Now, let’s move on to the second critical thought process that must take place before you enter the long term care conversation.

Let’s begin by recapping what we know so far about our case study involving John and Mary:

• We know that John and Mary are each retired and they need $10,000 per month to support their lifestyle
• They receive $5,000 per month from social security and pensions, so their level of Retirement Bucket™ Dependence is $5,000 per month or $60,000 per year.
• Their Retirement Bucket™ has $2 million dollars of investments in it. (a nice round number to work with)
• And, most importantly, we’ve determined that this amount is enough to provide them the income they need for the rest of their lives (including cost of living adjustments to compensate for inflation) without having to earn a crazy rate of return in order to make it happen.

Now, that’s terrific news assuming everything goes according to plan.

However, as we all know, rarely does everything go according to plan, so we have to closely examine the risks.

And, one of those “risks” is your health.

What’s Your Risk?

If you objectively take a step back for a moment, one of the conclusions you’d arrive at is that the downside “financial” risk of you passing away decreases over time, thus decreasing your need for life insurance.

However, on the flip side, the “financial” risk of caring for your health increases dramatically with age.

Once you’ve reached age 65, statistics illustrate that there’s a 30% chance that either you or your spouse will need to receive long term care in one of five ways:

• In your Home,
• In an Assisted Living Facility,
• In a Nursing Home,
• In an Adult Day Care Facility, or
• In Hospice

A 30% chance!!!  That’s a pretty big number.

Now, if we remove the emotional aspect of the care for a moment and strictly evaluate the financial risk that you face, it becomes a pretty daunting thought.

“Managing” Your Risk

So, what we’re after here is assessing and then “managing” the risk.  And, whenever you’re confronted with a risk, there are three questions that you must ask yourself (as we alluded to a few weeks back):

1. “What’s my potential financial loss?”  (Assuming you don’t have insurance already to protect yourself)    So, you have to actually put a number on it.
2. “What’s the probability that I’ll suffer this loss?”
3. “Am I willing to risk absorbing this entire loss myself, or should I pass on some or all of the risk to an insurance company by paying a premium?”

Let’s start with #1: what’s the potential loss?  The cost to receive care in your home or to move into a nursing home in many areas in and around the Boston area now exceeds $10,000 per month.

Given that the average length of stay is 2.9 years, that’s a total “potential” risk of well over $300,000 for each spouse.

Now, before we move on to anything else, let’s stop and think about that potential risk for John and Mary from our case study.

Remember that their Retirement Resource Forecasters™ looked fine given their need to withdraw $5,000 per month from their Retirement Bucket™.

However, if either John or Mary gets sick, hopefully not both, and it costs $10,000 per month for care, they now need to withdraw $15,000 per month from their Retirement Bucket™.

$5,000 for income and $10,000 for health care.

Clearly, if they continue at that pace for long, their Retirement Bucket™ won’t be able to handle it for very long and they’ll run out of money.

This is financially devastating for the healthy spouse who still needs the money to live.

The key is to know just how financially devastating for you personally.  In other words, what does their scenario look like if one of them needs care for three years?

For five years?

For seven years?

You need to define what your personal risk exposure is so that you can make an educated decision for yourself.

Please notice that all of this has to be worked out before you even think about how to ‘manage’ the risk.

How Do John and Mary Deal With This Dilemma?

At the risk of throwing cold water on the situation, let’s be blunt.

There are two ways to approach this problem.  The first is to take on 100% of this risk themselves.

In other words, if John or Mary need care, they’d assume 100% financial responsibility and deal with the extenuating consequences.

In my opinion, as long as they do this after a complete assessment of the risk, and the costs of passing some or all of that risk on to some other entity, I believe that’s fine.

After all, the chances are in their favor that they won’t need the care.

However, if their family’s health history is not great, or if they’ve personally witnessed hundreds of thousands of dollars walk out the door to pay for the care of a family member, they may have second thoughts about assuming 100% of this risk.

If that’s the case, John and Mary have two alternatives:

• pay for it themselves, or
• have the government pay for it through Medicaid

Qualifying For Medicaid Assistance

To be very clear about this, in order to have the government pay for their care though Medicaid, John and Mary have to qualify.

And, that involves relinquishing all control over all of their assets and giving them away to their family.

Or, they have to place their assets into an irrevocable trust (a decision they can’t change after they make it)

If their assets have been out of their ownership and control for five years, they may be able to qualify for help from Medicaid (which is government assistance for the poor).

In order to qualify for Medicaid (government assistance), you have to have virtually no assets in your name for five full years.

Your Other Option

On the flip side, if John and Mary don’t like that alternative and thus choose to pay for their long term health care themselves, they can purchase money at a discount to offset the potential costs, and that’s what long term care insurance is all about.

Although I’m a believer in using insurance as a last resort after you’ve exhausted all of your other options, I’ve yet to find anything that does what long term care insurance does.

Long term care insurance is nothing but a tool in your toolbox to help you “manage” this huge financial risk.

• It can be used to protect your spouse’s lifestyle in case you get sick and need care,
• It can protect your assets that you’ve worked so hard to build up over your lifetime for your kids.  And, finally
• It can provide you with options for your care. This is very important!  If you rely on the government’s Medicaid program to pay for your care, then you’re at their mercy to determine what care you will receive and where you will receive it.

So, if you’ve reached this point, and you believe you’d like to push some of this substantial financial risk on to another entity like an insurance company, now you can begin to intelligently talk about long term care insurance.

Can you see how absolutely critical it is to go through the thought process we’ve walked through these last two weeks?

If you don’t do that first, and become crystal clear on your own unique situation, you will be at the mercy of any commissioned insurance agent who comes knocking at your door.

And, that’s no position to be in.

You want to be in complete control so that you can custom tailor a plan that covers what’s most important to you personally.

That’s a really good question which has no cut and dried answer to it.  My answer always involves asking a lot of questions, so I thought I’d share those with you today in the hope of helping you arrive at a good answer in your unique situation.

To begin with, I find that folks ask this question for many different reasons.

One of them stems from the dogmatic belief that you should never have a mortgage in retirement!  It was drilled into their minds growing up and it’s never left.

That may actually be a very good belief to carry around in the majority of situations.  However, it’s certainly not an absolute as you’re about to discover.

Let’s take a look at some factors you’ll want to consider when evaluating if you should pay off an existing mortgage you have.

Factors to Consider

Factor #1: Do you have enough liquid money to pay off the mortgage?  In other words, for simplicity sake, if your mortgage balance is $200,000, do you have $200,000 readily available to use?

You’d be amazed at how many ask this question when they don’t have the $200,000 readily available.

By readily available, I mean do you have to pay taxes or penalties to get at the money?   For example, is all your money tied up in IRAs and/or tax deferred annuities?

If so, there’s a tax bill to pay first in order to free up the necessary money.  In the example I gave, in order to free up the $200,000 to pay off the mortgage, you’d have to withdraw approximately $275,000 from your IRA.  After paying roughly $75,000 in taxes, you’d have your $200,000 with which to pay off the mortgage.

For obvious reasons, this pretty much answers the question for you if all your funds are tied up in IRAs.

Factor #2: What’s the interest rate on the mortgage, and how long will that rate remain?  In other words, is it an Adjustable Rate Mortgage (ARM) where the rate will increase after a certain period of time?

Let’s start with the second part of that question.  If you have an ARM, the rate will adjust after a certain period of time.  If that’s in a year or two, you have to make some serious assumptions about what the interest rate will be.

For the purposes of this discussion, let’s assume you know what the rate will be throughout the remaining life of the loan.

What this all comes down to is can you “earn” a higher rate of return with the funds you have set aside than the bank is charging you in interest on the loan.

For example, if your outstanding balance again is $200,000 and your mortgage interest rate is 4%, the question is “can you earn more than 4% with the $200,000 you have on the sidelines that you would use to pay off the loan”?

If CD rates were much higher than they are today, 6% for example, this would be a no-brainer.  You’d keep your $200,000 in the bank CD earning 6% or $12,000, and continue making mortgage payments at 4% ($8,000 per year and declining).

To use a fancy term, this is a form of arbitrage and it’s used to make millions of dollars in the marketplace every day.

The challenge comes, however, in times like these where you can’t earn 6% on a CD.  You may very well be able to earn more than 4% in a diversified portfolio in the long run. (I sure hope you can)  However, there’s no guarantee.  So, in essence, you’re taking a gamble one way or the other.

It then comes down to how long you have to play the game, and how strongly you feel that you can “out-earn” the mortgage interest rate over that period of time.

Factor #3: The third factor is tax deductibility.  Because mortgage interest is potentially deductible, carrying a mortgage has another benefit.

The question is whether the mortgage interest is deductible for you.  Mortgage interest is only deductible for mortgage amounts lower than $1 million.

Second, it’s only valuable to you if you are itemizing deductions on Schedule A.  If you have virtually no deductions on your tax return, and you currently file using a Standard Deduction, the interest deduction from your mortgage is not helping you (unless the interest from the mortgage throws you over the top into using Itemized).

Another small factor, but still important, is maintaining some liquidity.  If you will have to use up all of your liquid funds to pay off your mortgage, you may want to give some thought to that.

The final Factor stands alone because it’s something I’ve discussed many times with members.

I can make all of the financial and economic arguments in favor or against keeping an existing mortgage (like in the examples above).  However, at the end of the day, if you have knots in your stomach, or you just can’t stand making mortgage payments, or if being “debt free” has been your lifelong goal and you have the means to pay off your mortgage, just go ahead and pay it off.

I’ve actually suggested this in many situations. I’m a big believer that you have to be able to sleep at night.

Finally, you’ll note that I’ve reserved my comments for evaluating paying off an existing mortgage.  I have some thoughts about entering into a new mortgage in retirement which I’ll share with you in the next issue.

Stay tuned!

While dissecting The Relaxing Retirement Formula™ over the last few weeks, and sharing the first three Principles and Guidelines to follow to help you answer the question of where to position your investments to produce the long term rate of return you need to earn while experiencing less volatility and paying less taxes to the government, I’ve focused on what TO DO as opposed to what NOT to do.

Today, however, before I provide you with Principle and Guideline #4, I’m going to take a brief detour and discuss what I’ve witnessed to be one of the most destructive theories and behaviors I’ve personally witnessed among retirees over the last 24 years.

In short, in order to clarify a principle, sometimes the most effective way to do so is to contrast it with what NOT to do.

Today’s Strategy is an example of that.

Whenever the stock market experiences a correction, investment discipline gets seriously tested.

It’s no picnic! Experiencing a 20-30% market correction at this stage in your life, where the money that you’ve built up over the years must now support you, is tough to take.

The emotional temptation is to fold up your tent and “wait it out” on the sidelines, i.e. sell everything and move it to cash.

This temptation is what is known as ‘market timing’ pure and simple. As much as folks don’t want to admit that they’re timing the market, there is no other way to classify it.

It stems from a belief, rational or irrational, that you know what markets are going to do in the short run and the long run.

By selling everything and moving your investments into cash, you’re making the assumption that market prices will continue to go down until some period of time in the future when things “settle down”. And, when things settle down, then you’ll get back in.

Much of this thinking and strategy stems from the notion that there is a small group of people out there who are “in the know”, who are outsmarting markets. They have a sixth sense and know when to get out and when to get in. They don’t suffer these losses like us “average” folks. They’re too smart for that.

Do you believe that? Unfortunately, too many people do.

If it was true, then how could John Paulson, famous for making hundreds of millions of dollars betting on the collapse of housing prices in 2008, have lost over 50% for his investors in 2011?

How could Harvard University’s massive endowment fund, run by world renowned money managers, have lost over $10 Billion during the 2008-2009 market drop leading to a complete change of direction for the most prestigious university in America, including sizable staff layoffs, discontinued programs, and cancelled projects?

Why Market Timing Is a Bad Idea

In theory, the concept of market timing sounds like the way to go. However, there are many reasons why engaging in the practice of market timing is a bad idea. Let me illustrate a few for you:

1. Selling out after the market has suffered a downturn virtually insures that you will sell low and then buy high, the opposite of what you want to do. Why?

Let’s say that a sharp decline in the equity prices leads you to sell off your stock based investments due to your fear that their prices will continue to drop.

The question to ask yourself is “what will have to happen in order for me to feel comfortable enough to invest my money back into my equity investments”?

The typical answer is “when the market settles down and isn’t in a downward ‘trend’ anymore.”

Well, in order for that to happen, the market will have to have several consecutive days or weeks of price appreciation.

In short, in order for you to feel comfortable enough to get back in, the market will have to have demonstrated sustained appreciation over time.

However, by the time that happens, you will have missed the appreciation and bought back in at the high! You will have been out of the market when the appreciation occurred.

In short, you will have sold low and bought high, the opposite of what you want to do.

2. Historically speaking, there are typically 8 to 10 days in a year where market movements really influence your overall rate of return. In other words, during most days in the market, movement is up or down 1% or less.

However, there have typically been 8 to 10 days in a year where that movement is greater than 1%. And, those are the days that really influence whether you’ll have a poor year, an average year, or a really good year.

If you sell everything and move onto the sidelines after a market downturn has taken place, you run the risk that you will miss one or more of those days on the upswing.

And, missing those days could be the difference between you achieving your “needed” overall rate of return or missing it. Consistently missing it could mean running out of money too soon.

3. Most importantly, once you start down the road of market timing, you can’t stop.

You will have bought into the theory that watching and reacting to daily or minute-by-minute moves in the market is the solution to your long term investment goals.

Your investment decisions will be 100% based on emotion, not a carefully thought out, disciplined, long term strategy.

Discipline and rational thought goes out the window and you will spend your life in reaction.

All of the legends of investing disagree with market timing. They have instilled in all of us to have a long term strategy in place and to remain disciplined in spite of short term movements in the market.

This doesn’t mean having “blind faith”. What it does mean is, if you’ve done your homework and you have a carefully thought out, custom tailored plan, i.e. The Relaxing Retirement Formula™, proactive discipline is the solution.

Proactive Discipline

At this stage in your life, where the money you’ve saved is now supporting you, your approach has to be rooted in “proactive” discipline:

• The discipline to tally up the amount of money you need to withdraw from your investments each year over and above what you receive from social security and your pension, i.e. your “level of Retirement Bucket™ Dependence

• The discipline to calculate the investment rate of return you must earn in order to produce lifestyle sustaining income (that keeps pace with inflation)
• The discipline to set aside the money you’ll need to spend over the next few years in short term instruments which are not subject to market volatility (even when the market has just jumped up and you feel as though you may be missing out)
• The discipline to properly allocate your investments among many different styles of investments, each with its own goal, as opposed to being lured by what is supposedly “hot” or “doing well” at the moment
• The discipline to strategically plan ‘where’ you’re going to hold your various investment holdings to take advantage of lower capital gains tax rates vs. higher ordinary income tax rates
• The discipline to consistently evaluate the allocation of your investments and make unemotional, rational adjustments
• The discipline to objectively monitor the performance of each individual investment vs. its peer group, and make adjustments when necessary

As I hope you’re seeing, it’s imperative at this stage in your life’s “retirement game” that you have a system of decision making with regard to everything that happens in your financial life.

Without it, you’re at the undisciplined mercy of the “news of the day”, or the latest sales gimmick.

Don’t fall prey like the undisciplined masses.

Next week, let’s move on to Principle and Guideline #4.

Don’t miss it!

Over the last few weeks, I’ve exposed you to the first steps in The Relaxing Retirement Formula™ which were all developed to help you determine your level of Retirement Bucket™ Dependence (the amount you need to withdraw from your investments each year, over and above social security and pensions, in order to live exactly the way you want).

You’ve done this by getting crystal clear on all of your income sources, and what it costs you to support the exact lifestyle you want.

This is THE biggest distinction between investing during your working years and your retirement years, and it’s the point that I will continue to help you focus on.

Every “retirement calculator” discussion or article I read begins with you assuming an investment rate of return you either want or think you can earn.

This completely puts the cart before the horse.  It’s what gets so many people into trouble, and what causes so much confusion and anxiety.

Once you’re past the first steps in The Relaxing Retirement Formula™, and you know just how dependent you are on your Retirement Bucket™, the next question is, “what rate of return do I need to earn on my investments?”

That rate is NOT chosen arbitrarily.  It’s the rate of return that allows your money to keep pace with inflation and remain intact year after year while allowing you to continue to spend what you want.

Consequences

When you’ve reached the stage where the money you’ve saved must now support you for the rest of your life, when you’re dependent on your money to “live” as opposed to receiving a paycheck from the work you do, you have to think very differently about how you’re investing your money.

This is no longer a game.  It’s no longer a race.  You can’t afford to lose this time because, if you do, you’ll be forced to do one of two things:

1. make drastic cutbacks in your lifestyle (who wants to do that after working all these years in preparation for this stage in your life where you get to reap all the rewards of being a diligent saver), or
2. you will have to go back to work to make up for the losses, something your health could prevent you from doing in the future.

Neither of those sound like very good outcomes, so that’s why you have to think very differently about investing at your stage in life.

And, it’s why you have to know the investment rate of return you must earn, as opposed to randomly investing your money in whatever appears to be the ‘hot’ thing at the moment.

The Medical Analogy

To draw an analogy, it would be like you taking a new medication without a doctor first analyzing your symptoms and doing a thorough examination to determine if you even need any medication at all.

When asked why you’re about to take this new potent drug, the doctor tells you that it’s a really popular drug right now.  It’s all over the news and everyone’s taking it.

Now, if that sounds ridiculous to you, you’re right.  However, this is how millions of Americans select their investments in retirement.

They don’t have a carefully calculated rate of return they’re aiming for.  And, because they don’t, they’re at the mercy of the next salesperson who sells them whatever makes that salesperson the most money, or whatever appears to be “hot”.

For all the reasons I mentioned above, this is extremely dangerous.  Don’t be lazy and fall into this trap.  Take the time to figure out the rate of return you need to earn first.

Then you can go about crafting an investment matrix with specific investments that have the highest likelihood of getting you that rate of return over the long run.

However, before we move on to that crucial step, we have to determine the investment rate of return that YOU need to earn.

We’ll do that in the next issue of The Retirement Coach Strategy of the Week!

Before we do that, however, I’d like to share a conversation I recently had which I believe will be very instructive, while also serving as a great starting point for our discussion.

Last September, I was referred to a very nice couple by one of our Relaxing Retirement members.

They were very well read and brought a lot of questions to the table which I really appreciate.

What led them to come in to see me was the fact that the husband was planning to retire after 35 years with his employer, and they now wanted to get a handle on “THE” right investment allocation in retirement.

They had done a lot of reading and the theory that made the most sense to them was the “100 minus your age” rule of thumb.

What this theory suggests is that the percentage of your overall allocation you should invest in equities (stock market based investments) is 100 minus your age.

So, for example, if you’re 65 years old, you should allocate 35% to equity based investments. (100 – 65 (age) = 35%)

Based on that theory, everyone who is 65 years of age should invest 35% of their holdings in stock based investments.

It doesn’t matter what your circumstances, priorities, or tolerance for risk are.

This is what is known as a classic “rule of thumb”, and as you can probably imagine, I have significant challenges with it for you.

Rules of Thumb

For starters, why do ‘rules of thumb’ exist?

They exist to provide a broad guideline to the biggest audience possible.  They have nothing to do with you personally.

If the consequences of blindly following rules of thumb like this weren’t so costly and dangerous, I’d settle for just saying they’re silly.

But, the stakes are just too high.

The question to ask yourself is ‘am I willing to bet my financial future on a broad ‘rule of thumb’ created for the masses’?

Before you answer, think about this.  If you have a serious medical condition, potentially life or death, do you base your actions on what is presented as a good ‘rule of thumb’ in medical publications?

Or, do you prefer to have a prescription designed for you personally after a series of tests and evaluations?

I would wager a lot of money that it’s the latter for you.

Why It’s Different in Retirement

As you’ve heard me say more than once, when you’ve reached the stage in life you’re experiencing right now (where you’re dependent on the money you’ve saved to support your lifestyle), your overall “strategy” has to drastically change because the stakes are so high now if you fail.

Although it would certainly be more convenient if there was ‘one’ answer to “THE” right allocation question in retirement, there simply is not.

Here’s why…

How Dependent Are You?

Let’s take a look at two couples, both age 65.  Each couple has $2 million dollars in investments, the same social security retirement income, and the same pensions.

John and Mary Independent have no mortgage or home equity line of credit, and have recently completed many of the major upgrades to their home, i.e. a new roof, vinyl siding, a new furnace, and new bathrooms.  They have always lived a very modest lifestyle with little or no debt.

Ron and Rose Reactionary still have $260,000 outstanding on a second mortgage they took out to pay for their kids’ college tuitions and weddings, and a condo down in Florida they bought a few years back.  They both drive high end cars.  And, while their home is very nice, after 29 years, it’s starting to look “tired” and could use some upgrades.

What’s the Difference?

The difference in this example is what it costs each couple to support their lifestyle.

The income that will be required by Ron and Rose will be much greater than John and Mary.

Consequently, Ron and Rose will need to withdraw a much bigger amount each year from their investments than John and Mary.

In short, even before looking at anything else, it’s clear that Ron and Rose Reactionary are much more dependent on their investments than John and Mary Independent.

Without knowing anything else, if the both couples have the same amount of money saved, but Ron and Rose need to withdraw much more each month than John and Mary, don’t Ron and Rose need to earn more on their investments to support these greater withdrawals?

Don’t they require a greater rate of return than John and Mary in order to have their funds remain intact?

Of course.

Following that same train of thought, if they require a greater rate of return, shouldn’t they allocate their investments where they have a better chance of achieving that higher rate of return?

Certainly.

If that’s true, then how can they use the “100 minus their age” rule of thumb as a guideline for investing?

The obvious answer is they can’t.  It would be foolish.

This rule of thumb can’t possibly be appropriate for John and Mary AND Ron and Rose.

Their level of dependence on their investments is so drastically different for that to be possible.

What I’d like you to take away from this week’s Strategy is an understanding that while it might appear entertaining, and feel like you’re pushing the “Easy Button” when you read “rules of thumb” like this put out there for the masses, relying on them in your own situation can be dangerously simplistic.

It would be nice if “the” solution was that simple.  It would make our work together that much more simple.

However, after 24 years of working hands-on helping our members seamlessly transition to retirement, I can tell you that it never is.

Next week, we’re going to begin building The Relaxing Retirement Formula™, i.e. “the missing structure” you need to develop unstoppable financial confidence during this critical stage in your life.

Gee, now there’s a surprise! Who could’ve predicted this??

Okay, humor and politics aside, no matter what agreement they reach, there are steps you can and should be taking right now to prepare yourself for one key area of the budget where you still retain some control: Capital Gains Tax Rates.

The one thing we already know is that tax rates on capital gains and investment income are going up in 2013 by 3.8% due to a provision in the Patient Protection and Affordable Care Act (i.e. Obamacare). As of today, this will apply to joint filers above $250,000 and single filers of $200,000.

What we don’t know yet is whether capital gains tax rates will also go up from 15% to 20%, or even higher.

Given this, I don’t recommend buying or selling anything yet, but I do recommend preparing for the announcement by doing some homework.

Before I share my recommendation, let’s quickly review capital gains tax law for a moment so we can clarify where this opportunity lies for you.

Capital Gains Tax Law

As a refresher, for investments you currently own outside of IRAs (you don’t pay capital gains when you buy and sell investments inside your IRA), all “realized” gains are taxed at capital gains tax rates.

For example, if you purchased a stock or stock mutual fund for $100,000 and later sold it for $150,000, you would owe capital gains taxes on the growth, i.e. $50,000.

On the flip side, however, if you purchased a stock or stock mutual fund for $100,000 and later sold it for $80,000, you can declare a capital loss of $20,000.

That $20,000 capital loss, while painful to realize, has significant value if handled properly. For example:

1. You may use it to offset $20,000 of capital gains you realized in the same year, thus eliminating taxes on $20,000 of capital gains. This saves the average taxpayer a minimum of $3,000 in federal taxes in 2012, not to mention state taxes here in Massachusetts. (And, as you’ll discover shortly, possibly more in 2013 and beyond).
2. If you don’t have $20,000 of capital gains to offset, you can use $3,000 of the loss to offset $3,000 of ordinary income you have this year. That would save the average taxpayer approximately $750.
3. You can then carry the unused portion ($17,000) over to next year and continue the same strategy. If you have a $17,000 gain next year, you can offset the entire tax due. If not, you can offset another $3,000 of ordinary income tax and carry the remaining $14,000 over to the following year.

An Opportunity From the ‘Dog Days’ of 2008-2009

Had you sold any investments during the downturn in 2008/2009, thus locking in and ‘realizing’ a capital loss, you now have the opportunity to recover some of your losses.

Or, if you have any investments held outside of IRAs that are currently in the red since you purchased them, you have an opportunity to lock in a capital loss right now and use it against your realized gains this or next year.

** The key point to grasp is that, if capital gains tax rates go up next year, any losses you had in the past that you’re carrying forward will be worth MORE to you next year.

So, if rates are definitely going to go up, carry your previously realized capital losses forward to use in 2013.

Here’s why: if you have $20,000 of capital losses that you’ve carried forward from prior years and you use them to offset $20,000 of capital gains in 2012, you save $3,000 in capital gains taxes.

However, if capital gains tax rates go up next year to 20%, and you’re also subject to the medicare surtax I mentioned above, thus increasing your capital gains tax rate to 23.8%, that same $20,000 capital loss will save you $4,760 instead of only $3,000!

Fiscal Cliff Capital Gains Tax Strategy

So you can be ready, my recommendation for you is three-fold:

1. Pull out your 2011 federal income tax return. Take a look at the bottom of Schedule D to determine if you have any unused capital losses carrying forward into 2012. And, if so, how much?
2. Take a look at your realized and unrealized gain/loss positions in your non-IRA account statements.
   1. Have you already realized some gains in 2012?
   2. Do you have sizable unrealized gains that you may want to lock in right now in 2012 to avoid paying a higher capital gains tax rate in the future?
   3. Do you have any unrealized losses?
   4. Do you have any stocks or stock mutual funds that you’ve thought about selling, but haven’t pulled the trigger yet for one reason or another?
3. If you own stock mutual funds, go to your fund company(s) website and you will typically find year-end “internal” capital gains distribution estimates. Do your best to determine what your short and long term gains will look like.

Once you’re armed with this information, now you’re ready to ACT when the President and Congress reach an agreement.

Remember that it’s your “net” investment returns (after taxes) that you get to spend! Paying more than you’re legally obligated to pay is not an act of patriotism. It’s laziness!

Take control in places where you still can!

They revealed the fact that while the S&P 500 Stock Market index earned 7.81% per year over the last 20 years, the average investor who invested in the stock market earned only 3.49%!

Go ahead and re-read that last sentence to let it sink in!

This means that that average investor earned 55% less than the market index, a measure of average returns, not above average!

55% less each and every year!

Since then, I’ve revealed several big reasons why this is the case.

In this article, I’m going to finish off by revealing a huge contributor to this massive underperformance problem.

And, it may very well come as a surprise to you.

Letting the Tax Tail Wag the Dog

Let me explain what I mean by walking you thru a real life Case Study of an employee of GE:

• Charlie was an employee of GE for 42 years
• He purchased GE stock shares through payroll deduction during entire career
• As a result of purchases and stock splits, when Charlie retired in January 2002, he owned 27,000 shares!
• At $41 per share, the value of his shares was $1,100,000
• What’s important to note is that these GE shares represented 63% of Charlie’s investments!
• The next important fact was that his cost basis in the GE shares (i.e. what he paid for them) only $50,000

Question #1 to Contemplate: Is it a good idea for Charlie to have 63% of his investments tied up in any one stock?

Question #2: If Charlie had $1.1 million in cash today, should he buy $1.1 million of GE stock?

Question #3: If the answer is NO, why would Charlie then hold on to them and not diversify?

The Answer: Taxes!

Because his cost basis was only $50,000, if he sold the shares back in 2002, he would have paid $210,000 in capital gains taxes, and walked away with $890,000.

Charlie’s focus was on the $210,000 he had to pay to free up the money and diversify.

He would have been far better off focusing on the fact that he had to part with 20% in order to free up the other 80%.

It sounds a lot better.

So, what did Charlie do?

Like the overwhelming majority of people, Charlie hung on to the GE shares to avoid paying any taxes.

Now, let’s take a look ahead to today and see how good of an idea that was.

• If Charlie sold the shares back in 2002, paid the tax, and reinvested the remaining $890,000 in a generic diversified S&P 500 Index Fund like Vanguard’s, from January 2002 to November 2012, the value would have grown to approximately $1,339,000.
• However, he would then have to pay capital gains taxes again of $90,000, so in November, 2012, he would have ended up with $1,249,000 after taxes if he had sold his shares back in 2002, paid the taxes, and reinvested in a basic diversified equity index fund instead.

Let’s now look at where Charlie is now since he didn’t sell his GE shares back in 2002 in order to avoid paying taxes.

• If he continued to hold GE shares, including reinvesting the dividends, his shares, in November, 2012, his shares are worth $825,000.
• When he sells them, he still has to pay the capital gains taxes that he’s been trying to avoid all along. Those would total approximately $155,000 leaving him with a “net” balance of $670,000.

To recap, had he sold, paid the taxes, and reinvested, he would have $1,249,000 (the after tax proceeds of the 500 Index fund shares sold in November 2012).

However, because he let taxes drive his investment decision back in 2002, today he only has $670,000 (the value of his GE shares today minus capital gains taxes).

The Penalty for Letting the Tax Tail Wag the Dog

If you do the math, that’s $579,000 that Charlie lost because he “Let The Tax Tail Wag The Dog” instead of using sound, rational judgment.

Charlie focused on the dollar amount that he had to pay in taxes back in 2002, i.e. $200,000. I agree that’s extremely painful (and the fairness of it is another topic we won’t touch today).

However, by focusing on that dollar cost, he drastically increased his risk and lost more than twice as much!

This is a classic example that I’ve personally witnessed time and time again. And, it’s one of the great lessons of why the average investor not only doesn’t beat market averages, but instead, as statistics have now shown, earns 55% LESS.

Stay out of the trap! Evaluate the tax consequences and the investment consequence simultaneously!

To refresh your memory, here’s what the report revealed for last year, i.e. 2011:

• The S&P 500 Stock Market Index earned 2.12% (including dividends reinvested) in 2011
• Over the same twelve month period, the return of the “average” investor who invested in the stock market (not an investment, but an investor, i.e. a person) was -5.73%.

However, anyone can have a bad year and this is too small of sample size, so Dalbar also presented their findings for the last 20 years ending on December 31, 2011:

• The Average annual return of the S&P 500 Stock Market Index from 1992 – 2011 was 7.81% (including dividends reinvested)
• However, the average annual return of the “average” equity investor (not an investment, but an investor, i.e. a person) over the same 20 year period was 3.49%

What these numbers tell us is that, while the S&P 500 Market Index delivered a strong average annual return over those 20 years of 7.81%, the average stock fund investor (a person, not an investment) only achieved 3.49%!

That means that the average equity investor’s return was 55% less than the broad market index each and every year!

Now THAT is a sad statistic!

The Underlying Problem

There is no ONE reason or one strategy you can use to close this gap.

However, over the last 23 years, there are several “strategic behavioral mistakes” that I’ve personally witnessed that I’d like to share with you that you can instantly employ.

Today, I’d like to discuss what I refer to as “The Underlying Problem”.

First, a statistic for you that you may have heard me share with you before: the average retirement age today in America is age 62.

If you are a 62 year old couple (and each of you does NOT smoke), insurance company mortality tables tell us that at least one of you will live to be 92 years of age!

Please take a moment to go back and read that last paragraph before going on.
That means that, if you’re age 62, you’ve got 30 years with which to provide lifestyle sustaining income.

30 years!

Not five.

Not ten.

Not even just twenty.

But 30 years!

The Goal: Lifestyle Sustaining Income

By “lifestyle sustaining”, I mean income that keeps your standard of living the same even when prices rise.

Let me put that into perspective for you.

In 1932, a first class stamp cost 3 cents.

In 1971, it was 8 cents.

In 1980, it was 15 cents.

Today, it’s 44 cents and rising!

Not to send a “better” letter, or even get it there faster as you’ve recently observed, but the same letter.

While there are very few guarantees in life, one that I believe we can take to the bank is the fact that life will continue to get more and more and more expensive.

As I just illustrated, the price to mail the exact same letter costs you three times what it did just 30 years ago.

That’s extremely instructive given the 30 year lifespan of a 62 year old retiring couple.

Protecting Principal vs. Protecting Purchasing Power

Now, here’s the problem from an investment standpoint…what is the dominant underlying governing issue among the overwhelming majority of retirees?

Protecting Principal!

If there’s a loss that everyone tends to focus on managing, this is it. Above all else, “we have to protect our principal.”

And, this governs their investment decisions.

Well, in reality, the biggest financial issue, as I’ve just illustrated, is the protection of your “purchasing power”, or your ability to sustain the same standard of living.

This has nothing to do with wanting “more” for yourself.

It’s about sustaining the same lifestyle.

Even if inflation is only 3% over the next 30 years, and I would strenuously caution you against using that low of a number, but even if it is only 3%, you’ll need $2.44 (2 dollars and 44 cents) to pay for the same goods and services that the dollar in your pocket pays for right now.

That means that if groceries currently cost you $100 per week, they’ll cost $244 for the exact same groceries.

Again, this is not a bonus to protect your purchasing power.

It’s a bare necessity! Yet, the overwhelming majority of retirees have as their #1 goal to protect their principal, when in fact it has to be the protection of their lifestyle sustaining income.

I can’t stress enough how important it is to clearly distinguish between those two goals if you want your hard earned money to be there for you for the rest of your life.

Next week, we’re going to continue on and discuss the second biggest contributor to horrific investment results among retirees, and what you can do about it right now.

The smell of Fall is in the air. There’s nothing like it.

The sun is bright, and the brown, orange, and yellow leaves are falling.

It’s 3:30 on a Saturday afternoon and you’re driving home from your granddaughter’s soccer game so proud of her for scoring the winning goal.

There’s nothing quite like the screams of an excited group of 11 year old girls.

As you’re driving along, you have the Notre Dame football game playing on your radio, but you’re not listening very carefully because you’re still caught up in the buzz of your granddaughter’s soccer game and the beautiful Fall foliage.

Pulling into your neighborhood, you catch the tail end of a breaking news sports update about the Red Sox.

Unable to hear it clearly, you reach down to turn up the volume so you can hear the announcement more clearly.

At that very same instant, some neighborhood children are playing soccer in their yard. As your car approaches, the soccer ball rolls out into the middle of the street where you’re driving and one of the kids chases after it in full speed forgetting to look both ways to see if a car is coming.

Just as you’re reaching for the volume knob on your radio, in the corner of your eye, you see him run out from behind that parked car, so you instinctively jam on your brakes.

But, it’s too late. You hear the sound you prayed you’d never hear, and he’s now lying on the ground motionless in front of your car.

As the paramedics arrive, the good news is the little boy is still breathing.

The bad news is that he’s not moving as they struggle to keep his body still and place him on the stretcher.

After what seems like an eternity, he’s taken in the ambulance to the hospital and you are left there to talk with the police about what just happened.

Two detectives are snapping pictures of the car and measuring your skid marks in the street.

2 Weeks Later

A few weeks have now passed. The shock of what happened has not gone away, but it has come into perspective.

The boy is still in the hospital, but will be coming home soon. Several bones in his body were broken, and after 3 separate surgeries, the doctors are confident that he’ll be able to walk just fine after a good 6 months of physical therapy.

However, the permanent damage done to his right leg will probably prevent him from playing competitive sports for the rest of his life.

What Does This Mean For You?

As if dealing with the emotional torment of accidentally hurting a young boy wasn’t enough, now comes the worst part. The police reports come back concluding that you were driving 36 miles an hour in a 30 mile an hour zone. And, because of that, you’re considered to be 100% at fault for negligence.

You didn’t mean to hit the child. You’re a careful driver. You’ve never had an accident in your life. Your driving record proves it.

But, all of that doesn’t matter right now because unfortunately, you’re going to be at the wrong end of a very expensive lawsuit. You can expect that within a few weeks, you will be summoned by an aggressive attorney requesting, among other things, a listing of all your income and assets.

And, the only form of compensation the attorney will get from the case will be from receiving a percentage of the damages collected from you.

And, it probably won’t be a small number.

Where Will This Money Come From?

The question for you is where will this money come from to pay for you to hire an attorney and to pay the eventual damages that will be brought against you?

It’s taken 40 years to build up enough money for you to be able to retire. You’ve given up so much in order to save for your future.

And, now, you’re finally reaping the rewards of your lifetime of hard work and disciplined savings. You’re retired and enjoying life like never before.

But now, everything you’ve worked your entire lifetime to save could be taken from you in an instant.

This Week’s “Strategy”

This is a horrible story that I hope never happens to you. But, as you can see, it can happen to anybody, so I’m telling it to you to motivate you to protect yourself.

The strategy and solution in most circumstances is to have the highest liability limits on your auto insurance possible. But, even more importantly, because potential damages could easily exceed the limits on your auto insurance, is to have a separate Personal Catastrophe Insurance Policy, otherwise known as an“Umbrella” Policy, also known in small circles as Lawsuit Insurance.

In most cases, if you have a quality policy with a quality insurance company, the combination of these 2 policies can protect you from the financial devastation of this horrible occurrence.

It won’t help in dealing with the emotional toll of injuring someone, but it can save you from the financial fallout, and preserve what you’ve taken your entire lifetime to accumulate.

And, the good news is that it’s inexpensive. Each million dollars of umbrella liability coverage costs only about $250 per year.

That’s a small price to pay for the peace of mind it can provide for you in case this ever happened to you.

Visit with your property and casualty insurance agent today and coordinate your homeowners, auto, and umbrella liability insurance. Discuss precisely what each policy covers and what it doesn’t.

This may take only 30 minutes but it could turn out to be the most important 30 minutes you’ve ever spent on your finances.

While very little consensus has been reached on income and capital gains tax rates, there has been progress on estate taxes since the 2010 election.

To refresh your memory, estate taxes are levied at your death on your assets above a certain amount. In other words, even after a lifetime of paying dozens of taxes, the largest of which is income tax, the federal government then taxes your heirs on what remains.

In tax year 2012, the amount that each of us can pass on without estate taxes is $5 million. After that, your heirs will pay a 35% estate tax or more to the federal government. (However, on the state level in Massachusetts, that threshold is still only $1 million.)

The better news, however, is that estate planning for most of our Relaxing Retirement members is now much simpler.

“Portability”

The provision that most particularly impacts our members is a brand new concept called “portability of the estate tax exemption”. What exactly does this mean?

It means a husband and wife can leave their federal estate tax exemptions to each other. The first spouse to die can automatically leave his/her $5 million estate tax free exemption to the surviving spouse, so the surviving spouse will have a $10 million exemption.

No longer do you have to create “credit shelter trust” estate plans to make full use of each of your exemptions.

This makes estate planning much easier, especially when most of your assets are in IRAs.

A Real Life Case Study

Let me give you a very simple, clean-cut case study. This will take a moment to clarify, but please bear with me because it’s all good news:

John and Mary Independent are married with three children. John’s only asset is a $5 million IRA, and Mary’s only asset is her $5 million IRA.

With $10 million of combined assets, they obviously want to make sure they take full advantage of their estate tax exemptions, so the full $10 million can eventually pass to their three children with no federal estate tax.

Without portability of the estate tax exemption, the only way they could have taken advantage of their exemptions was for the first spouse to die NOT to leave his or her $5 million IRA to the surviving spouse.

Under the old way of saving estate taxes for a married couple, we would tell John not to name Mary as beneficiary of his IRA!

If he did, Mary would wind up with $10 million of assets and only $5 million of exemption!

Under the old way of estate tax planning, the only way John could make use of his federal estate tax exemption would be to leave his IRA either directly to the children or to a “credit shelter” or “bypass” trust for the life benefit of Mary.

Leaving the IRA directly to the children could be a good tax move, but most members in my experience don’t like that because it takes money away from the surviving spouse.

Leaving the IRA to a credit shelter trust for the surviving spouse seems to protect the surviving spouse financially, and it definitely saves estate taxes for the children by keeping the IRA out of the surviving spouse’s estate.

However, on the flip side, it causes a huge loss of income tax benefits. There is no spousal rollover and no “stretch or inherited” IRA payout over the children’s life expectancy.

Instead, the entire IRA gets dumped out into the credit shelter trust over the single life expectancy of the surviving spouse, a much shorter period of time.

Prior to the new tax policy, members like John and Mary had to make a hard choice: Do we go for the income tax benefits of the spousal rollover by leaving the IRA outright to the surviving spouse, even though that costs extra estate taxes by wasting the first spouse’s estate tax exemption?

Or, do we save estate taxes by leaving the benefits to a credit shelter trust but give up on the long term deferral that would otherwise be available via the spousal rollover?

Thanks to the new law, you no longer have to make that particular hard choice.

Instead, John can leave his $5 million IRA outright to Mary and still leave her his $5 million estate tax exemption.

They can now get the income tax savings of long-term deferral of distributions via the spousal rollover, without having to waste one spouse’s estate tax exemption to get it. When Mary later dies, she will have a $10 million IRA and a $10 million estate tax exemption!

Two Caveats

First, as they do with many tax improvements, Congress left themselves a “sunset” clause, so this great benefit expires at the end of this year!

However, we’ll be keeping our eyes on their progress after the election as it’s highly likely that it will be extended.

Second, this doesn’t negate my recommendation to create and fund a revocable living trust.

I still strongly recommend it for probate avoidance and estate management reasons so don’t take this to mean that you shouldn’t have created living trusts. They still have significant benefit.