Tax Avoidance Versus Tax Evasion

With Mitt Romney, though, we have a different kind of animal. As a managing partner in Bain Capital, LLC, he routinely engaged in relatively complex transactions, held bank accounts offshore, and even had a self-directed IRA, in which he employed leverage and, apparently, a “blocking company” that allowed Romney to avoid paying “unrelated business income tax” that’s normally levied by the IRS on any gains in IRAs (or non-profits, for that matter) attributable to private enterprise or borrowed money.

These kinds of things aren’t terribly unusual among very high net worth people of any political stripe. But it’s regular Joes like us that cast votes in the election, so let’s take a closer look. The New York Times recently took a look at the blocking corporation technique, here. The criticism, of course, is that by parking assets offshore and using a blocking corporation, Romney is using techniques available only to the wealthy to avoid paying his fair share of income taxes.

The defense, on the other hand, is that this technique is not illegal at all. Far from it: It’s also common among labor unions, pension funds and charities, and their middle class beneficiaries benefit from the technique, as well, since it eventually means bigger pension payouts or charitable contributions. The NY Times makes liberal use of the term “tax avoidance,” and I suppose they think we’re supposed to connote something sinister from it.

Well, let’s bring this back down to earth, for regular Joes like us: Tax avoidance is legal. It’s also prudent. Tax evasion is not prudent, is illegal by definition, and could land you in jail.

As a financial planning practitioner, I work with clients and their tax advisors all the time on strategies like the use of retirement accounts, taking mortgage interest deductions, itemizing miscellaneous expenses, estate planning, life insurance planning, and choosing the most tax-efficient business entities, education funding, and scores of other ideas with one goal in mind: Helping our clients maximize their after-tax, spendable return. In most cases, that means working to minimize the amount of taxes they pay, through any legal means available. That’s our job. That’s why we’re worth our fees, many times over, in most cases.

We do not assist clients with concealing income, using illegal tax shelters, or condone or facilitate fraud. That’s tax evasion, and it’s a crime.

In the case of Romney’s blocking corporation, yes, some members of Congress think they should close that loophole, which, according to the New York Times, deprives the U.S. Treasury of about $10 billion per decade. Well, maybe they should prohibit using blocker corporations to avoid unrelated business income tax and maybe they shouldn’t. But so far, they haven’t closed it. Don’t let people trying to score points against a political candidate try to conflate the two in your mind. They are not the same thing. We help our clients take advantage of legal strategies to minimize taxes and maximize spendable return.

If you want to pay more, please do. There’s a line on your individual tax return that allows you to pay extra to reduce the national debt. You may be better off investing that extra money – and Uncle Sam might be better off if you invest that money, too. After all, the IRS will tax you on the gains, over time, which could well be more than the amount you donate in the first place. But we want that to be your choice, and nobody else’s.

Record Low Interest Rates. Now What?

Interest rates have been bouncing off the bottom for years now, and today they’re lower than they’ve ever been. If you have good credit and your ducks in a row, you can now get a home mortgage, 30 year fixed, at the sub-4 percent level.

The low interest rates, overall, are a Godsend to borrowers. Consumers with good credit, financially sound corporations and government are all able to borrow money dirt-cheap, and perhaps (only time will tell) at a negative real interest rate.

Those same low interest rates, though, are a curse for savers. You can’t get the same returns you used to get on a CD, in money markets, fixed annuities, fixed-index or equity-indexed annuities, or bonds.

So what does this mean for you? Here are a few thoughts:

• Can you refinance an existing mortgage?  If you’ve been paying at, say, 6 percent, on a mortgage you got a few years ago, and you can refi down at 4 percent or less, that could put a bunch of money back in your pocket every month.

• A 4 percent mortgage at a 25 percent effective tax bracket (plus, say, 5 percent in Oregon income taxes, for those of you who live in my state), is closer to 3 percent. That’s your capital hurdle rate. Can you reasonably get 3 percent on your money? Careful: It’s not as easy as it used to be!

• Are you paying down a home mortgage early? Are you paying on a 15 year mortgage when you can refi for a 30 year? With mortgage rates this low, it doesn’t make a lot of mathematical sense to pay down a mortgage faster than you have to. Yes, I realize that it just feels great to have a paid off mortgage, and there are emotional factors that come into play. But if you’re paying an after-tax 3 percent on a mortgage, and you’ve got something earning faster than that on the side, you can still make the decision to pay off your mortgage – and do it even sooner!

• Meanwhile, you still have your money. Not the bank. If you pay down a mortgage early, and then lose your job before you pay it off completely, you may need some of that money. But who knows how easy it will be for you to get a loan against your house, then? Better to keep that money on the side, where it can A.) grow faster, after tax, than the after-tax interest rate on your home mortgage, and B.) where you can control it.

• If you own a fixed-index annuity, and you’ve had it for a while, take a close look at the contract. Some issuers have lowered cap rates on it, so that where you used to be able to make up to 8 percent when stocks went up (and the contract guaranteed 2 percent in flat or down markets), now some contracts only give you an upside of 4 or 5 percent. Well, if that’s your maximum upside, there may be some more productive things you can do with that annuity. But be careful of surrender charges, taxes and penalties – the ‘dark side’ of annuities!

There are still some great ideas in the annuity world. But contracts vary so widely, and can be so hit-or-miss, that I would encourage anyone considering buying an annuity to sit down with a disinterested fee-only planner <ahem> and go through the contract to make sure it’s suitable for you, and not just for the agent’s wallet!

If you own bonds, suggest selling some of your longer-duration and/or longer-maturity bond holdings. Stick to the short end of the yield curve. Say, 5 years and less, if that far, for your bond allocation. Bond prices don’t have a lot of room to rise. And when bond prices fall, it’s going to be the longer duration issues that fall the most. And long-maturity zero coupon bonds and bond funds will eventually get clobbered!

The exception is if you have a large expense you are certain will happen at some point in the future. Zero coupons can be very good for saving for a known event at a distant point in time, if all you want is a guaranteed lump sum in five, ten or 15 years, and you don’t care what happens to prices in the meantime. (But interest rates are low, so even zeros are modest these days!).

• For life insurance and annuities, lean towards higher-rated insurers, with substantial cash reserves. These tend to be the giant mutual companies and steady dividend payers with AA ratings from Standard & Poor’s or the equivalent. (Nobody has AAA anymore, since U.S. Treasury debt got downgraded last summer, and these comprise a big part of the general fund for most insurers).

Strength matters. Remember – when these companies take your premiums and buy bonds for their general fund, they are still on the hook to honor promises and commitments they made years – even decades ago, when interest rates were much, much higher.

• This is going to be a terrific strain on the weaker insurers. If low interest rates persist, and we have one or two other serious problems, like a big avian flu outbreak that causes a big mortality spike, some of them may go insolvent. There are safeguards in place, but they’re limited and vary by state. Most insurers will weather the storm, but my preference is for the more conservative firms with huge surplus reserves. They may charge premiums that are a bit higher. But insurance is only as good as the claims-paying ability of the insurer.

A final note: Think ahead. Interest rates are low because people are scared of Europe and emerging markets now. There may be bargains there, and opportunities for the most risk-tolerant among us. But that’s small ball in the grand scheme of things. There’s an even bigger game afoot: World bankers everywhere are flooding the markets with liquidity. Cheap money. World bankers are more afraid of a deflationary cycle and collapse than they are of inflation. But if they keep up the cheap money too fast and too long, the end result, historically, is nearly always a kick-up in inflation. Take steps to inflation-proof your portfolio. More on that in a future article.

Retirement Planning: The Problems with Monte Carlo

Retirement planning is a lot like blackjack: The object of the game is to time your life to run out at the end of your money – but not beyond it. But we can’t play that way, so retirement planners instead try to manipulate your money so that it you won’t run out of money before your body – and your spouse’s body–runs out of gas.

Indeed, retirement planning is so much like blackjack that financial planners routinely run a stochastic analysis procedure called a “Monte Carlo” simulation. The goal: Find the client a combination of stocks, bonds and cash that promises less than a 5 percent chance of running out of money during your retirement years.

It’s crazy – they will sit with risk-averse client after risk-averse client, and run theoretical backward-looking scenarios, trying to show you one that only has, at most, a one in twenty chance at total catastrophic failure.

Monte Carlo, indeed.

That’s like trying to help your clients improve their odds of playing Russian roulette by looking for a bigger cylinder: Well, it’s better than nothing. But why assume catastrophic risk like that at all, if you don’t need or want to?

A study published in the Journal of Financial Planning attempted to wrestle with this subject.

Stochastic analysis is a fantastic tool for portfolio development and risk management, but it does have limitations:

• Future market moves are pretty much unknowable
• Once you start withdrawing money, the order in which bull and bear markets occur can make a huge difference on the likelihood of portfolio success.
• It is nearly impossible to predict the timing and severity of bull and bear markets.
• Since this is true, it is nearly impossible to assign meaningful probabilities to market movements in the future. Even if you were good at it, how could you check your work?

The ultimate limitation of Monte Carlo-style simulations is this: Even when the prospect of failure is very small – according to the flawed probability assumptions planners must use in these projections—the consequences of failure are irrecoverable. Portfolio failure means living on dog food in your golden years, with no options for charting your own course when it comes to health care, shelter, travel, choosing whether to live with your ungrateful children or on your own, or much of anything else. Once your earning years are over, there’s not much to be done, other than take Social Security and what’s left of Medicare/Medicaid by that time (hint: it won’t be much.)

My granddaddy always told me “don’t take risks you can’t afford to lose.” And this is a big one.

The problem: So many investment professionals know a lot about investing. They don’t know much about insurance products, including the most important financial instrument yet devised for minimizing the risk of running out of money during your retirement: The lifetime income annuity. It’s amazing how many older folks we talk to who have had stock brokers for years – good ones and bad ones – and are still surprised to learn that there are lots of companies out there who are happy to convert a lump sum into a stream of income for life – guaranteed.

My point: This segmentation is a huge problem in the financial industry. Because of the way licensing works, there is a wide fault line between commissioned insurance professionals and investment professionals. This is a major weakness in the commissioned financial services model: If I wanted to be a registered representative – a stockbroker – and sell stocks, bonds, and mutual funds, I’d have to align myself with a broker-dealer firm. Many of these firms don’t have good selling relationships with insurance companies, and they actively discourage their brokers from “selling away,” or placing products their firm doesn’t sell.

The same is true on the insurance side: Unless the agent also gets a securities license and signs up with a broker-dealer firm, you may never hear about the best investment products and concepts that may be right for you. They will try to solve every problem with a combination of life insurance and annuity products, and that may not be what you need.*

The segmentation of the financial industry is a big part of why I’ve opted out of that model. As a member of the fee-only financial planning community, I’m free to present any solution under the sun to my clients. Investments, insurance, precious metals, commodities, annuities – it doesn’t matter. Fee only planners have the key advantage of being beholden only to our clients. More on that concept in the next article.

Now, off to Monte Carlo!

* Australia has done away with that issue nearly completely. They passed a law called the Future of Financial Advice, or FoFA, which pretty much destroys the commissioned product sales business model, and is forcing both insurance and investment specialists to adopt a new way of doing business. In the long run, it’s a plus, but some more traditional Australian agents and financial advisors will not survive.