Onslo Graham is 59 years of age. His wife, Daisy, is age 58. They have been married for nearly 30 years. The Grahams currently live at 3456 Speedway, Anycity, Anystate 01010. They have an adult child, Rose, who recently turned age 28. Rose also lives in Anycity.
Because of their strong relationship, they have tended to own all of their assets jointly even though Daisy has been a homemaker all of their married lives. Onslo does have one real estate asset that is not jointly owned.
Onslo is the general manager of Tarantula Industries, a closely-held corporation, which owns a hockey team in an expanding southwestern minor league. The team is headquartered at 555 West Verity Road, Anycity, Anystate, 01010. Onslo has been involved in professional sports management for nearly 25 years, and he currently earns $137,500 per year in income. Rose is also actively involved with the team. She works in the front office and manages day-to-day operations. Onslo and Daisy hope that Rose will eventually take over management of the team once Onslo retires.
Use the following information to conduct a review of the Grahams' financial situation.
Global Assumptions (Valid unless otherwise specified in certain instances)
* Inflation: 4%
* All income and expense numbers are given in today's dollars.
* Planned retirement age: 66 for both
* Federal marginal tax bracket: 25%
* State marginal tax bracket: 4.72%
* Any qualified plan or IRA contribution growth rates are assumed to stop at the federally mandated limit unless otherwise restricted.
* All nominal rates of return are pre-tax returns.
* As of the date of the case, the Grahams are not subject to the AMT.
* They are currently qualified for Social Security benefits.
Income Issues
Onslo currently earns $137,500 per year and expects his salary to increase at 5% per year until retirement. They also receive $15,403 in nonqualified dividends and interest from miscellaneous other investments, all of which are reinvested. Onslo and Daisy are covered by employer-sponsored health care. The premium, which is paid by Onslo directly, is $2,400 per year. Onslo also contributes $9,600 into a 401(k) plan. The plan provides matching at 33 cents on the dollar with no maximum beyond IRC statutory limitations. These expenses are paid for with pre-tax dollars.
Expense Summary
Based on his salary, Onslo had $27,000 withheld for federal, Social Security, and Medicare taxes. He also had $6,565 withheld for state taxes. The following table summarizes other expenditures.
Tax Issues
The Grahams complete their own tax returns using a nationally known tax preparation software package. Onslo pays his company's accountant to double-check his calculations. Onslo and Daisy file married filing jointly and they claim themselves as exemptions. They are currently in the Anystate 4.72% marginal tax bracket, where taxes are linked with the federal AGI figure. They are eligible for a $1,250 state standard deduction and a $275 exemption per person. Onslo is considered an employee of his firm and does not pay self-employed income taxes.
Life Insurance Information and Planning Issues
Onslo and Daisy would like you to analyze their life insurance situation using the following assumptions and facts: (1)
* In the event of a death, household expenses would drop to $105,000 per year.
* Final Expenses (funeral and burial costs) will be $25,000 for each person.
* Estate and legal costs will be $69,930 for Onslo and $16,135 for Daisy.
* All outstanding liabilities will be paid at the first death.
* Other immediate needs should be funded with $10,000 each.
* They would like to plan conservatively in the event of a death by assuming a 6% before tax rate of return on any insurance proceeds both pre- and postretirement.
* They will be in a combined state and federal tax bracket of 30% before retirement.
* Full retirement age is 66 for both Onslo and Daisy.
* They would like to replace $90,000, before taxes, while in retirement for the surviving spouse.
* Daisy is eligible to receive $1,958 per month (in today's dollars) as a Social Security survivor benefit at age 66 (assumes that Onslo dies today).
* Onslo will receive $2,024 Social Security benefits per month (in today's dollars) in retirement at age 66.
* They are eligible to receive survivor benefits equal to a 71.5% reduction in full benefits from age 60 to 66.
* In the event of either spouse's death, the other spouse plans to stop working at age 60 and begin taking early retirement survivor benefits.
* For conservative planning purposes, the Grahams do not plan on using interest and/or dividends as an income source when determining insurance needs.
* They are willing to use all their retirement savings and $350,000 in other assets to offset life insurance needs.
* Onslo expects his salary to remain the same following Daisy's death.
* Daisy does not expect to work after Onslo's death.
Disability Insurance Information and Planning Issues
The Grahams have not focused too heavily on disability planning issues. They do know that they do not want to account for Social Security benefits in the event of a disability. A few years ago Onslo did purchase a long-term policy in the private market (not through a cafeteria plan at work). Information about the policy is summarized below: (2)
* The policy is defined as own occupation and is issued by an A.M. Best A rated company.
* The policy has a 6-month elimination period.
* The policy pays 50% of Onslo's current salary until age 65.
* All premiums are paid with after-tax dollars.
* They would like to continue to save for objectives if disabled.
Other Insurance In formation and Planning Issues
The Grahams do not currently have a long-term care insurance policy. Both are healthy, with both sets of parents still alive and well. In fact, Onslo and Daisy skate twice a week at the team's local indoor practice arena.
They have worked with the same property and casualty insurance agent for 25 years. Their agent encouraged them to purchase a $1,000,000 umbrella policy four years ago. This required that the Grahams increase their split limit coverage on their personal automobile policies to $100/$300/$100. Their current HO-3 homeowner's policy provides 100% inflation protection coverage.
Current Yield Information
Investment Class Yield Checking Account 0.00% Savings Account 2.00% Taxable Money Market Fund 3.00% Anystate Municipal Money Market Fund 2.40% EE Savings Bonds 3.50% I Bonds 4.50% Government Bonds 4.50% Corporate Bonds 5.00% High-Yield Bonds 6.50% Real Estate 3.75% Gold 0.00% Large-Cap Stocks 2.00% Mid-Cap Stocks 1.00% Small-Cap Stocks 0.00% Loan Rates 30-Year Mortgage * 5.95% 15-Year Mortgage * 5.75% Home Equity Line of Credit * 5.85% Home Equity Loan * 7.35% 5-Year Auto Loan 6.10% Personal Loan 8.25% * APR includes closing costs
Retirement Information and Planning Issues
The following information should be used when evaluating the Grahams' current retirement planning situation: (3)
* They would like to retire when Onslo reaches age 66.
* They anticipate being in the 25% marginal tax bracket while in retirement.
* Prior to retirement, they are comfortable assuming that future rates of return will be 10.72% before-taxes on their retirement assets and savings.
* If retired today, they would like to replace 90% of Onslo's salary.
* At retirement, Onslo will be eligible to receive $2,024 (in today's dollars) in Social Security benefits per month.
* Daisy has not yet earned 40 quarters for Social Security benefits. But she does qualify for spousal benefits.
* They are comfortable assuming a life expectancy of 95 years.
* Contributions to Onslo's 401(k) will increase by 3% each year.
* Daisy is the primary beneficiary of Onslo's retirement assets.
* All qualified assets held outside of the 401(k) are in traditional IRAs.
* After retirement they plan to allocate retirement assets to generate a before-tax return of 8.7%.
Estate In formation and Planning Issues
Onslo and Daisy have separate wills. Onslo's will leaves all his assets to Daisy. Daisy's will leaves all of her assets to Onslo. Their wills name their attorney as estate executors, and in the event of a simultaneous death it is assumed that Onslo will predecease Daisy. Other estate planning facts include: (4)
* Funeral and burial expenses will be $25,000 each.
* Estate and legal costs will be $5,000 each.
* Executor Fees will be approximately 2% of the gross estate before the marital transfer.
* The net growth rate of the survivor's estate is estimated to be, on average, 4% annually.
* Daisy is Onslo's sole beneficiary for his IRA and retirement plan assets.
* Onlso is Daisy's sole beneficiary for her IRA assets.
* Daisy has a strong allegiance to the University of Anystate. She would like to leave a legacy gift to the university, if possible.
* No other estate planning documents are known to exist.
Goals and Objectives
The Grahams have two primary goals. First, they would like to know if they are on or off track to meet an age 66 retirement date. Second, they feel that a thorough review of their current estate situation is in order. Specifically, they would like to minimize any estate taxes paid in the event death. Other planning objectives include reviewing their discretionary cash flow, net worth, and life insurance situation. They are looking for guidance on how to improve their general financial well being.
Case Questions
1. Which of the following statements most accurately reflects the Grahams' current discretionary cash flow position?
a. Their discretionary cash flow is greater than $0 but less than $1,000
b. Their discretionary cash flow is less than $0 but greater than -$1,000
c. Their discretionary cash flow is greater than $1,000 but less than $8,000
d. Their discretionary cash flow is less than $-1,000 but greater than -$8,000
2. Which of the following statements is (are) true?
I. Retirement plan assets make up approximately 5% of the Grahams' total assets
II. Given their age and income profile, one would expect the Grahams to have a substantially higher level of net worth
III. The Grahams' savings ratio, including reinvested dividends and interest is below industry benchmark levels
IV. The Grahams' emergency fund ratio is adequate at this time
a. I and II only
b. II and III only
c. I and IV only
3. Which of the following strategies can the Grahams use to increase their discretionary cash flow situation?
I. Refinance their 1st mortgage using a 15-year fixed rate loan
II. Pay off outstanding credit card debt using money market mutual fund assets
III. Use a two-year home equity loan to refinance the Mazda car debt
a. II only
b. I and II only
c. II and III only
d. I and III
4. According to your tax calculations, which of the following statements is (are) true?
a. The Grahams should use the standard deduction rather than itemizing expenses.
b. Given their adjusted gross income, the Grahams may deduct Daisy's IRA contribution because she is not an active participant in a qualified plan.
c. Even though Onslo is an active participant in a qualified plan, the Grahams may deduct his IRA contribution because he is over age 50 this year.
d. Both a and b are correct.
5. Which of the following tax planning statements is true?
I. The Grahams should, based on tax-equivalent investment calculations, transfer their money market mutual fund assets to an Anystate municipal money market fund.
II. By paying off their home equity loan early they will increase discretionary cash flow but lose a tax deduction.
III. Using municipal bond investments will increase both the Grahams' level of discretionary cash flow and their taxable income.
IV. Increasing 401(k) contributions will decrease the amount of taxes the Grahams will pay at the federal level.
a. I and II only
c. I, II, and IV only
d. II, III, and IV only
6. All of the following life insurance observations are true except?
a. Based solely on the relative cost of the policy, Onslo should consider using a 1035 exchange procedure to replace the $100,000 whole life insurance policy.
b. The death benefit from Onslo's current life insurance policies is less than his calculated life insurance need.
c. Term life insurance will provide the Grahams with the maximum amount of coverage for the lowest premium but leave them uninsured at some point in the future.
d. Using the nonforfeiture provision in the whole life insurance policy will result in a decrease in discretionary cash flow.
7. Which of the following statements is true?
a. The Grahams can afford to self-insure short-term disability needs by using a combination of cash flow and non-retirement assets.
b. Because Onslo purchased his disability policy in the private market, if he receives benefits 100% of this income will be subject to federal income taxation.
c. If the Grahams used all of their financial assets, excluding insurance cash values and Onslo's rental real estate interests, they would be able to self-insure Onslo's net long-term disability need.
d. Both a and c are correct.
8. Assume that long-term care costs in Anycity are currently $45,000 per year, and that these costs are increasing by 5% annually. If the Grahams anticipate that Daisy will enter a nursing home when she turns age 71 and stay for 5 years, and they can earn a 7% rate of return on investments, which of the following statements is true?
a. The Grahams currently have enough financial assets to self-insure nursing home costs for Daisy.
b. The Grahams do not need to worry because Daisy will qualify for Medicare benefits at that time.
c. The cost of coverage for 5 years will exceed the Grahams' ability to self-insure the loss.
d. Even if they wanted to purchase long-term care insurance, the cost to purchase this insurance today is prohibitively high.
9. In order to retire at age 66, the Grahams need to consider which of the following?
a. Be willing to reduce their income need in retirement
b. Increase the rate of return earned on retirement savings and assets
c. Increase the age of death assumption
d. All of the above.
e. Only a and b.
10. Which of the following statements is (are) true?
a. The Grahams currently have adequate cash flow to fund their age 66 retirement goal.
b. If Onslo can convert his rental real estate holdings to cash prior to age 66, the Grahams may meet their retirement goal.
c. Postponing retirement by one year will allow them to reach their retirement goal without using any additional assets.
d. All of the above.
e. Only b and c.
11. Which of the following assets will pass directly to Daisy if Onslo were to die today?
a. His 401(k) assets
b. Proceeds from his group term life insurance policy
c. His ownership interest in their house
d. All of the above
12. What is the approximate value of Onslo's gross estate today?
a. $1,000,000
b. $2,000,000
c. $3,000,000
d. $4,000,000
13. At the death of Onslo, assuming Daisy is still alive,
a. if Anystate is a community property state, Daisy will receive a step-up in basis equal to 50% on all jointly owned taxable property.
b. if Anystate is a community property state, Daisy will receive a step-up in basis equal to 100% of all community property.
c. Daisy will retain the original basis in all property held jointly.
d. Daisy will be required to pay estate and gift taxes on all property received from Onslo.
14. Which of the following statements is true assuming that Onslo were to pass away first in 2008, utilizing the marital deduction, and Daisy were to pass away second in 2008?
I. The unified credit in 2008 exceeds Daisy's estate tax liability
II. Utilizing the marital transfer over-qualifies Daisy's estate
III. An estate tax liability in excess of $1,000,000 awaits at Daisy's death
a. I only
b. II only
c. I and III only
d. II and III only
15. Which of the following estate planning tools will generally allow Onslo Graham to maintain full control of his assets today while eliminating estate taxes at his death in the future?
I. An A-B Trust Arrangement Funded at his death
II. A QTIP Trust Arrangement
III. An Irrevocable Living Trust Arrangement
IV. A Funded Revocable Living Trust Arrangement
a. I only
b. I and II only
c. I and III only
d. III and IV only
16. Onslo and Daisy have indicated to you that they are considering adding Rose as a co-owner on their checking and savings accounts. They have heard that gift and/or income taxes may apply if they decide to move forward with the idea. Which of the following statements best describes the tax consequences of adding Rose to the account?
a. Rose will owe a gift tax on 1/3 of the account balance when she is added to the account.
b. Onslo and Daisy may owe a gift tax when Rose makes a withdrawal from the account.
c. Rose will only owe federal income tax on her share of the account when either Onslo or Daisy dies.
d. Onslo and Daisy will owe a gift tax when Rose is added to the account.
e. Both a and d.
17. Daisy has been talking with a planned giving officer from the University of Anystate about funding a charitable trust that will also provide income during retirement. She and Onslo would like to begin funding the trust immediately and retain the right to add to the fund in future years. Which of the following gift alternatives will meet the Grahams' objective?
a. Charitable Remainder Unitrust
b. Charitable Reminder Annuity Trust
c. Pooled-Income Fund
d. All of the above
e. Both a and c
18. Recently, Onslo indicated being concerned about the general strength of the stock market. As he and Daisy get closer to retirement, he is worried that the market will drop at just the moment they need to be drawing money from their equity fund holdings. Even so, he is reluctant to sell his stock funds at this time. Which of the following investing strategies may provide Onslo with a solution to his dilemma?
a. Periodically sell an index option put.
b. Periodically buy an index option put.
c. Periodically write a covered put.
d. Periodically buy an index option call.
19. Onslo has occasionally thought about buying municipal bond securities, but he never has because he does not have great faith that his local elected officials will make good on the bonds. Which of the following municipal bond alternatives would be most appropriate for Onslo, assuming that he wants to know that bond interest and principal will be paid from earnings on a project rather than tax revenues?
a. Debenture Bonds
b. General Obligation Bonds
c. Revenue Bonds
d. Income Bonds
20. Before selling their taxable bond securities and purchasing municipal bond securities to reduce tax liabilities, Onslo and Daisy ought to consider which of the following factors as being true in their situation?
a. Given their level and sources of income and deductions, there is the possibility that owning certain municipal bond securities that generate preference item interest will subject them to the Alternative Minimum
Tax.
b. Anystate will tax all interest earned on bonds issued by another city in their state but not Anycity where Onslo and Daisy file taxes.
c. Although state income tax free, any municipal bond interest that they earn will still be taxable at the federal level.
d. Both a and c.