Top Year-End Financial Planning Moves

Most people are pretty busy with the holidays at this time of year. But now is an ideal time to make some financial decisions and take advantage of some planning opportunities – some of which will turn into a pumpkin at midnight on December 31^st!

Because almost all individual taxpayers and the vast majority of small businesses run on January-to-December fiscal year, November and December are key months for planning everything from taxes to investments to small business inventory and expansion decisions. Every case is different, but here are just a few of the routine things we look at when we conduct year-end consultations with our clients.

Tax loss harvesting opportunities
 If you have sold property this year at a profit, chances are very good you will have a capital gains tax liability for the year. However, tax rules allow you to subtract any capital losses you realized for the year against your gains. This means you have until the end of the year to find something to sell at a loss, in order to cancel out gains for the year.

At Vaerdi, we routinely go over each of our clients’ assets, helping our clients determine their cost basis in their investments, and work out a tax loss harvesting plan. We also help them plan for the opportunity to use excess losses over and above this years’ gains to offset taxes on up to $3,000 per year in income in future years – and help them navigate the so-called “wash sale” rules.

Alternative Minimum Tax assessment
The alternative minimum tax, or AMT, is actually a separate set of tax rules designed to ensure that high-income families and individuals cannot manipulate the system of available tax deductions to avoid paying significant income taxes altogether. If you have a solid upper middle class income, have a large home mortgage interest deduction, several children, and you take a variety of miscellaneous itemized deductions, now’s the time to make an AMT risk assessment. If you are subject to the AMT, some deductions may be disallowed. There are some things we can do to help you maximize your available deductions, or minimize your exposure to the AMT – but we have to do that planning by the end of the calendar year or many of those opportunities will vanish.

Fund Retirement Accounts
Sure, most of you will want to fund any IRAs you are eligible for by April 15^th. But some of you may have other options as well. For example, if you have your own business, you may be able to fund a SEP-IRA with up to $49,000 for the year – and $49,000 for the next year, or up to 25 percent of your income for the year – whichever is less. Special rules apply to account for those who are self-employed and have self-employment tax liabilities, but the opportunities are substantial – particularly if you can set the plan up by the end of the year. The IRS also gives businesses a tax credit to start up new small business retirement plans, such as solo 401(k)s and SEP IRAs, though it’s too late to claim the credit for a new SIMPLE plan this year.

Accelerate Deductible Expenses
If you were planning on making any deductible purchases, such as inventory or equipment for a business in 2012, you can use a credit card to accelerate those deductible expenses to the current year. That way, you’re using the bank’s money to get an immediate tax benefit. However, not all business expenses are fully deductible in the current year. Some expenses have to be amortized over the useful life of the investment. Special rules may apply for startup expenses and so-called “Section 179” small business expenses, which may allow you to accelerate the deductions on these expenses as well.

Tip: If this year is an AMT year, but next year will probably not be an AMT year, it may not make sense to accelerate deductions. You may be better off taking them next year.

Pay Your Advisor Early.
That’s me, I hope! Most investment advisory fees and tax preparation fees are tax deductible in the current year. By pre-paying your January commissions and fees for advice, you can move the deductions into the current year.

Use Flexible Spending Accounts
Some employee benefits, such as health care flexible spending accounts, operate on a ‘use-it-or-lose-it basis. Be sure to commit any flexible spending account money by the end of the year, or it could revert back to your employer! Now’s a great time to use that money to get new glasses, braces, Lasik procedures, buy needed medical equipment, or get prescriptions filled.

Education Expenses
Try to prepay education expenses for the first semester of 2012 before the end of the year. This is because under IRC 122, higher education expenses are an “above the line” adjustment to income. You don’t even have to itemize to claim the benefit of the college tuition tax credit, which could be worth up to $4,000. But that provision is set to go away in 2012, so you need to commit those funds before the end of the year.

These are just a few of the common year-end planning measures to consider. If you own a business, you may have other opportunities to save on taxes as well. Now’s the time to schedule these appointments, though, because once the new year rolls around, you’ve lost your window of opportunity.

Munipal Bonds – Tax-Free Income? Or Trouble Brewing?

Let’s take a look at municipal bonds, and discuss where they make sense.

In the United States, A municipal bond is simply a debt obligation of a state, county, city or other nonfederal public entity. The United States Government has long sought to make it more affordable for state and local governments to raise money. Therefore, these governments receive an indirect tax subsidy: Interest payments from municipal bonds are normally free of federal income tax. This subsidy allows state and local governments to pay lower interest rates on borrowed money than normally available to private borrowers. Meanwhile, investors in higher marginal tax brackets have an incentive to invest in municipal bonds, because their after-tax income is frequently higher from municipal bonds than they could get from buying taxable bonds – whether corporate bonds, federal agency bonds, or treasury bonds – of similar risk.

Here’s how this works:

Imagine an investor in the highest marginal income tax bracket: 35 percent under current law. He has a choice of two bonds. One is a corporate bond paying 10 percent, the other is a bond issued by his county government to build a new high school, paying 7 percent. The corporate bond would yield him an after-tax income of 6.5 percent, disregarding state income taxes. The municipal bond, however, still generates an after-tax yield of 7 percent, which is better than the corporate, even though the nominal interest rate on the corporate issue is higher.

The difference is even more marked in states that have a state income tax, since local issues are also typically free of state taxes as well as federal. Oregon does not currently have a state income tax, so this is not much of an issue for Oregon residents. The federal tax issue still applies, however.

Risks in Municipal Bonds

Municipal bonds in some areas are coming under a great deal of pressure. State income tax receipts have plummeted in recent years, and property tax receipts have fallen even more. Meanwhile, many obligations of state and local governments proceed apace. Perhaps most significant among them is a substantial and growing obligation to fund pensions and medical care for public retirees. Many of these governments have not set aside nearly enough money in pension accounts to fund expected benefits – a problem exacerbated by today’s low-interest rate climate.

Some state and local governments are already cracking under the strain. Last week, Jefferson County, Alabama went to court to stave off creditors in the largest municipal bankruptcy in history after failing to reach a deal on financing $3.14 billion worth of money they had originally borrowed to improve the Birmingham sewer system. When municipal bankruptcies happen, people who hold municipal bonds may not receive planned interest payments or principal payments on time, as promised.

Protecting Yourself

Obviously, we don’t expect every municipal bond issuer to go bankrupt. But some government entities are in bigger trouble than others. It therefore takes a lot of due diligence to identify quality municipal bonds, and to ferret out the ones most at risk.

The problem for bond buyers is this: Most commissioned bond brokers do little, if any, due diligence on these issues of their own. They’re too busy calling people, trying to make sales. Only a very few have the knowledge, time and energy to add much value in helping their clients try to avoid municipal bond blow-ups. Usually they parrot research that has been handed to them by higher-ups. But the higher-ups are more interested in selling off their inventory of bonds than in selecting the best bond investments for you, the consumer. And the worse the bond starts to look, the faster and harder they will want to sell it off.

That’s why it’s important to have an unbiased opinion on your side – and why we don’t take commissions from bond brokerage houses – and never will.

What do we look for?

Stability in tax revenues. Stable governments in the U.S. are usually characterized by a diverse economy in the municipal area, with income coming into the city, county or state from multiple, diverse sources.

General obligation bonds. There are two kinds of municipal bonds – those which are paid off from one specific source of revenue, such as a toll bridge – and those bonds which are general obligations of that city, county or state treasury. While these governments can’t simply print money to pay off bonds, like the federal government; they do have the legal authority to raise taxes to pay off bondholders. This is an important source of safety of capital.

Headroom. We look for entities with substantial room to raise taxes or other forms of revenue. Governments that already have high tax rates relative to their neighbors do not have an unlimited ability to raise taxes to cover their obligations. For example, if California tried to raise state income taxes much further, it would drive an increasing number of businesses into Oregon, Nevada and Arizona, and fail to raise the level of new revenue one would otherwise anticipate.

Responsible spending. This is getting particularly difficult to find in today’s muni bond market, but ideally we look for governments that tend to spend within their ability to raise revenue and don’t overexpand based on overly-rosy scenarios about future economic prospects

AMT Issues

If you are subject to the alternative minimum tax, you need to be careful about which munis you buy. Certain issues, called “private activity bonds” do not qualify for tax exempt status for those who are subject to the alternative minimum tax.

Tax-Free Income Alternatives

If you want tax-free income but don’t want to take a big risk on individual municipal bond issues, there are several excellent mutual funds that specialize in municipal bond investments. Some of them are specifically designed to avoid private activity bonds. These are the ones to look for if you expect to be subject to the AMT.

Roth IRAs

Alternatively, income from Roth IRAs is also tax free, provided you are over age 59½ and the money has been in your Roth for at least five years. Special rules apply in the case of hardship provisions for those under 59½. Otherwise you must pay a 10 percent penalty to the IRS on any gains.

Life Insurance Income Plans

You can also tap the cash value of a permanent life insurance policy, provided the policy is properly structured. You can withdraw any gains in the cash value over and above your basis, or the amount you have invested. After your gains are exhausted, you can access more cash in the form of a loan against the death benefit. The loan accrues interest, but you can choose whether to pay the loan back or not. Instead, if you don’t pay the loan balance, the insurance company pays itself back out of the death benefit. But you get the benefit of tax free income in the meantime.

For these plans to work, most families need to aggressively fund the policy with as much premium as possible in the early years, and hold on to the policy for a fairly long period of time.

They don’t work for everyone – and again, most insurance agents will try to sell these plans aggressively, often where they don’t make sense given the client’s liquidity. That’s another reason why you should consider having a fee-only financial planner in your corner – to give you unbiased advice about whether the product or solution proposed is the best solution for your particular needs at that time.

Warning

Sometimes we get questions about zero coupon bonds. Generally, these are treasury bonds, but they don’t make interest payments. Instead, you buy them at a deep discount to their value at maturity. They’re a great way to get a guaranteed lump sum of money at a certain date in the future, and are therefore popular vehicles for people saving for college expenses or balloon payments in the future, such as mortgages or car leases with known expiration dates.

However, just because the zero coupon bond doesn’t pay interest payments doesn’t mean you don’t have to pay taxes. You must declare the imputed income from a zero coupon bond – even though you don’t receive the income in cash. So be sure you have the money available outside of the money you’ve invested in the zero coupon to pay any taxes due, or use an IRA to hold the zero coupon.

Financial Advisors vs. Money Managers

I just joined a great group of finance professionals through the Alliance of Cambridge Advisors (ACA) - a premier trade group of independent advisors. Today as I was browsing through our internal archieve of articles, I came across this article by Bert Whitehead (author of several books, including Why Smart People Do Stupid Things with Money) – it’s a great, no-nonsense article for folks who wants to be educated about the advisory world and functional asset allocation.

Financial Advisors vs. Money Managers

Bert Whitehead, M.B.A., J.D.

Recently an ACA member’s client emailed me to comment that we were being paid to manage assets –stocks, bonds, real estate, etc.­— and that I should be suggesting some opportunities to help increase his portfolio during these exciting times.  This is a widespread attitude among clients, and I think it is a fair comment and merits addressing.

 There is a significant difference between ‘Money Managers’ (or ‘Investment Advisors’) and ‘Financial Advisors’ (or ‘Financial Planners’).  Money Managers generally charge based on the size of a client’s portfolio, i.e. assets under management (AUM).  They claim to add value by finding ‘opportunities’ for clients and timing the market.  Some claim they also advise clients on insurance, estate planning, taxes, etc. but they generally are not adequately trained in these areas.  Moreover, people generally do what they are paid to do, and if they are paid based on AUM, they focus on gathering assets and new, exciting investments.

 Financial Advisors take a much more comprehensive approach.  We are trained and credentialed to coordinate all of the financial aspects of a client’s life, with a focus on meeting their life goals.  Certainly investments are an important part of this, and our job is to recommend and monitor suitable Money Managers for clients.  To do this we use the principles of “Functional Asset Allocation” (FAA) and eschew the ‘carnival barker’s’ approach of touting the ‘next hot stock’, or the next investment “frontier”, or other market timing approaches.

 Many new advisors start out with the belief that they can add value by selecting investments.  I’ve been at this for 39 years, and when I started out I tried to convince clients that I could add value by my superior investment knowledge.  I managed portfolios of covered options, came up with strategies using fundamental principles for building portfolios, used technical analyses to determine when clients should switch asset classes, etc.

 In my early career, I did beat the market a couple of years in a row…and then I got whipsawed and was grateful to be able to get my clients’ funds out while they were still ahead.  Given that there are thousands of professional investors in the market, the theory of large numbers will always produce some who consistently beat the market year after year.

 Indeed, Peter Lynch managed Fidelity Magellan for 13 years and reportedly beat the S&P for 11 of those for an average 29% annual return.  The smartest thing he ever did was to quit while he was ahead.  His successors used his same formulae and strategies and have underperformed the market ever since.

(It’s also worthwhile to note that during those years the S&P index was the highest performing general index for only one year. For four of the 11 years the small cap index dominated, international stocks won in 5 of those years, and bonds won out the other 3 times.)

 Interestingly, most ‘financial advisors’ are really ‘investment managers.’  Their proposition is basically:  “Give me your money and I’ll make you rich!”  When I look up and down the street, from small financial firms to large wire-houses, they all make the exact same claim:  “We’re smarter! We know how to beat the market !”  As a matter of fact, most newer advisors, as well as day-traders, stockbrokers and insurance sales people, ultimately pin their success on their ability to convince themselves and their clients that they can produce superior results.

 At some point we have to realize that we don’t live in Lake Woebegone, where all the children are above average.  Every investment guru in the phone book can’t be beating the market at the same time unless they have a Madoff scheme.

 I happened to visit Wall Street during Lynch’s era and saw the office buildings filled with people and computers.  They spent most of their working lives trying to figure out the best investments.  How would I ever be able to outsmart them?  When I researched this more closely, I was struck by the fact that the S&P index outperforms 85% of large cap money managers!

 When I delved into managers who claimed to beat the market and carefully analyzed their performance, I noticed that their success was based on fudging the indexes or benchmarks they used. Many managers today are ‘closet indexers’ who invest most of their clients’ money in line with an established index but with small modifications that, they hope, will help outperform the index.

 I finally realized that most investment managers were charging extremely high fees because they could convince their clients – and their clients wanted to believe – that they produced higher returns.  John Bogle’s new book (“Enough: True Measures of Money, Business and Life”) is a classic expose of how the financial industry has overcharged consumers by creating the myth that there really are gurus out there who can improve investment performance because of their advanced understanding of markets.

 Take note that, of the thousands of studies done in academia, and by pension funds and investment houses, there has never been a single study that has shown that any market-timing scheme worked consistently.  All the credible studies have shown that the keys to investment success are consistent investment, reinvesting profits, and basic diversification.  Investors who jump from one investment to another, or even one asset class to another, consistently show lower returns than the market.  Much of these inferior results are due to excess transaction costs, taxes, and not being invested during up-markets because of wrong decisions based on fear and greed.

 This is when I developed FAA.  I found I didn’t have to decide what the next hot stock was, or if interest rates were going up or down, or if small cap stocks were going to beat large cap stocks.  All I had to do was balance my client’s portfolios to include a range of large cap, small cap, and international diversified no-load mutual funds or index funds.  This portfolio features a rock solid bond-ladder as a foundation to keep clients from jumping in and out of the market every time they listen to Jim Cramer tout the stock du jour on his nightly investment circus.

 The real value added by FAA is due to the comprehensive approach used to grow client portfolios.  Real estate is regarded as a key asset, clients are coached to not do stupid things, inflation is dealt with intelligently, a bond ladder is used as a hedge and to assure consistent cash flow, wealth is preserved by cutting losses, behavioral obstacles are addressed, and  tax strategies are employed to improve overall investment return.

 The key advantage for my clients is that, no matter what new investment frontier is touted as “hot”, our clients are already invested in it because they stay balanced.   When I look back at the thousands of successful investors I have known, none of them did it by ‘smart investing.’  Most wealthy people attain wealth by investing ‘sensibly’ and avoiding stupid mistakes.  The worst stupid mistake is to start believing in carnival barkers.

 The unique perspective of ACA members comes from being able to advise a client from a comprehensive view of their situation, which requires a higher level of credentials than is available in a field dominated by sales people.  We can include tax advice along with investment strategies, sensible insurance approaches to enhance estate planning, etc.

 The major problem in financial advice is not the lack of ideas about new opportunities. The fact remains that the majority of financial advisors are not true fiduciaries and are incentivized to give advice that is better for their own pocketbooks rather than their clients’.