Nerd's Eye View blog

Minimizing The Income Tax Bite Of A Bypass Trust

July 27, 2016 07:01 am 20 Comments CATEGORY: Estate Planning

The bypass trust is a popular estate planning strategy used to reduce a couple’s exposure to estate taxes, by leaving the assets of the first spouse to die not to the surviving spouse, but to a trust for his/her beneficiary instead. If the surviving spouse doesn’t inherit the assets directly, they’re not subject to future estate taxes when the second spouse ultimately passes away.

However, while the bypass trust is effective for saving on estate taxes, it’s not very favorable for income tax planning, given that trusts reach a top 39.6% tax bracket (plus the 3.8% Medicare surtax on net investment income) at “just” $12,400 of taxable income. And at that threshold, long-term capital gains (and qualified dividends) are subject to a whopping 20% + 3.8% = 23.8% tax rate as well. Plus state income taxes to boot (if applicable).

Fortunately, though, the tax rules for bypass trusts (and other “non-grantor” trusts) allow trusts that distribute their income to beneficiaries to distribute the tax consequences to the beneficiaries as well – allowing those beneficiaries to claim the income on their own personal tax returns (and be subject to their far more favorable individual tax brackets) while the trust claims a “Distributable Net Income” (DNI) deduction to avoid any double taxation.

Of course, the caveat to passing through income from a trust to the beneficiary is that while distributing the income to the beneficiary may minimize income taxes, it just compounds the estate tax problem the bypass trust was designed to avoid (by pushing the income back into the spouse’s taxable estate). However, given the significant rise in the Federal estate tax exemption over the past 15 years – from “just” $1M in 2001 to $5.45M today – many bypass trusts are actually no longer necessary. Which means it has suddenly become a far more effective strategy to start deliberately making income distributions from a(n existing) bypass trust to the beneficiary, who may no longer face any estate taxes, but can materially reduce the family’s income tax exposure in the process!

The Compliance #FinTech Gap Under DoL Fiduciary And The Next Generation Of Robo-Advice

July 25, 2016 07:01 am 6 Comments CATEGORY: Technology & Advisor FinTech

The current regulatory oversight structure for advisors is a patchwork combination of FINRA, SEC and state securities regulators, and state insurance regulators, depending on which types of insurance or investment products/services the advisor offers. Regardless of the regulator, though, the compliance process is substantively similar for all of them: the advisor is evaluated based on the final solution that is sold/implemented, and the focus of compliance is on substantiating that particular product recommendation or investment portfolio implementation.

Under the Department of Labor’s fiduciary rule, though, a new standard is emerging, in a manner that transcends the traditional dividing lines of product channels: that the advice must be in the best interests of the client. Which means not only must the product have been reasonable and not UNsuitable… a prudent expert would have to concur that the recommendation itself was actually in the best interests of the client and improved his/her situation.

In today’s compliance landscape, though, this introduces significant new challenges. The financial services industry has not adopted a standardized advice process for advisors to consistently adhere to, in order to demonstrate their fiduciary duty of care and due diligence. Nor is there any clear agreed-upon framework to determine when a particular recommendation is “best” or not, based on a specific set of client goals and circumstances.

Fortunately, technology can help to solve these problems, but will require a significant change from the compliance technology tools today. This may entail a shift in financial planning software (from being a mere analytical tool for advisors to an actual oversight tool for financial institutions), or the development of third-party software that takes an established advice process (or creates a new one) and institutionalizes it with due diligence and procedural checklists.

Or alternatively, the DoL fiduciary rule may actually spawn the next generation of “robo-advice” software, designed not directly for consumers, but as a compliance-driven solution to ensure that all advisors in the organization are giving the same consistent advice… and potentially transforming the financial advisor from the one who crafts the client advice, to someone who instead simply delivers the institution’s computer-generated advice and helps the client take the necessary steps to change their behavior, follow through, and implement?

Weekend Reading for Financial Planners (July 23-24)

July 22, 2016 02:51 pm 1 Comment CATEGORY: Weekend Reading

Enjoy the current installment of "weekend reading for financial planners" - this week kicks off with the news that the Department of Labor will soon be issuing some "follow-up" clarifying guidance about next year's fiduciary rule, as the DoL formulates a response to the most frequently asked questions coming in from advisors and financial institutions (relating primarily to advisor compensation and large-firm financial incentives related to the products they make available).

From there, we have a few articles related to advisor technology, including a good overview of the latest trends and developments in the advisor tech landscape from Joel Bruckenstein, coverage of the major deal announced last month between Vestorly (which provides content curation tools for advisors to drip market to clients and prospects) and Dow Jones (which will provide Wall Street Journal and other content to Vestorly users), and a review of financial planning software provider FinanceLogix.

We also have a few investment-related articles this week, from an analysis of the trends in securities lending by asset managers, to a look at how capital market assumptions for retirement planning projections could be adjusted to account for sequence of return risk, an examination of how mutual funds and ETF providers are preparing for the change in September when REITs will be removed from financial services sector and placed into their own sector instead, and two articles looking at how many of the foundational principles of investing and modern finance are breaking down as government bond yields keep trending lower and the "risk-free" rate on government bonds is approaching zero or even going negative in some countries (leading to strange outcomes where bond returns are primarily driven by capital gains, and investors are buying stocks for yield!).

We wrap up with three interesting articles: the first looks at a recent Capgemini study on the behaviors of young millionaires, finding that they are drastically more likely to hold cash (as much as 1/3rd of their net worth!), are more likely to invest in alternatives and diversify out of just holding 'traditional' stock portfolios, and are less likely than older millionaires to engage with a financial advisor; the second is a review of a few "savings" smartphone apps, like Qapital, Digit, Dyme, and Acorns, which are trying to use technology to make saving easier and more frictionless (the technology equivalent of modern 'pay yourself first' savings strategies); and the last is a fascinating study that finds financial stress and economic insecurity can actually lead to increased feelings of physical pain, which may help to explain the country's rising epidemic of prescription pain medications, and also raises interesting questions about the potential role and value of having a good financial planner!

Also, be certain to check out the video at the end, the trailer of an interesting new "documentary" movie from Mark Hebner of Index Fund Advisors and Robin Powell of Evidence-Based Investor, on the issues with Wall Street and active management and the ever-rising role of index funds (somewhat controversially titled "Index Funds: The 12-Step Recovery Program For Active Investors").

Enjoy the "light" reading!

What’s The Best Personality Type To Succeed As A Financial Advisor?

July 21, 2016 11:50 am 7 Comments CATEGORY: Personal/Career Development

According to most industry benchmarking studies, average income of an experienced financial advisor is roughly 2x to 3x the average household income in the U.S., which makes being a financial planner an incredibly appealing career, both to college graduates looking for a career, and those who may feel they have "topped out" in their current industry and wish to make a career change into financial planning. The caveat, however, is that financial advisors also have an incredibly high attrition and failure rate in the early years, which means the decision to try is not without significant risks. For many, their greatest fear in getting started is simply that they don't have the "right" personality type to succeed in the first place.

In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, we look at what kind of personality type it does take to succeed as a financial advisor, and how despite the conventional view that being a financial advisor is a quintessential career for extroverts (where you meet lots of people to work with and do business with), in reality many introverts are also very successful at being a financial advisor. Because while being an introvert might be a little more challenging when "prospecting" for potential clients, the fact that introverts more commonly form deeper relationships to fewer people is actually a great fit for establishing a great and loyal client base!

In fact, for many who start out as a financial advisor, the biggest roadblock is not about being an introvert versus extrovert, but simply about having the "grit" necessary to handle the emotional rollercoaster that is being an entrepreneur and building your own business. That includes both the sheer financial ups and downs of starting a business from scratch with no income, and the amount of rejection that occurs when prospecting for clients, where "just" being rejected 2-out-of-3 times is actually a fairly solid 33% close rate!

Fortunately, there is an alternative career path for financial advisors beginning to emerge as well - the employee advisor path, which starts out as an entry level "paraplanner" and climbs from there to an associate advisor, lead/senior advisors, and perhaps even to becoming a partner someday. Unfortunately, though, the relatively slow progression down that career path - which may take as long as 7-10 years to reach a senior advisor position - is for many career changers "too long" to wait to reach the income levels of their former careers.

Nonetheless, the bottom line is that the "right" personality type for being a financial advisor is not about being an introvert or extrovert - because either can create meaningful relationships with clients (and both will struggle if they are too extreme in either the introversion or extroversion direction) - but about having the patience and focus to build your career as an employee, or the sheer grit (and financial capabilities) to handle the entrepreneurial rollercoaster of starting your own advisory firm from scratch!

The End Of History Illusion And The Problem With Goals-Based Investing

July 20, 2016 07:01 am 23 Comments CATEGORY: General Planning

The very essence of financial planning is about helping clients to formulate the strategies to achieve their goals. In this context, the role of the financial planning is to help clients articulate their future goals, and then provide recommendations for how the client can best achieve them.

There’s just one problem: research suggests that we’re not actually very good at figuring out what our future goals will be. The fundamental challenge is that, despite recognizing how much we change over time (think back on how different you were 5, 10, or 20 years ago!), we just don’t know how to envision the ways we’ll be different in the future. In fact, researchers have dubbed the phenomenon the “End Of History Illusion” – we just don’t know how to project a future that’s any different from today (which is the end of our personal history as we know it).

From the perspective of financial planning, and the rising popularity of goals-based investing, the challenge of the End Of History Illusion is that we may be encouraging retirees to save towards a vision of retirement that they won’t actually care about when retirement comes. This doesn’t mean that retirement itself won’t be relevant, but that vision of a particular retirement home, vacations, a boat on the lake, or a certain lifestyle, may not actually be very desirable when the time comes.

Which means investors should actually be cautious about tying their saving and investing habits in a way that over-commits to a particular and specific long-term goal. Instead, if we recognize the uncertainty of future goals themselves, planning for flexibility to adapt to future goals may be more effective than investing for the goals themselves!

When Does It Make Sense To Join With A Financial Advisor Partner?

July 18, 2016 07:01 am 11 Comments CATEGORY: Practice Management

The explosive growth of technology has made it possible for individual financial advisors to be more personally productive than ever before, from software to automate key tasks to the use of (virtual) assistants to even further leverage the advisor’s time.

However, the reality is that every financial advisor eventually hits some personal productivity wall – the point at which there just aren’t any hours left in the day to serve more clients, even with the assistance of a technology and a team of support. In some cases, it’s the time to manage the team itself that becomes the biggest barrier to growing further.

At that point, the opportunity for growth shifts to the need to add a financial advisor partner, where the advisor has the potential to earn a smaller slice of a much-larger pie. And in this context, the ideal of usually not just to combine together two already-successful financial advisors, but to actually find advisors who have different and complementary skillsets, which enhances the potential for the new whole to be worth more than just the sum of the individual parts.

Unfortunately, though, for many advisors the biggest challenge in adding a financial advisor partner is simply finding one in the first place. For most, the path seems to be through financial advisor conferences and events related to their platform, where it’s most feasible to find like-minded individuals. And fortunately, the availability of third-party “financial advisor compatibility assessment” tools can help to ensure that the partners will likely be able to formulate a shared vision for the future growth of their new joint business!

Weekend Reading for Financial Planners (July 16-17)

July 15, 2016 02:01 pm 0 Comments CATEGORY: Weekend Reading

Enjoy the current installment of "weekend reading for financial planners" - this week's edition kicks off with an announcement that the SEC will begin to audit RIAs over the use of mutual fund share classes, seeking to verify that investment advisers are really using the lowest cost institutional shares available, and not trying to double-dip into 12(b)-1 or other back-end fees on more expensive share classes. Also in the news this week was the SEC's decision to bar Dawn Bennett and fine her a whopping $4M, for what started out as an investigation into overstated AUM on her radio show and in marketing materials, and then snowballed into a fight over the SEC's use of administrative law judges.

From there, we have a few articles related to how the Department of Labor's fiduciary rule continues to ripple, including a look at the likelihood of the rule being struck down by legislators (virtually impossible) or in the courts (still highly unlikely), how advisor recruiting amongst broker-dealers has fallen a whopping 40% in the first half of 2016 (attributed in large part to uncertainty about how DoL fiduciary compliance will play out), and the ways that broker-dealers are starting to push back on financial services product manufacturers to make their commission payouts levelized and more uniform from one company to the next. There's also an article looking at a new niche RIA custodian called MoneyBlock, which specifically targets advisors who are heavy implementors of options strategies with clients.

We also have a few marketing-related articles this week, including a discussion of how asking clients to send "referrals" is far less effective than specifically asking for introductions, the approach that one start-up financial advisor has been using to achieve a whopping 76% close rate on his prospective clients, and a Journal of Financial Planning cover story that interviewed a dozen financial advisor marketing experts for a wide range of marketing tips and strategies that advisors can implement.

We wrap up with three interesting articles: the first looks at how financial advisors may increasingly play a role in spotting financial abuse of seniors, as legislators change laws to make it easier for (or even require) financial advisors to report potential abuse situations; the second is a look at how the increasing volume of data used to manage an advisory (or any) business is leading to the rise of "business dashboards", central reporting tools that pull together the relevant business data (often from several sources) and make it easier to keep track of the health of the business; and the last is a valuable reminder that as successful advisors, it's important to give back to our communities, which is not only about being charitable but also recognizing that there's a business opportunity to "do well by doing good", too.

Enjoy the "light" reading!

How DoL Fiduciary Disrupts Trade Publications And Membership Associations

July 14, 2016 08:07 am 3 Comments CATEGORY: Planning Profession

The looming implementation of the Department of Labor's fiduciary rule has raised many questions about whether products like non-traded REITs, variable and indexed annuities, and actively managed mutual funds will still be able to survive and thrive when commissions are at least curtailed. And the shift raises significant challenges for the broker-dealer platforms that distribute those products. But as it turns out, broker-dealers aren't the only ones facing significant collateral damage from the coming product fallout.

In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, we look at how the contraction of commission-based products may also lead to a significant contract in financial services product advertising, which could have significant spillover effects into the industry trade publications and membership associations that are highly reliant on those advertising dollars to buy ad inventory and booth sponsorships.

Ironically, though, a contraction in financial services product advertising could actually be a boon for financial advisors, as a reduction in the advertising from financial services product manufacturers after our clients' money could leave more room for advertising from companies that actually create solutions for advisors themselves. There's more room for advisor FinTech firms and industry consultants to compete for advisors' attention when they're not being crowded out by large financial services product manufacturers.

But given that solution-providers for advisors tend to be much smaller companies, with less revenue and less advertising buying power, a contraction is still coming in industry advertising, which could have harsh consequences given the over-abundance of industry trade publications and conferences, all vying for advisors' limited attention.

In the long run, though, the reality is that financial services industry advertising may end out being larger than ever. After all, if financial services product manufacturers cannot compete by paying the best commissions, and have to compete by designing and offering the best product, there's even more pressure to market that product effectively. Which means more advertising, and more spending at conferences. But given the timeline for DoL fiduciary implementation, those dollars may not show up until 2018 and beyond. In the meantime, trade publications and membership associations may be facing a very tough 2017.

How Lapsing A Life Insurance Policy With A Loan Can Cause A Tax Bomb

July 13, 2016 07:01 am 25 Comments CATEGORY: Insurance

Life insurance serves a valuable social purpose, allowing families to protect themselves against the economic consequences of an untimely death of a breadwinner. In fact, life insurance is viewed as such a positive that Congress provides significant tax preferences for insurance policies, including tax-deferral on any growth in the cash value, and a tax-free death benefit for the beneficiaries.

Another popular tax feature of life insurance is the ability to access the policy’s cash value in the form of a tax-free loan. However, in reality the tax-free treatment of a life insurance policy loan is not actually a preference for life insurance under the tax code, but the simple recognition that ultimately a policy loan is just a personal loan between the life insurance company and the policyowner, for which the life insurance cash value is collateral. A credit card cash advance isn’t taxable, nor is a cash-out mortgage refinance, and a personal loan from a life insurance company isn’t, either.

However, while a life insurance loan isn’t taxable – nor is its subsequent repayment – the presence of a life insurance loan can distort the outcome if/when a life insurance policy is surrendered or otherwise lapses. Because the insurance company will require that the loan be repaid from the proceeds of the policy.

In the case of a life insurance death benefit, this isn’t necessarily problematic. The death benefit is already tax-free, and the loan is simply repaid from the tax-free death benefit, with the remainder paid to heirs.

When a life insurance policy is surrendered or otherwise lapses, though, the remaining cash value is again used to repay the loan… even though the taxable gain is calculated ignoring the presence of the loan. Which means in the extreme, it’s possible that a life insurance policy can lapse without any remaining net cash value, due to a loan repayment, yet still produce a significant income tax liability based on the policy’s gains. This “tax bomb” occurs because in the end, even if all of a policy’s cash value is used to repay a life insurance loan, it doesn’t change the fact that if the policy had a taxable gain, the taxes are still due on the gain itself!

Assessing Compatibility To Partner With Another Financial Advisor

July 11, 2016 07:01 am 1 Comment CATEGORY: Practice Management

Even the most successful individual financial advisors can eventually hit a wall, where it’s simply not possible to make themselves more productive by growing a team to support them. The biggest advisory businesses bring together multiple successful advisors, who can each contribute their own unique (and hopefully, complementary) skillset to make the business bigger than what any one of them could achieve alone.

The caveat, however, is that just because two advisors are individually successful doesn’t mean that they will be a successful partnership. At best, different skillsets result in partners taking on more specialized roles in the business, and needing to learn to communicate well with people who have a very different perspective. At worst, the partners have fundamentally different long-term goals that eventually create untenable conflicts that cause the partnership to fail.

In an effort to avoid failed partnerships before they begin, former advisors Tanya Rapacz and Lisette Smith formed Partnership Resource, a niche consulting business that specifically works with financial advisors forming and sustaining partnerships. And their latest offering is a “Partnership Compatibility Assessment” tool, built to help advisors figure out up front whether they have sufficient alignment in what motivates them personally to be able to build a successful business together.

Of course, in the long run, there’s more to a successful partnership than “just” an alignment of business objectives and an ability to communicate and work through conflict. But given the number of financial advisor partnerships that I’ve witnessed come together and fall apart over the years, I suspect that better assessment tools like this will go a long way towards heading off the most problematic partnerships before they even begin, to the betterment of all involved!