Financial Frontlines®

I’m asked so often from retiring service members about whether or not to sign-up for the Survivor Benefit Program (SBP); I figure it’s time for me to put an answer down on paper.

If you are thinking I’m going to state 100% “yes” or 100% “no”, you’re fooling yourself. As in any financial product, there is no totally good or totally bad product. Everything’s a shade of gray. I have no bias for or against SBP. It’s your family, not mine. I will help you define the issues and that should drive you to a clear choice for you and your family.

First, the basics. SBP provides a survivor the benefit of 55% of your base amount potentially for life. For this article I will assume your base amount will be your entire retirement paycheck amount—you have a choice you know. You are allowed to select, with the approval of your spouse, a base amount of coverage that can start at $300 a month up to the full amount of your retirement check. Your premium is typically 6.5% of your base amount.  Your premium could be less than 6.5% if you have service prior to 1990 and you select a base amount around or less than the threshold amount.  Check with your SBP office for the current threshold amount--it’s a relatively small amount.  And yes, as your base amount increases with cost of living adjustments (COLAs) each year so does your SBP premium since the premium is a percentage of your base amount.

So if your retirement check is $2500 a month and you cover the full amount under SBP, upon your death, your spouse gets $1375 a month for life with annual cost of living adjustments. Benefit payments are suspended upon remarriage and start again should the remarriage end. Those are the basics, now let’s define the issues.

The choice isn’t between SBP or life insurance. The choice is ‘SBP and life insurance’ versus ‘life insurance alone.’ You’re going to need life insurance regardless of SBP. Chances are 55% of your retirement pay is not close to your family’s current standard of living. If you are still working, you will be replacing two incomes, your job and military retired pay. Projecting into the future when you are “retired-retired”, as we say, you will be replacing income from military retired pay, a piece of Social Security, and possibly a part-time job. That means you will need life insurance to supplement the SBP payments. The extra life insurance will cover debts and/or provide an investment that can generate an additional income. Does your spouse earn a paycheck? If so, that probably minimizes the need for either SBP or some life insurance.

SBP is dirt simple; life insurance isn’t. It’s tough to put a price on simplicity but it is definitely valuable. When the military member dies, the survivor notifies the proper pay agent and the payments begin, that’s it. Payments keep rolling in every month and receive COLAs annually. The COLA adjustments will be extremely valuable when inflation is the double digits. An inflation rate of 10% means the costs of life doubles in 7 years.  Without SBP, you have investments usually created from life insurance.  How long will your investments last if your survivors need to withdraw larger and larger amounts to afford to live?  The regular and consistent payments of SBP are a source of supreme comfort to a survivor. Life insurance is complex and requires projections that may or may not come true.

How much insurance do you need now..later? What about in 10, 15, 20 years? You buy more later, it will cost you. If you have to buy more later, will you even qualify based on the health check? Bad things happen as we age. What type of insurance best serves your needs? After you die, what becomes of the huge lump sum? Is your spouse ready and able to manage a huge portfolio and make it last for decades? Will you use an immediate annuity to create a lifetime income with the life insurance proceeds? Who can you trust to manage the money for your family after you’re gone?  When inflation hits, your investment will have to be precisely managed to increase the return and allow for larger withdrawals or your family will run out of money early.

I’ll lower my base amount to decrease my premium. Sure, you can do this. However, it’s not about you and your premiums. You’re dead! It’s about your survivors and the amount you leave them. At some point, lowering the base amount to save on the premium makes the actual survivor benefit virtually worthless. A base amount of $500 gets the survivor $275 a month. Of value or not? Only you and your spouse know for sure. The benefit should drive the base amount decision, not the premium. Keep in mind that the premium comes out of your gross pay, pre-taxed, so the take-home pay is not impacted $1 for $1 due to the premium amount. The SBP premium reduces your tax burden so a 20% income tax rate is like getting SBP at a 20% premium discount.

Social Security may or may not be available. Social Security survivor benefits aren’t automatic for every survivor. A survivor with dependent children can collect benefits for the kids until they turn age 16. If there are no children, the survivor has to wait until age 60 to start survivor benefits. A survivor could start receiving benefits because of young children then stop receiving the payments once the children age out of the program. The survivor will go without benefits once the children age out of the program until the survivor turns 60. This hole in the Social Security coverage may cause a significant gap in your financial plan.

I earned that military retired pay! Without SBP, the military retired pay you risked your future for stops at death. This alone may cause some of you to get SBP just to ensure your sacrifice does not go for naught. Your spouse also had to pay for your military service. Lost career maybe, the stress, the worry, managing a household, taking care of kids alone, basically allowing you to keep your mind on the mission and not have to multi-task with things on the home front. There’s a lot to be said about the principal that the pay should continue because two people earned it.

How much life insurance do you need? Aw, the age old question. Generally, speaking, do you want coverage for only your debts, debts and short-term income needs or long-term income needs? There could be possible estate tax issues for some of you but that’s for another day.

* Debt only option.  This option leaves no money for living, just paying debts. If you want your family to be debt free at your death, add up your debts to get a total amount for life insurance purposes. What debts? Credit cards and loans pop into mind but what about…the mortgage? Kids college funds? Money to move? Burial costs? How might this figure change over the years?

* Income for a short-term? Short-term might be $40,000 a year for three years. Just do the math.

* Long-term might be lifetime income. Suppose you want $40,000 per year with an annual cost of living adjustment into the unforeseeable future. Now things get cosmic. I oversimplify this but to provide a thumbnail guide, figure the annual income is 4% of a lump sum investment. A $40,000 annual income would require a $1,000,000 portfolio. If these amounts represent how much you need today, with a high inflation rate as is expected, you may need $2,000,000 in 7-10 years for the same buying power–if you don’t die until later.  The tricky part is that this investment will need to last potentially a long, long time; many decades. It must be properly and carefully managed. Who you gonna trust? Another lifetime income option is to use the life insurance proceeds to purchase an “immediate annuity” from an insurance company. I used the Vanguard annuity calculator to determine a $1375 monthly lifetime income can be created by purchasing an immediate annuity with $470,000. It takes about $820,000 to generate a $3300 monthly income with an annuity.  Got that much life insurance or other assets you are willing to plunk down on an annuity?

How long will you need life insurance? The default answer is until you have enough in other assets to live on. Then the life insurance is no longer needed, theoretically. How long will that be? How much do you have in assets now? What’s your game plan for reaching the magic amount? How’s that game plan working so far with the economy and the markets? What happens if you lose a job for a while? The last thing you want to happen is having your insurance run out and your investment game plan didn’t work out. Guess you’ll be working a while longer. How’s that health?

Life insurance is cheaper than SBP. That may be true…but not always. We started with an example of $2500 military retired pay creating a $1375 benefit check. That benefit is $16,500 a year in income. That amount of income would require an investment portfolio of at least $415,000 ($16,500 / 4%); IF managed properly of course. Or, from my example above, a $470,000 investment in an immediate annuity. You may be able to find $500,000 in life insurance for less than the cost of $163 a month in SBP premium ($2500 x 6.5%). It all depends on your age, health, type of insurance, and length of insurance coverage.  What about generating $3300 a month ($40,000 yr)?  Now you need a $1,000,000 portfolio.  That monthly amount is from a $6000 a month retirement check or $390 a month in SBP.  An SBP payment of $3300 a month to a survivor will grow to $7800 a month in 10 years if future inflation averages 9%.  Will your investments allow an eventual $7800 mo/$93,600 yr withdrawal and not run out of money early?  The SBP COLA adjustment is a significant value that must be figured in the premium–its value will be hugely appreciated by survivors in high inflationary times.  This benefit is possible due to the heavy subsidies provided by the government for the SBP. 

That’s quite a bit to chew on. You and your spouse need to do a little role playing to put yourselves in the right frame of mind. To set the stage, the retired military member is dead along with the salary from the current job and the military retired pay. How will the remaining family survive financially; now and in the future? The best case scenario is the retired military spouse dies after the family has built enough wealth to continue at full financial strength. Worse case is death with no or little family assets. Keep in mind that even the best plans to build assets and wealth can go astray and at the very least it takes decades to built real substantial wealth. Money may not buy happiness but it sure buys security.

In 2010 the IRS will remove the income limit on conversions from Nondeductible IRAs and Traditional IRAs to a ROTH IRA. We anticipate the tax law change to create a marked increase in conversion activity in 2010. Undoubtedly, savvy individuals and investment managers will take advantage of this opportunity to insulate themselves and their clients against possible future higher income tax rates. Previous to 2010, households with Modified Adjusted Gross Income (MAGI) exceeding $100k were ineligible to make conversions to ROTH IRAs. This change is welcomed news for those households who have been unable to invest in deductible Traditional IRAs or ROTH IRAs due to income limitations.

The Tax Increase Prevention and Reconciliation Act of 2005, signed into law on May 17, 2006, created the loophole which takes effect in 2010. To demonstrate the potential benefit of this loophole, a previous ineligible household who has not made contributions to an IRA this year could ultimately fund a ROTH IRA with $20k by April 15, 2010. That number increases to $24k for qualified wage earners, married filing jointly, and at least 50 years old. How can this be done? It’s really a simple process. First, establish a Nondeductible IRA and contribute $5k for each spouse for 2009 and again in 2010, then convert the balance into a ROTH IRA in 2010.

Washington’s unabated printing of the U.S. Dollar is setting the stage for future income tax increases. Policy makers have already zeroed in on those earning $250k/year and we anticipate that number to creep lower as spending continues and the deficit surges. The federal debt for Fiscal Year 2009 was $1.4 Trillion. Enacting a conversion strategy now and in future years (until Congress changes the law) enables investors to keep more of their hard earned money as converted ROTHs will provide tax free growth and tax free distributions (as long as distributions are qualified).

Conversions of Traditional IRAs to ROTHs may also be a timely option for those impacted by the current economic downturn. Individuals who have seen a drop in their personal income can benefit from converting their Traditional IRA to a ROTH in 2010 as well. Reduced income levels and low current tax rates equate to a lower tax bill if converted now as opposed to the future when personal incomes recover and tax rates increase. In addition to personal income levels, many retirement accounts have also seen a significant drop in value. Converting now makes sense, as lower current account values translates into lower tax liabilities. The market has rallied nicely this year and as it continues to recover and account balances increase all the gains made over the ensuing years will be tax free when withdrawn as qualified distributions. As if it couldn’t get any better, the IRS is providing an additional benefit in 2010 by extending the timeline for payment of taxes.

Conversions completed in 2010 can be paid over a two year period, reducing the immediate income tax burden for those who convert. This can help offset cash flow concerns for investors in these tough economic times. Understanding the three possible taxation methods is critical and must be reviewed to ensure proper calculation of tax liability. Taxation is based on the type of IRA accounts you own, Nondeductible, Traditional or a combination of both.

1. Investor owns only a Nondeductible IRA: Taxation is based on the gain above contribution. If the investor previous to this year did not own an IRA, he could apply the strategy outlined in paragraph two and incur only a minimal income tax liability, (gain above contribution) while fully funding a ROTH IRA for 2009 and 2010. This is a significant benefit for those who were previously ineligible and made no prior IRA contributions.
2. Individual owns only a Traditional IRA: The entire conversion amount is taxed at their income tax rate.
3. Individual has both a Traditional and Nondeductible IRAs: The balances of each type of account must be aggregated to determine the applicable income tax liability. Example, if an individual has $20k in Traditional IRAs and $10k in Nondeductible IRAs, 2/3 of the conversion amount would be subject to the individual’s income tax rate.

The decision of converting a Nondeductible and/or Traditional IRAs to a ROTH IRA is one that must be analyzed. There are numerous assumptions and planning factors that should be considered to make an informed decision. If one can foresee the future and know that they will be in a higher tax bracket in retirement then the tax free growth and tax free qualified withdrawals are a convincing option for conversion. One should thoroughly research the 2010 conversion tax laws and assess their personal circumstances prior to making a decision and/or seek professional assistance.

• Typically conversions will benefit those who anticipate being in a higher tax bracket in retirement
• IRA Conversions which have not been taxed are includible in your gross income in the year of conversion (Taxes on conversions made in 2010 can be paid over a 2 year period)
• If funds are not available to pay the taxes it is not advisable to use retirement funds to pay the taxes
• You MUST submit IRS Form 8606 for Non-deductible IRA contributions each year a contribution is made
• Converted ROTH can play an effective role in Estate planning for taxes and minimum withdrawals

A perennial estate planning horror story is the one in which a man dies before revising his will leaving everything to his ex-wife instead of to his current spouse as he intended.  While none of us would allow this to happen, we could have other potential horror stories lurking in our retirement plans.  

 Beneficiary designations should be reviewed annually and updated whenever there is a significant “life event” such as birth, death or divorce.  That single document is more powerful than you might think because it can override the instructions in your will or trust.  Your plan administrator is responsible for maintaining these instructions but paperwork can get lost and what counts is the physical document itself not the electronic entry on a computer screen.  That is why you should keep an updated copy with the other important papers your executor will need.  

 Who you name as beneficiary is another important consideration.  Naming your estate or trust as beneficiary may not be the best choice since it can force heirs to take taxable distributions they might otherwise defer.  Naming a contingent beneficiary can be another important estate planning tool.  These issues are best discussed with your attorney. 

 While updating legal documents may be inconvenient it isn’t a whole lot of work.  More importantly, it is one more way to take care of your heirs.

Some of our most cherished family possessions are those that have been passed down, generation to generation. An old pocket watch or military decoration may not possess any intrinsic value but it can be a priceless memento of a beloved relative. Unfortunately sentimental value can be misapplied.

Take, for example, inherited shares of stock. The deceased may have been a savvy investor or may simply have acquired shares from his employer. How or why he bought the shares may have been important at one time, but no longer.

His heir has now become an “accidental investor.” It is doubtful that this heir would have chosen these shares on his own. In fact, it is likely that he has very different investment objectives than did the deceased. Elderly investors generally own income-oriented investments which are appropriate for their circumstances but are really not suitable for younger investors who can benefit more from growth-oriented securities.

Nevertheless, having inherited these shares, some people mistakenly begin to treat these securities like family heirlooms. There have been times when I have advised clients to sell inappropriate investments only to hear “Aunt Minnie left those shares to me so I could never sell them.” But if I asked if that would also apply to Aunt Minnie’s 2% passbook savings account the answer was generally “of course not!”

Sentiment has its place but not when it comes to investments.

I was recently asked to help an elderly couple find an estate planning attorney and to accompany them to the meeting to draw up the Will.  I did some checking around and found someone who could help them.  Their estate was relatively simple and they wanted to leave everything to each other and then when the second spouse passed away to distribute the estate to their children and grandchildren.  The attorney drew up the Will and the couple signed it.  Not that different from what many of us would do.

I asked the couple if I could look through their assets to make sure everything was o.k.  This is when I discovered they had a potential problem.  Even though they intended to leave everything to each other, their liquid assets (bank savings accounts and US Savings bonds) which were the majority of their non-real estate portion of their estate were held in joint tenancy with one spouse and one of their children.  For example, one savings account was a joint account with husband/father and son.  The couple did this so that the son could access the money if the husband was incapacitated.  However, this arrangement did not meet the couple’s goal to leave everything to each other.  Assets held in joint tenancy do not transfer in accordance with the Will, but become the property of the joint tenant.  This would mean that the surviving spouse (wife) would not inherit the funds but the joint tenant (in the example above the son) would.  This could put the surviving spouse (wife) in a difficult financial situation.  I immediately notified them of my concern and they started to rectify the problem.

Unfortunately, the husband died before all the assets could be re-titled.  The good news is that the children were informed of the intent of the couple and they are supporting that intent by a gifting program back to the surviving spouse, so in this case it turned out o.k.

There is a lesson here for all of us.  Check how your assets are titled and make sure that your Will and titling plan complement each other.  Remember, your Will only disposes of assets that you “control” such as those owned “fee simple” (like a car titled in your name only) or tenancy in common (similar to a partnership where you control your portion of the asset).  If joint accounts or joint tenancy with right of survivorship (JTWROS) assets are shared with someone other than who you want to inherit the asset it is time to take action to change the account ownership arrangement.