The Very Last Chance for a Massive Roth Conversion (2010-09-13)

by David John Marotta

A tax tsunami is coming at the end of this year. The higher your adjusted gross income (AGI), the closer you live to the coast where the tsunami will hit. This will be your last opportunity to safeguard your assets in a lifeboat and avoid getting swamped with taxes.

At the end of 2010, the Bush tax cuts will expire and tax rates will go up across the board. Even the 10% bracket will rise to 15%. There will once again be a marriage penalty on two-income families. A phaseout of itemized deductions and personal exemptions will return. The child tax credit will drop to half. The death tax will return at 55%. The capital gains tax will rise from 15% to 20%. Tax on dividends will increase from 15% to 39.6%.

And these are just the first wave of tax increases for 2011. Obamacare rolls out additional taxes each year clear through 2014. Taxes will be higher, but the country will still be in financial trouble. Like a merchant in danger of going bankrupt, the government is trying to raise prices to stay solvent. Cutting overhead, nearly always the solution, isn't even being considered.

It is time to take as much of your business elsewhere as you can before these rate hikes come into effect. Mercifully the government has provided a way for you to get a massive amount of your net worth out from under the growing tax burden. It is time to drive a Brink's truck through the legal loophole of Roth conversions this year. For those of you unwilling to take advantage of this opportunity, the road to serfdom is the default.

If you have an income over $100,000, this is the first year you can take money from your traditional IRA, pay tax as though that money is ordinary income and convert it to a Roth IRA. This procedure is called a "Roth conversion."

There are many reasons to do a Roth conversion this year. Each of them is a new tax burden being laid on the most productive members of society.

Traditional IRAs get you a tax deduction now, and you can delay paying taxes until after your investment has grown. With a Roth IRA there is no tax deduction when you deposit the money. But 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 will be higher when you withdraw the money than it was when you contributed.

In a Roth conversion you transfer your investment from your traditional IRA account into a Roth account. You pay tax on the value of what you transferred. The amount you can convert is unlimited. If you have traditional IRAs worth millions of dollars, you can increase your income this year by millions of dollars. If you are already in the top tax bracket, the conversion will not increase your marginal tax rate.

If you execute a Roth conversion now, you can change your mind later. If you decide the conversion wasn't worth it, you can move the money from the Roth account back to your traditional IRA account in a "Roth recharacterization."

Recharacterizing a Roth conversion can be done any time before you file your taxes, including the filing extension. 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.

If you convert this year, you can always recharacterize the conversion next year and undo it. But if you fail to convert this year, you miss forever being able to realize the income under the Bush tax cuts.

With a Roth IRA, you pay tax on the acorn. With a traditional IRA, you get a bigger acorn to start with, but 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. A year from now, we will all be in a higher tax bracket.

You are a good candidate for a Roth conversion in 2010 if you have the following characteristics. You have an AGI more than $100,000, and so until now conversion was not an option. You have a large IRA that could be converted. You expect your tax bill to be higher in the future. You have sufficient taxable assets to pay the tax. You would like to reduce the value of your gross estate and leave a tax-free asset to your heirs. You are willing to pay estimated taxes and higher tax preparation fees.

Even though this technique could boost your after-tax returns, 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.

As part of the nonprofit NAPFA Consumer Education Foundation we are offering a presentation titled "Roth Conversions: How, What, When & Why?" at the Charlottesville Senior Center at 1180 Pepsi Place on Thursday, September 16, from 5:30 p.m. to 7:30 p.m. The talk is free and open to the public. Bring your questions!

 

from http://www.emarotta.com/article.php?ID=414

Assessing Your Finances at Age 50 (2010-09-06)

by David John Marotta

I'm turning 50 this week, probably the most significant milestone after birth. It's a good time to assess progress on all fronts--physical, emotional, spiritual--and of course financial. If you are close to either side of 50, I'd like to outline the ideal scenario to help you make your own financial assessment.

We should have been saving 15% of our income regularly. Even if we don't want to retire until age 70, by 50 we should be well on our way toward securing our retirement. We have managed to save about eight times our annual lifestyle spending. With a $100,000 per year lifestyle, that means we should have saved about $800,000 toward our retirement.

Our savings should be in after-tax account such as a Roth or taxable account. Pre-retirement accounts must be discounted by about a 30% tax rate. Thus $800,000 in after-tax dollars is equivalent to about $1.14 million in traditional retirement accounts.

We are probably at the point where our children are in college or have recently graduated. When college funding is complete, it's time to reevaluate and perhaps drop term life insurance coverage depending on our individual circumstances. We purchased the insurance to make sure our children would have enough money to complete their education. When term premiums rise and college accounts are fully funded, we should probably drop our coverage.

Our estate plan should be in place and fully implemented. Various assets are handled differently. A thorough review at age 50 is in order to ensure the titling and beneficiary designations are correct on each asset from our Roth account to our Health Savings Account.

If we haven't been saving enough or were not invested wisely, we have one last chance after children and before retirement to catch up. Age 50 is the first year we are allowed to take advantage of increased savings and catch-up provisions. Maximum savings in a 401(k) or 403(b) account increases from $16,500 to $22,000 at age 50. Roth contributions also increase from $5,000 a year to $6,000. If we don't have eight times our lifestyle spending saved, now is the time to press these limits.

Saving well is half the battle; investing well is the other half.

At 50 we still have a significant amount of time before retirement. Even if we retired early at age 62, we would still have several years of growth before we needed to start taking withdrawals. At age 50 and even well into retirement our portfolio should still be invested aggressively in equities. An average asset allocation might put 81.6% in appreciating equities and only 18.4% in stable fixed-income investments.

A typical asset allocation at age 50 might be 3% short money, 12.4% U.S. bonds, 12.4% foreign bonds, 31.2% U.S. stocks, 35.3% foreign stocks, and 15.1% hard asset stocks.

At 50, men have an average life expectancy of 28 more years. Women get an extra 4 years. If we are fortunate, those numbers will be even greater. Age 78 is average, but with healthy life choices and medical advances, we may enjoy an even longer life. Those of us with the longest 20% longevity will live well into our 90s.

Of course life is too short to ignore meaning at any age. But for many people 50 is a milestone that reminds us to stop and reevaluate. There is still time for a whole new life of significance.

If we've been careful in our savings we could retire at age 50 and pursue a new calling regardless of its potential pay. We could retire at age 50 if we could live off 3.64% of our net worth. To retire with a $100,000 per year lifestyle we would need $2.75 million.

Financial independence can open exciting possibilities that were otherwise out of the question. If we don't need the money, we are free to do anything with our lives. People of purpose usually don't choose 28 years of recreation. Not when we finally have the time and the wisdom to make a difference in the world.

Counting retirement as a new career is a perspective we encourage. Beth Nedelisky and I teach an Osher Lifelong Learning Institute course each spring, "Financial Planning for Success and Significance in Retirement." In the first class we explore finding meaning in retirement and defining success. We use Marc Freedman's book "Encore: Finding Work That Matters in the Second Half of Life" in the class. His book encourages everyone passing 50 to find their calling in the second half of life and focus on what matters most.

I asked Freedman what he considers the most significant aspect of those over 50 finding a calling for the second half of their life. He answered, "When you reach the point in your life where you can celebrate the freedom to work instead of the freedom from work, that’s success. If just a fraction of people in the second half of life turn their experience, time and talent to our nation’s most pressing challenges, imagine the progress we could make."

Although you can have that attitude at any age, it is especially powerful when redefining the second half of life.

 

from http://www.emarotta.com/article.php?ID=413

Gold May Drop If Political Winds Change (2010-08-30)

by David John Marotta

Gold recently hit a high of over $1,250 an ounce. Gold advertisers and gold investment newsletters continue touting their wares as though gold only goes up in value. Commercials are promising cash for gold, and people who normally don't concern themselves with investments are asking if they should buy gold. But now may not be the best time to buy gold.

Gold tends to maintain its value. It doesn't go up; it doesn't go down. It just holds its purchasing power and keeps pace with inflation. On average it stays constant, but only on average. In the short term, gold fluctuates wildly, at times even more than the stock market.

In January 1980, gold reached its high of $850 an ounce on the expectation of rampant inflation. But such inflation did not follow the doomsday predictions of straight-line projections. In fact, gold prices reversed and began dropping as chairman of the Federal Reserve Paul Volcker took action to strengthen the dollar and broke the back of inflation.

Under a sounder monetary policy, gold continued to drop from $850 in 1980 all the way down to $260 in 2001. It lost 69% of its value over a 21-year period for a consistent annualized loss of 5.5%. It didn't return to $850 until 2008, 28 years later. You can't afford nearly three decades of no return while inflation eats away your buying power.

That $850 in 1980 had the same buying power as $2,249 in today's dollars. Gold trading at $850 an ounce then was like gold trading at $1,000 more than its current price. Those people who purchased gold in 1980 have lost over half their buying power during a 30-year investment.

Had they invested $850 in the S&P 500, their investment would have grown not merely to $1,250 but to $17,261. Which investment would you rather have chosen in 1980: gold that is up 47% while inflation has been up 166% or the S&P 500 that is up 1,931% and averaging 10.8% a year?

In his book "Stocks for the Long Run," Jeremy Siegel analyzes investments over the past 200 years. Gold typically just maintains its value over time. If you bought a dollar's worth of gold 200 years ago, after adjusting for inflation it would be worth about a dollar today. Because of inflation, a dollar today would only have had the buying power of about 7 cents back then! However, the stock market, on average, has been appreciating about 6.5% above inflation.

Inflation has been running at about 4.5% and equities have been averaging 10.8% over the last 30 years. You need to exceed inflation to grow the purchasing power of your portfolio and fund a long and successful retirement. Holding gold may help you sleep well tonight, but you won't eat well 10 years from now.

Although gold generally holds its purchasing value, it can fluctuate wildly based on other factors. The price of gold generally rises with expectations of inflation or worries about economic or political security. The recent appreciation of gold stems from an expectation that prolific and wanton spending by the federal government will excessively devalue the dollar and run up deficits that will lead to a catastrophic financial meltdown as well as worries that Iranian president Ahmadinejad is determined to nuke Israel and America.

Perhaps such dire predictions are correct and we are headed to Armageddon. If so, gold should not be your first purchase. First you should stock a year's supply of food. Then buy a gun to protect it. Only after you've purchased plenty of seed corn should you think about buying gold. Even then I would think that gold isn't a liquid asset at the end of the world as we know it. At that point a loaf of bread will buy a bag of gold. If you want liquid assets in such a catastrophic situation, try buying cases of Jack Daniels. It is cheaper, keeps just as well and will fetch more in trading value.

Perhaps we are rushing toward the meltdown of society as we know it. But perhaps not.

As strongly as I believe in the foolishness of government-created solutions to solve government-created crises, I believe even more strongly in the fickleness of the American voter. Who would have thought a Republican would be elected to Ted Kennedy's Senate seat?

Perhaps the pendulum is swinging back and reckless governmental socialism and spending will be repudiated in the midterm elections. If that happens, all the dire expectations that worried individualists have priced into the gold market will evaporate along with some of the value of gold investments.

We don't recommend holding more than 3% to 5% of your net worth in gold coins. You don't need any Eagles or Krugerrands to reach your financial objectives. Hard asset stocks do better than simply buying the underlying commodities. Holding diversified foreign equities protects against government monetary folly and would have protected even the citizens of Zimbabwe. Emphasizing those countries with a sound monetary policy is even better.

Having said all that, holding a few gold coins has had its benefits historically.

Some of our clients are old enough to remember Franklin D. Roosevelt's Executive Order 6102 in 1933 that restricted gold ownership. Owning gold was illegal until the early 1970s when Richard Nixon abandoned the gold standard for our currency and Gerald Ford signed a bill that legalized private ownership of gold.

Having gold during World War II was the only way to get family members safely out of Nazi Germany using bribery. Owning gold coins can provide some flexibility in dark and uncertain political times.

Although holding a small number of gold coins won't jeopardize your financial objectives, be prepared for their value to decline if the world's debt, deficit, socialist tendencies and Armageddon start looking a little less bleak.

 

from http://www.emarotta.com/article.php?ID=412

Dodd-Frank Bill Concentrates Financial Power (2010-08-23)

by David John Marotta

Congress recently passed the Dodd-Frank bill. At the signing, President Obama claimed, "Because of this law, the American people will never again be asked to foot the bill for Wall Street's mistakes. There will be no more tax-funded bailouts . . . period."

Washington excels at blame shifting. The financial crisis began and ended with the exercise of political privilege and power. Fannie Mae and Freddie Mac were given a lending environment superior to the private sector while the latter was forced to loosen lending requirements beyond reason. The blame for the financial meltdown belongs on federal regulators, not on a lack of regulation.

But beyond all this blame mongering is the assumption that the current legislation can bestow enough power in the hands of a few to steer the course of global finance for the better. As William F. Buckley, Jr. has often remarked, "Idealism is fine, but as it approaches reality, the costs become prohibitive."

The bill mostly just asks federal agencies to make sure that nothing bad happens in the future. It doesn't really tell them how to do that. But it does make it clear they will be held accountable. And they can't complain they didn't have the needed authority or clout. In the bill they are given a wide range of new and unchecked powers to do whatever it might take to make sure bad things don't happen.

Unfortunately, we now have to fear their exercise of these powers. Only if you swear by the genius of Caesar, trust in his altruism and believe in his divinity is this bill a cause for celebration.

For example, the bill creates a Financial Stability Oversight Council. The ten regulators in this group have the task of monitoring any systemwide risks in our financial system. They have also been given nearly unlimited power to address these risks by forcing financial firms to sell assets or close a portion of their business.

The utopian hubris of believing such a group will do more good than harm is unfounded by human history and experience. And the assumption that such a council will be untouched by self-interest is naive beyond belief.

In the chapter on politics in his book "The Blank Slate," Harvard psychologist Steven Pinker says, "We are all members of the same flawed species. Putting our moral vision into practice means imposing our will on others. The human lust for power and esteem, coupled with its vulnerability to self-deception and self-righteousness, makes that an invitation to a calamity, all the worse when that power is directed at a goal as quixotic as eradicating human self-interest."

Congressmen Christopher Dodd and Barney Frank themselves were given the simpler task of overseeing Fannie Mae and Freddie Mac. Their own self-deception and self-righteousness led them to defend and even praise Countrywide's reckless lending practices. In the meantime, they accepted more than $2 million in campaign donations from Countrywide, Fannie Mae and Freddie Mac.

The new bill is ripe for lobbying by special-interest groups. Almost all of the actual rule writing has been delegated to regulators. The legislation will be revised endlessly for decades, and all the power players with a stake in the game will be able through their contributions and lobbying efforts to leave their fingerprints on the rules.

Such concentrated power will be used to benefit one firm at the expense of another. The winners will be the most powerful financial firms, lobbyists and legislators. The losers will be smaller banks and financial firms, fee-only fiduciaries and consumers. Anyone who doesn't have millions of dollars at stake will not be a big enough stakeholder to bother gaming the system.

According to the Washington Post, "Some liberals have criticized the bill for failing to more aggressively alter the structure of Wall Street and for leaving so many critical decisions to federal regulators, who missed many of the warning signs before the crisis."

"'It's the dumbest argument I've ever heard,' Dodd countered. 'What do they expect me to write, a 100,000-page bill? This is far beyond the capacity, the expertise, the knowledge of a Congress to detail every new regulation,' he said."

Truer words could not have been spoken. Such work is also far beyond the agencies to which Congress has delegated the task. The bill is 2,319 pages long. It establishes 355 potential new agency rules. It mandates funding 47 studies. And it requires 74 different reports.

It will probably create more jobs than any of the bailouts efforts. But none of those hires will be working for consumers. Their number-one priority will be their personal reputation and power. Only tangentially will any of their interests align with yours.

None of this work will encourage competitiveness. No one will manufacture products for sale. These efforts will produce no real wealth. And hundreds of the potential new rules have nothing to do with financial stability.

The report has thousands of potential unintended and unanticipated consequences. For example, the Federal Reserve will now be authorized to limit the swipe fee that credit card companies charge merchants for debit card transactions. Such price controls have popular support. After all, who wants credit card companies to rake in high fees? But price controls are never good economics.

How will they decide what the limit should be? If limiting the fees to $6 is good, is limiting the fee to $3 even better? Why stop there? Why not limit the fee to $1? What are those fees for anyway?

Currently there isn't a limit on the fee because the fee can be a percentage of the total transaction amount. Part of the reasoning is that such a transaction may be fraudulent identity theft and the money transferred could be unrecoverable. Because the fee serves as insurance against this possibility, it is a percentage of the transaction. If the Fed limits the fee, such transactions could be eliminated as well. Alternatively, banks could simply charge the maximum and allow smaller transactions to subsidize the risks of larger transactions. None of this is good economics.

This is a consequence of price controls. Transactions that all parties would otherwise want to make become illegal. Either the price control is set too high and has no effect or it is set below the equilibrium and upsets the balance, making the service disappear altogether.

Maybe the genius of the Fed will set the swipe fee limit high enough so it will have no unintended consequences. But Fannie Mae and Freddie Mac should have been able to set lending requirements high enough to avoid the financial crisis in the first place. If politics did not allow something that simple, we certainly won't avoid mistakes with regulations as complex as this bill invites.

The Dodd-Frank bill can be likened to giving the government unlimited powers and asking them to eliminate evil. It sounds like a good idea in theory, but the task is impossible, and the means by which they will make the attempt is dangerous to life, liberty and the pursuit of happiness. Libertarians can't tell you exactly why the bill is a bad idea. No one can understand the complex interaction of our financial systems that well. And that is exactly why we know the bill will do more harm than good.

 

from http://www.emarotta.com/article.php?ID=411

Saving: The Most Fundamental Element of Wealth (2010-08-16)

by David John Marotta

Everything in wealth management begins with savings. All wealth comes from producing more than you consume. Unfortunately, most Americans are better at consuming than producing.

Have you ever met people who always have enough money to do what they want? Their peace of mind and confidence is no accident. Nor is it luck. It comes by carefully planning their spending and savings. They deny themselves some desires now in order to enjoy financial security later.

The character Mr. Micawber from Charles Dickens's novel "David Copperfield" offered a kernel of wisdom learned the hard way, now popularly known as the Micawber principle. He said (numbers updated), "Annual income $50,000, annual expenditure $48,750, result happiness. Annual income $50,000, annual expenditure $51,250, result misery."

Surplus income is wealth. Deferred consumption is the textbook definition of wealth, which can be used as a capital investment to produce additional wealth. Although by itself money certainly does not guarantee happiness, wealth can enable us to accomplish many goals in life. Without such a surplus we experience Micawber's misery.

Mr. Micawber is memorable for trusting that "something would turn up" to solve his financial problems. Americans are perennial Micawbers. The savings rate in America is abysmally low, and those who do try to acquire wealth are chastised by a punitive tax code. Micawberism, in contrast, has been rewarded so much, it is considered patriotic to shop until you drop simply to boost the economy.

Unfortunately, economics doesn't really work that way.

Most families who become mired in credit card debt do so because they fail to plan for emergencies. These unexpected events swamp their cash flow, and they have to resort to plastic. But cars break down. Roofs leak. And children need braces. We recommend saving 10% of your take-home pay just to meet these unanticipated expenses.

Saving fuels the financial engine that makes the rest of wealth management possible. Whatever your life goals, saving is most likely required to achieve them.

Saving is the logical choice if you have upcoming major expenses. Some families need to save small amounts to meet modest needs. Others have elaborate and expensive plans that require more complicated strategies.

One of the most important purposes of saving is financial independence or retirement. There isn't a simple dollar amount that will be sufficient. What matters is that you have saved enough to support your lifestyle. Having $1 million at retirement doesn't help if your lifestyle requires $200,000 per year. Dying young is never a good retirement plan.

Saving too little or too late requires more extreme adjustments in savings or lifestyle later in life. Worrying about how to meet your financial objectives should not haunt you. You will know if you are on track only if you know what that track looks like and you adjust your course regularly as needed.

Saving is powerful, but it is only half the story. If you do not invest your savings, inflation will erode your purchasing power every year. In contrast, savings that are invested grow and appreciate.

You should know how much to save today to exceed the needs and priorities of tomorrow. At a 10% rate of return, your savings will double every seven years. So for every seven years you delay saving, you are cutting your ultimate lifestyle and net worth in half.

All of this wisdom about saving can be summed up by the suggestion to "Start saving now." Beginning early in life is certainly the most significant factor in building real wealth.

Saving a million dollars isn't so difficult. Investing just $16.20 a day at a 10% rate of return grows to $1 million in 30 years. This phenomenal rate of growth comes simply by having $16.20 more in income than spending each day. By saving $162 a day, you could accrue $10 million after 30 years.

The most successful way to save is to automate your saving plan. Make savings your default setting. Establish an automatic electronic funds transfer from your checking account to your investment account the day after each paycheck is deposited. You won't miss what you don't see.

Making these decisions explicitly is much better than failing to plan and then being forced to take whatever options are still available late in the game with little time left for course corrections.

Comprehensive wealth management comprises many different elements. But saving is the most fundamental. It is like hydrogen, the first and most basic element. By its energy the sun gives us light and warmth, making all life on earth possible. Harness the energy of saving and put it to use for your life goals.

Most families with significant investments are simply the millionaire next door. They live well below their means and save and invest the difference. They grow rich slowly and steadily. Wealth is what you save, not what you spend.

Take control of your savings today. It is the cornerstone of your wealth management plan.

 

from http://www.emarotta.com/article.php?ID=410

Second Quarter of 2010 in Review (2010-08-09)

by David John Marotta

The market fell to its lowest point this year on the last day of June, closing the quarter and the first half of 2010 with some significant losses. Short-term trends can signal or counter longer term trends. Distinguishing which is which can be difficult.

About 96% of market movements are noise. Even long-term trends are three steps forward and two steps back. That makes it challenging to distinguish short-term changes from long-term trends. Reviewing the market movements from last quarter is useful only to the extent that such distinctions can be made.

Aim to structure portfolio allocations for 3- to 5-year trends, not for monthly fluctuations. Some of the investments that will do well--if the dollar weakens or if we have inflation--are the same investments that did not make money this last quarter. Other investments that did better are part of longer term trends that should signal you to adjust your asset allocation.

Stocks fell during the second quarter of 2010 as government debt in Europe and malaise at home slowed hopes of an economic recovery anytime soon. Over the quarter, the S&P 500 was -11.43%; the EAFE foreign index, -13.97%, emerging markets, -8.37%; and the Goldman Sachs Natural Resources Index, -9.76%.

The EAFE foreign index was down 2.54% more than the S&P 500. The prospects of bailing out Greek budget deficits devalued the euro against the U.S. dollar. Much of the movement in foreign stocks was due to currency exchange. The euro dropped 11% over the second quarter from $1.35 US to $1.20. As a result, the dollar strengthened, but we don't expect this trend to continue.

Bill Gross, cofounder of the Pacific Investment Management Company (PIMCO) and the country's most prominent bond expert, recently evaluated countries based on their total public sector debt as a percentage of gross domestic product (GDP) as well as their annual deficit, which is making matters worse. Gross singled out seven foreign nations that are heaping significant deficits on their mountain of debt and called them "The Ring of Fire." These countries comprise significant percentages of the EAFE foreign index: Japan 22%, United Kingdom 21%, France 10%, Spain 4%, Italy 3% and Ireland and Greece 1%. In total, 61% of the EAFE index is invested in the ring-of-fire countries.

But Gross included an eighth country in the ring of fire: the United States. He also warned, "Once a country's public debt exceeds 90% of GDP, its economic growth rate slows by 1%." Gross is probably underestimating the drag that public debt puts on economic growth. Rising public debt in the United States has been at the expense of economic freedom.

For the first time in the Heritage Foundation's Index of Economic Freedom, the United States was moved from the list of "free" countries to the second tier of "mostly free" countries. Investors seeking to avoid the European malaise by not investing in foreign stocks will find themselves 100% in the eighth ring-of-fire country, the United States. The phrase "American level of growth" used to describe something significantly higher than a "European level of growth." Now the distinction may have been removed.

This may be a unique time in investment history. Tilting toward mostly foreign but specific countries with low debt and deficit and high economic freedom may produce superior investment returns.

Countries that still rank as free according to the Heritage Foundation include Hong Kong, Singapore, Australia, Switzerland and Canada. These five countries already have an average five-year return of 8.04% versus the S&P 500's five-year return of -0.79%. Economic freedom is significant both to investors and to the welfare of their citizens. Debt and deficit also matter.

Going forward, you should continue to emphasize foreign developed countries with lower debt and deficits as well as the emerging market economies.

The 2010 World Economic Database of the International Monetary Fund (IMF) reports that while the United States and most other developed nations are experiencing increasing budget deficits, a select group of countries have been able to run a surplus. Norway (+9.67%), Switzerland (+1.37%) and Hong Kong (+.81%) are three such examples of fiscal health. Norway is blessed with an abundance of natural resources that make it the world's fifth largest exporter of oil and gas. Soaring public debt in the 1990s prompted Swiss voters to approve a constitutional amendment requiring revenue and expenses to balance over an entire economic cycle. Hong Kong's government has been a beacon of fiscal prudence as evidenced by its number-one ranking in the Heritage Foundation's index for 15 consecutive years. We believe that on average, businesses run within these fiscally responsible economies will outperform companies in countries with high debt or government intervention.

According to the IMF, emerging and developing economies will experience 6.6% GDP annual growth during the next two years while the advanced economies will only experience 2.5%. Perhaps "Emerging market level of growth" has replaced America as the land of opportunity. The emerging market index has averaged 12.73% over the last five years versus the -0.79% return of the S&P 500.

Average investors have nearly all of their assets in U.S. large-cap stocks and U.S. bonds. This represents one and a half of the six asset classes we recommend. We believe that adding any of the other asset classes may both boost returns and decrease volatility.

Regarding U.S. bonds, municipal bonds (or "munis") are becoming more popular. We do not recommend this strategy. Although a tax tsunami is coming at the end of this year, trying to avoid taxes by investing in muni bonds has its own pitfalls. With municipal debt rising, the risk of credit downgrades and insolvency threatens these investments.

Municipal revenue tends to trail economic recoveries by the year it takes for higher income and property taxes to be assessed and collected. Aid to municipalities from the $787 billion stimulus package is starting to wind down. Some municipalities are looking at deficits requiring tremendous reductions in spending. Warren Buffett, whose Berkshire Hathaway Inc. has been paring down its municipal bond portfolio, predicted a “terrible problem” for state and local government debt in his June 2 testimony to the U.S. Financial Crisis Inquiry Commission in New York.

Not all municipal debt is created equal. California's replacement of paychecks with IOUs is one example. Current-day financial stresses are highlighting the divide between those municipalities that have been spending beyond their means and those that have acted prudently. Reviewing your municipal portfolios is more important now than ever before.

Rebalancing after market declines on average provides a better return than a buy-and-hold strategy. Exiting the markets after declines is the worst of all possible strategies because it abandons a wise asset allocation simply because of short-term market fluctuations. But before rebalancing, make certain you have set a wise asset allocation in the first place.

 

from http://www.emarotta.com/article.php?ID=408

The Summer of Our Employment Discontent (2010-08-02)

by David John Marotta

The economy in the first half of 2010 has been disappointing, especially to investors and job seekers. High unemployment, market drops and less-than-stellar hopes for the future regarding taxes and regulation have all added to the general displeasure with our market environment. Now economists are generally predicting "more of the same" for the rest of 2010 at least. Evidently hope of a quick recovery was overly optimistic.

According to the Bureau of Labor and Statistics, the unemployment rate fell from a high of 10.1% last October to 9.5% in June. The decrease is hardly good news. More than 650,000 people are no longer counted as "unemployed" only because they are assumed to have given up even trying to look for work. The Bureau of Labor and Statistics U-6, a more comprehensive measure of employment underutilization, is currently at a seasonally adjusted 16.5%. Even this number excludes "part-time for noneconomic reasons." A survey by "Investor's Business Daily" suggests the number of people desiring more employment may be as high as 24%.

What little job growth is included in the statistics is mostly artificial stimulation from the government. Over a half million people were hired into temporary jobs as U.S. Census workers. As these temporary workers are let go, employment numbers are expected to remain sluggish through the remainder of the summer.

About 8 million jobs have been lost in the private sector since the start of the recession. About 2.7 million of those have been lost since the passage of the recovery act. But we need to add more than 100,000 jobs a month just to keep pace with population growth.

This worrisome shift from private sector jobs to public sector jobs has been measurable. In December 2007, 44.6% of personal income came from private sector jobs. By the first quarter of 2010, however, this number had decreased to 41.9%. Income from government programs rose from 14.2% to 17.9%. If every worker were paid the same, then for every 1,000 workers in America, 27 lost their job in the private sector and 37 of them were hired to work for the government. The remaining workers in the private sector paid an extra 9.8% of personal income to shoulder their increased burden.

Government assistance has taken what might have been a simple recession and turned it into a more lingering malaise. First we spent trillions bailing out corporations that should have just been allowed to fail. It would have looked worse, but it would not have really been worse. Banks would have failed, but the smaller bailout of those banks would have been less expensive and left the financial sector in the hands of those companies that practiced responsibility.

Then we tried simultaneously to juice the economy by spending like a drunken sailor and collect more revenue by raising taxes on sailors. Programs popularly described as "shovel ready," "homebuyer credit" and "cash for clunkers" wasted what could have been spent relieving the private sector from the coming tax tsunami. This reveille of utopia culminated in the health-care reform bill. It removed any limits on the increasing costs of health care other than government inefficiencies and rationing. It also laid the financial burden for those burgeoning costs squarely on the back of small business owners and investors by increasing taxes and capital gains on those with adjusted gross incomes (AGIs) of over $250,000.

Remember, although small business owners can have an AGI of $250,000, they only pocket take-home pay of $75,000 or less. They are heavily taxed on whatever they try to roll back into the business or when they expand their workforce. All this uncertainty is made even more dire with a tax time bomb set to explode in less than 200 days when the Bush tax cuts expire at the end of this year.

This bleak economic outlook sent the markets into a second dip for this recession. Over the second quarter the S&P 500 was down 11.43%. And from the peak on April 23 to the trough on the last day of the quarter, the S&P 500 was down 15.3%.

You might think all of this negative news would be a good reason to get out of the markets entirely. Many investors would agree and have done just that. But we believe that moving with the herd will underperform a more contrarian rebalancing strategy for four reasons.

First, all of this negative news has already been priced into the markets. The economy looks bleak, but it would have to look worse for the price to be driven lower. Second, many investors have already taken their money out of the markets. That is what drives the market lower. They can't drive the market any lower by staying out of the markets. Therefore a bottom often occurs when most investors are out of the markets. Whenever they move back in, they will drive stock prices higher.

Third, hundreds of millions of Americans work for publicly traded companies. Their very livelihood depends on them making those companies profitable for shareholders. I believe in the ingenuity of the American worker. I don't think all those American workers can be held back, not even by millions of new government hires.

And finally, I believe in the fickleness of American voters. They are willing to give new ideas about hope and change a chance. But they are also quick to reject those new ideas when they turn out to be nothing more than misguided and failed government intervention.

The Republicans proved they could spend like drunken sailors. Ultimately they were voted out of office. Now the Democrats have proven they can spend like drunken Republicans, and the electorate is taking note.

A full 59% of the electorate now describes themselves as "fiscally conservative and socially liberal." But only 26% would describe themselves as "libertarian." These changing winds will have their political effect in November. Even today more moderate Democrats are trying to break rank with Obama and Pelosi and extend the Bush tax cuts for the higher income tax brackets.

The economy will recover. Employment will rise. The ship of state will right itself. And even the American stock market will once again continue to advance and enrich its shareholders.

 

from http://www.emarotta.com/article.php?ID=407

Invest in All Six Asset Classes (2010-07-26)

by David John Marotta

Investors are challenged these days to know where to put their money. Everyone wants to know which asset class will perform the best and help them meet their retirement goals.

We use six different asset classes: three for stability and three for appreciation. In the stable asset classes, you loan a company money to be paid back at a fixed rate of interest. Examples include money market, certificates of deposit (CDs) and bonds. These asset classes are like the iron rods that support a sailing ship. They don't make the ship go faster, but they do keep it from capsizing in a storm.

Investors approaching retirement should have at least five to seven years of their safe spending rate allocated to stability. For them, replenishing their allocation to stability when stocks are appreciating helps secure future years of spending.

In the appreciation asset classes, you own a piece of a company and share in its earnings. Examples include shares of individual companies or the mutual funds or exchange-traded funds that invest in equities.

Portfolio construction begins with the most basic allocation between investments that offer a greater chance of appreciation (stocks) and those that provide portfolio stability (bonds). These decisions are the most critical in determining the overall behavior of your portfolio returns.

We divide the asset classes for stability into short money, U.S. bonds and foreign bonds.

Short money includes any fixed-income investment with a maturity date of two years or less, which includes money market accounts and many CDs. Short money investments are not paying a great rate of interest right now. But when interest rates rise, they will adjust quickly and be among the first investments to gain from the higher rates.

Many risk-averse investors put their money in a bank account or invest in CDs. But like any other investment, cash has its own set of risks. It is dangerous because the dollar can be devalued so the same number of dollars won't buy as much as they used to. There are good reasons to hold cash, but holding too much for too long makes it harder to grow your assets and can jeopardize your financial goals.

The second asset class, U.S. bonds, generally pays a higher interest rate the longer their duration and the worse their credit quality. But longer term bonds drop more in value when interest rates rise. And bonds whose credit rating drops lose value too because of the chance of default.

Putting money in stable instruments because you want to reduce risk only to invest in high-yield junk bonds is counterproductive. So is increasing the term of a bond when interest rates are very low. We recommend higher quality short- and intermediate-term bonds. Invest a portion of your assets in stable investments, and if you want a higher return, put the money into appreciating assets.

Foreign bonds are the third stable asset class. They can balance domestic currency values and interest rates with what's happening in the rest of the world. And they sometimes pay a higher interest rate. Foreign bonds also appreciate when the U.S. dollar is declining in value. Foreign bonds are subdivided into bonds in developed countries and bonds in the emerging markets. Like U.S. bonds, foreign bonds are categorized by quality and duration.

Appreciating assets are essential to your portfolio. They are the engine of your retirement savings. Even in retirement, you will need enough appreciation to keep up with inflation, pay the taxes and still have some real return left over.

We divide appreciation into U.S. stocks, foreign stocks and hard asset stocks. Most investors have primarily U.S. large-cap stocks, mimicking the S&P 500. They buy mostly large-cap growth stocks in the industry that did well last year with a high price-per-earnings (P/E) ratio. We don't recommend such portfolios.

On average, small cap outperforms large, and value outperforms growth. Although we recommend overweighting smaller companies with low P/E ratios, your portfolio should include a broad spectrum of stocks, including a generous helping of growth-oriented stocks. There may be times to overweight or underweight specific industries such as technology or health care.

The second appreciation asset class is foreign stocks. Diversification abroad can both boost returns and decrease volatility. Some people try to diversify internationally by investing in U.S. companies that gain a significant portion of their revenue from overseas. But these multinational companies still track fairly closely with other domestic companies, and they don't offer the same benefits as investing in foreign stocks.

Overweighting specific countries can be advantageous too. We use the Heritage Foundation's ratings to select countries that combine the greatest economic freedom with large investable markets. One yardstick of economic freedom favors countries with a low public debt and deficit and therefore a more stable monetary policy.

We recommend investing in the fastest growing countries. These emerging economies provide even greater diversification and returns. However, emerging markets are inherently volatile, so it is important to find the right balance and make adjustments as needed.

Finally, hard asset investments include companies that own and produce an underlying natural resource. These include oil, natural gas, precious and base metals, and resources like real estate, diamonds, coal, lumber and even water. We suggest diversifying hard asset stocks by resource type, geographic location of a company's reserves and company size.

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

Over time, dollars lose their buying power, and the goods and services we buy cost more. Commodities generally maintain their buying power in dollar terms. But investing in hard asset stocks generally appreciates at a rate much higher than inflation.

Hard asset stocks have a distinct set of characteristics and are categorized separately. Their movement is generally less correlated with that of other asset classes. They have a unique (and positive) reaction to inflationary pressures. And at certain periods in the longer term economic cycle, including hard assets helps boost returns.

Many advisors don't have an asset class for natural resource stocks. They select one portion of the category instead, typically real estate, and make that the asset class. This can 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.

Natural resource stocks 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 designated to stocks and the amount designated to bonds.

Many U.S. investors crowd their assets into a combination of large-cap U.S. stocks and U.S. bonds. This allocation represents only one and a half of the six asset classes described here.

Asset allocation means always having something to complain about. Investors are continually looking for the safe investment. But inflation, sovereign debt, globalization and diminishing U.S. economic freedom make a clear choice difficult. Thus we advise a diversified portfolio that overweights certain subcategories.

If you have set such an asset allocation, what did poorly this past quarter may be poised to do better in the coming year. If your asset allocation is wrong, change it. But if it is right, don't abandon a brilliant allocation simply because of short-term returns.

Finally, rebalance regularly. Without rebalancing, those categories that do well may continue to grow as a percentage of your portfolio until they significantly underperform the markets. The ones that do the best often bubble and finally burst.

 

from http://www.emarotta.com/article.php?ID=406

Life Planning Part 3: Twenty-Four Hours to Go (2010-07-19)

by David John Marotta

Life planning peels back the layers of our soul, seeking the best and highest calling for our existence. Seek out a financial advisor who understands what you truly value and structures your finances accordingly to best support your life's mission.

The idea is simple yet ingenious. Begin with the end in mind.

Let's take another look at George Kinder's well-known "three questions" that seek to uncover those goals and values most central in our lives. Number one is "If you had all the time or money you needed, what would you do?"

The response to this question typically provokes a long list of everything we want that money can buy. But with reflection, it goes deeper, stirring the longings of our heart.

The second question aims at these deeper desires. "What do you want to do or be so in the end you will feel that you've lived fully?"

These values most commonly revolve around three different realms. First, we yearn for meaningful connections with others starting with our immediate families and extending into our communities and the world at large. Second, we seek authentic spirituality, an odyssey that shapes and renews our very identity. And third, we revere beauty, creativity, nature and special locations. These three realms, righteousness, truth and beauty, are the areas where most of us find meaning and significance.

Kinder's third question can be encapsulated by the phrase "Twenty-four hours to go." It probes beyond our relationships and activities into the sum of our very existence. "Imagine that your doctor shocks you with the news that you only have 24 hours to live. Notice what feelings arise as you confront your very real mortality. Ask yourself: What did you miss? Who did you not get to be? What did you not get to do?"

This is a daunting question for many of us to even contemplate. Every day we get up preoccupied only with our to-do list, assuming we always have tomorrow. One day we won't have tomorrow. We all know intellectually that day will come, but we don't want to make our plans in light of it.

It is especially difficult to face our own mortality if we have not taken the time to deal openly and honestly with the issues in the first two questions. These three questions must be taken in order. We all want to perceive our lives as successful and significant. But justifying our existence is a daunting challenge.

Every day we face the dual desire to improve the world or to enjoy it. One requires judgment; the other, contentment. We struggle between the duty to do what we should and the passion to do what we love. The first structures our lives and the second strengthens and nurtures us. The consequences of these decisions are not always easy to understand because we must live our lives going forward. Kinder's third question gives us the opportunity to stop and look back, to assess how our decisions have changed the course of our life if our life were to end tomorrow.

How do you want to be remembered by your friends and family? Author Samuel Butler wrote, "Life is like playing a violin in public and learning the instrument as one goes on." Our faults are often embarrassingly obvious and humbling. First we have to learn to play the instrument. Then we need to learn to make our own music. At every moment we can confront our own mortality and reflect on the progress we have made.

Surveys have found that people regret what they didn't do more often than what they did. And when people express remorse about having done something wrong, it was usually what I call a "life buster"--one of those decisions that can greatly compromise your life.

Serious life regrets include marrying someone you knew wasn't right for you, getting hooked on drugs or breaking the law. You can recover from these, but you will lament the spiritual death and wasted opportunities along the way. A good rule of thumb is always to ask, "What's the worst that could happen?" If it might destroy your life, hesitancy is indeed a virtue.

Regrets about things we didn't do are more subtle. Our lives can change course dramatically and be filled with serendipity all because of some small decision on our part. How many times have we heard the story of how a happily married couple met, only to be surprised that it almost didn't happen? If the worst outcome of a decision is a little embarrassment, perhaps the chance is worth taking.

We each long to participate in something significant. And that requires foresight, planning and forgoing our momentary desires in order to work toward realizing our greater passions. The choices we make each day determine the ones we will have the opportunity to make in the future. Without those hesitant, often stumbling first steps, we can't complete the journey.

The Latin phrase "Audaces fortuna iuvat" translates as "Fortune favors the bold." We commonly use a milder version of it in our family: "You do not have because you do not ask." Often our hopes and dreams are unrealized because they are left unmentioned.

Voicing what we are passionate about can be scary. Beginning to act on our ideas can feel overwhelming. But courage isn't a lack of fear, it's action in spite of fear. And our fear may an indication that we are on the quest of our lives.

For entrepreneurs, overcoming fear is a regular occurrence. Many, perhaps even most, multimillionaires have at least one if not more failed businesses in their past. That's because only those willing to risk failure--and the lessons learned from it--have the grit to achieve success.

Entrepreneurship, or its equivalent, is a form of proactive living. You don't necessarily have to start a business, but you do have to begin the journey toward your life's goal. When you take ownership of your life, you can do what you think is best, go where you think you are called and be who you believe you should be. Life can have fewer compromises and therefore fewer regrets.

I asked Kinder why he championed his three questions among financial advisors. He answered, "Money is the facilitator of what is most meaningful for us in the world. When we understand this, everything about money becomes clear and falls into place. We don't hire a financial advisor just because they're a nice person, they show us interesting spreadsheets, and they seem pretty much on the ball. We hire them so that with their professional financial expertise they can best deliver our brilliance into the world. Without being crystal clear what our most profound goals are, we can't begin that process."

A violin resonates because of the laws of physics. But virtuosos have to feel the music in their souls. Only after we know what we are striving to do with our lives can we make financial choices that enable and reflect our own special music.

 

from http://www.emarotta.com/article.php?ID=403

Life Planning Part 2: Just a Few Years Left (2010-07-12)

by David John Marotta

George Kinder, a member of the National Association of Personal Financial Advisors and a fee-only financial planner, founded the Kinder Institute of Life Planning. He helped popularize the concept of financial life planning, which begins with the idea that financial advisors should understand their clients' life purpose and structure their finances accordingly. In other words, they should begin with the end in mind. This is both obvious and genius.

Kinder is probably best known for his now famous "three questions" that seek to uncover those goals and values most central in our lives. Number one is "If you had all the time or money you needed, what would you do?"

The response to this question typically provokes a long list of all our desires that money can buy. But with reflection it goes deeper, stirring the longings of our heart. As C.S. Lewis wrote, "One of the dangers of having a lot of money is that you may be quite satisfied with the kinds of happiness money can give."

Our materialistic culture seduces us into believing happiness can be packaged as a commodity and taken home in a shopping bag. As a result, we spend money on goods and services that at best provide fleeting satisfaction and may jeopardize long-term goals that could have brought us real fulfillment.

We may be tempted to judge our well-being not by the quality of our lives but by how we compare with others. Today's borderline poor live as well as the upper middle class did a few decades ago. But they still feel deprived. As we become accustomed to a higher standard of living, luxury quickly loses its luster. We always want more. Kinder's first question gets all these desires out on the table, at least partially, so we can move past them.

Kinder's second question, which can be encapsulated by the phrase "Just a Few Years Left," probes those values that money can't buy. "Imagine that you visit your doctor, who tells you that you have only 5-10 years to live. You won’t ever feel sick, but you will have no notice of the moment of your death. What will you do in the time you have remaining? Will you change your life and how will you do it? (Note that this question does not assume unlimited funds.)"

Take the time to explore this question periodically. A personal five-year plan isn't the sign of an obsessive-compulsive personality disorder. Systematically moving toward our goals is simply living intentionally.

If you have young children, your answer may focus almost exclusively on them and include few, if any, of your own personal goals. Certainly parenthood is a consuming responsibility. But it is only for a season of our lives. And even during that time, parents can often integrate some of their own dreams.

Kinder unfolds all of these ideas in his book "The Seven Stages of Money Maturity: Understanding the Spirit and Value of Money in Your Life." Many of us hesitate to take this personal journey. I regularly get letters questioning what spirituality and values have to do with financial planning. I believe these detractors miss the whole point.

Beth Nedelisky and I teach an Osher Lifelong Learning Institute course each spring, "Financial Planning for Success and Significance in Retirement." In the first class we explore finding meaning in retirement and defining success. A few participants are disappointed that they have to wait until later for the spreadsheets and income projections. But most are glad to talk about why a complete retreat from the working world followed by 24/7 recreation and a shrinking social circle is an impoverished environment for our souls.

We shouldn't shortchange the process of wrestling with the meaning of our lives at any age. Deep down many of us probably know what would be a more satisfying life, but we are afraid to contemplate the implications. Change can be intimidating. The alternative, however, is to keep living a life that in our own eyes may seem unimportant.

Even without small children, significance stems heavily from family and other close relationships. Loving others demands risking and being willing to change and adapt in order to connect deeply. At the end of life, people often regret the risks they didn't take. For many of us, it takes something drastic, like a serious medical prognosis or a near accident, to push us out of our comfort zone.

Often it requires getting older to find the wisdom and the grace to accept people as they are. The virtues of forgiveness and forbearance are necessary to live harmoniously. Relationships can be messy, but they are generally worth the effort. And it helps to remember that what is most important is being the right person, not finding the right person. We can learn to accept people without necessarily approving of their choices.

Once our personal relationships are healthy, many of us want to connect with the outside world and give back to others. Even small efforts to help others can make a significant impact on our communities and change the course of people's lives.

A second realm where people find significance is authentic spirituality. This is more than simply being religious, which is often expressed through practicing a specific tradition. Authentic spirituality often involves the totality of our life in which we seek to have our very identity renewed and shaped.

Compartmentalizing spiritual considerations into a small subset of our lives lacks authenticity. We long for a more meaningful life. At times these issues demand our attention and contemplation. We can start by relying on our spiritual traditions, but outward practices can only take us so far. Authentic spirituality is an odyssey of discovery and personal growth such that the truths learned change the way we live each day.

The third sphere where people seek a deeper and richer life is in the arena of beauty. Many people enjoy exploring their creativity, perhaps through music, the visual arts, or personal writing.

For others this sense of beauty is found in a reverence for nature. Places in the world like the redwood forests of California have a magical quality. Or we may find a special connection with urban locales like Central Park or the back alleys of Venice.

These three realms, righteousness, truth and beauty, are the three areas where most people find meaning and significance. They categorize what is most important to many of us.

I asked George Kinder about people's life goals and he said, "Sometimes I wonder why it is that so many of us make foolish decisions around money. Even with good advisors at our side, it seems. And then I reflect that perhaps the reason is that we have never really figured out what money is and what it's about. We think it's about spreadsheets and bank balances and rates of return and stock markets and buying things and getting into debt. Or at least those are some of the categories that might come up for us.

"But money really is the great facilitator of what is most meaningful for us in the world. It's meant to help us put together a life that best expresses our own individual genius, our brilliance, our creativity, our compassion, our values, our integrity, our spirit, our mission in life, what is most important of all that we realize and become."

Some thoughtful responses to these life planning exercises can help us set goals that are both meaningful and deeply personal and help us truly value our lives. Take the time to reflect on what you would like to do or be to live life to its fullest. Next week we will move on to the third life planning exercise.



from http://www.emarotta.com/article.php?ID=402

Life Planning Part 1: Plenty of Money (2010-07-05)

by David John Marotta

Thoughtful wealth management is more than just maximizing net worth. It also gives us the best chance of meeting our life goals. Wealth is only valuable because it helps us make a significant impact on our world. It doesn't give us meaning.

Life planning takes a holistic look at what you truly value. And for most people, their life is more important than their money. Only after exploring your life goals can you structure your finances to help you realize your dreams.

A fee-only fiduciary wealth manager sits on the clients' side of the table. With a deep understanding of clients' goals, the professional can manage their money just as the clients would if they had the same expertise.

We begin the process with a preliminary questionnaire that poses a series of easy questions to help us learn about a client's goals and values. We ask, "What charitable and/or professional organizations do you support? What interest/hobbies do you enjoy? What gets you out of bed in the morning? What would you like to be doing five years from now?"

This allows us to begin to know our clients at a deeper and more revealing level than what we learn from a tax return and net worth statement. It is difficult to write about life planning without sounding religious or moralistic, which is the point. Ultimately, our financial decisions are spiritually based. The process of financial planning pushes us to articulate which values we want to live by and motivates us to adjust our daily monetary decisions to fit those values.

Spiritually sensitive financial advisors, regardless of their specific perspective, ask astute questions that reveal these values. Christians, Zen Buddhists and many other perspectives share this common framework that spiritual concerns are critical. For example, <a href="http://www.kinderinstitute.com/" target=_blank> George Kinder </a>, author of "<a href="http://www.amazon.com/gp/product/0440508339?ie=UTF8&tag=davidjohnmarotta&linkCode=as2&camp=1789&creative=9325&creativeASIN=0440508339" target=_blank> The Seven Stages of Money Maturity: Understanding the Spirit and Value of Money in Your Life</a>," approaches life planning from such a perspective. He uses a series of three exercises to help people sort out when they might need to change direction. Each one is an experiment in which you ponder one potential scenario and imagine all the possible ways you might react.

The first one, called "Plenty of Money," starts with one of Kinder's famous "three questions":

"Imagine you are financially secure, that you have enough money to take care of your needs, now and in the future. How would you live your life? Would you change anything? Let yourself go. Don't hold back on your dreams. Describe a life that is completely and richly yours."

This scenario is playful and fun as well as revealing. I've seen several variations, such as "What would you do if you won the lottery?" or "What would you do if you had a million dollars that you couldn't spend on yourself?" But Kinder's format is probably the better one because it purposefully focuses not on the money but on your life's calling.

Like Eric Liddell in the film "Chariots of Fire," we are searching for meaning in our lives. He says, "I believe God made me for a purpose, but he also made me fast. And when I run I feel His pleasure." We are looking for a life so completely and richly ours that we feel God's pleasure. This is our area of genius. This is our calling.

This exercise may not result in a practical life change when you are done. But it will begin to uncover some of your inner longings that currently may be eluding you.

Another excellent way to explore this process is <a href="http://www.barbarasher.com/" target=_blank> Barbara Sher's</a> book "<a href="http://www.amazon.com/gp/product/0440505003?ie=UTF8&tag=davidjohnmarotta&linkCode=as2&camp=1789&creative=9325&creativeASIN=0440505003" target=_blank> I Could Do Anything If I Only Knew What It Was: How to Discover What You Really Want and How to Get It</a>." Subtitled "How to Discover What You Really Want and How to Get It," it offers practical ways to expand on Kinder's scenario and find your heart's desire.

You've probably heard the saying "Find a job you love and you will never work a day in your life." Studies show that deep joy comes from knowing exactly what you want and feeling like you are moving toward getting it.

Sher suggests the next time you are with a group of strangers, tell them the most offbeat idea you can think of. Say your dream is to raise Dalmatians in the Himalayas, but you have no contacts in Tibet.

People's interest perks up. They may even try to solve your problems. Some may react negatively, but most suggest ideas. But describe the same scenario to your family or friends, and they will try to save you from your folly. And that is one reason why we find it so difficult to dream long enough to determine what our dreams really are.

Another of my favorite exercises in the book comes after you create an ideal scenario. Sher then asks you to act on it for only an hour: Get the application. Find out about the job. Call some contacts. Make an appointment.

She says that planning is mostly science fiction, just a hopeful prediction. But following a plan gets us out into the world where something can happen. Anything that moves us toward what we want makes room for serendipitous events. It also forces us to confront any hidden resistance within us.

Finding our life's goals requires quiet times of thought and reflection over a long period to learn about ourselves and our place in the world. And often it takes experiences we can only have by trying a number of different endeavors.

All of this may sound too fuzzy or creative, but nothing is more important in the wealth management process. Balancing a family's financial goals and making financial choices according to those values is at the heart of comprehensive financial planning. Financial woes often come not from a lack of income, but from our failure to live according to our true values.

Take some time to imagine how you would live your life if you had plenty of money. Next week we will discuss the second life planning exercise.

 

from http://www.emarotta.com/article.php?ID=400

Virginia Land Preservation Tax Credits (2010-06-28)

by David John Marotta

A dollar saved on your taxes is more valuable than a taxable dollar you earn from your salary. The Virginia land preservation tax credit can reduce your state taxable income by 16%. For example, if you owe $3,000 of Virginia state tax, it will save you $480. If you owe $30,000, it will save you $4,800. Other states have similar programs, but the details vary.

Every Virginia taxpayer can profit from this technique. The process begins with landowners who donate a conservation easement against their land. In this legal document, owners of private property give up some of their development rights. Usually they donate them to a conservation nonprofit. Because development rights are valuable, their donation is tax deductible.

These donations preserve and encourage permanent open and undeveloped land while keeping the ownership of that land private. For those concerned that land lost is land lost forever, conservation easements are a way to reverse that trend. Land restricted by a conservation easement is preserved in perpetuity. In Virginia, currently 6% of the land not owned by the federal government is subject to permanent conservation easements.

Advocates suggest that conservation easements do permanently what taxation based on land use assessment tries to accomplish every year. That is, they keep open spaces, improving the quality of our air, water and food. To their way of thinking, tax incentives are better spent on land conservation easements than other more temporary methods of land preservation.

To encourage such preservation, the Virginia Land Conservation Incentives Act of 1999 offered strong tax incentives. It allowed a landowner to claim 40% of the value of the easement as tax credits. So if the easement was worth $1 million, the land owner received $400,000 in state tax credits.

Tax credits are much more valuable than tax deductions that only reduce the amount you are taxed on. For example, a dollar of deduction might only be worth 35 cents. In contrast, tax credits are a dollar-for-dollar reduction in your tax bill. And a refundable tax credit could mean the government will owe you money you never paid in the first place.

Land preservation tax credits are not refundable, however, which left some philanthropic families with thousands of dollars of unusable tax credits they could only roll forward for 10 years. So in 2002 the legislation was amended to allow the credits to be transferable.

Now generous donors could sell their $400,000 worth of credits to taxpayers at some negotiated discount. Willing taxpayers could either pay their $10,000 of Virginia state tax or buy credits to pay their tax at a discount. Donors are paid something for credits they can't use. And taxpayers get a discount on paying their taxes.

This scenario may sound too good to be true or even illegal. But Virginia budgets up to $100 million for qualified land preservation tax credits.

Advocates of smaller government argue that first the state reduces the value of the land it is taxing and then gives that value back in tax credits. All of these shenanigans further the goals of conservationists by burdening commercial land owners. Conservationists don't care about the lost revenue. They argue that Virginia spends the least on land conservation among the states and continue to push for a vastly increased budget to support these efforts.

We shouldn't moralize too much when engaging in tax management. If the tax code permits a huge deduction for brushing your teeth with your left hand while standing on one foot, it is still worth doing. The burden is light and the gain is great. Vote your conviction at the polls, but take the benefit.

In this case the benefit can be significant. In 2009, land preservation tax credits were sold at about a 16% discount. Each year this discount is subject to supply and demand. Sellers got about 73% of the value. Of the remaining 11%, 5% went to state transfer fees and 6% to the brokers who put the deals together.

Consider an example. If your income is $200,000 and your deductions are about $25,000, your taxable income of $175,000 means you owe Virginia $10,000. If you purchase credits at 84 cents on the dollar, you save $1,600. That's a significant savings for filling out a little paperwork.

Brokers do suggest you have at least a $2,000 tax liability before you decide to take advantage of these credits, which would save you $320. Obviously those with a $50,000 tax liability save a whopping $8,000 just for complying with the required clerical work.

The risks are small but do exist. Good brokers weed out questionable credits. They also ensure that sellers provide legal guarantees to protect buyers. In the worst case scenario, the credits are disallowed, the seller refunds your purchase of the credits and you have to pay the full tax you owed.

You must purchase the credits before the end of the year to use them to pay your tax in April. Each taxpayer can use up to $50,000 of credits per year, so a husband and wife could each buy their own and use $100,000. Unused credits can be carried forward for up to 10 years.

Purchasing credits in December at a 16% discount to pay a tax liability in April is an excellent short-term return. But it is even better when you consider that you can avoid paying any quarterly Virginia estimated tax payments throughout the year. Per state regulations, you will owe no tax because of the tax credits you have purchased.

Proactive certified public accountants or financial planners who review your finances and suggest ways to save thousands of dollars are worth their weight in tax credits. Ask your advisor about using this technique to save you money.

 

from http://www.emarotta.com/article.php?ID=397

Dorothy in Taxland: Tax Credits (2010-06-21)

by David John Marotta

Tax credits are much more valuable than tax deductions. Deductions only reduce the amount you are taxed on. One dollar of deduction might only be worth 35 cents. In contrast, tax credits are a dollar-for-dollar reduction in your tax bill. And a refundable tax credit could mean the government will owe you money you never paid in the first place.

The final tax formula is "Total tax minus payments equals the amount you owe or have overpaid." The critical part of this formula is that payments include not only the money you have given the government but also any tax credits you are eligible to receive.

But most people fail to claim all their legal tax credits and miss opportunities to gain some real wealth redistribution.

For example, if college students have earned income, they can receive the Making Work Pay tax credit. It's a refundable tax credit worth 6.2% of earned income with a maximum of $400 per person. This credit is phased out for middle-income families but not for their children. They are eligible as long as their parents don't claim them as dependents.

Even if these students pay no tax, they will still receive a check from the IRS for $400. That's the beauty of a refundable tax credit. Students who file a tax return can take advantage of several other tax credits.

As a parent of a college student, you could receive a Hope tax credit. Usually this is a $1,800 credit for the first $2,400 spent on a college education during the first two years. But for the past two years it has been enhanced for students in the Midwestern disaster area to be $3,600 on the first $4,800 spent. If you have saved in a College 529 plan, you cannot receive this credit for money disbursed from the 529.

But if you spend $24,800 on the University of Chicago, for example, you can reimburse yourself $20,000 from the 529 and still receive the full $3,600 Hope tax credit for having spent $4,800 out of pocket. Spending $1,200 outside the 529 allows you to keep an extra $3,600 inside the plan.

Alternatively you can get the American Opportunity credit, which gives you up to $2,500 on the first $4,000 of educational expenses. It isn't limited to the first two years of college and is partially refundable. You can also take advantage of the Lifetime Learning credit and get $2,000 on the first $10,000 spent. Even part-time students who only took a single class are eligible.

This year many adult children of millionaires will receive an $8,000 First-Time Home Buyer tax credit. Many wealthy families will receive a $6,500 Move-Up/Repeat Home Buyer tax credit. These credits were available for couples with incomes under $225,000 who purchased homes priced at $800,000 or less. It's good to know we are using our tax credits to support the truly needy.

In many very rich families, everyone got a new home this year. Money is being given to each child to help him or her buy a home and make payments. In three years all the homes can be sold for a profit. In the meantime everyone gets an $8,000 refundable tax credit.

If you install a new air conditioner, windows, doors, roofing, furnace or water heater, you can also qualify for tax credits. The replacements have to be more energy efficient. Nearly everything new qualifies. Even those with enough discretionary income to make improvements without any governmental incentives can get a $1,500 tax credit.

According to the IRS regulations, nearly every window sold today will qualify as more energy efficient than the older windows being replaced. But the window companies have lobbied for taxpayers who can't afford to replace their windows to subsidize wealthier individuals who can. Nearly anything can be justified these days by calling it green.

The geothermal heat pump manufacturers must have had an especially adept lobbyist. Their merchandise isn't subject to the $1,500 cap and is worth 30% of the cost. So are solar energy systems or small wind energy systems.

There's even a tax credit for contributing to your retirement account. Couples earning less than $50,000 can get a tax credit up to $2,000. They can get a tax deduction for the contribution and still receive the credit. Even students can qualify if they are part time and not claimed as a dependent.

Probably the largest of all is the Earned Income tax credit. It is intended as the primary way to help the working poor, defined as a family of four with an income less than $45,295. The maximum credit is $5,028 with two children.

If you choose to take your children as dependents, you may also qualify for the child tax credit. It provides a $1,000 tax credit for each child as long as couples earn less than $110,000.

Finally, there is still a federal energy tax credit if you buy a hybrid electric vehicle. Incredibly, the IRS has ruled that even golf carts qualify under the rules of the $700 billion bank bailout. Every golf cart manufacturer has applied to become a licensed motor vehicle dealer and modified its carts to be street legal and plug into the wall. Getting a $5,900 tax credit on buying a golf cart can't possibly be what legislators intended.

Most of these tax credits are just a percentage of what you have to spend to qualify. Because the poor don't have much discretionary income, these tax credits do not help them at all. Mostly they subsidize the upper middle class and the businesses in specific industries who have lobbied to qualify.

I've personally taken advantage of nearly every tax credit available. In fact, this year each of my children got refundable credits giving them thousands of dollars more than they actually paid. Tax planning and management is increasingly a crucial part of wealth management. But it is terrible public policy. I think it is every citizen's civic duty to vote against the hands that try to bribe special interest groups with tax credits.

Hundreds of other federal tax credits and a host of state tax credits are available as well. Simplifying the tax code is the easiest way to reduce or eliminate loopholes and bring sanity back to the process.

As always, the tax code is as easy to understand as a flying monkey. Perhaps this is another reason why most people leave hundreds or even thousands of dollars of refundable tax credits unclaimed. This is especially true of the poor who don't have tax professionals to help them decipher and access the multiple forms required.

The moral failing belongs to voters and politicians who support nearly every proposed tax credit and then are surprised at the consequences. Until our country comes to its senses, tax management will remain a way to build and protect your family's hard-earned wealth.

 

from http://www.emarotta.com/article.php?ID=396

Dorothy in Taxland: Overview (2010-06-14)

by David John Marotta

Many people who use tax computation software don't understand the changing structure of the U.S. tax code. They fill in the blanks, click Compute and pay the tax. Then they forget about the torture until next year.

Into this dark forest of the tax code, we throw college students and recent graduates. It is almost a rite of passage, better likened to a fraternity hazing than a step into adulthood.

The byzantine rules and regulations of the tax code are carefully crafted to cover up just how much we pay each year. In other words, tax laws are obscure by design. While you are busy trying to translate word problems written in Taxglish, you don't realize the IRS is asking all the wrong questions. Like Dorothy in the field of poppies, you can't seem to stay awake long enough to realize the danger.

A professional tax expert can help you get the correct deductions. But he or she likely won't motivate you to keep the right records unless you understand the benefits for yourself.

The three basic ways to reduce your tax burden are above-the-line deductions, below-the-line deductions and credits. The line in this case is your adjusted gross income (AGI).

Each method is used in one of the four general formulas on the 1040 tax form.

The first formula is "Gross income minus above-the-line deductions equals your adjusted gross income (AGI)."

Above-the-line deductions are subtracted from your gross income to compute your AGI. Therefore, they reduce your AGI, which also lowers your taxable income.

Above-the-line deductions are more common if you are self-employed. But if you are not a small business owner, there are still above-the-line deductions you can take such as stock losses up to $3,000, IRA contributions, student loan interest, moving expenses, alimony and several other items.

Payments to your Health Savings Account (HSA) can also be deducted above the line. In 2010, the family limit is $6,150 in tax-free contributions. One of every 10 patients consumes 69% of health-care costs. The other nine would benefit from an HSA.

The second formula is "AGI minus deductions equals your taxable income."

Below-the-line deductions are more uncertain. Like many items in the tax code, whether they will reduce your taxes depends on many factors.

You can either itemize your deductions or you can take the standard deduction, whichever is greater. For 2010 the standard deduction is $5,700 if you are single and $11,400 if you are married. And whether you itemize or not, you can take additional personal exemptions of $3,650 each.

Home ownership is the most common way to boost your deductions above the standard deduction. The IRS allows home owners to deduct their interest payments each year. If your home mortgage is at 6% and your payments are mostly interest, most of your mortgage is tax deductible. If your marginal tax rate is near a third, the government is paying 2% of your interest, and you are only paying 4% of your interest. For most middle-class families that results in a large tax savings.

If home ownership alone doesn't make itemizing worthwhile, your state and local taxes (including personal property taxes) along with any charitable deductions may push you over the top. Alternatively, if you have high medical expenses that exceed 7.5% of your AGI, you can deduct them as well.

In the third formula, after looking up your taxable income, you compute your total tax. Two different methods are used, and the higher of the two must be paid.

The first method uses the traditional tax tables. The second uses the Alternative Minimum Tax (AMT).

The AMT method of computing tax owed undoes many of the deductions you took in previous steps and turns much of traditional tax planning upside down. Increasingly middle-class families are hit by the AMT, whereas upper-class families pay such a high tax rate already, they are unaffected.

The fourth and final formula is "Total tax minus payments equals the amount you owe or have overpaid."

The critical part of this formula is that payments include not only the money you have given the government but also any tax credits you are eligible to receive.

Deductions only reduce the amount you are taxed on. One dollar of deduction might only be worth 35 cents in tax savings. In contrast, tax credits are a dollar-for-dollar reduction in your tax bill. And some tax credits are refundable. That could mean the government ends up owing you money you never paid in the first place!

Thus tax credits are much more valuable than tax deductions. But most people fail to claim all their legal tax credits and miss opportunities to gain some real wealth redistribution.

Investment management is central to building wealth. But comprehensive wealth management includes tax management as well. A proactive CPA is another essential component of the team. CPAs do more than just fill out your taxes. They may charge a little more, but they can earn their fee multiple times over.

 

from http://www.emarotta.com/article.php?ID=395

Regular Adjustments Maximize Retirement Success (2010-06-07)

by David John Marotta

Retirement planning consists of a wild scatter plot of potential projections. Navigating successfully through possible outcomes requires regular corrections and adjustments.

Most retirement software runs hundreds of possible retirement scenarios, called a Monte Carlo analysis. Success is defined as achieving 80% or more of investment outcomes where blindly following your planned strategy means staying solvent until you die. Keeping an 80% success rate ensures that your average is much higher than depleting your portfolio. You are prepared to deplete the portfolio, but over half the time you will leave a significant legacy.

Although these projections are useful, they are seriously limited.

One software vendor includes wild stock returns, often called black swan events, that might swamp your portfolio. So the allocation recommendation given the best chance of success for long periods of time is an all-bond portfolio, exactly the opposite of what you would expect.

I pressed the software makers to explain why their program gave such a strange result. They had tried to simulate black swan events in the stock markets. But they admitted they hadn't included any unforeseen bond or inflation events.

They did not consider a possible excessive bond default. And they simply assumed constant straight-line inflation at whatever input was provided. Muni bonds may default en masse. In fact, the United States may go the way of Greece. Alternatively, hyperinflation may return. In any of these scenarios, the all-bond portfolio doesn't seem so attractive for long-term investing.

At age 65, retirement projections are like Lewis and Clark leaving St. Louis heading for the Pacific. They start out due west but know they will need to alter their route as they navigate the terrain. And they can also rely on their Native American interpreter and guide.

Straight-line projections don't work within Monte Carlo. And you can't anticipate every unexpected event. The best approach is to diversify your portfolio to reduce the risks associated with one type of investment and to make continual course corrections.

We recommend a safe withdrawal rate based on age. At age 65 that rate is 4.36%, assuming portfolios with sufficient appreciation and projections adjusted regularly.

Assume you have a million-dollar portfolio as you retire at age 65. Your safe withdrawal rate is 4.36%, or $43,600 for the first year. Inflation averages about 4.5%. A balanced portfolio might earn 5% over inflation, or 9.5% total. So in an average year you would spend $43,600. The remainder of your portfolio would gain $90,858 for an end value of $1,047,258.

Our safe spending rate at age 66 increases from 4.36% to 4.43%. If you'd only earned 3% over inflation, you would receive an approximately 4.5% cost-of-living increase at $45,562 per year. Because you earned 5% over inflation, your safe spending rate increases to $46,394 annually. The extra $832 a year is available because 80% of the time the average return for your portfolio is above our planning.

The market typically appreciates more than planned and you get an increase greater than inflation. But some years the market drops significantly. You then have to hold your spending constant, waiting for your portfolio to catch back up with average market returns.

Our minimal expectation is 3% over inflation. That is the average return of a bond portfolio. When inflation is running at 4.5%, a bond portfolio offers about a 7.5% return. Investing everything in bonds, however, is a poor idea. It gives your portfolio no average excess return to come back from bad bond markets or hyperinflation. With all bonds, your failure rate is 50% or more, too high for a safe retirement plan.

Adding stocks to your portfolio will boost your average return. If bonds earn on average 3% over inflation, stocks earn 6.5% over inflation (11% if inflation is 4.5%). Adding stocks provides an engine of appreciation over 30 years of retirement.

A million-dollar portfolio at age 65 with average returns from a 30-70 tilt toward bonds will produce $4.0 million in spending through age 100. But tilting 70-30 toward stocks will produce $6.1 million. The decision to tilt toward stocks produces over $2 million more lifestyle spending over 35 years.

Investing in fixed income gives you peace of mind. You know your lifestyle for the next few years will be relatively stable and not depend on the whims of an inherently volatile market. Investing in stocks is appropriate when your time horizon is at least five years or longer. Being overly fearful of the markets may jeopardize your retirement lifestyle.

To balance your asset allocation, we recommend keeping the next six years of spending in fixed-income investments and the remainder in stocks. You can keep five years of spending in fixed income if you are aggressive and seven years if you are conservative.

Now your retirement spending is relatively secure for the next six years. We suggest putting the remainder of your portfolio into more volatile stock investments to achieve a better long-term rate of return. Not only do you have a maximum safe withdrawal, you also have a suggested allocation to fixed income to balance the need for six years of stable spending with the need for appreciation to cover the seventh year and beyond.

Thus at age 65, 25% of your portfolio should be in fixed income. This gives you six years of safe spending. Your fixed income allocation could range from a more aggressive 20% to a more conservative 30%. Outside of this range gives you a smaller chance of maximizing your lifetime retirement spending.

Outside of this range you must reduce your withdrawal rate. If you reduce your spending, you can afford to allocate more to fixed income because you don't need the growth. You can also allocate more to appreciation because the investments are really being managed for the next generation. If the markets drop significantly, you won't need the money to meet your lifestyle needs.

Small adjustments in asset allocation and withdrawals provide the constant course corrections necessary to reach your goals. And these regular adjustments give your retirement plan the greatest chance of maximizing total retirement lifestyle spending and the smallest chance of depleting your assets prematurely.

 

from http://www.emarotta.com/article.php?ID=394