Financial Planning

Step 4: Putting Together a Health Plan

Planning for healthcare in retirement is a tricky business. Some hardcore smokers live past 100, while some hardcore exercise and fitness gurus drop dead in their sixties. You just don’t know – which is why you need a plan.

Medicare

Once you turn 65, Medicare is available to most Americans. The problem is deciding what type of Medicare plan to purchase. Here is an overview:

Medicare Part A – This plan covers hospital stays, skilled nursing, hospice and some home health services. It is free for eligible beneficiaries but caps some benefit coverage and requires a deductible for each inpatient hospital stay. When a hospital stay is longer than 60 days, you’re required to pay a per-day rate – and that can add up.

Medicare Part B – This plan does charge a premium, and you have to buy it in concert with Part A. Part B covers doctor visits, preventive care, screenings, treatments, and medical equipment. It does not cover dental, vision, or hearing care and only pays for procedures deemed medically necessary. This plan also features a much lower deductible than Part A, but beneficiaries are responsible for 20 percent of covered services after the deductible.

Collectively, Parts A and B are what’s known as Original Medicare.

Medicare Part C – This plan is more commonly known as Medicare Advantage (MA). It is a paid alternative that combines coverage from Part A and B, plus offers add-on options for drug coverage, dental, vision, long-term care, etc. Plans vary significantly by insurer and may include any combination of deductibles, copayments, and coinsurance.

Medicare Part D – This plan offers coverage for prescription drugs. It charges a premium determined by your income, and deductibles, copayments, and coinsurance vary by plan. You have the option to purchase a standalone Part D plan when you enroll in Original Medicare.

Medigap – Also known as a Medicare Supplement Plan, this policy is a good idea whether you go for Original Medicare or an MA plan. That’s because it offers coverage for a lot of the gaps in those plans that generate high out-of-pocket expenses, including deductibles and coinsurance.

Long-Term Care

Among Americans who live past age 64, more than two out of three (70 percent) will at some point need long-term care. Whether you hire paid caregivers or move into a long-term care (LTC) residence, the cost of services currently averages between $60,000 and $100,000 a year in the United States. One of the biggest determinants of cost depends on whether you can get by with limited hours of help a day or need full 24-hour care. Note that for those with mobility issues (i.e., they cannot get to and from the toilet by themselves), 24-hour care is more likely.

Long-term care insurance (LTCi) can help you pay for this type of care so that you don’t deplete your savings quickly. This is especially important for couples, in which one spouse may need to enter an LTC residence while the other lives at home, with all the expenses that it entails.

The best time to buy LTC insurance is while you’re still healthy, as it is medically underwritten. The “sweet spot” is around age 55, but anytime in your mid-50s to early 60s is ideal. In most cases, policies are more expensive for women than men because women tend to live longer.

Caveats to Consider

• Policies typically pay out a limited daily amount, which may not cover the full cost.
• Policies typically pay out only for a limited period (e.g., 3 to 7 years)
• A policy may have a lifetime amount cap

All this is to say that you may purchase a generous LTCi policy, but if you outlive its limits, you will need to use your own money to pay for caregiving and/or rely on Medicaid when you run out of funds.

Hybrid Insurance

The biggest risk to purchasing an LTC policy is that you may never need it. Some policies offer a form of premium return, but like most insurance policies, LTCi generally uses it or loses it. To avoid this scenario, another option is to purchase a life + LTC insurance plan – also known as a hybrid policy. It provides a certain amount of life insurance upon death. However, if you need long-term care before you pass away, the policy will allow you to tap that death benefit amount to pay for it. This allows you to use the coverage either for LTC or as a life insurance payout for your beneficiaries.

Plan For These Expenses Now

While everyone is usually thinking about how to pay for household expenses, travel excursions, or a second home in retirement – they often don’t think about a health plan. As you can see, Medicare doesn’t cover everything and those expenses can add up, especially for people who live a long time.

But if you start planning long before retirement, you can contribute to an earmarked account that builds over time and uses that money to pay for medical expenses. The Health Savings Account (HSA) requires enrollment in a high-deductible health plan, whether offered by an employer or purchased on your own. Contributions made to an HSA are tax-free (which reduces taxable income), and the funds can be invested for tax-free growth in a variety of investment options. Withdrawals are also tax-free as long as they are used to pay for eligible healthcare products and services.

Note that HSA proceeds are your money, no matter what. It differs from employer-sponsored accounts such as an HRA (health reimbursement account) or an FSA (flexible savings account) because you have only a limited time to use those funds – then they revert back to the employer. In other words, you can’t access that money once you retire.

Step 2: Clarify Goals

You’re never too young to start a bucket list. That’s because some things (such as bungee jumping) you probably want to knock out in your twenties. Women may want to have children before their forties – that sort of thing. A bucket list is comprised of all the things you want to do before you “kick the bucket.” It should be a running list that you add to and check off throughout your lifetime.

If you haven’t started a bucket list yet, a good time to do this is during your pre-retirement planning. It might be better to complete some items, such as expensive travel or home renovations, while you’re still working. That way, you can pay for them with your current income rather than take on debt or withdraw excess funds during retirement.

Another reason to develop your bucket list with your pre-retirement plan is to give life after work a greater purpose. Many people don’t think past the joy of simply not having to get up every morning and go to work. For some, the appeal of retirement is to no longer have to deal with exhausting corporate politics. However, if these are the only reasons you’re looking forward to retirement, they will not likely be as fulfilling a couple of years into it.

In fact, many retirees find they miss both the structure of the workday as well as the responsibilities and intellectual stimulation of a job. If you don’t establish additional and specific goals for your retirement years, you may end up bored, watching television most of the day, short on social stimulation, and wondering where the years went.

Some common goals set by retirees include:

• Volunteering
• Home renovation/redecoration
• Gardening
• Reading/book club
• Babysitting/spending time with grandchildren
• Traveling
• Writing a book/memoir
• Learning another language
• Painting/arts & crafts
• Learning to play an instrument
• Carpentry
• Regular socializing with friends/game night
• Culture (theatre, symphony)
• Regular exercise routine
• Mentoring
• Taking classes

Aim For Local

Not everyone wants to see springtime in Paris, so recognize that your bucket list is unique to you. If you’re running low on bucket list items, think locally and personally. For example, there might be places nearby you haven’t visited in years (or ever), such as a museum, art gallery, zoo, symphony, or opera. Even if you do attend regularly, consider taking your grandchildren with you during retirement to expose them to your passions and develop memories they will hold onto for life.

As you develop your bucket list, think about how activities could achieve additional goals, such as fitness and socialization. Some of the risks of growing older are increased health problems and potential isolation – particularly if you lose a partner or outlive your friends. Constantly expand your social network to include younger folks, particularly neighbors. Helping them out with occasional babysitting or taking care of pets while they are out of town help “pay it forward” for those elder years when you could use a bit of help yourself.

Achieving a successful retirement is all about good planning and preparation. You want to have money to enjoy your life, good health to keep staying active, and friends and loved ones to spend time with. These are the core elements that contribute to a long life, so start planning today by developing goals and seeing them through.

Step 1: Develop a Budget

Once you are truly good and retired – no phase-out, no gig jobs, no income-earning hobbies – most people end up living on a “fixed income.” While that income may fluctuate somewhat based on cost-of-living increases and investment gains, those increases may be few and far between. What you really need to work on before you retire is a “fixed budget.”

A fixed budget is a line-item record of your living expenses, from housing and insurance to food and utilities to transportation and healthcare. Bear in mind that those are not exactly “fixed expenses” either. Seasonal changes and inflation can swell prices on household goods and insurance rates, while higher interest rates impact auto purchases and credit card debt. These are all factors a pre-retiree needs to consider when developing a post-retirement budget.

Retirement Income

However, the first step in developing a budget isn’t to add up your expenses, it’s to figure out how much money your retirement income sources will provide. Many folks pull from three basic sources of retirement income: Social Security, a pension, and personal savings – comprised of savings accounts, employer-sponsored retirement plans, and an investment portfolio. Bear in mind that with a few exceptions (e.g., savings accounts, Roth IRA), you’ll need to factor in paying taxes on distributions from these accounts during retirement. Add up how much post-tax income you will likely receive each month/year in retirement.

Retirement Budget

Depending on your retirement goals, you may need less or even more income than you earned while still working. One way to break down anticipated retirement expenses is to categorize them as essential (e.g., food, housing, transportation) and discretionary expenses (e.g., travel, entertainment). Calculate a monthly total with considerations for other outlying expenses, like paying for auto or home insurance and property taxes once a year to take advantage of discount savings.

Also factor in periodic expenses for home and auto maintenance. In addition to your monthly budget, consider how much you should retain in a liquid savings account for emergencies, such as the deductible for a major auto repair to replace the roof on your home or the occasional big-ticket appliance.

Reconcile Income with Expenses

Next, compare the total of your income sources with your total budgetary needs. Bear in mind that if your income comes up short, you have a few options. You can create a plan to reduce your essential expenses, perhaps by selling your home and moving into a smaller, cheaper-to-maintain home. You may want to take another look at your discretionary expenses and decide to cut out country club fees or travel abroad. It is possible to enjoy retirement while playing golf or tennis at public facilities and vacationing at the extraordinary locations that America has to offer.

One retirement strategy is to ensure that all of your essential living expenses in retirement will be covered by guaranteed income sources, such as Social Security, an employer pension, and an annuity. For discretionary expenses, plan to pay for them via an allocation of your retirement assets to other investments that are not guaranteed, but offer growth potential. In fact, you may be more inclined to invest these other retirement assets more aggressively when confident that your essentials are covered through guaranteed income sources.

Income Strategies

One of the more common ways retirees draw income is to simply spend down their assets. This basically means withdrawing however much you need each month above and beyond what you receive in Social Security and pension benefits. Bear in mind that if the amount you withdraw each year is too high, you risk running out of money in the later stages of retirement.

Some investors cap how much they withdraw each year at about 3 percent to 5 percent and adjust their budget to meet this limit. In doing so, they can ensure the rest of their investment portfolio has the opportunity to continue growing. To keep up with annual increases in the cost of living, you may want to allocate an equity component in your portfolio to allow for income growth opportunities throughout retirement. However, be aware that stocks can have down years so that 3 percent to 5 percent distribution might deliver less income when the market is volatile.

You also may consider ways to increase your retirement income. Developing a retirement plan a decade or so before you actually retire will give you time to max out your annual retirement account contributions and perhaps even create some form of passive income to help supplement retirement expenses. Many pre-retirees plan ahead by creating passive income sources, such as rental property or royalty payments on writing, music, or a patent on intellectual property.

The Social Security Caveat

Currently, the trust fund that supplements Social Security benefits is projected to fund 100 percent of total scheduled benefits until 2033. Thereafter, the fund will be able to supplement only 79 percent of scheduled benefits. The upcoming election is important for a lot of reasons, but what is currently under the radar is the need to reform how benefits are funded. The options include reducing benefits, increasing the retirement age, allowing people to invest their account funds privately, and increasing or removing the Social Security tax cap on individual wages ($168,600 in 2024).

Because the direction of Social Security reform is unknown, pre-retirees need to work harder to create their own income sources. While the federal government has the authority to make changes to shore up Social Security solvency, individuals, by contrast, have less flexibility to plug holes in their retirement income plans.

There are many steps to planning for retirement. Some are legal and financial, some are about communication, and some involve introspection – thinking about your life now and how you want to live the rest of it.

By the time most people start thinking about a retirement plan, they have a pretty decent foundation. Perhaps its assets – a house, savings, a retirement portfolio. Perhaps a strong social network comprised of family, friends, and colleagues. Furthermore, most folks have a sense of who they are, what they like, and what they don’t like. Some people may have all three of those factors in hand, while others have just one or two. What’s good to remember is that once you hit a certain age, you have a lot of the knowledge and logistics in place to create a sound retirement plan. And that’s a good place to start.

This article is Part 2 of a two-part primer on pre-retirement planning. The first article previewed the first three steps: 1.) Budgeting; 2.) Setting goals; and 3.) Finances. The following is an overview of the subsequent steps.

4. Health

The good news is that Medicare will cover many of your most basic healthcare needs in retirement. However, if you have extensive medical problems, you could be on the hook for hundreds of thousands of dollars. It is a good idea to earmark a separate funding source for potential medical expenses, such as a Health Savings Account (HSA). You can only fund one of these until you qualify for Medicare at age 65; hence the importance of pre-planning years in advance.

Long-term care is even more difficult to plan for because you might not need it. This is one of those high-cost scenarios best covered by insurance. However, be aware that long-term care insurance policies typically provide a limited per diem rate, which might not cover the full cost of caregiving. Therefore, you should keep some assets in reserve in case you need it for caregiving later. Another aspect of your health plan involves end-of-life decisions – make sure you communicate them to your loved ones.

5. Estate Plan

Another gift to loved ones is to leave them a roadmap of what to do with your assets after you pass away. At the very least, complete a will with instructions. And don’t wait until you retire; the burden of determining how to manage your assets is just as egregious if you pass away before retirement.

While there are financial components to your estate plan, there are logistical ones as well. Imagine if you (and your spouse/partner) both passed away suddenly in a car wreck. Is your house in order? Not only should you organize your financial house so loved ones can find your legal documents, but you also get the physical house in which you reside. Now is the time to think about downsizing and decluttering. Go through the closets, the attic, the garage and get rid of things you no longer need. Some of it your children or friends might love to have, some would make valuable contributions to local organizations, and some of it is just junk. Part of your estate plan should be to make it easier for your children to manage your property – and all the things in it – after you’re gone.

6. Legacy Plan

Your legacy is how you want people to remember you after you die. You can create your own legacy in different ways. For one, through philanthropy. If you expect to outlive your assets, develop a legal plan for giving. This could include to your children or grandchildren and/or charitable contributions to causes that represent your passions and priorities.

But your legacy is more personal than that. As you get older, you will lose people in your life, and you could die unexpectedly. Your pre-retirement plan should consider how you can repair and strengthen relationships with people in your life with whom you are estranged or not on easy terms. After all, how they remember you will also be part of your legacy.

7. Find Your Raison d’Etre

If you live a long life, you will lose friends. You may lose your spouse or life partner. You may lose siblings and even children before you pass on. How will you feel/survive/bear it? Translated from French, your “raison d’etre” means “your reason to be.” More than any other time in your life – when all your goals, dreams and relationships were ahead of you – in retirement you or your spouse may end up alone. It is vitally important that you think about and figure out what things make you happy, and are sustainable to keep making you happy should you outlive loved ones or even suffer from health problems. This is not an easy task, and a later article in this series will offer ideas on how to approach it.

The next seven Financial Planning articles in this series will discuss in more detail each of the steps previewed in this pre-retirement planning guide.

One of the more insightful quotes of baseball great Yogi Berra was, “If you don’t know where you’re going, you’ll end up someplace else.”

When you’re young, first starting out in life and career, the path to professional success and personal fulfillment isn’t always clear. Most people start out on a track and then adjust as they go along — based on what they learn, who they meet, and cultivate their choices given their opportunities.

Fortunately, the path to retirement need not be so nebulous. By the time you start thinking about retirement, most people have quite a few certainties in their life, such as career, family and assets they hold like their home and investment portfolio. Clearly, this is a great foundation for retirement planning. But it is only the beginning.

There are a lot of factors to be considered before entering this new phase of life. The following is Part 1 of a two-part series on the steps to take in pre-retirement planning.

1. Budget

Most people live on a budget, whether they mean to or not. That’s because, barring excessive spending on credit, most people can only spend as much as they earn. Once you retire and are no longer earning income, spending is generally reduced to match your new income sources, such as Social Security, a pension, investment interest, and dividends, etc. For most retirees, that means they need to spend less than they did before, at least in terms of regular monthly expenses.

Therefore, the first step in planning for retirement is to identify what your income sources will be, how much they will provide each month, and compare that to how much you will need. It is generally advisable to keep working until you have paid off major debts such as your mortgage(s), car payment(s), and any significant balances on credit cards, home equity or personal loans. The ideal plan is to retire when your annual household expenses match or are less than your long-term retirement income sources.

2. Goals

Just as you did as a young adult, you should establish goals for your retirement years. You may have already accomplished buying a house, having a family, and working a fulfilling career — but life doesn’t end at retirement, and neither should goal setting. Otherwise, days can turn into months and years, and you’ll wonder why you never landscaped the backyard the way you wanted or took that trip to Europe. Setting goals and funding sources before retirement gives you these projects to look forward to.

3. Finances

Up until now, your finances may be all over the place. You may have one or more 401(k) plans still managed by former employer custodians. You may have investment accounts in various places, having been persuaded to open new accounts by different brokers, college savings plans, and health savings accounts. If you’re married to someone with lifelong income and investments, double that scenario.

When you start thinking seriously about retirement, consider consolidation. It’s time to roll over old accounts into a Roth or traditional IRA. It’s time to think about whether it’s more efficient to pay taxes on tax-deferred money now or after you retire, depending on your current and future income tax brackets. It’s also time to buckle down and max out your current investment options, such as a 401(k) and IRAs. In 2024:

• Each spouse over age 55 may contribute up to $23,000 to an employer retirement plan (e.g., 401(k), 403(b), 457(b), or Thrift Savings Plan), plus an additional $7,500 in catch-up contributions, for a total of $30,500 on the year (up to $61,000 for a working couple).
• Each spouse over age 55 may contribute up to $7,000 to a traditional or Roth IRA (or combined between the two), plus an additional $1,000 catch-up for a total of $8,000 (up to $16,000 for a working couple).

For a two-income household behind on retirement savings, these opportunities alone offer the ability to save $77,000 a year until retirement. But you may ask: How can you afford to save that much and still maintain household expenses? Check out next month’s Part II: Pre-Retirement Planning Guide for additional steps on how to design a comfortable and secure retirement.

If you would like to donate artwork to an eligible charitable organization, you might be able to take a deduction on your tax return. However, the rules are complex. There are different requirements for different values, and there are scams you want to avoid that could lead to severe consequences for taxpayers who abuse this deduction.

Generally, the deduction for donated art is based on the fair market value of the property. This refers to the price the artwork could reasonably be expected to sell for on the open market. To qualify for the deduction, note that the value of an art donation may be limited to between 20 percent and 60 percent of the taxpayer’s adjusted gross income, based on the type of organization and whether the deduction must be reduced.

For the donation to qualify for a deduction at the full fair market value, the artwork must be used by the charitable organization in a way that relates back to its charitable purpose. For example, art is donated to an art museum or school. Otherwise, the deduction is limited to the amount of capital gain realized had you sold the property instead of giving it to a charity.

Requisite Tax Documentation

The IRS requires the following records to claim a charitable art donation deduction:

• Name and address of qualified receiving charitable organization
• Date and location of the donation
• Detailed description of the artwork

The following details require additional documentation based on the value of the art donation:

• $250 or more requires a documented acknowledgment from the recipient
• $500 or more must file Form 8283 with a tax return, and records must be retained documenting how and when you obtained the artwork as well as its cost basis
• $5,000 or more, the donor must obtain a documented qualified appraisal no more than 60 days before the contribution date
• $20,000 or more must include the signed appraisal with your tax return
• $50,000 or more, request that the IRS appraise the artwork and issue a Statement of Value to substantiate the value

Fractional Gift/Deduction

It is possible to make fractional deductions for an art donation as long as the artwork is wholly owned by the donor or shared between the donor and the charity. Furthermore, fractional donations must be completed within 10 years of the initial fractional gift or the donor’s date of death.

Artist Donation

The art tax deduction is more beneficial to collectors than artists. If an artist decides to donate a piece to a charity, he can deduct only the cost of the materials used to create the art – assuming he hasn’t already claimed them as a business deduction.

IRS Caution

Recently, the IRS has published warnings about art tax deduction schemes being promoted by fraudsters. It starts with a promotion encouraging (usually high net) taxpayers to buy art at a “discounted” price. The entity or person will offer various accompanying services, such as appraisal, storage, and shipping. The promoter may then help the taxpayer donate the artwork to one or more specific charities in order to claim a higher deduction than the purchase price.

The scheme generally involves waiting a least a year before donating in order to claim the deduction at an inflated fair market value. Some promoters work with taxpayers to donate art on a rotating basis every year in order to continue receiving the artificially inflated deduction. The following are some red flags from the IRS that indicate an art deduction scheme.

• Be wary of buying multiple works by the same artist, especially when the art appears to have little to no market value beyond what the promoter is advertising.
• Be wary of an appraisal that does not adequately describe the art in terms of rarity, age, quality, condition, the stature of the artist, the price paid, and the quantity purchased.
• Remember that taxpayers are ultimately responsible for the accuracy of information reported on their tax returns. Avoiding taxes by participating in an overvalued art scheme could lead to back-tax payments, additional penalties and interest, additional fines, and even imprisonment.

Another option is to simply sell the art and donate the proceeds to a charity. The donor may owe capital gains taxes on the sale, but it’s possible that the charitable donation deduction will offset this expense.

As with all complex tax deductions, it’s a good idea to consult with a tax professional or legal advisor when donating artwork. This can help ensure that both the taxpayer and the charity are able to maximize the potential benefits of the donation.

A widow or widower is eligible for a survivor’s benefit from Social Security even if they never worked – as long as the deceased spouse qualified for benefits based on his or her own income record. Also, note that surviving spouses must have been married to their most current spouse for at least the nine months prior to their passing or for 10 years if the couple was divorced.

When Can You Claim?

A widow/er may apply for benefits once she turns age 60, age 50 if she qualifies as disabled or if she is responsible for the care of a child under age 16 (or a mentally or physically disabled child aged 16 or older). However, if the widow/er applies for a surviving spouse’s benefit starting at age 60/50, that benefit will be permanently reduced from the maximum amount available if she were to wait until her own full retirement age.

What Is Full Retirement Age for the Widow/er?

For anyone born from 1945 to 1955, their full retirement age (FRA) is 66. If born between 1955 and 1959, FRA increases by two months each year from age 66 to 67. FRA is age 67 for anyone born in 1960 or later.

How Much Can You Get?

First and foremost, all Social Security beneficiaries receive the highest benefit for which they qualify. Therefore, if a surviving spouse would receive a higher benefit from her own record of earnings than that of the deceased spouse, then that’s the amount she will receive.

If the deceased was receiving Social Security disability benefits when he passed, the survivor benefit is based on the deceased’s disability benefit.

Normally, the spousal benefit equals half the benefit of the higher-earning spouse. However, the surviving spouse’s benefit equals 100 percent of what the deceased worker would have received, including any delayed retirement credits he earned by postponing benefits to age 70.

The minimum surviving spouse benefit at age 60 is 71.5 percent of the available amount. This represents a permanent loss of 28.5 percent of the benefit available at FRA. The widow/er benefit is reduced for each month shy of his or her own FRA, so the closer they get to FRA before applying, the higher the benefit. The amount freezes once they begin drawing benefits, although it will increase incrementally based on cost-of-living adjustments.

The maximum benefit a widow/er may receive is 100 percent of what the deceased spouse would receive if he was still alive. However, that amount may already be reduced. For example, if the deceased began drawing benefits at age 62 instead of waiting until FRA, then that is the maximum benefit the widow/er is eligible for. If she begins drawing early before her own FRA, that benefit will be reduced further.

Ideally, the deceased will not have started receiving Social Security before his death. In this scenario, even if he died in his 50s, his maximum benefit is what he would have received at FRA. Now it’s up to the widow/er to time her survivor benefit – she can wait until her own FRA or take a permanently reduced benefit.

Delay Strategy

One strategy a widow/er may want to consider is to begin her own benefit at age 62, even if it is less than what she would draw as a survivor. Then, she can delay drawing the survivor benefit until it grows higher – ideally, the highest benefit at her FRA.

If the widow/er does not have her own benefit from earnings or can’t live on that amount alone, she may want to withdraw income from other sources, such as retirement savings or an annuity. While that may reduce her overall net worth, it’s important to remember that the Social Security benefit continues for life, so it may be worthwhile to get the highest benefit possible. Other accounts, such as an IRA or 401(k), will stop paying out income once they are depleted.

If the widow/er has a stronger earnings record, another option is to begin drawing the survivor’s benefit early and delay taking her own benefit until FRA or age 70, to receive a higher benefit for life based on her own record. Once she applies for her own benefit, the payout will increase to a higher amount.

Seek Professional Advice

Knowing when to begin drawing a widow/ers benefit can be challenging. The best option is usually based on factors such as other income resources and even the widow’s health. If in poor health and not expected to live many years, it may be wise to begin the survivor’s benefit as soon as possible. Otherwise, it’s probably better to wait and get a higher payout for as long as she lives.

Another thing to keep in mind is that if the widow/er doesn’t know the deceased spouse’s FRA benefit at the time of death, she is not likely to find out until age 60. The Social Security shuts down the deceased’s account at death and won’t reveal the benefit until the widow/er is of qualifying age to begin receiving it. It’s always a good idea for both spouses to check (and share with each other) their accrued benefits each year so that they have accurate numbers to plan with in case one spouse passes away.

When a company decides to conduct a reverse stock split, also referred to as a stock consolidation, the number of shares available to investors is reduced.

In a normal (forward) stock split, a company increases its number of outstanding shares without changing their market value. For example, one share of stock valued at $200 may split into two shares, with the shares then valued at $100 each. So, with a shareholder who holds 10 shares for a total of value of $2,000, a traditional one-to-two (1:2) stock split would change his holding to 20 shares – still valued at $2,000. The difference is that the value of each stock would change from $200 to $100.

The opposite occurs with a reverse stock split; a company decreases its number of outstanding shares without changing their market value. Using the same example, a shareholder who owns 10 shares at $200 would hold only five shares after a 2:1 reverse stock split. However, the worth of each share would double in value to $400.

Why Conduct a Reverse Stock Split?

A reverse stock split often indicates that a company is in financial distress, its stock price is on a downward spiral and it wants to reverse that momentum by giving investors a higher share value. This makes individual stocks more valuable to sell. In many cases, the company’s sinking stock price puts it in danger of losing its place on a stock exchange, which would then limit the pool of possible buyers – particularly fund managers and stock brokers. In most cases, companies that conduct a reverse stock split are small, lightly traded companies as well as some exchange-traded funds.

Impact on Small, Retail Investors

Smaller investors are more likely to be negatively impacted by a reverse stock split because they are more likely to own fewer numbers or fractional shares. For example, if a company conducts a 20:1 reverse stock split, investors receive only one share for every 20 they hold. However, if a shareholder owns less than 20 shares, he will simply be paid cash for his shares and his position would dissolve. This also holds true if the investor owns an uneven multiple of the reverse split. In the scenario of a 20:1 stock split, if the investor held 110 shares, he would receive five new post-split shares and be paid in cash for the remaining 10 shares.

How Do Stocks Perform After a Reverse Split?

While the total value of a shareholder’s holding would not change after a reverse stock split, history has shown that share prices after a reverse split tend to stagnate or continue to drop. After all, the company was likely already in financial distress, and this action serves to increase the price of a failing stock. It does not usually entice new investors or motivate current ones to invest more money in the company.

Potential Advantages and Disadvantages of Reverse Splits

To remain listed on a major stock exchange such as the NYSE or Nasdaq, a company’s share price must trade at $5 or higher. The advantage of a reverse stock split is that it increases the value of shares, which may allow them to remain listed on a major exchange. This offers value to both the investor and the company, as exchanges attract far more investors whose interest can help drive up the stock price.

Another scenario in which a reverse stock split is advantageous is if a corporation is planning to spin off a portion of its business into a separate company. By conducting a reverse stock split before the spinoff, shares of the new company are assured of having a high enough stock price to be listed on a major stock exchange.

However, a reverse stock split is most often a signal that the company is failing, is worried about a pervasive decline in its stock price, and is seeking a way to artificially increase investor share prices.