Financial Abundance

Many of my baby boomer clients are questioning their ability to retire before they reach their Full Retirement Age (FRA) for Social Security.  When we do our annual retirement planning, we always explore several different retirement options to allow for the abundant retirement they desire.

The goal of any retirement plan is to live throughout the retirement years without depleting retirement savings.   An abundant retirement provides adequate income to continue living the current lifestyle plus additional funds to better enjoy retirement through additional activities such as travel and hobbies.   As there is a 40% probability that at least one person in a healthy 65 year old couple will live an additional 30 years, providing for an abundant retirement requires advanced financial planning.

One factor that is not often fully appreciated in retirement planning is the large “cost” of early retirement.  However, if you are actively saving for your retirement years, there is  a seldom explored option to early retirement.

The goal is often to retire at age 62, the earliest age at which Social Security payments are available.  An option to taking this early retirement is to stop making contributions to your retirement plan saving at age 62 and use these funds to better enjoy your final working years.  By doing this, retirement savings continue to grow, Social Security payments continue to increase by approximately 8% per year and your pre-retirement years can include the travel and hobbies that may have previously been unaffordable.

Let’s consider an example of how this option can help assure an abundant retirement:

Mary and John Smith, both age 61, have a combined income of $100K per year.  Throughout their careers they have saved 15% of their pretax earnings, providing them with $800K in retirement savings.  At their full retirement age (FRA) of age 66, their combined Social Security benefits will be $40,000 per year.  They have determined that they will need $80K per year to live the abundant retirement that they desire and would like to begin retirement when they are age 62 and eligible for Social Security benefits.

If John and Mary retire at age 62, their annual Social Security benefits will be reduced to $30,000.  They will need to spend $50,000 per year from their retirement savings to provide the required $80K in annual income.  Assuming no inflation and a 3% real rate of return on their investments, John and Mary could deplete their funds in 22 years, when they are only age 84.

Since both John and Mary are in good health, there is a very high probability that one or both of them will live past age 84.  They must reconsider other options if they wish to have the desired abundant retirement.

Mary and John meet with their financial planner to explore other retirement options.  Their planner suggests that they continue working until their Social Security FRA age of 66.  However, he also suggests that instead of continuing to save for retirement, they use their annual $15K in retirement savings for vacations and new hobbies that they have been postponing due to lack of funds.

When John and Mary retire at age 66, their $800K in savings, growing at just 3%, will have grown to $900,407.  At age 66, they will receive their full Social Security benefits of $40,000 annually, reducing the annual savings withdrawal to $40,000 per year.  With these changes, John and Mary’s savings will now last for 38 years.

By working an additional 4 years and spending their annual retirement savings of $15K on vacations and hobbies, John and Mary will be able to live an abundant retirement and never deplete their savings.

If your company offers a 401(k) match, continue to contribute to your 401(k) up to the company matching amount.   Take the amount contributed to your 401(k) plan out of a taxable investment account.  You will still come out ahead thanks to the “free money” contributed by your employer’s match

Retirement options need to be explored before you retire.  Work with a qualified financial planning professional to explore all of your retirement options.  A relatively small change can make a huge difference in your ability to have and maintain an abundant retirement.

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One of the greatest blessings of my life was to be the father of two children.  When we become parents, it is understood that we are taking on a large, new financial responsibility.  Most young parents believe that their financial responsibility will end when their children graduate from college.  Many parents of grown children have found that these expenses can continue well past college graduation.

Many people who are approaching retirement, provide financial support for their grown children, even when doing so places their retirement at risk.  Regardless of your child’s age, you can decrease and eventually break your children’s financial co-dependence.  Here are a few approaches to consider:

1. Agree that you will only pay for in state college tuition.  When our children were young, my wife and I determined that Colorado had excellent state colleges.  When our children began to consider their college options, they were allowed to consider all colleges.  Our children knew that we would pay for any state supported college in Colorado. If they wanted to attend a more expensive school, they would be responsible for the increased costs.  This approach allowed our children to share the financial responsibility for their college choice.
2. While our children both chose state supported colleges, had they chosen more costly schools, they would likely have required student loans.  If your child requires a student loan, keep the loan only in the student’s name.  Even if you choose to help your child pay this loan after college, by keeping the loan in your child’s name, you avoid personal responsibility for a loan that would always be with you, even if you or your child declared bankruptcy.
3. Never co-sign any financial obligation with your child.  If you agree to co-sign a lease, a car loan, a mortgage or any other financial instrument, you are effectively taking 100% ownership of the obligation.  If the financial obligation is something that you wish to support, such as a mortgage, take the mortgage out in your own name and have a separate agreement with your child.  This gives you complete control over the property should things not work out as planned.
4. If your child requires on-going financial support that you are willing to provide, pay their bills directly to the party to which they are owed.  This will assure that your financial support is going to where it is intended.
5. Be sure that your grown child has medical insurance.  Many young people do not see the need for medical insurance.  If your grown child can no longer be on your medical insurance policy and you are financially able to help them, use the first dollars of your support to assure that they have adequate medical insurance.
6. If you are supporting your grown child, develop a mutually agreed upon plan to terminate this support.  While the plan may require months to complete, you are demonstrating to your child your faith in their ability to succeed financially.  Your faith in your child’s ability to succeed financially will be one of the best gifts that you can ever give.
7. If required, allow your grown child to fail financially.  It is human nature to learn more from failure than success.  While it is extremely difficult to see grown children struggle, by letting go and allowing them to determine how to get out of a financial jam, we allow them to grow as adults and we show our faith in their ability to solve their financial dilemma.

Parents wish for their children to be financially secure.  As counterintuitive as it may seem, one of the best ways to assure this is to let our grown children have the responsibility of taking care of their own financial well being.  While some critical financial support is often required, showing our faith in our children’s ability to be responsible for their own financial health is a gift to both your children and your retirement.

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The economy, government spending and debt, unemployment, housing foreclosures and our banking system all contribute to a fear of the financial future.  These fears are all outside of our control.  However, we can control many decisions related to our own financial future.

Financial Abundance Guide (available free at www.finabguide.com) identifies many areas of personal finance that can be controlled.  I also developed the Seven Steps to Financial Abundance to help people reach their financial goals.  With so much fear of the financial future, following the seven steps can help increase our power to control our financial future.

“Spend less than you earn,” is the required first step.  Over a 40 year career (age 25 to age 65), assume that your average income is $80,000 (in 2011 dollars) and the annualized investment real rate of return is 5%.  Saving 10% of income ($8K) each year will produce savings of over $1 million (in 2011) dollars at age 65.

By “maximizing your financial resources” (step 2) , savings can be increased with no negative impact on spending.  If a company offers a 4% of salary match with their 401(k) plan, by contributing at least 4% of salary, this amount is matched by the company. Using the previous example, annual savings are increased from $8,000 to $11,200, increasing the savings available at age 65 to almost $1.5 million.

“Minimizing your taxes” (step 3), also provides additional savings with no impact on spending.   Financial Abundance Guide provides many tax savings techniques available to people of all income levels.  One example is a spousal IRA, allowing a non working spouse to contribute $5,000 per year to an IRA.  For a couple paying 25% in federal taxes and a 5% state income tax, a $5,000 IRA contribution would yield $1,500 in annual tax savings.  Continuing with our example, the additional $1,500 in annual tax savings would  provide almost $1.7 million in 2001 dollars by age 65.

“Managing your investments” (step 4), can significantly increase investment returns.  This may require the help of an investment professional.  If so, carefully choose an investment advisor and be wary of anyone providing “free” advice.  A “free” advisor must be compensated through commissions on the investment products they sell.  Fee only advisors are compensated by the fees they charge to manage investments.  Continuing the above example, if the real rate of investment return is increase by only 0.5%, the couple would have almost $1.9 million at age 65.

Using the simplistic assumption that a couple, at age 65, can withdraw at least 4% of their investments each year and never run out of money, $76K (in 2011 dollars) can be withdrawn each year throughout retirement.  Since their previous annual expenses were $72K, with $8K per year in savings, even with no Social Security or other retirement benefits, our couple can more than maintain their lifestyle throughout retirement.

Fear of the unknown often produces a sense of financial scarcity.  “Protecting your financial resources” (step 5), through appropriate, lower cost insurance products can help keep this fear at bay.   An insurance product that is often overlooked is a $1 – $2 million umbrella liability policy.   In our litigious society, one may be sued because someone was hurt on their property or by a car driven by a family member.  For very little money, peace of mind can be secured by adding an umbrella liability policy to your auto or home insurance policy.

Financial planning helps “control your personal finances” (step 6). There are many available resources to help you produce you own financial plan.  If you have neither the time nor interest in financial planning, engage a fee only Certified Financial Planner (CFP^®)  who will listen to your concerns and provide a comprehensive plan that enumerates the options available to meet your financial goals.  A financial plan helps increase control over personal finances.  Planning will reduce the fear of scarcity, providing more financial security on the path toward financial abundance.

“Have faith in continued abundance” is the seventh step. Implementing the first six steps addresses what you can control in your personal finances.   Faith that financial abundance will continue helps eliminate the doubts and fears of the unknown often caused by events over which you have no control.

Financial abundance is a lifetime pursuit.  There will always be ups and downs in the economy and markets.  By applying the seven steps and seeking appropriate outside support as required, you will be on the pathway toward financial abundance.

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Whenever I see advertisements for a mutual fund family, I am reminded of the famous saying by Garrison Keillor “Welcome to Lake Wobegon, where all the women are strong, all the men are good-looking, and all the children are above average.” Similar to the children of Lake Wobegon, mutual fund families want you to believe that they all provide above average returns.

John Bogle is the founder of Vanguard funds and arguably the world’s most famous proponent of low cost investing.  In a recent Financial Times article, Bogle does an excellent job of deconstructing the misleading numbers that are often provided by purveyors of financial products.  Let’s examine his logic:

Bogle first reminds us that a stock’s value is NOT its current price.  As Benjamin Graham first recognized in the 1920s, the value of a stock is represented by the discounted value of the company’s future cash flow.  He called this the “intrinsic value” of a company.  At any particular time, the price of a share of stock may greatly exceed or be significantly less than its intrinsic value.  However, in the long term, a stock’s price will center around its intrinsic value.

Bogle next states that, due to the reduction of the stock dividends from the historic average annual rate of nearly 4.5% to the current rate of approximately 2%, nominal annual stock returns for the next decade will likely center around 7% instead of the historical 9.5% rate.  Thus, if a 9.5% rate of return for future stock appreciation is used in financial projections, these projections will likely be significantly overstated.

As an example, if you invest $50,000 for 20 years, with a 9.5% nominal rate of return, $50,000 would become $307,080.  However, if the nominal rate of return is 7%, in twenty years the nominal value of $50,000 would be $193,484.

A second “mistake” that Bogle notes is when projections show investment returns in nominal terms instead of their “real rate of return.”  The real rate of return is the nominal return return less the rate of inflation.  If the expected nominal rate of return is 7% and inflation over the next 20 years is expected to match the historic long term annual rate of 3%, the real rate of return is 4%.  Thus, using the same $50,000 investment over a 20 year period, the “spendable dollars” returned is only $109,556, a $200,000 reduction from the originally projected amount.

The third “mistake” is not including investment costs when considering total investment returns.  Investment costs include fund operating expenses, trading costs, loads (including 12b-1 fees) and asset management expenses.  These combined annual expenses can easily be 1.5% or more of your invested assets.  If these fees are included, your annual real rate of return can be reduced to 2.5% or less.  Including the reduction from investment fees, the $50,000 equity investment may only grows to a “spendable” $81,931 in 20 years.

All of the above calculations assume that the invested funds are held in a retirement account.  If not, tax consequences could further reduce the investment returns.

After considering these dramatic reductions in projected investment returns, it may seem prudent to forgo investing in stocks.  However, keeping money in a “safe” CD or money market fund will likely provide the historic long term real rate of return of -1% for these types of investments.  With this real rate of return, these “safe” investments will provide a “spendable” $40,895 on the original $50,000 investment in twenty years.  The “safe return” is approximately ½ of the return from the equity investment.

The message behind Bogle’s article is to be wary of future performance projections portrayed by many mutual fund companies and other financial service organizations.  By avoiding these three common mistakes, often ignored by investors and pension fund plans as well, you can identify more appropriate investment rates of return.

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I have met few baby boomers who are not concerned about their ability to have an abundant retirement.  Except for the very wealthy, Social Security income is an important factor in supporting a successful retirement.

Social Security is a complex system that few people truly understand.  Effectively, Social Security is an “immediate annuity” that increases in value with both the rate of inflation and by each year in which you delay receiving benefits (up to age 70).  Let’s consider how you can maximize this important benefit.

A common misperception about Social Security is that, if benefits are available, you should begin taking them as soon as you retire.  If a healthy person retires in 2011 at age 62, they are eligible for a monthly payment that is approximately 75% of the Social Security benefits that they would receive at age 66, their Full Retirement Age (FRA).

Assuming that the FRA Social Security benefit is $2,000 per month, the benefit at age 62 would be only $1,500 per month.  At age 85, with 0% inflation, a person will receive $414,000 in Social Security benefits if they begin taking them at age 62.  If the same person waits until their FRA of 66 before receiving benefits, they would receive a total of $456,000 in benefits by the time they reach age 85.

It is especially important to delay taking Social Security benefits before your FRA, if you have any significant earned income.  Earning more than $14,160 in any year before FRA will decrease Social Security benefits by $1 for every $2 earned above that amount.

Many believe that they should begin taking Social Security benefits no later than their FRA, at which time they will receive 100% of benefits due.  However, for each year beyond FRA that Social Security benefits  are postponed, the monthly benefit increases by 8%.  Thus, with a FRA of 66, postponing benefits until age 70 will provide monthly benefits that are 132% of FRA benefits.

If FRA benefits are $2,000 per month, waiting until age 70 to begin receiving benefits would increase the monthly Social Security benefit to $2,640 (with 0% inflation).  Upon reaching age 85, the total (non inflation adjusted) amount that would be collected is $475,200, $61K more than starting benefits at age 62 and  $19K more than the benefits collected starting at FRA.  When inflation is considered, these additional amounts are significantly larger.

For a married couple, in good health, in which one spouse has earned significantly higher Social Security benefits than their partner, it is often prudent for the higher earner to delay starting Social Security benefits until age 70.  If spouses are both age 66 and in good health, the odds that at least one spouse will live past age 90 is almost 40%.  If the higher earning spouse is the first to die, the remaining spouse can claim 100% of the deceased spouse’s benefit.  Thus, the monthly payments for the higher earning spouse, representing an inflation adjusted 132% of FRA benefits, continues until the second spouse passes.

If you retire before age 70, delaying Social Security benefits will require spending more retirement savings than would otherwise be necessary.  However, for most people, their primary retirement concern is running out of money before they die.

For those that have saved adequately during their pre-retirement years, running out of money will often only occur if one spouse lives well beyond “normal” life spans.  If you or your spouse (or both) are alive at age 90 or beyond, having an additional 32% of inflation adjusted Social Security income (or 76% more than those who take Social Security benefits at age 62) could provide a significant boost to your lifestyle.

A successful retirement requires that you make informed decisions concerning Social Security benefits.   Your health, age, income differences with your spouse and the amount of other financial resources available must all be considered.  Working with a financial advisor who understands the vagaries of Social Security system can help provide thousands of extra dollars for your retirement years.

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In our previous article, we provided an easy to calculate approach to determining if you will be able to retire when you wish.  For some people, this simple calculation helps confirm that they will be able to retire when they wish.  For others, the “income gap” is too large to safely retire when they would like.  In this article, we explore ways to decrease income gaps.  We will also provide techniques to convert financial resources into income that is required for an abundant retirement.

The following are simple approaches to reducing the income gap:

1.    Continue to work past your projected retirement age.  This provides three advantages by a) delaying the need to begin taking Social Security benefits, b) increasing these benefits when they are begun and  c) reducing the number of retirement years by each additional year worked.

2.    Increase savings while working.  Lowering your current expenditures could substantially increase your annual retirement funds.

3.    Spend less in retirement.  Lowering your discretionary spending in retirement will decrease the income gap and increase the number of years that your retirement income will last.

4.    Increase returns on your investment assets.  By carefully monitoring your investment assets you will likely increase investment returns, providing a larger retirement asset base.

Once all acceptable steps for reducing your “income gap” have been taken, the next step is determining  the best approach for converting financial resources into income.

Many people use a systematic withdrawal plan (SWP), in which they withdraw between 4% and 5% of total retirement savings each year.  With an SWP, it is important to carefully consider the tax consequences associated with withdrawals from each type of investment.

Typically, it is prudent to first withdraw funds from taxable accounts, as these assets provide the most flexibility in tax planning.  With tax deferred accounts, such as IRAs and 401(k) plans, all withdrawals are taxed at the same rate as earned income.

For most people, the most tax efficient withdrawal approach is to use taxable accounts for withdrawals before age 70½, after which you withdraw only the required minimum distribution (RMD) from tax deferred accounts, for as long as you are able to do so. If possible, avoid using any Roth IRA funds.  Roth IRA funds are the perfect inheritance in that they can continue to grow on a tax free basis throughout the lifetime of the beneficiary.

With the SWP approach, the retiree assumes all of the income risk.  This often leads to a significant portion of the total portfolio being put into less risky investments.  This conservative investment allocation may reduced long term investment returns, thereby reducing funds that are available in retirement.

Another approach is to use immediate annuities to fill the “essential income gap.”  This approach can help assure that the funds required for your essential well being are available for the rest of your life.  Since inflation will eat into these funds, it is prudent to provide for at least 33% more income than is required.  In the early years, this additional income can either be reinvested or used to fill the “discretionary income gap.”

If you chose to use immediate annuities to fill deficits in your “essential income gap,” a systematic withdrawal plan (SWP) of remaining funds can provide for your discretionary spending.  Since your essential expenses are covered, it is possible to use a riskier investment allocation for the remaining funds that provide for your discretionary spending.

There are many variations to the above approach, including laddered immediate annuities, laddered long term treasury bonds, laddered TIPS etc.  Details of how to use each of these approaches is beyond the scope of this article.

The key to a successful retirement is working long enough to assure that both your essential and your discretionary incomes gaps can be filled by a combination of your Social Security, pensions, investment income and retirement savings.  Once this is accomplished, maximize retirement income by determining the most tax efficient methods to convert your savings into retirement income.  If this task appears overly burdensome, find a capable financial advisor who can help you accomplish your retirement goals.

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A common question of the baby boomer generation is “when I can retire?”  At Financial Abundance, LLC, we have a detailed, proprietary approach to help our client’s answer this question.  However, there is an easy to perform, 9 Step calculation that may help you answer this question.  Here is how it works.

Step 1: Separate expenses into either essential or discretionary expenses.  Essential expenses include food, clothing, housing, property and casualty insurance, taxes and medical expenses.  Essential expenses should also include all “required” expenses, including telephones, cable, internet, pet care, hair care, etc.  All other expenses, including expenses (such as travel) that you would like to increase in retirement, are classified as discretionary expenses.

Step 2: Identify available lifetime income streams.  This annual income will include pensions and Social Security (starting as early as age 62) as well as any lifetime annuity or trust income.  If these income streams are not inflation adjusted (as is Social Security), use only 2/3 of the annual amount to adjustment for future inflation.

Step 3: Subtract the amount in Step 2 from annual essential expenses.  This provides the essential income gap.

Step 4: Identify annual income expected from sources other than the lifetime income streams.  This would include income expected from taxable and tax deferred investment accounts, income from rental properties, post retirement employment income and all other income sources available during retirement.

Step 5: Subtract the amount in Step 4 from annual discretionary expenses.  This provides the discretionary income gap.

Step 6: Add the values found in Step 3 and Step 5 to determine your Total Income Gap.  If the sum is negative, you should have more than adequate resources to retire and meet your income requirements.  Most people will find that this number is positive.

Step 7: Sum all of your investible retirement assets including taxable accounts, tax deferred accounts, Roth accounts and the net sales value of any properties or other assets that might be sold in retirement.  If you included income from rental properties in Step 4, do not include those properties in Step 7.

Step 8: Divide the amount calculated in Step 7 by the Total Income Gap (Step 6) to determine the number of years that investment resources will last after retirement.

Step 9: Add your planned retirement age to the number found in Step 8.  If this sum is over 90, retirement in the planned year may be possible

Let’s look at an example of how this would work:

The Smith’s are both age 60 and plan on retiring at their full Social Security retirement age of 66. After examining their current expenses, the Smith’s have determined that their “essential” expenses are $50,000 per year and their “discretionary” expenses are $30,000 per year.  This figure includes an additional $10K per year that they will spend on travel after they retire. Total retirement expenses are $80,000 per year.

Based on current Social Security statements, their combined monthly Social Security income at age 66 will be $3,225 or $38,700 annually.  Mr. Smith will receive a non inflation adjusted $500/mo pension from a previous employer.  The annual inflation adjusted pension amount is  12*$500*2/3 = $4,000, for a total lifetime income of $42,700.  Subtracting this amount from the essential expenses of $50,000 leaves a $7,300 essential income gap.

The Smiths have approximately $600,000 in taxable and tax deferred retirement accounts, yielding 2.5%% annually.  These investments provide an annual income of $15,000.  Since their discretionary expenses are $30,000, their discretionary income gap is $15,000.  The Total Income Gap is $22,300.

By dividing $600,000 by $22,300, the Smiths find that their savings should last 26.9 years after they retire at age 66.  Since they will be 93 at that time, their current savings will likely be sufficient.

While this is a rudimentary approach to determining retirement preparedness, it is an easy method of estimating one’s ability to retire at a given age.  Next month, we will consider some approaches to help close the income gaps and reduce the age at which you can retire.

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Even though its 2011, there may still be ways to reduce 2010 taxes.  Funding an IRA between now and April 15 is one of the few remaining methods to reduce 2010 taxable income.  Let’s look at three popular IRAs to determine if a year-end contribution is appropriate for you.

If you are self-employed and have no employees, a SEP IRA may be the best way to reduce your taxable income.  If your company is an S or C Corporation, you can contribute up to 25% of your W-2 income to a SEP IRA.  With a sole proprietorship or an LLC your maximum contribution is 20% of your net adjusted self employment income.  Net adjusted self employment income is calculated by subtracting ½  of the self employment tax from net self employment income. The maximum annual contribution to a SEP IRA is $49,000.

If you cannot contribute to a SEP IRA, you may be eligible to contribute to a traditional, deductible IRA or to a Roth IRA.  To determine if you qualify for an IRA contribution, you’ll need to understand the rules.

To contribute to a traditional IRA, you must be under 70½ years old and you (or your spouse) must have earned income.  In 2010, the maximum IRA contribution is $5,000 ($6,000 if over age 50).

When covered by a company retirement plan, you may deduct the maximum contribution amount if your Adjusted Gross Income (AGI) is no more than $56,000 as a single tax payer or $89,000 as a joint filer.  If your spouse is not covered by a retirement plan and you are, your spouse may contribute the maximum amounts to an IRA, as long as your joint AGI is under $167,000.

If neither you nor your spouse is covered by a retirement plan, you may each contribute the maximum contribution amounts, regardless of your income.  The “spousal IRA” rules allow both spouses to contribute to an IRA, even when only one spouse has earned income.

If you expect to pay higher taxes in retirement than you pay now, contributions to a Roth IRA may be a better choice.  To contribute to a Roth IRA, your Adjusted Gross Income (AGI) must be less than $105,000 as a single filer or $167,000 as a joint tax filer.  As with a traditional IRA, your maximum Roth IRA contribution is $5,000 ($6,000 if you are over age 50).  If you make any traditional IRA contributions, the maximum Roth contribution is reduced by the amount contributed to the traditional IRA.

Sometimes, the decision on whether to fund an IRA or a Roth IRA is made for you.  If you are not covered by a company retirement plan and a single filer with an AGI over $105,000 or a joint filer with an AGI over $167,000, you may only fund a traditional IRA.  If you are covered by a company retirement plan and your AGI is over $90,000 but less than $167,000, as a joint filer, or over $56,000 but less than $105,000 as a single filer, you may only fully fund a Roth IRA.

Your age can also be a factor.  If you have earned income and are over 70½, only a Roth IRA may be funded.

Funding a Roth IRA instead of a traditional IRA has other advantages.  If you are buying your first house, all of your contributions to a Roth IRA plus $10,000 of growth and income can be withdrawn with no taxes or penalties.   If funds are required for any purpose before age 59½, a Roth IRA usually allows contributions to be withdrawn, with no taxes or penalties.  With a traditional IRA, withdrawals before age 59 ½ will always be taxed and will usually include a 10% early withdrawal penalty.

For people under age 40, the tax free growth and ease of withdrawing funds often make Roth IRA contributions a better choice.  As an estate planning tool, Roth IRAs provide an excellent mechanism for passing tax free funds to your children.

Whether you chose a SEP IRA, a traditional IRA or a Roth, if you are eligible to fund an IRA in 2010, do it before April 15.

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If you are considering retirement and have an ownership position in your business worth $250K or more, the two year extension of the “Bush tax cuts” could provide an opportunity for significant tax savings.

For the next two years, long term capital gains and qualified dividends will be taxed at a maximum rate of 15%.  In 2013, capital gains tax rates will likely increase to at least 20% and could increase to 28% on the “wealthy” (couples earning $250K or more per year).  On top of this likely tax increase, 2013 will also usher in increased Medicare taxes which could add 3.8% in taxes to all investment income.   Let’s look at what this could mean if you are considering the sale of your business interests.

We assume that you are married and that you and your spouse’s Adjusted Gross Income is $250K.  Let’s also assume that your business ownership interest has a net value of $1 million.  If you sell your business ownership interest by the end of 2012, the federal income taxes owed from the sale of your business interests will be $150K, allowing you to keep $850K.  However, if the same business ownership is sold at the end of 2013, federal taxes owed will likely be significantly higher.

Assuming that long term capital gains rates “only” rise to 20% in 2013, you will owe $200K in capital gains taxes, an increase in federal taxes of 33%.   However, since your 2013 AGI remains at $250K, the $1 million income from the sale of your business will be fully subject to the 3.8% Medicare tax, providing an additional $38K in federal taxes owed.  Selling your business at the end of 2013, instead of 2012, will likely add a minimum of $88K to your federal tax bill, representing a 58% federal tax increase.

Many people believe that the capital gains rates for the “wealthy” could increase to the 1996 level of 28% in 2013.  If this occurs, the total federal taxes that could be owed on the sale of a $1 million business interest would rise to $318K, leaving only $682K remaining after federal taxes.  If this scenario occurs, postponing the sell of a business could more than double the amount of federal income taxes that must be paid.

Thanks to the recent extension of current tax rates, there is a two year window of tax certainty.  Based on previous government actions, it seems reasonable to expect that nothing further will be done regarding taxes until the end of 2012, at the earliest.  If you are considering the sale of a substantial business interest in the near future, it might be wise to begin this process now, so it can be completed before the end of 2012.

As with all investments, you should never let the “tax tail” wag the investment dog.  If you are enjoying your business and expect it to keep growing in value over the years to come, short term tax consequences will be diminished by the increase in total value that you will receive by selling your business in the future.

However, if your business is not growing rapidly and you are not enjoying it like you once did, it may be time to sell.  As the economy continues to improve and banks begin to offer business loans, preparing your business for a sale by the end of 2012 could maximize your after tax business returns.

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