Let the Tax-Shifting Begin!

"We contend that for a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle”

Winston Churchill

In a Bloomberg News story appearing November 5th, the dots are finally being connected between spending programs on one hand and the need for additional federal revenues on the other. See here.

The U.S. government is spending $787 billion to stimulate the economy, the deficit is $1.4 trillion and Congress is debating costly changes to health care. The taxpayers’ bill to pay for it isn’t far behind.

“Something is going to have to be done to raise revenue unless entitlement spending is cut,” said Gerald Prante, senior economist for the Washington-based Tax Foundation.

While the final resolution of the competing aims is being debated, what is under discussion has pundits opining that Federal tax rates may rise in 2011 to as high as 39.6 percent, up from 35 percent (for those earning more than $373,650). The House version of the health reform bill sets an additional 5.4 percent surtax on adjusted gross income for high- income individuals. Long-term capital gains rates may reach 28 percent, from 15 percent today, Prante said.

Tax advisers intend advising clients to take advantage of lower rates and expiring tax breaks on 2009 and 2010 returns, a tactic that could save millions for clients in the top brackets. Strategies range from investing in film production, deferring large-scale expenses into future years, investing in energy credits, to exercising non-qualified stock options.

“For many of our clients, particularly those who run their own businesses, there may be an opportunity to accelerate significant amounts of income -- even as much as $50 million to $100 million of taxable income,” said Mark Nash, a Dallas partner at New York-based PricewaterhouseCoopers Private Company Services, whose average client has assets of $150 million or more. The tax savings from moving income into 2009 or 2010 would be 4.6 percent of that amount, he said.

To me this just says "It's coming". The whole article is worth a read.

Another Measure of Long Term Value of the U.S. Market

From Smithers & Co., their informative visualization of long term value of the U.S stock market:



From their website, an explanation of their methodology and results:

US CAPE and q chart

The US Flow of Funds data (“Z1”) have just been published (17th September, 2009) for Q2 2009. We also have 99% of the EPS on the S&P 500 for Q2 2009. On the basis of these data, and allowing for the 16% rise in the stock market since 30th June, 2009, US non-financials on 17th September, with the S&P 500 @ 1069.45, were 40.6% overvalued (using q) and the total market including financials was 36.5% overvalued (using the cyclically adjusted PE “CAPE”).

From being around fair value at the end of March, the US stock market has become significantly overvalued again. In the case of q this is largely because of the rise in the market, aided to a small extent by falling asset values, largely of real estate, and rising liabilities.

In the case of CAPE the increase in the overvaluation of the market is also largely due to the change in share prices but, as current EPS, measured at constant prices, are around half those recorded 10 years ago, the cyclically adjusted EPS is also on a downward path, which is likely to continue for some time.

What is q you say? "q" is the ratio between the value of companies according to the stock market and their net worth measured at replacement cost.What is CAPE? CAPE is the cyclically adjusted PE ratio as formulated by Robert Shiller. Both of these measures (CAPE and q) have been statistically determined to be significantly correlated to LONG TERM returns.

But did you catch what Smithers & Co. was saying about long term returns going forward? "From being around fair value at the end of March...". That would be after a 29% rally off the March 9 lows to about the 810 level on the SP500. We now sit (November 3rd) at 1045.

Have people telling you the market is cheap? Not that it can't rally from here, but cheap it's NOT.

Year-End Tax Planning

Taxation *with* representation ain't so hot either. ~Gerald Barzan

Here's some basic tax strategies to consider implementing before the end of the year to keep your income taxes as low as possible.

Review the New Tax Credits and Deductions
There's some new tax credits and deductions available for 2009. First, if you purchased a new car or truck you can write off sales tax even if you didn't itemize as part of the new vehicle sales tax deduction. If you are a homebuyer, you should review if you are eligible for the $8,000 tax credit for first-time home buyers. Homeowners should also review whether it would be advantageous to take the additional standard deduction for property tax in lieu of itemizing.

Individuals who have two jobs and Social Security recipients who are working should review their eligibility for the Making Work Pay tax credit.

Boost Tax Deductible Expenses
Every year you should look at strategies for increasing your deductible expenses versus those that are not. Make an extra mortgage payment. The extra interest you pay will be added to this year's mortgage interest by your lender, boosting your itemized deductions. (But confirm with your lender that your payment will be credited as paid in the current year!)

Pay your property taxes.
If your property tax bill is due early next year, you might want to pay it now and take the deduction.

Donate to charity.

Pay Deductible Medical Expenses.
Pay doctor bills, insurance premiums, buy eyeglasses, or stock up on prescription medications. You can take a deduction for medical expenses exceeding 7.5% of your adjusted gross income.

Boost business expenses.

Business owners and independent contractors can buy office supplies, invest in new equipment, or pay bonuses to their employees. They should also review their retirement plans or decide about setting up a retirement plan. Many retirement plans need to be established by the end of the year if owners want to make tax-deductible contributions for the year. You will want to review what constitutes a legitimate business expense just to make sure it will be tax-deductible.


Manage Your Investments to Take Deductible Losses
Sell losing investments to offset capital gains. Investors can lower their capital gains taxes by selling securities that have lost money. Losses offset gains dollar for dollar, and losses in excess of your gains can be deducted, up to $3,000 per year.

Max out your retirement savings. Contributions to a retirement plan reduce your taxable income.

Tax Strategies Beyond Form 1040
Check your:

* Tax-free gifts for education through Section 529 plans
* Maximizing Your Flexible Spending Accounts
* Lowering Estate Taxes Through Gifts

Questions? See your tax attorney and/or your financial advisor!

The "Stretch" IRA

In your late night studies on retirement investing vehicles, you may have come across the term 'stretch IRA'. This is actually not a category of IRA, such as a Traditional, Roth, SEP or SIMPLE IRA. It is more like a financial-planning or wealth-management strategy imbedded in the product (IRA) provisions.

The "stretch" provision is one you might be interested in if you are using your IRA primarily to provide for your beneficiaries. That is, if your retirement needs will be funded by other assets (lucky you!. Then, you may want to take advantage of this provision in order to structure flows to persons other than yourself.

Identifying the Concept

Does your IRA allows the beneficiary to distribute the assets over a life-expectancy period and also allow him or her to designate a second-generation beneficiary of the inherited IRA? If so, it is this provision that allows a beneficiary to designate a second-generation beneficiary (and even a third, fourth and so on)that determines whether the IRA has the "stretch" provision. It allows the IRA to be passed on from generation to generation, thereby stretching the life of the vehicle.

How It Works

The beneficiary must follow certain rules to ensure he or she doesn't owe the IRS excess-accumulation penalties, which are caused by failing to withdraw the minimum amount each year. How so?

Let's use an example:

Huey's designated beneficiary is his son Dewey. Huey dies in 2008, when he is age 70 and Dewey is age 40. Dewey's life expectancy is 42.7 (determined in the year following the year Huey died, when DDewey is age 41). This means that Dewey is able to stretch distributions over a period of 42.7 years. Dewey elects to stretch distributions over his life expectancy, and he must take his first distribution by Dec 31, 2009, the year-end following the year Tom died.

To determine the minimum amount that must be distributed, Dewey must divide the balance on Dec 31, 2008, by 42.7. If Dewey withdraws less than the minimum amount, the shortfall will be subject to the excess-accumulation penalty. To determine the minimum amount he must distribute for each subsequent year, Dewey must subtract 1 from his life expectancy of the previous year. He must then use that new life-expectancy factor as a divisor of the previous year-end balance.

Now, remember our assumptions. The IRA plan document allowed Dewey to designate a second-generation beneficiary, and he designated his son Louie. If Dewey were to die in 2013, when his remaining life expectancy is 38.7 (42.7 - 4), Louie could continue distributions for Dewey's remaining life expectancy. It is important to note that only the first-generation beneficiary's life expectancy is factored into the distribution equation; therefore, Louie's age is not relevant.

In this example, Huey could have chosen to designate Louie as his own beneficiary, resulting in a longer stretch period. In such a case, Louie would be the first-generation beneficiary, and his life expectancy instead of Dewey's would be factored into the equation.

Primary Benefits of the Stretch Concept

Tax Deferral

The primary benefit of the stretch provision is that it allows the beneficiaries to defer paying taxes on the account balance and to continue enjoying tax-deferred and/or tax-free growth as long as possible. Without the stretch provision, beneficiaries may be required to distribute the full account balance in a period much shorter than the beneficiary's life expectancy, possibly causing them to be in a higher tax bracket and/or resulting in significant taxes on the withdrawn amount.

Flexibility

Usually, the stretch option is not a binding provision, which means the beneficiary may choose to discontinue it at anytime by distributing the entire balance of the inherited IRA. This allows the beneficiary some flexibility should he or she need to distribute more than the minimum required amount, say in the case of a financial emergency.

Benefits for Spouses

Remember, a spouse beneficiary is allowed to treat an inherited IRA as his or her own. When the spouse elects to do this, the spouse beneficiary is given the same status and options as the original IRA owner and the stretch concept is not even in play. However, should the spouse choose to treat the IRA as an inherited IRA, then the stretch rule may apply.

Conclusion

Consult your current IRA provider or financial institution if this concept is of interest to you. IRAs can be transferred if this provision is not present in your provider's IRA plan documents. Finally, be sure to consult with your tax and financial professional for assistance. This concept must mesh with your financial profile and your wealth-management goals.

Inflation vs. Deflation

We have been discussing what I call the most important choice that planners must make in fashioning their clients' portfolios: Will we have inflation or deflation? Over what term? Now comes a bit of evidence from the Social Security Administration on what environment presently prevails. For the first time in 50 years, no cost of living adjustment for seniors. Why? Read on.

From the Associated Press:

There will be no cost of living increase for more than 50 million Social Security recipients next year, the first year without a raise since automatic adjustments were adopted in 1975, the government announced Thursday.

Blame falling consumer prices. By law, cost of living adjustments are pegged to inflation, which is negative this year because of lower energy costs. Social Security payments, however, cannot go down.

But if Social Security payments aren't rising and rates that savers receive are paltry, what to do? Provide artificial increase through "one-time" stimulus, of course.

Thursday's announcement comes a day after President Barack Obama called for a second round of $250 stimulus payments for seniors, veterans, retired railroad workers and people with disabilities.

The payments would match the ones issued to seniors earlier this year as part of the government's economic recovery package. The payments would be equal to about a 2 percent increase for the average Social Security recipient.

Problem solved!

Gentle Reminders- Taxes

Taxes: Of life's two certainties, the only one for which you CAN get an automatic extension. ~Author Unknown

Thursday October 15th is the last day to file your 2008 tax return without penalty. It's also the last day for self-employed persons to fund a SEP-IRA for 2008. Wait! There's more! It's also the deadline for submitting any late or corrected foreign bank account reports to the Treasury.

I'll have some year-end tax planning tips for you in a few days. Yes, it's that time of year. Sigh.

Overvalued Markets and Average Ten Year Forward Real Returns

So a reader asks about my comment about staying out of overvalued markets. How does one DO that? The answer is that there are several measures that I personally use to gauge value but I am going to show you a simple analysis as to how this might be done. Remember that I will be talking about AVERAGE RETURNS. This is an important point. We are trying to control for risk. Sometimes our risk control measures will be well rewarded. Sometimes not. And sometimes the stock market presents you with a hand to be played that ON AVERAGE you should just toss back. Here goes.

In this analysis we are going to assume that the broader stock market represented by the S&P 500 Index is the proper benchmark for comparing stock market returns. And we are also going to assume that, on average, that what investors are concerned about is returns ten years out. I know, that 's a lifetime for some and if investor behavior during the recent crash is any indication, many have hair trigger fingers.

In the first analysis the price to earnings or PE ratios and the corresponding ten-year forward real returns were grouped in five quintiles (i.e. 20% intervals).



The cheapest quintile had an average PE of 8.5 (you paid 8 and 1/2 times earnings for the shares)with an average ten-year forward real return of 11.0% per annum, whereas the most expensive quintile had an average PE of 22.6 with an average ten-year forward real return of only 3.1% per annum.

This analysis clearly shows the strong long-term relationship between real returns and the level of valuation at which the investment was made.

Although the above analysis represents an update to and extension of an earlier study by Jeremy Grantham's GMO, (an investment advisory having billions of dollars under management and having splendid risk-adjusted returns over its lifetime) it was also considered appropriate to replicate the study using dividend yields rather than PEs as valuation yardstick. The results are reported in Diagrams below and, as can be expected, are very similar to those based on PEs.



So where does the market sit based on these measures? The fourth most expensive quintile based upon PEs and the most expensive quintile based upon current dividend yields. Does that mean the market is about to fall tomorrow? No, research shows that in the short term market performance bears little relationship if any to these valuation measures. But for an investor who needs the money in 2019 for a child's education and also needs a 10% return in order to fully fund it, these analyses should give reason for pause. COULD expectations be met with an investment here? Sure, outliers exist in life and what we are presenting here is a RANGE of performances. But, as we began his analysis, ON AVERAGE, investments here are not well rewarded.