Tax Diversification

Congress has a mountainous struggle ahead with debt. We’re already borrowing 40 cents for every dollar of federal outlays. Structural and demographic issues hardwired into the Social Security program since the baby boomers were born are about to make themselves felt – overwhelming payroll tax receipts. And Medicare is in even worse shape. Meanwhile, Congress stripped 500 million from Medicare over the next 8 years to fund ObamaCare, which we now know will cost about $800 billion more than advertised over the next ten years.

One way or another, taxes are going to go up.

What we don’t know is how. Will Congress raise taxes on Social Security income, as the Clinton Administration did in 1993? Will they raise the retirement age to 70 and beyond to balance Social Security cash flows? Will they get out of the Medicaid business and leave it in the hands of the states? Will they move to nationalize 401(k) and other pension assets, or tax their growth? Will they make Roth IRA income taxable?  Take away the homeowners mortgage interest tax deduction? Raise income tax rates or lower exemptions? Tax life insurance cash value accumulation and/or death benefits? Raise the estate tax or slash the current exemption of $5 million?

We don’t know.

You’ve heard of investment risk and inflation risk. In the bond world, you have default risk. Well, all investors in America must also deal with the presence of legislative risk: The possibility that Congress will pass laws that substantially change the present or future value of your assets, and present changes to the set of assumptions that guide your investment and savings decisions.

Tax Diversification

That’s why it’s important to spread your legislative risk among many different types of assets: Tax deferred retirement accounts, pensions, home equity, savings in taxable accounts, municipal bonds, dividend paying stocks, cash value life insurance – all have an important role to play in building a tax-diversified retirement portfolio.

We believe it’s important to divide assets among at least three “buckets,” the taxable bucket, the tax-deferred bucket, and the tax-free bucket

Taxable Assets

These are assets that don’t present an income tax bill after the year in which you receive them – at least, under the current set of laws. Instead, Congress levies capital gain taxes on any profits you make – though they may charge income tax of some kind on dividend income these sources generate.

The main benefit here is the favorable rate accorded to long-term capital gains – that is, profits on assets you held more than a year.

You can also mitigate your tax liability through techniques such as tax loss harvesting – that is, selling some losers to generate capital losses, to offset your gains (and up to $3,000 of income in any given year).

Examples of assets in the taxable bucket include most things you hold outside of retirement accounts, including rental real estate, your own home (you do get a $250,000 or $500,000 capital gains exemption on your personal residence, depending on whether or not you are married, though Congress can modify this at any time as well). CDs, bank accounts, money market accounts, bonds, mutual funds, stocks, and investment property, including collectibles, tends to fall in this category unless you put it in a retirement fund.

Tax-Deferred Assets

Tax deferred assets include things like deferred annuities, 401(k)s, SEP IRAs, SIMPLE IRAs, 403(b)s, and traditional IRAs. These assets are most vulnerable to an increase in income tax rates in future years. Congress could also begin charging for transactions within them, to some extent, though they would have some difficult questions to explain to the public about why they were changing the rules after investors had committed these funds.

Tax Free Assets

Tax free assets include assets you already paid taxes on, which current law allows to grow tax free, and generate tax free income to you. This works for you very well if you front-loaded your income taxes when rates were comparatively low – as they likely were during the Bush Tax Cut era. Congress is quite likely to repeal the Bush cuts at some point – perhaps after the economy has recovered somewhat and the Democrats retake control of the House.

Examples of assets currently inhabiting this bucket include Roth IRAs, designated accounts in 401(k)s, and cash value life insurance (funded under modified endowment contract limits).

By dividing your assets among each of these tax buckets, you can go a long way towards avoiding a severe shock to your retirement income or plans to pass on assets to the next generation.

Part of our process is looking beyond your assets and asset classes to help ensure you are diversified against acts of Congress as well as acts of God and acts of neurotic stock market players and bond players.

Year-End Tax Tips – 2012 Edition

I don’t remember a time when there was more uncertainty over the tax scheme in the years ahead. Both parties have very different visions about where they want this country’s tax code to go – and they are at variance with the current law, which will automatically enact a substantial tax increase in January that nobody wants. But the two sides may not be able to come to a year-end agreement – particularly if the opposition party wants to hamstring whoever wins the White House this year by sticking them with the sequestration tax increases, spending cuts, and probable recession that would result.

Despite the uncertainty, though, there are some moves I’m comfortable suggesting:

• Harvest those tax losses. If you have an investing portfolio with both winning positions and losing positions in it, you can use your losses to cancel out your gains – reducing or eliminating your capital gains tax for the year – a technique called “tax loss harvesting.” If you have more losses than gains in any given year, you can deduct those losses against future capital gains. If you have no capital gains to deduct them against in the following years, you can use those losses to cancel out up to $3,000 of income per year.
• Sell winners. Consider doing so even if you can’t offset capital gains with losses: Taxes on capital gains are set to increase by as much as 33 percent come January 2013, when the tax on long-term gains will increase from 15 percent to 20 percent.
• Close out any sales of closely-held businesses you’re trying to put together, for the same reason. If you sign over appreciated stock in your own corporation, or assets at a profit, delaying the transaction from December to January could be very expensive.
• Remember the 3.8 percent surtax on capital gains. If you make more than $200,000, or $250,000 as a married couple, it’s even more important to move gains into this year to avoid the 3.8 percent tax on capital gains imposed by the Affordable Care Act. That’s in addition to the across the board capital gains increase.
• Careful with mutual funds. Are you considering a mutual fund? Look up the funds’ distribution date, which often falls in November. If the fund has a lot of embedded capital gains, you could get stuck with a big taxable distribution. That means you will have to pay capital gains tax on money other people made. That doesn’t mean mutual funds don’t make sense. Just go in with your eyes open.
• Do you control a C corporation? Take as much dividend income as you can this year. If you wait until next year, you could wind up paying 39.6 percent on those dividends, rather than the 15 percent on qualified domestic dividends you get this year.
• Oops… did I say 39.6 percent? Add the 3.8 percent Medicare surtax to that figure if you wait until next year. That’s what will happen under current law, unless Congress intervenes. I suspect it will… I don’t think either Republicans or Democrats want a full sunset of the Bush tax cuts, plus the Medicare surtax to hit all at once. But Congress has done dumb things before – and you can’t ignore what the law on the books says now.
• Self-employed? Try to push income to 2012 rather than take in 2013, if possible. That will save you 2 percent on your self-employment tax, since the employee’s share of the tax is increasing by 2 percent as of January 1, from 4.2 to 6.2 percent.
• Schedule an AMT review with your tax advisor. You may need to make some moves with stock options, or push certain deductions to a non-AMT year. You may also want to accelerate income to the current year, or hold off on constructive receipt of income until 2013, depending on your overall situation. Everyone is different when it comes to the AMT.
• Do you itemize? Schedule a Pease limitation review with your tax advisor. You might want to push deductions to this year rather than risk losing the ability to take certain deductions next year

These are just the basics. There is a lot to discuss when it comes to taxes as we come to the end of the year. We’ll certainly be covering them, looking at these in more detail and digging into other year-end tax planning issues, too. Keep tuning in to my blog Penge Snak!

On Getting Out of Debt

Let’s get the obvious out of the way: Being debt-free is much better than having debt. In terms of the end state, it’s a no brainer: Nobody who was debt free at the time ever got foreclosed on or had to file bankruptcy.

There is a lot of truth to the Biblical adage “the borrower is servant to the lender.” And if you can get to the point where you are completely debt free, you are going to feel pretty good about it. As well you should.

But that doesn’t mean I’m a zealot about aggressively paying down debt ahead of schedule, either – especially where you’d have to liquidate productive assets to do so, and where the interest on the debt is tax deductible, such as on a business loan or home mortgage.

The Economic Situation

The United States stands on the edge of what pundits are calling a “fiscal cliff.” Unless Congress intervenes with a budget deal, then there are going to be some big changes to the economy – and those changes are going to be disruptive to a lot of people.

Specifically, come January 2014, a number of tax increases will become effective – and will begin rippling their way through the economy almost immediately. On top of that, the so-called “sequestration” provisions of the Budget Control Act become effective. In a nutshell, because Congress couldn’t reach a deal on the budget, the automatic spending cuts kick in, and each federal department will have to cut spending by a significant margin. Specifically, 2013 the across-the-board cuts will result in 8.4 percent cut in most non-defense discretionary programs. Defense programs will get slashed by 7.5 percent, Medicare provider payments will fall by 2 percent, and all other programs will take an 8.0 percent  cut. This is going to hit discretionary programs the hardest. A lot of non-essential government workers could be let go – and defense contractors are already beginning to issue notices of mass layoffs.

The California Housing Bubble of the Mid 90s

If you’ve been around the markets a while, you may remember a massive housing bust in California in the early to mid 1990s. This happened because of the large-scale cutbacks in defense spending as we came out of the Cold War – a lot of defense industry companies are concentrated in the Southern California Orange County-San Diego corridor. Housing prices there collapsed by nearly half in some areas – and this when the economy was much stronger than it is now.

The effects of sequestration aren’t going to be evenly spread across the country. They will affect areas with a high concentration of federal employees and federal contractors first. And the effects will not be limited to those employees but felt throughout the economy at large. Those workers will cease going out to dinner, they will buy less gas, they will go to the movies less. They will take fewer vacations. They will move in search of employment elsewhere and they will have to sell their houses in the teeth of a severe bust where they are coming from. They will default on loans and foreclose.

Yes, federal employees have the option of borrowing from their Thrift Savings Plan. But only when they are still federal employees! Once they leave the service of the federal government, they can no longer take a TSP loan.  And most of them can’t rely on home equity loans, either – with no jobs and concentrated in areas with declining home prices.

At a certain level. These workers are only about to share the pain the rest of the private sector has been experiencing for years. Federal workers have mostly been sheltered from it, as have workers in private sector federal contractors, who benefited hugely from the so-called “stimulus” law of 2009, in which the government flooded the economy with nearly a trillion dollars in debt-financed spending.

With this in mind, I’m suggesting being cautious with an aggressive debt paydown. With interest on 30 year home mortgages now nudging below 4 percent, tax-deductible, there’s not much reason to pay down mortgage debt ahead of schedule. After all, a 4 percent loan, with tax deductible interest, comes out to about 3.5 percent, and if you’re imaginative, patient and willing to accept some short-term risk, you can usually do better than that rate, over time, by investing it elsewhere.

The most important thing is not so much to get debt free. That was nice when we had a more stable economy, and a laudable goal. But for now, I’m suggesting that becoming debt free should take a back seat to being solvent.

If you are able to maintain a liquid reserve, do so. The ideal is to have cash reserves sufficient to pay down your debt if you wanted to… but keep those reserves invested in something that will keep up with the rock-bottom interest your lenders are charging.

But if your income may be effected by sequestration – directly or indirectly – or if you live in a neighborhood with a lot of federal workers, or you could otherwise be effected, you can’t count on your income to see you through a tight spot. If you lose your income, your credit cards won’t be much help, and it will be tough to get a loan from any source, other than unemployment.

Sure, high-interest credit cards have got to go. They shouldn’t have been added to your balance sheet to begin with. But until the fiscal shocks of the 2013 tax increases and spending cuts from sequestration wind their way through the system, I counsel dialing back the aggressive debt pay-down for now.

I’m not calling for panic. I never do. Just a watchful and conservative prudence, keeping enough in hand to be able to deal with a bad-case scenario should it play out for you and your family.

Meanwhile, preserve your cash as we head toward this fiscal cliff. Go into it sitting on a nice cushion, because chances are higher than usual that you’re going to need it.