Maria



Profile

Maria, 68, is a retired schoolteacher who lives in California’s Napa Valley. A single mom, she would like to one day leave her three grown children an inheritance.

Maria is in a good position to do that. During her working years, she saved a portion of her earnings in a 403(b) plan, the retirement vehicle commonly used by schools and nonprofits. She receives a nice pension benefit from her tenure as a teacher. She lives in a 7-year-old home and drives a 4-year-old car, both of which she owns free and clear. And she has no consumer debt.

Maria also owns a rental property in Silicon Valley, on which she holds a mortgage. She asked Bankrate for a Money Makeover because she wants to see if she has enough money to last through her retirement and where improvements can be made in her personal finances.

Maria


Profile: Retired schoolteacher wonders if her money will last through retirement.

The challenge: Maria must decide where to live, and her finances need professional scrutiny.

The plan: Certified Financial Planner Tim Maurer gives Maria high marks for excellent stewardship of her finances.

The challenge

Maria has lived a frugal lifestyle, which has worked to her benefit. She continues to live below her means, even saving a good portion of her pension check. While this has given her peace of mind, it comes at a price: “I realize that the cost of such luxury (peace of mind) means having to pay more taxes for not having significant tax deductions to offset income,” she says.

Right now she is undecided about where she would like to live. In 2002, she bought her primary residence in Napa Valley for $365,000, which recently appraised for $320,000 due to the housing downturn. She is considering selling it and using the proceeds to pay off the mortgage on her investment property. That small, 1,025-square-foot home in Silicon Valley is worth more than $1 million, primarily because of the land value. She holds a mortgage of $300,000 on the investment property at a fixed rate of 5.5 percent. Her monthly payment of $2,000 is quite manageable, as she currently collects rental income of $2,450 a month.

Maria also wonders if she should use her retirement accounts to pay off the mortgage on the rental property. Even though she’d lose tax benefits, she’d gain more peace of mind.

She’s also considering a cash-out refinancing of her primary residence and using the proceeds to improve her rental home, after which she would move into it. Another idea is to purchase a different property altogether in another California town.

Maria has lots of options, thanks in large part to the careful way she has managed her finances. But she also has several personal finance concerns.

Key issues:
  • Should mortgage be paid off or not?
  • Consolidate bank and retirement accounts.
  • Reconfigure investment portfolio.
  • Re-evaluate insurance needs.
  • Update estate planning documents.

This Money Makeover was prepared by Certified Financial Planner Timothy Maurer, director of financial planning at The Financial Consulate, an independent fee-only financial management firm in Hunt Valley, Md.

Next: The plan.



The plan: Settle property matters first

Maria has positioned herself strongly enough so that she has options. Our projections indicate that Maria could reasonably maintain a comfortable income, even over her current standard of living, by maintaining the rental property or selling it.

Scenario No. 1: If she continued to receive her pension, took only the income and gains from her investments (assuming a 5 percent rate of return) and continued to rent the house in Silicon Valley, paying down the mortgage per the standard amortization, she would maintain a gross annual income above $100,000 in today’s dollars, accounting for inflation.

Scenario No. 2: If she sold her primary residence in Napa Valley and paid off her mortgage and moved into her Silicon Valley property, her pension and investment income would still maintain a level of between $77,000 and $87,000 of gross annual income. If she were to choose this path, however, she had indicated she would want to put $100,000 to $150,000 into that home for renovations. Since the estimated value of her primary residence would likely only pay off the mortgage on the rental property, she should consider taking the money for renovations out of the cash proceeds of the sale and then refinance to a very low mortgage. This is preferable to taking the funds out of retirement accounts, in which case she would be required to pay tax on those distributions in the year they’re taken.

Scenario No. 3: Both of the above scenarios presuppose that she would be taking the assumed annual average rate of return out of her investment portfolio each year for living expenses. However, she currently saves money each month, primarily living off of her pension. Therefore, if she left her investments untouched and they grew at a 5 percent rate of return, her accounts could be worth more than $2 million on her hundredth birthday. Better performance in her investments, coupled with added savings, would only further compound that gain.

As a side note, a capital gain exclusion of $250,000 would apply to the sale of her Napa Valley home, but not to the Silicon Valley investment property if Maria elected to sell it in her lifetime. In the past, a property owned as a rental property that became a primary residence would get the exclusion if the owner had made the home his or her primary residence for at least two years. The rules have changed, and her ownership of the home would be figured on a pro rata basis over time. But since the cost basis of the home is very low, she would realize a significant gain if she ever sold it.

But if she improves the investment property, moves in and lives there indefinitely, the heirs of the home would get a step-up in cost basis to the value of the home on her date of death. That would be a significant windfall for them.

Consolidate accounts

Maria has her cash holdings scattered in several different bank accounts. While it’s wonderful that she is cash-flow positive each month, there are inefficiencies in maintaining so many accounts. She’s getting a higher than average rate of return on her Schwab checking account, so she should consider moving enough money there for emergency purposes. In addition, she should consider opening a liquid, taxable investment account in her name to warehouse cash that is beyond her emergency needs. This account should be invested more conservatively than her retirement accounts and could be used for short-, medium- or long-term needs.

Maria also has several 403(b) accounts that can be consolidated in her traditional IRA via direct rollovers. The only advantage to leaving them in these vehicles is that federal rules protect these accounts from access by creditors. Since that’s not a concern for her, Maria has little to gain from that advantage, but can enjoy many benefits if she consolidates: efficiency, freedom of investment choice and preferential treatment for heirs. Beneficiaries of a 403(b) may be required to take a full, taxable distribution within five years of her death, but beneficiaries of an IRA may stretch the distributions over their lifetimes.

However, before consolidating these accounts, Maria should determine what, if any, surrender charges may apply. She’s likely beyond the surrender periods with two of the accounts, but one has a current surrender charge of 18 percent! (These products have fallen under close scrutiny in recent years for good reasons, including astronomical surrender charges.) Most of these contracts, however, allow you to take a 10 percent withdrawal “free” of surrender charges each contract (not calendar) year. After further review of the policy to determine if this is the case, she should consider conducting a trustee-to-trustee transfer of that free surrender amount each year to her consolidated IRA account and wait until the surrender charge goes down before taking additional principal withdrawals.

Finally, Maria should consider converting some of her traditional IRA assets to her Roth IRA each year. While this will create taxable income in the amount that is converted each year, it could be a wise maneuver because of current expectations of higher taxes in the future. Also, since she wishes to leave an inheritance behind for her children, the Roth is far preferable to the traditional IRA since traditional IRA distributions are 100 percent taxable to heirs while Roth distributions are tax free.

Reconfigure investment portfolio

While Maria has shown remarkable wisdom in her real estate investments over the years, she could use professional guidance with her investment portfolio, which reflects a disjointed strategy. Her portfolio should not contain high-risk investments — she doesn’t have the need to take risk, especially in the current market environment.

Our research suggests that the following mix would be suitable for Maria with her low tolerance for risk:

Maria’s low-risk investment portfolio:
  • 15 percent in individual equities and mutual funds
    • 3 percent to 5 percent of that geared toward commodities
    • 5 percent to 7 percent toward Asian markets 
  • 50 percent in fixed income
    • 15 percent of that in short-term CDs
    • 20 percent in global bond mutual funds
  • 35 percent in cash
    • U.S. government money market preferable

It’s extremely important to note that these recommendations are the basis for an actively managed portfolio — not one that is static. The sell decisions for the above parameters are far more important than the buy decisions.

Re-evaluate insurance needs

Maria has a $2 million umbrella policy that protects her from lawsuits should someone get hurt on her property. This is important in her case because tenants currently occupy her rental property. The other coverage that she has for her homeowners and auto policies are in line with our recommendations.

Maria should ensure that her rental property has replacement coverage in case of a catastrophic loss, as well as sufficient contents coverage.

If she hires someone to do work around her home or the investment property, she would be better protected from both a liability and tax perspective if she dealt with a company rather than individuals. If she pays a contractor to do significant work around her home, she should get a certificate of insurance coverage directly from the contractor’s insurance carrier to reduce her personal liability exposure.

She should also conduct an in-home inventory of her personal assets — ideally with a video camera — to document the contents in case of a serious claim that requires replacement. This evidence of assets should be stored outside of the house or in a fireproof safe.

Update estate planning docs

Maria’s estate isn’t valued near the $3.5 million level that is currently exempt from federal estate taxation, so estate taxes are not a concern this year. But unless Congress intervenes, in 2011 the estate tax reverts back to levels of the past so that estates worth more than $1 million will be subject to tax. A $1 million exemption could mean a federal estate tax of up to $250,000 that would be payable by her estate. The value of Maria’s retirement accounts coupled with her California real estate means this will be a concern in the future.

Maria’s estate planning documents need to be updated. One of her trust documents deals with the disposition of a property she has since sold. Other estate planning documents, such as the durable power of attorney and her advance health care directive, are out of date.

The revocable living trust documents need review and revision. It’s extremely important that Maria funds the trust fully for it to be of value. This requires her to change the titles on not only her real estate, but also her investment and bank accounts. The exception would be retirement plan assets, including IRAs and Roth IRAs, which should name direct beneficiaries so that her children can take advantage of the “stretch” provisions, allowing them to stretch any taxable distributions over their lifetimes.

To address these matters, Maria should consult a California estate planning attorney to draw up new documents.

Bequests of real estate can create difficulties in estate equalization since it is difficult to split up the assets equitably between children. The most equitable way to transition her estate would be for the real estate to be sold after her death and the proceeds divided. But if an understanding can be reached with her children, it can be a great blessing to pass real estate on to heirs. Maria should have an open conversation with her children to see what they desire.

Finally, she should consider having her trust distribute the trust principal in multiple installments over an extended period of time (for example, at ages 30, 35 and 40). While this is in part to ensure that the money is handled responsibly by her heirs, it is also added protection in case any child suffers through a divorce during this time period. More of the principal would be maintained in the trust that the ex-spouse would have difficulty attaching. Between principal distributions, the trust could still distribute the interest to her beneficiaries and even principal for their health, education, maintenance and support.

The health of Maria’s retirement prognosis, even employing conservative assumptions, is good enough that she should be able to live comfortably and still pass on a very nice inheritance to her children. This should be seen as a much deserved blessing for a lifetime of excellent stewardship of her finances. After living frugally all these years, Maria should reward herself by enjoying the occasional extravagance throughout her retirement.

The plan in 5 steps
1) Decide where to live.
  • Option No. 1 is to stay in Napa Valley.
  • Option No. 2 is to sell the Napa Valley home and use sale proceeds to improve property in Silicon Valley, move there and refinance that mortgage.
  • Avoid tapping retirement funds to pay for remodeling or pay off mortgage.
  • Capital gains exclusion would apply to sale of Napa Valley home, but not to Silicon Valley property.
  • Option No. 3 is to buy a different property altogether.

Tip: Brush up on the new capital gains tax rules that affect owners of a second home.

2) Consolidate accounts.
  • Move money from scattered bank accounts into the Schwab account. Use this as an emergency fund.
  • Open a liquid, taxable investment account to warehouse cash for short-, medium- and long-term goals.
  • Move 403(b) accounts that don’t charge surrender penalties into traditional IRA.
  • Convert some funds from traditional IRA into a Roth IRA.

Tip: Search Bankrate for the highest yields on money market funds.

3) Reconfigure portfolio.
  • Invest 15 percent in stocks and funds.
  • Small percentage of that should go to commodities, Asia.
  • Allocate 50 percent to fixed income.
  • Fixed income should include short-term CDs and global bond funds.
  • Invest 35 percent in U.S. government money market funds.

Tip: Learn about investing by reading “How to build a sound portfolio.”

4) Re-evaluate insurance
  • Homeowners and auto insurance policies provide adequate coverage.
  • Ensure that rental property has replacement and contents coverage.
  • Get certificate of insurance coverage from contractors’ insurance carriers.
  • Conduct an in-home inventory of personal assets and store in fireproof safe.

Tip: Brush up on five essential types of insurance coverage.

5) Update estate planning docs.
  • Update durable power of attorney and advance health care directive.
  • Change titles on real estate, investment and bank accounts to fund revocable living trust.
  • Consult a California estate planning attorney to draw up new documents.
  • Discuss property matters with children for equitable disposition.
  • Consider having the trust distribute its principal in multiple installments to beneficiaries.

Tip: Learn about wills and trusts in Bankrate’s Financial Literacy series on Planning for your heirs.

This Money Makeover was prepared by Certified Financial Planner Timothy Maurer, director of financial planning at The Financial Consulate, an independent fee-only financial management firm in Hunt Valley, Md.

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