The COVID-19 pandemic of 2020 has affected the United States and the world in profound ways.  In an attempt to inhibit the spread of the virus from increasing exponentially and overwhelming our hospital capacity and medical system and to save lives, the majority of states have shut down all but essential businesses and asked the majority of Americans to observe recommendations to shelter-in-place and self-isolate with their immediate families.

These measures undertaken voluntarily have led to the quickest and broadest decline in economic activity that we have experienced in the United States at least since the great depression of the early 1930s.  These broad efforts have curtailed employment in many industries including those related to travel, live events, and restaurants as well as many others.  As of the end of April 2020, a bit over 30 million people had filed for initial unemployment claims just in the 6 weeks prior.

In response to the predictably severe economic impact, the United States government has taken unparalleled steps to enact fiscal and monetary measures to mitigate some of the severe economic impacts of social distancing.  Most notably, Congress passed several major legislative initiatives, including the original $2 trillion CARES Act (Coronavirus Aid, Relief and Economic Security Act) signed on March 27, 2020, which has numerous provisions to immediately help many Americans and affected businesses. Subsequently, Congress added another $484 billion in additional support in the Paycheck Protection Program and Health Care Enhancement Act which was passed on April 24, 2020 bringing total support to nearly $3 trillion.

Here are some of the notable provisions of these laws and how they are designed to benefit individuals and businesses to get through this challenging time.

Help for Small Businesses

In the original CARES act, $350 billion was set aside to provide low interest forgivable loans to small businesses to prevent layoffs and business closures during the pandemic. Companies with 500 or fewer employees who maintained their payroll during the coronavirus outbreak were offered two year loans (called Paycheck Protection Program or PPP loans).  This initial allocation for small business support ran out quickly, so the Congress extended the pool of available funds on April 24, 2020.

Businesses using the funds within 8 weeks of the date the loans were funded to cover payroll and other approved categories of expenses and could then apply for partial or complete loan forgiveness of those amounts.

Enhanced Unemployment Benefits

To assist individuals laid off or furloughed by their employers, the Cares Act allocated $250 billion to cover extra unemployment insurance payments, the Act also expanded unemployment eligibility to independent contractors and freelancers, and offered an additional $600 per week to each person filing for unemployment for an extra four months, over and above what state programs would have normally provided in unemployment pay.

This provision provides extra cash flow to affected families though the ability of some states to handle a surging volume of unemployment applications has overwhelmed their administrative capabilities at least initially.

Benefits for Individuals with Retirement Accounts

Required minimum distributions on all qualified retirement accounts are now waived for 2020.  This means that if you are over the age of 72, you do not need to take your required minimum distribution from your retirement plan account this year - this allows you to skip one year of taxes and defer the withdrawal which helps to grow the tax-free compounding of your account for one year and prevents you from having to draw money out of your account when the market as been temporarily impacted by the coronavirus crisis (assuming you don’t need the money due to economic hardship this year).

In addition, the Cares Act contains special provisions for “coronavirus-related distributions”.  You qualify for a coronavirus related distribution if:

• If you, a spouse or dependent have been diagnosed with COVID-19 or
• If you have experienced adverse financial consequences as a result of being quarantined, furloughed, laid off or having work hours reduced due to COVID-19 or you have been affected by the closing of or reduced hours of a business owned or operated by the individual

Normally, individuals with retirement assets such as IRA accounts or 401k plan assets are subject to a penalty in addition to taxes due if they withdraw funds from these plans early (typically prior to age 59 ½).

In order to help families affected as outlined above who have retirement savings, the Cares Act included a provision to allow withdrawal up to $100,000 from their qualified retirement accounts, retroactive to Jan 1, 2020, without paying the 10% IRS penalty that would normally apply for early withdrawals.

Unless returned, withdrawals would still be taxed eventually, but that tax burden is allowed to be spread out over the next three years.  In addition, those taking advantage of this provision are also permitted to return the amount withdrawn from their plans within three years, in which case they could completely avoid having to pay the tax. 

If utilized, the withdrawal would be equivalent to an interest free loan to yourself as long as it was returned back into the account within three years.  In addition, the withdrawal could be taken from a 401(k) plan (if allowed) but then returned to your IRA plan effectively allowing a type of transfer for your workplace 401(k) plan to your own IRA.

If you have loans that you previously borrowed from your retirement plan, you may be able to stop making a payment on those loans for up to one year.  In addition, if your retirement plan - such as a 401k plan - allows loans then the maximum loan size has doubled (from $50,000 normally) to $100,000 until September 23, 2020.

Benefits for Student Loan Borrowers

There is good news if you have federal student loans outstanding. Payments and interest on federal student loans, including direct loans, Perkins loans and Federal Family Education Loans owned by the U.S. Department of Education, are automatically suspended from March 13 through Sept. 30, 2020. That means eligible borrowers do not have to make payments during this period.

Keep in mind, the CARES Act only applies to federal student loans. Other private student loans may still have to be paid back in a timely fashion unless the private lender makes some other direct offer of forbearance to the borrower.

Tax Deadline Extension

The IRS has delayed the tax-filing deadline for 2019 from April 15 to July 15.   This means that if you owe money, you don't need to file your tax return until this deadline and you don’t need to make payments until then.  This extension applies to all tax filers including individuals, businesses, trusts, estates and more.  Payments will not incur additional penalties or interest up to the new deadline.  Note that since the IRA contribution deadline is the tax deadline, the above extension means that the IRA contribution deadline has also been extended.

Many states have followed suit with an equivalent extension, but some have not, so you need to check your own state deadline as well.

For the Federal extension there is no need to file an extension request; the delay to July 15 is automatic.  However, you will still need to file an extension if you need additional time beyond the July 15 automatic extended filing date.

Net Operating Loss Carryback Provision for Businesses

Under the Cares Act, a net operating loss (“NOL”) that arises in a tax year beginning in 2018, 2019 or 2020 can be carried back for five years.  The Act also allows for NOLs arising before January 1, 2021 to fully offset income.

Also, the Act removes limits enacted in 2017 whereby NOLs were limited to 80% of taxable income and could not be carried back to reduce income in prior tax periods.  By allowing carryback of losses for up to five years, the Act allows corporate tax payers to benefit from NOL carrybacks to years when the corporate tax rate was as high at 35%.  This provision may also apply to pass through entities which pass losses through to their individual owners.

This is a relatively advanced provision of the Act and impacted tax payers may be able to file amended tax returns and receive income tax refunds on taxes previously paid as a result of this provision.  If this provision applies to you, consult your tax professional as it creates significant tax planning and deduction opportunities for eligible business owners including those with substantial real estate and capital equipment assets.

In our Part One article on passive income strategies, we discussed 7 Basic Strategies to Generate Passive Income In Retirement.  That discussion was the first of our two part series on retirement income strategies.

In that article, we talked about the importance of focus, understanding the main assets that generate passive income, and several more fundamental strategies upon which to build your retirement income foundation.

This week, we reveal eight additional advanced passive income strategies and options to further accelerate your retirement income goals. 

In this Part Two article in our passive retirement income series, we discuss each additional advanced passive income building strategy including  important details, the pros and cons associated with each option, and even when to consider using each strategy in your own portfolio.

Generating passive retirement income from your investments is critical to enjoying good financial health and is also central to making sure that your investments really work for you before and during your golden years. 

The reason that positioning yourself for passive income on your investments is so important is that as you approach retirement, you need to have created enough regular income coming in to comfortably cover your expenses and supplement your lifestyle when you are no longer getting earned income from employment.

Only with a good passive income generation strategy implemented within your portfolio can you really enjoy your retirement years with ample freedom and security.

Any passive income investment strategy, including all the strategies we cover in our two part series, must be able to handle and fund your expenses to withstand the challenges of:

• Inflation which is a steady and gradual increase in prices that tends to happen over time.  Remember how much milk and gasoline and rent used to cost thirty years ago?  These items are much more expensive today because of inflation.  Inflation obliterates the purchasing power of your savings and investments.  Because of inflation, if you have mostly fixed income streams such as bank accounts, CDs, or bonds, or even large amounts of cash you are not protected against rising costs which will gradually erode the value of your savings like a headwind that never goes away
• Increased health care expenses which are one of the most predictable expenses in retirement.  Health care costs in the US have tended to rise much faster than inflation and your retirement income strategy must be able to fund a portion of these rising expenses (at least those not covered by Medicare)
• Market volatility  which is the fact that markets and stock prices are volatile in the short-term, though they tend to rise in the long-term.  Passive Income from investments helps to buffer volatility and can help you ride out market dislocations.  You can wait for a recovery and even reinvest some of your cash flow into lower market prices while collecting your income.  As I write this article, the US is going through the Corona-virus disruptions that accelerated in March 2020 and are continuing into April.  Those with passive income are better positioned than those without

Without any further delay, let's dive right into our discussion of the eight advanced passive income strategies.

Advanced Strategy #1 - Consider Adding Convertible Bonds to Your Portfolio

Convertible bonds are a lesser known niche within investment markets.  Unlike regular bonds, which offer only a return of interest and principle, convertible bonds have a unique feature. 

Just like regular bonds, convertible bonds promise to pay you back with some interest and a return of your principal at maturity. 

However, unlike regular bonds, convertibles provide an option to convert each bond into a predetermined number of shares of the company that issues the convertible bond.

Because of this unique conversion option, convertible bonds are considered hybrid securities offering the “best of both worlds” i.e. income, downside protection, and upside participation.

The bond part gives the investor downside protection and income, while the option to convert into equity gives the investor the possibility of higher growth and higher average returns.  Each bond has its own conversion ratio (number of shares of common stock the bond can be converted into) and requires research and expertise to add to your portfolio.

Types of Convertible Bonds:

• Regular Convertible Bond - Investors have the choice to hold the bond until maturity or convert it to stock (typically at any time prior to maturity that they choose) so conversion is optional and not mandatory. If the stock price has decreased since the issue date, the investor can hold the bond until maturity and get paid the face value. If the stock price increases, the bond can be converted to stock, thereby getting more than the face value (sometimes much more).
• Mandatory Convertible Bond: Required to be converted by the investor at a specific conversion ratio and price level.  The investor typically collects a greater distribution yield under the mandatory conversion date.  When we speak of opportunities in convertible bonds, we are usually referring to regular convertible bonds

When to Use Convertible Bonds In Your Portfolio
Convertible bonds are great for investors who want to generate income in retirement and enjoy more downside protection than investing directly in the stock market.  When the stock market rises, convertible bonds will not typically rise as much, but they also offer more downside protection (if they are not trading well above par at the time of purchase).

Advanced Strategy #2 - Add Dividend Growth Stocks Into Your Portfolio

Not all stocks pay dividends, but many do.  Dividends are simply the cash a company chooses to pay out to its shareholders.   Many companies pay dividends from a share of the after-tax profits that the company is generating. Dividends are generally declared and distributed to shareholders on a regular basis (usually quarterly, but sometimes monthly).  Some growing companies pay dividends and others do not.

Most companies that pay dividends are usually well established, with a profitable business and a regular history of profits so the fact that they are paying a dividend at all can be a positive signal of the quality of the business and their capital allocation policies.

Within the area of all dividend paying stocks,  companies that have average or even below average current dividend yields, but are expected to grow their dividends consistently and at an attractive rate for many years to come are called dividend growth companies. 

Dividend growth companies can be good for earning higher income and greater total returns for long-term investors.  At Ridgewood Investments, we have an entire team dedicated to finding great dividend growth investing opportunities.

To implement our dividend growth strategy, we look for well established, profitable, secure and well-run companies that pay a dividend yield currently averaging around 3%, with positive annual dividend growth.  The steady growth of the dividends helps to increase total returns and provides some long-term downside protection.

When to Use Dividend Growth Stocks
Dividend Growth Stocks are great for investors who want to generate growing streams of portfolio income and have a long-term time horizon to let the compounded effect of dividend growth companies work to really produce dividends (pun intended ).

Advanced Strategy #3 - Invest in Private Debt and Private Lending Opportunities

Private money lending involves lending money on negotiated terms to borrowers including real estate rehabbers and/or businesses.  Typically the loans are made at interest rates between 6% and 15% often secured by valuable assets such as real estate. 

Most private debt and lending opportunities have maturities from six months to three years though some can be longer.

One of main areas of opportunity within private debt are so-called “hard money” loans.  They are generally short-term loans (most commonly 12 to 18 months) made to real estate investors, operators or developers who intend to buy property below fair market value with a plan to improve and sell the property within a defined period of time.

The reason that private lending opportunities at such attractive income rates exist is that the borrower typically needs to move quickly to take advantage of an attractive real estate investment or rehab opportunity.  In these cases, banks usually cannot move quick enough to meet their needs and the opportunity has enough profitability to make sense for them despite the extra costs so they turn to private lenders at higher rates instead.

Most people work continuously to earn income. Some even live paycheck to paycheck which causes stress and leaves no margin of error in case of an unexpected disruption to their employment or paycheck (like a recession or other economic disruption).

Of course, after a lifetime of working hard, the majority of people also hope to enjoy some time in their retirement “golden years” to travel and have time to enjoy life.  The key to being able to enjoy freedom and comfort in retirement is to have a strategy to develop passive streams of income and then implement this strategy intelligently.

Unlike many working people, the wealthy tend to have created multiple streams of income. Indeed, many of them eventually have the ability to live very comfortably on just their passive income alone.  According to some sources, sixty-five percent of multi-millionaires have at least three income streams and about one-third of them have five or more income streams, some of which are passive. 

As billionaire investor Warren Buffett quipped, “If you don't find a way to make money while you sleep, you will work until you die”. This quote sums up a key attribute of passive income: You don’t have to labor to receive it. Indeed, you can make it even while you sleep. 

Generating passive income is an opportunity available to everyone if you are focused on the goal and know how to intelligently go about it.  Even by starting small and regularly adding to your assets with investments that produce passive income streams you can eventually accumulate a very significant passive income stream for your own golden years.

The key to successfully creating passive income is to have a solid plan, have savings to work with, and to intelligently pick up the right investments especially when they are available at bargain prices. 

Read on below as we reveal some key strategies and insights on adding passive income to your own portfolio.

Strategy #1: Focus on Assets that Generate Income

In order to begin the process toward creating passive income, you will need to accumulate some assets whose specific purpose is to generate income. Just as a seedling grows into a large tree by routine watering and fertilizing, you need to look for and routinely add to your portfolio of passive-income producing assets.

Once you have one or more passive income streams, you can accumulate even more income generating assets by reinvesting the income you produce from those you already own.  Of course, while you are working and saving, making the effort to add additional money from your periodic employment or business income on a regular basis, such as monthly or quarterly, can significantly accelerate your progress towards a nice retirement income stream that you don’t have to work for in your later years.

Over time, with the infusion of new cash and reinvestment of ongoing income, you will find that the total income produced by your passive investment assets keeps going up. At some point, especially if you generate income from two or three different streams, your passive income may enable you to partially defray or even fully cover your living costs. This may be particularly important when you get closer to or ready to retire.

Strategy #2 - Understand the Main Assets That Generate Passive Income

Some of the main assets that generate passive income are businesses (e.g. privately owned or public stocks), loans (for the lender) and income real estate (for the owners). The passive income generated from owning stocks includes the profits of the firm, often reinvested back into funding the firm’s growth, and and the dividends they distribute, which are usually derived from the businesses cash flow from profits.

Lenders who loan money usually receive their passive income in the form of interest payments made by the borrower who borrows the money.  The borrower also has to repay the original amount that they borrowed either over time (amortization) or at the end of the loan term (balloon payment).  Loans can be secured by assets (such as real property) or can be unsecured.  Bonds are just loans that are traded in markets.

The passive income received from real estate is called rent.  After expenses for property taxes, maintenance, management, and mortgages, the remainder can be distributed to the owners as their share of the profits.  Of course, buying real estate on a very small scale tends to be challenging to manage and often produces limited passive income streams.  Because of the work involved in managing single properties, this approach is hardly passive at all.  However, owning high quality income producing commercial real estate on a large scale can generate worthwhile streams of passive income as well.

Strategy #3 - Collect Stocks That Generate Profits and Dividends

Stocks represent ownership in a business. Businesses exist to provide something of value, usually goods or services, to the public and to earn a profit for their shareholders. Stocks, then, represent the way ordinary folks participate in the profitability of companies. Holders of stocks, called investors, buy them to earn a reasonable return because they can participate in the future profits and cash flows of the underlying business.

Let’s take AT&T as an example. Note that this is just an example and not necessarily indicative of a company that we would actually add to any particular client’s holdings.  We just chose this company as an example because it is large and known by many investors. AT&T is in the telecommunications arena. That means they provide the ability for people to speak and interact with one another using mobile phones, computers and other devices. Shareholders of AT&T participate in the profitability of this business and collect a generous dividend payment every quarter. Currently AT&T pays a dividend yield of 5.5%, not a bad passive return to receive while you sleep.  There are many other companies that pay dividends and some even pay monthly.

Over the long term, stocks have averaged an annual return of 8 to 10% per year.  Around 2 to 3% of this return is in the form of dividends that they have paid out over time.  Many successful long-term investors hold their stocks for years, without frequent buying or selling. Although the prices of their stocks fluctuate, their profits and dividends received and overall portfolio go up in value over the long term if they have been careful about buying the right stocks in promising companies and holding on to them while collecting their growing income streams.

Strategy #4 Invest in Real Estate For Income from Rents

Monthly rental collection from real estate forms a wonderful stream of passive income for many investors. Real estate is property generally consisting of land and buildings. The term derives from the fact that this kind of property is physical, immovable and tangible, i.e. “real”.

Homes, apartment buildings, agricultural acreage, timberland and other types of real estate can be lucrative investments for passive income generation. Everyone needs a place to live but not all people own a home. Those who do not own their dwelling place generally live in rental property. They pay a monthly rent to the landlord.

At Ridgewood Investments, unlike many advisors, we have substantial in-house experience in identifying and assisting those clients who want to own passive income commercial real estate as a portion of their portfolio to do so intelligently and securely and in a way that can throw off a stream of growing passive income for years in the future.

Strategy #5 Access Interest Income from Loans and Bonds

Lending money is another way to generate passive income.  Most loans require borrowers to pay interest back to the lender each month which can give the lender a nice and reliable stream of passive income.  Loans can be short-term or even very long term.

Of course, loans are only as good as the borrower’s ability to pay them back with interest.  This is why the better more secure loans usually have collateral, i.e. an asset of some substantial value (often real estate but could also be other assets) that back up the promise of the borrower to repay the lender.  If a loan has collateral, for example a valuable piece of real estate, and the lender legally secures that loan in the proper ways by establishing and filing their interest over the collateral, then if the borrower does not pay, the lender is said to have recourse by taking the underlying asset.

Banks and private lenders, including Ridgewood Investments, have expertise in finding and creating opportunities for our clients to generate passive income through secured loans that we find for our clients.  Participating in private loans like these can return high income streams from interest (often in the range of 4 to 8%) per year. 

However, bonds that are traded in the fixed income markets, such as treasury bonds, municipal bonds, corporate bonds, mortgage back bonds, and asset backed bonds are all just different categories of loans that investors can also tap into for passive income.

In today’s very low interest world, however, public bonds offer lower yields, currently in the 1% to 3% range, so using them in the right proportion can be supplemented by private loans that generate higher returns if you know where to look and how to add them to the portfolio.

Strategy #6 Optimize Passive Income from Social Security

For most working families, their social security benefit which they accrue by working and contributing into the social security system for at least 10 years (40 quarters) is another valuable source of passive income.  Social security is a very valuable benefit because it is a life-annuity provided by the Social Security Administration with many other bells and whistles.  It is income “insurance” so those who pay in are the ones who later get a benefit.

If you are someone who has paid into the social security system, you used to receive estimated benefits statements in the mail annually.  In 2017, however, the Social Security Administration announced that it would stop mailing paper benefit statements to most eligible participants.  However, the social administration website has a Retirement Estimator that anyone can use to estimate the monthly benefits they would be projected to receive starting at age 62 (early) as well as at 67 (standard) and 70 (deferred).  Remember also that many couples have two individuals who work, both of whom may be entitled to their own individual benefit which should also be compared to the spousal benefit that they may be entitled to receive under their spouse’s benefit.

One of the keys to maximizing the value of passive income from the social security benefit you receive is to determine when to begin taking the social security benefit in the first place.  This determination is more involved than it may appear at first glance and doing it incorrectly can cause thousands in lost income.  Many inexperienced participants try to defer their benefit to 70 because the monthly income will eventually be higher, not properly considering the lost income in the first 3 to 8 years.

An experienced advisor like Ridgewood Investments can assist you to maximize the value of this passive income source as part of a solid financial plan.

Strategy #7 Start As Early As Possible with A Sound Plan to Maximize Long-term Passive Income Opportunities

As the saying goes, “Rome Wasn’t Built In A Day” and neither are the best portfolios of passive income streams built overnight.  The power of working towards passive income regularly and over a period of years cannot be overstated due to the power of steady compounding.

The key to having a good plan is education on the various alternatives and how they all fit together.  Most people are very busy and lack the expertise to make all the decisions needed to find and assemble all the passive income opportunities together in a way that will serve them and their goals. 

One of the benefits to having a plan is that it also helps you avoid many common mistakes that can get you sidetracked from achieving your income goals as efficiently as possible.

Most high income professionals and business owners get hit with significant income tax bills each year. Of course professionals in this category such as many physicians, law firm partners, engineers, consultants and business founders or high level business executives are the fortunate minority to be in such a high income category in the first place.  Still no one likes to pay more taxes than necessary.

What amount of income does it take to be in this high income category?  If you make an annual income of $300,000 or more (even into the millions) per year - then read on below as we explain how setting up and using an advanced retirement planning option called a defined benefit plan (also known as a defined benefit pension plan or sometimes called a cash balance plan) could save you hundreds of thousands per year in your annual income tax bill as well as give you an opportunity to vastly accelerate your savings for retirement.

In addition, if invested well, a defined benefit pension plan can also give you the additional benefit of tax-deferred growth of your contributions to such an extent that your defined benefit or DB plan could result in millions of dollars in additional savings and earnings that can then be used to fund a substantial income distribution for you in your retirement years.

Introduction to Defined-Benefit Plans

Why does the government allow businesses to set up defined benefit plans with such powerful benefits for business owners and their high income partners?  One of the reasons is that government policy recognizes that it is preferable to have individuals incentivized to be prepared for their own retirement years rather than being dependent on the public welfare. 

Since high income business owners and partners typically have higher earnings and expenses in their earning years, tax policy recognizes that they might need tools to save higher amounts from their incomes to create the replacement income they will need to sustain into their retirement years as well.

Of course retirement plan non-discrimination rules also require some of the benefits to be shared with other less highly paid employees as well.  However in the right situations, the defined benefit plan option can be very beneficial for the key high income employees and owners of a closely held business.

Defined Benefit Plan Set Up

Each defined benefit plan (just like all other retirement plans including 401(k) plans) is a legal entity distinct from the business that sets it up and is also separate from the individual participants in the plan.  A new retirement plan like a defined benefit plan is set up via a plan document that outlines the terms and provisions of that plan.  Since plan documents involve some complexity, most plans are drafted by experienced advisors like a third party administrator working with an experienced CPA and/or financial advisor to the employer.  A plan trustee (typically someone affiliated with the employer) then “adopts” the plan document thereby creating the new plan. 

Defined Benefit Plans Are Separate and Protected Assets

In 1974, the US Congress passed a law called the Employee Retirement Income Security Act (ERISA) for short.  ERISA outlines a variety of rules, regulations and protections that protect retirement and pension assets such as Defined Benefit Plans. 

As a separate entity, the new retirement plan usually has its own tax identification number and its assets and liabilities are distinct from those of the business that it is affiliated with such that any funds held in the retirement plan cannot be commingled with or used for the assets or liabilities of the business. 

What this means is that even if the business later fails or has debts to its creditors, the assets in the retirement plan that were set aside for the retirees should still be untouched and available to provide them the retirement income from their assets.  As an additional line of defense, a quasi- government agency called the Pension Benefit Guaranty Corporation or PBGC for short assesses insurance premiums on all such pension plans and steps in to provide a safety net for the small number of covered pension plans that end up getting into trouble usually because of mismanagement or underfunding of the plan.  This means that DB plans are relatively safe places to have funds invested for you.

One major additional benefit of DB plans as a result of ERISA is that plan assets in retirement plans are typically protected not only from the employer’s creditors, but also from the individual employee’s creditors as well.  So in addition to all the above benefits of defined benefit plans, high income individuals especially those in fields that have professional liability exposure can also benefit from setting up a DB plan to enjoy asset protection benefits protecting any assets placed into their defined benefit plans.

Defined Benefit Plans vs 401(k) Plans

Though both are types of retirement plans, Defined Benefit (DB) Plans are different from Defined Contribution (DC) Plans like 401(k) and 403(b) plans.  The differences stem from how these plans work and how their benefits are calculated as well as the maximum contributions allowed.

Unfortunately, many business owners and high income professional firms and their CPAs are more aware of SEP IRAs and solo or traditional 401(k) plans than they are about how and when to properly set up and use a DB plan structure. Although 401(k) type retirement plans are also good tools for retirement savings, they have lower annual deductible contribution limits than defined benefit plans.

The main difference is that in a defined contribution (DC) plan such as a 401(k) plan each employee gets to decide how much they want to save for their own retirement (if any). This is most commonly done by choosing to save a certain percentage of their salary.   The main burden is therefore on each employee to save for their own retirement. Those employees who contribute more eventually get the greater income benefit, those who don’t will not get much if any benefit in retirement.

Also, with defined contribution and 401(k) plans there is a lower maximum limit to the employee contributions.  Though it increases every few years to account for inflation, in 2020, the employee contribution to a 401(k) plan is a maximum of $19,500 from salary deferrals - though someone who is 50 or older can contribute an additional “catch-up” contribution amount of $6,500 in 2020.  In addition to the employee contribution, the employer can also contribute either a “matching” contribution or a profit sharing contribution, but the total maximum contribution into a 401(k) profit sharing plan in 2020 is $57,000 for those under 50 and $63,500 for anyone 50 or over.  Note that this employer contribution portion is optional and varies company by company depending on how they decided to set up their retirement plan benefit in the first place.

In contrast to the 401(k) Defined Contribution plans, however, in a Defined Benefit Plan, the contribution amounts and tax savings can be much larger for the owners and key employees.  The reason is that it is the benefit or stream of retirement income promised to the beneficiaries at retirement age (not the contribution) that is used to determine how much needs to be contributed to fund a DB plan.

To calculate contributions to a DB plan, an actuary analyzes the employee “census”, i.e. the list of the employees, their age, their salaries and hire dates.  Based on this information and the retirement income formula that the plan is promising to provide for the employees after they reach retirement age, the employer then makes tax-deductible contributions to the plan that will be sufficient (along with future projected investment returns on plan assets) to fully fund and pay the benefit promised to participants.

If this sounds familiar, it should.  Defined Benefit plans are not new.  In fact, they are much older than 401(k) and other DC plans.   They are, in essence, just a version of the traditional pension plans larger companies like General Motors and Verizon and various unions, and government employers used to set up for their employees and sometimes still do.

However, as the costs of contributions to traditional pension plans continued to increase and many plans became underfunded, many large companies decided to cut off their DB pension plan benefits and shifted the responsibility and liability onto their employees by setting up 401(k) plans instead.

For smaller but highly profitable firms, however, if the plan is properly designed and administered, the benefits to the partners can far outweigh the costs of providing the benefit to other qualified employees.

If the total number of non-highly compensated or non-owner employees and their relative compensation is manageable relative to the owners and professionals, then DB plans can work particularly well.  Age also matters in this analysis - if the non-key employees (on average) are young relative to the partners the math on these plans tends to work well.  One of the best scenarios is for “top-heavy” companies with a handful of highly compensated owners/executives and few or no other supporting employees (or much younger ones).

Another key difference between 401(k) plans and defined benefit plans is how and by whom the plan assets are to be invested.  In a 401(k) plan the employer or their plan provider sets up a limited menu of investment options (typically a handful of diversified mutual funds) to choose from in the plan. Each employee then decides how they individually want to invest their own portion of the plan (based on their own contributions as discussed above).  Each employee therefore has their own “account” within the 401(k) plan that they can view and invest using the limited options provided by the plan sponsor.  If their account is conservatively or badly invested the responsibility is largely on them.

In contrast, in a defined benefit plan it is the responsibility of the employer to manage the assets of the plan such that the plan can meet its obligations to provide the benefit streams promised to employees.  If the plan is overfunded, the employer benefits from the excess surplus and if it is underfunded the employer is responsible to contribute more to make up for the shortfall.  In choosing investments, the DB plan has far more options and can invest in all public and some private investments as well which means thousands of stocks, funds, and even bonds are eligible investments.  Most DB plans have advisors or experienced individuals managing the plan assets who know how to navigate the myriad of investment options available.

The first step in figuring out what type of retirement plan would be most beneficial to your own company, is to gather a current employee census (Ridgewood Investments has a free employee census template we can provide upon request).  Based on an analysis of the census, an experienced advisor can help you to determine if you are a good candidate for a DB plan or a DC plan or both.

Note that many DB plans are set up side by side with a 401(k) component because this type of plan (often called a cross-tested plan) can create the greatest benefits and flexibility for all concerned.

Clearly, defined-benefit and cash balance retirement plans can be extremely powerful tools. They allow for large, sometimes enormous tax-deductible contributions that are able to produce tax-deferred growth and the assets can also eventually be rolled over into an individual's IRA account upon retirement.

If the high income business owner has no or very few employees, the owner can deposit the entire amount to fund his or her own retirement. Even with employees, the percentage of contributions allocated to the owner(s) can be as high as 80% to 90% of the total contributed (all tax deductible) to the business.

 Some of the types of small businesses that are good candidates for a defined-benefit plan include medical and dental practices, legal firms, engineering and consulting businesses and some online or niche entrepreneurial firms.

How To Set Up A Defined Benefit Plan For A Business

Setting up a defined-benefit plan for a small business is more involved than opening up a personal IRA or contributing to a 401K.  But, because of their powerful advantages for high income professionals and owners the cost and complexity can be well worth the effort.

Here are the steps involved:

An Amazing Case Study On The Power of Defined Benefit Plans

As an example, a few years ago a business owner and his spouse were able to deduct nearly $900,000 in a single year all on a tax-deferred basis using a newly established defined benefit plan.

This individual was in his early 60’s and about 5 years away from his anticipated retirement, and was having his most profitable business year ever, with several million dollars in income. He expected his business to continue to be profitable even over the next 5 years. In addition, he had no employees except for his spouse. His potential tax liability on his income that year was projected to be quite large. 

He wanted to significantly reduce his taxes while at the same time accumulate wealth for his own retirement. Also, he wanted to construct an annual contribution plan that was linked to the profitability of his business. He wanted to front-load his defined-benefit contributions into the current year, given his high current profitability, and then make lower contributions in future years until his plan was fully funded.

Because he was in his 60’s, and relatively close to retirement, he was allowed under the rules to make higher tax-deferred retirement contributions to a defined-benefit plan than a younger business owner would have. Indeed, he was able to make the maximum allowed contribution of over $409,000. In addition, he was able to “double-up” on a household basis, and direct a contribution for his spouse as well. Because of her age and compensation from the business, her contribution was almost as large as his, nearly $397,000. Finally, he added a 401K for each of them and was able to stash away an additional $50,000 tax-deferred.

While the size of his contributions are not typical, it is not uncommon for owners to be able to save between $100K to $300k each year for many years depending on their age and income when they start a defined benefit plan.  Note that this allows owners to contribute for more than a corresponding 401(k) or SEP IRA would have allowed.

What Happens at Retirement - Choosing Between A Lump Sum Distribution Versus An Annuity

At retirement age and/or after the plan has been fully funded and terminated by the sponsor each plan participant in a defined benefit pension plan has the option to take their benefit as either an annuity or as a lump sum rollover into their own individual retirement account or IRA.

Since defined benefit plans (similar to most large company pensions) are set up to provide an income stream to covered employees in retirement, participants eventually have the option to start taking a monthly distribution (also known as an annuity).  These distributions are typically taxable in the year taken and can be used along with social security benefits to supplement and pay for living expenses into and through their retirement years.  Annuities come in multiple forms - some continue until death of the initial participant while others continue longer but result in a lower amount of distributions.

In most cases, participants also have a second option to take their share of the plan assets in a single “lump sum” payment.  In order to avoid immediate taxation of the entire amount, this lump sum is typically rolled over into a traditional or rollover IRA set up to receive these assets from the defined benefit pension plan without triggering taxes.

In order to determine whether you would be better off taking a lump sum or an annuity from your pension plan it is necessary to compare the monthly amount you would get from the plan to the amount you would get if you opted for a lump sum and how much income you would be likely to get if you invested this lump sum through your own IRA.

This analysis can be complicated so an experienced investment advisor like Ridgewood Investments can really help you analyze the options and even guide you to properly invest the lump sum to maximize your benefits and income distributions over time.  Another benefit of the lump sum is that it might also enable you to provide additional assets left over for bequests to inheritors if you so desire.

Many people dream of becoming wealthy.  For most this might mean having a net worth in the millions or perhaps even in the tens of millions someday.

In the history of humanity, however, very few have successfully achieved wealth so vast that they are billionaires. 

In modern times, the first US dollar billionaire was probably John D. Rockefeller who in 1916 was thought to have a net worth of $1.4 billion (this is back when the average American earned only $3,300 per year) so his wealth in equivalent terms today would be closer to $33 billion adjusted for inflation.  Rockefeller was so wealthy that even today, six generations later, some of his descendants retain billionaire status based largely on his success.

Going even further back, to ancient Roman times, there is speculation that Marcus Crassus, a member of the first triumvirate (along with Julius Caesar and Pompey) was “the richest man in Rome” who would have been a billionaire in dollar equivalent terms based on his vast real estate and other holdings - though of course this was far before the industrial revolution and the creation of the US dollar.

We all know it is not easy to go from a regular person to becoming a billionaire.  However, not only is it possible, but today we are going to share with you the incredible but true story of someone who went from being an almost-unknown Midwesterner to a billionaire himself.

His name is Mr. Stewart Horeji (pronounced hor-ish). Read on below for his story and how he created such wealth in a single lifetime. 

We share his story because it is interesting and also because his experience provides many powerful and valuable lessons that the rest of us can apply to building personal wealth for ourselves and our families at any scale.

While our own goals may not be to become billionaires, in our own way, we can learn from and apply these lessons to enjoy much more investment and financial success if we understand the investment ideas and principles that made Stuart a billionaire from this one great investment.

Who Is Stewart Horeji?

Stewart Horeji is an unassuming man with an estimated  net worth of approximately $2,000,000,000. That ranked him at number 1277 on the Forbes 2019 list of billionaires. 

Stewart graduated from the University of Kansas in 1962, after which he returned to his hometown of Salina, Kansas to work in the family welding-supply company. By 1980, Stuart was running the family business which was running into challenges on multiple fronts.  Competitors were eating away at his profits and even the survival of the family business itself was in question.

With finances on his mind, he read a book entitled The Money Masters, by author John Train. This book summarized the habits and tactics of some of the world’s most successful investors, people such as John Templeton, Benjamin Graham and Warren Buffet. Inspired by this book, he decided to take action.

Stuart bought 40 shares of Berkshire Hathaway stock, a holding company managed by Warren Buffet, for $265 per share. Within a few months time he added a bit more to his holdings and had by then purchased a total of 300 shares. Little did he know that from this modest beginning his life and his net worth would, in time, be transformed completely.

As the years went by, he continued to invest some of his income from the family business in Warren Buffet’s company.  At his peak, he owned 5,800 Berkshire shares.

Today, each of these share of Berkshire Hathaway Class A stock (BRK.A) is worth $353,000. By investing in just this one stock (and crucially holding on with a long-term view) he became a billionaire.

Characteristics Of Berkshire Hathaway

Berkshire Hathaway is a holding company that invests in wholly owned business and stocks that the CEO, Warren Buffet, and his partner Charlie Munger believes are great businesses that he can acquire at fair prices.

While they prefer to buy entire business because of the ability to control their management and cash flows, Berkshire also purchases many public securities when whole businesses meeting their criteria are not available.

As a result of their philosophy on capital allocation, ownership in Berkshire represents ownership in a variety of private wholly owned businesses such as insurance, electricity generation, and railroads and minority interests in a variety of well known companies like Coca-Cola, Apple, Bank of America, GEICO, Southwest Airlines and American Express.

Crucially, Berkshire used the “float” generated by well run insurance companies he acquired to leverage his investment returns using low or no-cost money from the premiums paid by policyholders of his sprawling insurance operations.

As a result, Berkshire provided stellar returns for its long-term shareholders like Stewart Horejsi. Its average annual growth of 19.0% since 1965 is vastly superior to the 9.7% annual return from the S&P500 basket of stocks over a similar time period.  Remember that even a small increase in the compounding rate leads to a large difference in the end result over time.

Other billionaires who derived their wealth mainly from Berkshire Hathaway include Charles Munger, David Gottesman, Albert Ueltschi and Harold Alfond. The last two are also little known names, just like Stuart.

Today Berkshire Hathaway is a very large company with a market capitalization of around $550 Billion.  Given its size it may be unlikely to grow at the rates that earlier investors like Stuart enjoyed. 

However, the ability to invest in Berkshire when Stuart did was available to everyone since Berkshire has been a publicly traded company for many decades. 

Back then, Buffett and Berkshire were not as visible as they are today.

Though the same opportunity was available to just about every American, how many people actually took advantage of this incredible opportunity?

As Stewart’s example, illustrates, the right investments can create tremendous leverage in our lives and our results. 

Today, Berkshire is not going to repeat its past success and rates of growth.

Lessons From Stewart Horejsi’s Path to Investment Success and Billionaire Status

Embedded in Stewart’s example are a number of powerful lessons that all of us can learn from and use to increase our investment returns and enjoy far more success.  Let’s look at some of the most important investment lessons from Stewart Horejsi’s example summarized below:

Ever since I can remember, I have been interested in business and investing.  Part of this interest may be cultural, as I hail from an area in India called Gujarat where the culture encourages business ownership and entrepreneurship.

Since my parents emigrated to the United States when I was 5 years old, I wanted to make an impact in my adopted country.  Even back then, when we lived in a small apartment, I remember having the desire to pursue success in business and investments.  So I started working on getting good at this - initially purely to help myself achieve my goals.

Starting in high school (I attended St. Peter’s Preparatory School in Jersey City), I was often reading and preparing myself for future investment success by collecting books and articles on successful people like Warren Buffett.   I realized that studying and modeling others who were good at the things that I wanted to become exceptional at was one of the surest ways to achieve my goals.

In today’s complex world, many jobs can seem difficult to understand.  I am convinced that for many years, my own mother, who is also a happy client, did not really understand what investment and financial advisors do for a living. 

If you have ever wondered what investment advisors, wealth managers and financial advisors do for our clients and how our work “works”, read on below for detailed insights on our profession and the tools we use to help our clients succeed and avoid costly mistakes.  We will also share tips on what to look for in a good advisor, and how to tell apart the real experts from the many pretenders who you should avoid at all costs.

Why Even Smart People Can Benefit from Good Objective Advice

In early 2019, we redesigned our website to simplify our message so that it was easier for Ridgewood Investments visitors to immediately understand what we do as a fee-only investment and financial advisor based in New Jersey and California. 

Our prior website had a reference to Isaac Newton along with his picture right on the home page entitled “Even Geniuses Need Help”.  (If you are curious, you can see this for yourself on the Wayback Machine which archives old websites by going to the old Ridgewood Website)

The reason we highlighted Sir Isaac Newton is that he is very aptly considered one of the smartest men who ever lived with an estimated IQ of around 190.  His accomplishments in Physics and as an inventor of Calculus are staggering.  He was, apparently, also a successful investor for much of his life.  Nevertheless, as is well known, he invested and lost a fortune in 1720 at the advanced age of approximately 78 in a speculative bubble known as the South Sea Company when it collapsed and wiped out his £20,000 investment (approximately equivalent to around $4.5 million in 2020).

So how could such a smart and capable person make such a costly error?  After this experience, he is quoted as having said “I can calculate the motions of heavenly bodies, but not the madness of men.”

Newton was gripped by a speculative mania in the South Sea Company that ruined thousands of others and had ripples throughout the economy when it collapsed.  Bubbles are not a thing of the distant past, in recent memory we have lived through a tech bubble and a real estate bubble just within the last few decades.

Robert Greene in his talk on “The Laws of Human Nature” in Talks at Google, reviews the above anecdote about Newton and explains in detail that Newton like all human beings was subject to subconscious and emotional forces hard-wired into primitive parts of our brains (like the limbic system) that are far more powerful than the logical capabilities of more recently evolved brain structures such as the neocortex.

At the most basic level, investment and financial advisors can add tremendous value by our ability to guide clients to avoid pitfalls and more consistently stay rational in their investment and financial decisions.

As Newton’s example illustrates, it is very difficult to become (and stay) objective and rational (especially about yourself and your personal situation).  This is especially true whenever stress or anxiety (emotional responses) are triggered by the environment.

Most people could really benefit with the help of an experienced, rational, and objective advisor to help them make better decisions and avoid blunders.

At the most elementary level, before even getting into the details of the exact investments we make and the specifics of the tools and models we can bring to bear, a great financial advisor can add tremendous value by helping clients avoid costly mistakes of both omission and commission. 

Along with this value, a caring and compassionate advisor can also help clients feel happier and more secure because they know they have someone in their corner who is watching out for them and keeping them safe now and in the future.

Financial Advisor Pretenders

Unfortunately, sometimes people pose as competent advisors, but really aren’t even real advisors at all - sometimes they call themselves advisors but are just glorified product peddlers.

Sadly, financial advisor scams are nothing new.  It can be difficult for many people to distinguish between experts who can add tremendous value and dishonest individuals who are in it for their own short-term gains.

Misrepresentation of credentials or capabilities is a typical way in which unscrupulous people and their firms mislead the unsuspecting investing public. Indeed, in the middle of the last decade, the CFP Board produced an amusing advertisement to highlight the problem of unscrupulous financial pretenders that brandish false credentials.

In this ad, a dreadlocked disk-jockey masquerades as a clean-shaven financial expert. Despite the fact that he has absolutely no training in investing or finance, he convinces many of his prospective clients to trust him.  Of course, this is an advertisement so at the end of the ad, the “truth” is revealed to the surprise and chagrin of the unwitting victims of this staged charade.

The Core Job of a Financial Advisor

So, what does a competent financial advisor do?  Our primary responsibility is to assist clients in making sound investing and financial decisions.

The best advisors start with a detailed understanding of your financial goals and personal situation. They help co-create a plan that fits your situation, take concerns into account, outline the steps that need to be taken and the most efficient ways to work towards achieving those goals.

After outlining the right plan, a good advisor will work on your behalf to execute the plan and check on its progress over time.

Of course, a great advisor is skilled especially with a strong foundation in investments and has the expertise, knowledge and tools to help your portfolio grow and build wealth for you over the long term.

However, most good advisors will also have the ability to advise you more broadly with other tax and estate planning questions, liability management, heath expense funding, investing inheritance windfalls, and retirement income generation, to name just a few sources of valuable advice.

Advisors Help You Make Fewer Financial Mistakes

Perhaps one of the key areas in which a good investment advisor or wealth advisor can assist you is in the avoidance of devastating financial mistakes.

Numerous studies have shown that the average person’s mind is wired to make errors in judgement when operating in the financial marketplace. This is because our brains evolved over millions of years but the modern world is very recent and presents different challenges than we are ill adapted to through evolution to handle.  As discussed above, our thoughts and emotions, particularly those of fear and greed, and fight or flight can cause us to do foolish things.

• Some of the common mistakes that many investors make include:
• Waiting too long to start investing
• Holding too much cash not earning anything
• Believing you always have to beat the market to be successful
• Not investing enough when you have sufficient resources
• Buying (and selling) based on emotion.
• Buying when everyone else is excited
• Selling when everyone else is scared
• Excessive trading
• Not basing investments on long-term outcomes and losing patience
• Buying confusing and high-fee commission products like annuities
• Failing to do their own thinking and homework and investing in things they don’t fully understand
• Forgetting to look for value and acting decisively when it presents itself
• Failing to pay sufficient attention to liquidity
• Confusing the difference between good debt and bad debt
• Failing to think as much about risk as they do on reward

By partnering with a trusted and competent advisor, many of these mistakes will be minimized if not eliminated. This is not to say that your investments will always go up in value every month or every year; that’s not the way the markets work and is not realistic. However, a great advisor can add far more in value to you than their fees to cover the cost for their services.

By crafting a long-term plan that fits your objectives and takes risk-mitigation into consideration, and by basing the majority of decisions on logic rather than emotion, a great financial advisor like Ridgewood Investments can help you minimize mistakes and be much more successful over the long haul than you would be on your own.

Tools Used By Financial Advisors

Another benefit of working with a financial advisor is the tools they bring to help you accelerate your financial success. As you may know, sound investing can require hard work and sustained effort as well as an understanding of market history and reliance on sound frameworks like diversification, margin of safety, compounding, asset allocation, reversal to the mean and others.

Skilled investment and financial advisors spend tens of thousands of dollars for access to research and financial planning tools that they can use to optimize your portfolio and your financial plan. Besides the direct cost of these tools, the training needed to use them successfully is also quite costly.  Most advisors provide these benefits to their clients as part of their standard fee.

Experience and Education: Core Components of a Good Advisor

When shopping for an excellent financial advisor, make sure you take the time to review their education, experience, credentials and core competencies. A good advisor will be patient and spend the time to talk to you about their education, experience, how long they have been in business and their impact with other clients.

They should possess the following characteristics:

• A passion for and extensive experience in finance, wealth planning and investing
• A top education and credentials
• A positive yet grounded mindset
• A holistic mindset with humility and curiosity about the economic landscape
• The ability to explain and converse in easy-to-understand terms
• An understandable investment philosophy based on long-term value investing principles
• Commitment to be responsive and service-oriented
• Fee-only focus without the conflict of interest that can be created by commissions
• An education-oriented and not sales-oriented approach to their practice

Introduction to Trusts

Perhaps you have heard a bit about Trusts and know that wealthy families and their highly paid advisors know when and how to set up trusts to protect and grow their wealth and save on taxes.  If you are curious about how trusts work and how they might benefit you and your own family read on as we reveal a lot of the “inside baseball” on how trusts work and some key ideas related to their pros and cons and situations in which using them can be beneficial.

To start, a trust is simply a legal entity through which property or assets such as cash, real estate, or other investments can be protected, invested and set aside to provide for specific people or causes you care about with certain conditions or guidelines as established by the grantor (the person setting up the trust who generally contributes assets to create the trust in the first place).

Generally, a trust names certain beneficiaries - the people or organizations the trust is intended to help - often subject to the conditions attached to the trust.  Trusts usually also have one or more Trustees - who can either be professionals or other individuals (or a combination of both) who are charged with controlling and managing the trust by making decisions on its behalf. 

Trustees are accountable to manage the trust in a way that meets the original objectives of the Trust grantor and takes care of the beneficiaries in the ways intended by the people who set up the trust.  They typically need to take actions that a “prudent” person would do if they had been charged with the same responsibility.

A trust is generally created by writing and signing a Trust agreement - this is a legally binding document that can be created during a person's lifetime or stipulated to be established after their passing by their will.  An attorney is often hired to help draft the trust document or the will that creates a Trust.  Although hiring an attorney to create a trust is not a legal requirement, trusts can be complicated and subject to some complex rules so having an expert help in creating a trust is usually a good idea to make sure it is done correctly and works as intended.

In summary, a trust holds assets and property in a fiduciary relationship by one party for the benefit of another (for example a charity or a person’s heirs). Once assets are put into the trust they belong to the trust itself, not to the trustee or the beneficiary or the creator of the trust and remain subject to the rules and the instructions of the trust document that created it.

Examples of Wealthy Families Who Have Used Trusts

The Rockefellers are perhaps one of the most famous and wealthy families to use trusts to pass on their  wealth. John D. Rockefeller made his fortune in the early days of the oil business, setting up Standard Oil Company of Ohio - the predecessor of today’s Exxon Mobil. 

The first Rockefeller trusts passed the bulk of his wealth to his heirs when he set them up in 1934. Now entering its seventh generation of beneficiaries, with more than 170 heirs, the Rockefeller family was estimated to have still enjoyed an $11 billion fortune in 2016 - so many years after the founding Rockefeller established the initial corpus from his vast holdings and wealth.

Here’s another, more contemporary example. In 1945 Sam Walton bought his first retail store. From this humble beginning, the great Wal-Mart business empire ensued creating over $170 billion for the Walton family. Sam Walton died in 1992 and his wealth at the time was estimated at around $10 billion.

Due to his smart planning, and use of a Trust his family continue to benefit from his legacy as Walton Enterprises and the Walton Family Holdings Trust own half the retailer, he successfully established a structure that has continued to preserve and grow one of the world's biggest family fortunes well after his passing.

As illustrated by both of these examples, one of the reasons to set up a trust is to protect wealth on a multi-generational basis.  Instead of giving money or wealth directly to the next generation of the family, founders create trusts and give some or a substantial portion of their wealth to a trust instead. 

This can have many benefits, including protecting that wealth from dissipating more quickly through mismanagement by heirs who may not be as sophisticated as the founder.  Depending on their terms trusts can also protect the beneficiaries from losing assets to subsequent lawsuits or divorces. 

Trusts can also allow the founder to establish some guidelines and conditions to when and how the beneficiaries are to be assisted.  These “strings” can help the founder to establish some requirements from the beneficiaries to receive support or guidelines as to when and how much support from the trust is to be provided.  This approach can help to prevent wealth left in the trust from becoming a negative that enables frivolous expenditures or an unproductive lifestyle.  It also can help the wealth left in a trust to last much longer and be helpful to multiple generations of the founder’s descendants.

Finally by putting wealth into a trust and appointing one or more sophisticated Trustees to oversee the wealth in the trust, founders can actually increase the likelihood that the Trust assets will be managed in a way that preserves and grows that wealth so that one or more generations of beneficiaries also gets maximum support if so desired by the grantor.  Done correctly, a good trust can, over time, distribute far more to its beneficiaries than the initial amount contributed into the trust through a combination of prudent stewardship and intelligent investing of the assets.

Different Types of Trusts

There are many different types of trusts. While a detailed discussion of the various types is beyond the scope of this article, we touch on some of the main types below.

Which types are appropriate in any given situation varies based on your own specific needs and goals, the type of assets you’re trying to protect, and your desired outcome for the assets in the trust.

Some of the most common types of trusts are:

• Living Trusts
• Testamentary Trusts
• Life Insurance Trusts
• Charitable Trusts and Charitable Remainder Trusts 
• Asset-Protection Trusts, and
• Special-Needs Trusts

In addition, all of these trust types can be revocable or irrevocable, depending on how and why they are set up.  Revocable simply means that the trust can be dissolved and the assets returned if so desired.  An irrevocable trust is a more permanent structure and once it is set up it cannot be undone by the grantor or trustees later.

Key Steps In Setting Up A Trust

At a high level, the steps needed to establish a trust are as follows:

1. Collect key details and information
2. Seek out professional assistance from a trusted financial advisor and attorney
3. Draft and execute the governing Trust Agreement
4. Register the trust with the Internal Revenue Service by obtaining a tax identification number
5. Transfer assets into the trust
6. Administer the trust in accordance with the trust's legal guidelines.
7. Invest the Trust assets intelligently
8. File tax returns and follow the proper procedures on an ongoing basis

Trusts: Main Uses

Trusts can be created for a variety of reasons. Here are some typical situations:

• To manage and control spending and investments to protect beneficiaries from their own lack of experience, poor judgment, immaturity or tendency to waste or spend excessively
• To reduce income taxes and to shelter assets from estate and transfer taxes
• To provide a vehicle for charitable giving
• To avoid court-mandated probate and preserve privacy
• To protect assets held in trust from beneficiaries’ creditors
• To hold, preserve and manage unique assets such as timberland, art, mineral interests and vacation properties
• To hold life insurance policies, pay premiums and hold insurance payoffs to care for beneficiaries
• To hold assets while planning for business succession
• To hold assets to provide for beneficiaries with special needs such as physical or mental incapacities

 These are but a few of the most common reasons behind the establishment of a trust. Once you realize their versatility, you may find that a trust may be beneficial for your own personal situation. A discussion with a trusted financial advisor may be a particularly good idea if you think you may be a good candidate for setting a new one up or already have a trust that needs to be looked at and perhaps improved in one or more respects.

Pros and Cons of Trusts

Trusts are not magic, but they are extremely powerful and versatile and can help you solve a wide variety of financial concerns or objectives. For example, a simple revocable trust can enable you to pass your property to your heirs without going through probate, which can streamline asset disposition and preserve privacy in your estate plan.

An irrevocable life insurance trust can remove ownership of your life insurance policy and proceeds from your estate thereby saving your heirs tens of thousands or even millions on your eventual estate tax bill down the road.

On the downside, the biggest difficulty with trusts can be the cost and complexity of getting them set up in the first place. Moreover, besides the preparation costs they will generally require that you retitle your assets in the name of the trust.  This is an important step because its not uncommon for people to create wills or trusts and then delay or forget to properly retitle their assets on a timely basis so that the trust actually works as intended.

Are Trusts Only For The Wealthy?

Trust funds have long had a reputation of being a tool used primarily by the wealthiest families. Although many ultra-wealthy families use trusts, others may benefit from them as well. 

Indeed, certain types of trusts such as life insurance trusts, asset protection trusts, trusts to benefit disabled or handicapped beneficiaries, or trusts set up to avoid probate are more common and useful for a wider range of families.  In these cases, families with wealth ranging from as little as $500k to $5 million in assets might be good candidates for setting up certain types of trusts. 

On the other hand, other types of trusts are more applicable only to families with $5m or more in wealth (sometimes much more). 

Tip #1: Take Stock of Your Current Situation

First and foremost, conduct an honest assessment of your current retirement savings. For most folks, retirement assets and income will come from three sources: (1) qualified retirement plan accounts from work such as IRA’s and 401k’s, (2) social security benefits, and (3) personal savings. Of course, your personal situation may be different, such as owning some income producing rental real estate, but for the majority of Americans, the big three sources are among their primary vehicles for retirement planning and saving.

Here are some questions to review to begin an honest assessment of your retirement savings status.

Do you have any money working for you in IRA’s or a retirement plan at work? If so, how much? Are you making regular contributions to these accounts? Are the investments optimized to give you the best retirement income?

Will you be eligible for Social Security, and when can you expect to begin receiving benefits? In most cases, your social security benefit will not be enough to fully provide for your retirement - but is a nice supplement that is worth paying attention to.

Have you established a wealth-generation portfolio of stocks, bonds, and other assets like income real estate that are outside of your qualified accounts and available to generate additional income for your golden years? Do you add to this account regularly?

Your retirement assessment is a snapshot in time and will reveal how much you have saved and how well it is positioned to grow your resources before retirement. Moreover, it will provide an indication of whether you are in reasonable financial shape going forward, or perhaps a bit behind and need to have a plan to do some catching up.  If you are not sure you are prepared to do this yourself, a qualified advisor like Ridgewood Investments can help.

Tip #2: Consider Increasing Your Savings Percentage

Perhaps the simplest way to start getting back on track if you find you are behind is to increase your savings rate for retirement. If you are not systematically saving a specific amount for retirement, late is better than never (and it's never really too late if you have a sensible plan). Assuming you have the income, are willing to reduce discretionary spending when it makes sense and save and invest the surplus intelligently, you can quickly start catching up on your long-term goals.

Let’s say you already save regularly.  Note that any increase will start to accelerate your progress.  If, for example, you are already directing 5% of your paycheck to a 401k or IRA, increase your percentage to 7% or more. Furthermore, if you are already maxed-out on your eligible IRA and company retirement plan contributions, start a systematic long-term investment program outside of a qualified plan in other taxable investment accounts to maximize your options.

If your current income from your main profession does not permit you to save more, consider developing a money-making side-gig or part-time position or business. The key is to start slowly and work with something that you love. According to Entrepreneur magazine, developing an Amazon-seller business, becoming a freelance writer, starting an affiliate-related business, and/or teaching something that you know and love can all be used to supplement your main income. Since the side business is supplemental, you can direct most of these extra profits to your retirement goals.  Even better is that business income allows you to have access to higher retirement contribution limits though accounts like a Solo 401k plan or a SEP IRA.

Tip #3: Take Advantage of Catch-Up Contributions in Retirement Plans

Catch-up contributions for qualified retirement plans can enable you to make some accelerated progress towards boosting your retirement savings. Designed for people 50 years old and above, catch-up contributions allow eligible retirement savers to contribute amounts in excess of the standard limit to their qualified retirement accounts. The reason these exist is that the government recognizes that many people are behind on their retirement savings goals, so they have created an incentive to make optional extra contributions for those beyond a certain age.  Here are the key facts to know about Catch-Up Contributions:

For 2019 and 2020, the standard IRA contribution limit is $6,000 a year, while the catch-up limit is $7,000.

If you are enrolled in a 401(k), 403b or 457b plan, you can generally contribute as much as $19,000 each year from salary deferral alone. If you are age 50 or older and your employer allows catch-up contributions, your limit increases by $6,000 for 2019 and $6,500 for 2020 over and above the normal $19,000 salary deferral limit.

If you have a SIMPLE 401k plan, the catch-up contribution is $3,000 over and above the standard $13,000 limit for 2019 and 2020.

Tip #4: Have You Been Too Conservative With Your Retirement Portfolio?

Perhaps you’ve been a little too conservative in your investment allocation with your retirement savings. This may be the case if your retirement accounts are all or mostly in cash equivalents, such as money market funds or certificates of deposit. 

People who tend to be fearful or risk averse often make this mistake.  Partly because they don’t know how to invest better on their own.  Unfortunately, if your investments are too conservative, the growth potential you can get is so limited that it will be putting all the burden on your ability to save as much as possible.  It would be like having a 100 horsepower engine in your car but turning off more than 50% of your engine and getting by with what is left over.

As of early 2020, most cash-equivalents are paying a very low interest rate of return.  The current Fed Funds Rate is 1.75%. Based on The Rule of 72, which helps you estimate how long it will take to double your investment at a certain return, investing in cash equivalents will take over 40 years to double your account.  If you generate little or no growth on your savings as a result of your overly conservative investment allocation - it can actually put your options for retirement well-being at risk.

In contrast a more balanced portfolio that includes a healthy allocation to stocks, bonds, and income real estate can result in growing your retirement accounts well beyond the amount that you can personally save. 

Consider putting your retirement portfolios on a growth trajectory, especially if you are early in your retirement savings program. Generally speaking, common stock investments as well as bonds and income real estate can add growth that can really benefit your retirement income.  At even a still modest 6 to 7% return per year - your money doubles in 10 to 12 years which is a lot faster - and after several doublings your retirement options are far more robust.

Tip #5: Evaluate Your Asset Mix and Consider Rebalancing Your Portfolio

Most investment professionals recommend a mix of stocks, bonds and cash-equivalents for retirement portfolios. The exact mix is likely to vary with your age, becoming more conservative as you close in on retirement.

A portfolio invested 60% in a diversified global stock fund and 40% in a total bond market fund would have earned 5.74% annually from 2008 through 2017, much better than a pure cash investment. Other asset mixes that can be tailored to your individual situation can perform even better than a 60/40 portfolio. 

“To whom much is given, much is expected” is a famous quote that has been used by presidents and preachers as a reminder that the most successful in our society also have a duty to give back to the benefit of others.

Fortunately, this edict is second nature to the wealthiest Americans.  A 2019 study found that the United States is still the most generous country in the world for the last decade.  Even within the United States, the wealthiest Americans give the most both in total charitable dollars and even as a percentage of their incomes.

According to the Philanthropy Roundtable, the top 1% of income earners (approximately $400,000) income or higher per year provide about a third of all charitable dollars in the United States.  And those earning $2 million or more per year donated approximately 14% of their incomes to charities whereas households earning between $200,000 and $2 million per year were still donating a very generous 8.5% of their income on average.

Done correctly, charitable giving can be integrated with your investment and tax planning to create and maximize benefits to both the donor and the recipient charities.

Of course, there are many rules that govern the tax and investment implications of the various ways that you can give. With this article, we review some of the most common opportunities and strategies associated with charitable giving.

Charitable Gifts and Their Tax Deductibility

The simplest and perhaps most common situation involves donations of cash or property to a qualified charity.  In order to take a tax deduction for the donation, the following criteria must be met:

• The charity must be qualified. An IRS qualified charity is one that has a 501(c)(3) tax-exempt status or is a church or religious organization.
• You must meet several documentation requirements. You must keep good records, including cancelled checks and acknowledgement letters to back up your deductions if the IRS asks.
• You must donate cash or property. You actually have to make an actual donation of money or property in the year for which you are claiming a tax deduction. A pledge or promise to donate is not sufficient.
• You need to file using Form 1040 and itemize your deductions. You can claim a tax deduction for charitable giving on Schedule A, Form 1040, if you qualify to itemize. If you claim a standard deduction, which is larger than it was a few years ago, you cannot deduct your donations as a line item.

Charitable Giving Through Wills and Trusts

Wills and trusts are legal documents that direct the dispersal of assets at the time of a person’s passing. A will is typically written to name one or more beneficiaries, who are individuals or entities to which the decedent wishes to leave property, cash or other assets upon death.

It is very important that due consideration be given to a person’s will and/or trust while they are living and of sound mind. There are a lot of details to consider, including selection of the beneficiaries. In most cases, a professional - typically an attorney who practices trusts and estates law - is consulted to assist in the creation of wills and trusts. If done improperly, or if the deceased has no will, a court will likely get involved which can cost much more and result in substantial delays. In such cases, the actual wishes of the deceased may or may not be carried out at all. 

Because of the tricky nature of wills and trusts, and due to the fact that probate law can be involved, most people like to talk with a financial professional, even before they get a will or trust drawn up. This is especially true for high net-worth individuals. An experienced investment and financial advisor, like Ridgewood Investments can advise you throughout this process.

Charitable Trusts: Charitable Lead vs. Charitable Remainder Trusts

A charitable trust is an entity set up to hold a set of valuable assets, usually liquid assets such as stocks and bonds but sometimes also private assets such as real estate or collectibles, which a donor signs over or uses to create a pool of value to benefit one or more causes of interest.  One or more persons are usually named as trustees to oversee the operations of the trust. Charitable trusts can be excellent vehicles through which to transfer your wealth for charitable purposes to support one or more causes that particularly resonate with you. They come in more complex flavors: Remainder trusts and Lead trusts.

Remainder Trusts. In a remainder trust, the assets are signed over to a trust for a specified length of time. When the time is up, the assets (and any profits that have been accumulating) become the property of the organization.  Remainder trusts can often provide for some or all of the income from the trust before it ends to be given back to the donor or someone the donor designates.

Lead Trusts. Conversely, in a lead trust, the donor does not give up control of the assets. Instead, any gains or interest the assets produce, or a specific portion thereof, are given to the charitable organization. However, when the lead trust expires, the assets revert back to the owner or his or her beneficiaries.

Charitable trusts can provide some outstanding tax benefits to the high-net-worth donor. For example, highly appreciated stocks are especially vulnerable to enormous capital gains and estate taxes, but if transferred to and held in a charitable trust, donors can get an immediate federal tax deduction based on the value of the amount donated while simultaneously saving on the upfront capital gains taxes that would be due.

Charitable trusts can be quite complex, and many factors need to be considered before entering into one. A trusted financial advisor such as Ridgewood Investments can personally guide you through the many details involved and work closely with your other advisors such as your estate attorney and CPA to help create and implement a smart financial plan to take maximum advantage of the legal structure that can give you the most efficient and beneficial outcome.

Private Family Foundations and Similar Entities

There are several other tax-beneficial charitable entities worth considering. These are private family foundations, donor-advised funds and community foundations.

• Private Family Foundations. This is an entity that is set up and directed by a family and funded with the family’s assets. They are created to enable the family to make charitable or philanthropic gifts. The family gets a tax deduction every year a contribution is made.  Using a private family foundation can help to avoid or minimize capital gains taxes and can reduce potential estate taxes. Setting one up generally involves a lawyer or CPA, as they can be more complex and somewhat expensive to do correctly.
• Donor-Advised Funds. A donor-advised fund is comparable in many respects to a private family foundation without the complexity of having to set one up on your own.  A Donor-Advised fund acts almost like a pooled family foundation shared with many others families for efficiency.  One main distinction is that, after making an irrevocable contribution, the donating family can make recommendations to the sponsor, but the organization itself handles the fund’s management and all necessary record keeping.  Your irrevocable contribution is tax deductible in the year it is given. Moreover, just as with a private family foundation, there are no capital gains taxes on gifts of appreciated assets.  Another advantage of donor advised funds is that they can be quite cost effective and the gifts of assets can still be invested to grow well into the future.  Due to their many advantages, it is not surprising that Donor Advised Funds have become increasingly popular, especially among affluent families with charitable intent.
• Community Foundations. These are tax-exempt, publicly funded charitable organizations dedicated to improving people’s lives within a local community setting. The first of these in the US, the Cleveland Foundation, was founded by Frederick Goff, whose intention was "to pool the charitable resources of Cleveland's philanthropists, living and dead, into a single, great, and permanent endowment for the betterment of the city”. Donors to community foundations may be eligible for a tax deduction, up to IRS limits. Some community foundations offer Donor-Advised Funds.  The main difference is that community foundations are public charities subject to additional requirements.

Of the above options, the Donor Advised Funds are growing the fastest, are the easiest to set up and offer substantial tax and investment advantages.  One major benefit of the donor advised fund is that it allows the timing of the donation and the timing of the gifts to be separated.  Someone with appreciated investments can transfer some of the position to the Donor Advised Fund and take a deduction immediately.  The money can then be invested within the Donor Advised Fund to grow and increase in value.  The donor can then direct gifts whenever he or she wants to support a worthy cause in the future by asking the donor advised fund to give a certain amount of the previously transferred funds and investments to a particular cause.

If you are like the vast majority of people, the thought of paying more taxes than legally necessary is troubling.  Unfortunately with our busy lives pulling us in all directions, it is easy to get distracted and not have the time to focus on potential sources of tax savings throughout the year.

However, the end of the year is a good time to take a few hours and focus on potential tax savings opportunities that you might be able to lock-in before the new year arrives.

Doing that every year-end could help you to save thousands on your tax bill due the following April.

Let’s take a look at a few of the most common year-end tax-savings opportunities:

Give To Charity

The period from Thanksgiving to the end of the calendar year is the time when Americans tend to give the most to charity. In many cases, this is done for two reasons: to give back to worthwhile causes and to save a bit on your taxes by generating a charitable deduction.

In order to have your donations qualify for a tax break, you must itemize them on Form 1040. You do not qualify for the tax break if you don't itemize and instead claim the standard deduction. In the Tax Cuts and Jobs Act of 2017, Congress made the threshold for itemizing higher than it had been in previous years, but many givers, particularly generous ones, still qualify.

Note that in order to make a charitable contribution, you must have charitable intent.  For most people, the tax savings represents only 35 or 40% of the value of the charitable deduction, so it makes sense to do it if you both want to help and donate as well as save on taxes.

Another area to remember is that donating appreciated assets such as stocks that have increased in value and or art for example can be even more attractive because you save on the potential capital gains that you would have owed had you sold that asset as well as getting a tax deduction equal to the current full market value of the donated asset.

Charitable gifts can also involve more advanced approaches for somewhat larger donations, such as setting up a donor advised fund account or donating an assets over time while it continues to generate income for the donor.  These are more advanced charitable donation strategies that would be beyond the scope of this article.

Tax-Loss Harvesting

End of year is a good time to review your investment holdings. In particular, review your unrealized and realized capital gains and losses for the year.

Capital gains are taxable at the prevailing rate in the year they are realized. Capital losses, however, can be used to offset gains.

Here’s how it works: If you have more capital losses than you have gains for a given year, then you can claim up to $3,000 of those losses and deduct them against your ordinary income.

Fortunately, if you have more than $3000 in capital losses, then you're allowed to carry the excess forward for use in future years. You calculate and claim the capital loss deduction by using Schedule D of your Form 1040 tax return as part of your required reporting of sales of investments throughout the year.

Depending on your investment holdings, year-end can be a good time for you to look at your holdings and sell the ones that could allow you to generate a capital loss in the current year.  This can be especially valuable if, as per the above, you have gains that can be offset with these year end losses. 

This process of looking at your holdings for unrealized losses in your taxable investment accounts is called tax loss harvesting and your cpa or investment advisor can help you with this process.

Tax loss harvesting is subject to some specialized rules, such as the wash sale rule.  This rule states that you can only realize the loss upon the sale of a holding if you do not buy it back within 30 days (before or after) the sale. 

If the position is one that you expect to appreciate over time, you may not want to tax loss harvest it (as you will miss out on the gains for the next 30 days) or alternatively, you may want to identify some other correlated position to own during the time when you are subject to the 30 day wash sale rule.  Of course, on the 31st day you are free if you so desire to buy back you original position and still take the tax loss from selling the position.

Defer Taking Capital Gains Until Next Year

In addition to tax-loss harvesting, you may wish to defer any unrealized capital gains until next year. Remember, you will pay capital gains tax on gains realized during the tax year. You could elect to simply keep your paper profits going forward without realizing the gain. This may also make sense as part of a long-term investment plan focused on high-quality securities that you really want to hold for the long term anyway.

Some mutual funds distribute capital gains distributions at year end.  On the other hand, by owning individual securities and exchange traded funds, you can defer you gains (and continue to compound them) for potentially a long period of time.

Even if you are sure you want to liquidate a position, once you start getting towards the end of the year, you may be better off waiting until the early part of the following year to actually sell the position for two reasons.

First, by deferring the gain on the sale into the new year, you defer the tax due by around a year.  Second, many securities tend to decline at year end and bounce back in January (potentially due to tax loss selling by many investors) so you might get better execution by waiting for the new year as well (at least on average).

Qualified Retirement Plans

If you are eligible for qualified retirement plans such as IRAs and 401-Ks, make sure that you maximize the tax-deductible contributions before year-end. In many cases, folks make regular bi-weekly contributions deducted from their payroll compensation. Also check to see if your situation qualifies for other types of deferred retirement plans?

For example, self-employed folks can set up a solo 401(k), or Simplified Employee Pension (SEP) IRA.  Depending upon your situation, the amounts that you can contribute may be substantially higher than in a Traditional or Roth IRA.

The deadline for establishing and contributing to a SEP IRA is the tax-filing deadline, including extensions.

A more advanced type of qualified retirement plan is called a Defined Benefit or Cash Balance Plan.  This type of retirement plan is more complicated and generally needs an actuary and a third party administrator.  It typically costs a bit more to set up and maintain as well.  However, for small but highly profitable businesses it can provide very large tax deductions as well as allow accumulation of substantial retirement plan assets.

Review Your Medical Bills

Fortunately, the tax code provides for tax deductibility for qualified medical expenses. For 2019, you can deduct the total qualified and unreimbursed medical care expenses that exceed 10% of your adjusted gross income.

Qualifying expenses include things like:

• Costs incurred for medical services from physicians, surgeons, dentists, and other medical professionals.
• Purchases of medications prescribed by a medical professional.
• Costs of medical devices, equipment, and supplies prescribed by a medical professional, including, among other commonly needed items, eyeglasses.
• Premiums paid by you for health and dental insurance.
• Long-term care costs and insurance.
• Transportation and lodging costs for traveling to a health care facility including mileage

If you have a high deductible qualified health insurance plan, you may also be eligible to set up and fund a Health Savings Account or HSA prior to year end.

Since health care costs in retirement as a significant concern and expense for most individuals, the HSA is an excellent strategy with significant tax benefits to those who qualify and set it up properly.

Ridgewood Investments is experienced in setting up HSA’s and can assist you to do so.

Look for Tax Incentives

Tax incentives are benefits, legally defined in federal and state tax codes, designed to attract business or encourage a specific economic or social activity. They are often used to help create affordable housing, catalyze job growth, set up enterprise zones, assist with historic preservation, and to encourage environmental responsibility.

Examples of these that you may qualify for include tax credits for installing energy-efficient residential appliances, tax breaks for using biodiesel fuel, and tax incentives for a wide variety of improvements for Americans with disabilities, to name a few. Consulting with your accountant may uncover a few that you can use prior to year end.

Make An Extra Mortgage Payment

Making an extra mortgage payment is something you might consider doing, especially if your monthly interest on the mortgage is relatively high. This simple trick may give you an extra amount of interest to deduct at the end of the year if you itemize. It may also reduce your principal more quickly as well.

This strategy can make sense if you want to payoff your mortgage more quickly or if you have a high interest mortgage (relatively rare these days). 

However, if your interest rate is lower than you average investment return, it may not make sense to accelerate your mortgage payments at year end despite the tax deduction.  This is especially true these days when the deductibility of mortgage interest was curtailed in the Tax Cuts and Jobs Act of 2017.

Avoid Future Estate Taxes

If you are a high-net-worth individual, looking at your estate tax situation may be highly beneficial. In 2019, the estate tax applied to folks with over $11.4 million in assets. You can reduce your potential estate, and its future tax burden, by making gifts. You can give up to $15,000 per person completely gift tax-free this tax year.

For example, each of you and your spouse can gift the above amount to each of your children (and even grandchildren).  Interestingly, the gift tax exemption is not limited to relatives.  Any amounts that you give as gifts reduced the future size of your estate and if the gifts are invested properly by or on behalf of the recipient the benefit in terms of future estate tax savings can be quite meaningful.

As an experienced investment and financial advisor based in New Jersey, Ridgewood Investments has comprehensive knowledge on a wide variety of savvy investing strategies and year-end tax-saving and planning ideas.

Take an opportunity to take advantage of a few of the above year-end tax saving moves to make your tax burden less taxing.