David John. Marotta CFP®, AIF®, is President of Marotta Wealth Management, Inc. of Charlottesville providing fee-only financial planning and wealth management at www.emarotta.com. Subscribe to "Money Advice," our free weekly email newsletter, at www.emarotta.com/newsletter-sign-up. Questions to be answered in the column should be sent to questions at emarotta dot com or Marotta Wealth Management, Inc., One Village Green Circle, Suite 100, Charlottesville, VA 22903. To continue to view our weekly posts, visit us at www.marottaonmoney.com/continue-to-avoid-the-ring-of-fire-countries/

Continue to Avoid the 'Ring of Fire' Countries

by David John Marotta

Americans seem to be divided on the importance of raising the U.S. debt ceiling. Regardless of your personal politics, avoid investing in countries that cavalierly allow their debt and deficit to balloon.

A year ago I wrote the column "Avoid the 'Ring-of-Fire' Countries" that suggested readers should underweight investments in countries with a high debt and deficit and low economic freedom. That recommendation has proven brilliant. Given the dangers of worldwide sovereign debt, this may be one time when investors should continue to tilt foreign and toward specific countries.

Bill Gross, cofounder of the Pacific Investment Management Company (PIMCO) and the country's most prominent bond expert, coined the term “ring of fire” to highlight the dangers associated with countries with high debt and deficit. The eight countries he identified were Japan, Italy, Greece, France, the United States, the United Kingdom, Ireland and Spain.

Last year we forecast that U.S. "GDP [gross domestic product] growth, which has historically averaged 6.5%, is liable to slow to a more European rate of 3 to 4%. Official unemployment numbers will lower but only as people drop out and are no longer counted. Real unemployment is likely to remain high for some time."

Our predictions were accurate. GDP growth is at a sluggish pace of 1.8%, and even officially, unemployment remains at 8.7%.

We also suggested "lightening up on foreign investments that primarily just follow the MSCI EAFE index." EAFE stands for Europe, Australasia and the Far East. It represents all the developed countries outside of the United States and Canada. This includes large investments in all seven of the non-U.S. ring-of-fire countries. The EAFE consists of 22% Japan, 21% United Kingdom, 10% France, 4% Spain, 3% Italy and 1% Ireland and Greece. In total, 61% of the EAFE index is invested in ring-of-fire countries.

But before you stop investing in foreign stocks altogether, remember that 100% of domestic stocks are invested in the eighth ring-of-fire country, the United States. As I wrote a year ago, "Going forward may be one of the times when a strong tilt toward specific foreign countries may provide superior long-term returns."

This past year was a dynamite period for the markets. The MSCI Net EAFE return through the end of last month was 30.7%. The seven countries in Bill Gross's ring of fire, however, averaged only 17.9%. When weighted according to their share of the EAFE index, they performed a slightly better 21.7%, pulled up by the United Kingdom and France.

Underperforming the EAFE index by a weighted average of 9% is a poor return comparison against the benchmark. The United States, now well in the ring of fire, earned 24.2% by comparison.

I advised investing more in emerging markets. They returned 28.8%, beating the United States and the ring-of-fire countries.

I also recommended emphasizing countries with economic freedom such as Hong Kong, Singapore, Australia, Switzerland and Canada. These five countries beat the EAFE index, averaging 31.7%.

And I suggested overweighting mostly free countries with lower debt such as Denmark, The Netherlands, Finland, Sweden, Austria, Germany or even Norway. These seven countries did the best, averaging 35.9%.

Investing in countries with economic freedom continues to provide gains since I first mentioned it in a column in 2004. Underweighting countries with high debt and deficit is another important screen.

Last week I wrote about the advantages of a gone-fishing portfolio. My biggest worry with such a portfolio is that for simplicity's sake it invests heavily in the EAFE index. But the global sovereign debt crisis will likely continue for another decade and drag the returns of many countries.

My first adjustment to a gone-fishing portfolio would be to replace much of the EAFE index with countries with higher economic freedom and a lower debt and deficit. Such a change adds a great deal of complexity, but the additional returns are probably worth the headache of more holdings. These countries should outperform their debt-laden counterparts.

As Gross ended his newsletter over a year ago, "Beware the ring of fire!"

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Marotta Wealth Management, Inc. of Charlottesville provides fee-only financial planning and asset management. Visit www.emarotta.com for more information. Questions to be answered in the column should be sent to Marotta Wealth Management, Inc., One Village Green Circle, Suite 100, Charlottesville, VA 22903-4619.

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from http://www.emarotta.com/article.php?ID=457

Where in the World Should You Invest? (2011-03-28)

by David John Marotta

Finding countries where you can plant your investments in fertile soil may be one of the most important asset allocation decisions you make for the next several years.

In 2002 I coauthored a column with my father, George Marotta, entitled "Will the US Go the Way of Japan?" in the "Charlottesville Business Journal." Our answer to the question was no. We argued that when the United States has an Enron go under, there isn't a too-big-to-fail syndrome. But when a large Japanese company is in danger of failing, the government comes to the rescue. The company becomes a drag on their economy for the next decade or more.

In that column we wrote, "The ruthless culture that allows large companies to go bankrupt in the US hurts less in the long run than the Japanese style of business subsidies. In the US, the government keeps hands off business; in Japan the government interferes with the operations of business and commerce."

My, how times have changed. Now, unfortunately, the United States is going the way of Japan.

Now Japan is struggling to recover from a devastating earthquake. I was asked recently if that tragedy would stimulate its economy. Regrettably, nothing could be further from the truth.

I would suggest that everyone read Henry Hazlitt's classic "Economics in One Lesson." In Chapter 2, "The Broken Window," Hazlitt debunks the fallacy that a hoodlum throwing a brick through the window of a baker's shop is somehow good for the economy.

Certainly the baker has to pay to have his window repaired, but now he only has his window back and no money to buy a new suit. The community is poorer one new suit that could have been made and in exchange simply got its window back. But the community doesn't see what is never made.

The broken window fallacy may seem obvious, but it comes in many forms. Some pundits are mistakenly arguing that the earthquake and tsunami will be just the economic stimulus Japan needs to pull out of its malaise. This conclusion confuses need with demand.

In our country we print stimulus money and believe we have created wealth. Stimulus money may increase government spending, but the growth of government is a negative in the equation of economic prosperity. This fallacy mistakenly equates purchasing power with money.

Economic fallacies like these are "so prevalent," Hazlitt writes, "that they have almost become a new orthodoxy. . . . The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consist in tracing the consequences of that policy not merely for one group but for all groups."

The politicians in many countries focus instead on the short-run effects on a special-interest group and ignore or belittle the long-run effects on the community as a whole.

Japan wasn't the best place to invest even before March 11. Its economy is smaller now than it was in 1992. The MSCI Japan Index averaged an annual total return of -0.29% from March 1996 through February 2011. Japan dropped another 9% this month as a result of the earthquake. Most of Japan's troubles have been self-inflicted by its own government. Freedom matters.

Japan scored 72.8 out of 100 (mostly free) in the Heritage Foundation's Index of Economic Freedom. Since 1994, the Heritage Index has systematically measured economic freedom in countries worldwide. The foundation defines economic freedom as "the ability of individuals to control their own labor and property. In an economically free society, individuals are free to work, produce, consume, and invest in any way they please, with that freedom both protected by the state and unconstrained by the state."

Overall Japan is the 20th most free country, which isn't bad but is not great either. Not when 9 of the top 11 countries have large markets with easy ways to invest in them directly. In two important categories, Japan's scores are particularly poor. It ranks 145th in fiscal freedom. The top corporate income tax rate is 41%, the highest in the world. Even Japan realizes this is too steep. Next month they are cutting that rate to 36%. The U.S. top corporate tax rate is 35%, rising to 39.5% in 2013.

Japan also ranks 114th in government spending. Japan has some of the highest sovereign debt and deficit. Their ratio of outstanding gross debt to gross domestic product has risen from 68% in 1990 to about 230% in 2010.

Freedom matters. You can't afford to plant your investments in anything but fertile soil. If you simply invest in the MSCI EAFE foreign index, 22% of your investment is in Japan. What's worse, about 65% is in countries with low economic freedom and a high debt and deficit.

This isn't a reason to keep your investments here, however. Last year the United States lost its place in the list of countries with the most economic freedom for the first time in the 15-year history of the index. Part of the lower scores was a result of the U.S. debt and deficit exploding. If 65% of foreign investments are in countries with a high debt and deficit, then 100% of U.S. investments have the same problem.

Today, perhaps more than ever before, may be the time to overweight very specific foreign countries with low debt and deficit and high economic freedom. Put your investments in fertile soil where they can grow unimpeded.

I will be presenting an analysis of each country you should overweight in your portfolio at this week's NAPFA Consumer Education Foundation meeting, "Where in the World Should I Invest?" This presentation will describe what could be the most important trend to follow in today's sovereign debt investment landscape. The talk, which will take place on Tuesday, March 29, 2011, at the Charlottesville Northside Library Meeting Room from 7 to 8 p.m. with a question-and-answer session to follow, is free and open to the public.

 

from http://www.emarotta.com/article.php?ID=445

Save 97 Percent of Any Windfall (2011-03-21)

by David John Marotta

Surprisingly, studies show that onetime windfalls can actually impoverish you. They make you feel rich, which inevitably leads to overspending. But wealth is what you save, not what you spend.

With large windfalls, people tend to spend about 40% of the money. So if you get $20,000, you might spend $8,000. But if the amount is small, you will squander a greater percentage, often more than you received. Thus if you win $75, you may actually spend an additional $125 before you stop celebrating.

Either of these scenarios will make you poorer. One goal of wealth management is to increase the amount you can spend each year rather than adopting a lavish lifestyle followed by thrift and austerity. A lifestyle is defined here as everything you can do with money, including generous donations to the charities of your choice. The goal of an ever-increasing lifestyle is not to consume more each year but rather not to allow your choices to outpace what you can continue to maintain. A year of living extravagantly is foolish if it isn't sustainable.

Consider this extreme example to see why spending even 40% of a onetime windfall breaks this principle. Imagine that instead of an annual salary you receive all your lifetime earnings in one $2 million lump sum at age 20. Spending 40% the first year is neither maintainable nor advisable. After blowing $800,000 the first year, you have reduced your potential standard of living by 40% for the rest of your life. Getting $1.2 million at age 21 is barely half as good as the original deal. Not only is your future spending severely diminished, but your expectations after a year of an $800,000 lifestyle are extremely inflated. You will struggle not to spend at least $400,000 the next year and may still feel slighted.

It is easy to expand your lifestyle and spending but very difficult to contract. Even if you give most of the $800,000 to charity, the organizations will want those funds again the following year. Prudent spending, even charitable giving, often involves continuous annual spending over a long period of time.

If your windfall is a once-in-a-lifetime event, only spend a very small percentage of it. If you are young, 3% would be reasonable and sustainable indefinitely. Saved and invested in a diversified portfolio, you should be able to earn at least 3% more than inflation.

Imagine inflation is running at about 5% and your investments are making 8%. So after a $2 million windfall, you can spend 3%, or about $60,000. Your $2 million portfolio will grow 8%, appreciating to $2,160,000. After spending $60,000, you will have $2,100,000 left. You may think you have more money, but you don't. Because this is only 5% more than you had originally, the increased amount will have the same buying power after adjusting for inflation.

The second year you can again spend 3% of the increased $2,100,000 amount, or $63,000. This will offer you the same lifestyle because prices are now 5% higher. As your portfolio increases 8% each year, you spend 3%. The other 5% simply keeps up with inflation.

Most people believe they are doing well when they save 60% of a windfall and contain their celebration to only 40%. Don't be fooled. It's like saying because it is OK to have a glass of wine every night why not just have 150 in one night and then not drink for the rest of the year. Moderation matters. You can't restrain your lifestyle and still spend 40% of a large windfall.

If you don't adjust your lifestyle spending, you will jeopardize your retirement plan. Progress toward retirement is measured by how many multiples of your standard of living you have saved. At age 40 you should have about 10 times your annual spending saved. If you spend about $60,000, you should have $600,000 saved.

You might think a windfall of $400,000 could only help your retirement plan. Now you have $1 million! Surely you should be able to spend more now that you are a millionaire.

You are better off, that's true, but only if you don't spend any of the windfall. If you do, you will have increased your lifestyle. That translates to increasing the amount you should have saved by age 40 as well as the amount you need to save each year to stay on track toward retirement.

Spend just $40,000 of your $400,000 lifestyle and your lifestyle balloons from $60,000 a year to $100,000. So by age 40 you should have ten times your standard of living or a full $1 million in savings. But because you spent $40,000, you are now $40,000 short.

Increasing your retirement goal also means increasing your annual saving toward that goal. You should be saving an additional 15% of your lifestyle each year. At $60,000, saving 15% meant saving $9,000 a year. But with your lifestyle now at $100,000, you ought to save $15,000 a year. Sustaining that increased level of savings will mean a lower standard of living in future years.

Escalating your lifestyle anything more than slightly can ruin your retirement plan. You can increase your spending each year by just 3% of any windfall. There are really few exceptions to that rule. Only a small number of families are sufficiently disciplined to rein in their celebration and save 97% of a windfall. Be one of those few. Build real wealth by saving and investing. In the end, your investments will be a dynamic engine of wealth creation and you'll enjoy financial peace of mind.

 

from http://www.emarotta.com/article.php?ID=444

Multiple Accounts: An Essential Management Tool (2011-03-14)

by David John Marotta

To build real wealth, you need specific wealth management tools. One of these is opening the right accounts and using them correctly. Most families have less than half of the accounts they really need, and young newlyweds often only have a checking account.

Here is a description of each wealth-building account, roughly in the order a young couple would need them.

<b>Joint checking account:</b> This account should only hold money you need to maintain your lifestyle. Keep the balance between two and three times your monthly spending. Save and invest any additional. Bank managers always encourage you to open a savings account along with your checking account. Resist. You aren't just trying to save money. You need to save and invest. Bank savings accounts are not investment accounts. Pick a bank with the lowest fees, and don't worry about the interest rate.

<b>Taxable investment account:</b> Many couples mistakenly believe that wealth is built only in qualified retirement accounts. But the government limits how much money you can put into retirement accounts. The excess has to go somewhere. You don't want to spend it, and accumulating cash won't grow your wealth. Saving and investing is the way to build significant wealth. This is the most important and overlooked account.

Investment accounts are best opened with a broker, not a bank. Pick a discount broker with relatively low trading fees. I've written previously about <a href="http://www.emarotta.com/getting-started-with-investing/">"Getting Started with Investing,"</a> available on our website.

Here is a short list of discount firms to consider: E*Trade (<a href="https://us.etrade.com">www.etrade.com</a>), TD Ameritrade (<a href="http://www.tdameritrade.com">www.tdameritrade.com</a>), Scottrade (<a href="http://www.scottrade.com/">www.scottrade.com</a>), Charles Schwab (<a href="https://www.schwab.com/">www.schwab.com</a>) and Fidelity (<a href="https://www.fidelity.com/">www.fidelity.com</a>). Competition changes charges regularly. Avoid brokers with anything more than a small trading fee. Each broker has special promotions that may offer free trades, cash or electronic goods. Taking the best promotion is tempting, but first evaluate brokers without considering the promotion.

<b>401(k) or 403(b) retirement accounts:</b> If your employer offers a match in its retirement plan, take it. A safe-harbor match protects the plan against the claim that it only benefits the highest paid employees. With safe-harbor match your employer typically matches the first 3% you put in dollar for dollar, and the next 2% you put in is matched 50 cents on the dollar. For example, if you contribute 5% of your salary to the plan, your employer will match it with an additional 4% of your salary. This is an immediate 80% return on your money! Unfortunately, many employees fail to take advantage of this opportunity.

Your contributions always belong to you, and you can take them with you if you change employers. Sometimes what the company puts in requires you to continue working there for a number of years before you receive the full amount, which is called being vested. Learn the vesting rules, but some portion of the match will probably be yours even if you leave early, so go ahead and take advantage of the full match.

You will need two accounts, one for each spouse, through your employment. Each account can be subdivided into three subaccounts: One account is your contributions, one is the employer match that may or may not be fully vested and a third might exist for any corporate profit sharing or bonuses.

A 401(k) is more common in the private sector, whereas 403(b) accounts are for education or nonprofits. The principles are the same for each. Their names refer to the section of the IRS tax code that makes provisions for the account.

<b>Roth IRA accounts:</b> Unlike a traditional IRA, a Roth account does not get you a tax deduction, but there is no tax due when you take money out in retirement. Additionally, you can withdraw the amount you put in tax free after five years or more. There are limits on how much you can put into your Roth account. Put in the maximum each year.

Consider it this way. Imagine your taxable investment account has built up $100,000. Every year the government will allow each of you to move $5,000 from your taxable investment account into your Roth accounts where it will never be taxed again. Move the maximum each year. Your tax bracket will never be as low as it is right now. As you grow in wealth, your tax rate will grow considerably. Take advantage of your low rate now, and fund your Roth IRAs with the maximum allowed each year.

To fund a Roth IRA you must have earned income, but a spouse's earned income can count toward funding your own Roth. Therefore a couple needs two Roth accounts, one in each person's name.

<b>Health Savings Account (HSA):</b> You need health insurance to limit catastrophic medical risk, not to pool everyday expenses. This is especially true for relatively healthy young families. The best coverage to consider is a High-Deductible Health Plan (HDHP). The deductible is thousands of dollars. For everyday expenses within the deductible, consider a Health Savings Account (HSA).

An HSA is the only account where you get a tax deduction for putting the money in and you are not taxed when you use the money for a qualified medical expense. The money in the account can also be invested, and all interest, dividends and capital gains in the account are not taxed. And HSAs come complete with debit cards and checks. Your employer may provide you with an easy method of payroll deduction for your HDHP and HSA. Alternatively, you can sign up for an individual plan.

<b>IRA rollover accounts:</b> When you leave an employer you will want to roll your 401(k) or 403(b) accounts into an IRA rollover account where you can manage it yourself. Although the matching aspect is wonderful, a 401(k) account has limited choices and higher fees. Moving that money into an IRA is nearly always the right decision. Both you and your spouse will ultimately need IRA rollover accounts.

<b>Living trust accounts:</b> Estate plans can be written in many different ways. Some estate plans set up a bypass trust only after one spouse has died. Other estate plans prefer to set up a living trust each for husband and wife while they are still alive and fund it with investments. Make sure you understand your will and estate plan well enough to structure your investment accounts in accordance with your wishes.

<b>Inherited IRA accounts:</b> If your parents or grandparents have died they may have left you money outright or they may have left you their traditional or Roth IRA account. If they have left you an IRA account, leave the IRA account as a qualified account where the interest, dividends and capital gains grow tax deferred. Taking the money out gradually, only the amount of required minimum distributions, provides the greatest tax benefit.

<b>Segregated Roth conversion accounts:</b> Tax law allows you to take the money in your IRA or IRA rollover account, pay the tax and convert those assets to a Roth account. Before you pay the tax, you even have the opportunity to recharacterize and unconvert the conversion. An additional tax-planning technique suggests dividing the portion you convert into separate accounts. Segregating the assets into different accounts allows you to invest them differently, keep the one that does the best and recharacterize the ones that underperform.

<b>Charitable gift account (or donor-advised funds):</b> To facilitate your charitable giving, you are allowed to transfer appreciated securities to the account. As you transfer them, you receive a tax deduction for the full value. They are sold and may be reinvested in a limited number of choices. And at any time you can direct that donations be made to qualified charities. This is an easy way to get the tax write-off for donating large blocks of appreciated securities and then subsequently give smaller amounts to individual charities.

More than a dozen different accounts are listed here, but you may not have them all until you are well on your way to becoming a millionaire.

 

from http://www.emarotta.com/article.php?ID=443

Don't Retire: Keep Significant Goals (2011-03-07)

by David John Marotta

Most Americans fail to plan adequately for retirement and consequently miss out on opportunities to enjoy the last third of life. The best and most rewarding financial planning is not just about the numbers but rather takes place in the context of personal goals.

Retirement used to mean not only a complete withdrawal from the workforce but often a retreat from life. Even the word "retire" has the connotations of shuffling quietly off to bed.

We call that traditional concept a "cliff retirement" because it is so abrupt. One day you are working full time, and the next you are playing full time (or slumped in your chair watching TV feeling unwanted and over the hill). We all need meaning and significance in our lives. And close social relations are an intrinsic part of our humanness. For many people, work provides meaning, significance and social relationships.

Try this retirement planning exercise. Draw a large circle and write the names of 10 people inside the circle who you are genuinely close to. Don't include any relatives. They have to love us, and although our connections with our families can be very nurturing, it is friends who help validate us and widen our horizons.

Now cross out any of the 10 names you know through your work, which might eliminate half or more of the people you listed. Thus a cliff retirement can devastate not only your meaning and purpose but your social network as well. Retirees who no longer work at all say their close friends dwindle to an average of about nine people.

As a result of their isolation, people who opt for a cliff retirement often deteriorate quickly and die relatively young. Financial planning is easy when you die young, but we don't recommend it. Here are some suggestions to consider as you approach what is traditionally considered retirement age.

Consider postponing retirement. Delaying retirement until age 70 increases your Social Security benefits and also shortens the time you will be withdrawing from your portfolio. It gives you additional years to save and your portfolio more time to grow. By delaying retirement from 65 to age 70, you may have more than a 50% higher standard of living when you do stop working.

Or instead of taking a cliff retirement, think about retiring gradually. Move from full time to 30 hours a week, and then to half time. With this less hasty transition you can maintain contact with the people and purposes that give your life meaning and also have the time to develop goals and a network of relationships for your later years.

Envision your final years not as retirement but as financial independence. Now that you don't need to work exclusively for money, make a list of activities where you would like to focus your energies and use your skills and experience.

Consider developing a health and fitness routine. If work kept your mind and body engaged, you will need to replace that activity with other pursuits. Again, going part time allows you the luxury of processing the transition and adjusting to a new lifestyle.

Challenge and reexamine those stereotyped and overly rigid assumptions about retirement. Two books that may help you tailor your retirement to be a productive and satisfying time of your life are "Encore: Finding Work That Matters in the Second Half of Life" by Marc Freedman and "The New Retirementality: Planning Your Life and Living Your Dreams at Any Age You Want" by Mitch Anthony.

Of course crunching the financial numbers is critical as you begin to contemplate retirement. But your personal calling, support network and health and well-being are just as important. In the end, a holistic approach to your life is always the best starting place.

We offer just such an approach every year through the Osher Life Long Learning Institute at the University of Virginia. Beth Nedelisky and I are teaching the workshop "Planning for Success and Significance in Retirement." The course, intended for people age 50 to 70, covers cash flow projections and asset allocation as well as meaning of life issues. The three-week course begins Thursday, March 10, from 11 a.m. to 12:30 p.m. at Meadows Presbyterian Church. You may register online <a href="http://www.virginia.edu/olliuva/">(virginia.edu/olliuva)</a> or at the first class.

 

from http://www.emarotta.com/article.php?ID=442

Pay Yourself First

by David John Marotta | 02-28-2011

The greatest engine to generate real wealth is saving and investing. And the best way to ensure that your default is saving and investing is to automate the process. Pay yourself first, and your savings will grow exponentially.

Wealth management is based on the idea that very small changes can yield enormous gains in your family's finances. This process, both easy and simple, is worth millions. Unfortunately, only a tiny percentage of American families take advantage of the tools available to implement this automated technique.

All income should flow into your joint taxable investment account. Make saving and investing your default. Putting all of your money in this account helps ensure that you move only the money intended for some other purpose into a different account.

Automating the process of saving and investing is like damming a river to form a reservoir.

For working families this means an automatic deposit of paychecks into their joint account. Banks will try to entice you into setting up automatic payroll deposit into their checking account. They will offer you additional interest if you do so. Resist. The additional interest is not worth the failure to not only save but to save and invest. Your taxable investment account should be the default.

For retired families this means an automatic deposit of Social Security checks. It also means their required minimum distributions (RMDs) from their individual retirement accounts (IRAs) should be deposited first into this account.

From this account you can then withdraw what you need for daily expenses. Do this by setting up a regular transfer of funds from your joint investment account to your checking account. Make sure the transfer matches the amount you have allocated in your budget, ideally 65% or less of what you need to support your lifestyle. The other 35% should remain in your joint taxable account, much of it to be invested.

Gift appreciated stock from this account and leave enough cash to reinvest and replenish the value. This plants the seed for future gifting. You save on capital gains tax, and with your new purchases you can rebalance your portfolio.

Another part of what remains is the 10% you have designated for unknown unknowns. In the ideal world, this money will not be needed, but few families can anticipate every possible expense. Each stage of life presents new challenges. Having the financial margin to absorb some of life's shocks is simply wisdom and offers financial peace of mind.

Because the time horizon for this emergency money is unknown, invest it in a balanced portfolio. If unused, your emergency money will double in 7 to 10 years and provide a greater safety net for your family. If you have to dip into this fund, keep track of the amount. If it approaches the full 10% every year, you are using your emergency money to extend your budget, not simply for unanticipated expenses.

The less you use this account, the more quickly you will reach financial independence. These funds are mixed with your other taxable investment savings and continue to grow your net worth. If you are meeting all of your expenses without any major surprises, these funds can be used to purchase a home, start a business or for additional charitable giving.

Another portion of what remains in your taxable investment account will be the 5% you are specifically designating as taxable savings. Because this 5% gets mixed in with charitable giving that is being invested and your unknown expenses, the entire portfolio should be balanced. If an emergency arises, any portion of the portfolio could be sold to furnish the needed funds. Similarly, when you want to gift appreciated stock, any portion of the portfolio could be gifted.

The last portion might be the 10% for funding your retirement accounts each year. Many people put this money directly into a retirement account as part of the payroll process through a pretax deduction. If that is the situation, you don't need to flow anything through your taxable investment account. But you may want or need to fund your retirement outside of a payroll deduction. One example is funding your Roth IRA each year. In this case you may want to collect the money in your taxable investment account and then transfer it to a Roth account.

If you want to fund a Roth IRA account for the maximum $5,000 (in 2010), you could transfer the entire amount once during the year or set up a monthly transfer of $416.66. The money from your paycheck would provide the liquidity, either letting it build up throughout the year or supply the funds for each month's transfer.

Busy people forget to make the necessary transfers each year. That's why a monthly transfer is preferable. Saving and investing should be automated so it occurs regularly without any additional effort. Whatever is in your checking account you are likely to spend. Whatever is in your investments you are less likely to spend.

Automating the process of saving and investing is like damming a river to form a reservoir. The alternative is the manual process of hauling buckets of water from your stream to a water tower. You will never grow rich by hauling buckets, and it's much harder work.

No matter what income you have, you probably already have enough to grow rich. Saving and investing just $10 a day builds a million dollars over your working career at average market returns. You build wealth by what you save and invest, not by what you spend. Automating the process of saving and investing grows your wealth while you sleep.

Raising Money-Savvy Kids

by David John Marotta | 02-21-2011

Many people lament that schools don't teach children to be financially responsible. But studies show that book learning doesn't work when trying to teach about finances. Here is a guide for what will give your children the best chance of handling their money well.

Financial responsibility is more about self-discipline than about knowledge. Think of it like dieting or staying physically fit, not solving math problems. It isn't simply information you learn from a book, it is a skill you learn by doing.

I coached soccer for many years and was assistant coach to one of the best. Excellent coaches understand how to design exciting games that teach specific skills. They are able to motivate the players about the game and at the same time teach them the skills they need to be successful.

You learned your best life lessons by experience. You cannot teach your children to live within their means if you keep supplementing their means.

 

Training to be financially adept requires the same three methods needed in sports: communication, example and application.

Communication alone is the least effective. Imagine I was teaching you the proper way to kick a soccer ball. In a textbook you read, "Take aim and then look back to the soccer ball as you shoot. Approach slightly from the side. Plant your non-striking foot beside the ball. Strike the middle. Keep the knee of your kicking leg over the ball. Follow through."

If that was the end of the lesson, all players would remain abysmal once they got on the field. Head knowledge isn't enough, and it doesn't help you visualize what is possible. Also, knowing how and why is very different than actually being able to do it.

Most coaching involves simply giving players an example. You do something and you say, "Kick the ball like this." Although "like this" could mean a thousand things, children are very good at abstracting what is important. Similarly, our children can learn financial perspectives and habits simply by growing up in our homes.

Our example as parents gives them a default of what to try first. But unfortunately, most families don't provide a very good model. The average family's finances are appalling. Credit card debt averages $6,500. Half of American families have no retirement accounts. The other half have only saved $35,000.

Getting your own financial house in order is half the battle. The other half is bringing your children into your circle of trust as they mature. Most children feel they are in the dark regarding family finances. My most valuable education came from my mother, who shared every aspect of her household budget with us.

Before age 10, I knew what my father's salary was, the amount of our mortgage and the interest rate we were paying. I knew how much a week's worth of groceries cost and the value of buying term life insurance and investing the difference. Parental actions can be ambiguous, but when they are accompanied with a commentary of values and decision-making skills, they offer sage mentoring.

Communication and example are important, but practice is the key to raising financially savvy children. Given enough time to practice, even children without guidance and good examples will learn from trial and error, just like young soccer players accidentally learn that spinning balls curve.

The physics that causes a lateral deflection of a spinning object are quite complex. But with some trial and error, it is much easier just to learn to do it. Even children with no knowledge of physics can ultimately bend or curve a soccer ball around a wall of players and into the corner of the net.

To raise financially savvy children, give them as much practice time with real money as you can. Encourage your children to make spending decisions as early as possible. Let them make mistakes and learn from them. Give them practice in spending, investing and earning.

They should not be asking you for money. Let them make the tough calls about needs and wants and be forced to choose. If they are not obligated to make hard decisions, you are giving them too much money or not making them pay for enough things. You learned your best life lessons by experience. You cannot teach your children to live within their means if you keep supplementing their means.

Also, they should only be paying for things you are willing for them not to purchase. For example, if you make them pay for a school trip, you must be willing for them to decide not to go. And if they have spent all of their allowance, do not loan them money. Finding that you want to buy something but you have already spent everything is a critical lesson. Make sure your children don't miss it.

Children need experience not only saving, but saving and investing. It takes a while to understand the principle of compounded interest. I thought the lesson was essential enough to cheat and shorten the time horizon. The first time my children had $100, they were allowed to invest the money for one year with an extra 100% return on their money. They could keep whatever they earned plus an additional $100. They were young, and a year was a long time for them.

As part of our firm's quarterly reporting, clients receive a chart showing the net cumulative investment versus the portfolio value, which drives home the power of investing. Even $100 invested teaches the lessons of compounded market rates of return.

Finally, children must learn how an ethic of hard work and persistence produces a financial return. Grit is a better indicator of financial success than IQ. And running a small business requires more persistence than smarts.

My children were allowed to get jobs at age 14 and were eager to do so. That year they also started funding their Roth IRAs and took over more of their everyday spending. They had been prepared and were able to assume much of their own financial independence.

At every age of your children's lives, think through how you can communicate, be an example and give them real-world practice, first at budgeting, then at investing and finally at running a business that provides real value.

If you'd like to further your children's financial education, come to this month's NAPFA Consumer Education Foundation meeting. This Wednesday, February 23, my topic will be "How to Raise Money-Savvy Kids" at the Charlottesville Northside Library Meeting Room from 7:00 to 8:00pm. The talk is intended for parents and teenage children, although younger children are welcome.

For Valentine's Day, Work on a Budget Together

by David John Marotta | 02-14-2011

An overwhelming number of people in failed marriages cite financial troubles as a major factor in their breakup. It's not surprising because the way we use our time and money reflects our values. Without a strong set of shared values, marriages may founder. But dealing with finances together can bring a couple closer. Developing and remaining faithful to a budget is probably the best way to build both your wealth and your marriage.

You may think financial planning is unromantic, but marriage is so much more than gazing into each other's eyes. It is as much a business merger as any corporate contract. And nothing is more romantic than planning how to realize your shared hopes and dreams for the future.

Finances tend to be a taboo subject. Often engaged couples do not know what their prospective mates earn or how much savings or debt they have accumulated. Most couples have deeply conditioned emotions and expectations about financial matters that they unconsciously project onto others. So in addition to selecting a china pattern and the floral arrangements for your big day, make sure your marriage has the financial footing and monetary habits to meet life's challenges.

Couples who have worked together on a budget already agree on the big picture. Once they make the hard decisions about what will help further the family's values, specific purchases in each category are much less critical.

Planning for financial security helps engender a loving environment of shared goals, respect and communication within which romance can flourish. If you can't share details about your finances, it doesn't bode well for your relationship. A professional may help facilitate the necessary discussions. An advisor can ask sensitive questions without judgment, listen to each person's goals and make recommendations to which the couple can respond without any hurt feelings.

I especially enjoy working with young families. Wealth management is all about small changes that produce large results over an extended period. And young couples have enough time to grow richer year by year as they age gracefully together.

Many new couples mistakenly believe they are doing well if they live within their means. This is a common misconception. Couples should keep daily expenses within 65% of take-home pay and reserve the other 35% for very specific purposes.

Ten percent should fund your retirement accounts, and an additional 5% funds your taxable savings. Set aside another 10% for large unexpected purchases. Without budgeting for these large emergencies, anything could swamp your finances. The roof might leak, the car could require major repairs or you could need to fly home for a family emergency. And finally, you may decide to put aside an additional 10% for charity and gifting.

If you add these values up, 35% of your regular take-home pay can't be spent on daily living expenses, leaving only 65% that can. Without this foresight, your finances or savings will be deluged by the regular large waves of unexpected immediate needs. This might be the single choice separating those who will grow their finances and those who won't.

Having a budget gives you more freedom, not less. Couples without one often fight about every dollar they spend. Each purchase becomes a battleground where values and priorities clash. And there are always impulsive purchases that provide fodder for an argument.

Disputes about how to spend money can be ongoing in families that are struggling to make ends meet. But a spending plan should never be exploited as a weapon. It can only be used as a tool for couples who are working together toward a common goal.

Most people occasionally buy something that their spouse considers frivolous. The way to contain the havoc these purchases wreak on a budget and a marriage is to set a boundary within which they can be enjoyed and beyond which they will not threaten other financial goals.

We recommend that couples make a line item in their budget for a husband's frivolous purchases and a wife's frivolous purchases. I suggest 1% total or half of 1% for each spouse. So long as spending stays within the budget, there should be no arguments.

Couples who have worked together on a budget already agree on the big picture. Once they make the hard decisions about what will help further the family's values, specific purchases in each category are much less critical.

When people follow a carefully constructed household budget, they do not need to worry about spending until a category exceeds the prescribed amount. Having decided how much money the family can afford to spend on clothes for him and for her, for example, it doesn't matter if he prefers lots of inexpensive clothes and she prefers a few more expensive outfits. A budget allows a certain degree of freedom that forestalls any controversy.

And when a family does overspend one category, they can decide in a monthly budget meeting how the category allocations might be adjusted going forward. There may still be disagreements, but at least with a budget there won't be petty discussions about every dollar or even an attempt to figure out where the money was spent.

As we grow older we can enjoy great peace of mind if we have resolved our money issues together. For Valentine's Day, work on a budget together. It is a calorie-free way of building lasting harmony.

Save Your Social Security Payroll Tax Cut

by David John Marotta | 02-07-2011

This year the government reduced Social Security taxes by 2%. More than 150 million workers will receive up to $2,136 each. The assumption is we can spend our way out of unemployment. You should boost your savings rate by 2% to ensure you don't fall behind on your retirement savings.

We can't spend our way out of economic trouble as a country any more than we can grow taller by pulling on our shoestrings. Increased spending is an indicator of economic health only when it follows increased production and earnings. Rich people generally spend more. But that certainly is not what makes them rich.

A far better scenario would be if we as a country tried to save and invest our way out of a recession. Imagine if everyone invested their rebate by creating new businesses or building factories. Then we as a nation would produce more. Increased annual production could be sold, which would increase our gross domestic product.

Consuming more goods doesn't really help our economy when half the stuff we buy comes from China anyway. In fact, deferred consumption is the definition of capital and would allow us to use that money to build more productive companies. It would lower unemployment and reduce inflation.

President Bush tried the exact same gimmick in May 2008, issuing tax rebates in the form of stimulus checks.I respondedjust as vehemently that the rebate was a cheap insult directed at the American people and free markets. Every time the government bureaucracy engages in centralized spending plans, the economy is weakened. They believe they are better off, butworkers will actually be poorerif the check increases their spending habits by even a penny.

Average workers earning about $50,000 a year will see their take-home pay rise by 2%, or $1,000. Normally their standard of living after taxes and savings might be $37,000. By age 50 they should have saved about 10 times their standard of living, or $370,000. But if they spend an additional $1,000, they increase their annual lifestyle to $38,000. They will fall $10,000 behind on funding their retirement.

The United Auto Workers supports the idea of the payroll tax cut. They claim, "Working families will likely spend this money in their local communities, creating jobs and stimulating overall growth." Anyone who spends more than 4% actually loses ground in saving toward retirement. Thwart the UAW's advice and start saving and investing an additional 2% of your income this year.

To replace your income and be financially independent at a reasonable age, you should be saving 15% of your take-home pay toward your retirement. I received the following reply to that advice from one of my readers. She wrote, "Few people I know, except for well-paid professionals, can save 15% of their income for long-term retirement goals. . . . Sorry, but most people don't live in this author's rosy world."

No matter what your salary, there are people living comfortably off 15% less money and still managing to save 15% of their smaller salary. We could easily begin to ask uncomfortable questions about this reader's lifestyle. We might find at least 15% in discretionary spending that more frugal people could easily eliminate. My reader would have made a more convincing argument if she said we are already being taxed more than 15%, which ought to be enough.

Most workers don't know how much they are taxed for Social Security. The correct figure is 12.4% for Social Security plus an additional 2.9% for Medicare, a total of 15.3%.

Of the 12.4% for Social Security, 6.2% is deducted from the employee's paycheck. The other 6.2% is withheld by the employer, who reduces salaries accordingly. In truth, without these government-imposed taxes, the labor market would settle at paying employees 15.3% higher wages. Management doesn't care whose share it comes out of. Either way employees bear the burden of the entire tax.

Saving 15.3% over a working career ought to provide all employees with a retirement income at or greater than their wage during their working years. Instead, the return on Social Security investment is minuscule if you are a rich white woman and negative if you are a poor black man. Nonworking spouses, who never contributed anything to Social Security, are the only group that can claim to have won in the exchange.

White House economic adviser Jason Furman said, "The payroll tax cut has absolutely no effect on the solvency of Social Security." Only in Washington do they pretend the emperor is clothed. How can collecting $112 billion less in Social Security taxes have no effect?

The Treasury Department has been instructed to replenish Social Security with additional borrowed money against Treasury bills. The entire Social Security fund is a stack of IOUs written against future tax collection. So I guess adding a few more without first squandering and spending revenue doesn't really change the solvency. In other words, the system is bankrupt either way.

Take ownership of your own financial securityand increase the rate you are saving and investing by at least the 2% Social Security tax cut.

Roth Recharacterization 2011 (2011-01-31)

by David John Marotta

Last year was the year of the Roth conversion. Now it's time to consider how much of the conversion to keep. Although that decision depends on a hundred different factors, here is a simple rule of thumb to use as a starting point for discussions with your CPA.

Up until December 2010, it looked like a tax tsunami was coming. The higher your adjusted gross income, the closer you lived to the coast where the tsunami would hit. Now Congress has hit a two-year snooze button, but you should still safeguard your assets in a lifeboat and avoid getting swamped with future taxes.

At the end of 2012, the Bush tax cuts will expire and tax rates will go up across the board. Even the 10% bracket will rise to 15%. There will once again be a marriage penalty on two-income families. A phaseout of itemized deductions and personal exemptions will return. The child tax credit will drop to half. The death tax will be reinstated at 55%. The capital gains tax will rise from 15% to 20% and then to 23.5%. Tax on dividends will swell from 15% to 39.5%.

Although the timing of this change has been pushed back, it should still factor into your tax management. Two years is a relatively small tax-planning window through which you should drive a Brink's truckload of savings.

The IRS allows you to change your mind. Last year I advocated converting more value to Roth IRAs than you intended to keep. Now you can decide the conversion wasn't worth it and move the money from the Roth account back to your traditional IRA account in a "Roth recharacterization."

Recharacterizing a Roth conversion can be done any time before you file your taxes, including the filing extension. Filing an extension allows you to determine which accounts to keep, but you must still pay whatever tax is due by the normal tax filing day, which is April 18 this year. Then by October 15 you can recharacterize part or all of what you converted.

If you failed to convert anything last year, you missed an opportunity. If you converted much more than you probably wanted to, now you have to decide how much to keep. If you took our advice, you created five different accounts and invested them each in a different asset class (e.g., bonds, U.S. stock, foreign stock, emerging markets and hard asset stocks).

At this point the five accounts have appreciated differently, but the entire portfolio will be fairly well balanced. Now you must determine how many of the five accounts to keep and how many to recharacterize.

If you pay taxes in the highest marginal tax rate, you might as well keep all five. Even though the top marginal rate will continue to be low for another two years, the rate of taxes you pay if you convert in subsequent years won't be any lower. You might as well start growing the assets tax free in a Roth account as soon as possible.

If you pay taxes in the low 15% tax bracket, consider keeping just one of the five conversion accounts. You obviously will keep whichever account has appreciated the most. Recharacterize the other four accounts, moving the money back into a traditional IRA account. Then, after 31 days, you can convert the IRA to five new Roth accounts and begin another set of Roth Segregation accounts for 2011.

If you pay taxes in the middle tax brackets, you might hold on to two of the five conversion accounts. The goal is to try to convert the entire amount over three years while the tax rates are low but avoid pushing yourself into a higher tax bracket. After maintaining two this year, create five new Roth Segregation accounts for 2011 and plan on keeping three in 2012. Anticipate finishing your conversion in 2013 by retaining all five.

This general principle will keep 40% of the total amount the first year, 36% the second year and 24% the third and final year. The smaller percentages the second and third year would have had longer to grow, which helps equalize the converted amounts.

The information here is not intended to replace specific tax-planning advice. Don't try to fly solo about how much Roth conversion to keep and how much to recharacterize. Seek professional tax advice. This approximation will give you and your CPA a starting place for discussion.

The perfect tax-planning answer primarily depends on where you are in the progressive tax tables. Using your Roth conversion to increase your income to the top of your current tax bracket is a more refined answer to the question of how much to keep. Your accountant will be able to compute this amount as well for comparison.

The markets appreciated significantly in 2010, making it attractive to hold on to more of your conversion amount this year. And as soon as you have made that decision, recharacterize the remaining amount, wait 31 days and then start another set of five Roth Segregation accounts for 2011.

 

from http://www.emarotta.com/article.php?ID=437

2010 Non-U.S. Stock Lessons Learned (2011-01-24)

by David John Marotta

Reviewing last year's investment returns provides a blueprint for where you should consider investing in the new year. Last week we looked at U.S. stocks and bonds. This week we broaden our horizons. Here are five principles to consider.

<b>The United States isn't the only or even the best place to invest.</b> Domestically, the markets enjoyed a great year, but the countries with more economic freedom and less debt did even better. Hong Kong was up 23.23%, Singapore up 22.14% and Canada up 20.45%. I would also add Australia to that list, even though its markets were only up 14.52%.

By comparison, the MSCI EAFE Foreign Index was up 7.75% for the year, recovering 24.18% in the last half of the year after dropping precipitously in the first half as Greek sovereign debt threatened the solvency of the European Union. A total of 61% of the EAFE index is invested in the so-called ring-of-fire countries with high debts. European countries with more government restraint did better, with Switzerland up 11.79%, Austria up 12.67% and Sweden up 33.75%.

<b>Economic freedom and government restraint matter.</b> All developed countries are not equally attractive places to invest. The United States has entered the ring of fire and expected to underperform in future years as a result. It is much easier to spend your way into deficits than it is to exercise austerity as a way into prosperity.

<b>Emerging markets will continue to emerge.</b> The MSCI Emerging Markets Index gained 18.88%. And this increase was not primarily from Brazil, Russia, India and China (the BRIC countries), which together were only up 9.57%. Mexico, in contrast, gained 27.45%, and Chile gained 47.13%.

Fighting the trend of globalization is not merely muddled economic thinking. It is socially evil. Poor workers in developing countries need employment even more than American workers. This is not a transfer of jobs from the United States overseas. It is a transfer of value from overseas to the United States. If we in the United States do what we do best and we let other countries do what they do best, both sides of the equation can gain. This is the most basic tenet of economics: Voluntary trade benefits both parties.

<b>Hard asset stocks are an important inflation hedge.</b> Hard asset investments include companies that own and produce an underlying natural resource. Examples include oil, natural gas, precious metals (particularly gold and silver), base metals such as copper and nickel and other resources such as diamonds, coal, lumber and even water.

Investing in hard asset stocks is not the same as investing directly in commodities. Buying gold bullion or a gold futures contract is an investment directly in raw commodities or their volatility, whereas buying a gold mining company is a hard asset stock investment.

Over time, dollars lose their buying power. The goods and services we buy cost more. Officially, inflation this past year was 1.1%. The government has a large incentive to underreport inflation. Unofficially, a barrel of oil went from $67 to $88 (up 31%) and an ounce of gold from $1,125 to $1,375 (up 22%).

Commodities as an asset class generally maintain their buying power in dollar terms. Stocks as an asset class generally appreciate over inflation after dividends are factored in. And recently, hard asset stocks have been appreciating nicely.

Hard asset stocks provide an inflation hedge. Due to the underlying value of the tangible commodity that natural resource companies produce, their earnings are tied to inflation. Their resources are worth more as the dollar declines in value. This situation can occur in times when the supply of money and credit is increased to fund government spending and budget deficits.

For 2010, the S&P North American Natural Resource Sector Index, which contains a portion of everything in the hard asset category, gained 23.88% for the year. Going forward we recommend deemphasizing gold and focusing on energy and real estate.

<b>Stability should be truly stable.</b> You don't put money on the stability side to make the most money. Therefore you shouldn't keep more money on the secure side than you need for the next five to seven years. Investors should consider what is and is not stable. For example, we recommend putting a portion into emerging market bond funds such as the Pimco Emerging Market Bond Fund (PEMDX/PEBIX), up 12.36% for the year. We continue to expect high volatility in the municipal bond markets due to economic strains in local and state governments. As a result, we don't recommend investing in municipal bonds at this time.

This review of 2010 can help provide an investment guide for the coming years. Analyze your portfolio against these observations to see where you should adjust your investment philosophy.

 

from http://www.emarotta.com/article.php?ID=436

2010 U.S. Stock and Bond Lessons Learned (2011-01-17)

by David John Marotta

Over the long term, stocks outperform bonds and bonds outperform cash, which was affirmed in 2010. Analyzing the breakdown of asset categories will help you craft portfolios that will perform best in this new year and beyond.

<b>Fees matter.</b> The S&P 500 finished up 15.06% for 2010. Your index fund probably underperformed this benchmark by whatever expenses the fund incurred. If your fund is very efficient, this amount was small. But if your funds fees are excessive, your performance was reduced even more.

For every additional 1% you earn over your working career, you can retire seven years earlier or 50% richer, a huge effect. In the financial world, a single percentage point is broken into hundredths of a percent. Each hundredth is called a "basis point," abbreviated "bps," and pronounced "bips" in financial parlance. Saving just 15 bps in expenses during your working career allows you to retire a year earlier, a dramatic advantage. That's how important fees are.

Compare your funds to the iShares S&P 500 Index ETF (IVV). It returned 14.97% with an expense ratio of only 0.09%. See if excessive fees are reducing your returns.

<b>Stocks on average beat bonds, and bonds are more complex than stocks.</b> Last year followed this trend. The Barclays Capital U.S. 1-3 Year Treasury Bond Index finished the year with a meager gain of 2.40%.

The expense ratio on iShares Barclays 1-3 Year Treasury Bond ETF (SHY) is 0.15%, which means you are charged more for investing in short-term bonds. Bond investing is more intricate than stock investing. Every share of Apple stock is exactly the same, but every bond's unique characteristics must be evaluated. No bond index fund can perfectly track the index, so they approximate the index and either over- or underperform. This year iShares SHY returned 2.22%, slightly underperforming its benchmark minus its expense ratio.

<b>Setting the right benchmark matters.</b> A fair benchmark for your portfolio is a combination of the S&P 500 for your equities and 1-3 year Treasury bonds for your fixed income. Blend these two indexes according to how much you have in appreciation and stability. For example, an investor with 70% of her portfolio in equities and 30% in fixed income would calculate her benchmark index as 0.7(15.06) + 0.3(2.40), or 11.26% for all of 2010. Knowing your benchmark return keeps you from being satisfied with an 8% return when at this level of risk you should have had an 11.26% return.

<b>Risk is usually rewarded.</b> For the past two years, appreciating assets have done better than stable fixed-income investments. In 2008, however, risk was punished severely. Equities return an average of 6.5% over inflation, and fixed-income returns 3% over inflation. So when inflation averages 4.5%, equities average 11% and bonds average 7.5%. In 2010 inflation was only about 1.1%.

Diversification means putting money in equity investments that ought to do better than the S&P 500 with reasonable risk and in fixed-income investments that are liable to do better than the 1-3 Treasuries with reasonable risk. Against these two benchmarks you can compare the plethora of other indexes.

<b>Knowing which indexes are worth an allocation is critical.</b> The thousands of different indexes each have their own return. The S&P 500, a large-cap U.S. stock index, is only one subsector of one of our six asset categories. Over the past decade, nearly every other subsector or asset class has done better than the S&P 500.

Let's begin by looking at subsectors with U.S. stocks. One way to divide U.S. stocks is using the style boxes popularized by Morningstar. The vertical axis on the 3 by 3 Morningstar grid represents size, from large cap at the top to small cap at the bottom. The horizontal axis represents value on the left to growth on the right.

<b>Generally small-cap stocks do better than large-cap stocks.</b> This year was no exception. The Russell 2000 Small Cap Index returned 26.85% versus the S&P 500's 15.06%. Your investments should include a healthy share of mid- and small-cap stocks even if they are more volatile.

<b>Generally value stocks do better than growth stocks.</b> This year that truism was mixed. Large-cap value beat large-cap growth. But in mid and small cap, growth performed better. Tilting value is recommended in every market except a roaring bull market. If your crystal ball doesn't forecast that clearly, we recommend maintaining a continuous value tilt.

<b>In the United States, emphasize technology.</b> Another method to divide the U.S. stock market is by sector of the economy. Information technology, the largest sector, comprises 18.4% of the economy. It includes Apple, Microsoft, IBM and Intel. The subsectors have all done well, with hardware up 23.36% and software up 22.64%.

This is what we do best. Our government now heavily regulates the financial, health and energy sectors. That's 39% of our economy. How can our banking industry compete globally with heavy regulation and a corporate tax rate of 35% when Hong Kong or Singapore has all the safeguards needed and a corporate tax rate of 10% or 17%, respectively? You don't want your investments dragged down by a lack of economic freedom. So overemphasize those sectors left free to innovate and compete on the global market.

Although technology historically is the highest performing sector of our economy, it also has the highest volatility. Interestingly enough, health care has been the second highest performing sector but with much less volatility. Not so this year. In 2010 health care was the second worst performing sector behind utilities, returning only 6.49%. The Patient Protection and Affordable Care Act, aka Obamacare, has begun to affect that sector of the economy negatively. Construction on doctor-owned hospitals has halted. Insurance rates are up. My own High Deductible Health Plan (HDHP) is no longer available to the public. My personal coverage will continue as long as I don't change any of the terms. So much for freedom and choice. In light of increased socialization, my standard advice to emphasize health care has to be reevaluated.

These eight observations should help you improve your U.S. stock returns. Next week we will look at the lesson to be learned from looking at last year's returns on foreign investments.

 

from http://www.emarotta.com/article.php?ID=435

A New Opportunity: Donating to Charity from Your IRA (2011-01-10)

by David John Marotta, Beth Anderson Nedelisky

Congress has reinstated the ability to donate to a charity directly from your IRA without any tax penalty. You may benefit from this provision if you fit the right criteria.

The IRS normally collects tax every time you withdraw funds from your IRA. For example, if you take $100,000, the amount increases your adjusted gross income (AGI). It can cause your deductions to phase out or trigger taxation of your Social Security benefits. In the past this was true even if you subsequently donated the entire amount to charity.

In addition, many retirees do not itemize. Thus they were taxed on their charitable giving without the benefit of a tax deduction if the gift was below their standard deduction. If the gift was a significant percentage of their AGI, much of the write-off had to be carried forward and realized in subsequent years.

Artificially inflating your AGI has other negative consequences. Medical expenses and miscellaneous deductions must exceed a percentage of your AGI. So increasing your AGI may mean you are no longer able to take these deductions.

But the tax law signed on December 17, 2010, is less restrictive. It allows taxpayers age 70 1/2 or older to donate up to $100,000 from their IRA directly to a charity. The amount of the charitable contribution is excluded from taxable income. Therefore it won't artificially inflate AGI and trigger an excessive tax burden.

You are normally required to withdraw a certain amount called the "required minimum distribution" (RMD) from your IRA account each year. Charitable contributions from your IRA can now satisfy this RMD requirement.

Because the law was passed so late in the year, you have until January 31, 2011, to make the transfers and still have them count for 2010.

You don't have to be a big donor to take advantage of this opportunity. Perhaps your 2011 RMD is only $10,000. But you don't need the money and normally give $5,000 to qualified charities. You can transfer half to charity. Only the other half will increase your AGI. This simple change could be enough to keep your Social Security from being taxed.

If your IRA contains both before-tax and after-tax dollars, you can save even more by giving. Qualified charitable distributions made from this type of IRA are taken from the portion of untaxed dollars first. This represents a radical departure from the typical IRA model that requires you to withdraw the pre-tax and after-tax dollars proportionately. Under the new act, you'll be able to give away the dollars that carry the highest tax liability. At the end of the day, you'll have a higher percentage of after-tax dollars left in your IRA.

All of these savings are liable to be small, perhaps only realizing about 5% of the value you give to charity. I've written previously about the benefits of giving appreciated securities in your taxable account. That technique is superior to this one in many ways, but not all. Giving appreciated securities adds the benefit of avoiding capital gains taxes that approaches an additional 15% benefit if the security is highly appreciated. But in some cases giving from your IRA would be the preferred method.

If you don't have a taxable account with appreciated securities, giving from your IRA is clearly the next best choice. And if you are older and not planning on selling any of the appreciated securities, your heirs will get a step up in cost basis and realize the capital gain without paying any tax. If you don't need the money for living expenses and already choose to do charitable giving, you might be the right candidate.

Transfers must be made directly to the charity or checks written made out to the charity. Each custodian has its own safeguards to ensure your transfer will qualify. No special forms are required. The IRS does not need to be notified. Your tax preparer will need to note the transfer on your taxes when you file.

Qualified charitable distributions are just one tax-planning tool that may save you money. We advise our clients to meet with their tax professional throughout the year long before the filing deadline. Tax planning is complex and time consuming but can be well worth the effort.

 

from http://www.emarotta.com/article.php?ID=434

Compute Your Net Worth Once a Year -2011 (2011-01-03)

by David John Marotta

Since the end of last year the markets are up about 13%.  Putting the last two years together the markets are up about 44%. Those are huge gains for two years. You may not have been on track for your goals two years ago, but now you should reevaluate again. The wave has propelled you miles toward your goal, and at least once a year you should measure your progress.

Everything in the financial markets has changed again: materials, emerging markets, real estate, foreign small cap, even the dollar. If you are within 20 years of retirement (age 45 to 65), it's critical to get your retirement planning updated. Computing your net worth annually is like taking a sextant reading to chart your course toward financial security.

Net worth gives you a snapshot of how much money would be left if you converted everything you owned into cash and paid off all your debts. Compute your net worth by creating four lists.

<b>Liquid assets:</b> An asset is something you own that has significant value. A liquid asset can be sold in a matter of days. Include personal bank accounts (checking, savings and money market), certificates of deposit, bonds, mutual funds, stocks and exchange-traded funds. Use values as of December 31 of the previous year so all of your amounts are calculated on the same day.

<b>Nonliquid assets:</b> Nonliquid assets are those things you own that incur a penalty when they are sold. Include the value of your retirement accounts (IRAs, 401ks, 403bs, SEPs, profit-sharing plans and pension plans). Add real estate investments as well as the market value of your home. Use the assessed value.

Other nonliquid assets may include proprietorships, partnerships or company stock in a firm that is not publicly traded. Add the cash value of any life (nonterm) insurance. Some people include jewelry, collectibles, cars and boats in this category. Although these items often have a high retail value, their true worth is often a small fraction of their initial cost. I do not recommend including personal property.

<b>Immediate liabilities:</b> List what you owe to creditors. Immediate liabilities include credit card debt, car loans, student loans, other loans and any bill or debt that must be paid within two years.

<b>Long-term debt:</b> For most people, long-term debt is primarily their home mortgage, but it may encompass other real estate or business loans.

The first time you gather all of this information will be challenging, but it gets much easier each subsequent year. By keeping an annual record of your net worth, you're creating a valuable financial planning tool.

Next compute three additional values. For your <b>total assets</b>, add your liquid and nonliquid categories; for your <b>total liabilities</b>, add your immediate liabilities and long-term debt; and finally, for your <b>net worth</b>, simply subtract your total liabilities from your total assets.

Use these net worth numbers to compute other values useful for reaching your financial goals. For example, your <b>emergency reserve</b> (liquid assets minus immediate liabilities) should be at least half your annual income. Any extra can be invested more aggressively for appreciation. Your debt load ratio (total liabilities divided by total assets) should be under 35%, with your home mortgage comprising most of your debt.

If you are trying hard to pay off your mortgage ahead of schedule instead of making a huge effort to save and invest, your attempts are laudable but mistaken. The quickest path to wealth includes holding a home mortgage you could pay off but you choose not to in order to take advantage of the tax benefits. The rich leverage wisely and invest.

A net worth statement helps you measure your progress toward retirement. At age 65 you can only withdraw 4.36% of your portfolio to maintain your lifestyle. In other words, to keep the same standard of living, you will need about 23 times what you spend annually.

Take your net worth and divide it by your annual take-home pay. The result shows you how many times your annual standard of living you have amassed in savings. If you are younger than 40, the number probably comes to less than five, which is adequate for now.

By age 45, you should be worth about seven times your annual spending. More sophisticated retirement planning includes the difference between taxable, tax-deferred and Roth accounts as well as Social Security guesses and defined benefit plans, but the method described here will approximate your progress. This table shows by what age you should have saved different multiples of your annual spending. <table><tr><td valign=bottom align=center><u>Age</u></td><td align=center><u>Annual Spending Saved</u></td><td valign=bottom align=center><u>Age</u></td><td align=center><u>Annual Spending Saved</u></td></tr><td align=center>26</td><td align=center>1</td><td align=center>53</td><td align=center>11</td></tr><td align=center>31</td><td align=center>2</td><td align=center>54</td><td align=center>12</td></tr><td align=center>34</td><td align=center>3</td><td align=center>55</td><td align=center>13</td></tr>

<td align=center>38</td><td align=center>4</td><td align=center>57</td><td align=center>14</td></tr><td align=center>41</td><td align=center>5</td><td align=center>58</td><td align=center>15</td></tr><td align=center>43</td><td align=center>6</td><td align=center>59</td><td align=center>16</td></tr><td align=center>45</td><td align=center>7</td><td align=center>60</td><td align=center>17</td></tr><td align=center>47</td><td align=center>8</td><td align=center>61</td><td align=center>18</td></tr><td align=center>49</td><td align=center>9</td><td align=center>62</td><td align=center>19</td></tr><td align=center>51</td><td align=center>10</td><td align=center>63</td><td align=center>20</td></tr></table>

If your net worth is higher, congratulations! You may be able to retire earlier than 65. For every 1 unit you are over, you could consider retiring about a year earlier. Conversely, for every 1 unit you are under your age's benchmark, you may have to work an additional year beyond 65.

Between ages 40 and 50, your net worth should increase by 1 unit of your annual spending every two years. That means your current net worth divided by your take-home pay should be 1 unit greater than it was two years ago. And if you are between age 50 and 65, your net worth should have increased this year by 1 times your take-home pay.

Want to retire younger? Try lowering your standard of living. Most retirees spend about 70% of the gross salary they earned while working. If you can live off 50% of your take-home pay, it's not as essential to save as much.

Need to catch up? Save more than 15% of your take-home-pay. Determine how far you are behind and what additional percentage you can save each year. For example, at age 30, you should be worth 1.5 times your annual income. If your numbers don't match that ideal, an additional 0.3 times your annual income will help you get there. You could save an additional 10% of your income (for a total of 25%) for three years. If that's too much, try saving 20% (an additional 5%) for six years.

Money makes money. By the time you reach your 40s, you should have enough investments to be earning about half of your annual spending each year. Early in life what you save is most important for building wealth, but as you approach age 40 what you earn on your investments becomes critical. While you are young, the best advice a professional can offer is to "save." As you amass significant wealth, it is more pressing to "manage" well what you already have.

All financial planning begins with a clear understanding of your net worth. A PDF template on our website <a href="http://www.emarotta.com/networth"> (www.emarotta.com/networth)</a> can help you compute and keep track of your net worth each year. Contact us or visit our website to download a free copy.



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