by David John Marotta

In my first job teaching computer science, someone stole my wallet off my desk during my office hours. Although I canceled all my credit cards, the thief used them around town, buying everything from clothes to tobacco. In those days cards were run manually on paper, and there was usually no instant electronic verification.

Identity theft is becoming distressingly common as personal information becomes easier to swipe. Internet sites all ask the same security verification questions. One site could easily collect your information and then try using it on others. For example, a student filled out a credit card application outside a university football game with the promised bonus of a free T-shirt. The perpetrators used all his information on a real credit card application but changed the mailing address. By the time the student realized his identity had been stolen, creditors were hounding him for hundreds of dollars of charges.

Having your identity stolen costs an average of $40 and 10 hours defending your name and cleaning up the mess. It happens to about 0.8% of the U.S. population each year. Even if your time is worth $100 an hour, the average loss to you is only about $8 annually. So clearly it's not the monetary cost that bothers people. What's really worrisome is the potential vulnerability and personal violation they feel. Fortunately, there is a simple and easy way to acquire a full credit lockdown so no one can initiate changes to your credit without your permission.

Your credit information is stored at three main credit bureaus: Experian, Trans Union and Equifax. At the end of 2003, Congress passed legislation that requires these bureaus to allow you to put a fraud alert on their credit reports. The alert only lasts 90 days, but during that time lenders have to verify your identity before they can issue a credit card in your name.

Since then, several companies have used this law to offer a renewal of the fraud alert every 90 days on your behalf. <a href="http://www.lifelock.com/" target=_blank>LifeLock</a> is the best known among these services. The company went so far as publishing its CEO's Social Security number and daring people to try and steal his identity.

LifeLock's one-stop service initiates a fraud alert with all three bureaus and renews and monitors your credit status for $10 a month. As a result, you receive less junk mail and sleep better at night. They will pay up to $1 million in losses due to stolen credit.

This service angered the credit bureaus. They make most of their money by selling credit information about you to lenders. If the lenders actually have to verify the information, it becomes too expensive for them to act on. The data for LifeLock customers wasn't worth the cost required to verify it, damaging the bottom line for the credit bureaus.

In retaliation, the credit bureaus accused LifeLock of deceptive marketing practices. Experian sued in California court claiming that the 2003 law only permits individuals to put an alert on their credit. They claimed that LifeLock posed as individuals and put alerts on an account even when no suspicion of identity theft existed, costing Experian millions of dollars to process the requests.

In a decision last month, a California judge found LifeLock's practice illegal. Only family members, guardians or an attorney can make the request on behalf of an individual. Fraud alerts ought to be standard and permanent for everyone.

The decision is surprising, and the case seems disingenuous for the credit bureaus. They have turned free credit report legislation into a multimillion-dollar industry through their own deception and fear mongering.

Although LifeLock's service was convenient, you can still duplicate their services by placing a credit security freeze on your own credit record. A credit freeze does everything a fraud alert does and more. First, it is permanent, not just for 90 days. Second, it prevents lenders from seeing your credit report unless you specifically grant them access. This strategy prevents identity thieves from getting new credit in your name even if they have every bit of your personal information.

If you do apply for additional credit, you will have to remove the freeze temporarily or give the specific party who wants to access your information your personal identification number (PIN).

If you plan on applying for additional credit cards or getting a new cell phone provider or cable package, a credit freeze may not be advisable. And those promotions linked to new credit card applications will no longer flood your mailbox. But these deals are never a way to build real wealth. Get the few credit cards you need, and don't let any promotional offers suck you in.

For Virginia residents to initiate a security freeze, each credit bureau charges a onetime $10 fee. If you have already been the victim of identity theft, the charge is waived. However, some states do not permit credit agencies to charge its customers for placing a security freeze. We recommend a credit freeze for anyone who has already established the credit they need. A freeze both reduces the frenzied marketing of additional credit opportunities and the potential harm of compromised personal information.

After a few minutes of effort and $30 in payments, your credit should be locked for life. Here is how to accomplish securing your credit at each bureau:

-At Experian (888-397-3742), go to <a href="http://www.experian.com/consumer/security_freeze.html" target=_blank>http://www.experian.com/consumer/security_freeze.html</a>.

-At Trans Union (888-909-8872), go to <a href="https://annualcreditreport.transunion.com/fa/securityFreeze/landing" target=_blank>https://annualcreditreport.transunion.com/fa/securityFreeze/landing</a> to start the process.

-At Equifax (1-888-766-0008), you can put a lock on your credit by visiting <a href="https://www.freeze.equifax.com" target=_blank>https://www.freeze.equifax.com</a>.

The process is not standardized across the three credit bureaus. Each uses a different methodology. But with a little effort, your credit will be safe and secure.

Each bureau will give you a PIN. They are likely to be all different. Don't lose these. Trying to get a security freeze lifted when you have forgotten the PIN necessary to change your credit security is a catch-22 you don't want to experience.

 

from http://www.emarotta.com/article.php?ID=345

Last-Minute Tax Savings for College Expenses (2009-07-06)

by David John Marotta and Matthew Illian

My youngest will be a first-year student at the University of Virginia this fall. My coauthor Matthew's oldest child is almost two years old. So he is just beginning to think about college funding and I'm about to start withdrawing from my final 529 plan.

With a well-designed 529 college savings plan, you can fund a college education at a deep discount. But even if you haven't saved much for college beforehand, simply passing college expenses through a 529 plan can save you $200 to $2,000.

A 529 college savings plan offers three types of tax savings. Virginia residents receive a state tax deduction in 2009 on contributions up to $4,000 per account. Students are permitted to attend a college out of state. If you don't live in Virginia, you can research your own state’s tax benefits. In every state you receive both federal and state tax-deferred growth and tax-free distribution when you are ready to use the money. These latter two tax benefits are the most significant. But you must invest early.

The Virginia state tax deduction, in contrast, is available merely for putting money into a 529 plan. You are allowed to make a withdrawal immediately to pay for college expenses. This worthwhile tax deduction can help trim expenses. Consider it Virginia's way of promoting higher education.

Make sure you understand what counts as an educational expense before you begin this process. The withdrawal must be for tuition, fees, books, supplies and equipment required for enrollment or attendance at an eligible educational institution. In a recent change, a personal computer now also qualifies.

If you are paying tuition and fees, have a check sent directly from your 529 account to the college. This direct deposit will simplify bookkeeping and make filing your taxes easy. If your fees are spent elsewhere, keep receipts of all the qualifying expenses.

Consider Paul and Ali Hewson, whose oldest child Jordan will begin college in the fall. The Hewsons haven't saved much, but Paul's career is really taking off. So they now have the money to pay for Jordan's college expenses. As Virginia residents, they are entitled to a $4,000 state tax deduction if they put at least this amount into one of the state's approved 529 plans. At the 5.75% state tax rate, they will net a $230 savings for 2009 after they file taxes in 2010.

Jordan has decided to bypass Virginia's fine in-state institutions and attend a more expensive private college. Consequently, the Paul and Ali now have $40,000 of upcoming qualified educational expenses they can pass through a 529 plan to build a decade worth of carry-forward state deductions. Virginia 529 plans allow for an unlimited carry-forward deduction until the amount of contributions has been deducted. Assuming the tax laws and rates remain the same, the Hewsons will take a $4,000 deduction each year for the next decade. They will accrue a total savings of $2,300 savings over this 10-year period.

Paul and Ali can use any of the three different 529 plans in Virginia to accomplish this savings. We estimate it should take no more than an hour to set up the accounts and an hour to make the disbursements.

The <a href="https://www.americanfunds.com/college/college-america/" target=_blank>CollegeAmerica</a> program, the state-sponsored plan run by American Funds, must be accessed through a financial advisor. Unless you have a relationship with a fee-only advisor, you will pay a hefty commission to use this plan. If you can access the American Funds without paying a commission, invest your pass-through money in the Money Market Fund, the most liquid and stable investment in the plan. This fund requires a $1,000 minimum deposit for the initial setup. With the American Funds, expect to pay a $10 account setup fee and a $10 annual maintenance fee that kicks in if you hold the account through the end of the year.

Investors can access the state-run Virginia Education Savings Trust (VEST) program directly at <a href="www.va529.com" target=_blank>www.va529.com</a> to begin online enrollment. The plan charges a $25 annual fee in November and no other setup costs. It also has a money market fund available as part of its nonevolving portfolio investment options. Both the VEST and CollegeAmerica programs have received the highest scores from a recent Wall Street Journal report and other rating groups.

Virginia also has a program administered by the Union Bank & Trust called <a href="http://www.virginia529.com/SavOptCollegeWealth.asp" target=_blank>CollegeWealth</a>. You can open a money market account at a Union Bank branch to receive the state tax deduction. If you are comfortable completing this task online, you may find working with a local bank difficult only because you must go there to complete all your paperwork.

Better than waiting until the last moment to start funding a 529 plan, consider investing now. With a depressed stock market, your funds can expect a healthy return for the next several years until your child is ready for college. If you have grandchildren you can get the same tax deductions by opening accounts for them. If you do not have a lump sum available to invest, start a monthly contribution from your paycheck directly into a college savings account. Although you may have to wait until your children bless you with grandchildren, they will ultimately thank you for it.

 

from http://www.emarotta.com/article.php?ID=344

Safeguard 8: Avoid an Advisor with a Lavish Lifestyle (2009-06-29)

by David John Marotta

There will always be swindlers masquerading as investment advisors. You can learn to recognize such people by their over-the-top lifestyle. Avoid them at all costs.

The differences between the manager of a Ponzi scheme and a model citizen are almost imperceptible, which is not surprising. Those who would perpetrate a Ponzi scheme are usually not the demons everyone makes them out to be. And they are obsessed with appearing successful.

This fixation on appearances, however, is the red flag. If you are the millionaire next door, you know that frugality is one of the marks of an effective financial advisor.

But you may have to train your eye to recognize an immoderate lifestyle. If someone in business is worth $300 an hour, some apparent extravagances may in reality be productivity gains.

For example, if you hire a chauffeur to drive you to and from work each day so you can be productive, society gains. If you hire a gardener so you can continue contributing in your area of expertise, society gains. And if you hire a butler or a chef, so long as you employ someone else for less than $300 an hour, society gains.

Productivity gains are not synonymous with a lavish lifestyle, and with some careful observation you can learn to discern the difference. Productivity gains are all about function, and if you discover them you will find out accidentally. In contrast, the whole purpose of an extravagant lifestyle is to be noticed.

Consider Bernie Madoff. He and his wife lived in a $7M penthouse apartment in New York City and a house worth $3 million in the Hamptons. They also owned a $9.3 million Palm Beach mansion. Plus they maintained a $1M million chalet and two boats on the French Riviera.

They spent an average of $100,000 monthly on the corporate credit card on chartered jets, limousines, top hotels, fine wines, world travel and shopping. When they drove themselves, they rode in style in a BMW and or one of two Mercedes. Madoff bought a vintage Aston-Martin for his brother as a company car. The couple owned a Steinway concert grand piano worth $39,000. Madoff purchased tickets at the Mets Citi Field at $40,000 a season.

Madoff was also a prominent philanthropist, but his interests were anything but altruistic. He started the Madoff Family Foundation and gave to charities, which in turn invited him to serve on their boards. Madoff then invited them to invest their endowments.

He and his wife also gave more than $200,000 to the Democratic Party. He gained high-level connections to those in Congress who write the laws and are supposed to provide regulatory oversight. Madoff was one of the first to exploit kickbacks for brokerage order flows. He argued they should remain legal and not alter the price that customers received. His connections prevailed.

The Madoffs themselves owned $62 million in securities and $45 million in municipal bonds. They loaned their sons $22 million and $9 million, respectively. Oddly enough, having siphoned billions, the couple only has a net worth of about $823 million.

Wealth is what you save, not what you spend. That's why an ostentatious and excessive lifestyle is a red flag for an investment advisor. The middle class buys liabilities like boats and cars. The rich buy investments. If Bernie Madoff had bought businesses and investments, he would be able to make restitution of those initial investments. He might even be able to pay a fraction of the gains he claimed to have.

We all wonder what happened to the $65 billion. Much of it was phantom gains, and a lot of it was simply spent a million here and a million there. Excessive spending is a warning sign that your advisor doesn't understand wealth building personally.

In April this year, the Securities and Exchange Commission (SEC) charged Shawn Merriman of Aurora, Colorado, of collecting $20 million in a Ponzi scheme "to support his lavish lifestyle." He lied to investors, reporting "impressive and consistent annual returns" as high as 20%.

Merriman was known for showcasing his high-end art collection. U.S. marshals seized hundreds of works of art including some by Rembrandt and Picasso from his sprawling three-story home. Also seized were a silver Aston Martin, 1932 and 1936 Auburns and a 1932 Ford Highboy.

This spring the SEC also filed charges against Pennsylvania advisor Tony Young for allegedly stealing $23 million from investors to "support a lavish lifestyle for his family, including payments for expenses related to horse ownership and racing, construction, boats, limousines, chartered aircraft and other luxuries." That lifestyle included an opulent vacation home in Palm Beach, Florida, near the Madoffs' vacation home. Young also lied to accountants who prepared statements and claimed his losses in 2008 were only 5.8%.

Ponzi schemes are often discovered after market downturns when investors make the mistake of fleeing to safety. They want to take their stellar returns and put the money someplace safe while the storm blows over, only to find that no money is really there.

Additionally, the news cycle runs in themes. After the Madoff scandal, every Ponzi scheme became national news. The theme, played over and over, is that all financial services, from Fannie Mae to AIG, are rife with corruption and mismanagement and need more government regulation.

But more control won't protect you from dishonesty. More law can't protect you from an unethical person. Fannie Mae and Freddie Mac had direct congressional oversight. Madoff was good friends with the regulators. Regulation is more likely to be used politically than responsibly.

Your best defense is to engage an advisor whose daily practices reflect ways to safeguard the money under his or her fiduciary care. As part of identifying such an advisor, make sure there is a mutual understanding that an ostentatious lifestyle is not a valid financial goal.



from http://www.emarotta.com/article.php?ID=343

Safeguard 7: Avoid Investment Advisors Who Sugarcoat Reality (2009-06-22)

by David John Marotta

We've already discussed the many ways you can safeguard your money. But these methods cannot protect you from an unscrupulous advisor. My brother, who is a lawyer, has a saying we must all take to heart: "You can't do a good deal with a bad person."

Morality can be described as a continuum from pure altruism to unadulterated self-centeredness. All advisors have their shortcomings, of course. But excellent advisors work hard to cultivate certain traits, and among them honesty is paramount. This quality in an advisor includes communicating clearly and straightforwardly exactly how bad the markets have been and can be.

Advisors naturally want to look good, and you must overcome your own desire to have a good-looking advisor. You need the truth. You can handle the truth, and without it, you certainly can't make realistic financial plans.

The markets are profitable. The markets are volatile. You can't pick just one. Even in our recent financial meltdown, I believe the wisdom of rebalancing back into fallen markets will be vindicated. But you still need to know the facts.

There are certain red flags to watch for with advisors, ways they may try to circumvent the tough honesty you need. I include both what conscientious advisors should do for their clients, as well as how financial salespeople hide their mistakes.

Ask your advisor to provide a return for your entire portfolio, not just the underlying investments. Reporting how each investment did doesn't show how you did. Your advisor can buy an investment at the very end of the quarter and then report it did well during the entire quarter. Or your advisor can sell investments that are not doing well toward the end of the quarter. These changes do nothing for you, but they help an advisor who doesn't report a return on your entire portfolio look successful.

Also, advisors should give you an accounting of your return net of all fees and expenses. Any fund expenses, fees, commissions or trading costs diminish the bottom line of the return. Only by receiving information at the portfolio level can you measure the net effect of every expense you were charged.

Always insist on a time-weighted return (TWR). Returns can also be dollar weighted, sometimes called an internal rate of return (IRR). Often the IRR looks better. It is possible for the TWR to be negative and the IRR to be positive.

A TWR removes the effects of cash flows, which allows you to judge how your advisor's underlying investment strategy performed. If your advisor reports both, that's fine. But he or she should include the TWR as well, which is considered the industry standard and allows you to compare apples with apples between two different strategies.

Returns should be reported consistently over standard and preestablished time periods. In addition to the quarter that just ended, our firm reports year-to-date, the past 18 months, and the returns gained since we began to track the portfolio. We chose 18 months because it is the shortest time period that is still long enough to discern significant market trends.

One year isn't long enough to eliminate market noise. We've considered adding three- and five-year returns, but whenever an advisor changes the time periods reported, it is cause for concern.

The bottom of the last market occurred in October 2002, so three-year returns started looking good in the fall of 2005 and five-year returns in the fall of 2007. The recent market downturn provides an opportunity to report these longer time periods without arousing suspicion that these intervals are being changed simply for window dressing.

Getting an accurate accounting of your portfolio's return shouldn't be optional. If your advisor can't supply it, perhaps it means they don't know themselves or don't consider it important to their recommendations. Unfortunately, many so-called advisors in the financial services world would prefer to focus instead on how their own fees and schedule of commissions are doing.

Even if you safeguarded your money in the many ways we have suggested, you should also insist on only entrusting your money to an advisor who regularly reports what total TWR, net of all fees and expenses, your investments have made for the quarter and for longer periods of time.

 

from http://www.emarotta.com/article.php?ID=342

Investment Strategies Part 4: Don't Rebalance at the Sector Level (2009-06-15)

by David John Marotta

Rebalancing between asset classes boosts returns and decreases volatility. But setting your asset classes based on sectors of the economy is not an effective strategy.

You can rebalance your investment allocation at three levels: stocks and bonds, between asset classes and among subclasses. At the highest level, rebalancing between stocks and bonds reduces risk. Selling some of your stocks after the market has appreciated limits your portfolio’s volatility and locks in some of your gains.

Correlation between investment categories helps define asset classes and sort out which are merely subclasses. The lower the correlation, the greater the bonus you can gain by rebalancing regularly. Rebalancing between U.S. stocks, foreign stocks and natural resource stocks offers a significant bonus because these asset classes have the lowest correlation.

Smaller bonuses are available within each asset class for categories with a higher correlation. But the law of diminishing returns comes into play as the number of categories continues to double and the correlation between divided subcategories approaches 1 (one).

Some investors try to allocate and rebalance between sectors of the economy. For example, Dow Jones divides the economy into these 10 sectors: Financials, Consumer Services, Telecom, Industrials, Basic Materials, Consumer Goods, Utilities, Oil and Gas, Technology and Health Care.

I don't recommend rebalancing at this level. You cannot know what percentage to allocate to each category. Putting 10% in each sector doesn't make sense because the division is arbitrary. Dow Jones puts Oil and Gas together in one sector. If they had divided it into two sectors, it would not have justified twice the investments. Dow Jones divides the index one way, and the S&P 500 indexes another.

Additionally, some of these sectors represent a greater percentage of the economy. If you set your target percentages now, the economy will change and your targets will be out of date. Technology has grown significantly as a percentage of our economy. Investors who continually moved out of technology missed much of the best returns during the 1990s.

Ten sectors taken two at a time produces 47 different pairings, each with its own correlation and rebalancing bonus or penalty. I computed those statistics using annual returns from 1992 through 2008. Some pairings have a bonus, and some have a penalty. I don't recommend rebalancing at the sector level, but an analysis of which sectors offer a bonus and which cost a penalty can suggest some investment strategies.

Some have a high correlation and have little or no bonus, such as Consumer Goods and Financials. Consumer Services, Telecom and Technology are also all highly correlated.

Basic Materials and Oil and Gas are subcategories of the natural resources asset class and therefore highly correlated. Oddly enough, they have one of the largest rebalancing bonuses partly because they represent different natural resources that are subclasses of the natural resources asset class. This is also true because Oil has had its bubbles.

Categories with a higher average bonus for rebalancing include Financials, Telecom, Technology and Oil and Gas. These are all sectors that have expanded and then corrected sharply.

Rebalancing out of bubbles is always warranted and valuable. But of course recognizing them is challenging. The bonus for rebalancing out of technology is the smallest of these because the growth in technology was mostly a shift in the economy and only a bubble at the very end of that trend. Shifting out of technology early would have killed returns. Timing the shift perfectly would have been difficult.

Rebalancing in this case is a poorer version of tilting toward value. A better bonus would be gained simply by emphasizing those stocks with a low price-to-earnings (P/E) ratio. When stocks in a sector bubble, they often experience high P/E ratios because they represent a greater percentage of the S&P 500.

The markets are smarter than the experts. It is by definition that they know what market cap a given industry deserves. It may bubble in its growth getting there, but you only know the bubble is over after it bubbles.

Four sectors offer a large rebalancing penalty with each other. They are Industrials, Basic Materials, Consumer Goods and Services.

Sectors of the economy wax and wane with the business cycle. As a result, when stocks in one sector of the economy are performing poorly, they may continue that way for some time. This form of rebalancing will result in lower returns than if you just let the market cycle adjust your portfolio.

Business cycles vary in length. As a result, annual rebalancing will incur a large penalty when you move out of a sector that did well last year into a sector that will do poorly next year. The penalty appears to be the worst for sectors that peak and valley at similar times during the business cycle, such as Industrials and Basic Materials or Consumer Goods and Services.

In this case, intelligent rebalancing, which takes the business cycle into account and rotates which sectors you are emphasizing, would at least try to capture the bonus and avoid the penalty. Knowing where you are on the business cycle, however, is just as demanding as predicting which industry will have the highest return.

Utilities are the least highly correlated to other sectors. They are a defensive sector and often do better than other sectors when the market is dropping. A sector rotation strategy suggests overemphasizing utilities and underemphasizing stocks when P/E ratios are high.

Sectors of the economy grow or dwindle based on global macroeconomic trends. Over time, companies responding to market conditions increase the capitalization of those goods and services that society demands and decrease those that are phasing out of the economy.

In the beginning we were an agrarian society. Then the industrial revolution began in America and Great Britain. Now we have more of a service-based economy. Perhaps genetics will bring about a health-care boom in the near future.

The lifetime of my grandparents spanned the Wright Brothers to landing on the moon. Your grandchildren may choose a college major that hasn't even been invented yet.

Setting percentages of your portfolio at a level of the sector of the economy doesn't make sense. If you set those percentages today, based on current levels in the S&P 500, our economy may never again match those percentages. There is no reversion to the mean for sectors of the economy.

Setting investment percentages also doesn't allow you to make strategic investments in sectors that you expect to grow and outperform over the next three to five years.

Rebalancing at the capitalization level (large cap and small cap) makes sense because large- and small-cap companies will always exist. Small companies have a higher expected rate of return because it is easier to double the size of a small company than a large company.

Similarly, it makes sense to rebalance using investment style (value and growth) criteria because these are universal descriptions of stock types and not specific to industry. A company can move between value and growth based on its price. Overweighting value companies outperforms growth stocks because of the risk of a growth company faltering in its expansion and causing a serious price correction. Limiting your investment in such stocks slightly smooths and boosts your returns.

Although the markets as a whole often revert to profitability and growth, this isn't true of individual stocks or industries. Most of the dot-com stocks that bubbled at the beginning of 2000 will never regain their former glory. Buggy whip manufacturers are no longer ubiquitous.

A better strategy is to look for three- to five-year trends in the economy and simply overweight those that have the best chance of continuing to grow in importance. Such trends last long enough for investors to take advantage, assuming they are looking forward to what may do well and not backward to what has been recently bubbling. Two such industries I would expect to do well going forward are health care and technology.

The most critical expertise that an investment manager can provide is a good investment philosophy. Investment analytics give you the best chance of matching your specific financial goals with the diversified investment mix that is optimum to meet those goals.



from http://www.emarotta.com/article.php?ID=341

Investment Strategies Part 3: Rebalance Regularly Between Asset Classes and Subcategories (2009-06-08)

by David John Marotta

The investment metric correlation helps you continually take your gains off the table for safe spending. And it helps you determine what constitutes an asset class and which subcategories to consider for further diversification. Once these categories are defined, correlation can also reveal how much of a bonus to expect from your returns when you rebalance between two categories.

In his 1996 article "<a href="http://www.efficientfrontier.com/ef/996/rebal.htm" target=_blank>The Rebalancing Bonus</a>," William J. Bernstein presented a brilliant formula to approximate the extra return you can expect by rebalancing your portfolio regularly. We rarely focus on a formula in this column. But there is deep wisdom here, both for portfolio construction and for determining which categories are worth regular rebalancing. Here is the formula:

B_1,2 = P₁P₂{σ₁σ₂(1 - c) + (σ₁ - σ₂)² / 2}

Where B is the bonus, P is the percentage allocation, sigma (σ) is the standard deviation (SD) and c is the correlation between the two assets.

The implications of the formula are useful, even for average investors. We can learn six valuable lessons from Bernstein's model.

First, notice the approximate size of the rebalancing bonus. A 50-50 allocation between two investments with a 0.5 correlation where each investment has an SD of 20% might be typical for equity investments. Such a mix has a rebalancing bonus of 0.5%. We will use the formula to demonstrate ways to boost this bonus. Even a half percentage point is noteworthy.

Investment professionals divide an extra 1% into hundredths of a percent, called "basis points." Earning an extra 50 basis points is huge. Investment advisors bend over backward for an extra 10. So rebalancing pays.

Second, the rebalancing bonus is the sum of all possible rebalancing bonuses. Our example of a 50-50 allocation has a 0.5% bonus because there is only one potential allocation mix to rebalance. With three categories allocated 33-33-33, the bonus rises to 0.67%. Each of the three rebalancing opportunities contributes 0.22%. Four categories split 25-25-25-25 provide a 0.75% bonus by giving six smaller rebalancing opportunities. Five categories of 20% each give 10 separate pairs of rebalancing for a 0.80% bonus.

Investors are taught to minimize the number of investments and investment categories. Although there is a gradual law of diminishing returns, diversification provides investment gains any time the investment itself is worthwhile and the correlations are low. With computer support for the analysis and rebalancing, investors can handle a large number of categories and holdings.

Third, note that the rebalancing bonus is proportional to the product of the percentage allocated to each holding. With a 50-50 allocation, the product is at its maximum at 0.25. A 60-40 allocation is nearly as high at 0.24. With a 70-30 allocation, the product drops to 0.21. And 80-20 drops all the way to 0.16.

The bonus is at its maximum when roughly equal allocations are made to each asset category. The smallest allocation should be at least half the size of the larger allocations. Our example, with four equal holdings of 25-25-25-25, resulted in a 0.75% bonus. An allocation of 30-20-30-20 is still high with a 0.74% bonus. But a 40-10-40-10 allocation drops the bonus to 0.66%. And an allocation of 85-05-05-05 drops the bonus way down to 0.27%.

Thus when an option is investment worthy, it merits a significant allocation. A good rule of thumb is to only skew an investment choice as much as two thirds to one third. Always invest at least a third into the smaller allocation.

The remaining lessons come from the terms inside the curly brackets of the formula. The allocation product is multiplied by the sum of these two terms. Maximizing their sum augments the bonus gained from rebalancing. Either of these two terms might be zero under certain circumstances. Each term has lessons to teach the savvy investor.

The first term depends on the correlation between the two investments. That is, the lower the correlation, the higher the bonus. A correlation of 1 has no bonus. Our example had a correlation of 0.5 and a bonus of 0.5%. If the correlation drops to zero, the bonus doubles from 0.5% to a full percentage point. At negative 0.5, the bonus becomes a full percentage point and a half.

So lesson 4 teaches us that the lower the correlation between two investments, the greater the importance of rebalancing. Rebalancing at the asset class where correlation is the lowest is more consequential than rebalancing between suballocations with a higher correlation.

Fifth, we learn that the higher the volatility of the investments, the greater the bonus in actually rebalancing. In our original example, both investments had a SD of 20%. The higher each SD, the higher the rebalancing bonus. By raising the SD of both investments from 20% to 30%, the rebalancing bonus increases from 0.5% to 1.13%. At 40%, the bonus is 2%. At 50%, the bonus is 3.13%.

Emerging market investments are extremely volatile. When they appreciate, an excellent strategy is to trim the position and take some profits off the table. When it drops precipitously, it is equally critical to reallocate and invest some more. Volatility equals opportunity if you rebalance regularly.

The last term is the difference between the SDs. It was zero in our example because the SDs were both 20%. To consider the contribution to this term, take the case where one of our investments has a 20% SD. But the other investment is as secure as possible and has a SD of zero. The first term becomes zero, but the second term makes up the difference.

With half invested in stable investments, the rebalancing bonus when the other half has a SD of 20% again is 0.5%. As the equity investment becomes more volatile, the bonus increases. At 30% SD, the bonus is again 1.13%. At 40%, the bonus is 2%. And at 50%, it is 3.13%.

Thus the greater the difference between the SD of two investments, the greater the bonus from rebalancing. Moving money from bonds back into stocks after a market correction yields substantial gains. A recent study from Fidelity shows exactly that: "Millionaires who used past recessions as buying opportunities now boast an average of $1 million more in investable asset than millionaires who shifted into more conservative investments."

Finally, we must learn to recognize when rebalancing provides a good chance of boosting returns and when it is unimportant. Rebalancing between two categories of U.S. stocks with a 0.85 correlation only gains a 0.15% bonus. In contrast, rebalancing between fixed income and emerging markets gains nearly 1.5%.

I asked formula creator William Bernstein how he might caution investors. He answered, "Rebalancing works best with high-volatility, low-correlation assets with similar long-term returns. Although this usually boosts the return of the equity part of the portfolio, if the returns are different enough, as occurred with Japanese equity over the past two decades, it can actually reduce return. This is not a free lunch."

The markets are inherently volatile. Rebalancing works best for categories that qualify as asset classes or subclasses. Next week we explore which investment categories do not warrant rebalancing because you are more likely to reduce returns than boost them.

Rebalancing is always a contrarian move, selling what has done well and buying what has done poorly. Many investors don't have the discipline to take that step when it is appropriate. But regularly rebalancing your portfolio offers expected returns about a percentage point better than buy and hold. Rebalance your portfolio regularly, and take advantage of this bonus.



from http://www.emarotta.com/article.php?ID=340

Investment Strategies Part 2: Use Correlation to Define Asset Classes (2009-06-01)

by David John Marotta

To boost returns and protect your investments, you can use the investment metric called correlation. It will rebalance your portfolio at three levels of investment allocation: stocks and bonds, asset classes and sectors of the economy. The dominant categories of stability and appreciation are the most basic way to view your portfolio. By continually trimming your stocks while the market appreciates, you can replenish the money that we hope you are setting aside regularly for safe spending.

Over a long enough time, an allocation to lower performing investments such as bonds generally results in a lower expected return. Thus asset allocation at this level helps control risk. It also provides enough allocation to stable investments to cover a period of safe withdrawal rates of five to seven years, so the appreciating assets have time to recover after a market correction.

Below the broadest categories of lower risk bonds and higher returning stocks are candidates for asset classes. Asset classes are used to set the percentage of your investments that you will put in each category. Each investment advisors may define their asset classes differently. But studies have shown that diversifying among categories with the lowest correlation produces the most return for the least risk. Therefore these categories represent the optimum candidates. As the correlation rises, assets are more apt to be classified as merely sectors or subsectors of the investment world, rather than asset classes.

Six-month correlations fluctuate over time. Many of the correlations between investments were near their lows in mid-2007. Throughout this article I cite correlations at these lows usually against the S&P 500. Recently, six-month correlations have been relatively high. A demand for dollars has caused all categories to move down in sync with one another.

The Natural Resources Index at 0.38 has one of the lowest correlations to the S&P 500. This index does not represent commodities but rather the companies that produce or provide them. For example, the index tracks oil and mining companies, not the price of oil or minerals.

Examples of these natural resources include oil, natural gas, precious metals (particularly gold and silver), and base metals such as copper and nickel. It also covers other resources like diamonds, coal, lumber and even water. Real estate is also included because land serves as the underlying hard asset. Having such a low correlation clearly shows these companies deserve their own asset class.

Many advisors don't have an asset class for natural resource stocks. Instead they select one portion of the category, typically real estate, and make that the asset class. This can also be a good idea. Real estate indexes have correlations as low as 0.49 against the S&P 500. We use real estate as a subclass within the natural resources category because at times it has a low correlation with energy and other commodity movements.

Not only do natural resource stocks have a low correlation to other U.S. stocks. They have an even lower correlation to U.S. bonds. Natural resources (commodities) often exhibit a negative correlation to fixed-income investments due to their inverse relationship to inflation. So their optimum allocation depends on both the amount you designate to stocks and the amount you designate to bonds.

The second best candidate for an asset class is foreign stocks. The correlation of the EAFE Foreign Index is 0.57. It hasn't always been that low. The correlation between U.S. stocks and foreign stocks fluctuates over time between 0.4 and 0.9. When the correlation is high, many advisors argue that no benefit will accrue from investing in foreign stocks. When the correlation is low, it is often because foreign stocks are doing better.

At the end of April 2009, for example, the EAFE index hadn't lost anything over the past 10 years. Compare that with the S&P 500's negative 2.48% annual return resulting in a 22.2% loss for a decade's worth of investing. At times little diversification may be realized by investing in foreign equities. But the benefits happen consistently enough for our firm to consider foreign stocks its own asset class.

Some people try to diversify internationally by investing in U.S. companies that gain a significant portion of their revenue from sales abroad. But studies have found that these multinational companies still track fairly closely with other domestic companies. And they don't offer the same benefits as investing in foreign stocks.

We use country selection and emerging markets as our subclass allocation. At 0.50, the Emerging Markets Index correlation to the S&P 500 is even lower than the EAFE. It has also has had some of the best returns, recently averaging 8.24% and totaling 120.7% over the past 10 years.

And these stellar returns include having lost 42.90% over the last year! Sometimes you have to make a large profit to still have decent returns after a market correction.

Because correlations fluctuate, defining what constitutes an asset class and what constitutes a subclass is subjective. It is always open to review and reevaluation. Generally, a correlation that can drop below 0.6 with other asset classes is a good candidate to become its own asset class. The correlation of around 0.85 between emerging markets and other foreign stocks suggests it should simply be a subclass of foreign stocks.

Within the asset class of U.S. stocks are also several subclasses that provide opportunities for diversification. The Russell 2000 small-cap index, for example, has a correlation of 0.75 against the S&P 500.

Using correlation to define our top-level asset categories, therefore, we use three asset classes for stability (short money, U.S. bonds and foreign bonds) and three for appreciation (U.S. stocks, foreign stocks and natural resource stocks). Then within each asset class, we suballocate for additional diversification.

Most investors and even many advisors use investment categories entirely contained within U.S. stocks and bonds. A low correlation investment strategy, in contrast, would suggest broadening your horizons to obtain the lower volatility offered with a broader definition of asset classes.



from http://www.emarotta.com/article.php?ID=339

Investment Strategies Part 1: Rebalance into Stable Investments in an Appreciating Market (2009-05-25)

by David John Marotta

Diversifying your portfolio means finding assets that have value on their own merits but do not move exactly alike. A critical investment metric called "correlation" is used to construct a portfolio most likely to meet your personal financial goals.

Correlation measures how much two different investments move together, measured on a scale of positive one (+1) to negative one (-1). A perfect correlation (1.00) would mean that both investments always move in the same direction with the same magnitude. A perfect inverse correlation (-1.00) would mean that two assets always move in opposite directions.

Correlation comes into play at three levels of investment allocation: stocks and bonds, asset classes and sectors of the economy. At each level it can provide you with a better chance of boosting your returns and protecting your investments. But the way correlation is used is different at each level. In this column we will cover its use at the highest level.

The most basic allocation in your portfolio is between investments that offer a greater chance of appreciation (stocks) and those that provide greater portfolio stability (bonds). These two categories have the largest negative correlation. Thus decisions made at this level are the most important in determining how well behaved your portfolio returns will be.

Not only do these two categories have the largest negative correlation, but they also have very different expected average returns. Stable investments like bonds have an average return of about 3% over inflation. Appreciating assets like stocks have an average return of approximately 6.5% over inflation.

If your portfolio is 100% in stocks, it will have the greatest long-term appreciation, but it will also be the most volatile. Consequently, it may not give you the best chance of meeting your goals. For example, a long-term average return around 10% from U.S. stocks certainly sounds appealing. But they also have a 19% standard deviation. So about six or seven times a century, you will experience a decade of flat or negative returns.

These awful returns happen even more frequently than a Gaussian function (or bell curve) would predict because stock market returns are not well-behaved Gaussian statistics. They behave more like fractal power laws, which in lay terms means the curve has lumpy tails far from the average.

We all know, at least experientially, what a lumpy tail looks and feels like because we just lived through one in 2008. According to Gaussian statistics, you should not experience such terrible years in the U.S. stock market as frequently as you do. Sometimes such events are called "black swans," or outliers. Sometimes we just say that the markets are inherently volatile.

This wild volatility may threaten the fulfillment of your financial goals. Aiming for a 10% return with wild volatility doesn't make sense if you only need a 7% return to guarantee meeting your financial goals. So sometimes slightly lowering your expected return can vastly lower your expected volatility. As a result, you increase the odds of exceeding the modest return you need to meet your goals.

Because of the difference in returns between stocks and bonds, they won't rebalance themselves over time. Left to itself, the allocation to stocks will grow larger and larger until it represents close to 100% of your investments. As this happens your portfolio will also grow more and more volatile and your goals more susceptible to market corrections.

Due to the difference in expected returns and the need to handle withdrawals during retirement, we consider the categories of stability and appreciation to be larger than asset classes. Correlation at this level will not boost returns because stocks normally outperform bonds. But it will definitely protect your investment. Consistent rebalancing by selling stocks and buying bonds helps protect your net worth and consequently your lifestyle. The reverse, selling bonds and buying stocks, is not as necessary and only appropriate for younger investors who are still adding to their portfolio.

Older investors should have at least five to seven years of their safe spending rate allocated to stability. For them, replenishing the allocation to stability during times when stocks are appreciating helps secure future years of spending.

Only younger investors who are still a number of years away from retirement or who have more stability than they need to support their lifestyle can afford to rebalance from stability back into stocks after a market correction. Doing this can help boost returns somewhat, but it has risks if the markets continue to decline. Therefore never shift more than you can put at risk back into uncertain appreciating assets.

All investors should set a limit to their losses and allocate that limit to stability. That limit generally should be five to seven years of safe spending, but it could be eight to 10 years for very conservative investors. If an investor is frugal enough, he or she can afford to be 10 years in stability. Forgoing the chance of appreciating won't endanger a sufficiently frugal lifestyle.

Using the negative correlation between stocks and bonds properly means trimming stock market gains regularly to keep portfolio risk and volatility under control. This discipline gives you the best chance of supporting your safe withdrawal rates during retirement.



from http://www.emarotta.com/article.php?ID=338

Achieving Family Harmony in Estate Planning Part 2: Make Sure Your Plan Fits Your Unique Needs (2009-05-18)

by David John Marotta

Estate planning must begin with family harmony as the goal. Thus personal dynamics are more important than avoiding probate and estate taxes. Planning begins by selecting the right trustee. Here are some additional principles to help you assure family harmony in your estate planning.

First, have an up-to-date plan. Too many people either fail to prepare an estate plan or let their plan become outdated. Changes in the law occur frequently. As Will Rogers said, "The only difference between death and taxes is that death doesn't get worse every time Congress meets."

Plus, your circumstances can change. Toward the end of your life they seem to change faster. Between ages 40 and 65, have a new estate plan drawn up every decade. In your 70s and 80s, consider revisions every 12 months.

Second, you have unique circumstances that your estate plan must address. Everyone does. As a result there are very few "simple estate plans."

For example, an attorney related to me the story of a man who wanted so-called simple estate plan drawn up for him and his wife. In the first 15 minutes, the estate planner learned the client was a citizen of the UK, his 25-year-old son had bipolar disorder and the son was actually not his biological or adoptive child, although he and the young man's mother have been married for 23 years.

In another case, a very wealthy man was seeking "a simple estate plan" for him, his wife, and his family. But he was in a second marriage, had three children from his first marriage, his new wife had four children from her first marriage and one of his daughters was in a prison for kidnapping.

You are unique. Here are some of the questions you may answer in a unique way: Do you donate regularly to charity? Or make substantial gifts to family members? Do you want those gifts to continue if you lose capacity? Do you own a business? Do you own property that should not be sold? Do you have a beneficiary who is likely to cause trouble or owes you money? Do you want to provide for the continuing care of a pet? Do you have a working farm or farm animals? Do you want to be cared for at home regardless of the cost?

Your estate plan should be carefully crafted to address your specific needs and circumstances. The more tailored your plan, the less room there is for family disagreements.

Third, be careful not to change your plan inadvertently. Suppose, for example, you have a will that provides for your estate to be distributed equally among your three children, and you have named your daughter Susan as your executor.

To make it easy for Susan to access your bank accounts in the event of a medical emergency, you have added Susan's name to all of them. What you have done without realizing it is to change your plan. Under Virginia law, those bank accounts will belong to your daughter at your death and will not be shared by your other two children. As a result, your estate might be distributed differently than you intended. It can also result in family feuds or adverse tax consequences.

Before doing any self-help planning--even something as simple as adding a child's name to a bank account--check with your legal advisor to see how it impacts your plan.

Fourth, make sure your fiduciary/executor gets adequate help. The actions of your executor, trustee or agent under a power of attorney are subject to a rigid and sometimes unforgiving legal standard. It is easy unintentionally to run afoul of those rules. If you name a child to serve in these capacities, introduce him or her to your legal adviser. Make it clear in your legal documents that your fiduciary is authorized to pay for that help from your estate.

Fifth, check that the person you choose is willing to act as your fiduciary before naming him or her in your legal documents. You may find an unwillingness or a reluctance related to some concerns that need to be addressed. For example, a child may never feel comfortable giving consent to take you off a ventilator, even knowing that was your wish.

Finally, use your discretion, but consider telling your family in advance what arrangements you have made. Explaining your plan to your family upfront gives you the opportunity to address any concerns, answer questions and clear up misunderstandings. Once you lose capacity or die, it is too late. Many family fights could have been avoided with an open and frank discussion, so everyone is best prepared to handle a loved one's loss of health or life. Eliminating surprises helps eliminate family fights.

In summary, most people who plan do pay enough attention to concerns such as probate and estate tax avoidance. But the best estate plans are drafted with family harmony as a priority.

<hr>See also:<ol><li><a href="http://www.emarotta.com/article.php?ID=335">Achieving Family Harmony in Estate Planning Part 1: Leave Your Estate in the Right Hands</a>

<li><a href="http://www.emarotta.com/article.php?ID=337">Achieving Family Harmony in Estate Planning Part 2: Make Sure Your Plan Fits Your Unique Needs</a></ol>



from http://www.emarotta.com/article.php?ID=337

American Mercantilism Descends into Fascism (2009-05-11)

by David John Marotta

Most people think the government should do something to solve perceived problems in corporate America. In my most charitable moments, I believe these sentiments are well-intentioned naiveté. In my more cynical moments, I believe fascism is on the rise in America.

Fascism is socialism hiding beneath a capitalistic facade. Whereas socialism abolishes private ownership, fascism retains the appearance of private ownership but intervenes in the free markets to bully nominal owners to act in the so-called greater national interest.

The fact that many of you will ask, "What's wrong with the government forcing individuals and businesses to act in the greater national interest?" shows the prevalence of fascist thinking in America today. Mussolini argued that in the fascist state, citizens should honor the nation over their own selfish motives. Hitler argued that the state should retain total control to ensure that property owners could not use their property against the interests of others. Currently, both these dictators would receive accolades all around. Your own first reaction may be in sympathy with these views. But consider carefully before you decide to support the evils of governmental intrusion.

Political theory is lost on most of us without a concrete example. So let's consider my experience with the government's intervention in General Motors (GM). I purchased a GM bond in 2005 scheduled to mature at the end of 2014.

Even when I bought the bond, all was not well with GM. The company's hourly labor costs in the United States were $73.73 an hour, compared with only $48 for Toyota. Both firms actually paid about $40. But at GM, union-negotiated benefits had swamped profitability.

On the positive side, Rick Wagoner, GM's chairman and CEO, was moving toward profitability. GM's foreign production was profitable and growing. Wagoner cut GM's expensive American workforce from 177,000 to about 92,000. He also globalized GM's engineering, manufacturing and design. None of these changes were popular with the UAW, of course. Unfortunately, without enough concessions from the union, GM's international profits couldn't support its domestic labor costs.

Now GM is on the brink of bankruptcy. You might think I would welcome a government bailout. But as a GM bondholder, bankruptcy is not the worst outcome. What would be worse is a restructuring that leaves bondholders with only pennies on the dollar so the government and the UAW can siphon off most of the company's value.

GM has been paying insurance to the Pension Benefit Guaranty Corporation for years. Under current law, if the company goes bankrupt the government must cover retirees. Thus the government has a great incentive to avert bankruptcy. It would save massive pension insurance costs and also pay back the UAW for its support of the Democrat Party.

The union also has a financial motive to avoid bankruptcy because otherwise retirees' benefits would be capped. They would no longer receive company-sponsored health benefits. The government and the UAW are thus motivated to collude in any deal that isn't as drastic as the restructuring under a regular bankruptcy.

But these are both losses that hundreds of bankrupt companies have unloaded on workers and federal pension insurance in equivalent situations. What is completely unprecedented is to force bondholders, who had nothing to do with owning or running the company, to pay these losses. Bondholders are private entities or individuals who loaned the company money, expecting to be compensated. And in a standard bankruptcy reorganization, they are near the head of the line to be repaid.

When the government intervenes in the free markets, overrides the normal legal process and takes a position to help some people to the detriment of others for its own political purposes, that is fascism. The government is not intervening out of a sense of altruism. No benevolence is being shown to the widow whose pension includes a GM bond. The government is not forgoing its savings in the pension insurance program to help the company. Instead, it is taking the lion's share of GM capital when legally it deserves nothing.

Just because we don't see any storefronts with broken glass doesn't mean it isn't fascism. Many average investors are seeing their investment confiscated by political intervention to benefit federal pension insurance money and political special-interest groups such as the UAW.

On March 29, President Obama forced CEO Rick Wagoner to resign. Wagoner was responsible for increasing GM's focus on highly profitable trucks and SUVs at the expense of more politically correct fuel-efficient cars.

As the primary shareholder in a corporation, the government is in no position to experiment with socially engineering that will concentrate on green vehicles, only to turn around and pass tax credit legislation for manufacturing or buying such vehicles. It's this massive corruption and conflict of interests that makes fascism so dangerous.

GM has also gained most of its profitability from overseas manufacturing and sales. But with the government running the company for the benefit of the UAW, it will never approve GM expanding offshore. Even if it makes perfect business sense, the government would never allow GM to build a big new facility anywhere outside the United States. Rather than acting in a responsible fiduciary manner toward its shareholders and making the company profitable, it will pander to the political sentiment that opposes outsourcing jobs.

Many justify government intervention by citing the 1979 bailout of Chrysler under Lee Iacocca. Of all the misguided strategies of the past, the continued failure of Chrysler should be evidence enough. Perhaps if we hadn't rescued Chrysler, some of their market share would have helped make GM more profitable.

In fact, in 1979 it was again the government that profited from the Chrysler loan guarantees by exacting $300 million from the company in stock options. Bailing out Chrysler helped destabilize GM. And bailing out GM will destabilize Ford.

Since I purchased my GM bond, the political winds certainly have changed for the worse. I feel like Captain von Trapp in the "The Sound of Music." Max warns him, "What's going to happen's going to happen. Just make sure it doesn't happen to you."

The winds are blowing cold for free enterprise. I hear the crushing march of jackbooted capitalism. If all of this seems melodramatic, so did the fuss over a few broken windows among some Jewish small business owners in 1938.

And thousands like me have still been preempted in line to get our bonds paid back.



from http://www.emarotta.com/article.php?ID=336

Achieving Family Harmony in Estate Planning Part 1: Leave Your Estate in the Right Hands (2009-05-04)

by David John Marotta

The most important product of estate planning isn't avoiding probate or reducing estate tax exposure, it's achieving family harmony. As a result, we must watch out for personal dynamics that might threaten disharmony when a person dies or becomes incapacitated.

First, think carefully when you choose your executor or trustee. Being selected to manage an estate for someone who can no longer do so because of death or incapacity is an implicit compliment. It shows you trust the person you've named to do the right thing in the right way.

But it is also a very big job. Unfortunately, it can--and often does--feel like a thankless one. And what's worse is that lack of thoughtful planning too often results in irreconcilable family feuds.

We all know that someone must settle our estate when we die. But because people live longer these days, more of us will experience a period of incompetence before our death. We must plan for the possibility that someone will become responsible for our physical and financial well-being long before a final settlement of the estate can be made.

We often choose a close family member, who probably has no knowledge of what's required of a "fiduciary," the term used to describe a person to whom property or power is entrusted for the benefit of another. Taking on a new and unfamiliar task is stressful and difficult, especially if your life is already full.

Remember that serving as a fiduciary, whether as an agent under a power of attorney, an executor under a will or a trustee under a trust agreement, is a post of honor, but it is not an honorary post.

Don't name an oldest child just because he or she was born first. Ask yourself if your oldest has the traits of a good executor or trustee. Is he organized? Is she trustworthy? Will he see a job through to completion? Is she diplomatic and fair-minded? Might he abuse the position to settle old scores and wounds that are sometimes 30 years in the making? Is she sensible? Will she know when she is over her head and needs professional help?

In short, given all your available choices, is this child the best person for the job?

People sometimes want to name more than one executor so no child will feel left out. If you're so inclined, ask yourself, "Am I putting two scorpions in the same bottle?" The administration of an estate is not intended to be a therapeutic exercise that will ameliorate 20 years of bad feelings between brothers. Now don't get me wrong. Coexecutors can be a good way to go. But ask yourself first if they are people who can work together. Will they help or hinder each other?

Second, think through how you are leaving your estate behind. Family disharmony provisions are all too common.

For example, if you are in a second marriage, it's sometimes hard to be fair both to your spouse and to the children of your first marriage. In one situation, a 50-year-old man had concerns about his father's will. His dad left virtually everything in trust for his second wife. Such a trust commonly provides limited amounts of income and principal to the spouse during the surviving spouse's lifetime. When she dies, the assets pass to his children from his first marriage.

But because the stepmother is 55 years old, Dad effectively disinherited his kids. Don't set up a plan where your children are waiting for their stepmother to die to get their inheritance. Think of creative ways to be evenhanded to your present spouse and your children when you die. And there could be problems naming either the stepmother or the children as trustee.

Another planned disaster is leaving real estate equally to all your children. In Virginia, real estate drops like a rock through probate. It's not like money you can divide up equally. If your kids can't agree unanimously on what to do with the real estate, it can be a serious problem, for the only remedy the law provides is a partition suit. To keep the peace, provide an enforceable mechanism for either one child to buy out his or her siblings or for an executor to sell the real estate and divide the net proceeds up among the children.

Here is another dilemma that requires special consideration. You might recognize the need for one of your children to have his or her inheritance left in trust because of a poor credit record, mental instability, financial instability or a bad marriage.

Suppose that child resents the arrangement, which is quite possible. Who are you going to name as trustee of that child's trust? Are you going to name a sibling as the trustee of another sibling's inheritance? How will that decision affect the sibling relationship?

And if you name a professional trustee, such as an attorney or bank, are you putting your child at the mercy of that professional trustee? What if they provide poor service after you die? Or raise their fees? All those problems go away if you give someone you trust--such as the child you were thinking about naming as trustee--the unlimited power to fire the professional trustee and appoint a new one. It's no surprise how much better professional trustees perform when they know they can be replaced at any time.

Estate planning begins with selecting the trustee who will handle it best. Probate and estate tax avoidance is easy. Selecting the best trustee is critical. Be sure you structure everything legally in a way that will create unity, not animosity. Make that decision well, and you are halfway to drafting your estate plan with family harmony in mind.

 

from http://www.emarotta.com/article.php?ID=335

Roth Segregation Accounts (2009-04-27)

by David John Marotta

The world of retirement accounts is a confusing tangle of IRS codes. The average family does not take full advantage of the tax laws. They can find financial tax planning equally bewildering.

A complex technique called "Roth segregation accounts" could earn your investments an extra 30% over the next two years, so you'll have to study this column carefully to understand how it works. But trust me. Learning about this strategy will be well worth the time.

There are two types of individual retirement accounts (IRAs): traditional and Roth. With a traditional IRA, contributions are tax deductible for middle- and lower-income families and the values grow tax deferred. But as you withdraw the money, you have to pay ordinary income tax rates on it. If your tax rate is lower in retirement when you take the money out than it was when you originally received the tax deduction, a traditional IRA account can offer great benefits.

Upper-income families don't get a tax deduction if they are an active participant in an employer plan. However they can still contribute to a traditional IRA. Money they put in that didn't qualify for the tax deduction still grows tax deferred. But when they withdraw the money their tax liability is lower. Imagine they contributed $10,000 that was tax deductible and $5,000 that was not because their income had risen above the limit. After many years their $15,000 contribution has grown to $100,000. When they withdraw the money in retirement, 5% of it is not taxed because of that $5,000 after-tax contribution.

Traditional IRAs are also subject to required minimum distributions (RMDs). Starting at age 70 1/2, owners of traditional IRAs must take a certain percentage out of the account and pay ordinary income tax. The government requires the withdrawals because it wants to start collecting tax on the money. But because account values have dropped so much lately, Congress has waived the RMD in 2009. (The government evidently wants account values to recover to maximize the taxes collected.)

With the second type of retirement account, the Roth IRA, there is no tax deduction when you deposit the money. You must pay the tax on the income first and then contribute to the Roth. And only middle- and lower-income families are permitted to contribute. The investments grow tax free rather than tax deferred. Qualified distributions from Roth IRAs are not subject to any income taxes. Roth IRA accounts are to your advantage if your tax rate is higher in retirement when you withdraw the money than it was when you contributed.

With a Roth IRA, you pay tax on the acorn. With a traditional IRA, you pay tax on the oak. Many families have actually lost money by investing in their traditional IRA when they were young and in a lower tax bracket only to find themselves in a much higher bracket during their retirement. In fact, so much money has accrued in retirement accounts that if it were all withdrawn today, it could pay off a significant percentage of the federal deficit.

In fact, you can do just that. In a "Roth conversion," you take money from your traditional IRA, pay tax as though that money is ordinary income and convert it to a Roth IRA. Currently only middle- and lower-income families can do this. But the law will change in 2010, allowing families with any level of income to convert to a Roth.

If you execute a Roth conversion in January of year 1, you may not have to pay the tax on that conversion until April 15 of year 2. You also may change your mind. If you decide the conversion wasn't worth it or you were over the income limits allowed for a conversion in 2009, you can move the money from the Roth account back to a traditional IRA account. This is called a "Roth recharacterization."

Recharacterizing a Roth conversion can be done any time before you file your taxes, including the filing extension. So you can change your mind any time before October 15 of year 2. And you can decide to recharacterize part or all of what you converted.

In the midst of all these changing tax laws, the tax rates are also in flux. At the end of 2010, the Bush tax cuts will expire. The Obama administration is not expected to alter the rates significantly before then. They don't want to be blamed for raising taxes before the midterm elections. They would rather implicate the previous administration for a crazy expiring tax law.

Until then, tax rates are at a historic low. After 2010, counting all the tax changes, top marginal tax rates will probably rise from 44.6% to 62.4%. Thus you will only have to pay a maximum of 44.6% on income you can take before 2011, but after that you may have to pay 17.8% more in tax.

The upside is that you can use all these laws and changes to gain an extra 30% on your investments. During the next few years, tax planning and management will be a significant part of wealth management. But it needs to be put together as part of a larger plan.

Here's the timeline of how to use a Roth conversion to maximize your investments. Early in year 1, do five Roth conversions of equal amounts into five separate accounts. You aren't going to keep them all, so you can convert five times as much as you want to end up keeping and actually paying tax on. Invest each Roth account in a different asset class (e.g., large-cap U.S. stock, small-cap U.S. stock, foreign stock, emerging markets and hard asset stocks).

The five accounts will appreciate differently, but the entire portfolio will be fairly well balanced. Before April 15 of year 2, decide if you will be keeping only one account or more than one. If more than one has appreciated significantly, you may want to keep more than one account's conversion. Compute your tax liability for the year and pay the tax, but instead of filing your return, file an extension.

Before the October 15 extension deadline, decide which of the five accounts you are going to keep. By now, nearly a year and three quarters has elapsed. You can easily determine which account has appreciated the most. Keep that one and recharacterize the other four. Because you only have to pay taxes on the amount you originally converted, it's like betting on the horse race after the winner has already been determined. After recharacterizing the accounts, file your tax return before the October 15 extension.

If all of the accounts decrease in value, recharacterize them all and pay no tax. Financially you are none the worse for having filled out a folder of paperwork. If only one account appreciates significantly, you only keep one conversion. But you have increased the odds of your Roth account going up by five times.

The average return of the S&P 500 is about 11%, but the standard deviation is about 19%. All of the other asset classes have an even higher standard deviation. It is likely, for example, that emerging markets will be either the best or the worst performing asset class over any two-year period. Using this technique you can guarantee that the Roth conversion you keep will have been invested in the best asset class during that year and three quarters.

Segregating each of the five conversions into a separate account allows you to decide to recharacterize or let each account stand separately. The difference in returns between the average and the best account is liable to be 20% or more over the year and a half before you have to choose which accounts to keep. Coupling the 17.8% tax savings and this Roth segregation technique could boost your returns by 30% or more.

In the quite likely event that all five accounts have appreciated significantly, you may decide to keep them all. Once you have reached the maximum tax rate, the top marginal rate does not increase from there. Those most fearful of expectations of higher tax rates soaking the rich after 2010 would be those most likely to benefit from converting everything.

If you are under the threshold for Roth conversions for 2009, you can start this year. This is especially appropriate for people older than 70 who are forgoing their RMD withdrawals. At least convert the same amount as you would have been required to withdraw anyway. Better yet, convert five times that amount in five separate accounts and keep the one which performs the best.

If you are over the income limits for Roth conversions this year, those limits go away next year. You can convert in January 2010 and you'll have until October 15 of 2011 to decide which accounts to keep and which accounts to recharacterize. If you do not qualify to make either Roth or deductible IRA contributions, you can still contribute $5,000 to a traditional IRA for 2009 even though you are ineligible for any deduction. Contribute another $5,000 in the beginning of 2010. Then immediately convert the entire $10,000 to a Roth IRA in 2010. If you do not have any other traditional IRA accounts, you will only have to pay tax on any growth over the $10,000 you contributed but for which you received no deduction.

As if tax matters couldn't get any more complex, Roth conversions during 2010 are taxable 50% in 2011 and the other half in 2012 unless the taxpayer elects to have them taxed completely in 2011. Generally, with rising tax rates, paying the tax in 2011 could be best, but individual situations may warrant spreading the tax over two years.

Even thought this technique could boost your after-tax returns by as much as 30%, be careful. Executing a Roth segregation account requires professional assistance. Such a technique should be just one small part of a larger comprehensive financial plan. And you should seek the guidance of a personal fee-only financial planner and certified public accountant (CPA), who have a legal obligation to act in your best interests. The laws are changing annually, and as a result so is the optimum path.

 

from http://www.emarotta.com/article.php?ID=334

Getting Started With Investing (2009-04-20)

by David John Marotta

There isn't a better time to invest than today. The way to build real wealth is by living well below your means and then saving and investing the difference. The poor buy things; their homes are cluttered with them. The middle class buys liabilities like second homes and boats, and then they are obliged to make payments and upkeep on them for years. In contrast, the rich buy investments that appreciate and pay them dividends and interest for decades.

Despite recent market turmoil, historic long-term returns still average 10% to 12%. At a 10% rate of return, your investments should double every seven years. So $100 invested today becomes $200 in 7 years, $400 in 14 years and $800 in 21 years. Even at a modest 7% rate of return, your investments should double every 10 years.

Getting started may seem as daunting as embarking on any new hobby, but on average this kind of hobby pays you money rather than costing you. Every hour you spend learning about investments is an hour of free entertainment. It is an hour you are not spending money at the mall or on a more expensive pastime. And ultimately investing will be your engine of income and appreciation. It will subsidize what might otherwise be a subsistence lifestyle based solely on Social Security checks during retirement.

The first step is getting some money together. In the beginning, the amount you save is most important. Later, after you have amassed a significant multiple of your annual spending, the amount you make on your investments becomes much more significant. At that point (at age 40 or when you have five times your annual spending to invest), it's time to seek a personal fee-only financial planner in your area. Visit the website of the National Association of Personal Financial Advisors at <a href="http://www.napfa.org" target=_blank>www.napfa.org</a>. for information.

In step 2, open an account where you can do your investing. E*Trade (<a href="http://www.etrade.com" target=_blank>www.etrade.com</a>) is a discount firm. Account minimums are $2,000 with less than $50,000 in combined assets, and stock trades cost $12.99. TD Ameritrade (<a href="http://www.tdameritrade.com" target=_blank>www.tdameritrade.com</a>) offers accounts with a $2,000 minimum and trades of $9.99 each. Scottrade (<a href="http://www.scottrade.com" target=_blank>www.scottrade.com</a>) offers $7.00 per trade with a minimum of just $500. Charles Schwab (<a href="http://www.schwab.com" target=_blank>www.schwab.com</a>) offers trades at $12.95 with a $1,000 minimum account size. Fidelity (<a href="http://www.fidelity.com" target=_blannk>www.fidelity.com</a>) charges $19.95 per trade with a $2,500 minimum.

Competition continues to force brokerage companies to adjust their charges on a regular basis, so verify the fees before signing up. Be sure to ask about any monthly inactivity charges. Avoid any account with monthly or annual fees. You plan on investing in a balanced portfolio and then going fishing. You don't want to be charged for the 11 months between now and your annual rebalancing. Make sure you know what the account minimums are too. They should never be more than a few thousand dollars. Although you don't plan on transferring your account, ask what the charges are to do so, and make sure they are reasonable, typically about $75.

Each broker has special promotions that may offer free trades, cash or electronic goods. Taking the best promotion is tempting, but evaluate brokers without considering the promotion.

Setting up an account is easy, and you may be able to do it online. If you need to sign account agreements, read them carefully. Not only should you understand what you signing, but this is the first step in your financial education, and your goal is to gain wisdom and experience.

Half of any area of expertise is learning the vocabulary, which gives you both a shorthand for discussing finance and possibly a new a way of thinking about the world of investments. If you don't understand something, check it out at Investopedia (<a href="http://www.investopedia.com" target=_blank>www.investopedia.com</a>) or call your broker's toll-free number.

In step 3, get money into your investment account. Many brokers allow you to link your checking account to your investment account electronically so you can transfer money at any time. Better yet is setting up a monthly automatic transfer. A day or two after your paycheck is deposited into your checking account, an amount you have designated is automatically transferred into your brokerage account.

The principle is to pay yourself first. You deserve to build wealth, and wealth is what you save and invest, not what you spend. Think of a rich person simply as a poor person who has saved a lot of money. Save and invest as little as $100 a month for 46 years earning 10%, and you can retire with a million dollars. And $500 a month grows to an astounding $5 million.

Those 46 years of saving ideally take place between ages 20 and 66. If you are beginning later in life, you may have to invest more to save the same amount. In fact, for every seven years you delay saving and investing, you cut your retirement lifestyle in half.

Today is the day to decide if you want to be financially free. I can't emphasize enough that time in the markets is more crucial than timing the markets. Who among us doesn't wish we had invested as much as possible in the markets at the prices 46 years ago?

Push yourself to save as much as you can automatically each month. No one should save less than $100 a month in their taxable savings, and this taxable savings is in addition to any work-related retirement accounts.

After you have begun adding money into your taxable savings account, it's time for step 4, actual investing. Knowing the best mix of investments requires a great deal of research and analysis. Investment advisors can add significant value for large portfolios. But for small amounts when you are just getting going, how much you save each month is more critical than the asset allocation you select.

To pick a fund, go to <a href="hhttp://www.maxfunds.com" target=_blank>www.maxfunds.com</a>. This is an excellent laymen's site for fund analysis. In the drop-down box "Show me these funds" select the category you want to purchase. I will tell you which categories to purchase later, but for now assume you know. Next, in the drop-down box "That are sorted by," select "Highest MAXFunds Rating." Finally, click "Go."

The tool lists many investment choices, ranked from their highest score downward. If you can invest at least $2,000, buy an exchange-traded fund. These funds are purchased with a transaction fee ($8 to $20). The amount you are purchasing should be significant enough so the transaction costs to purchase the fund are well under 1% of your initial investment. For amounts less than $2,000, consider waiting and accumulating more to invest or else purchase a no-load mutual fund without any transaction fee.

The site puts a yellow star next to their favorite fund, which is a good place to begin. If you are evaluating funds on your own, look for a fund where the TYPE is ETF and the expense ratio (EXP) is as low as possible. That is often the best choice of a fund. The lower the costs, the more you will keep of the return.

Finally, let's talk about investment categories. Start with a fund that follows U.S. large-cap stocks, and then as you gather additional investment money add funds in the order in which they are least correlated with each other. Here is the order for your first five investments.

Launch your investment portfolio with a "Large Cap Value" fund or better yet a "Blend" fund such as Vanguard Total Stock Market ETF (VTI) or iShares Russell 1000 Index Fund (IWB). Make your first investment in this fund at least $3,000. This should cover all the stocks in the S&P 500 and more.

Second, add an "Intl. Diversified" fund like iShares MSCI EAFE (EFA) or Vanguard Europe Pacific ETF (VEA). Third, add a "Natural Resources" fund like iShares Natural Resources (IGE). Fourth, add a "Small-Cap Value" fund like iShares Russell 2000 Value Index Fund (IWN) or Vanguard Small Cap Value ETF (VBR). Fifth and finally, add an "Emerging Market" fund like iShares MSCI Emerging Markets Index (EEM) or Vanguard Emerging Markets ETF (VWO).

After investing in these five funds, you will probably know enough to evaluate your asset allocation with more sophistication than this simple allocation. If you want, go back and add another share to the "Blend" and "Intl. Diversified" allocations. By then you should have over $20,000 and be on your way to growing rich. Getting started can be intimidating, but these simple steps will help you through your first few years of investing.

 

from http://www.emarotta.com/article.php?ID=333

It's Time for a Tea Party (2009-04-13)

by David John Marotta

Some people try to defend the practice of earmarks with three arguments. First that earmarks only account for 1.9% of the budget. Second that earmarks stimulate the economy. And third that earmarks support many worthy causes. But in each case, the harm done by earmarks is much worse than the average citizen believes.

If you think earmark spending represents such a small and identifiable portion of the federal budget, you must believe it would be easy to eliminate. So let's do away with all wasteful spending as an act of responsibility, consensus building and bipartisanship. The impossibility of doing just that shows clearly how earmarks are tied significantly to the way money corrupts. The truth is that all of government spending would change if earmarks were eliminated.

Earmarks represent the graft and bribery that grease the passage of a pork barrel budget. Congress just approved a $410 billion spending bill, 1.9% of which was required in personal kickbacks (called earmarks) to buy votes. That so-called small percentage amounts to 2,484 times the compensation of the AIG executives. Bonuses at AIG were given to 400 employees with only seven receiving more than $3 million. In contrast, the average member of the House received about $18 million in earmarks.

Increasingly, in an attempt to show their transparency and responsiveness, representatives are inviting committees to review and prioritize projects based on efficient-sounding criteria. My own district representative invited the input from local bureaucrats who have the largest stake in feeding at the government trough. This tactic provides enough of an appearance of involvement for political cover without actually taking into account any of the small business owners who really pay the bills.

Earmarks themselves aren't the government waste. They are the price of the graft to corrupt politicians into supporting the real waste. For you who believe $18 million can't corrupt a politician, bear in mind that every congressional district is making off with more money annually than the $11 million perpetrator of our local Ponzi scheme scandal did over several years. Not content with the average $18 million, my representative attached his name to $159,630,155 worth of earmark requests.

This is not partisan criticism. The best we can say about members of one party is they can be bought for less pork or they cover their graft with more worthy-sounding causes. But these comparisons shouldn't lessen our outrage. Nothing can justify what Bernie Madoff did, even if he donated liberally to charity.

The second defense of earmarks claims they stimulate the economy. They do not. Economic resources are clearly limited. Money confiscated and spent by government has alternative uses that in most cases would have better stimulated the economy. Private enterprise can only spend money where their return would be positive, creating new jobs and causing economic growth. No economic growth means it is unsustainable in the private sector.

Not so with government spending. Unlike private enterprise, the government can deficit-spend indefinitely on programs with no redeeming value in the economy. I've looked over the 51 earmarks requested in my district. None of them relates in any way to sustainable business ventures.

My first column for the Charlottesville Business Journal was coauthored with my father, George Marotta, in 2002: "Will the U.S. Go the Way of Japan?" The fall of Enron was fresh in everyone's mind, and our answer to this question was no because "In the US we allow companies to go bankrupt when they cannot succeed in business. In Japan, both banks and corporations that are bankrupt are allowed to continue and drag down the economy. 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."

But times change. Our government's intervention in the financial markets, its dictation of contractual bonuses and the firing of company CEOs is unprecedented statism and deserves to be described as socialism or even fascism.

Senator Charles Grassley of Iowa suggested that AIG executives should "resign or commit suicide." He advocated an attitude in corporate America that would emulate the Japanese model, saying, "People that run a corporation into a ground have violated their trust with the stockholders and maybe even the taxpayers."

The bailouts transform a private mistake into a public crime. A business goes under because of poor management, and the assets are sold or distributed as part of the company's liquidation. But if the government guarantees the enterprise, it becomes a crime against society for the company to fail. Failure now becomes a political scandal.

There must be charges of mismanagement. There must be an inquiry. Those responsible must be held accountable. Those innocently injured must be made whole. And all of this supposedly must be accomplished by government.

As a result, the so-called bailouts will prolong the economic malaise. The government should not have intervened. We would be better off if those over leveraged financial institutions had filed for bankruptcy. No company is too huge to fail. And those that claim to be are too big to subsidize at the expense of hundreds of small companies.

Make no mistake: there will still be a recovery, but it will be in spite of government's actions not because of them. The very livelihoods of scores of employees of publicly traded companies depend on them making a profit. The recovery will be on the backs of millions of workers, but congressional leaders will claim the credit, as always, if and when private enterprise can overcome government disincentives.

And finally, the third defense of earmarks claims they support many worthy causes. I expected this argument to be difficult to refute because discerning "worthy" is very subjective.

Interestingly enough, this claim isn't hard to refute because all the criteria selected are economic. In my district, appropriation requests were prioritized based on criteria that would give representatives economic political cover: (1) the potential to transform our economy, (2) the greatest impact on economic development, and (3) the ability to create or attract jobs.

First, all of the earmark projects were solicited by governmental agencies in and around the district. They are all justified by their descriptions as "This project is a valuable use of taxpayer funds because [fill in blank]." But in each case, simply allowing citizens to keep that money would have been a more valuable strategy. As government spending consumes an ever-larger portion of our economic output, less remains for real investment and economic transformation.

Efforts to attract jobs through subsidies or protectionism that can be done more efficiently elsewhere always lose money. If every district spends $1 million competing to attract new industries from other districts, it is a complete waste of $425 million. Even if the jobs we are trying to steal are outside of the United States, it's still a bad idea. Spending that money to force Americans to take jobs away from developing countries that aren't profitable enough for our citizens by putting incentives in place to make those jobs more attractive is a losing proposition. Why not simply allow our citizens to fulfill the roles in the global economy where we are more competitive?

Small businesses create all the new jobs and profitable industries in the United States. But no incentives are being offered for current entrepreneurs to expand or start new ventures. Two thirds of small business profits are earned in households making more than $250,000, yet every spending program has been justified with promises that it will be paid by those earning over $250,000. The marginal tax rate of these small business owners is expected to rise from 44.6% to 62.4%. At those rates, small business owners will change their behavior.

Business owners will not choose to maintain their level of productivity with a 62.4% marginal tax rate. They will simply work less. This is not a new idea in the history of freedom.

The most productive wage earners are among the hardest workers. According to Steven Landsburg, leisure used to be evenly divided among the classes, but it isn't any longer. Although Americans as a whole have an extra four to eight hours of leisure per week, it is those in the lowest tax bracket who enjoy this extra leisure. Today, more than ever, it is the working rich and the idle poor.

I've been studying the life of John Adams and continue to be impressed by his political insights. He feared our democracy would ultimately vote itself bread and circuses at the expense of individual rights and freedoms. "Property," he wrote, "is surely a right of mankind as real as liberty."

Just because a majority of citizens think it is a good idea doesn't make it so. Half of the country doesn't even pay taxes. Among the remaining half, even a small number in favor of a project tips the scales. Compare it to two foxes and a hen voting on what to have for dinner.

For those of you who would like to vent some of that righteous indignation, Tax Day rallies are held April 15 in nearly every major city. Charlottesville's Tea Party takes place on the east end of the Downtown Mall at 3 p.m. on Wednesday. For information on the Tea Party movement, visit <a href="http://www.taxdayteaparty.com" target=_blank>www.taxdayteaparty</a>.com. More details on the Charlottesville event are available at <a href="http://vateaparty.wordpress.com" target=_blank>vateaparty.wordpress.com</a>.

The organizers are asking people who would like to speak at the rally to keep their speech nonpartisan, supporting fiscal integrity and not a particular party. That makes sense to me because those who truly favor fiscal integrity probably couldn't support either party.

<hr>See also:<ul><li><a href="http://www.emarotta.com/article.php?ID=325">Government-Provided Economic Security Is an Illusion</a></ul>

 

from http://www.emarotta.com/article.php?ID=332

Social Security 6: The 70-66 Strategy (2009-04-06)

by David John Marotta and Matthew Illian

Every retiree has significant choices to make regarding Social Security benefit options. One way to analyze the possible scenarios is by calculating the joint lifetime benefits for couples. This method suggests the higher wage earner should often delay filing to receive a maximum benefit at age 70.

If a higher earning husband opts to delay his retirement, the next decision involves when a lower earning wife should file. Let's consider the case of James and Betty Butterworth again. We have already established that if James is healthy, he should delay his filing. He should only consider the file-and-suspend option if his family history and/or personal health implies a premature death. Betty's short working life means she is only entitled to a small benefit of her own. Thus she will receive a spousal benefit from the point that her husband files, preferably at age 70, for the rest of his life.

You might assume Betty should file as soon as possible because she most likely will inherit James's increased benefit. But this decision may overlook the 25% penalty carried over from Betty's reduced personal benefit to her spousal benefit. Current retirees who file at age 62 have their monthly Social Security check reduced by 25%. If Betty files at 62 for her own reduced benefit, this 25% cut will apply to her spousal benefits. So instead of receiving half of James's increased benefit (e.g., $1,533 = half of $3,066) when he files at age 70, she will only get $1,149 monthly. If she waits until age 66 to file on her own record, her spousal benefit will not be reduced. The 25% cut does not carry over to survivor benefits. So in any case Betty will assume James's full $3,066 monthly benefit when he dies.

To avoid this reduction on both the personal and spousal benefit, Betty should file at age 66. This 70-66 strategy is a smart and very common way to maximize Social Security income for healthy couples. Waiting until age 66 means that Betty will receive her the full spousal benefit when James files. The 70-66 strategy can increase a couple's income 14% over filing early and 22% over both filing at full retirement age.

There's no incentive for a lower earning wife to delay her filing beyond age 66. Because a spouse can inherit no more than 100% of a benefit, filing at age 66 maximizes both spousal and survivor benefits. Thus no benefit accrues if both James and Betty wait until age 70 to file. He should file at 70 and she should file at 66.

If the wife is the high wage earner, her incentives are quite different. Unless she is much older than her husband, she will most likely outlive her spouse. But even in this case the wife should still consider delaying her own filing to secure maximum benefits for herself.

Interestingly, a higher earning married woman's Social Security income maximization incentives resemble those for a single person. Single people and higher earning wives should only consider their own life expectancy when making filing decisions. If healthy, they should delay filing. Filing early only makes sense for people who have reasons to doubt their longevity. Informed decision making should take all these calculations into account.

Delaying your filing means you could likely have a reduced income during these gap years. You may want to use that time to convert some of your pre-tax investments to a Roth IRA.

Converting some of the money in a traditional IRA to a Roth IRA requires paying ordinary income tax rates on the amount in question. If you can orchestrate some years in which your income is as low as possible by delaying Social Security benefits, you can minimize the tax required when the money comes out of your IRA.

To maximize your family's Social Security benefits, you must integrate Social Security legislation with your personal situation: your ages, earning histories and your best guess at life expectancy. Careful tax planning to anticipate future earnings and the potential for Roth IRA conversions should be part of your plan.

Finally, if you are eligible for Social Security disability or have been divorced, the rules become even more complex. Don't make these decisions quickly or carelessly. How you handle your choices about Social Security benefits can be worth more than a quarter of a million dollars.

 

from http://www.emarotta.com/article.php?ID=331