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February 1, 2003

Evaluating an Early Retirement Offer

Even if you aren't thinking about early retirement, you may be tempted by an early retirement offer. Before taking that offer, however, consider several items:
  • Evaluate personal factors first. Decide whether you are psychologically prepared for retirement at this age and what you will do after retirement. You may decide to work at another job, giving you time to increase your retirement assets while drawing retirement benefits from this job. Find out if you really have a choice in accepting the offer. If it is a company-wide offer, you may be able to turn it down without repercussions. But if the offer is made to a certain division or a certain group of employees, you may find your job eliminated in a couple of years anyway. Typically, earlier retirement offers are more generous than later offers. So, if you think the company is going to continue to downsize, you might want to take this offer.

  • Understand what additional benefits are being offered. Usually, for purposes of calculating benefits, these offers add several years of service and/or several years to your actual age. Most offers, however, don't adjust your current salary, which is a significant factor in benefit calculations.

  • Get help in analyzing the offer. You typically need to compare several options that require complex calculations, such as what your retirement benefits would be at normal retirement age versus the current offer, how early retirement will affect your other retirement investments, and how to handle pension distributions. These decisions typically must be made within a short time period and can't be changed later on.

  • Ask about Social Security supplements. Since you won't be eligible for Social Security benefits until age 62, find out if the company is offering an annual supplement until that time.

  • Find out whether health insurance is offered. Medicare coverage is not available until age 65. You don't want to go without coverage, but paying for health insurance yourself can be very expensive. Whether the company will provide health insurance to age 65 can be a significant factor in deciding whether to accept the offer.

  • Negotiate with your company. Don't assume that the offer is fixed and can't be negotiated. You may know of other employees who received more generous offers. Use that knowledge to increase your offer.

Deciding on a Bond Maturity Date

Bond yields typically increase as maturity date lengthens, since more risk is assumed when holding a bond for a longer time. When interest rates are low, it is tempting to lock in higher yields by selecting bonds with longer maturity dates. However, use that strategy with care. If you purchase a long-term bond knowing you'll need to sell it before maturity, interest rate changes can significantly affect your bond's market value. Two fundamental concepts about bond investing apply:
  1. Interest rates and bond prices move in opposite directions. A bond's price rises when interest rates fall and declines when interest rates rise. That is because the price of an existing bond changes to provide the same yield to maturity as an equivalent, newly-issued bond paying prevailing interest rates. You can eliminate the effects of interest rate changes by holding the bond to maturity, when you receive the full principal value.

  2. Bonds with longer maturities are more significantly affected by interest rate changes. Since long-term bonds have a longer stream of interest payments that do not match current interest rates, the bond's price must change more to compensate for the interest rate changes.

Although you can't control interest rate changes, you can limit the effects of those changes by selecting bonds with maturity dates close to when your principal is needed.

Market Declines and Your Estate Plan

The recent market declines have caused many individuals' investment portfolios to decline significantly. Individuals who thought they had more than enough assets to fund their own retirement and leave significant bequests to heirs may now wonder if that is still possible. If you are in that situation, evaluate your estate plans, considering the following:
  • Take another look at your plans for distributing your estate. Your estate plan may distribute specific assets to specific heirs, such as a business to one child and investments to another child. While those assets may have been equal in value in the past, declines in your investment portfolio may make that distribution unequal. You may want to place provisions in your estate plan to equalize distributions.

  • Review amounts being placed in different trusts. Many estate planning documents indicate that trusts should be funded with assets equal to the unified applicable exclusion amount or the generation-skipping transfer tax exemption amount. Lower asset values coupled with significantly increasing exemption amounts between now and 2009 could result in placing too large a percentage of your estate into trusts.

  • Use lower asset values to leverage your lifetime gifting strategies. In 2003, you may gift up to $11,000 ($22,000 if the gift is split with your spouse) to any individual free of gift taxes. This amount is adjusted annually for inflation, in $1,000 increments. You may also gift up to $1,000,000 during your lifetime without paying gift taxes. While your investments' values are low, you might want to gift some of those assets to your heirs. There are other strategies to leverage gifts, such as setting up trusts that discount the value of the gift and using family limited partnerships or limited liability companies.

  • Consider converting traditional Individual Retirement Accounts (IRAs) to Roth IRAs. If your adjusted gross income does not exceed $100,000, you can convert. Amounts rolled over from a qualified pension plan, such as a 401(k) plan, to a traditional IRA can also be converted to a Roth IRA. Transferred amounts must be included in income if they would be taxable when withdrawn (e.g., contributions and earnings in traditional IRAs and earnings in nondeductible IRAs), but are exempt from the 10% federal income tax penalty. While there are many factors to consider before converting, a major factor is the ability to pay the income taxes with funds outside the IRA. With lower investment values, your tax bill will be lower also. Once the IRA is converted to a Roth IRA, qualified distributions, whether taken by you or your heirs, will be received on a tax-free basis.

An Evolving Estate Plan

Due to changes to the estate tax system over the next several years, you need to keep an eye on your estate plan. Estate tax rates and exemption amounts will be changing, possibly requiring adjustments to your estate plan.

For instance, the unified applicable exclusion amount is scheduled to increase from $1,000,000 in 2003 to $1,500,000 in 2004, $2,000,000 in 2006, and $3,500,000 in 2009. The maximum estate tax rate is scheduled to decrease from 49% in 2003 to 48% in 2004, 47% in 2005, 46% in 2006, and 45% in 2007. Then, in 2010, the estate tax will be repealed only to be reinstated again in 2011 based on 2001 tax laws. For 2010, inherited property will not receive a step-up in basis, but will have a basis equal to the lesser of the decedent's adjusted basis or the property's fair market value at the decedent's date of death, with some adjustments.

The lifetime gift exemption remains at $1,000,000, although the maximum gift tax rate will equal the maximum estate tax rate through 2009 and then will equal the maximum individual income tax rate.

The Generation-Skipping Transfer (GST) tax exemption increases from $1,120,000 in 2003 to $1,500,000 in 2004 and then follows the estate tax exemption schedule, with the GST tax rate equal to the maximum estate tax rate. The GST tax will also be repealed in 2010 and reinstated in 2011.

All these changes can make it difficult to determine whether your estate plan should be revised to take advantage of the changes. Some points to consider include:

  • Determine how to incorporate higher exemption amounts in your estate plan. Many estate planning documents indicate that trusts should be funded with assets equal to the unified applicable exclusion amount or GST exemption amount. Evaluate whether those amounts are still appropriate considering those amounts will increase significantly. Those amounts may leave more than you intended to your grandchildren or may place so much in a credit shelter or other trust that your spouse may receive very little of your estate outright. You may want to put a cap on the amounts placed in trust, even if that means you won't fully utilize your exemption amounts.

  • Make sure you have sufficient solely-owned assets to fund these trusts. Once you have decided how much should be placed in trust, you need to have sufficient assets titled in your own name.

  • Consider whether you need to add a disclaimer provision to your estate planning documents. This provision details what happens if one of your heirs disclaims his/her inheritance. That way, your heirs can decide after your death how much should be placed in various trusts. For instance, a husband can leave all his assets to his wife with the condition that any disclaimed assets go into a trust paying her income for life, then passing the principal to their children after her death. This gives the wife the opportunity to divide the assets based on her needs and wishes at the time of her husband's death.

  • Review your gifting strategies. You may still want to continue gifting strategies that utilize your annual gift tax exclusion ($11,000 in 2003 or $22,000 if the gift is split with your spouse) and your lifetime gift exclusion amount. For those with estates large enough to be subject to estate taxes, these strategies remove assets from your taxable estate without paying any gift taxes. When using your lifetime exemption amount of $1,000,000, look for ways to maximize your tax-free gift. For instance, individuals who transfer noncontrolling interests in businesses, farms, real estate, and other assets during their lifetime may be able to assign a minority interest discount to the gift's value. By gifting assets to certain types of trusts, such as qualified personal residence trusts and grantor retained annuity trusts, you can place an asset in trust now, use the asset for a period of time, and place a lower value on the gift.

  • Consider making charitable contributions during your lifetime. While charitable contributions made after death are free of estate taxes, that may not be a consideration due to higher exemption amounts. Charitable contributions made during your lifetime will still lower your taxable estate and you receive an income tax deduction.

  • Reevaluate your life insurance needs. Since the estate tax will only be repealed for the year 2010, you may still want life insurance to help your heirs deal with estate taxes. Even if you die in the year 2010, any inherited assets will not receive a step-up in basis, perhaps leaving your heirs with a large capital gains tax burden.

  • Review how specific assets are distributed. In 2010, inherited property will have a basis equal to the lesser of the decedent's adjusted basis or the property's fair market value at the decedent's date of death, with three exceptions: 1) $1,300,000 of basis can be added to assets; 2) unused capital losses, net operating losses, and certain built-in losses can increase this cap; 3) an additional $3,000,000 of basis can be added to assets inherited by a surviving spouse. Due to these exceptions, you may want to specifically allocate assets with low basis to your spouse and assets with a higher basis to other heirs to ensure the step-up in basis is maximized.

Look Out for These Tax Mistakes

If your objective is to pay the least amount of income taxes, then you need to be aware of these common tax mistakes:

  • Maintaining poor tax records. Don't rely on your memory to keep track of deductions. During the year, accumulate tax receipts and notes concerning deductions in one place.

  • Withholding too much in taxes. When you receive a refund, you've given the government an interest-free loan for the year. Consider reducing your withholding and investing the extra money.

  • Not contributing to your company's retirement plan. Not only will the plan help you save for retirement, but it may also help reduce your current-year tax bill. For instance, in 2003, you may contribute a maximum of $12,000 to a 401(k) plan. If you're in the 38.6% tax bracket, contributing $12,000 may reduce your current-year tax bill by up to $4,632.

  • Failing to bunch deductions. It only makes sense to itemize deductions if your total deductions exceed the standard deduction amount, which for 2002 is $7,850 for married taxpayers filing jointly and $4,700 for single taxpayers. In addition, some deductions must exceed certain thresholds -- medical expenses are only deductible to the extent that they exceed 7.5% of Adjusted Gross Income (AGI) and miscellaneous expenses are only deductible to the extent that they exceed 2% of AGI. Many expenditures can be bunched into one year or another to take advantage of these limits. For instance, if your total itemized deductions are slightly below the limit, you might consider prepaying property taxes or state estimated tax payments.

  • Overlooking charitable contributions. In addition to cash and property donations, you may deduct mileage, parking fees, postage, and long-distance phone calls made while performing charitable work.

  • Not considering filing separate returns. In some situations, it may be more beneficial for a married couple to file separately. Once you file jointly, your return can't be amended to file separately, so calculate your tax both ways before filing.

  • Forgetting deductions carried over from prior years. Don't forget about items you carried forward because you exceeded annual limits, such as capital and/or passive losses, charitable contributions, and alternative minimum tax credits.


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