For an avid baseball fan, I can now imagine what it would be like to be all together at one time in a stadium with Babe Ruth, Willie Mays, Hank Aaron, Cal Ripken, and Brooks Robinson. I can now imagine this level of excitement and awe because I am intrigued with different economic perspectives and investment models, and last week, I attended an exclusive conference in La Jolle, California where many of the world’s greatest spoke. Normally, a conference will have one or two headline personalities. This one had more than ten. In future emails I may detail their exact viewpoints and predictions, but for now, I merely want to offer the bios of some of the presenters and give a very general overview of their wisdom. In addition to being world-class economists, most are also well- regarded authors. The conference was limited to approximately 300 individuals, and it was very humbling to receive insights in such a personal forum from the very same people whose books have helped me manage clients’ assets over the years, and who are regularly interviewed on CNBC, Bloomberg, Barron’s, The Wall Street Journal, the New York Times and the like. Allow me to welcome:
1) Niall Ferguson
Niall is an Oxford-educated author and world renowned speaker. He has written The World’s Banker: The History of the House of Rothschild and The Ascent of Money: A Financial History of the World. In 2004, he was named by Time Magazine as “one of the world’s hundred most influential people”. He is a professor of history at Harvard University as well as a professor of business administration at Harvard Business School.
2) Claudio Macchetto
Claudio is the Director of Global Platforms for Paulson & Co., the company that was featured in the book, The Greatest Trade Ever describing how Paulson ingeniously defied Wall Street betting against subprime mortgages to earn a spot in financial history.
3) Jason Cummins
Jason is head of economic research for Brevan Howard, one of the world’s largest hedge funds. Prior to joining the company, he was a Senior Economist at the Federal Reserve Board.
4) Dr. Lacy Hunt
Lacy is the author of two books as well as numerous articles in leading magazines, periodicals and scholarly journals. He is an internationally known economist and the Executive Vice President of Hoisington Investment Management Company, a firm that manages $5 billion for pension funds, endowments, insurance companies and others.
5) John Mauldin
John is a New York Times best-selling author and the editor of the highly acclaimed Thoughts from the Frontline e-letter which is read by more than 1.5 million readers weekly.
6) George Friedman, Ph.D.
George is an internationally recognized specialist in security and intelligence issues. He is the author of numerous articles and books on international affairs, warfare and intelligence. His most recent book, The Next 100 Years: A Forecast for the 21st Century is also a New York Times best seller.
7) Dr. A. Gary Shilling
Gary is well regarded for his forecasting record and his numerous books relating to economic themes and investment strategies. Since 1983, he has been a regular columnist for Forbes. He was also an informal economic advisor to President George Bush.
8) Dr. Michael West
Michael is the CEO of BioTime, Inc. and Embryone Sciences, Inc. The companies are focused on developing an array of research and therapeutic products using human embryonic stem cell technology. He has focused his academic and business careers on solutions for age-related degenerative diseases.
9) David Rosenberg
David is Chief Economist and Strategist for the Toronto-based investment firm of Glushkin Sheff. David ranked first in economics in the Brendan Wood International Survey for Canada for the past seven years and has been on the U.S. Institutional Investor All American All Star Team for the last four years, and ranked second overall in the 2008 survey.
10) Paul McCulley
Paul is Managing Director of PIMCO, one of the world’s largest fixed income managers. He is the author of the monthly research publication Global Central Bank Focus.
There were many other presenters who also provided great economic and investment insights. All but two of the presenters painted a very bleak economic picture in particular for the United States and Europe. There were serious arguments made why this past recession was not a normal recession and why a double dip is certainly within the realm of possibilities. All were concerned about record-breaking world deficits, taxes, increasing debt service expenses and the fact that just like Greece is experiencing today, there is no real easy way to unwind the mess that’s been created. The defensive stance that I have taken was very much affirmed. The bottom line was that markets are not always a gauge of the underlying economy. The economic stimuli have helped to cushion the fall but we are far from out of the woods and we are likely to face many, many headwinds moving forward.
Stay tuned. It will not be boring.
The opinions voiced in this material are for general information and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, you should consult a financial advisor prior to investing.
Tuesday, May 4, 2010
Tuesday, April 20, 2010
Are Your Expectations Realistic? ...written by Greg Gann
On several occasions, I have heard realtors say that clients lie. Realtors say this because their clients say that they will only buy a home that specifically meets a variety of stipulations, but then they see a house with none of the required features, and they buy it. This got me thinking about investors and what they say and do.
Investors commonly tell me that they are “conservative”, yet their holdings are the complete opposite. Investors say that they want to incorporate defensive strategies to protect and preserve wealth, yet when the market surges, they question why their assets are not appreciating at the same rate as the “market”. Investors say that they don’t want to invest in stocks when the stock market is down, but then they question why their results are less than the stock market when they are not invested in stocks and the stock market is in the stratosphere. Investors say that they want investments that over time have strategies to make positive returns irrespective whether the market is up or down, but some today can’t fully grasp why their portfolio isn’t keeping pace with a stock market that has surged 75% in just one year.
Since March, 2009, the stock market, as measured through the S & P 500, is up 75%. I do not know of another time in history when this index has surged to this extent, especially in light of the fundamentals in the economy being as tenuous as they are and unemployment hovering around 10%. Dorsey Wright & Associates, a leading investment research organization, on April 14, 2010, recorded more new 52-week highs for stocks in that one trading day than in any single trading session since January 2004.
Based on irrefutable measurements of supply and demand, Dorsey Wright showed that the stock market was very much oversold March 2009. A year later, we are experiencing a market which is very much overbought. Markets can continue trends for periods that defy rationality, but when a market becomes overbought, caution and defense should be the call to action. Warren Buffett admonishes investors to be greedy while others are fearful, and fearful while others are greedy. Many investors become greedy when the market surges and becomes overbought. They develop symptoms of FOMO, an acronym and investment diagnosis known as “Fear of Missing Out”. And when we are in the red zone, as we are as of April 15, 2010, FOMO manifests itself by enticing investors to get back in the game at the absolute worst time. Markets are like rubber bands. They are flexible and can stretch and stretch and stretch. But, eventually they can only stretch so far before there is a snap.
For the decade that ended December 31, 2009, the S&P 500 was down over twenty-four percent. Therefore, $10,000 invested January 1, 1999 was only worth $7600, a full ten years later. The 75% surge in the S&P 500 since March 2009 has been a huge gift. It should be treated as a gift, not only because the fragility of the economy, but also because if an investor’s long-range expectation is to generate growth of say 7% per year, then the returns that have been reached actually in less than one year, should have taken ten years to accumulate. Also of significance is that fact that even after this maybe once in a lifetime 75% one year surge, the S&P 500 is still approximately 22% below its value as of March 2000.
I regularly speak with investors who tell me that their investments took a blood bath in 2008. They also referred affectionately to their 401k’s as “201k’s” in 2001 and 2002 because of the losses in that period. In 2008, the 201k was walloped and became a 101k. These same investors today tell me that they are no longer concerned about the status of the portfolios because they are “back”. When someone tells me that he is back, I know two things immediately. I know that he has tremendous exposure to the stock market and I know that he does not have adequate defenses in place to help secure the net worth from the next correction or “snap”. A year ago, there were serious discussions taking place as to how to prevent a second great depression. Unprecedented government involvement and spending has helped to thwart an imminent crisis. Analysts’ earnings expectations last year were so depressed that in hindsight, it has not required too much for corporate America and beyond to exceed those projections. While it is easy to catch a ride on the euphoria train today, the world still has not presented an exit strategy to unwind government spending and correct unprecedented non-global wartime deficits. Nor is unemployment or housing showing real signs of improvement.
As an asset class, bonds are considered safer than stocks because when we acquire a bond, we become a lender, and in the event of failure, lenders get paid before stockholders, who are the owners. Lehman Brothers was a huge guarantor in world markets. When the government allowed Lehman Brothers to fold in 2008, confidence in the entire financial structure was called into question. If you couldn’t trust Lehman to survive, who could you trust? Because of the uncertainty and fear that this and other failures created in the market last year, bond prices got slashed. Bonds provided stock-like returns, but with significantly less risk. Because of this anomaly, I over weighted clients’ portfolios to individual bonds.
After the stock market has zoomed in one year at a rate at which most of us would be very content if it were realized over a decade, it is easy to forget that a year ago, all of us had real concerns just how deep the recession could go. I believe that stimuli of governments around the globe have significantly helped economies and alleviated panic. I also however believe that they have camouflaged the underlying problems and they have not proposed viable exit strategies or safeguards to prevent the next re-occurrence. For all of these reasons and a variety of others about which I have written in the past, I have exercised with caution over the last twelve months. We have used defensive strategies and a host of safeguards. We have very, very little stock exposure. It is impossible to incorporate these safeguards and defensive investment strategies and expect to earn anywhere near what the stock market does in a year during which the market provides a decade-like return in one tenth of the time. Until the fundamentals of the economy show prolonged and consistent signs of improvement and until unemployment is not near a double digit number, I believe that the prudent investor should remain cautious. Wars, deficits, unemployment, wages, deflation, tax increases, and tremendous regulatory uncertainties, all tell me that while fear and panic are no longer THE sentiments of the day, we are nonetheless not out of the woods. A huge part of increasing net worth is maintaining defenses to minimize losses.
The point is that we can’t have it both ways. The investors with whom I speak who tell me that their portfolios are “back” from the losses of 2008 also tell me that their losses in 2008 were 40% and worse. The S&P 500 gave these investors a gift in the past twelve months. I do not think that it is wise investment policy to only have an offense and to rely on “gifts” to grow wealth. And, one last point, just like car buyers always want to brag about the deal they negotiated on their auto to show off their negotiating prowess, investors at cocktail parties notoriously deflate their losses and significantly exaggerate their gains. So, the next time your friend tells you at the party or on the golf course that he is up 75% this year, take solace in the knowledge that he probably had huge losses in 2001 and in 2002 and in 2008 and probably hasn’t realized growth in over a decade.
I am writing this to give you the perspective that there are always periods during which a particular methodology will surpass another, and time periods can always be conveniently established to make one methodology look particularly beneficial. Offense-only, buy-hold strategies while rewarded with stellar performance in the last twelve months, have resulted in huge losses for more than a decade. Returns are temporary, but strategies are resilient. A fifty percent loss still requires a hundred percent gain just to break even. I rely on a number of both fundamental as well as technical research sources to negotiate the market and deal with whatever curve ball it throws. What all of this tells me is that this is not the time to get caught up in the rapture. It is not the time to take our eyes off the ball. It is however the time to take in the entire picture to set and maintain realistic expectations. For any investor who perceives 2008 as a once in a hundred year flood year, well then so too should they recognize the ensuing twelve months which followed.
The opinions voiced in this material are for general information and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, you should consult a financial advisor prior to investing.
Investors commonly tell me that they are “conservative”, yet their holdings are the complete opposite. Investors say that they want to incorporate defensive strategies to protect and preserve wealth, yet when the market surges, they question why their assets are not appreciating at the same rate as the “market”. Investors say that they don’t want to invest in stocks when the stock market is down, but then they question why their results are less than the stock market when they are not invested in stocks and the stock market is in the stratosphere. Investors say that they want investments that over time have strategies to make positive returns irrespective whether the market is up or down, but some today can’t fully grasp why their portfolio isn’t keeping pace with a stock market that has surged 75% in just one year.
Since March, 2009, the stock market, as measured through the S & P 500, is up 75%. I do not know of another time in history when this index has surged to this extent, especially in light of the fundamentals in the economy being as tenuous as they are and unemployment hovering around 10%. Dorsey Wright & Associates, a leading investment research organization, on April 14, 2010, recorded more new 52-week highs for stocks in that one trading day than in any single trading session since January 2004.
Based on irrefutable measurements of supply and demand, Dorsey Wright showed that the stock market was very much oversold March 2009. A year later, we are experiencing a market which is very much overbought. Markets can continue trends for periods that defy rationality, but when a market becomes overbought, caution and defense should be the call to action. Warren Buffett admonishes investors to be greedy while others are fearful, and fearful while others are greedy. Many investors become greedy when the market surges and becomes overbought. They develop symptoms of FOMO, an acronym and investment diagnosis known as “Fear of Missing Out”. And when we are in the red zone, as we are as of April 15, 2010, FOMO manifests itself by enticing investors to get back in the game at the absolute worst time. Markets are like rubber bands. They are flexible and can stretch and stretch and stretch. But, eventually they can only stretch so far before there is a snap.
For the decade that ended December 31, 2009, the S&P 500 was down over twenty-four percent. Therefore, $10,000 invested January 1, 1999 was only worth $7600, a full ten years later. The 75% surge in the S&P 500 since March 2009 has been a huge gift. It should be treated as a gift, not only because the fragility of the economy, but also because if an investor’s long-range expectation is to generate growth of say 7% per year, then the returns that have been reached actually in less than one year, should have taken ten years to accumulate. Also of significance is that fact that even after this maybe once in a lifetime 75% one year surge, the S&P 500 is still approximately 22% below its value as of March 2000.
I regularly speak with investors who tell me that their investments took a blood bath in 2008. They also referred affectionately to their 401k’s as “201k’s” in 2001 and 2002 because of the losses in that period. In 2008, the 201k was walloped and became a 101k. These same investors today tell me that they are no longer concerned about the status of the portfolios because they are “back”. When someone tells me that he is back, I know two things immediately. I know that he has tremendous exposure to the stock market and I know that he does not have adequate defenses in place to help secure the net worth from the next correction or “snap”. A year ago, there were serious discussions taking place as to how to prevent a second great depression. Unprecedented government involvement and spending has helped to thwart an imminent crisis. Analysts’ earnings expectations last year were so depressed that in hindsight, it has not required too much for corporate America and beyond to exceed those projections. While it is easy to catch a ride on the euphoria train today, the world still has not presented an exit strategy to unwind government spending and correct unprecedented non-global wartime deficits. Nor is unemployment or housing showing real signs of improvement.
As an asset class, bonds are considered safer than stocks because when we acquire a bond, we become a lender, and in the event of failure, lenders get paid before stockholders, who are the owners. Lehman Brothers was a huge guarantor in world markets. When the government allowed Lehman Brothers to fold in 2008, confidence in the entire financial structure was called into question. If you couldn’t trust Lehman to survive, who could you trust? Because of the uncertainty and fear that this and other failures created in the market last year, bond prices got slashed. Bonds provided stock-like returns, but with significantly less risk. Because of this anomaly, I over weighted clients’ portfolios to individual bonds.
After the stock market has zoomed in one year at a rate at which most of us would be very content if it were realized over a decade, it is easy to forget that a year ago, all of us had real concerns just how deep the recession could go. I believe that stimuli of governments around the globe have significantly helped economies and alleviated panic. I also however believe that they have camouflaged the underlying problems and they have not proposed viable exit strategies or safeguards to prevent the next re-occurrence. For all of these reasons and a variety of others about which I have written in the past, I have exercised with caution over the last twelve months. We have used defensive strategies and a host of safeguards. We have very, very little stock exposure. It is impossible to incorporate these safeguards and defensive investment strategies and expect to earn anywhere near what the stock market does in a year during which the market provides a decade-like return in one tenth of the time. Until the fundamentals of the economy show prolonged and consistent signs of improvement and until unemployment is not near a double digit number, I believe that the prudent investor should remain cautious. Wars, deficits, unemployment, wages, deflation, tax increases, and tremendous regulatory uncertainties, all tell me that while fear and panic are no longer THE sentiments of the day, we are nonetheless not out of the woods. A huge part of increasing net worth is maintaining defenses to minimize losses.
The point is that we can’t have it both ways. The investors with whom I speak who tell me that their portfolios are “back” from the losses of 2008 also tell me that their losses in 2008 were 40% and worse. The S&P 500 gave these investors a gift in the past twelve months. I do not think that it is wise investment policy to only have an offense and to rely on “gifts” to grow wealth. And, one last point, just like car buyers always want to brag about the deal they negotiated on their auto to show off their negotiating prowess, investors at cocktail parties notoriously deflate their losses and significantly exaggerate their gains. So, the next time your friend tells you at the party or on the golf course that he is up 75% this year, take solace in the knowledge that he probably had huge losses in 2001 and in 2002 and in 2008 and probably hasn’t realized growth in over a decade.
I am writing this to give you the perspective that there are always periods during which a particular methodology will surpass another, and time periods can always be conveniently established to make one methodology look particularly beneficial. Offense-only, buy-hold strategies while rewarded with stellar performance in the last twelve months, have resulted in huge losses for more than a decade. Returns are temporary, but strategies are resilient. A fifty percent loss still requires a hundred percent gain just to break even. I rely on a number of both fundamental as well as technical research sources to negotiate the market and deal with whatever curve ball it throws. What all of this tells me is that this is not the time to get caught up in the rapture. It is not the time to take our eyes off the ball. It is however the time to take in the entire picture to set and maintain realistic expectations. For any investor who perceives 2008 as a once in a hundred year flood year, well then so too should they recognize the ensuing twelve months which followed.
The opinions voiced in this material are for general information and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, you should consult a financial advisor prior to investing.
Thursday, April 15, 2010
Realized Versus Unrealized Gains and Losses....written by Greg Gann
A client recently was looking for clarification when reviewing the 1099 for her investment account before presenting it to her accountant. She couldn’t quite comprehend how her account could have had such gains while the 1099 was reporting so many losses. I used a metaphor to explain the difference between realized and unrealized gains and losses that she found helpful. This got me thinking that there are probably plenty other clients who might appreciate and benefit from the same discussion.
As you know, I am an active investment manager. I have no objection to holding onto investments indefinitely. However, if an investment loses value over a stipulated level, I am programmed to sell before the losses become intolerable. This is because to quote the famous economist, John Maynard Keynes, “trends can continue longer than any of us can stay solvent.” I am also not afraid to sell an investment that has had good growth once that growth trend reverses to preserve embedded gains. Most people acknowledge that they have no problems acquiring investments. Their frustration is that they did not have a game plan to sell, and especially during rough market periods, this inertia cost them dearly.
The 1099 documents investments which were sold in a tax year to determine if there was a long-term or short-term gain or loss that would have tax implications. The 1099 does not summarize account values. It only relates to sales of investments within the year. The motto by which prudent investors should live is to let your winners run and to cut your losers short. Just as even the most outstanding baseball player strikes out with greater frequency than he hits home runs, so too investment gains come from singles, doubles, and the occasional home run. Investment gains also come from cutting losers short. When an investment is sold at a loss, that loss is reported on the 1099 tax form. This is a realized loss. When an investment is sold for more than its purchase cost, this is reported as a realized gain. However, investments that have appreciated in value, but have not yet been sold have unrealized gains. Because investments which have unrealized gains have not yet been sold, they do not appear on the 1099 tax form. The analogy I used to clarify this distinction is home equity. Let’s say we own a house for which we originally paid $ 100,000. If the house today is worth $500,000, but we still own it, then we have unrealized earnings (equity) in the house of $ 400,000. However, we do not get a 1099 tax form for that equity, nor do we owe taxes on the gain if we have not sold the house and realized the gain in this tax year. If let’s say there were a dilapidated building on the property that we sold for a loss, then that loss would have tax relevance.
The gains in your investment account are indicated on summary statements, and the value on these statements is net of all losses that may have been realized from selling other investments. The point is that the 1099 shows realized gains and losses, but for account valuation purposes, we really need to pay greater attention to the unrealized gains and losses, similar to home equity. We might have losses reported for tax purposes, but gains that are more relevant, but for which there is no tax consequence in a particular tax year. And, this entire discussion only applies to taxable accounts. It is not pertinent to retirement or other tax-advantaged accounts.
Hopefully that clarifies how we can have “losses” in years in which we have gains.
The opinions voiced in this material are for general information and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, you should consult a financial advisor prior to investing.
As you know, I am an active investment manager. I have no objection to holding onto investments indefinitely. However, if an investment loses value over a stipulated level, I am programmed to sell before the losses become intolerable. This is because to quote the famous economist, John Maynard Keynes, “trends can continue longer than any of us can stay solvent.” I am also not afraid to sell an investment that has had good growth once that growth trend reverses to preserve embedded gains. Most people acknowledge that they have no problems acquiring investments. Their frustration is that they did not have a game plan to sell, and especially during rough market periods, this inertia cost them dearly.
The 1099 documents investments which were sold in a tax year to determine if there was a long-term or short-term gain or loss that would have tax implications. The 1099 does not summarize account values. It only relates to sales of investments within the year. The motto by which prudent investors should live is to let your winners run and to cut your losers short. Just as even the most outstanding baseball player strikes out with greater frequency than he hits home runs, so too investment gains come from singles, doubles, and the occasional home run. Investment gains also come from cutting losers short. When an investment is sold at a loss, that loss is reported on the 1099 tax form. This is a realized loss. When an investment is sold for more than its purchase cost, this is reported as a realized gain. However, investments that have appreciated in value, but have not yet been sold have unrealized gains. Because investments which have unrealized gains have not yet been sold, they do not appear on the 1099 tax form. The analogy I used to clarify this distinction is home equity. Let’s say we own a house for which we originally paid $ 100,000. If the house today is worth $500,000, but we still own it, then we have unrealized earnings (equity) in the house of $ 400,000. However, we do not get a 1099 tax form for that equity, nor do we owe taxes on the gain if we have not sold the house and realized the gain in this tax year. If let’s say there were a dilapidated building on the property that we sold for a loss, then that loss would have tax relevance.
The gains in your investment account are indicated on summary statements, and the value on these statements is net of all losses that may have been realized from selling other investments. The point is that the 1099 shows realized gains and losses, but for account valuation purposes, we really need to pay greater attention to the unrealized gains and losses, similar to home equity. We might have losses reported for tax purposes, but gains that are more relevant, but for which there is no tax consequence in a particular tax year. And, this entire discussion only applies to taxable accounts. It is not pertinent to retirement or other tax-advantaged accounts.
Hopefully that clarifies how we can have “losses” in years in which we have gains.
The opinions voiced in this material are for general information and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, you should consult a financial advisor prior to investing.
Wednesday, April 7, 2010
Wonder what might be Driving this market?.....written by Greg Gann
As crazy as it may sound, TrimTabs, a highly regarded investment research company, catering mostly to institutions to which I also subscribe reported that rising mortgage delinquencies are actually providing a boost to the U.S. economy. On March 15, 2010, Lender Processing Services reported that 7.4 million residential mortgages are non-current. This equates to 13.5% of all mortgages. Of these 7.4 million mortgages, only 2.0 million are in foreclosure, leaving 5.4 million owner-occupied residences in which owners are not paying their full mortgages. In fact, there are surely numerous instances where homeowners are paying nothing at all. This means that there are a great number of homeowners who are living for free, which may account for why retail sales figures are as good as they are. Banks can book mortgages which are more than 90 days delinquent as assets that are non-paying but accruing interest until the property is foreclosed. Therefore, although the delinquencies are impacting the cash flow of banks, they are not yet translating into a loss of banks’ retained earnings or net worth. Annual mortgage payments average between $12,000 to $18,000 annually. Multiplying these dollar figures by 5 million, delinquent mortgages result in $60 billion to $80 billion of additional economic “stimulus”.
This is why it’s always critical to appreciate the facts beneath the facts.
The opinions voiced in this material are for general information and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, you should consult a financial advisor prior to investing.
This is why it’s always critical to appreciate the facts beneath the facts.
The opinions voiced in this material are for general information and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, you should consult a financial advisor prior to investing.
Friday, March 26, 2010
New Health Overhaul: What’s Included and Who Pays....written by Greg Gann
It is certainly a noble goal to provide health coverage to more citizens. And who could argue that no one should be discriminated based on a pre-existing illness. I find it interesting that the details of a law that is being described by legislators on both sides of the aisle as one of the most sweeping changes in more than fifty years is so murkily understood. Hopefully, this will shed light on some of the issues that are most opaque.
1) Who is Affected
The law requires most Americans to have health insurance by January 1, 2014. Failure to procure insurance will result in penalties, unless they are issued an exemption due to financial hardship, religious beliefs or the like. Medicaid, the federal-state health program for the poor and disabled, would provide this insurance for those who fall within the established poverty levels. Individuals whose income falls between $14,400 to $43,320 and for a family of four whose income falls between $29,326 and $88,200, may be eligible for government subsidies to help pay for private insurance that would be sold in new state-based insurance marketplaces called exchanges. Initially, the exchanges will only be available to those who work for companies with 100 or less employees as well as the unemployed, self-insured, or retirees not yet eligible for Medicare. The exchanges are supposed to have four levels of care, each accompanied by a requisite cost.
The legislation does not require companies with fewer than 50 employees to offer insurance. However, they may be eligible for tax credits if they do offer the insurance, depending on average wages of the employees. Companies with more than 50 employees that fail to offer health coverage will be subject to a fee of up to $2000 per full-time employee if any employee opts for the government subsidized insurance options through the exchanges. The first 30 employees are waived in terms of calculating this penalty.
The law also enriches the Medicare Part D prescription drug benefit program that was enacted under President George W. Bush by providing richer prescription benefits through reducing the doughnut hole. However, in exchange for this addition, government payments to Medicare Advantage, the private plan part of Medicare, will be cut substantially. This means that the 10 million enrollees could lose eyeglass and hearing aid benefits.
Another provision of the law which has been glossed over relates to long term health care. Details definitely have to be spelled out, but the law establishes different tiers of long term care, and all employees will be covered unless they opt out. Yet, there are no mandates that employers, regardless of size, have to provide this coverage. The law requires the insured to pay into the system for at least five years, otherwise, she will receive no benefits. The government is hoping that by making it an opt-out, younger employees will participate, thereby offsetting the costs for the older participants covered under the plan. I still do not know what will happen to the individual who gets ill within the first five years because the law says there are no benefits for period. I also don’t understand how the government is going to protect itself from adverse selection, namely only the old who are more likely to collect having paid in for less time. In addition, there are provisions allowing the government to raise rates if it would otherwise be insolvent. Medicare and Social Security are on the brink of bankruptcy, so I would tread very, very cautiously before I would rely on a government “permanent” benefit that can always be enacted away by a future Congress.
2) Who Pays
The short answer to the question who pays for this quasi-universal health care are the people from whom the federal government can collect more taxes. In particular, the money will come from significantly higher Medicare taxes for individuals whose incomes are $200,000 and greater and for couples whose incomes are $250,000 and over. The Medicare tax will increase from the current 1.45% to 2.35%. This will affect approximately 1 million individuals and 4 million couples who file jointly. This legislation is sweeping in one other way. It represents the first time ever that Medicare taxes will be imposed on unearned income such as capital gains, dividends, interest, rents and withdrawals from IRA’s and 401k plans and the like. The rate of this tax will be 3.8%, and this will affect everyone regardless of income levels. The Obama budget also proposes allowing the current 15% tax rate on dividends and capital gains to rise to 20% as of January 1, 2011. This means that the new effective tax on these funds will rise to 23.8% come January.
The Medicare taxes superseded the tax on “Cadillac” plans. That 40% excise tax was delayed until 2018 when it will apply to benefits over $10,200 for individuals and $27,500 for couples. These thresholds will be indexed to inflation, which grows at a much slower pace than the cost of health care, meaning the tax will escalate more substantially over time.
The law also imposes significant restrictions on health savings accounts. Furthermore, beginning in 2013, the threshold to deduct medical expenses will change from 7.5% of adjusted gross income to 10%. And as crazy as it might sound, the cost of frequenting tanning salons will increase due to the 10% excise tax placed on the industry. While I don’t mind the tanning tax, the law also imposes a 2.9% excise tax on the purchase of wheelchairs.
3) Economic Ramifications
Christina Romer, Professor of Economics of University of California, Berkley, and Chair of Council of Economic Advisors in the Obama Administration, work shows that for every new dollar raised in taxes, it reduces economic growth three-fold. Markets generally do not respond favorably to increases in taxes. They certainly do not encourage job growth. Markets also do not generally respond favorably to uncertainties, and there are tons of issues that are unclear. While private industry has scaled back considerably, the government has grown. This is a critical time in the markets to have strategies to help preserve wealth because things can change quickly and catch many people who are unprepared in their wake. I’d like to believe that we could cover all Americans with adequate healthcare while growing the economy and stimulating job formation. Maybe Obamacare will work, and I wish for nothing more. But now is the time to make sure your financial house is in order. Now is the time to work towards financial goals irrespective of rules and regulations and tax changes. Although it is growing massively, now is not anymore appropriate a time to rely on the government because he who giveth can just as easily taketh away. I guess this is all part of the new normal.
Because U.S. Treasuries are backed by the full faith and credit of the U.S. government, they should and most commonly do provide a lower yield than corporate bonds, Bloomberg recently reported that bonds issued by Proctor & Gamble, Berkshire Hathaway, Johnson & Johnson, and Lowe’s Cos. provided lower interest than federal government bonds of comparable maturities. This indicates that the market considers bonds issued by these companies less risky than similar bonds issued by the USA. Maybe this is because, as predicted by Moody’s Investors Service, the U.S. will spend more on debt service as a percentage of revenue this year than any other top-rated country except the U.K. America will use about 7% of tax revenues for debt service in 2010 and almost 11% in 2013, moving “substantially” closer to losing its AAA rating, Moody’s said last week.
We are in a new normal. That which was once unusual is becoming common. This market is not your dad’s Oldsmobile. It requires more proactive attention and a strong arsenal of defensive strategies.
The opinions voiced in this material are for general information and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, you should consult a financial advisor prior to investing.
1) Who is Affected
The law requires most Americans to have health insurance by January 1, 2014. Failure to procure insurance will result in penalties, unless they are issued an exemption due to financial hardship, religious beliefs or the like. Medicaid, the federal-state health program for the poor and disabled, would provide this insurance for those who fall within the established poverty levels. Individuals whose income falls between $14,400 to $43,320 and for a family of four whose income falls between $29,326 and $88,200, may be eligible for government subsidies to help pay for private insurance that would be sold in new state-based insurance marketplaces called exchanges. Initially, the exchanges will only be available to those who work for companies with 100 or less employees as well as the unemployed, self-insured, or retirees not yet eligible for Medicare. The exchanges are supposed to have four levels of care, each accompanied by a requisite cost.
The legislation does not require companies with fewer than 50 employees to offer insurance. However, they may be eligible for tax credits if they do offer the insurance, depending on average wages of the employees. Companies with more than 50 employees that fail to offer health coverage will be subject to a fee of up to $2000 per full-time employee if any employee opts for the government subsidized insurance options through the exchanges. The first 30 employees are waived in terms of calculating this penalty.
The law also enriches the Medicare Part D prescription drug benefit program that was enacted under President George W. Bush by providing richer prescription benefits through reducing the doughnut hole. However, in exchange for this addition, government payments to Medicare Advantage, the private plan part of Medicare, will be cut substantially. This means that the 10 million enrollees could lose eyeglass and hearing aid benefits.
Another provision of the law which has been glossed over relates to long term health care. Details definitely have to be spelled out, but the law establishes different tiers of long term care, and all employees will be covered unless they opt out. Yet, there are no mandates that employers, regardless of size, have to provide this coverage. The law requires the insured to pay into the system for at least five years, otherwise, she will receive no benefits. The government is hoping that by making it an opt-out, younger employees will participate, thereby offsetting the costs for the older participants covered under the plan. I still do not know what will happen to the individual who gets ill within the first five years because the law says there are no benefits for period. I also don’t understand how the government is going to protect itself from adverse selection, namely only the old who are more likely to collect having paid in for less time. In addition, there are provisions allowing the government to raise rates if it would otherwise be insolvent. Medicare and Social Security are on the brink of bankruptcy, so I would tread very, very cautiously before I would rely on a government “permanent” benefit that can always be enacted away by a future Congress.
2) Who Pays
The short answer to the question who pays for this quasi-universal health care are the people from whom the federal government can collect more taxes. In particular, the money will come from significantly higher Medicare taxes for individuals whose incomes are $200,000 and greater and for couples whose incomes are $250,000 and over. The Medicare tax will increase from the current 1.45% to 2.35%. This will affect approximately 1 million individuals and 4 million couples who file jointly. This legislation is sweeping in one other way. It represents the first time ever that Medicare taxes will be imposed on unearned income such as capital gains, dividends, interest, rents and withdrawals from IRA’s and 401k plans and the like. The rate of this tax will be 3.8%, and this will affect everyone regardless of income levels. The Obama budget also proposes allowing the current 15% tax rate on dividends and capital gains to rise to 20% as of January 1, 2011. This means that the new effective tax on these funds will rise to 23.8% come January.
The Medicare taxes superseded the tax on “Cadillac” plans. That 40% excise tax was delayed until 2018 when it will apply to benefits over $10,200 for individuals and $27,500 for couples. These thresholds will be indexed to inflation, which grows at a much slower pace than the cost of health care, meaning the tax will escalate more substantially over time.
The law also imposes significant restrictions on health savings accounts. Furthermore, beginning in 2013, the threshold to deduct medical expenses will change from 7.5% of adjusted gross income to 10%. And as crazy as it might sound, the cost of frequenting tanning salons will increase due to the 10% excise tax placed on the industry. While I don’t mind the tanning tax, the law also imposes a 2.9% excise tax on the purchase of wheelchairs.
3) Economic Ramifications
Christina Romer, Professor of Economics of University of California, Berkley, and Chair of Council of Economic Advisors in the Obama Administration, work shows that for every new dollar raised in taxes, it reduces economic growth three-fold. Markets generally do not respond favorably to increases in taxes. They certainly do not encourage job growth. Markets also do not generally respond favorably to uncertainties, and there are tons of issues that are unclear. While private industry has scaled back considerably, the government has grown. This is a critical time in the markets to have strategies to help preserve wealth because things can change quickly and catch many people who are unprepared in their wake. I’d like to believe that we could cover all Americans with adequate healthcare while growing the economy and stimulating job formation. Maybe Obamacare will work, and I wish for nothing more. But now is the time to make sure your financial house is in order. Now is the time to work towards financial goals irrespective of rules and regulations and tax changes. Although it is growing massively, now is not anymore appropriate a time to rely on the government because he who giveth can just as easily taketh away. I guess this is all part of the new normal.
Because U.S. Treasuries are backed by the full faith and credit of the U.S. government, they should and most commonly do provide a lower yield than corporate bonds, Bloomberg recently reported that bonds issued by Proctor & Gamble, Berkshire Hathaway, Johnson & Johnson, and Lowe’s Cos. provided lower interest than federal government bonds of comparable maturities. This indicates that the market considers bonds issued by these companies less risky than similar bonds issued by the USA. Maybe this is because, as predicted by Moody’s Investors Service, the U.S. will spend more on debt service as a percentage of revenue this year than any other top-rated country except the U.K. America will use about 7% of tax revenues for debt service in 2010 and almost 11% in 2013, moving “substantially” closer to losing its AAA rating, Moody’s said last week.
We are in a new normal. That which was once unusual is becoming common. This market is not your dad’s Oldsmobile. It requires more proactive attention and a strong arsenal of defensive strategies.
The opinions voiced in this material are for general information and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, you should consult a financial advisor prior to investing.
Wednesday, February 17, 2010
Important Tax Changes for 2010 -- Part Two.....written by Greg Gann
A) Federal Estate Taxes:
The big news is that for the 2010 tax year, there are no estate taxes; well that is unless the law is repealed and made retroactive. This is a repeal with a one year term limit. Estate taxes are only applicable for “wealthy” estates. Certain members of Congress have politicized the tax by branding it as a “death” tax, and encouraging a large percentage of the population for whom estate taxes have no relevance to fight the battle for permanent repeal. In reality, by and large, only one to two percent of the entire American population is subject to these taxes, yet clever marketers have incited people of average means to join the tea party. The amount of an estate that can be left to beneficiaries exempt from federal estate taxes has been increasing since the enactment of the 2001Tax Act. In fact, the exemption has escalated from $ 1 million in 2001 to $ 3.5 million in 2009. The Byrd Rule is legislation which limits the duration of laws with a negative fiscal impact to ten years. It was anticipated back in 2001 that Congress would re-enact the terms of the estate tax law prior to 2009 and disqualify the one year suspension of any federal estate tax. However, that never happened. Therefore, under present law, there is no tax in 2010; however, due to the Byrd Rule, the tax reappears in 2011 back to the 2001 level of $ 1 million.
At first blush, as a beneficiary, it would appear that 2010 might be a really good year for your loved one to pass away, speaking only fiscally of course. However, there were other parts of the 2001 Tax Act that have not been sufficiently publicized or politicized, and these provisions will in reality negatively impact far more estates than the estate tax would have.
The provision in the law about which I refer relates to what is commonly known as a “step-up” in cost basis. The step-up allows beneficiaries to value the assets that they inherit based on the market value at the date of the donor’s death. Here’s the kicker. Although the estate tax has been eliminated for 2010, the step-up in cost basis has been significantly altered to the detriment of taxpayers. Under present law, the estate of a decedent who dies in 2010 can allocate a maximum of $1.3 million as an aggregate step-up. Beyond that, the beneficiary will step into the “shoes” of the decedent and receive his/her cost basis in the assets. Therefore, when the beneficiary in turn sells those inherited assets, he/she will pay tax on the gains over and above what the donor paid originally for the asset, over the $ 1.3 exemption. If the asset happens to be property that the donor owned for a great number of years, the gains could very well be very substantial. Assets left outright to a spouse receive an additional $3 million “spousal property basis increase”.
Unless the law is modified, 2010 may very well turn out to be a windfall year for a super-wealthy person to die, from solely a tax perspective. However, it may be a disaster for a middle class estate. The following example will elucidate the dilemma. Let’s say two widows at the date of death each owned the same numbers of shares of stock purchased on the same day. And, let’s say the cost basis of that stock was $10,000, and that the market value at the date of death was $100,000. Let’s also assume that the wealthy widow’s estate was valued at $20 million and that the middle class widow ‘s estate was valued at $1 million. In this example, the wealthy widow gets a big advantage in 2010 because she will incur no federal estate tax, which in 2009 and other prior years would have resulted in roughly $50,000 in estate tax. Her beneficiary will have to pay capital gains tax on the $90,000 gain resulting from the sale of the stock. With the capital gains tax rate of 15% through 2010, the beneficiary will incur a capital gains tax of approximately $13,500, approximately $36,500 better than had the estate been subject to federal estate taxes. In contrast, the middle class widow in 2009 would still have fallen within the federal estate tax exemption, and hence had a zero estate tax. In 2009 and prior years, her beneficiaries would have received the step-up in cost basis for the stock and therefore, they would have incurred zero capital gains taxes. In reality, in 2010, the beneficiaries of the wealthy and the middle class widows incur identical capital gains taxes on the gains from the stock sale. Consequently, the middle class heirs owe the $13,500 in capital gains taxes, thereby reducing their net inheritance by this amount. The bottom line is that the super-wealthy may turn out to be the big winners in 2010, and the middle class may be incurring even greater proportions of the tax burden in the U.S.
B) Other Significant Tax Changes:
1) The maximum amount of equipment placed in service that a business can expense as a deduction is cut by nearly 50% from $250,000 to $135,000.
2) Taxpayers age 70.5 and older can no longer make a charitable contribution directly from their IRA’s, and thereby avoid income taxation on the amount donated. This could have a huge negative impact on a non-profit’s budget.
3) 2010 represents the last year during which capital gains will be taxed at the rate of 15% and 0% for taxpayers in the 10% and 15% tax brackets. Next year, the rate goes to 20% for most taxpayers and 10% for taxpayers in the lower brackets. However, gains on assets held for five years or longer, beginning in 2011 will be taxed at 18% and 8% respectively.
4) For taxpayers in tax brackets of 15% or higher, 2010 represents the last year in which dividends will be taxed like capital gains at a significantly reduced rate of 15%. After 2010, dividends will be taxed at the highest earned income rate. Ouch.
C) Important Take-Aways:
1) It is important to appreciate that there is no federal estate tax in 2010; however, significant gift taxes which affect the majority of taxpayers remain, making it equally as expensive to gift in 2010 as it was in 2009. A donor can gift up to $1 million as a lifetime exemption as well as $13,000 per year as an annual gift exclusion amount, but gifts in excess of these exemptions remain taxable transactions.
2) The estate tax in Maryland remains unaffected by changes to the federal system. As such, estates whose values exceed $1 million are still subject to Maryland estate taxes.
3) Because the federal estate tax exemptions have been changing regularly over the last several years, it is common language in wills and trusts to leave assets to non-spouse beneficiaries up to the federal exemption amount with the residual to go to the spouse. As an unintended consequence of your estate planning documents, your estate plan may leave everything to children or other relatives, unintentionally disinheriting your spouse.
Clearly 2010 is a year of significant tax and estate planning review. Feel free to contact me regarding any specific situation where you have concern or just seek clarity. We are also well suited to recommend accountants and estate planning attorneys who specialize in these areas. In law school, I remember references in several business and tax classes to a famous United States judge and judicial philosopher by the name of Learned Hand. Judge Hand professed, “Anyone may arrange his affairs so that his taxes shall be as low as possible. And, there is not even a patriot duty to increase one’s taxes. Nobody owes any public duty to pay more than the law demands”. In a year where we will all be affected by rising tax rates, it is important to heed the advice of Judge Hand and plan accordingly.
Sincerely,
Greg Gann
Please talk to your financial advisor and tax advisor for advice on your specific situation prior to executing any strategy as individual situations may vary.
The big news is that for the 2010 tax year, there are no estate taxes; well that is unless the law is repealed and made retroactive. This is a repeal with a one year term limit. Estate taxes are only applicable for “wealthy” estates. Certain members of Congress have politicized the tax by branding it as a “death” tax, and encouraging a large percentage of the population for whom estate taxes have no relevance to fight the battle for permanent repeal. In reality, by and large, only one to two percent of the entire American population is subject to these taxes, yet clever marketers have incited people of average means to join the tea party. The amount of an estate that can be left to beneficiaries exempt from federal estate taxes has been increasing since the enactment of the 2001Tax Act. In fact, the exemption has escalated from $ 1 million in 2001 to $ 3.5 million in 2009. The Byrd Rule is legislation which limits the duration of laws with a negative fiscal impact to ten years. It was anticipated back in 2001 that Congress would re-enact the terms of the estate tax law prior to 2009 and disqualify the one year suspension of any federal estate tax. However, that never happened. Therefore, under present law, there is no tax in 2010; however, due to the Byrd Rule, the tax reappears in 2011 back to the 2001 level of $ 1 million.
At first blush, as a beneficiary, it would appear that 2010 might be a really good year for your loved one to pass away, speaking only fiscally of course. However, there were other parts of the 2001 Tax Act that have not been sufficiently publicized or politicized, and these provisions will in reality negatively impact far more estates than the estate tax would have.
The provision in the law about which I refer relates to what is commonly known as a “step-up” in cost basis. The step-up allows beneficiaries to value the assets that they inherit based on the market value at the date of the donor’s death. Here’s the kicker. Although the estate tax has been eliminated for 2010, the step-up in cost basis has been significantly altered to the detriment of taxpayers. Under present law, the estate of a decedent who dies in 2010 can allocate a maximum of $1.3 million as an aggregate step-up. Beyond that, the beneficiary will step into the “shoes” of the decedent and receive his/her cost basis in the assets. Therefore, when the beneficiary in turn sells those inherited assets, he/she will pay tax on the gains over and above what the donor paid originally for the asset, over the $ 1.3 exemption. If the asset happens to be property that the donor owned for a great number of years, the gains could very well be very substantial. Assets left outright to a spouse receive an additional $3 million “spousal property basis increase”.
Unless the law is modified, 2010 may very well turn out to be a windfall year for a super-wealthy person to die, from solely a tax perspective. However, it may be a disaster for a middle class estate. The following example will elucidate the dilemma. Let’s say two widows at the date of death each owned the same numbers of shares of stock purchased on the same day. And, let’s say the cost basis of that stock was $10,000, and that the market value at the date of death was $100,000. Let’s also assume that the wealthy widow’s estate was valued at $20 million and that the middle class widow ‘s estate was valued at $1 million. In this example, the wealthy widow gets a big advantage in 2010 because she will incur no federal estate tax, which in 2009 and other prior years would have resulted in roughly $50,000 in estate tax. Her beneficiary will have to pay capital gains tax on the $90,000 gain resulting from the sale of the stock. With the capital gains tax rate of 15% through 2010, the beneficiary will incur a capital gains tax of approximately $13,500, approximately $36,500 better than had the estate been subject to federal estate taxes. In contrast, the middle class widow in 2009 would still have fallen within the federal estate tax exemption, and hence had a zero estate tax. In 2009 and prior years, her beneficiaries would have received the step-up in cost basis for the stock and therefore, they would have incurred zero capital gains taxes. In reality, in 2010, the beneficiaries of the wealthy and the middle class widows incur identical capital gains taxes on the gains from the stock sale. Consequently, the middle class heirs owe the $13,500 in capital gains taxes, thereby reducing their net inheritance by this amount. The bottom line is that the super-wealthy may turn out to be the big winners in 2010, and the middle class may be incurring even greater proportions of the tax burden in the U.S.
B) Other Significant Tax Changes:
1) The maximum amount of equipment placed in service that a business can expense as a deduction is cut by nearly 50% from $250,000 to $135,000.
2) Taxpayers age 70.5 and older can no longer make a charitable contribution directly from their IRA’s, and thereby avoid income taxation on the amount donated. This could have a huge negative impact on a non-profit’s budget.
3) 2010 represents the last year during which capital gains will be taxed at the rate of 15% and 0% for taxpayers in the 10% and 15% tax brackets. Next year, the rate goes to 20% for most taxpayers and 10% for taxpayers in the lower brackets. However, gains on assets held for five years or longer, beginning in 2011 will be taxed at 18% and 8% respectively.
4) For taxpayers in tax brackets of 15% or higher, 2010 represents the last year in which dividends will be taxed like capital gains at a significantly reduced rate of 15%. After 2010, dividends will be taxed at the highest earned income rate. Ouch.
C) Important Take-Aways:
1) It is important to appreciate that there is no federal estate tax in 2010; however, significant gift taxes which affect the majority of taxpayers remain, making it equally as expensive to gift in 2010 as it was in 2009. A donor can gift up to $1 million as a lifetime exemption as well as $13,000 per year as an annual gift exclusion amount, but gifts in excess of these exemptions remain taxable transactions.
2) The estate tax in Maryland remains unaffected by changes to the federal system. As such, estates whose values exceed $1 million are still subject to Maryland estate taxes.
3) Because the federal estate tax exemptions have been changing regularly over the last several years, it is common language in wills and trusts to leave assets to non-spouse beneficiaries up to the federal exemption amount with the residual to go to the spouse. As an unintended consequence of your estate planning documents, your estate plan may leave everything to children or other relatives, unintentionally disinheriting your spouse.
Clearly 2010 is a year of significant tax and estate planning review. Feel free to contact me regarding any specific situation where you have concern or just seek clarity. We are also well suited to recommend accountants and estate planning attorneys who specialize in these areas. In law school, I remember references in several business and tax classes to a famous United States judge and judicial philosopher by the name of Learned Hand. Judge Hand professed, “Anyone may arrange his affairs so that his taxes shall be as low as possible. And, there is not even a patriot duty to increase one’s taxes. Nobody owes any public duty to pay more than the law demands”. In a year where we will all be affected by rising tax rates, it is important to heed the advice of Judge Hand and plan accordingly.
Sincerely,
Greg Gann
Please talk to your financial advisor and tax advisor for advice on your specific situation prior to executing any strategy as individual situations may vary.
Monday, January 25, 2010
Important Tax Changes for 2010.....written by Greg Gann
There are two very important tax differences which distinguish Roth IRA’s from traditional IRA’s. The first is that distributions taken from a Roth are not taxed, provided the Roth has been funded for a minimum of five years and the distributions commence after the recipient reaches age 59.5. The second benefit is that a Roth does not require taking minimum distributions beginning at age 70.5 as do traditional IRA’s. They also can be left for a beneficiary without the beneficiary having to deplete from her inheritance the applicable income taxes, as would be the case for a beneficiary who is left a traditional IRA. A Roth allows annual contribution amounts of up to $5000 or $6000 for folks age fifty and over provided adjusted gross income falls between $105,000- $120,000 for single filers and $167,000-$177,000 for joint filers. Prior to January 1, 2010, in order to convert a traditional IRA into a Roth, adjusted gross income could not exceed $100,000.
Today, however, there are no income limitations as to who is and who is not eligible to convert. In addition, there was an added change provided by the IRS, which only exists for the 2010 tax year. The change is that the IRS has granted the option to claim 50% of the conversion amount as income in 2011 and the remaining half in 2012. If one elects to defer and pay the tax over the two year period, he or she will pay the tax based on his or her tax bracket for that year. This could be more costly and therefore less advantageous if say the taxpayer expected a bonus or other qualifying event that would make 2012 a higher tax year. Because money in a traditional IRA has never been taxed, any distribution from a traditional IRA is considered income in the year in which it is received. Converting from a traditional IRA to a Roth IRA is considered a distribution, and therefore can substantially impact income taxes due in the year of conversion. It can even throw a taxpayer into a much higher tax bracket. This part of a conversion for tax purposes is very clear. Where it gets a little more complicated is for those tax payers who maxed out on deductible retirement plan contributions, but nonetheless funded a traditional IRA with after-tax contributions in order for the proceeds to grow tax deferred.
Unfortunately, we are not permitted to segregate the pre and post-tax contributions thereby allowing the post-tax contributions exclusively to be withdrawn to avoid income taxation when making a conversion, and a specific three step formula must be followed. Step one is to divide the total after tax contribution by the total IRA account balance to come up with a non-taxable percentage. Step two requires multiplying that percentage by the total amount that is desired to be converted. The quotient reached in step two is subtracted in step three from the total amount desired to be converted.
Example: Let’s say we contributed total after-tax contributions to a traditional IRA over the years of $50,000. And, let’s also establish that the total value of the traditional IRA, (including both pre and post tax contributions totals $300,000). And let’s say that we desire to convert $100,000 of the IRA.
Step 1: Total after-tax contributions / Total IRA account balance: ($50,000/ $300,000 = 16.67%)
Step 2: 16.67% x 100,000 = $16,667
Step 3: $100,000 - $16,667= $83,333.
The example illustrates that converting $100,000 from a traditional IRA to a Roth IRA will result in our having to pay additional income tax on 83,333 of income in that tax year. However, there may be a way around this aggregation rule. If an employee’s company retirement plan such as a 401k plan allows rollovers into that company-sponsored plan, then the employee could roll just the pre-tax contributions into that company plan, leaving the IRA with only the post-tax contributions.* This would result in the IRA holding only contributions that have already been taxed, and therefore, a rollover of this amount could avoid the above pro-rata aggregation rules. For self-employed individuals or even part-time independent contractors, it may make sense to open an individual 401k plan for that full or part-time business, particularly if they have made fairly significant non-deductible IRA contributions over the years. In any event, as you can see, there are complex rules relating to Roth IRA conversions, and there is no easy one size fits all answer for all individuals. But, with the present bonus of the option to pay the additional taxes spread over two years as well as the income restrictions being lifted in the 2010 tax year, it may make sense to know all your options. It is also important to note that the decision to convert can be circumvented after the fact through what is called a re-characterization. The re-characterization effectively makes the prior transfer null and void, but the decision must be made by October 15th of the calendar year after the year of conversion. If there were large gains in the IRA account which would result in large taxes, then it might make sense to re-characterize.
Stay tuned. Part two will highlight other significant tax changes for the year.
*Depends on your 401(k) plan. Please see your plan administrator for information on your particular plan. Please talk to your financial advisor and tax advisor for advice on your specific situation prior to executing any strategy as individual situations may vary.
Today, however, there are no income limitations as to who is and who is not eligible to convert. In addition, there was an added change provided by the IRS, which only exists for the 2010 tax year. The change is that the IRS has granted the option to claim 50% of the conversion amount as income in 2011 and the remaining half in 2012. If one elects to defer and pay the tax over the two year period, he or she will pay the tax based on his or her tax bracket for that year. This could be more costly and therefore less advantageous if say the taxpayer expected a bonus or other qualifying event that would make 2012 a higher tax year. Because money in a traditional IRA has never been taxed, any distribution from a traditional IRA is considered income in the year in which it is received. Converting from a traditional IRA to a Roth IRA is considered a distribution, and therefore can substantially impact income taxes due in the year of conversion. It can even throw a taxpayer into a much higher tax bracket. This part of a conversion for tax purposes is very clear. Where it gets a little more complicated is for those tax payers who maxed out on deductible retirement plan contributions, but nonetheless funded a traditional IRA with after-tax contributions in order for the proceeds to grow tax deferred.
Unfortunately, we are not permitted to segregate the pre and post-tax contributions thereby allowing the post-tax contributions exclusively to be withdrawn to avoid income taxation when making a conversion, and a specific three step formula must be followed. Step one is to divide the total after tax contribution by the total IRA account balance to come up with a non-taxable percentage. Step two requires multiplying that percentage by the total amount that is desired to be converted. The quotient reached in step two is subtracted in step three from the total amount desired to be converted.
Example: Let’s say we contributed total after-tax contributions to a traditional IRA over the years of $50,000. And, let’s also establish that the total value of the traditional IRA, (including both pre and post tax contributions totals $300,000). And let’s say that we desire to convert $100,000 of the IRA.
Step 1: Total after-tax contributions / Total IRA account balance: ($50,000/ $300,000 = 16.67%)
Step 2: 16.67% x 100,000 = $16,667
Step 3: $100,000 - $16,667= $83,333.
The example illustrates that converting $100,000 from a traditional IRA to a Roth IRA will result in our having to pay additional income tax on 83,333 of income in that tax year. However, there may be a way around this aggregation rule. If an employee’s company retirement plan such as a 401k plan allows rollovers into that company-sponsored plan, then the employee could roll just the pre-tax contributions into that company plan, leaving the IRA with only the post-tax contributions.* This would result in the IRA holding only contributions that have already been taxed, and therefore, a rollover of this amount could avoid the above pro-rata aggregation rules. For self-employed individuals or even part-time independent contractors, it may make sense to open an individual 401k plan for that full or part-time business, particularly if they have made fairly significant non-deductible IRA contributions over the years. In any event, as you can see, there are complex rules relating to Roth IRA conversions, and there is no easy one size fits all answer for all individuals. But, with the present bonus of the option to pay the additional taxes spread over two years as well as the income restrictions being lifted in the 2010 tax year, it may make sense to know all your options. It is also important to note that the decision to convert can be circumvented after the fact through what is called a re-characterization. The re-characterization effectively makes the prior transfer null and void, but the decision must be made by October 15th of the calendar year after the year of conversion. If there were large gains in the IRA account which would result in large taxes, then it might make sense to re-characterize.
Stay tuned. Part two will highlight other significant tax changes for the year.
*Depends on your 401(k) plan. Please see your plan administrator for information on your particular plan. Please talk to your financial advisor and tax advisor for advice on your specific situation prior to executing any strategy as individual situations may vary.
Subscribe to:
Posts (Atom)
