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.

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.