You Have to let it Simmer

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One of the questions I get most often is why investment advisors don’t jump in and out of the market. Most recently I was asked “Why don’t investment advisors drastically change their portfolios when something bad has clearly happened?”

The answer you have probably heard, and maybe even from me, is because frequently trading your portfolio begins to cease looking like investing and begins to resemble gambling. How many people do you know that often come back from Vegas with more money than they left with? You don’t jump in and out of the market because to do so effectively you have to correctly time the market twice; you have to have the insight to know when to sell high when most investors will be pouring in money in a euphoria and you have to have the insight to know when to buy low when most investors will be sprinting for the exits in temporary fear. Even if you do somehow manage to time the market correctly, you’ll be burdened with more transaction fees and taxes as a result of your more frequent trading. That’s why most professional investment advisors don’t jump in and out of the market, and as far as jumping in and out of the market after something bad has clearly happened, professional investment advisors don’t do that because the "bad event" has already occurred and some of the market’s biggest gains often come on the heels of something less than ideal.

After 9/11 did you want to be invested? Think back to 2008-2009 right after Lehman Brothers collapsed and the Great Recession began. Did you really want to be invested? What about in 2011 after the credit rating of the United States was downgraded? Did you want to be invested then? At the time of those events, my answer would have been no. When events like that happen in the future, my answer will be no again, but it has to be yes. You have to stay invested.

Check out the link below to visuals from Putnam Investments. I found these incredible statistics as I was researching and working on my correspondence with the individual who most recently inquired about market timing.

https://www.putnam.com/literature/pdf/II508.pdf

Two of the Dow Jones Industrial Average’s biggest days occurred within eleven months of 9/11! Seven of the Dow’s best days since 2001 occurred between October 2008 and March 2009! One of the Dow Jones’ biggest days in the last 15 years occurred within a week of the unprecedented US credit downgrade! If you had invested $10,000 in the Dow at the beginning of 2002 and stayed invested, you would have had around $28,700 by the end of 2016 and have averaged an investment return of around 7.3% per year. If you had jumped in and out of the market and missed those ten best days I just mentioned that were relatively right after 9/11, the Great Recession, and the US credit downgrade just happened, you would have only had around $14,700 by the end of 2016 and averaged an investment return of around 2.6% per year! If, instead of the ten best days, you missed the twenty best days, you would have only had $9,600. You would have lost money over a fifteen year period due to missing twenty days!

I love to cook. One of my specialties is spaghetti with a homemade meat sauce. It’s ground beef slowly cooked with salt, pepper, Worcestershire sauce, and hamburger seasoning. I carefully dry the cooked meat on some paper towels on top of a plate. The meat then joins my pot of tomato sauce and I add in garlic salt, pepper, and Italian seasonings. I then slowly melt in some parmesan cheese to make the sauce richer and a little thicker. Like my mother taught me, I always taste with a clean spoon, but I keep sampling and throwing in a little more of this and that until it’s just about right. Then I put a lid on the pot and let it simmer. It’s only after simmering with an occasional stirring that all the ingredients truly come together and I end up with my desired result. Long-term investing is similar. Add the proper ingredients, tweak a little as needed to taste, and prudently monitor, but you’ll only get your desired result if you let it simmer.

-Tom

Qualified Charitable Distributions

Credit: Stuart Miles at FreeDigitalPhotos.net

If I were a betting man, I’d say there is probably a pretty good chance that you have recently put the finishing touches on your tax return. If I’m wrong, congratulations on getting your taxes done early! Your CPA thanks you, trust me. If I’m wrong because I just reminded you that your taxes are due on April 18th this year, save this post for later and make double sure that your CPA is filing you an extension!

Either way, while taxes are still likely fresh in your mind, I wanted to mention something to you for this year called Qualified Charitable Distributions. For those of us who do not like to type or write long words, we affectionately call them “QCDs.”

Qualified Charitable Distributions allow an IRA owner who is over age 70 ½ the opportunity to directly transfer up to $100,000 annually from an IRA to a qualified charity tax-free. QCDs are not new in the sense that they were created by Congress back in 2006 as part of the Pension Protection Act, but they have had a roller coaster history ever since. In the initial legislation, QCDs were only to exist for two years, and at the end of 2007, the opportunity to make QCDs was no more. QCDs became popular during that time period though, and almost every year since 2007, Congress hemmed and hawed over whether to bring them back each tax year or not. Some years they did, some years they didn’t, and some years they did retroactively (I wish I could do things retroactively…). To put it simply, it was a mess. Thankfully, as a result of the Consolidated Appropriations Act of 2016, QCDs are back, and for now at least, they are back permanently.

When a taxpayer makes a QCD, they don’t report taxable income for transferring money from their IRA and they don’t report a charitable deduction, either. It’s almost like it never happened for tax purposes. If a taxpayer just withdrew money from their IRA and donated it like normal, they would report the taxable income and they could take a charitable deduction. The taxpayer gets hit with the “stick” of the additional income, but receives the “carrot” of an additional deduction. So which should you do?

I’ll be honest with you, in most cases, the initial difference on your taxes from charitably gifting by making a QCD or not making a QCD usually appears pretty small, but that doesn’t mean you shouldn’t consider a QCD. By not having to report the additional income when you make a QCD, it’s possible you can avoid triggering or reduce the damage of some of the tax laws currently in place that penalize taxpayers. Charitably giving by making a QCD could reduce your income taxes on your Social Security benefits, it could reduce a phase-out of your itemized deductions, and it could keep your income under one of those heinous Medicare income thresholds so that your insurance premiums don’t increase. If you don’t have a lot of deductions and take the standard deduction instead of itemizing your deductions, a QCD is likely a good idea for you because otherwise you will be recognizing income and not having enough deductions to get any credit on your taxes.

I know that was a lot, and I’m sorry. I’m still a recovering CPA... My point is if you or someone you know is over age 70 ½, they have an IRA, and they are charitably inclined, make sure they ask their CPA about this new potentially tax-saving tool that we now permanently have in our taxpayer toolbox. Just do your CPA a favor, and ask them after April 18th!

-Tom

Normal Investors – Overconfidence

Credit: stockimages at FreeDigitalPhotos.net

There I was at the starting line of the famous Peachtree Road Race. I was finally old enough to be a part of the 4th of July tradition I’d watched my dad do every year of my life. I was stoked. I was a soccer player and I ran after the ball for a full hour without stopping every Tuesday, Thursday, and Saturday, so this so called “10-k” was going to be a piece of cake! When our wave started, I took off. My dad stayed with me for the first bit and then he started telling me we needed to slow down to save some of our energy for the finish. What did he know? Besides, a few runners were actually passing us! I think that first mile may have been my only career eight minute mile, but boy, by the fifth mile of the race, twelve-year-old Tom knew his dad was right.

I like to think I was a pretty cool guy in high school. In some ways I was. In some ways I was probably not. Being an avid ultimate Frisbee player with some of my band buddies was probably not my coolest hour, but we sure did have fun. We were good, too. So good that word travelled and some friends on the cross country team challenged us to a game one Saturday. Cross country whatever! I was in great shape! For a solid week my band friends and I went over and over how bad we were going to destroy our cross country friends. I think that was the last day I enjoyed running…

Of course there was that accounting test my junior year in college. I was tired. I wanted to do something other than study. Besides, I had things under control. I usually did well on tests. My scholarly roommate and fellow accounting major urged me to go over that small little bit the professor glossed over about a couple of terrible things called deferred tax assets and deferred tax liabilities. I actually remember saying, “If he asks me about that on the exam, he can have it!” I cannot tell you how much I ate those words. Literally, my roommate waited for me to look up and make eye contact across the room so he could give me that told you so look. Yes, yes he did.

I like to think I’m a pretty self-effacing guy, but from time to time in my life, I’ve been overconfident. Most of the times when I’ve been overconfident, it hasn’t worked out too well. Most of the time when investors are overconfident, it doesn’t work out too well, either. Humble pie doesn’t taste so good!

What? You don’t think you’re ever overconfident? Well let’s see about that. Do you consider yourself an above-average driver? You might be, you might not be, but studies suggest as many as 95% of people think they are above-average drivers, and that’s just impossible. Statistically, 50% have to be above-average drivers and 50% have to be below-average drivers. In the Atlanta metro area, I dare say a lot of people are the latter! Either way, overconfidence is the fourth tendency that I would suggest many normal investors have.

I think overconfidence is a pretty natural thing. I think that people tend to value their own judgments and opinions over those of others, even if other people are “experts.” Think home projects, grilling, sports, parenting, politics, etc. In the investment management world I believe this is why many investors have a little trouble letting someone else professionally manage their portfolio. They value their own judgments and opinions, they want to be in control, and they want to see action in their portfolios. This leads to many "do-it-yourselfers" trading more in their portfolios than I would typically recommend, and that usually means more trading fees and expenses, more taxes, and a lower investment return over the long-term. Consider this chart presented by Saturna Capital that assumes a 7% annual return for ten years and a 23.8% tax rate:

Lower turnover (aka less trading) typically means higher portfolio values. Be an investor, not a trader!

Finally, I wanted to share an interesting study that I came upon done in 2001 by the Quarterly Journal of Economics. They studied portfolio turnover and the investments of male and female households and they found that single men trade the most, married men trade second most, married women trade the third most, and single women trade the least. Guys, based on what we learned from the chart above, I think that means the women are right again!

If you enjoy investing and you like the rush of trading, I encourage you to carve away a small portion of your assets and make it a hobby. It’s one thing to open a box with a zillion pieces, not completely read the instructions, watch a video online, and tell your wife you’ve got it under control - maybe you do, maybe you don’t. It’s another to be overconfident when it comes to your family’s nest egg!

-Tom

Next up: status quo

Normal Investors – Overreaction and Underreaction

The second tendency that I would suggest many normal investors have would be the tendency to overreact and underreact. (If you missed out on the first part of my behavioral finance series on five of the characteristics most “normal” investors seem to have, you can catch up right here!) Of course, before I dive into how investors can, and often do, overreact, I must consider my own behavior this past weekend…

As many of you know, my wife and I are fairly avid UGA fans. Fine, fine, we’re full-fledged Georgia Bulldog fanatics! I mean I got up at 3:30 a.m., left my home at 4:00 a.m., and arrived in Athens at 5:38 a.m. to claim a small piece of generally lucky land between two curbs that my family, friends, and I have tailgated at for the last six years for a game that kicked off at 3:30 p.m. Who would do that? Well evidently me and several thousand more of my closest Georgia brethren considering “our spot” was already taken by someone even crazier than me! Oh the genuine rage I felt as my low beams displayed his silhouette on my very own game day island! That didn’t keep my group down though as we continued with our pregame festivities in the middle of what must have been a monsoon; festivities that included steak, seafood, a houndstooth cake and elephant ears (so we could eat the opposing mascot), and a crimson punch (so we could drink the opposing mascot). Then there was the wretched game where our beloved and favored Bulldogs were supposed to avenge our painful championship game defeat a few years ago only to be shellacked, annihilated, and otherwise dismantled by one of our hated rivals from the West.

A lot of pretty normal people are college football fans, but there is a good portion of that last paragraph that might lead you to believe that I'm a little bonkers. My point is that sports fans often overreact. They react with way more pride and celebration after victories and way more dismay and disgust after losses than they probably should. Many investors do the same thing. Investors can have a good experience with a product or service, and then they suddenly want to buy some stock in the company that made the product or delivered the service based solely on their positive experience. Investors can enjoy some decent growth and gains in a stock they have previously bought a little bit of, and they can develop an insatiable and blind appetite for more and more of that very same (and already appreciated) stock. Investors can get more and more excited about a roaring bull market (think the Dotcom Bubble) and want more and more stock exposure in their portfolios even though the investment return party has been going on quite a while. Of course, investors can also panic more than a Southerner in a snowstorm and completely sell out of a position based on the rampage of some talk show host who is trying to get ratings. A chain email about tax rates going up or a presidential or congressional proposal can also get an investor to sell out of everything just as if they’d seen a mouse, snake, or spider.

Overreacting as an investor can be dangerous. It can lead to one-way bets. It can lead to frequent trades which are costly and tax-inefficient. It can lead to dangerous concentration in one stock. It can lead to dangerous concentration in cash. There are certainly times as an investor where swift and substantial action is needed, but if you are investing prudently, that shouldn’t be very often. Part of my job is being the voice of reason, being the voice that isn’t that worried about the scary financial spider that man on the radio was yelling about, and being the voice that isn’t so sure that someone has really found that Fountain of Youth your neighbor confided in you about. Overreacting about football is one thing - it’s a game. Overreacting as an investor is another - it costs real dollars and cents.

The second part about normal investors reacting is actually underreacting. I like to illustrate this by considering Western Union’s lack of interest in Mr. Bell’s telephone patent, IBM’s lack of interest in the Xerox machine, and Kodak’s lack of concern with digital technology. In my own experience, I have found that investors rarely underreact when it comes to their investment portfolios, but instead they underreact when it comes to their own financial trajectory. I stand by that spending all that you are making is not a terribly successful retirement strategy, going into retirement with a large mortgage remaining is not a positive for your retirement cash flow, and that recurring credit card debt is one of the worst things since Brussels sprouts, but not everyone adequately reacts to those messages. Similar to ignoring a scratchy throat a few mornings in a row or that ant you saw in your kitchen the other day, underreacting to financial matters that could be nipped in the bud now can lead to some real serious financial problems in the future.

It’s normal and human to not always react in the optimum way, but financially, it’s important to try to. Maybe it’s all the children’s books I find myself reading now, but I kind of think of Goldilocks. Don’t overreact, don’t underreact, try to react juuuuuust right!

-Tom

Next up: familiarity

A Variation on Buying Low and Selling High

Credit: Stuart Miles at FreeDigitalPhotos.net

There are a lot of people out there who will tell you that the key to success in the stock market is buying low and selling high. From a strictly value investing strategy standpoint, I tend to agree. From an overall investment strategy standpoint, however, College GameDay’s Lee Corso comes to mind; "Not so fast my friend!"

The reason I’m a little cautious to blindly endorse buying low and selling high is because it can teeter right on the brink of an evil term called market timing. I say evil because market timing is often what gets investors in trouble when they repeatedly or completely buy into and sell out of the stock market. The problem with someone trying to time the market is that they are assuming that they know what direction the market is going in the short term, and, to be honest, I haven’t met many people who do. To make matters worse, if someone is going to buy low and sell high successfully and not leave any possible gains on the table, they will need to successfully time the market twice. Twice because they will need to know when a particular stock has gone as low as it is going to so they can buy it, and again when that same stock has hit its near-term peak so they can sell it. If a market timer is wrong, they can miss out on income and market movement, but they are also punished by incurring unnecessary transaction fees, expenses, and possibly taxes. Please believe me when I tell you that correct market timing is really hard once; it’s darn near impossible twice!

As I alluded to earlier, I really do like the idea of buying low and selling high, but within reason. So instead of making one-way, all-or-nothing bets that can be largely influenced by chance, I would propose you consider two, subtle but profound variations:

1. Stay invested and just periodically rebalance your investments by selling parts of your “winners” and reallocating the proceeds to other areas to bring your portfolio back in line with your long-term investment strategy.
2. Go ahead and try to time your withdrawals and deposits as best you can. In essence, deposit when the market is low and withdraw when the market is high.

Some of you may disagree with my tips, and that’s fine. There are times when there are tactical opportunities when it may make sense to totally enter and exit particular stocks, industries, and asset classes, but I believe that is more of an exception than a rule. I personally find comfort in thinking that I have about 60 – 70 years left in this crazy world, and I expect the stock market will be higher then, than it is now. Something about these historical stock market charts just gives me comfort…

 

A lot of investment managers I’m familiar with make money by buying low and selling high, but they do it by trimming their exposure as their holdings have gone up, not by timing the market. A lot of investors I know have made good financial decisions by sticking with their long-term, prudently diversified investment strategies and periodically rebalancing, not by timing the market.

 

Don’t try to time the market. Try to make your deposits and take your withdrawals strategically.

 

-Tom

How Famous People Lose Their Money

Credit: photostock

One of the saddest lessons I’ve learned during my time in the wealth management/financial advice business is that no amount of money or income can make someone immune from overspending. If you don’t live within your means, you can blow it; if you don’t properly diversify your assets, they can vanish; and if you do something that’s just plain stupid, you can make a lot of dollar signs go bye-bye, too. When I started writing this post I was going to give you some specific examples of how some famous people lost their fortunes, but the more I researched, the sadder I got. I just couldn’t believe what I was discovering. So, I’ve decided I’ll give you the examples, but I’ll remove the celebrities’ names. This will protect the identities of the personally innocent, but financially guilty. After all, they don’t need any more pain; they’ve already lost most of their money.

• Can you believe that an actor who has been in films grossing more than $4 billion has been reduced to having to take almost any role thrown at him because he lost tons of money on highly speculative investments and wasn’t paying his share in taxes? Maybe so, but he also bought a castle, a dinosaur skull, 22 cars, 47 pieces of art, and a bunch of real estate. Are you kidding me?
• Can you believe that a pretty famous golfer nearly lost it all as a result of gambling away $60,000,000? Sorry, but the zeroes were for effect!
• Can you believe an actress walked away from a movie she had agreed to be in knowing it would cost her $9 million not to honor her previous commitment? Oh, and by the way, she probably could have written a check for the $9 million if she hadn’t recently purchased part of an actual town!
• Can you believe a boxer could throw away $250 million through a bunch of divorces and alimony and child support payments? Of course, there was also a 109-room house…
• Can you believe a really successful musician would buy a $30 million mansion? Actually, I can. What I can’t believe is that he paid 200 people to be part of his “entourage,” and it cost him $500,000 per month! How could anyone maintain that sort of lifestyle? Better yet, why wasn’t I invited to be part of his entourage?
• Can you believe a world champion (and likely hall of fame) pitcher would invest almost everything he earned in his entire career in one, single, solitary investment? Guess what? It didn’t work out! And now he’s too old to pitch…
• Finally, can you believe an actor who has made millions and millions of dollars since 1999 thought it would be okay not to file a tax return reporting his income until 2006? Did he think what happened in 1999-2005 would go away? A lot of back taxes (with penalties and interest) and a little jail time just rocked his oblivious world!

Like I said earlier, I started this post intending for it to be funny, but the stories aren’t funny – they’re sad. I can’t help but think of what I could have done for them if they had sought some genuine, unbiased advice. I can’t help but think about what they could have done for themselves if they’d just lived within their ample means, prudently diversified at least a portion of their assets, and avoided doing things that just aren’t smart. They had it, and they threw it away. Grrrrrrr.

 

-Tom

 

A Traditional 401(k) vs. A Roth 401(k)

Credit: Stuart Miles

Another question that came up a few times from readers submitting questions for The Lightning Round was whether I would recommend a Traditional 401(k) or a Roth 401(k). This is actually a very difficult question to answer because it depends on the future tax rates of the individual asking the question. I tried to write an answer (I really did), but I also know that there are times when writing less is worth more. I think this is one of those times. Let’s look at an example…

Suppose Tom has two different 401(k) contribution options. With option one, he can contribute to a Traditional 401(k) plan where pre-tax income is deducted from his paycheck and placed in a tax-deferred account. Tom will have to pay taxes when he takes withdrawals from the account in retirement. With option two, he can contribute to a Roth 401(k) plan where after-tax income is deducted from his paycheck and placed in a retirement account. In this case, Tom will not have to pay any additional taxes when he takes withdrawals in retirement. Suppose Tom’s tax rate is 25% as he contributes and will remain 25% in the future when he takes withdrawals in retirement. Suppose Tom contributed $5,000 per year from his paycheck. Suppose Tom’s investments return a steady 5% per year.

     What would happen if Tom went with a Traditional 401(k)?

     What would happen if Tom went with a Roth 401(k)?

Are you surprised to see $21,239.15 as the answer to both scenarios? Don’t be! In the Traditional 401(k) scenario, Tom is deferring paying taxes now, so it’s only fair that he pays taxes on his contributions and earnings in the future, right? However, in the Roth 401(k) scenario, Tom is paying the piper (aka the IRS) up front, so why should he be taxed any more on his contributions or earnings years from now?

Great. I’ve mathematically proven to you that it might not make a difference whether you decide to go with a Traditional 401(k) or a Roth 401(k). How does that help you? I hope it helps you focus on the fact that saving for retirement is what really matters, not the Traditional vs. Roth decision.
If you’re expecting to have higher income in retirement than you do now (from things such as Social Security, a pension, or a large inheritance), I’d normally recommend you go with a Roth 401(k). If your income (and your tax rate) will be higher in retirement than it is now, there may be a mathematical difference between choosing a Traditional 401(k) and a Roth 401(k), and a Roth 401(k) will likely be in your favor.

If, like most people, you’re expecting to have a lower income in retirement once your big salary goes away, I’d normally recommend you go with a Traditional 401(k). Save on taxes now while you’re at a higher tax rate and gladly pay taxes on your retirement withdrawals at a lower tax rate when your income is lower. If your tax rate is lower in retirement than it is now, there may be a mathematical difference between choosing a Traditional 401(k) and a Roth 401(k), and a Traditional 401(k) will likely be in your favor.

That leaves one last question. What if tax rates or tax law change between now and when you retire and take withdrawals? Neither of us knows the implications of such a change until it is implemented, but based on our growing federal deficit, I’d guess that if tax rates are going to move, they will be going up. If you’re still on the fence choosing between a Traditional 401(k) and a Roth 401(k), that logic might be a small nod to the Roth 401(k).

In closing, saving is what matters the most – not whether it’s a Traditional 401(k) or a Roth 401(k). If you expect higher taxes in retirement, go with a Roth 401(k). If you expect lower taxes in retirement, go with a Traditional 401(k). If you’re still unclear or nervous about tax rates in the future, hedge your bets - contribute half to a Traditional 401(k) and half to a Roth 401(k). You’ll be half right!

-Tom

The Lightning Round: Take 3

Credit: FreeDigitalPhotos.net

Thanks to all of you for the many questions I received. Some of you even submitted more than one! You asked the questions, and now it’s time for me to share my answers to five of them...

1. I recently sold my house and have the profits sitting in a money market account. I'm relatively young,  have no more debt to pay off, already contribute to my work retirement account, have my rainy day fund, and would still like to put this profit toward my future as well. Is having this money sitting in a money market account the best “bang for my buck" or is there a better way to invest it?

- Anonymous                   

First of all, congratulations on selling your house for a profit! Real estate is not always a profitable investment, but it is certainly nice when it works out. Let me get this straight - you’re debt-free, you’re contributing to your 401(k), and you have set aside enough cash to form an adequate rainy day fund? Well done! You are certainly on a path towards financial success!

There are a lot of things you could do with the excess cash you have in your money market account that would provide you a bigger “bang for your buck.” Unfortunately, given current interest rates, the difference between burying your excess cash in your backyard and leaving it in your money market account earning interest is just not that much. I don’t know the ins and outs of your financial situation, but for someone in your shoes I’d usually suggest you redeploy some of that excess cash and put it to work for you. I’d suggest you consider increasing contributions to your 401(k) plan, opening and contributing to a Roth IRA, or opening and funding a diversified brokerage account. For simplicity’s sake, I’d probably lean towards increasing your 401(k) contributions. For 2014, you can contribute up to $17,500 per year (and if you’re age 50 or older, you can contribute up to $23,000 per year), and any additional contributions you make could be a nice boost to your long-term retirement savings. If you’re contributing to a Traditional 401(k) (not a Roth 401(k)), these additional contributions could also lower your 2014 tax bill, which makes increasing your contribution amount kind of a win-win. Two other things to consider, though: 1) Your 401(k) investment returns could provide you a much bigger “bang for your buck” than you would get in a cash account, but you could also see the value of your money go down in the short-term or during market downturns. 2) My guess is that your money market account balance will go down over time to help you sustain your current lifestyle if you decide to contribute more to your 401(k) going forward because your take-home pay will decrease to facilitate that change. I say that because I don’t want you to be surprised or concerned. By contributing more to your 401(k) going forward, you are essentially slowly and surely reducing your cash on hand and putting your excess cash to work. Just remember, if your money market account gets lower than you would like, you can adjust your 401(k) contributions back down to a level that will allow you to normally sustain your desired cash balance.  

Please let me know if you would like to discuss further.

2. Can you explain, in layman's terms, what supplemental income needs to be reported come tax season and how to do so? For example, I sell Thirty-One on the side and it's not a lot of money, so I'm curious if I even need to report it, and if so, how?

- Amanda                         

When it comes to miscellaneous supplemental income tax law implications in layman’s terms you’re asking a lot (just kidding), but I’m happy to try to translate. Your question is a great one and addresses a common misconception held by many taxpayers. Per the IRS, taxpayers “must also report other income such as: cash earned from side jobs, barter exchange for goods and services, awards, prizes, contest winning, and gambling proceeds…. It is a common misconception that if a taxpayer does not receive a form 1099-MISC or if the income is under $600 per payer, the income is not taxable. There is no minimum amount that a taxpayer may exclude from gross income.”

If you have income outside of basic things like your wages, salary, interest, and dividends, it really is best to talk with your CPA, and if you don’t have one, find one. That’s because supplemental income is tricky. I think you’ll agree that based on the IRS wording above, it’s pretty clear that supplemental income must be reported, but what is not always clear and most of the time cannot be put in layman’s terms is where to actually report the income. In some cases it might belong on Form 1040 itself, in some cases it might belong on Schedule C, in some cases in might belong on Schedule E, and in some cases, it might also need a Schedule SE (Self-Employment Tax) filled out, too. There could also be an opportunity to reduce the amount of your supplemental income you will be taxed on by specifically listing any expenses (such as travel expenses or postage expenses) you personally incurred by generating that supplemental income, but of course these expenses might belong on Schedule A, but then again, they could belong on Schedule C or Schedule E depending on how you actually generated the supplemental income. I’m about to answer your question, but for non-Thirty-One supplemental income earners I wanted to make two points: 1) See why the tax law really needs to be reformed and simplified? 2) If you have supplemental income, you probably need more than do-it-yourself tax software to make sure you get it right and report the supplemental income in the most tax-efficient (and legal) way possible.

So, I dug and dug for Thirty-One-specific tax guidance and was able to find buried on page 16 of their Consultant Guidebook some surprisingly helpful advice:

“Yes, you’re required to report your commissions and other earnings from your Thirty-One business as income in your tax filings each year. Your other earnings include your Overrides, free products, hostess and other business credits, etc. For tax purposes, you are “self-employed” and it’s important that you keep complete and accurate records of your business income and expenses.
There are some tax benefits for self-employed individuals that may allow you to deduct certain business expenses. We strongly recommend that you talk with your own tax advisor to learn how the tax laws apply to your Thirty-One business.
As a Consultant, you’re a self-employed, independent contractor of Thirty-One. You’re not an employee of Thirty-One and we won’t issue you a Form W-2.
The U.S. Internal Revenue Service (“IRS”) requires us to issue a Form 1099 to every Consultant who earns $600 or more during the previous calendar year. By January 31st of each year, we’ll issue you a Form 1099 for the previous calendar year. Your Form 1099 will include all of your earnings from your Thirty-One business, including your commissions and the other earnings described above.
You’ll have to report the income from your Thirty-One business on Schedule C of your federal income tax return. Because you are self-employed, you may be able to deduct certain business expenses like the use of your vehicle or home office. You can discuss this with your tax advisor and/or contact the IRS for more information at www.irs.gov or (800) 829-1040.
Also, if your state and/or city collect income tax, you may need to file income tax forms with them too.”


I hope this is what you were looking for. To recap in layman’s terms: you have to report the income, you are deemed to be self-employed, you are deemed to be an independent contractor, and Thirty-One will send you a 1099 by 1/31/15 for Tax Year 2014 to get you started. As always, I’m happy to help you specifically address your tax situation offline, but I really think you’re going to want the services of a paid tax preparer as well!


3. For the life of me, I do not understand the ad valorem tax. I've read a few government documents on it, but none of them are explicitly clear. Can you please explain for us new-to-Georgia folks? 

- Amanda                         

Sure, I’ll be happy to. Don’t you love it when people explain things in a way that’s so complicated no one can understand it?

On March 1, 2013, Georgia changed the way it taxes motor vehicles. For people who have cars that were purchased before March 1, 2013, nothing changed: you renew your tag right before your birthday and you get to pay an annual ad valorem tax (sometimes nicknamed the “birthday tax”) as part of that process. (An ad valorem tax is a tax based on value.) For people who have bought cars (or will buy cars) since March 1, 2013, the rules have changed: you no longer have to worry about paying an annual ad valorem tax when you renew your tag, but you do have to pay a title ad valorem tax all at once when you buy a new motor vehicle. The title ad valorem tax is calculated based on the fair market value of your new vehicle (less any trade-in value you may have gotten from your old car and less any discounts or rebates you may have received from the dealer) times 6.75%. I know the new title ad valorem tax has the words “ad valorem” in it just like the old tax, but try to ignore that and just think of the new tax as a sales tax of sorts. The new tax is essentially tax pain all at once as opposed to slow tax pain by a lash every time you have a birthday.

A couple of additional “nuggets:”
     - The title ad valorem tax also applies to purchases of used vehicles.
     - If you’re a Georgia resident and you buy your car out of state, you’ll still get to pay the Georgia title ad valorem tax even if you've already paid another state's tax.
     - If you transfer the title of a vehicle within your family, you will trigger a reduced title ad valorem tax.
     - The title ad valorem tax rate is scheduled to increase to 7% in 2015.


I hope that’s clear as mud. If it’s not, please let me know. Here are two other links that might help you: 1) a Georgia Department of Revenue Title Ad Valorem Tax Calculator and 2) a FAQs page about the new rules.

4. I have an opportunity to move to a state that I would prefer not to live in for a really good job opportunity. What should I be thinking about financially as I weigh the pros and cons? 

- Anonymous                    

Nice question, and one I’ve never been asked. Whatever you decide, congratulations on earning the opportunity to take the job!

If the job opportunity was something you were really excited about in a state you were really excited about, I don’t think I’d try to be a wet blanket on your job opportunity as long as it was financially lucrative. I believe there are more currencies in life than just money, such as time, happiness, and fulfillment, so I wouldn’t want financial implications to unnecessarily sway your decision. That being said, since the situation you are describing is "only" a really good job opportunity in a state that you are less than excited about, I can definitely see digging into the financial implications a little bit more.

I’d advise you to consider your new state tax rate versus your current state tax rate. I’d look into what your new property tax rates would be, and maybe even more importantly, how much a suitable home would cost you in your new state versus your current state. I’d look into potential cost of living differences in terms of utilities, transportation, and groceries. Once you factor in the cost of the physical move with these cost adjustments, versus any change you would experience if you took the job in terms of compensation and benefits (don’t forget benefits like 401(k) matching, paid time off, health insurance, etc.), I think you may be better able to gauge whether taking the job would be financially good for you or not.

If you’d like more specific assistance, I’d be happy to try to help you. I have also come across this nifty, little tool developed by the National Center for Policy Analysis that attempts to help you determine how much you will gain or lose by moving to another state, and I’d suggest you check it out. I’m not trying to dismiss your question in any way, but unless it really comes down to financially making it or financial ruin (which you should be able to figure out pretty quickly), I’d spend more energy on considering how your potential move could affect your family and friends, what amenities you might gain or lose, how stable your potential new employer is, and what your growth potential in your new role could be.


5. Do you recommend taxable bonds or municipal bonds for your clients?

-David                              

That’s a very good question and is a question that all investors should ask their financial advisors or brokers and CPAs. (Actually, financial advisors or brokers should be discussing this with their clients and their clients’ CPAs, but that’s a different story.)

As I respond to so many “general” questions, I must also respond to this one: it depends. Bond investors are typically looking for investments with high yields and less volatility than the stock market. They basically have two general bond types to choose from: taxable bonds and municipal bonds. Taxable bonds are typically issued by corporations and offer a higher interest rate, but an investor will have to pay federal and state taxes on their gains. Municipal bonds are typically issued by state and local governments and offer a lower interest rate, but an investor will not have to pay federal taxes on their gains. If the municipal bond is from the state or a locality in the state that the investor resides in, the investor may very well not have to pay any state taxes on their gains either!

So, in summary, I recommend both taxable bonds and municipal bonds to the clients I work with, and in some cases, a combination. If someone is in a 25% tax bracket, they’d much rather have a 5% municipal bond than a 6% taxable bond that would only yield 4.5% after taxes. If someone is in a 10% tax bracket, they’d much rather have a 6% taxable bond that would yield 5.4% after taxes than a 5% municipal bond. My recommendations are client-specific, and under the right circumstances, could even be bond-specific. The one other general comment I can throw your way is that in light of municipal bonds usually having lower interest rates than taxable bonds, municipal bonds rarely ever make sense inside a tax-deferred investment account such as a 401(k) or IRA. A 401(k) or IRA is already pretty much exempt from income taxes until you take a withdrawal or distribution, so the potential after-tax “savings” of municipal bonds would really be of little to no value in these types of accounts.


I hope that helps!


Thanks again for all of the questions. The Lightning Round is a lot of fun for me, but please always feel free to reach out to me with your financial questions year round!

-Tom

Your Humble Abode(s)

Credit: nonicknamephoto

I want you to think about a few things with me. Think about how much the property taxes are on your home. Think about how much your homeowner’s insurance costs. Think about your monthly water bill, gas bill, and electric bill. If you pay someone to mow your lawn, think about that. Do you have an exterminator or a cleaning person? What about the annual fee for your alarm system monitoring? Do you have HOA fees or neighborhood dues? Do you need a pencil and paper yet to add all of that up? Don’t forget there are also those periodic home maintenance surprises that come up like replacing an air conditioning unit, hot water heater, dishwasher, or roof. The point I’m trying to make is that owning and maintaining real estate is expensive.

If you’re a homeowner you already knew that, but have you ever thought about the significant portion of your living expenses that is tied to the upkeep of your residence? Even when not considering any outstanding debt you might have on your house, having your own place requires a lot of cash flow and chews up a lot of assets. It’s important to realize this when you are working, but it is absolutely critical to understand this when you are planning for retirement.

In order to make it in retirement, you have to live off of any income you have coming in (like pensions or Social Security) plus small portions of your investment assets. Some people can live solely off of their retirement income streams, but most people slowly draw down their investment assets over time to supplement their lifestyle in retirement. The thing is, you don’t want to outlive your investment assets, so you’ve got to have a plan to make your nest egg last. A big part of making your investment assets last in retirement is by reducing your fixed expenses, and as we just discussed, a big part of your fixed expenses is often tied to your humble abode(s).

Whether you are planning for retirement, nearing retirement, or finding that you're eating up your nest egg too fast in retirement, here are some tips that might help:

• Pay off your mortgage(s) before you retire. This will likely reduce your fixed expenses significantly and help you make ends meet in retirement.
• Do major capital improvements to your real estate before you retire. If you’re going to redecorate, finish a basement, or get a new refrigerator, do it while your working cash flow is still coming in. It will make you feel better and give you peace of mind. Think of it as investing in staying put.
• Don’t keep multiple residences if you find it difficult financially or physically. Dusting one house stinks. Dusting two houses is awful! Pick one. Think of all of the property taxes, insurance premiums, utility costs, and lower back pain you will save!
• Get out of town. Sure, stay near the kids, but move to the suburbs or the country. Homes are cheaper, property taxes are lower, and the cost of living is likely lower, too. You’ll feel like you have more purchasing power, and you can add the difference between your urban home selling price and suburban home purchase price to your nest egg to strengthen your overall financial position.
• Consider state taxes on retirees. It’s probably not worth moving states just to save on state taxes, but if you’re on the border or a good portion of your family is in a different state, why not consider it? Take a look at this interactive map, and you’ll see that all states’ taxation is not created equal!
• Finally, think about downsizing. All I’m saying is that if you no longer need five bedrooms, why have five bedrooms? If all of the kids come at once, you can help fund their stays in a nice hotel, and you’ll probably still save money versus maintaining your own five-bedroom “bed and breakfast.” If you do decide to downsize, be careful and make sure you don’t more elegantly furnish a smaller house as opposed to actually downsizing and leaving yourself with some extra proceeds to put with your nest egg.

 

Personally, I plan to have a place on the beach when I retire. If my wife and I can swing it, we’d probably like to keep a place near my parents and her parents and/or near our eventual kids and their families. If we can’t swing it, we’ll just visit a lot because it is often a lot cheaper to pay for a hotel or even rent a place for a few weeks than it is to maintain an extra humble abode!

 

The How to Retire Early Series will continue next time with a look at an important piece of everyone’s retirement puzzle: health insurance.

 

-Tom

What You Should Do If You Owed Taxes

Credit: Stuart Miles

Last week I posted some suggestions about what you should do with your tax refund. A majority of Americans do receive tax refunds, but what if you’re not expecting a refund? What if you actually owe more taxes to dear Uncle Sam or your state’s department of revenue? I want to help you, too!

The first thing you need to do is pay up. It stinks, but don’t add penalties and interest to your pain. Realize that if you promptly settle up by April 15th, you really haven’t done anything wrong. On a brighter note, at least you can have the satisfaction of knowing that you didn’t let those people in Washington, D.C., hold any more of your money than they should have. If you invested some of your money last year and now owe taxes, you may have even come out a tiny bit ahead than if you had gone ahead and withheld more taxes or made larger estimated payments!

The second thing you need to do is figure out what happened. Do you always owe more taxes? If so, you may want to consider changing your tax withholdings or making larger estimated payments. If this is the first year you owed more taxes, what changed? Did you make more money (larger income base, higher tax brackets)? Did your stocks do unusually well (more dividends, realized gains, or capital gain distributions)? Were you healthier? Did you refinance or pay off a mortgage (we refinanced in 2013 and definitely noticed a difference on our mortgage interest deduction!)? Did you give less to charity? Any of these changes can result in fewer itemized deductions. Did you somehow stumble into Alternative Minimum Tax? It’s also worth mentioning that if you owed Uncle Sam, you will probably need to pay either 90% of your expected tax for 2014 or 110% of the tax shown on your 2013 return (whichever is smaller) to avoid an estimated tax penalty next year. Consider meeting with your CPA to take a good hard look at what happened in 2013 and what is likely going to happen in 2014. You have time to adjust things for 2014 now, but you won’t in April 2015!

There are tons of things you could do to make sure you get a refund, including beginning to make estimated tax payments (or making larger estimated payments), increasing contributions to your Traditional 401(k) (so that you have less taxable income), or simply adjusting your automatic tax withholdings. Since people most commonly owe more taxes because they have gotten a raise or an itemized deduction decreased (like medical expenses or mortgage interest), it is important to periodically think about adjusting your withholdings proactively.

To adjust your withholdings, go to your employer’s accounting or human resources department and tell them you’d like to adjust your withholdings. They will likely give you Form W-4 and your state’s equivalent to the W-4. The form is pretty simple and people most frequently elect to have more taxes withheld from their checks if they’re married by putting a “0” on Line C (because they have a working spouse, they work two jobs, or earn a lot of income), or if they’re single, by requesting to have more withheld from each paycheck on Line 6. If you need more assistance, the IRS has put together this little withholding calculator app to try and assist taxpayers. As always, I’m happy to help anyone with questions, but this is another example of where tax preparation software may not be all you need to help with your taxes and tax planning!

I prefer to get a small refund, and I think most people feel the same way. It just feels better and makes things easier. If you find that you owe more than you paid in this year or got a refund that was so small you could barely purchase breakfast, as painful as it may be, I’d suggest you go ahead and start thinking about your taxes for 2014.

-Tom

Required Minimum Distributions

Credit: Stuart Miles

In my line of work, I get to surprise people all of the time. Sometimes my advice or the conclusion of my financial analysis evokes an elated and relieved response. Sometimes it does not, but instead confirms a painful reality or brings about sadness and temporary distress (not to worry: I’m happy to develop a new plan or strategy for my clients who find themselves in temporary distress).

One of the most frequent surprises I get to deliver is the news that in the year you become 70 ½ years of age, if you have certain retirement investment accounts like a 401(k), Traditional IRA, or qualified (tax-deferred) annuity, you are required to start taking minimum distributions, whether you want to or not! Technically, you could choose not to take your minimum distributions and agree to pay one of the most onerous IRS penalties of 50% of the amount you should have withdrawn, but since I’ve never had any takers on that strategy, let’s push forward assuming you will take your required minimum distributions (RMDs).

The amount that has to be distributed is based on IRS life expectancy tables and the age of your spouse (or designated beneficiary). It’s a relatively simple multiplication problem consisting of your account’s previous year-end value and your applicable life expectancy factor, but there are so many tables and beneficiary circumstances to consider that I’d suggest you let your financial advisor or CPA do it for you. There are some brokerage firms and custodians that will actually calculate your RMD for you on your brokerage statements when they become required, but please note that brokerage firm calculations will only be relative to the accounts you have with them. If you have multiple accounts that require RMDs, you’ll need to be careful, and make sure you take enough in total and from each account to avoid the before-mentioned “bear” of a tax penalty.

This required distribution can be a good surprise. If you’re not already withdrawing from your retirement account, this distribution can feel like a little extra income that could be used for anything from family trips to home renovations. I should mention, though, that your distribution does not have to be spent! You have to withdraw it and you have to pay taxes on your withdrawal, but you’re welcome to top off your savings account or reinvest the proceeds in your after-tax brokerage account.

This required distribution can be a bad surprise if you didn’t know you had to do it (or forget to do it), but even if you’re on top of things, it still stinks because the tax man cometh. Uncle Sam wants to wish you a happy birthday from age 70 ½ on, and to commemorate the occasion, he’s going to want ordinary income taxes from your distribution amount to help fill his empty coffers.

If you’ve read this post, there is no reason to let RMDs surprise you. If you are 70 ½ or older, please double check with your financial advisor and CPA to make sure you are taking your RMDs. If you’re almost 70 ½, I’d urge you to meet with your financial advisor and make sure you have a game plan in place for your RMDs as there is often an opportunity for meaningful and significant tax and cash flow planning. If you’re nowhere near 70 ½, I bet you can think of someone you care about who is and would appreciate you looking out for them.

-Tom

Wag the Dog

Credit: Maggie Smith

Wag the Dog is a 1997 comedy featuring Robert De Niro and Dustin Hoffman in which a “spin-doctor” publicist and a Hollywood producer work together to cover up a presidential scandal. I won’t ruin the movie for you if you haven’t seen it, but the gist of it is that the publicist and producer help create a fake war against Albania to take the American people's attention away from the inappropriate actions of the president. While it’s quite a humorous movie (and I must confess that it makes me wonder how often “significant” events have been cooked up in the past to give our leaders a little breathing room), allowing something to divert one’s attention away from what it should be on (letting something “wag the dog”) isn’t funny at all.

As I’ve said before, it’s my job to try to help people and to make strategic financial suggestions to the clients I serve, but I never tell people what to do. Sadly, in spite of my best efforts and persistent explanations, I’ve had several experiences as a CPA and a financial planner where the clients I serve have been unable to focus on their overall financial situation because of their obsession with a specific portion of their financial situation - usually this has to do with their taxes. That’s why I want to focus on a few tax-related issues that I have seen “wag” my clients from doing what I truly believe is in their best interest.

• Capital Gains
• I’m convinced there is nothing that gets CPAs and investment advisors yelled at more than capital gains. If clients have capital gains, they are usually mad because they owe taxes, but if clients have capital losses, they are usually mad because they have lost money. Either way, in terms of recognizing capital gains, selling out of a stock position that has gone up a considerable amount often makes sense because you are taking your gain off the table and giving yourself the opportunity to buy a different stock position that has more potential for future, additional growth. Yes, you’ll have to pay taxes on the amount the stock position went up or appreciated, but isn’t that better than the alternatives? If you wait for the stock price to go back down before you sell, you probably won’t owe any taxes, but you also won’t have any gain, and if you’re not willing to sell the stock during your lifetime, what good is the stock to you in the first place (unless you plan on charitably gifting it or specifically bequeathing it)? No matter the stock or investment, there comes a time when it makes sense to sell your position, take your gain, and run. Please don’t let capital gain taxes solely wag you from considering taking that gain.
• Income Timing
• Some people have jobs with steady incomes, and their tax picture is about the same every year. Some people have jobs with fluctuating incomes; some years they will be in lower tax brackets, and some years they will be in higher tax brackets. Whether still actively working or retired, by taking a multiple-year view towards your income stream, you can attempt to manage unusual “bursts” of income, such as stock options, lump sum pension payments, deferred compensation payouts, IRA distributions, and annuity distributions, in a tax-efficient manner. The problem is that some people want all of their money at once and give Uncle Sam a massive portion of their income, as opposed to cumulatively giving the government less if income is more evenly spread out. There are also people who want to pay as little in taxes as possible every year and keep putting off stock option exercises, distributions, and payouts until they back themselves into a year when they have no choice but to give Uncle Sam a massive portion of their income. As usual, there is often a sweet spot in the middle where by prudently spreading out your income you can have long-term tax savings. Please don’t let a complete disregard for income tax implications or a blind focus on minimizing current year income taxes wag you from potential tax savings.
• Having a CPA
• It concerns me how many people choose not to have a CPA prepare their taxes. I know tax preparation fees can be high, but having someone who knows the latest in federal and state tax laws, gift tax laws, and estate tax laws is invaluable. Having the ability to point your finger towards someone else should there be an issue and the IRS comes calling is nice, too! If you don’t have a CPA, I would strongly encourage you to consider finding one unless you know all about the Georgia Retirement Income Exclusion, the changing AGI threshold for itemized medical deductions, and how to plan on utilizing the portability of your now inflation-adjusted estate tax exemption. I know, TurboTax and its brothers are great, but accidentally misusing tax software does not excuse you from any errors or penalties that may be related to those mistakes. As the Tax Court said in a case back in 2000, “Tax preparation software is only as good as the information one inputs into it.” Please don’t let the fees of having a CPA prepare your taxes (which are likely tax deductible) wag you from having your taxes done as correctly and as efficiently as possible.   

 

Taxes are the main “dog-wagger” I see, but there are others. Trying to save too much money too fast by shortchanging your quality of life is letting your savings goal wag the dog. Trying to pay down debt too fast by jeopardizing your emergency fund is letting your debt reduction plan wag the dog. Trying to max out your 401(k) contributions by cutting your ability to comfortably pay monthly expenses is letting your investing strategy wag the dog. I could go on and on.

 

Get some popcorn, watch the movie, and try to remember that just as a dog should wag its tail, your overall financial situation should drive your specific financial decision making.   

 

-Tom

Trading vs. Investing

Credit: rattigon

Last week I ended up waiting in line for a fairly long time while my car’s emissions were tested at a very busy car maintenance facility. I had come straight from work, so I was still dressed up in a suit and tie, and in hindsight, I guess I might have looked a little out of place at a Jiffy Lube. Another customer who had finished reading the same sports section of the newspaper I had, and seemed to be even less interested in the Judge Judy rerun playing in the background than I was, decided to strike up a conversation with me. I’m fairly social and am always up for meeting new people, so it wasn’t too difficult to chitchat until he asked me what I did. When I responded that I was a financial planner and investment advisor, he countered with, “So, you’re a stock trader?” I politely replied, “Of sorts,” but that’s not what I do; that’s not even what I recommend. A harmless conversation with a nice stranger at a Jiffy Lube was not the place to dive into the important differences between trading and investing, but it got me thinking that today’s post just might be!

Trading and investing might be synonymous to some people, but not to me. In my mind, “trading” usually means the frequent buying and selling, or sudden buying and selling, of financially significant quantities of a handful of securities. When I think of the term “investing,” I think of a long-term time horizon, occasional and strategic buying and selling, and a well-diversified portfolio. Before you stop reading and accuse me of splitting hairs, please let me give you three reasons why trading is not investing, and why I believe investing is better. 

• Taxes – Let’s say a single lady makes around $75,000 this year. When you look at the 2013 federal tax brackets, she falls in the 25% bracket. This lady is doing pretty well for herself, but she’s doing even better considering that she bought 5,000 shares of Bank of America stock in August of 2012 for $8 a share. She likes “dabbling” in the market from time to time, and she felt she had made a great pick with Bank of America, but now she wants to buy another stock, so she sold the 5,000 Bank of America shares in June of 2013 for $13 a share. Because she held those Bank of America shares for less than a year, her gain must be taxed at her ordinary income tax rate, so her investment will land her roughly $18,750 after federal taxes (((5,000 shares x $13 sales price) – (5,000 shares x $8 purchase price)) x (1 - 25% tax rate)). If she had treated those Bank of America shares as a longer-term investment and sold them in August of 2013 (after she had held the position for a year) for the same $13 a share, the federal long-term capital gain tax rate of 15% would have applied! Her investment could have landed her roughly $21,250 ($2,500 more than $18,750) after federal taxes (((5,000 shares x $13 sales price) – (5,000 shares x $8 purchase price)) x (1 - 15% tax rate)) even though the theoretical sales price was the same! There are certain situations where selling a security with a short-term gain makes plenty of sense, but it’s always worth considering the potential tax benefits of longer-term investing versus the potential tax consequences of shorter-term trading. 
• Costs/Fees – Whether someone is into stock trading or investing, there are times when new securities need to be bought and old securities need to be sold. In my book, transactions should always have a strategic aim, be executed for tactical, security-specific reasons, or be completed to free up cash, but everyone should remember that transactions are not free. There are costs and fees to facilitate transactions, and depending on your investment custodian and/or investment advisor, these costs and fees could range all over the place. For argument’s sake, let’s consider E*Trade’s fee of $9.99 per trade. If someone were to make 10 trades a year through E*Trade, they would incur around $100 in fees. That might be peanuts to some people, but $100 worth of fees on a $10,000 brokerage account is a loss of 1% of the total account! That means, at best, those fees would dampen the positive performance of someone’s $10,000 brokerage account, and at worst, those fees are just additional salt in the wound of the negative performance of someone’s $10,000 brokerage account. Costs and fees are too insignificant to drive a stock trader or a stock investor’s transaction decisions, but they are significant enough to consider, particularly if the number of transactions is excessive and/or the account’s value is relatively small.
• Diversification – When I was a senior in high school, there was a statewide contest to see which group of economics students could grow the largest fantasy investment portfolio over a three month period. The rules were that participants could only place trades at the end of the day and could only buy stocks that were trading at more than a dollar, so I quickly convinced my group that the only way we were going to get enough stock price movement to have a chance to win was to go all-in on a single stock that was trading near a dollar that was scheduled to have an earnings announcement in the next couple of days. (PLEASE NOTE I ADVISE AGAINST THIS STRATEGY AND IN NO WAY RECOMMEND IT UNDER ANY CIRCUMSTANCES WHATSOEVER.) As luck would have it, the company whose stock we picked announced that they had beaten earnings expectations and were in talks to be bought out, so the stock soared. The problem was that two other groups of students in the state had done the same thing, and we were all tied in first. My group elected to sell the next day with the hopes that the stock would return to orbit, but the other two groups held on as the stock eked up a few more pennies, thus landing us in third. First place in the state won fame and fortune, and third place won a T-shirt, so we decided to roll the dice again with our all-in, single-stock strategy by buying shares in a company that had an upcoming earnings announcement. This time, the company we picked failed miserably compared to expectations, and some of their executives had decided to leave, so the stock fell like a lead balloon filled with lead balloons. Our strategy had hit us a home run once on the very first try, but as we tried it again and again for the rest of the contest, we lost and lost. We actually finished second to last in the state. I told you that long story because I wanted to share my powerful, first lesson in why diversified investing is better than non-diversified trading - singles and doubles over the long term are a lot better than one home run and a lot of strikeouts in the short term!

If you enjoy trading, that’s wonderful, but call it what it is: a risky hobby. If you’re trying to reach financial independence or if you are trying to maintain financial stability, I urge you to invest, not trade. Trading is sexier, and it may make you feel like you are actually doing something about your holdings more often, but the tax effectiveness, cost effectiveness, and diversification benefits of letting the market do its thing over time are hard to argue with.

 

Are you a stock picker says he? No. I’m an investment advisor says I!

 

-Tom

Alternative Minimum Tax

Credit: renjith krishnan

First of all, let me wish a happy end of “busy season” to all my Certified Public Accountant brethren out there who just finished the most stressful time of their year! Secondly, let me ask you: Did you have to file Form 6251?

Unless you have an incredible memory or were frighteningly thorough in reviewing your tax return, you may have already forgotten. If by some unfortunate twist, you, your tax software, or your accountant determined you actually owed Alternative Minimum Tax on Form 6251, you probably do remember that wretched form. Either way, even I, as a former tax preparer, have a white, hot hatred for the Alternative Minimum Tax, because it is an entirely parallel tax system that, in my opinion, has overreached its original intent.

You see, this mess all started when a predecessor, “Minimum Tax,” was enacted in 1969 when the federal government noticed that around 150 high-income taxpayers were not paying any taxes due to massive deductions and tax breaks. Congress addressed this national outrage by passing a bill that subjected around 19,000 taxpayers to an additional tax. The potential additional tax liability began in 1970, and was calculated as 10% of a taxpayer’s special tax preference items (certain deductions and tax breaks that had previously been allowed) that exceeded $30,000 in addition to their originally calculated tax liability. As most tax laws do, the “Minimum Tax” changed multiple times over the course of the 1970s and 1980s, and the most dramatic change occurred in 1982 when the “Minimum Tax” went away and the Alternative Minimum Tax (AMT), that we currently know and love, came into existence.

Whereas the “Minimum Tax” was an additional tax, AMT is a second tax system. To calculate AMT, you essentially start with your regular taxable income and add back quite a few deductions, credits, and exemptions, and then multiply your new AMT income by a rate between 26% and 28%.  In a nutshell, AMT is less generous than the normal tax system, and even according to the Internal Revenue Service, AMT is supposed to "limit the benefits that can be used to reduce total tax.” I wouldn’t begin to try to walk anyone through an entire tax system in a few paragraphs, but if you took fairly large deductions when compared to your income for state and local taxes, medical expenses, miscellaneous expenses, investment expenses, or mortgage interest to name just a few potential AMT-triggering items, you are going to want to be careful. In some cases, if you have passive income or passive losses, a net operating loss, foreign tax credits, or incentive stock options, you, too, could face AMT. The bottom line is that most individual filers with more than $50,000 worth of income and most married filing jointly taxpayers with more than $75,000 worth of income will need to figure out their tax liability under the normal tax system and the AMT system and be prepared to pay whichever is greater. (This surprisingly nice tool provided by the IRS can also help you decide if you will be required to pay AMT.)

Now as I’ve said before, I don’t do politics on 2MuchCents. However, I did make the “loaded” comment earlier that I believe AMT has overreached its original intent. What I meant is relative to the fact that in 1969, the government was going after 150 taxpayers; in 2011, around 4,000,000 taxpayers paid AMT and an estimated $39 billion was generated for the government by those taxpayers' additional liabilities. Don’t get me wrong, I’m for people earning their share and paying their share; I’m just not sure that the AMT that has evolved over the years (or could evolve in future years) is what the Congress of 1969 had in mind.

Not everything about AMT is doom and gloom, though. There are a few brighter spots. First, while the American Taxpayer Relief Act did not do a lot of things many people hoped it would do, it did permanently index some of the AMT parameters for inflation. While this will supposedly keep around 4 million taxpayers paying AMT annually, it is an improvement over the historical practice of always needing eleventh-hour congressional “patches” to increase AMT paramters for inflation that were annually reverting to their original 1982 amounts which, if left unchanged, would have caused millions more of Americans to face AMT consequences. Second, while AMT may not feel fair to you if you have to pay it, you are earning an AMT Credit. If you have ever previously had to pay AMT, and in the future you find your regular taxable liability is calculated to be higher than your AMT liability, then you could be allowed to reduce your regular tax liability down to the lower AMT liability, or by an amount equal to as much AMT as you have previously paid. It’s also worth mentioning that AMT credits are carried forward for an unlimited number of years.

To be completely honest, I always saved AMT calculations for last, like some rancid dessert, when I prepared individual tax returns and corporate tax returns. (Oh yes, there’s a corporate AMT as well, but I spared you from that!) AMT calculations could be complicated, confusing, and I never seemed to make anyone happy when I had to deliver the bad news that they faced Alternative Minimum Tax…

It’s my hope that you will look at Form 6251 a little closer next year. If you are an overachiever and look at your 2012 return and find that you are facing AMT or were pretty close, I would urge you to reach out to your CPA (or financial advisor) before their next “busy season” and after they’ve had a few weeks off because there are some planning strategies available that could save you from the dreaded AMT.

-Tom

Out of the Mouths of Babes

Credit: stockimages

A few weeks ago, I had a pretty neat experience.  I had the opportunity to go with some of my coworkers to a local middle school and teach a group of seventh graders for four hours. The program was sponsored by Junior Achievement, a nonprofit organization that teaches students about money management and how business works, and featured a basic curriculum that covers the different ways people can pay for things, the importance of budgeting, and the relationship between different jobs, their required levels of education, and their average salaries. I hope the students learned a thing or two from their substitute teacher, but I actually heard some refreshing things from them that I think are worth sharing with you today.

The lesson on mechanisms people can use to pay for things was primarily designed to teach the kids to be careful using credit cards. I figured this would be a tough sell, but I was wrong. One kid told me that his mom told him never to use credit cards and to pay for everything with cash. (Now that’s a little extreme, but it’s better than piling up credit card debt.) Another kid told me that her parents always pay off their credit cards every time they get a bill because “the interest is bad.” Impressed, I asked her what interest was, and she told me that “it’s the extra money people have to pay for spending too much.” (Well I don’t know many people who haven’t paid some interest towards a student loan, a car, or a house, but when it comes to credit cards, the girl had a point.) For the record, they all thought writing a check was really cool.

I thought the concept of budgeting would be pretty complex for a group of seventh graders, and I was right, but sometimes it even takes me quite a while to come up with appropriate budget proposals that are sustainable and can achieve most or all of my client’s goals. I’m proud to say that by the end of the activity, every single kid was able to make a budget that saved a little money or at least broke even, but they left me with two specific takeaways. First, every student except one put something on the charitable donation line without me even having to explain the potential tax benefits or discuss the moral and religious obligations many people feel towards giving charitably. (Wow, maybe there is hope for the world!) I should also tell you that the one kid who did not budget charitable donations wanted to, but could not, because his randomly-drawn “occupation card” did not make enough money for him to look after his family’s needs and give to others. Second, I got to see our country’s ongoing philosophical debate about taxes that we hear about every day on the news through the eyes of seventh graders. When I asked the students to define taxes, one kid told me that taxes were “money the government takes from your check to give to the army and other people.” Another student waving her hand quickly told me that taxes were “money everyone gives to the government to help those who need it.” I thought I was in a room with middle schoolers, but what I heard sounded a lot like the differing views of many opinionated adults I know. (I guess you start forming your political beliefs at a young age!)

The last lesson also featured the “occupation cards” I previously mentioned. Essentially, every kid drew a card that had a profession on it and an average monthly salary before and after taxes. While I had an improbably high number of doctor and lawyer “wannabes” at first, we had a surprisingly diverse workforce by the time I was done. Some of the kids were more interested in higher education, some were more driven to do something they were good at, and some were more focused on doing something they enjoyed. Sure, I gave them the lines about being whatever you want to be and doing something you love, but we ended up having a fairly deep conversation about the importance of balancing your interests and skills with your capability and probability of making a living. I knew I had delivered my assigned message of teaching them to balance interests, skills, and financial practicality in planning for the future when the most outspoken girl told me she was going to “do her favorite thing that paid her enough money to buy a BMW.” Mission accomplished, sort of.

Finally, I have to tell you one last thing I learned during my experience: Being a teacher is hard work! Even though I believe Junior Achievement’s program is much-needed and a great idea (and I plan on volunteering again), I was exhausted, a little low on patience, and had a splitting headache by the end of my four hours with twenty-four crazed twelve- and thirteen-year-olds . Go find one of your old teachers, tell them thank you, and by all means, give them a bottle of ibuprofen. They deserve it!

-Tom