Warren Ward Associates

One for You, Nineteen for Me . . .

One of my favorite poets, George Harrison, wrote those lyrics for the Beatles’ song Taxman almost 40 years ago. Although US rates have never quite reached the 95% level at which George was taxed in the UK, they always seem high enough that planning for them makes sense.

I have just returned from the first of several tax update schools which I will attend this year, trying to keep abreast of the changes which will affect our clients. With four new laws and many updates to assimilate, I thought I’d share at least some initial observations.

The past twelve months have brought an interesting combination of tax breaks intended to stimulate the economy: increased deductions for business use of automobiles (to encourage vehicle purchases), extension of reduced capital gains tax rates (to encourage people to sell property and spend the money on something else) and the mailing of stimulus checks so people have some money to spend. All of this, of course, will reduce potential tax revenues, perhaps by as much as $150 billion dollars.

Those reduced capital gains tax rates of 5% and 15% are not, in fact, the lowest ones available. For individuals with an Adjusted Gross Income (AGI) below $41,500 (or a couple with an AGI below $83,000) the rate is 0, yes, zero. This provides a great opportunity for people who qualify to reduce their cost basis in at least some appreciated assets, whether property or securities.

Congress also acted to extend some other tax breaks, including the one available to those who have reached age 70½ and must take Required Minimum Distributions from IRAs. If they choose, these individuals can continue to make direct transfers from their IRAs to qualified charities. Although there is no deduction for the gift, there is no tax on the withdrawal which provides a greater benefit.

On the other side of the coin, tighter restrictions continue on the valuation of clothing, household items and automobiles which are given to charities. New for this year, appraisers are to receive increased oversight. In hopes of increasing tax revenue, whistleblower rewards have been increased to 30% of the amount collected by the IRS for those willing to "turn-in" someone who has cheated on their taxes.

I think the biggest break overall relates to those who have gotten in over their heads in the depressed real estate market and must "walk away" from a mortgage. In the past, if someone abandoned a home and the lender forgave the difference between the amount owed and the amount realized from an eventual sale, that difference was treated as income to the mortgage holder and therefore taxable. The new rule states that up to $2 million of forgiven mortgage debt is not income and therefore not taxable. Although Congress was slow to act, they made the provision retroactive to January 1^st, 2007 and a subsequent law extends the tax break until December 31st, 2012. That figure seems extreme to those of us living in the Midwest but Congress clearly intended to settle the issue once and for all whether dealing with someone in Columbus, Indiana or Palm Beach, California.

To encourage home purchases, buyers who are required to obtain Private Mortgage Insurance (PMI) may now consider those premiums to be interest, making them deductible. In addition, there is a new first-time homebuyer’s credit of up to $7500. Although actually an interest-free loan, it provides additional incentive for people to start buying homes again.

By now, most taxpayers will have received a stimulus check (or electronic deposit). Those who did not qualify this year will have a chance to try again next year. Twenty million middle-income taxpayers who might have had to deal with the Alternative Minimum Tax (AMT) have been granted additional relief. This too should leave people with a bit more money to spend.

On a procedural note, the IRS has provided additional clarification on which of a divorced couple gets the exemption for a child. It has also increased the mileage reimbursement rate to 58.5 cents. With gasoline rates falling as the dollar gains strength, I suspect 2009 will bring the first ever lowering of that rate.

Taxes must be collected so that our government can continue to operate and there are a range of opinions about who does or does not pay their fair share. According to the IRS website, here’s a breakdown of which earners paid what percentage of income taxes collected for 2006. Each row includes the one above it, i.e. the Top 1% are also included in the Top 5%.

	AGI threshold	% of all taxes paid
top 1%	$388,806	39.89
top 5%	$153,542	60.14
top 10%	$108,904	70.79
top 25%	$64,702	86.27
top 50%	$31,987	97.01
bottom 50%	<$31,987	2.99

In the early 1950’s, US tax rates involved many more brackets than today including a marginal rate of 92%, quite close to what George Harrison once had to pay. Although economics has famously been called "the dismal science" it is, in fact, much more an art. Whether recent changes in tax codes and rules by Congress and the IRS will have the desired result remains to be seen. I will certainly continue my study of the topic and hope to share what I learn.

Silly Season Suggestions

Following last week’s tax-related investment cautions, I thought I’d share a few last minute tax-related suggestions for people to consider.

If you are not ready to file by the 17th, an easy-to-file extension is available. Either you or your tax preparer can file it and it is automatic, i.e. it does not require approval. This six month extension is from having to file your taxes, not pay them. If taxes are owed, interest (and probably penalties) will accrue from the 17th. If a refund is due, the IRS will pay you interest.

The IRS has tightened-up a couple of categories of deductions. Donated items must now be in "good" condition, although "good" is not defined. I think that asking for a receipt which includes a description of the item’s condition might be a prudent step. In prior years, cash contributions of up to $250 did not require documentation but for 2006 and going forward, proof must be provided.

Tax-efficient investing can be accomplished in a number of ways beyond IRAs and other tax-deferred strategies. No load variable annuities make sense in some cases, as do mutual funds which are managed with tax efficiency in mind. We have begun using a "buy and hold" strategy with individual dividend-paying stocks, an approach that is showing promise.

If you are thinking about retiring and are covered by a retirement plan, be careful how you go about taking a rollover. It is important to follow the correct procedure so taxes are avoided. As I mentioned last week, we see a lot of people roll 401(k) plans over into annuities. These insurance-based products include significant "overhead" which must be covered before positive investment results begin to make money for you. We are aware of no advantage in selecting an annuity over a roll-over IRA.

If a significant portion of your retirement nest-egg is in a company’s stock, give careful consideration to diversifying. Even the best companies can suffer difficult periods and, as we learned from the Enron fiasco, in the case of fraud, literally everything can be lost. It is sometimes possible to diversify in ways which allow tax savings, so be sure to ask for advice if this is an issue.

An inheritance can provide a welcome cushion to a nest-egg but care should be used in deciding how to "take" it. Inherited IRAs can be rolled over and, although distributions are then required, taxes are deferred. If a larger estate is involved, be sure to take advantage of potential deductions based on estate taxes already paid.

If you expect to leave a large estate, look carefully at how your life insurance policies are titled (especially if there is a trust involved). Also, review the named beneficiaries of both insurance policies and IRAs. Those are among the categories of assets which pass "by operation of law" before the terms of a will come into effect. That means that the provisions of your will not be considered as far as those assets are concerned.

If you have a second home, you will have do choose between making it your first home so you can take advantage of the capital gains exclusion or use the 1031 exchange method to swap it for another investment property. Neither of these strategies is particularly difficult to execute but each must be done carefully so that tax advantages are not lost.

If you own other investment property, using a 1031 exchange to "get out of the property management business" can be an appealing strategy. It is entirely possible to "swap" into a professionally managed investment and realize regular income from it. There are strict time limits on identifying and purchasing the replacement property and the services of a Qualified Intermediary are required. Again, ask for advice if you are in this situation. If you own a business and plan to sell it to help finance your retirement, be sure to obtain competent tax advice. There may be alternative methods of sale that can reduce your tax burden.

Although Warren Ward Associates does not prepare tax returns for our clients, we do keep up with changes in tax law. If you are doing your own taxes and are considering bringing in a professional, we’ll be glad to make a recommendation based on your specific situation.

The Silly Season

As the weather turns warmer, people’s minds just naturally turn to thoughts of . . . well, in many cases, taxes. As April 15th approaches (actually it’s the 17th this year), people become more susceptible to making an investment decision based on tax issues instead of common sense. At this time of year, products containing a tax "hook" are brought up by salespeople and sometimes even the most prudent investors find themselves considering an investment they wouldn’t look at otherwise.

In approximate order of popularity, here’s a roundup of the usual suspects:

Variable Annuities (VAs) – These are basically mutual funds held within an insurance policy. Since they are insurance products, they receive the traditional benefit of tax-deferred growth. However, we often see them recommended for IRA rollovers which are already tax-deferred, making the added annuity costs a drag on investment performance. VAs do provide insurance in the amount of the original investment, even if the value of the mutual fund investments drop. On the other hand, accounts continue to be charged for insurance costs even when the investment value rises, providing something for nothing to the company and nothing for something to the investor. Typically, an investor will be penalized for withdrawal within the first five years, so these contracts should not be entered into lightly. We have researched "no load" VA’s and do recommend them when we believe they provide the best solution for a specific situation.

Equity Indexed Annuities – These are similar to the VAs above but are not considered "investment products" by regulators, so they are available through thousands of additional insurance agents who are not licensed to sell securities. Instead of having a mutual fund inside an insurance policy, these are [effectively] a stock index option inside a policy. Again, these commonly include layers of cost which are charged to the buyer and they often have even longer surrender penalty periods than VAs. We recently reviewed one with a 12 year penalty period which had been sold to a 62-year-old. We are not saying that an EIA is never the proper solution and we do not hesitate to suggest them, depending on specific circumstances. However, they are often presented as a "blanket" solution, appropriate for almost everyone, and we do not believe that to be the case.

1031 Property Exchanges – Like so many things in the financial planning world, the 1031 is named for a section of the tax code. It allows the owner of an appreciated investment asset (other than a business) to exchange it for another. These can be a very effective tool in a number of situations but are governed by a strict timeframe and should not be attempted without strategic consideration. Do not allow yourself to be rushed into a significant property investment because you have just sold another. Carefully review your overall investment objectives to be sure you are making a good long term decision.

Annuity Trusts – These have garnered significant interest following a 1969 IRS ruling. They have been used to attempt to avoid, or at least defer, taxes on appreciated property. The IRS came up with new rules in October 2006 and cited taxpayer abuses of the strategy as the reason for their clarification. If someone suggests one of these to you, I would be very careful, as I believe the new rules are sending the message that all such trusts are liable to be challenged.

It is our belief that a good investment must first make economic sense, then tax issues should be considered. It is an unusual situation indeed, when allowing the tax "tail" to wag the investment "dog" proves to be the most appropriate strategy.

They Are From The Government and They Are Here to Help

Once again, I have turned to former president Ronald Reagan for a quotation in a political context, slightly modifying his "nine most terrifying words" for the title of this article.

The year is coming to an end and while Warren Ward Associates does not generally recommend major shifts in financial plans to accommodate taxes, it certainly makes sense to consider any strategy which offers the potential for tax savings.

Unless a last minute bill is passed, a couple of portions of the tax code will change with the year end/new year. First, if you are now taking Required Minimum Distributions from an IRA, you are allowed to make a gift directly from your IRA to a church or charity. This counts as your RMD and avoids your having to take the distribution, pay the taxes, then make the contribution. Under the current law, 2007 is the last year a gift may be made in this way. Your broker or the charity you wish to support can provide specific instructions on how to accomplish such a transfer.

Second, there are adjustments coming related to the "kiddie tax". That’s the section of the tax code which causes a child’s earnings above a certain level to be taxed at the parent’s highest marginal rate. Beginning this January 1st, the age at which it is applied will rise from 17 to 18 and, for the first time, full-time students up to the age of 24 (with some exceptions for those who are working) will also be covered. Especially for families with students in college, it might be worth making a quick gift of appreciated stock to a child over 17, allowing the proceeds from its sale to be taxed at her or his lower rate. This does not make sense for everyone, however, since income in a child’s name tends to reduce need-based college financial aid.

As always, people who own individual stocks (whether kept in a lock box or on deposit with a brokerage firm) can donate appreciated shares, rather than a gift of cash, to a charity. Givers receive a deduction based on the present value of the stock and neither the donor nor the charity pays tax on the gain.

On the other hand, if you own stocks which have lost value, this might be a good time to "clean out the closet" and use some of those losses to offset other gains, perhaps from mutual funds. Application of such losses against ordinary income is limited to $3000 per year but can be carried forward to subsequent years. If you believe in the long-term potential of one of your stocks, it is possible to sell it then re-purchase it later, although you must wait 30 days before buying the same stock again. If you believe in an industry rather than a specific company within it, you could make a sale of one company followed by the immediate purchase of a competitor. You might also be able to locate an ETF which includes the stock you like. Again, your own broker can provide you with specifics.

Finally, most flexible spending (Section 125) accounts have a calendar year end, so be sure you spend yours before the cut-off date.

WWA has never believed that taxes should be allowed to drive investment decisions but neither do we believe that investing can be sensibly done without considering tax implications. I hate to be a political cynic but taxes are the lifeblood of government. I’d like to think that our politicians consider their taxing and spending decisions to be in the best interests of all of us and that they really are "here to help". Whether that’s true or not, keeping up with changes in the tax laws which our representatives enact is an important part of the financial planning process, at least as practiced at Warren Ward Associates. Your tax advisor can supply specific advice about the appropriateness of any of these strategies in your own situation.

Tax Dates to Remember

I suspect that most everyone who reads my periodic comments about financial planning and investing is familiar with April 15th, tax day for most US citizens.

Another, less well-known tax date is Tax Freedom Day®, a date which has been calculated by the Washington DC-based Tax Foundation (www.taxfoundation.org) since 1971. For 2008, they figure it to be April 23rd, meaning that, on average, we work the first 113 days of the year to pay for our governments and their services. While there is legitimate debate about what this figure/date actually means, it is at least a stab at answering the question: "What does our government cost us?"

Income taxes have been imposed by most countries at one time or another but, in the United States, it took ratification of the Sixteenth amendment to make it clear that the federal government could legally do so. The first rate was 1% on yearly incomes above $3000 (about $60,000 in today’s dollars) with an additional 6% surcharge for incomes above $500,000 (about $10,500,000 today).

Services like police protection and maintaining a standing army appear to be here to stay. Even the staunchest advocates of "small government" agree to the need for at least some services which can only be provided by the government. These services, whether provided at the federal, state or local level, obviously require taxes to fund.

I avoid debates about the fairness of taxes, since I know I’m unlikely to influence the outcome. Instead, I try to help my clients understand the system and orient their financial planning and investment decisions to accommodate it.

Seventeen years ago, when I earned my first brokerage license, interest rates were relatively high and tax-free municipal bonds were often a very appropriate investment. As interest rates fell, we searched for a strategy to replace tax-free bonds in our clients’ portfolios. Over the past couple of years, we have implemented a process for selecting dividend-paying stocks which provide a similar result. Our clients receive tax advantaged income (in the form of dividends) but we are able to choose when to take any capital gains by deciding when to sell the stocks.

Recent changes in interest rates have made municipal bonds somewhat more attractive, so we have begun to consider that option again, at least for some clients.

When we choose managers for our clients’ assets (usually through mutual funds), one of our screening elements is tax efficiency. Different managers employ different strategies but we generally try to place our clients’ non-retirement assets with managers whom we expect to be able to minimize current-year taxation.

Here’s one final tax date to think about. On December 31, 2010, our current federal estate tax structure will expire and we will revert to the 2001 rules. The original estate taxes were enacted largely to help break up the huge family fortunes amassed by the early steel and railroad "barons". The effects of inflation eventually brought those taxes to bear on most middle class families. The 2001 revision of the law brought a phased adjustment, moving most of the middle class back out from under them. As this revision approaches its "sunset", debate continues about the fairest way to implement estate taxation.

I spend more hours in continuing education every year on taxation than any other topic. Our hope is to always be able to make suitable options available for our clients, regardless of what form taxation might take.