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!

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.

Why DIY investors don’t make it!

If you look at the stock market over the past 30 years or so, things look pretty good. Stocks have, in theory, created a lot of wealth for investors, in the aggregate – at least if you just look at share price increases. During the 20 year period from 1991-2011, the Standard & Poor’s 500 index of U.S. large cap stocks returned an annualized 7.81 percent.

But  how much of that wealth did individual investors actually realize? After all, unsophisticated DIY retail investors – the ones that watch those stock-picking shows on TV and call into Cramer asking for his advice off the top of his head – are motivated by fear and greed. And they tend to get fearful and greedy just when everyone else is, too.

As a result, the typical DIY investor buys after stocks have already risen substantially – and sells after they’ve already declined. We know this by interviewing investors, monitoring cash flows into and out of mutual funds. Buy low and sell high is not as easy as it sounds eh?

DALBAR has just published its much-anticipated Quantitative Analysis of Investor Behavior – an annual report that monitors the difference between market returns, and the cash-flow adjusted returns that the average individual retail investor actually realizes.

What did the average investor see? Just 3.49 percent.  That’s right: Over 50 percent of the wealth that should have been generated by stock price increases and dividends simply vanished, as far as the individual investor is concerned. It was eaten up by fees, commissions, and money that sophisticated investors and institutions earned, using Main Street dupes as counterparties. Every share the unwashed masses bought at the wrong time was sold by someone – likely a professional or institution, selling at the right time.

That has profound implications for the DIY investor and his/her retirement plans. Those numbers mean that DIY stock investors took all the risks of equity-holders, but achieved results worse than bond-holders had a right to expect. They got hurt worse by bear markets (in 2000 and again in 2008) and benefited less from bull markets. And those numbers reflect the difference between clobbering inflation and barely keeping pace.  And they reflect the difference between a secure retirement with piece of mind and one of sacrifice and worry.

What hurt investors in 2011? A lot of them got discouraged by lousy markets in the summer and fall, and gave up. They pulled out of the market before a year-end recovery, and missed out. Incidentally, they pulled out into one of the lowest interest-rate environments on record for safe vehicles like CDs, money markets and fixed annuities! So for 2011, even though the S&P posted a small gain of 2.12 percent for the year, the average equity mutual fund investor actually lost money that year – posting a loss of 5.73 percent.

The 2012 DALBAR study validates our investment approach here at Vaerdi. As usual. Specifically, it’s clear that the investor who buys and holds a broad index fund – mostly ignoring the ups and downs of the market, while keeping expenses low, in the aggregate, outperforms the typical unassisted, unsophisticated retail investor, year in and year out.

The problem: So few people even know about index funds – or the fact that some online brokers don’t even charge a commission on trades using their exchange-traded funds – the index funds you can buy and sell during the day like a stock.

That doesn’t mean index funds are the end-all-be-all of investing. They aren’t great risk management tools, for example, and come with no guarantees. But if you’re looking to capture the full effect of the wealth generated by American capital markets, they can’t be beat.

The study also reinforces the value of guarantees for the average American: The less likely an actual investor is to at least approximate market returns in his own portfolio, the more valuable we see that traditional, defined benefit pensions are, and the more value we see in annuities, which come with at least some guarantees, depending on the contract.