,000 for it, so that half is going to be $94,500. Combine that with his original refinance of $107,500. I get a cost basis of $202,000.
I think different people could look at those series of transactions differently, so it could be that he gifted his parents $28,000 on the refinance and they gifted him half of the house. That ends up being worse for him. Call it $202,000. What your cost basis is, is going to be important if you then convert that property to a rental because you're going to be able to depreciate the property at the lower of fair market value or cost basis. Depending on whether the current value is above or below that $202,000, that's going to determine how much you can write off from a depreciation standpoint.
The other thing to consider is that when you're renting to family members, the IRS considers that to be basically a not-for-profit type of rental situation, so you could only write off your expenses to get to a net of zero. In order to combat that, you could charge your parents market rent. If they're paying market rent already, you're good; otherwise, you might have to increase the rent or consider bringing in someone else that can increase the rent in order to fully capture those tax benefits that he talked about.
Brokamp: The bottom line, as far as I'm concerned, is get a good accountant.
Southwick: Is that who you call in, in a situation like this? An accountant to help you understand it?
Brinsfield: Yes, definitely. In the past it sounds like maybe there were some gifts that weren't accounted for on gift tax returns. You might need to catch that up a little bit. You might need to do some digging on how much cost basis you can really find. A lot of times people have additional cost basis from buying a house for all these transaction costs that can increase their cost basis ultimately. It can be worth it to find someone to dig through the documents, and if you can increase your cost basis by $5,000 you've avoided tax on that $5,000 in the future, so it pays for itself.
Southwick: The next question comes from Edgar. "I've always thought that while I am earning a salary my income is higher than it will be when I'm retired. However, a few times on the show I've heard Bro say your income could be higher in retirement. How could that be? My wife and I are 53 with a nest egg of about $700,000 and are putting away a minimum of 15% of our $114,000 income for retirement. We are a one-person-earner household. We have a mortgage that is targeted to be paid off at age 62, at which time I want to think about stopping work -- at least the miserable nine-to-five I hold now."
Brokamp: When you look at lifetime earnings -- as well as lifetime expenses -- when you start off in your early twenties, both grow very rapidly and certainly people who have professional degrees and professional professions at a rate that exceeds inflation. It starts to level off in your 40s and for most people their income peaks in their late 40s to early 50s and at that point it basically keeps up with inflation or, in many cases, it doesn't keep up with inflation, especially if you're in service industries or something like that.
So when I have said that it's possible you could have a higher income in retirement, I'm generally talking about people who are younger. If you're just starting out in your 20s, hopefully you'll have a higher income in retirement because you're going to be a good Fool and you're going to save a lot and have a decent portfolio and retire. That's why we often say for younger people the Roth makes the most sense. It's because they're in a lower tax bracket today. It has nothing to do with the fact that they are further away from retirement. It's not about time. It's about being in that lower tax bracket.
Now in your situation, Edgar, you're 53. You're probably at your peak lifetime earnings and in your situation you're absolutely right. Your income probably will be lower once you retire and if you were making a decision between a Roth and a traditional, the traditional would probably make more sense.
I love the fact, also, that you're planning to pay off your mortgage before you retire. I'm a big fan of that. I would say that just given the numbers you've provided, you might want to see a financial planner before you retire to make sure that you have enough. $700,000 is a nice-size nest egg. Depending on which guideline you look at -- and we've talked about these in previous episodes, Fidelity puts out these guidelines and T. Rowe Price puts out these guidelines -- you're either right on track, or a little bit behind.
As I recommend for everyone, when you're a few years from retirement, just go see a qualified fee-only financial planner to make sure that you have enough before you finally quit. And by the way, I'm sorry you don't like your job. One of your goals might be just to find another job that you like from like age 62 to age 68.
Southwick: Or sooner!
Brokamp: Or sooner!
Southwick: Why wait? The last question today comes from Jerry. "I have a question about 401(k) company stock. I have been told by Aon Hewitt that at the time of my retirement I can elect that all of my company stock be converted into actual stock, which means it will be considered as capital gains and not regular income. Do you know if this is true?"
Brinsfield: Part of this rumor is true. We're not going to talk about the specifics, but this is referring to a provision called "net unrealized appreciation," which is specific to when you own your employer's stock within your 401(k) plan. Normally they don't care about cost basis inside a retirement account because it's all going to come out as ordinary income anyway.
In this specific case, you do want to track your cost basis inside your retirement account for employer securities. And the reason is that when you retire, you have 12 months to take a full liquidation of your 401(k) to get this treatment. A full liquidation doesn't mean you have to cash out everything, but it has to leave the 401(k) structure, and you can take your employer's stock and put it into a taxable account. And rather than being taxed on the full value, -- which would be the traditional treatment of any sort of distribution -- you're only taxed on the cost basis of that stock.
So if you've been working with the same employer for a long time and accumulated little by little, you can also select the lowest-cost-basis stock to hang on to and keep outside. The benefit of that is that you are paying on a lower distribution amount. Then when it comes out, you're taxed at long-term capital gains rates as you dispose of that stock.
That's a pretty beneficial treatment to get stock out and not have to pay those ordinary tax rates. It could be a big tax hit at once, though, if you've accumulated a lot of stock, and so again, I think this is another area where you would want someone to come in and take a look at your specific situation.
Brokamp: Employer stock can get very complicated. You want to make sure you do it right and you want to make sure you're working with someone who not only knows the rules about employer stock in general, but has a good handle on your particular plan.
Southwick: That covers it for the questions, today! Megan, thank you so much for joining us!
Brinsfield: Thank you!
Southwick: It's been great having you, as always!
Southwick: Time for some listener feedback.
Brokamp: I'm ready! I'm ready to be fed.
Southwick: Remember our listener who writes in with the postcards often from Asia and he listens while swimming?
Southwick: So I messed up his last postcard. I wrote that he has no fixed income, but actually, he writes, "I live in hotels year-round because I have no fixed home." I can see how the h in home could have been mangled and read as income, thus becoming no fixed income. I think it's probably all my bad.
Anyway, it turns out he's a pilot on 747 cargo jets and because of "how crew scheduling is done in the cargo aviation business," he writes, "most of our trips are single 17-day-long or longer trips flying back and forth across the ocean or doing laps around the planet. Of course, my airline pays for my hotel for these days and then I just pay for hotels out of pocket for the other 13. I'm not paying for rent for those 17 days of work when I wouldn't be sleeping in my own bed anyway." Kind of cool!
Brokamp: That's kind of exciting!
Southwick: Yes, it is kind of exciting! Anyway, whenever we're in Singapore Jim's going to buy us a drink.
Southwick: We'll have to tape in Singapore. Graham has a concern with you trying to teach an English lesson.
Brokamp: Uh-oh! What did I do now?
Southwick: You know what you did? "Just to let you know, us Brits do not use the expression 'a dog's breakfast.'"
Brokamp: Oh, that one!
Southwick: "We use the expression 'a dog's dinner' only, and it means a mess, as in 'That work you have done is awful. You have made a right dog's dinner out of it.' Hope that helps. Love your show."
Brokamp: But in my own defense...
Southwick: Let's hear it.
Brokamp: ...the term "dog's breakfast" came from an article I was quoting, so I didn't come up with the term.
Southwick: "Dog's dinner" has that alliteration, so it's better. It's way better.
Brokamp: That's true.
Rick Engdahl: I think I want to hear that dog's dinner line again, but with the accent.
Southwick: Oh, gosh! Uh..."That work you've done is awful. You've made a right dog's dinner out of it!"
Brokamp: Very nice!
Southwick: That was like my chimney-sweep British.
Brokamp: Jolly old good!
Southwick: That's so bad! That's so bad! I'm so sorry, Graham! I can do other equally horrible British accents. That's just one. OK, here we go. So David's writing with another correction, so way to go. I don't know if you said this or not. But apparently on the show we talked about getting an FHA home loan and paying PMI and that it drops off when you reach 20% in equity.
Dave writes, "With today's FHA loans that's not the case. PMI never drops from a loan payment. The only way to escape PMI on an FHA loan is to pay off the loan; i.e., selling the house or refinancing it to a conventional."
Brokamp: Well, if it's incorrect I'm sure I didn't say it, but...
Southwick: There you go.
Brokamp: ...but it may have been me.
Southwick: Next is from Ernie. Ernie listened to our podcast about preparing to have kids. He writes, "My wife and I teach a marriage preparation class to engaged couples. To help encourage everyone to do the estate planning. We say that a will and an estate plan is a way to show your love for your family. If one or both parents suddenly dies, having the will and estate plan will make things easier for the surviving members of the family at a difficult time. Your love for your family will be shown since you are helping them through this difficult time, even though you are not there." So there you go! Isn't that nice?
Brokamp: That's a great sentiment!
Southwick: It's a lovely sentiment! Get your estate plan going. We also have some postcards.
Lesley sent one from Saint Lucia, but originally from London. "Love the show. Thanks for 25 years as a Motley Fool subscriber." Isn't that awesome?
Brokamp: Wow, that's great!
Southwick: And then said a bunch of other really nice things. Shoots -- good old Shoots...
Brokamp: Good old Shoots...
Southwick: ...sent a card from Havre, Montana. Shoots, I'm going to be in Montana this August, so maybe I'll see you on the streets of Missoula at some point. Say hi if you see me and thanks for the card from Havre! He wanted me to quiz you guys on how to say Havre and he assumed I knew how to pronounce it, but I don't. So now I feel bad, but I'm being honest.
Southwick: Hay-ver? He said it's pronounced like the old song, I Don't Want Her, You Can Have Her.
Engdahl: You can hay-v her.
Southwick: You can hay-v her.
Brokamp: She's too fate for me.
Southwick: Now you're speaking with a fun accent, aren't ya? And we also got a couple of postcards from I think it's saying Anon and Anonymous. Two anonymous people. But they're saying, "From the top to the bottom of the world." They sent us postcards from Buton and I guess from Antarctica. There's a little penguin.
Brokamp: Oh, look at the guy!
Southwick: Isn't that cute? "By the way, we've been practicing FIRE long before it had quotes and we've been able to now see many beautiful people and lands around the world." Ah!
Brokamp: That's great! FIRE, of course, standing for Financial Independence/Retire Early.
Southwick: Retire Early. They've been doing it before it had a name. And we also got a card from Malta! From Allen and Roxanne. And they decided to save a few dollars and mail it once they got home, which I am totally all right with it. I think that makes perfect financial sense. So thank you guys, for keeping the postcards coming in! Summer's just around the corner, so I'm looking forward to finding out where all you guys are going for spring break and summer and all that good stuff.
Brokamp: Do you want to repeat the address just to get everyone ready?
Southwick: Sure! Get your pens ready and send us your postcards from all around the world. Our address is The Motley Fool, 2000 Duke Street, Alexandria, Virginia 22314. That's the show! It's edited TGIF-ingly by Rick Engdahl. For Robert Brokamp, I'm Alison Southwick. Stay Foolish, everybody!
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Alison Southwick has no position in any of the stocks mentioned. Rick Engdahl owns shares of Alphabet (A shares), Alphabet (C shares), and Berkshire Hathaway (B shares). Robert Brokamp, CFP owns shares of Berkshire Hathaway (B shares). The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), and Berkshire Hathaway (B shares). The Motley Fool owns shares of General Electric. The Motley Fool has a disclosure policy.