The Graham Case

A GENERAL PLANNING MINI-CASE

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 todays 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 pretax returns. As of the date of the case, the Grahams are not subject to the alternative minimum tax (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 pretax 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. Table VI.21 summarizes other expenditures. Tax Issues The Grahams complete their own tax returns using a nationally known tax preparation software package. Onslo pays his companys 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-employment income taxes. The Grahams assets are summarized in Table VI.22. Their liabilities are summarized in Table VI.23. Asset Summary Liability Summary Life Insurance Information and Planning Issues Onslo and Daisy would like you to analyze their life insurance situation using the following assumptions and facts: 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 post-retirement. 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 todays 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 todays 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 spouses 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 Daisys death. Daisy does not expect to work after Onslos death. Table VI.23 summarizes life insurance policy information for Onslo and Daisy. 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 purchased a long-term policy in the private market (not through a cafeteria plan at work). Information about the policy is summarized below: The policy is defined as own-occupation and is issued by an A.M. Best A-rated company. The policy has a six-month elimination period. The policy pays 50% of Onslos current salary until age 65. All premiums are paid with after-tax dollars. If disabled, they would like to continue to save for objectives. Other Insurance Information 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 teams 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-million umbrella policy four years ago. This required that the Grahams increase the split-limit coverage on their personal automobile policies to $100/$300/$100. Their current HO-3 homeowners policy provides 100% inflation protection coverage. Current yield information for use when solving case questions is provided in Table VI.24. Current Yield Information Retirement Information and Planning Issues The following information should be used when evaluating the Grahams current retirement planning situation: 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 Onslos salary. At retirement, Onslo will be eligible to receive $2,024 (in todays 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 Onslos 401(k) will increase by 3% each year. Daisy is the primary beneficiary of Onslos 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 Information and Planning Issues Onslo and Daisy have separate wills. Onslos will leaves all his assets to Daisy. Daisys 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 predeceases Daisy. Other estate planning facts include: 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 survivors estate is estimated to be, on average, 4% annually. Daisy is the sole beneficiary of Onslos IRA and retirement plan assets. Onlso is the sole beneficiary of Daisys 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 whether 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 of 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

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 could 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 one-third of the account balance when she is added to the account.

b. Onslo and Daisy might owe a gift tax when Rose makes a withdrawal from the account.

c. Rose will owe only 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. A charitable remainder unitrust.

b. A charitable reminder annuity trust.

c. A 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 could 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 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 AMT.

b. Anystate will tax all interest earned on bonds issued by another city in their state but not by 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.