Eight ways to avoid the AMT

My colleagues at the Alliance of Cambridge Advisors (ACA) are a smart bunch! Earlier this week we had a great discussion about Alternative Minimum Tax (AMT) and the implications for said tax for millions of middle-class Americans. Below is an excerpt of a very recent ACA blog post highlighting some of the issues/difficulties around planning for AMT.

As the election season heats up, we’re hearing about the presidential candidates’ plans for the economy and taxes. I’m all in favor of revamping the tax code to make it simpler and more straightforward to understand, especially when it comes to reforming the out-of-date Alternative Minimum Tax (AMT) system. If you haven’t had the pleasure of meeting the AMT, it is a parallel tax system instituted in 1969 when it was discovered that 155 people with adjusted gross incomes greater than $200,000 paid no federal income tax on their 1967 income. According to a May 2001 report by the Joint Economic Committee, the ensuing outrage prompted more letters of complaint to Congress than the Vietnam War. In response, Congress enacted a minimum income tax, the precursor to the AMT. One could argue that the real purpose of the AMT was to diffuse the outcry about some not paying their fair share. Sound familiar? But because the AMT was never permanently indexed for inflation, when combined with effect of the 2001 and 2003 tax cuts, more and more taxpayers who were never originally targeted have been caught up in the calculation and millions of Americans now pay AMT. Each year in recent years, Congress has passed a patch to index AMT for inflation to keep an additional 16 million taxpayers from being subject to AMT.

It is hard to know exactly who will be snagged by the AMT, but the likelihood is increased if any of these apply: your gross income exceeds $100,000, you have several children, significant itemized deductions, large capital gains, you own a business, or receive incentive stock options. I have seen a definite increase in the returns that must at least run through the calculation, as well as those that are subject to the tax. Fall is a good time to do a “sneak preview” of your taxes and head off any surprises with good tax planning.

Here are eight ways to avoid AMT
1. Don’t prepay state income and property tax in years you are subject to the AMT.
2. If your employer reimburses business expenses, such as mileage, make sure you have an “accountable” plan to keep them off your return.
3. Consider not claiming exemptions for college-age children. The AMT disallows personal exemptions, so there’s no extra tax to pay by giving them up. Letting children claim their exemptions can save income tax and possibly qualify for tuition credits that may be lost.
4. Avoid private activity municipal bonds, and consider using AMT-free mutual funds where they make investment sense for you.
5. Defer exercising Incentive Stock Options where it makes investment sense.
6. Capitalize, rather than deduct, investment expense.
7. Schedule business equipment purchases when you can use your full depreciation deductions.
8. Defer recognizing capital gains as they increase taxable income subject to the AMT.

You can read the full post here – it is worth a read.

Thomas

Getting a New Car – Should I Buy or Lease?

First of all, congratulations on your upcoming purchase! Buying a car can be a stressful experience for some – but it’s mostly fun, if you go about it right. Hopefully, you’ll leave the lot really enjoying your new ride!

We get asked about buying versus leasing a new car quite a bit. For a long time, we were advocates of buying a car outright, rather than leasing, if at all possible – for all the traditional reasons. In recent years, though, there’ve been a few developments that make leasing a bit more palatable. And in some special situations, leasing rather than purchasing makes a lot of sense. The key is knowing when that applies.

Advantages of Buying

• You don’t need to worry about mileage charges.
• No one’s going to charge you extra if you spill ketchup on the seat.
• Your kids can mess up the back seat and it won’t cost you extra (until you sell).
• You can sell the car. When you account for the resale value of the car, the cost of owning is generally much lower over the life span of a particular car than leasing is.
• If you finance a car, your monthly payments will eventually end.
• If you buy a car for cash, your monthly payments end right away!
• Cash can help you get a substantial discount if you ask the right person.
• Factory warranties on new cars are more robust than ever. Ongoing service was a big advantage of leasing: If your car broke, the dealer typically had to repair or replace the car, which worked for the driver. Then Hyundai started guaranteeing its new cars for seven years, and other manufacturers’ warranties have been getting longer, which took away a big advantage of leasing.

Advantages of Leasing

• Monthly payments are lower.
• You can use the money saved productively. For example, you can invest it, just as well as a finance company can. This opportunity cost is an often overlooked consideration.
• Maximize business cash flow. We all know cash flow is critical. Leasing, rather than purchasing a vehicle can preserve this precious resource for businesses, but also for households as well.
• Tax laws allow businesses to deduct the full amount of a lease against their earnings as a business expense. Purchases normally have to be depreciated over a number of years, under MACRS rules. However, this isn’t as big an advantage as some people think, because you can also get a substantial first-year deduction by purchasing a vehicle under Section 179.

Also, keep in mind that if you put a lot of business-related miles on the car, you can choose to deduct mileage instead of actual lease expenses. This might be a lot more than your lease fee or your payments on a purchase. If so, it pretty much negates some of the advantages of leasing. As of this writing, you can deduct 58 cents per mile for the business use of a car. This is true even if you are an employee and your employer does not reimburse you your mileage expenses. (Remember that you can only deduct for the business use of a vehicle. If you use a vehicle 20 percent for personal reasons, you can only deduct 80 percent of expenses and 80 percent of your lease payment.)

Insurance Considerations

A lot of people forget about this one. But when you wreck a leased car, your insurance carrier will generally cover the replacement cost of the car at its market value when you wrecked it – minus your deductible, of course. That might be a good deal less than the amount you still owe on the lease. You may need to get “gap” coverage to cover the difference. The premium for this coverage could eat up a big chunk of the difference between a purchase price and a lease price.

Special Circumstances

Life doesn’t happen in a vacuum, and neither should your purchase decisions. Here’s a case where leasing makes a lot of sense: We know a military reserve officer who is frequently called to active duty — not just for deployments, but for various service schools and other training engagements. The Soldiers and Sailors Civil Relief Act requires dealers to cancel leases when a reservist is called to active duty. Every time this officer is activated, he simply turns in the car he doesn’t need anymore, goes off on his duty tour, and signs a new lease when he returns. Meanwhile, when he’s home, he drives very cheaply. If he owned the car, it would sit idle in his garage for months at a time.

This is an extreme example. But let’s say you planned on moving to the mountains in two years. You would want an SUV then. But if you live near the coast now, you may get more enjoyment out of a low-mileage convertible for the next two years. In this instance, you may want to lease one while you save money for that SUV.

Or, perhaps you plan on moving to Hawaii in two years. You may not want to pay the cost of shipping a car you own, or going through the stress of trying to sell a car while you get ready to relocate. This is another case where leasing works well in the real world.

Other Options

If you’re very sensitive to the price difference between leasing and purchasing, consider another option: Buy a pre-owned car. It doesn’t need to be a clunker – you can buy very good one- to four-year-old cars, or “off-lease” vehicles. For example, some companies have “certified pre-owned” programs that give you a break on the new vehicle price, while still coming with many of the guarantees and warrantees that come with a new car – or you can buy an extended warranty if you want still more security.

Note that you may have to come up with more of a down payment. Generally, pre-owned cars don’t qualify for the “no money down” programs you hear advertised.

One thing we help people with is a process called a “break-even analysis.” This is a pretty straightforward financial planning process where we help clients work through the math of two or more different financial courses of action.

But financial planning is only part mathematics. Some of it is psychology and some of it is art. This isn’t an algebra class, and the math doesn’t always work the same way for everyone. If you need to work through the pros and cons of leasing versus purchasing, give us a call today!

What Kind of Life Insurance Do I Need? Telling It Like It Is

When you turn on the news, you often see talking heads pounding the table and saying “buy term insurance! The only life insurance you will ever need is term insurance!”

Well, that’s not true, by a long shot. Most of these folks can barely spell “insurance.”

Here’s a little secret: The best kind of insurance to own is the kind that is in place when the insured dies.

And here’s the corollary to that law: The best amount of life insurance to buy is the amount you can easily afford.

Both policies – term insurance, and cash value policies, have their place. Don’t trust anyone who’s a zealot for one kind of policy over another: That’s like someone who waxes rhapsodic over the benefits of hammers when you’ve handed him a screw! Use the policy that 1.) you can afford, that 2.) best fits your need, and 3.) most likely to be in force when the insured dies.

Do these three things, and it’s tough to go wrong.

Two Kinds of Needs

Sure, you can get fancy with things like cash values and non-direct recognition accumulation of dividends and the so-called “be your own banker” or “infinite banking” ideas (more on those in a future column). But when you get down to brass tacks, life insurance is all about providing a tax-free death benefit to whoever will have a desperate need for immediate cash when the insured dies. That’s it. All the cash values, and all the gee-whiz tax benefits of life insurance are in the death benefits, and only there because of the death benefits.

Now, there are two kinds of death benefit needs: Temporary and permanent. Temporary needs will go away after a certain period of time. Permanent needs will never go away. They will still be there no matter how long you live. The best way to do life insurance planning is to make sure the right kind of insurance is covering the right kind of needs.

Here are some common examples of temporary needs. Think term insurance for these:

• Providing for a college fund for children.
• Pay off your mortgage.
• Pay off a debt your estate will owe if you die.
• Provide money to raise your children for as long as they live at home.
• Any needs that might be permanent, but you can’t afford permanent insurance premiums yet.
• Lock in coverage at a favorable rate when you’re young and healthy.

For these kinds of needs, term insurance is usually the most cost-effective way to provide large amounts of coverage for a finite period of time.

Here are some permanent needs. These are the kinds of things you would match up with permanent insurance policies, such as whole life or universal life (again, more detail on these kinds of policies later).

• Provide for a final expense or funeral fund
• Pay off possible medical expenses
• Pay anticipated estate taxes (so your family won’t have to hold a fire sale on illiquid property or small business interests to raise cash quickly
• Provide enough cash to tide your heirs over until other assets make it through probate
• Pay off mortgages taken later in life, when term insurance premiums will no longer be economical.
• Equalize an illiquid estate. For example, one child may have a desire to take over the family business. Another child may have no desire or aptitude for it, and may want cash instead. A cash death benefit may allow one heir to buy out your other heir’s interest in a business, farm or other property.
• Fund a buy-sell agreement for a business
• Create a non-qualified executive compensation plan, or “golden handcuffs” for a key employee.

For temporary needs, use term insurance. My preference is for “convertible” policies, that allow you to convert to a permanent policy if your needs change – preferably priced at the age at which you bought the original term policy. Some policies you can’t convert to permanent, even if you wanted to. The company may not even sell permanent, or the kind of permanent policy that you want.

Why term? It’s cheap in the short run, and most people can afford a lot of it – even early in their careers. You can always drop part of a large death benefit if you don’t want it later. But if your health goes south, or even if you get a DUI, it’s tough to buy more insurance later in life.

But permanent policies, such as whole life, and in some applications, universal life, serve an important role, too. The need for liquidity at your death won’t go away just because your 20-year term expires. And your “invest the difference” money could be stuck in probate for months, leaving your heirs in a tight spot.

Here’s the thing to keep in mind: Term policies are actuarially designed to lapse. Only about 2 to 5 percent of term policies ever pay a claim. That’s why they’re so affordable! Plus, if you buy a term policy at any age – and hang on to it to your actuarial life expectancy, you will pay more in premiums than your heirs will ever receive in a death benefit. In the short run, term is very affordable. In the long run, term is expensive. Very expensive.

With permanent policies, it’s quite the opposite: Whole life policies, in particular, require a pretty big commitment for the same amount of death benefit. Very few young families can afford permanent insurance for the total amount of death benefit they need. But in the long run, if you live to your actuarial life expectancy, you will get far more out of a whole life policy than you ever put into it – either via cash value or via the death benefit.

In the short run, whole life is very expensive. In the long run, it doesn’t cost anything. You just have to commit to it for an extended period of time.

Lapsed policies

A few rules of thumb to bear in mind:

George S. Patton, the great American WWII general, was fond of saying that “the best is the enemy of the good.” By the same token, the second best policy that you can afford to keep in place is much better than the perfect policy that you will lapse.

It is better to buy convertible term now, and figure out the best policy later, than to go uninsured while you make up your mind – and risk dying, or becoming uninsurable.

Permanent insurance is oversold to the people who can’t afford it, and undersold to the people who can. Stick with what you can easily afford.

Some insurance agents will try to sell you a cash value policy to supplement retirement plans, or college savings, or for tax or wealth protection purposes. When the right kind of policy is placed with the right kind of client, these can be excellent vehicles. But they are not a great fit for everyone. If you’ve got an agent proposing a plan like this, no worries filling out an app and getting into underwriting. It’s all theoretical until you get an offer, anyway. But give us a call before you accept delivery of the policy. Your agent should give you an illustration, which is a projection of the policy’s cash values, premiums and death benefits into the future. We’ll help walk you through it give you an impartial assessment of it, and help you determine if that particular policy is the best one for your needs. A small investment now could make a difference of tens of thousands down the road.

Thomas