How does Social Security work for self-employed small business owners? Is there a solo 401(k) that allows after-tax contributions? How much cold, hard cash should you keep on hand? Why do advisors suggest buying a fixed indexed annuity, and how do qualified charitable distributions work? Finally, is it a good idea to pre-pay the mortgage on a real estate investment, and how do you calculate the tax on a home you inherited?
- (00:44) How Does Social Security Work for Self-Employed? (Jim, Santa Cruz – voice message)
- (05:52) Solo 401(k) That Allows After-Tax Contributions (Priya, Irvine)
- (12:24) How Much Cash Should I Keep on Hand? (April, Tinley Park, IL)
- (15:39) Choosing Stable Value Funds (Smitty in the Villages)
- (16:54) Our Financial Advisor Suggests a Fixed Index Annuity (Jesse, ND)
- (24:49) Qualified Charitable Distributions (QCD) Explained (Dan, Auburn, CA)
- (28:7) Should I Pre-Pay the Mortgage on Investment Property? (Tyler, New Jersey)
- (37:44) What’s the Tax on a House Inherited From My Uncle? (Michael, Escondido, CA)
Free financial resources:
LISTEN | YMYW Podcast #367: Dollar Cost Averaging, Small Cap, and Stable Value Funds
Your questions run the gamut today on Your Money, Your Wealth® podcast 376, how does Social Security work for self-employed small business owners? Is there a solo 401(k) that allows after tax contributions? How much cold, hard cash should you keep on hand? Why do advisors suggest buying fixed indexed annuity, and how do qualified charitable distributions work? Finally, is it a good idea to pre-pay the mortgage on a real estate investment, and how do you calculate the tax on a home you inherited? I’m producer Andi Last with the hosts of Your Money, Your Wealth®, Joe Anderson, CFP® and Big Al Clopine, CPA. Visit YourMoneyYourWealth.com and click Ask Joe and Big Al On Air to send the fellas your questions as an email or a voice message:
How Does Social Security Work for Self-Employed? (Jim, Santa Cruz – voice message)
Jim: “Hello, YMYW team. This is Jim from Santa Cruz calling. The last time I submitted a question, Joe just tore it to shreds on air, but fortunately I’m a fearless glutton for punishment. So here comes another one. Our friends, Jack and Diane are deciding on a social security strategy. Each is 62 years old. Because Diane was the primary earner she plans to claim benefits at age 70. Jack was self-employed, but since he is now working less than 45 hours per month, he’s tempted to claim his benefits now. He expects to earn around $2,000 a month for the balance of this year, which exceeds $1,630 a month allowed by the SSA. Jack understands that 50% of the excess benefits will be withheld. Our question is, how does the social security administration determine Jack’s earnings? Their website indicates that benefits are withheld in the first months of the following year. The tax returns often aren’t filed until April or until October with an extension. How, and when does the social security administration determine the amount of withheld benefits for self-employed persons? Thanks in advance for your answer and for your consistently great show.”
Andi: It was nice to actually hear Jim from Santa Cruz. And this time he actually was calling. He always says in his emails this is Jim from Santa Cruz calling. This time he actually did.
Joe: Wow. He just came out blazing with a very technical question.
Al: He did! Do you have an answer?
Joe: I’m going to pass this one over to Al.
Al: The Social Security Administration, if you are before full retirement age and you’re making more than about $20,000, then you’re making too much to get your full benefits and you’d have to give some of those back. I guess, if you’re a W2 employee, the IRS knows pretty quickly because the W2’s are filed and the IRS gets a copy. Those are filed by January 31st. If you’re self-employed, it’s a whole different ball game. You may literally extend your tax return and not file until October 15th. In that case, the IRS is not going to know until October 15th. So that’s the point where they’d either withhold from your future benefits or, they also send a letter requesting a payment back, to catch it up. If you can’t pay it, they’ll just withhold from future payments. It just extends the period of time from January, February to maybe even October.
Joe: Why does he care? I guess what is he trying to solve for? That’s where I’m at.
Al: What he read was the withholding of benefits will start the following year. So you don’t get a full year of benefits. But Self-employed, the IRS isn’t going to know until you file your tax return. That was his question. How, how do they know? And the answer is they don’t. They can’t make this calculation until you actually file your return when you’re self-employed.
Joe: So here’s what happens. Let’s say that Jack exceeds the earnings limit. So you can make $1950 give or take. So every $2 earned over that they take a buck back of your benefit. Jack is self-employed and then he gets a big contract. So he’s claiming his benefit because he doesn’t think he’s gonna make a lot of money. Hey, I’m winding down. I’m working 45 hours per month. I mean, that’s what Al works.
Al: And that’s still a lot. (All laughing)
Joe: 45 hours a month and then at the end of the year, all of a sudden, a contract lands on his plate then comes $100,000. He’s already claiming the benefit. How does the social security administration know? Well, they don’t, you’re going to get your benefit again the following year, until you file your tax return. Once you file your tax return, then they see the income and then guess what all of that money gets paid back. You’re not going to receive any type of benefit. Let’s say Jack retires, totally. He does not make a dime. And then he’s waiting for that social security benefit to come, but it’s not going to come to him because he has to pay back. It’s not like they’re taking it back from him. What they’re really doing is doing a calculation on a month by month basis of saying, since you made this much over that limit, we’re taking the dollar back, but we’re assuming that you didn’t claim it at all. You’re just giving it back. That you didn’t claim it. So you didn’t really claim it at 62. You claimed it at 63. So you’re going to receive a higher benefit once all of that benefit is paid back. If that makes sense.
Al: That’s exactly right. You’re right. You haven’t lost the money. It’s just that the money you got, you weren’t really entitled to. You either pay it back or you have it withheld from future benefits. That’s the concept and you’re right, Joe, you don’t get penalized. You’ll get it as if you never filed for those benefits. So you will get the money back eventually.
Solo 401(k) That Allows After-Tax Contributions (Priya, Irvine)
Joe: Our good friend Priya. She writes back in from Irvine, California. She goes, “Hello, Joe, Big Al and Andi. Thanks for the wonderful podcast and TV show. I’ve learned so many concepts, new tax laws, certifications of key financial terms. The information I got from your TV show.” She’s plugging the TV Big Al. By the way, we have a TV show.
Al: It seems hard to believe, but yeah, we’ve been doing this for eight years, the TV show and the podcast radio has been a lot longer.
Joe: A lot longer than that. Eight years. I think we got eight views.
Al: Between your mom and my mom. That covers it.
Joe: “One of the information I got from your TV shows regarding any AB150.” Oh wow. That’s getting deep. You remember talking about AB150 Big Al?
Al: AB, yeah I do.
Joe: In one of the episodes, Big Al mentioned AB150 in saving taxes. I haven’t heard of it. So I did a little research on Google and some YouTube videos. I found out that applies to me as I have a one person escort. My CPA forgot to mention this, but at least I caught it before the business tax filing deadline and contributed to get the PTE credit for 2021.”
All right. Very good. Saving some money here. Now for the information she wants to provide us is from a caller from episode 370, Heather in Irvine, California. I wonder if Heather and Priya are buddies?
“She had many questions regarding solo 401(k), SEP IRA, mega backdoor Roths, et cetera. Again, I learned about solo 401(k) from your podcast in 2020, I spent so many hours trying to figure out a solo 401(k) plan that allows after tax contributions. Big brokerage companies like TD Ameritrade don’t offer that. One company I found offers a solo 401(k) plan that includes after tax and will provide all necessary paperwork, like 1099R and 5500, et cetera, is my solo 401(k). Yes, that’s the company’s name. Solo 401(k) is all they do. Their customer service was exceptional. Reasonable fees to set it up. No, I don’t have any affiliations with my solo 401(k). I just want to pass information to others who are looking for the same information as I did. If this violates your company’s policy, you don’t need to read this on the air.” I don’t know if this is part of the company policy or not. I read whatever Andi throws in front of me.
Al: True. That’s our policy!
Joe: If Andi gives it to me, I just read it. “So keep up the good work.” Priya likes me. She doesn’t think I’m arrogant. “Maybe enthusiastic when he’s speaking.” That could be true. “Thanks again.” So my Solo 401(k). For those individual employers out there that want to do the Megatron, the backdoor Roth, Super barn door.
Al: garage store. All those names,
Joe: Go to my solo 401(k). You’re going to have to set up a plan doc. The main templates of 401(k) plans. Probably don’t have it. Like she said, she went to TD Ameritrade. They have a solo 401(k), but you couldn’t put after tax contributions in it. You go to Fidelity, probably the same, go to Charles Schwab, probably the same. You have to really design your own plan. It sounds like my solo 401(k) has a pretty good template that if you meet with someone and you can tell them what your goals are. How much money that you want to save. They can construct the over 401(k) to suit your needs. We don’t have any affiliations. But Hey, if Priya likes it, we like it.
Al: It must be good. For people that do want to do that extra large Megatron 401(k), it requires that you can put after tax money in the account. That can be a great way to go. I want to talk briefly about AB 150 since she brought that up. This is only for California people. Sorry if you don’t live in California, although your state may have something similar. What this is, is a law was passed in California last year, maybe in the summer or spring, where if you had a small business, like a one-person S Corp, something like that, LLC. There’s other rules too because you can have partners, but it’s too complicated to go right now. But the concept is that you can actually pay the taxes from the profits, from that S Corp business through the business, and then you can get a tax deduction on your personal return. Because right now you guys know that your taxes that you paid a franchise tax for or any state taxes for that matter are only deductible up to $10,000. This is a workaround from that rule. You basically have to make that payment by the filing date, which happened a week ago or two, you know, whatever a couple of weeks ago.
Joe: So this means nothing to you?
Al: It’s for next year. Yes, at least in California, the law still stands. There’s talk about changing the federal tax law to allow state tax deductions up to $80,000 is the last number I heard, but that’s been stalled. Who knows. Anyway, if your state has something like this and if you’ve got a small business, this is worth looking into.
Self-employed small business owners, you know your financial and retirement planning requires special attention. Visit the podcast show notes at YourMoneyYourWealth.com to read a helpful guide on small business tax filing, and to learn 5 Retirement Mistakes Small Business Owners Make and How to Avoid Them. Click the link in the description of today’s episode in your podcast app to go to the show notes, access the free financial resources, Ask Joe and Big Al your money questions, and to share the show and the resources. Or you might prefer a more in-depth review of your entire financial situation. Click the Get an Assessment button in the podcast show notes and schedule a personalized, one on one, free financial assessment with one of the experienced professionals on Joe and Big Al’s team at Pure.
How Much Cash Should I Keep on Hand? (April, Tinley Park, IL)
Joe: April writes in from Tinley Park, Illinois. “Hi Joe, Big Al and Andi. I hope Joe had a great big vacation honeymoon.” Oh boy cat’s out of the bag.
Al: Well, you’re the one that said it. I’m always very careful not to bring it up.
Joe: it was like just like right at the end of the show.
Al: People pay attention.
Joe: People don’t listen all the way through the show. They listen to the first, maybe. Our consumption rate is like 5%. They listen to Andi’s opening and then they’re like, okay, that’s good.
Al: It’s not that good of a show.
Joe: This show sucks, I don’t know why I keep subscribing. Well, thank you April, it was quite lovely. “I continue to listen to the show every week and an oldie, but goodie every once in a while. Just a small non Roth question. Thank you. I keep hearing that you should keep some cash in the house? How much? We use credit cards and automatic payments for everything.
It is rare that I have over $20 in my wallet. We have a fireproof safe at home that we could throw some cash into, but not sure how much or how much is enough? But not too much. I don’t know. Thank you, April.” Big Al what do you think, she’s got the safe. Hard, cold cash.
Al: I don’t have any, I have a couple hundred bucks in my wallet. That’s all I have, but I’ll tell you what I’m hearing more and more people say that they feel more comfortable having cash in their home. I think it’s a little bit more of a personal thing. The concern is if something happens really bad to the banking system or whatever, at least you have some cash to pay basic bills.
I don’t think that’s a bad idea how much you need, it’s hard to say. If I had to throw out a couple of figures, I’ve heard people say $10,000, I’ve heard people say $25,000, but it’s more of a personal choice.
Joe: $25,000. That’s what I keep in my wallet.
Al: I know you have a big wallet.
Andi: Who’s got the big wallet?
Joe: My wallet looks like George Constanza’s.
Al: That’s why you have a little hole dug out in your chair so you can fit the wallet.
Joe: Exactly. That’s why I had back surgery. That’s a really good question. I like to keep cash. I keep about $10,000, somewhere in my house.
Al: You do?
Joe: Yes. Buried in the backyard in an old coffee can.
Al: Your sock drawer? Just so I know when I come over.
Joe: Maybe I’m old school. My dad always carried a ton of cash. On the golf course too, you know, if you gamble a little bit. It’s like can I Venmo you? I’m like, no, you’re not Venmo me $20. I want cash. I’m not a big fan of that. I like cash. I like $10,000 or $20,000. Put it in the safe. Get you a generator. Get a whole bunch of bottled water too.
Al: I suppose.
Joe: Lock it up with your gun, gun safe. $20,000 that’s the answer? What do you think?
Al: Okay, I’ll take that.
Choosing Stable Value Funds (Smitty in the Villages)
Joe: Let’s see, we got Smitty, We haven’t heard from Smitty in a long time. Smitty in The Villages, cruising around with all the ladies in his golf cart.
Al: I remember. Yeah.
Joe: I’m going to retire and hang out with Smitty.
Al: You’ve said that before. I think you should.
Joe: I live vicariously through Smitty.
Al: I think he’s got golf buddies. I think there’s only three of them, him and two others. They’re waiting for you, Joe, to join them. I’m pretty sure.
Joe: The foursome coming Smitty, bad ass. “Hey, Andi, Joe, and Big Al, can you guys talk a little bit about stable value funds? How do they compare or contrast to money market funds or short-term bond funds? I have my account with Vanguard and they have more than a few to choose from. How would I go about choosing the right one?” Schmitty, We are not here to give advice on stable value funds. But what I would do is, you can look at Vanguard, just go into the profile of the fund and then you can kind of see what the makeup of the stable value fund is.
They could have treasuries in there. They probably have short term bonds. It’s a little bit more diversified. We did a whole show on stable value funds. Didn’t we?
Andi: I think it was one of our Waukesha listeners who had asked about stable value funds. I’ll find that podcast episode number and I’ll put it in this one to go along so that somebody can go and listen to it.
Al: I like that idea.
Joe: Saves us time.
Our Financial Advisor Suggests a Fixed Index Annuity (Jesse, ND)
Joe: Jesse, he writes in from North Dakota. “Our financial advisor is suggesting we take out a fixed index annuity. I know you’re not a big fan of annuities, and we feel we would likely do better in the stock market. My husband, and I would appreciate your thoughts.” Don’t do it. All right. Next! “Our nest egg isn’t large from the sounds of most callers. Al you’re going to probably say, well, you don’t have that much money.
Al: I do realize when I said it, when it came out of my mouth, it was like, I didn’t really mean it that way. And of course you called me on it.
Joe: “Our next egg isn’t large enough with the sounds of most collars, but it is what it is.” Jesse don’t you worry about a thing. “I’m 61. My husband is 62 and I make $95,000 a year and he makes 60,000. TSP, 401(k) contributions are 17% with 5% match for me. And 15% with 3% match for my husband, we currently have $500,000 combined in these accounts.”
That’s a ton of cash.
Al: It is. That’s probably the top 10% in the country. Wouldn’t you say
Joe: By far. You’ve got $500,000, be proud. “with no other accounts. Our accounts are in target date funds with a 60/40 stock bond mix. We both plan to retire at 65. He wants to start taking social security at 65. His benefits are $2,200 a month. If I wait until I’m 70, it’s going to be $3,200 a month. As I have a pension abruptly, $2,200 a month once I retire. We will be debt-free in 24 months. Post retirement expenses are estimated to be $4,000 a month. Is an annuity something we should consider to guarantee a set amount of income to go along with what we will be receiving, or are there better options for us? We are both healthy and active. So don’t anticipate chronic health issues in the future. We both drive Toyota’s and a Harley Davidson.” Jesse, North Dakota just cruising along in that Harley.
Al: A black bandana can you imagine?
Joe: Black and orange for sure. “Pets have all passed on. None of them now as we’re enjoying our travels. Beverage of choice, bud light.” Oh I thought she was going to Busch Light in North Dakota. Okay. Jesse, no, absolutely not. Do not buy the fixed index annuity. That thing is just jammed with BS and it’s full of commissions. And I would fire your advisor. You don’t need the income. You are going to have a very healthy income. You have 32 51, a month from yours. You’re going to have 21 7 0 plus 22, 5 0. So 12 times that they’re going to have close to a $100,000 of fixed income. They spend $50,000. He’s like, Hey, you need an annuity for more income. What the hell are you talking about? You have a healthy, fixed income. They don’t spend a lot of money and their fixed income, their pension, her pension alone will cover almost three quarters of their expenses. You throw in social security on top of. So you turn on the annuity or you buy the annuity, you get locked in. The advisor makes a huge commission on it, probably $50,000. He’s not going to disclose that in the fixed index annuity, which is total garbage. to say, oh, we got a benefit for you that you’re going to get more income on that.
And it’s going to be guaranteed for life. Well, you already got $100,000 guaranteed for your life. Don’t you want some walking around money? Maybe you want to buy another Harley. Maybe want some leather chaps, buy some more bud light. Don’t lock that thing up. No, go on a very conservative portfolio. Stay in cash. I don’t care.
Al: More vacations, right?
Joe: Your income will provide that too. Annuities are for people that need income that are worried about longevity, that don’t have a lot of fixed income. You are exchanging cash for a guaranteed income for life. That’s what an annuity is. It is not an investment. It is income. It’s insurance. So you’re buying more insurance to guarantee an income stream where you already have a guaranteed income stream, that’s covering your expenses. So why would you buy more insurance on that?
Yeah, I’m 100% with you. How does the fixed index annuity work? I don’t know how much time we have, but if you could explain that.
Joe: I was going to say a little comment from Tommy boy. Here’s how it’s sold. You could get stock market-like returns with no downside risk. Who doesn’t want stock market returns with no downside risk. It sounds great. But there’s caps. You have to take a look at, alright, how much will this thing actually produce for me. What the fixed index annuity really is doing or what the insurance company is doing is buying bonds. They’re buying call options on the bond for the S&P 500 or the NASDAQ or whatever, or the Russell 2000. So you’re picking, oh, I want the S&P 500. You’re not buying the S&P 500. There’s no dividends. It’s an option that the insurance company is doing. They’re very smart people in these insurance companies that package these products. And then they distributed it to a Salesforce of insurance agents to say, here, sell this product. You’ll make a lot of commission because it locks up that money on the insurance balance sheet, because there’s a huge surrender penalty. And people are like, well, I don’t want to pay the penalty and I want to use it for guaranteed income. And so they’re going to slowly drip some income out for me, and I’ll slowly get my principal back over the next 30 years. And I’m not going to get a true IRR on that overall investment until I’m 85 years. You gotta be careful. You have to really understand how these products work. If someone is selling it to you, and it sounds like it’s a really good investment. If you can get all these great returns and you’re not going to have any risk and it’s guaranteed and oh, by the way, there’s these riders that can give you income. An annuity is insurance for income. If you don’t need the income. You can control your income, I would keep it in your 401(k) or your TSP or, or roll it to an IRA. The issue that they’re going to have is taxes. So then they could control the taxes. Now, if they turn on the annuity, they’re even going to have more income. Now, it’s probably $125,000. That’s going to pop them into another tax. The income that they receive from that guaranteed annuity is going to be less than what they thought because of the taxation that they’re going to have to pay. Keep it in the lump sum and then maybe slowly start converting some of these dollars out to Roth IRAs, and then that would reduce the overall RMD. Now you’re going to have a lot more flexibility when things happen. How about if something happens long term, I mean, they’re healthy. They’re riding around on their Harley’s but who knows? Jesse could have a couple pops, a bud light trips down the stairs, she might need a little medical care. Well, now you’ve got some cash that you can use to help pay for it. Oh. And by the way, when you take it out of the IRA, you can offset because it’s a medical deduction. I mean, there’s so many more benefits than just leaving the dollars alone and being conservative with it and having a globally diversified portfolio than buying that crappy product.
Al: All right. I’m with you. Good for you. Good summary.
Qualified Charitable Distributions (QCD) Explained (Dan, Auburn, CA)
Joe: Dan writes in from Auburn, California. “IRS publication states, a QCD is a distribution made directly by a trustee of your IRA other than an ongoing, separate, simple IRA to a charitable organization. Question, does that mean SEP in simple IRAs don’t qualify and, or what is meant by, on going? My 1099 R distribution has the SEP simple box checked, but I have not contributed for years. Can I claim a QCD from that IRA? Last question. IRS transactions states enter distribution amount on line 4a enter zero, then line 4B, then enter QCD next to the line 4b.
How do I do that since I’m not using an online tax program and not filling out the form manually.” So Dan thinks he’s sitting in his CPA office, writing to the CPA and giving us the lines. It was like, Hey, my turbo tax is not, I’m doing this by hand. Help me out. I got this simple IRA. I haven’t contributed in years. I want to do a QCD. What the hell.
Al: I think when you started seeing IRS instructions and lines, that’s why you got indigestion at that one.
Joe: I had a panic attack.
Al: First of all, a QCD qualified, charitable distribution is available. You can make a contribution directly out of your IRA once you hit 70 ½ . When you hit age 72, now that can count as your RMD required minimum distribution up to a $100,000, but you can’t do it out of an active SEP or simple IRA, that’s what is ongoing. Yes, you can do it out of a SEP or simple IRA, as long as it’s not currently active. If it’s an old plan or you’ve retired and you’re not using it anymore, or you’re not adding to it, the fact that you have the box checked on the 1099, IRS thinks it’s active, so you could try it, but I wouldn’t recommend it. I would not do it out of those accounts until you’re not part of this plan. It’s not part of an active plan. Joe, as far as where to put the QCD, if you’re doing it yourself in turbo tax, there’s a box that you check somewhere where it says QCD, and that will put it in the right place. If you’re doing it by hand, just write it in. Or if you take it to your CPA, they’ll know what to do.
Joe: You could do that too, or just roll it into an IRA. If you’re not using it, what’s the difference? Just take it from a SEP and put it in a traditional IRA, then you don’t have to worry about all the forms.
Al: That would work too. Then you don’t have to worry about it. You’re exactly right.
So Smitty, that episode was number 367, stable value funds, that was a question asked by Sharon in Waukesha, you can find that in the podcast show notes at YourMoneyY ourWealth.com. In the meantime, are you subscribed to YMYW on YouTube? Watch Joe and big Al answer your podcast questions on video, and catch YMYW TV! From tax planning to Social Security to cryptocurrency and more, the 8th season of the Your Money, Your Wealth TV show is required viewing. The latest episode is on Estate Planning, how to Build Your Legacy Now and Beyond. Watch, subscribe, and Download the Estate Plan Organizer and Survivor’s Guide for free from the podcast show notes at YourMoneyYourWealth.com. Just click the link in the description of today’s episode in your podcast app.
Should I Pre-Pay the Mortgage on Investment Property? (Tyler, New Jersey)
Joe: “Hi, Joe, Al and Andi, this is Tyler from New Jersey. I’ve got a question regarding prepaying mortgage debt. Not the typical primary resident question of an investment property that I don’t live in anymore. There’s roughly 18 years left on a 20 year mortgage at 3.37%. The current rents covered the mortgage taxes, insurance and property management. Even with setting aside 10% for repairs, 10% for capital expenditure and 10% for vacancy, the property is still cash flows, but I don’t touch the money. It just sits in the property checking account. I’m considering using some of the cashflow to prepay the mortgage. What seems like a sin in the personal finance community. Every time this comes up in a forum or Facebook group, people lose their minds. However, why wouldn’t you pay this off sooner to have free cash flow and reduce the total interest payment. If I go ahead with this plan, I’ll have the property paid off in roughly 14 years when I’m 47 years old. If rents never go up from there, where they are today, I’ll still have $3,000 a month cash flow, after paying my tax insurance and property management. Plus I’ll save about $20,000 in interest. I understand if I took a couple hundred dollars and invested in the stock market today in a brokerage account, I could do better than 3%, but even if it grows at 8 and we ignore capital gains tax, that’s not going to give me $3,000 a month in passive income at age 47, even backing out ordinary income tax on this $3,000, you have the 24% tax bracket. I would still net out $2,000 a month for only a couple of hundred dollars today making this extra payment today would still leave a positive monthly cash flow. Am I missing something in this? FWIW”
Andi: For what it’s worth.
Joe: Thank you, Andi. Did you know that Big Al?
Al: I had to think about it. I didn’t know, right off the bat.
Joe: Oh, for what it’s worth. Wow. “I maxed out my 401(k), a Roth IRA, backdoor, a HSA, and put $5,000 a year into my brokerage account. I have a six month emergency fund and the mortgage is my only debt. Tyler.” All right, Tyler. Great question. Big Al has had a lot of investment property, and I think it really depends on your goals, but I’ll let you take a crack and I’ll give you my opinion.
Al: Here’s my feeling is the reason why financial planners will tell you not to if you’re paying a mortgage of 3.37% and the stock market, maybe over time globally, diversified portfolio might earn 6 or 7%. So there’s an arbitrage there that you can keep, or you create some of that extra profit. You accumulate a down payment, you buy another property, you grow your wealth out that much more quickly. Which of course the problem with that is it’s more risky as well. But that’s kind of the financial planning community. I would take a step back. Personally, I don’t really care if my mortgage is paid off on a rental while I’m working, but it would be really cool if there is no mortgage when I retire, because that’s when I’m going to need the cash flow. I actually favor that idea, even though I know that I would be missing out on the arbitrage.
Joe: There’s two things, there’s arbitrage. That you’re getting a higher rate of return. probably in another investment due to the very low interest rate that he’s locked in on for the next 20 years. Interest rates are going up and so on and so forth. I don’t know if we’ll ever see the interest rates at 3% or 3.5% in the next 15, 20 years. I don’t know. Maybe we will, maybe we won’t, but it’s a low rate. Historically. It probably makes sense to keep that, but I see where his head’s at, but he’s got to look at things maybe a little bit differently because he’s got a mortgage on it.
What are you holding that property for right now? Are you holding it for growth or are you holding it for income? Because if he’s holding it for growth then you probably don’t want to pay off the mortgage because then that’s leverage. Because you’re looking at the growth of the overall equity versus if you pay it down, your percentage of growth is going to be a lot higher because your cap rate or cash on cash is a lot higher when you have debt. Then you put that money into a side fund, and I get what he’s saying. He’s like, I’m doing the math. And when I’m 47, this side fund that grows at 8% is not going to produce $3,000 a month. Well, that side fund at that point could probably pay off the entire mortgage and you still have excess capital on top of the mortgage. It really depends on what math that he’s running and what his goals are. If he wants to retire at 47 and needs the cash. Well then pay it off. If that’s your goal to have additional cash flow at 47, then by all means, but I don’t know if he wants to retire at 65, it might make sense, you know, to keep the note.
Al: I agree with that. It all depends upon retirement. If 47 is the retirement date, then I like the plan. If 65 is then I would just let it run its course, use that extra money to, to build up reserves, to invest in other assets. To me, having a mortgage on a rental is actually just fine. As long as the rental income covers the payments and you don’t necessarily need the cash flow because you’re still working. It’s a whole different ball game when you retire, you might want that cash flow, I think paying a couple hundred bucks a month extra, psychologically is a little easier than making a lump sum payment. Although in his case, he’s only gaining about four years. So it’s not that big of a deal.
Joe: We have a little bit of time, run an example, let’s say like a cap rate or cash on cash. When you look at real estate with a mortgage versus not, on a growth angle. He’s still a young guy and it’s like, okay, well maybe he wants to continue to build his wealth versus getting cash flow. If he has the note versus not, the rate of return on that property from a growth perspective is going to be higher.
Al: Let me just do a real simple example. $100,000 property, which I know you can’t find, but the math is easy. A $100,000 property. We’ll say that you put down 20%, $20,000. Or actually let’s do 10% easier Math. You put down $10,000. Now the property goes up 5%. It was worth $100,000, one year later it’s worth $105,000. It increased in value by $5,000, but you put a down payment of $10,000. Now your equity, which is the difference between the value and the mortgage, is $15,000. You made $5,000 of growth on a $10,000 investment. That’s a 50% growth rate. Of course you have to figure out the cash flow and debt payments. But if you can cashflow the property, which is hard to do, and many locations, not as hard in other locations, but if you can cover the payments, cover the mortgage payment and other expenses, that’s a great deal. You can earn 50% of your money, maybe you break even otherwise. The next year, when you make $5,000, now it’s $5,000 gain compared to $15,000 of equity. That rate of return goes down and some people after a period of time, they think about, well, maybe I should sell cause I’ve got a lot of equity. I could buy more properties with that equity. That’s how growth accelerates with real estate. It’s also how you lose a lot of money quickly. When the market goes down, I have personally experienced both of those things when it’s going up, it’s super fun when it’s going down, it’s not a lot of fun either. Your equity evaporates really quickly with debt when properties are going down.
Joe: Thank you. Let’s say he paid cash for it at $100,000 but then he gets that 5% rate of return. Or now it’s worth $105,000. It’s a 5% rate of return versus a 50% rate of return. But it’s a double-edged sword. That’s why you need time. He’s young, he’s got time and does he have cash flow? It’s cash flowing. He’s already got the reserves for vacancies. He’s got the reserves for repairs. I mean, he’s a smart guy. He’s got his stuff together. And so if there’s a recession or if there’s a dip in the overall real estate market, can he continue to cashflow the property fine with the debt service? If it’s too tight, well then you pay that thing off and cash flow it and live happily ever after. It depends on risk tolerance. It depends on your goals. It depends on your other assets, so on and so forth. So we can’t really look at it in a bubble, but either answers, right. Depending on what you’re trying to accomplish. When you’re in the Facebook forums and they’re losing their minds, those guys are.
Al: Don’t go there. It’s not worth your sanity. I would summarize by saying, if your goal is to hold this property forever and your goal is cash flow, and this is a good property for cashflow, then your strategy of having it paid off by 47. If that’s when you want to retire, I’m all for that. I think that’s a great idea.
What’s the Tax on a House Inherited From My Uncle? (Michael, Escondido, CA)
Joe: Michael writes in from Escondido, California. “I live in California and I inherited a house in Florida as part of my uncle’s trust. I was wondering what my tax hit would be once I sell this inherited house. Also I plan to sell my house in California in about a year and a half or so when I retire. Will the look back requirements affect me when I sell my California home, which I reside in. If I get slaughtered.” Wow. That’s aggressive Michael. “slaughtered, maybe I can look into renting one of the houses. Thank you. And I look forward to clarity on this.”
Al: I assume he meant if I get slaughtered in taxes.
Joe: I hope so. You inherited a house. We can talk a little bit about this. I don’t know what uncle’s trust means. Was it a revocable, irrevocable trust?. Was it kind of a complex trust or I’m guessing Al that it is probably a standard revocable living trust. Michael was the beneficiary of the trust or one of the beneficiaries and he inherited this nice house in Florida. What happens at death is there’s a full step up in tax basis. In most cases, depending on the title of it, I’m assuming he probably got a full step up or maybe half step up, but let’s just assume a full step up. What does that mean? Uncle Larry bought it for $100,000. Uncle Larry dies and it’s worth $500,000 and Michael is the beneficiary of that home and he sells it. Michael’s new cost basis is $500,000. When he sells it, there will be no tax due or if he sells it a year later and now it’s worth $525,000 then there would be a taxable gain, only on the 25,000, not the cost basis of when uncle Larry purchased it.
Al: The only time that’s not true is if it was in a, like an AB trust a and so you have an irrevocable part. So that the basis in that particular case is the same as what it was at the time that was set up when the first spouse passed away. There are other types of irrevocable trust, as well. But usually Joe you’re right? Usually it’s a living trust. You get a full step up in tax basis. You sell it, you have very little tax to pay, virtually no tax to pay if you sell it within a short period of time.
Joe: If you sell your house here in Escondido, California, that’s your primary residence. So then you get the 121 tax exclusion on your primary. As long as you lived in the house, what 2 out of the last 5 years, If you’re single, you get to write off $250,000 of gain. And if you’re married, it’s a half a million, so $500,000. So let’s say you bought your house in Escondido for $500,000. It’s worth $1,000,000 today and you’re married and you’ve lived in that Escondido house 2 of the last 5 years and if you sell it, there would be no tax there either. So, I don’t know if he’s going to get slaughtered. I don’t think so.
Al: I don’t think so either. And in all likelihood, and if you sell that Escondida home for 1.2 million, then you’ve got a $700,000 gain. You take away the $500,000. You only pay tax on $200,000. So that’s how that rule works.
Joe: Hey, that’s it for us. Thank you, Andi. Welcome back from your vacation.
Andi: Thank you. And Al great to have you with us from Hawaii. I’m really glad that we were able to make this happen today.
Al: Yeah, very fun.
Joe: For a segment you just killed it, right out of the gate. That’s it for us. The show is called Your Money Your Wealth®.
Al’s wife Annie and more from Smitty from the Villages in the Derails at the end of the episode, so stick around if you’re a fan of the total nonsense side of YMYW.
Your Money, Your Wealth® is presented by Pure Financial Advisors. Sign up for your free financial assessment.
Pure Financial Advisors is a registered investment advisor. This show does not intend to provide personalized investment advice through this broadcast and does not represent that the securities or services discussed are suitable for any investor. Investors are advised not to rely on any information contained in the broadcast in the process of making a full and informed investment decision.
• Investment Advisory and Financial Planning Services are offered through Pure Financial Advisors, LLC, a Registered Investment Advisor.
• Pure Financial Advisors LLC does not offer tax or legal advice. Consult with your tax advisor or attorney regarding specific situations.
• Opinions expressed are not intended as investment advice or to predict future performance.
• Past performance does not guarantee future results.
• Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values.
• All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy.
• Intended for educational purposes only and are not intended as individualized advice or a guarantee that you will achieve a desired result. Before implementing any strategies discussed you should consult your tax and financial advisors.
CFP® – The CERTIFIED FINANCIAL PLANNER™ certification is by the Certified Financial Planner Board of Standards, Inc. To attain the right to use the CFP® designation, an individual must satisfactorily fulfill education, experience and ethics requirements as well as pass a comprehensive exam. Thirty hours of continuing education is required every two years to maintain the designation.
AIF® – Accredited Investment Fiduciary designation is administered by the Center for Fiduciary Studies fi360. To receive the AIF Designation, an individual must meet prerequisite criteria, complete a training program, and pass a comprehensive examination. Six hours of continuing education is required annually to maintain the designation.
CPA – Certified Public Accountant is a license set by the American Institute of Certified Public Accountants and administered by the National Association of State Boards of Accountancy. Eligibility to sit for the Uniform CPA Exam is determined by individual State Boards of Accountancy. Typically, the requirement is a U.S. bachelor’s degree which includes a minimum number of qualifying credit hours in accounting and business administration with an additional one-year study. All CPA candidates must pass the Uniform CPA Examination to qualify for a CPA certificate and license (i.e., permit to practice) to practice public accounting. CPAs are required to take continuing education courses to renew their license, and most states require CPAs to complete an ethics course during every renewal period.