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As we cross the midpoint of 2022 and celebrate America’s independence, we thought it appropriate to recognize that many of our clients are on their own paths to freedom: financial freedom. Reaching financial independence can be a daunting goal to think about, so we’ve set a few big milestones to guide you on your journey.

Level 1: Freedom from Bad Debt

If you find yourself carrying balances on credit cards, falling behind on medical debt, or dealing with payday lenders, then eliminating debt needs to be your top financial priority. According to WalletHub, the average interest rate on an existing credit card account is 14.56%. Many borrowers face interest rates quite a bit higher. It’s not uncommon to encounter credit card interest rates of 20% or more. 

An interest rate north of 20% means that your debt will likely double every 3.6 years if you don’t pay down principal.  Consider cutting discretionary spending as much as possible or adding a side hustle to climb out of this hole.

It’s also important to know the difference between bad debt and not-so-bad debt. The latter category consists of things like home mortgages, low-interest car loans, and student loans. The interest rates on these items tend to be more reasonable, 

Some may argue that a car loan is not good debt since a car depreciates. While that’s true, for many a car is necessary to get to work and earn an income. And so while we don’t think of the car itself as an investment, it is an investment into mobility and flexibility that makes someone more predictably employable. 

It can be frustrating to battle debt, it’s a tremendous accomplishment when you pay it off. And the “muscle” that you use to pay down debt (living below your means) is the same one that you’ll use to build savings.

Level 2: Emergency Fund Attained

Once you free yourself from high interest debt, it’s important to avoid backsliding. One way to stay out of debt is to build an emergency fund. A general “rule of thumb” suggests that you should save up 3-6 months worth of expenses in cash. In reality, your emergency fund should reflect your broader financial situation.

For example, someone with high income volatility whose income depends on commissions or bonuses may want to save at least 6 months of expenses. This cushion could mitigate the impact of slow business cycles. Meanwhile, someone with a stable income in a stable industry may be comfortable having a lower emergency fund saved.

Another factor to consider is your vulnerability to large expenses. For example, if you own an old home, chances are likely that you’ll face some significant maintenance costs. In contrast, someone who rents an apartment won’t have to worry as much about big repairs. 

Whatever amount you decide for your emergency fund, building a cash reserve for the unexpected is the second level of security on the road to financial freedom.

Level 3: Have One Year Worth of Expenses Covered

Having a full year’s worth of expenses covered means that you’re more secure in the event of an emergency. It also provides you with more power and flexibility in how you operate your life. For example, you won’t be trapped if your boss or job becomes. You’ll have the ability to step away and re-evaluate if needed. If you want to start a business, you’ll have some time and money to try something new.

You could think of this as an extended emergency fund, but by definition this money doesn’t all need to be in cash. Instead, these are funds that should be accessible if you need them, but can be allocated to a longer-term goal as well. 

For example, you could save in a regular (taxable) brokerage account, as opposed to a 401(k) or IRA account. There is no age requirement to access those funds This makes a taxable brokerage account a flexible option for either long-term savings, or to tap in an emergency.

Level 4: Partial Financial Independence

Partial financial independence can express itself differently depending on someone’s personal goals and circumstances. The most common instance that we see people shooting for is a downshift or “Coasting” situation.

To achieve partial financial independence, your retirement savings should be at a level where you have accumulated a meaningful amount. You don’t need to save at the same rate. Rather, you just need time for your assets to compound and grow. 

We see this most often with high-intensity careers. Perhaps you’ve been in management and want to return to a technician role. Or perhaps you have a hobby or passion project that could be profitable, just not at the income level that you’ve been used to.

The Coasting phase could smooth your transition as you approach full financial independence, and also might allow you to work at a job you’re happy to do. Many of the people we work with are happy to keep working as long as the work they do provides them meaning and purpose on a daily basis. Getting to this level of partial independence means that you can control your time.

You could also choose to express partial financial independence through taking a sabbatical or break with the intent to return to your full-time career. Having a meaningful nest egg saved up for retirement provides you with freedom and opportunities you may not otherwise enjoy.

Level 5: Full Financial Freedom

The pinnacle of financial freedom comes when you have enough resources to never work again and still meet all of your expected needs. One common method for determining whether you’ve reached this point is by using a 4% expected withdrawal rate. If you can live comfortably by spending 4% of your nest egg each year, you’ve saved enough to stop working. 

Reversing the 4% withdrawal rate can be instructive. Withdrawing 4% each year should allow you to live off of your nest egg for 25 years. So you can determine your savings target by multiplying your annual income needs by 25. If you plan to fully retire early, you might want to target closer to 27-30x your expected needs to be safe. Or if you’re expecting to retire at a later age, perhaps 22-24x your needs will be fine.

“If I ever won the lottery I wouldn’t quit my job, but I’d sure be a lot harder to supervise!”

Sadly, I can’t remember the origin of this joke… but it’s a similar position to those who have accomplished full financial freedom. Once you have reached this level of accumulated savings, the world is your oyster. If you continue to work, you do so knowing that it is your choice. To the extent you enjoy your work or want to continue building generational wealth you can. But your time is your own to make choices with.

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Whatever level you are at today, our hope is that this framework gives you some clarity around how Craftwork Capital thinks about financial freedom. Freedom isn’t a single destination that you are decades from as an early saver. Each rung on the ladder provides a new level of autonomy that gives you increased control over your financial outcomes and your life in general.

Investors today tend to focus on three major elements in their investing: income, growth, and tax minimization. So, it makes sense that a product that might be able to offer guarantees in the income department and benefits in the tax department could sound appealing. But, beware – the tax benefits of annuities are not always what they seem.

In particular, we will address tax-deferred annuities (annuities purchased using after- tax money) and three potential tax traps..

Gains are taxed as ordinary income.

A big selling point for non-qualified variable annuities is tax deferral. Money you put into the contract can grow tax-deferred (much like it would within an IRA) and taxes are not due until distribution. For an investor in a high tax bracket the abilityto avoid an additional tax bill is a benefit. Whether you rebalance your investments inside the contract, dividends get paid, or the investments simply appreciate in value, none of that activity creates an additional tax burden.

The tax bill comes later.

Eventually, investors want to access their funds. Upon distribution, all growth within the contract is treated as ordinary income. Ordinary income rates currently span from 10% on the low end to 37% on the high end. Had the investor held securities outside of an annuity contract, their growth may have instead been subject to long term capital gains tax rates which currently range from 0% to 23.8%, if you include the 3.8% Medicare surtax. Wherever you fall in terms of income, long term capital gains tax rates are more favorable than ordinary income tax rates.

Example:

Investor A owns an annuity contract worth $100,000 and within the contract invests in the All Stock Portfolio. They hold the contract for 10 years and it grows to $200,000. They withdraw the full amount while in the 24% income tax bracket. They will pay $24,000 in taxes (24% x $100,000 in growth).

Investor B owns $100,000 worth of the All Stock Mutual Fund, but not inside of an annuity. They hold the fund for 10 years, and it grows to $200,000. They withdraw the full amount while in the 24% income tax bracket. They will only owe $15,000 in taxes (15% x $100,000 in growth) because though their income is taxed at 24%, they fall within the 15% long term capital gains bracket.

Tax efficient portfolios can be constructed outside of annuity contracts. Securities like individual stocks are not taxed until sold and would benefit from long term capital gains tax rates if held for over a year before sale, as would qualified dividends.  Municipal bonds may also be an attractive vehicle for those seeking tax efficient income.

Last In, First Out.

Annuities are subject to a disposition method called LIFO – Last In, First Out. For annuities, this means that any withdrawals from the contract must first consist of growth before you get to withdraw anything representing principal. We know that growth is taxed at ordinary income rates and, with LIFO treatment, it means that every dollar you withdraw is subject to those rates until you take enough out of your contract to only be left with tour initial purchase/investment.

This differs drastically from what investors may expect from a traditional portfolio held outside of an annuity contract. Typically, when you sell a security to take a withdrawal, that sale will consist of both basis and growth. This means that a portion of those funds will be a non-taxable return of your initial purchase.

Example:

Investor A bought an annuity for $100,000 which has since grown to $200,000. They need to take a distribution of $10,000. The full $10,000 will be taxed at ordinary income tax rates. If they are in the 24% income tax bracket, their tax bill would be $2,400^[1].

Investor B bought $100,000 worth of ABC, Inc. stock. It has since grown to $200,000. They need to sell enough shares to take a $10,000 withdrawal. Upon the sale, $5,000 will represent a return of basis and not be taxable. $5,000 will be taxed at long term capital gains rates if the stock was held for more than a year. If they are in the 15% long term capital gains bracket, their tax bill would be $750.

An annuity can create drastically different experiences from a tax perspective for retirees. Having to realize ordinary income on an accelerated basis can have a broad reaching impact. For example, Medicare premiums are determined by your Modified Adjusted Gross Income (MAGI). An annuity distribution representing 100% income versus a sale partially representing a return of capital could be the difference between one Medicare premium and another.

Step up? Not today.

A strong legacy tool built into our tax code allows for appreciated property to receive a “step up” in basis when transferred upon death to help the recipient avoid capital gains taxes. While this benefit applies to many assets, it does not apply to annuities. When an annuity contract is inherited, the beneficiary will owe income taxes on growth within the annuity.

Though the timing of that tax liability may vary depending on the payout option selected by the beneficiary, an annuity does leave them with a tax bill that could have been avoided by choosing to invest outside of an annuity wrapper.

Example:

Investor A purchases an annuity contract for $100,000 which grows to $200,000. Investor A passes away. Their beneficiary will owe ordinary income taxes on the $100,000 of growth the contract experienced.

Investor B purchases shares in ABC, Inc. for $100,000 which grows to $200,000. Investor B passes away. Their beneficiary will receive a step up in basis on the shares from $100,000 to $200,000. They could immediately sell the shares for $200,000 and owe no income or capital gains taxes on the transaction.

If your financial plan consists of leaving a legacy, think about how assets will pass to your heirs and what kinds of tax implications they will face is critical. Position your assets in a way that aligns with your ultimate goals.

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It is clear that while annuities offer some tax benefit, there are potential pitfalls. The tax rate you pay on your investment gains, and the timing of when you pay for those gains are critical concerns. And if one of your investing goals is to leave a legacy for the next generation, you should also consider the taxation of the assets you plan to leave behind.

The advisors at Craftwork Capital can help you put together a plan that can be tax sensitive^[2] but also avoid the tax traps associated with tax-deferred annuities. Book a consultation today with one of our advisors today to understand whether the Craftwork platform is a fit for your unique financial situation.

^[1] This example illustrates how a withdrawal is treated, not an annuitization. If a contract is annuitized, payouts are treated as a prorated combination of basis and gains. Even with an annuitization, gains are treated at ordinary income rates.

^[2] Craftwork Capital is not a tax advisor. Discussions regarding taxes as part of a financial plan will be strategic in nature, but you should always consult with your tax preparer/advisor before making decisions that will impact your taxes.

“While pessimists sound like they’re trying to help you, optimists sound like they’re trying to sell you something.”

– Professor Steven Pinker, Harvard University

In the age of 24-hour news networks, great political division, and what seems like a devolving level of discourse – it’s easy to feel down about forward looking prospects today. Whether your candidate just won or lost may feel like a beacon of hope or dark cloud is looming. Business for many Americans has been disrupted in a major way in 2020, with some thriving and others faltering as a result of protocols and changes in consumer behavior and even the simple facts about how business is conducted. It would be easy to feel unsettled right now.

In financial services, times like this make it easy to sell products that are rooted in fear. The two products that seem to get sold hardest during these periods are precious metals like gold and silver, and annuities that can insure against market losses. While there are totally legitimate reasons that you may own either commodities or an annuity, considering them in an emotionally charged state is likely to lead to less-than-desirable outcomes.

What makes this so tempting is that it’s not illogical at all. If you become convinced that a crash is coming you’d be silly to sit in equities, right?

As long-term minded investors, we like to think of ourselves as rational optimists. Our base perspective, similar to what Professor Pinker teaches, is that our world is generally improving. Technology is making huge leaps in many fields, computing power that was once unthinkable is now at our fingertips, and our standard of living continues to expand in a big way. Our chosen path isn’t ever to say the crash isn’t coming – we essentially assume it always is. But we also believe in the power of innovation, patience, and prudence to overcome it.

Make no mistake about it, as a human you are hard-wired to have trouble with this mindset. In fact, we would argue many of the same instincts that have kept us alive as a species are the same ones that make patient investing difficult. We learn at a young age to avoid things that hurt us. Putting a hand on a hot stove burns, we should avoid it. If we see a dangerous animal, we should keep a distance and get away from it. When we start seeing red on our investing statements, that same fear response that has kept us alive kicks in. Get your hand off the hot stove; get away from that bear.

Investing is done best with the opposite response. In times of market turmoil we are often served best by adding to our risk assets, or at the very least just leaving them alone. We want to get ourselves out of harm’s way, and instead we should be running towards it or simply waiting for it to pass. One of the world’s oldest and most quoted adages is “Buy low, sell high.” But in practice it’s the hardest to execute.

This is all situational of course, and it starts by not painting yourself into a financial corner before the turmoil starts. If your investment allocations are too aggressive for your situation, you might end up in a spot where you are forced to sell into a bad market simply for liquidity needs. Similarly, if you maintain a risk-on position too close to your anticipated retirement, you may need to keep working simply to give your portfolio time to recover.

Rather than putting yourself in a position where the late-night gold salesman starts sounding like the smartest guy on TV, we recommend getting a second look at your portfolio when cooler heads are prevailing. Make sure your assets are actually in alignment with your plans.

We would encourage you to Book a Consultation if you are concerned about whether you’re positioned correctly. One of the financial planners at Craftwork Capital would be happy to help you evaluate whether our practice capabilities are a good fit for your needs, and make sure your portfolio is set up for the peace of mind that you deserve.