Bogue's Blog

On January 1st the federal estate tax ceased to exist. I’m actually surprised that they let this expire without doing something about it, but Congress I guess had other fish to fry. There many people that were hoping to see this happen, but I would be careful for what you wish for. These are some of the complications that can occur with this event:

-First off, this is only temporary. As it is currently written in the books, the federal estate tax is set to reappear in 2011 and even worse, goes back to the old rules with an estate exemption of $1 million (it was $3.5 million last year).

-This doesn’t prevent the federal government from reinstating the estate tax for this year and make it retroactive to the beginning of the year. Now some people may claim that this is unconstitutional and they may be right or wrong; but then it goes to the courts and who knows what would happen.

-This doesn’t stop the states from still imposing their tax system in regard to estates.

-The carryover in cost basis changes. Prior to this year, property of the estate was granted a carry-over in cost basis based on the value of the property on the date of death. So if the deceased bought a stock for $1 a share and it was $80 on their date of death, the heirs cost basis would be $80 if they ever sold the property. The carry-over is limited now to $1.3 million in assets and an additional $3 million is added if the beneficiary is the spouse. For amounts above this level, the heir would have to pay a capital gain of $79 if they sold the stock. In addition, most people have a hard time figuring out a cost basis for stock if its been held for a long time. This may pose a problem for some estates and a potential stealth tax may occur.

-The federal gift tax is still in effect. The estate tax disappeared but you can only give away $1 million in gifts before the gift tax takes effect.

-Estate planning strategies that use clause formulas: Some estate planning strategies employ the use of formula’s to transfer as much money tax free to their heirs. For example, some may allow that the maximum estate tax exemption or generation skipping tax exemption be passed to a non-spousal beneficiary so that they maximize the amount of the amount of money they pass to their remaining family tax free upon the death of both spouses. The problem occurs when there is no exemption amount because there is no federal estate tax, the formula without an exemption creates an unlimited dollar amount and if at the death of the first spouse could leave the spouse in the lurch. If you have such formula use in your documents or aren’t sure exactly what you use, I would review this with an estate planning attorney.

With anything in life, change brings opportunity but trade offs as well. If you think any of the changes may potentially alter your plans, do your homework to make sure how the federal estate tax code affects you now, but also how it can affect you in 2011.

Newly enacted legislation allows taxpayers making donations for the Haiti relief efforts to deduct this off of their 2009 or 2010 tax returns. This was enacted on January 22nd and applies to donations made after January 11th and by February 28th.

Just keep in mind that this does not apply to donations that are property or goods and the taxpayer must itemize deductions to be able to claim the deduction. Beyond the popular methods of giving such as by check, debit card or credit card, the legislation recognizes giving by text as well. Any text donations must be made to an IRS approved charity and you should keep a receipt of your donation similar to what you have to do with other charitable donations.

What was the best performing mutual fund of the past decade? It was the CGM Focus Fund which made over 18% annually and outpaced its second place rival by over three percentage points during that time period.

Investors in this fund should have been delighted in these gains. But this wasn’t the case. Matter of fact, investors in the CGM Focus Fund lost an average of 11% annually during this time period according to Morningstar.

How can this be? Wouldn’t fund returns and investor returns be the same? Not necessarily. Morningstar not only reports on the return on the fund, but the dollar weighted returns, which takes into consideration the net inflows and outflows of the fund that the investors of the fund made over time. The greater the disparity between fund returns and investor returns, the more it is a reflection of how investors bought on the tail end of higher than average returns and sold after below average performance.

And this would make total sense based on how this particular mutual fund works and how investors historically make lousy timing decisions. This fund is a high risk fund that invests in roughly 25 companies at a time. Its manager Kenneth Heebner swings for the fences and risk management isn’t a priority here. The portfolio is very volatile in nature. In 2007, it made 80% and the following year it lost 48%. And when the fund had great years the money followed and then everyone ran for the hills during the bad years.

The buy high and sell low mentality is well documented. Research firm Dalbar has kept track of stock mutual fund returns vs. actual investor returns over the past twenty years and updates them annually. As of the end of 2008, the S&P 500 has made 8.35% over the last twenty while the average investor made 1.87% and actually lost money after inflation was considered. So the above doesn’t surprise me at all as this is common with hot stock funds. For example, who really held Fidelity Magellan during its great years all the way to the day Peter Lynch left? Similar to people who live in the Alberta, I know people live there, but I have never met anybody from there yet.

In the end, I really don’t know who or where these below average investors are. Everyone I meet is a great investor and beats the market every year. But I suspect that if these people ran their own numbers they would change their tune. There are the stories of luck, but they are only that. Far too many people think they can select the outperformers and in conjunction time it on a consistent basis. If only they knew how much of their wealth they were destroying and far much further they were pushing themselves away from their goals.

What if I told you that you met with a financial planner and they helped you determine and prioritize your goals and then developed a plan of action to help achieve these goals. By the time you are through you should have a clear idea of where you currently stand and what it will take to get to where you want to be in the future. This in effect should bring clarity and confidence in your life.

What if I told you that later on you found out that your planner didn’t do the work, but was done by a stranger that you never met? How confident would you be about your plan?

Outsourcing is becoming more and more of a common trend in the industry and you are more apt to see it in the larger firms and institutional firms such as brokerage firms, banks and other financial service firms that tend to have proprietary product. The tendency being for these relationship managers to see as much people and drive more business growth for the firm that way rather than working on the technical aspects of the relationship.

There is a big problem when a third party does your planning work. The most critical aspect is the level of intimacy within a financial planning engagement. Not only does a plan need to take into account your circumstances and what you want to accomplish, but personal values need to be understood. There are a lot of between the lines issues that need to be understood. If the person prescribing the solution doesn’t even know you, it increases the chance that the plan will not work. Also financial planning is supposed to be a give and take process. It’s supposed to be interactive; not a hard copy report that you dust off the shelf every so often to see where you are in life. This type of planning engagement tends to get stale easily and has a lot more room for error when the planner is not doing the work.

How can you tell if your plan is done by an outsider? One hint may be the level of interaction in the presentation of the plan. Does the presenter tend to hide behind a hard copy, glossy, bound report? Is the presenter willing to discuss various what if scenarios and is flexible to refine the findings to reflect any adjustments that you want to make after the initial findings? After a plan is completed and something comes up, how nimble is the plan to adjust to these new circumstances? Does the presenter go over the data and underlying assumptions within the plan and can explain clearly why they made the embedded assumptions? Do the reports appear boilerplate? Is the planning work extraordinarily cheap or even free and is this more of a loss leader for the presenter to sell you proprietary or commissioned product? There are little indicators that can tell you if your planner is really planning.

Before you engage with a planner, ask them directly if they do the planning work themselves or if they outsource this. Now planners may use outsourcing for the data entry work. This is totally fine as long as the planner dictates the varying underlying assumptions in the plan, reviews the data for accuracy and then is the one who analyzes your situation and develops the recommendations. But before you enter a financial planning engagement, you better make sure who is actually doing the planning.

Always enticed by opening up a Roth IRA, but never could because your income level is too high? Starting in 2010, there’s a way around this.

Beginning in 2010, the income limitations are waived for converting from a Traditional to a Roth IRA. In the meantime, although there are income limitations for making a “deductible” Traditional IRA contribution, there are no income limitations for making a non-deductible IRA contribution. The backdoor Roth strategy entails making a non-deductible Traditional IRA distribution then immediately converting it to a Roth. Voila, you now have the Roth.

I find this option really attractive for people who have a significant amount of assets tied up in their tax-deferred employer based retirement plan, are currently fully maxing out these tax-deferred contributions and wants to further diversify the tax ramifications of their accounts between tax-deferred and tax-free, but weren’t eligible to get into the Roth beforehand. I find this a much better alternative than using a variable annuity although there are limitations to what you can contribute to an IRA annually.

This does not work if you are over age 70 ½ or if you don’t have enough earned income to support the rules allowing one to contribute to a Traditional IRA. Also you need to have a time horizon of at least five years before the amount of the Roth conversion can be withdrawn without penalty. So you should view this as a long term holding. Finally it doesn’t work as well if you already have a sizable Traditional IRA with mostly tax-deferred contributions. This is because you can’t segment the portion of the IRA that was non-deductible and convert it, the pro rata rule divides the amount of nondeductible contributions by the sum of all the IRA accounts to determine the conversion amount that is tax free. So unless it makes sense to take the tax hit with the partially taxable conversion, this isn’t the most ideal move.

As I always say, do your homework. The Roth is great but only under the right set of unique circumstances that you have. I don’t know if this loophole will be closed, but for the time being the income limits on Roth contributions essentially have been eliminated.

What would you think about making an investment that would only pay off if a publicly traded company lost more than half its value within nine days or less? What if I told you that it paid off and that you made 159 times your money? Pretty crazy but truth is stranger than fiction – a mystery investor spent $1.7 million on options betting on Bear Stearns to go down and for their troubles they made $270 million. This appears to be one of the most conspicuous incidents of insider trading that ever happened. Even crazier is the SEC hasn’t figured out who this investor was.

In the October 15th issue of Rolling Stone, the article Wall Street’s Naked Swindle by Matt Taibbi discusses how this trade by what Taibbi calls “Mystery Nostradamus” against Bear Stearns was done on March 11th, 2008. Coincidently the same day a meeting was held at the Federal Reserve Bank of New York, headed by Fed chief Ben Bernanke and then New York Fed president Tim Geithner and attended by anyone that had pull on Wall Street – all except Bear Stearns. This meeting was never publicly announced and only was discovered by a reporter from Bloomberg accidentally. Participants of this meeting have refused to comment and testifying before the Senate, Geithner and Bernanke both said they were unaware about Bear’s problems until two days later. But one thing was known, the run on Bear Stearns began that day. We all know what happened afterwards. The genie came out of the bottle, JP Morgan came in to buy what was left after the toxic waste was removed by the government and one less competitor on Wall Street ceased to exist.

Taibbi in the article describes that the characteristics of how Bear fell was a classic case of a “Bear Raid” where various investors negatively manipulate the stock of one company and spread rumors to feed the fire. And the companies that were in the private meeting were widely rumored to be the source of the manipulation. The primary weapon used against Bear was employing “naked short selling.” Simple short selling is when you borrow shares, sell them on the open market and at some point, repurchase the shares and deliver them back to the lender. If the stock price falls, you make money. The “Naked” aspect is when the lender never really gives the stock to the short seller to sell, but the short seller sells gets the proceeds of the sale anyway like they actually received the stock. Regulations state that delivery of these shares needs to be made, but it is rarely enforced and the stock manipulators are well aware of this. When these shares are sold, but never delivered it is called a “fail” or “fail to deliver.” The implications of large “fail to deliver” short sales are analogous to a huge printing press. The market is flooded with phantom stock which sends the stock price plunging.

How prevalent is this? Often companies will find more proxy votes in their annual meetings than there are shares outstanding. For example, Overstock.com had at one point 42 million shares of claimed company ownership when fewer than 24 million shares were truly outstanding on their books. What happened to Bear? On March 11th, close to 202K shares failed to deliver, the next day this was 1.2M, that Friday it passed 2M, then the Monday after it reached 13.7M. The same thing happened to Lehman. On June 27th, 2008 there were 705K fails and this more than doubled by July 1st. After a one month moratorium where you had to pre-borrow shares before you sold them, it continued along and was 1M by September 9th and finally reaching 32.9M on September 12th. The CEO of Overstock.com pleaded with the Feds to stop the tactic of naked short selling for years. Last fall, it took only days for Morgan Stanley to convince the Feds to disallow all short selling (including legitimate short selling) for financial stocks.

Bear and Lehman were certainly poorly managed, but naked short selling had a large hand in driving them out of existence and seized up the rest of the economic world while some very greedy people profited from it. In the end, this is a very eye opening display of the corruption that permeates on Wall Street. If you haven’t yet, I would also highly recommend reading Taibbi’s article in Rolling Stone this summer called, Inside the Great American Bubble Machine as well.

There’s been a lot of buzz about the new rules which will eliminate the restrictions on who can convert from an IRA to a Roth IRA. Currently your modified adjusted gross income (MAGI) needs to be below $100,000 (not including the taxable conversion amount) and you can’t claim married filing separately on your tax return. This all goes away at the beginning of the year. Keep in mind that this only applies to conversions. Contributions to a Roth IRA are not allowed for individuals with MAGI at or over $120K or married couples with MAGI of $176K or more. However people who aren’t eligible for Roth contributions can sneak around the issue by making non-deductible Traditional IRA contributions and THEN convert these amounts to a Roth. Finally, taxpayers who convert in 2010 have the option of paying this in their 2010 tax return or split this up in 2011 and 2012.

The beauty of the Roth IRA is its tax free nature. You don’t get any up front tax benefit when contributing, but qualified distributions from a Roth are free of income taxes and aren’t subject to required minimum distributions when you reach 70 ½. The rub with conversions is that you have to pay the tax on the converted amounts in the year of the conversion (except with the one time option above for 2010). Then you have to hold the converted funds for five years to avoid the penalty on withdrawing conversions. Each individual conversion has a five year time window. The nice thing about conversions is you can have a “do-over” and recharacterize the Roth back into the IRA if you do it prior to October 15th of the year following the conversion. So if the investment tanks after the conversion occurs, you have the option for a short time to reverse this. I recommend that any converted amounts be placed in a separate Roth if you currently have a Roth as the recharacterization calculation can be complicated when commingling this with already established Roth accounts.

Being someone who personally uses a Roth IRA and has contributed and converted in the past, I think it’s an excellent investment tool as it allows you a better chance to control your tax destiny and has a lot of other attractive characteristics. Now I think this change in conversion rules is great, but I believe it has been over-hyped. Converting isn’t for everyone. Here is where I see it making sense:

1.) If you have the cash outside of the account to pay the tax. You can use the funds within the conversion to pay the tax, but it is subject to income taxes and penalty for those under 59 ½ which neutralizes the whole benefit of the conversion.

2). If you don’t plan to leave your IRA to charity. Tax deferred IRA’s and other investment accounts are great vehicles to leave to charity. Converting funds with a charitable beneficiary doesn’t make sense though.

3.) If you expect to be in a higher tax bracket when you withdrawal the funds. It’s nice to avoid taxes later, but not at the price of paying more now. Most people saving for retirement don’t fit this scenario as their working years places them in higher tax brackets now rather than when they retire. You should also take into consideration if you plan to live in another state when you retire and how the income tax system comes into play. People who were laid off and/or had extraordinarily low taxes in one particular year may want to covert. Also retirees who will be subject to large minimum required distributions may want to convert enough each year prior to age 70 ½ that will keep them within their current marginal tax bracket, but offset some of the adverse ramifications of these future distributions.

4.) If you are subject to federal or state estate taxes. If it is a strong desire to leave more assets to your heirs and there isn’t a great reliance on needing these funds, converting these can be a sneaky way of reducing your taxable estate. This is because the tax created from the conversion reduces the overall estate value and the underlying tax as a result; heirs receive an asset that is free of income taxes.

5.) If assets in your IRA are at extremely depressed values. This may be a situation where you may want to consider converting even if you are expected to be in a similar tax bracket later on when you are making distributions from the Roth.

6.) The more time the better. Although converting Roth’s during retirement isn’t necessarily a DON’T, I find that the younger you are, the more power you will receive from the ongoing compounding of returns over many years.

I will remind you that you shouldn’t automatically decide to convert based on what I have above. Everyone has their own set of individual circumstances that they should consider and bringing this up with your tax accountant would be a smart move. Although you take the tax pain up front, Roth conversions can be a beneficial tool to your retirement game plan.

For 2009, required minimum distribution requirements (RMD’s) were suspended for any defined contribution plan or IRA. Despite this, some people continued with their RMD’s either because they were unaware of the rule or their plan rules required these distributions to continue.

The IRS has provided relief for those participants and surviving spouses (as beneficiaries) who received distributions that would be required under the normal rules, but weren’t required to do so and would have kept the funds within the plan or IRA if they had the choice. The deadline for rolling over these non-required RMD’s back into another plan or IRA is the later of 60 days after the distribution or November 30th, 2009.

This however does not apply to all situations. A non-spousal beneficiary is not eligible. Nor is a person who is under age 59 ½ and is taking a series of substantially equal periodic payments. It only applies to non-required RMD’s – so if you took out more than what your RMD was, you can’t reverse this excess distribution amount. Finally, you can only roll one distribution from a particular IRA within 12 months; so if you took out several distributions in varying times that made up the RMD, only one of those distributions (not all) can be reversed.

With that, if you are eligible and want to reverse any non-required RMD distributions, you may want to move quickly on this. As always, this blog may bring light a potential opportunity for you, but you have to do your homework to make sure you are indeed eligible and what you are allowed to do based on your circumstances. For guidance on the subject see: IRS Notice 2009-82 & IRS Notice 2009-41.

At this time of the year, most savvy investors turn to tax loss harvesting strategies. But for some people, they may want to take a look at harvesting their gains.

For the people in the lowest two tax brackets, the long term capital gains rate is 0% and this applies to all capital gains that would be subject to the 15% long term capital gains rate if you were in the higher tax brackets. This would apply to single individuals with taxable income of $33,900 and $67,900 for married individuals filing jointly. Finally if someone is in the eligible tax brackets and their long term capital gains go over the eligible tax bracket, this does not disqualify the whole gain; only the gain that is over and above the 15% tax bracket would be subject to the tax. This tax treatment is eligible for this year and next year although I wouldn’t rule out the rules changing for 2010.

This strategy is especially useful for people with low taxable incomes that have investments with an extremely low cost basis. Often these are long time holdings that people have been resistant to selling in the past due to the tax ramifications, but at the same time make up a large percentage of their overall investment portfolio, thus high concentration risk. This may be the opportunity to sell and be more broadly diversified. The person could actually repurchase the shares, establish a higher cost basis and future tax ramifications could be less expensive.

I see this being useful for retirees, people that have been laid off during the year and need to generate extra cash flow and those who want to gift. If you are in the higher tax bracket and were thinking of gifting to a child or parent who is in the lower tax bracket, this may be a great time to do this as the beneficiary could potentially sell without the tax pain that’s often associated with gifting since the cost basis remains the same. Just keep in mind that this should only be done with children that are over 21 or 23 if they are full time students to avoid the kiddie tax and of course are in the eligible tax bracket and take note the annual gifting limit of $13K per individual before becoming subject to federal gift taxes.

Now there are some caveats to be aware of. Depending on where you live you may still have to pay state taxes. Also the capital gains tax may be zero, but there are some stealth taxes that may come into play. For example, the level of Social Security that is taxed depends on income levels, so this may increase your taxable income and underlying tax. Also some deductions and credits are phased out based on your adjusted gross income (e.g. itemized medical deductions), thus recognizing more income may reduce the tax benefit. But despite this, the residual cost still may be minimal to the benefit received.

Like all strategies, this isn’t for everyone. If this looks like an attractive alternative, before you move forward, do your homework based on your unique circumstances to determine if this is a beneficial move for you.

Many people over the next several weeks will be required to update their employer provided benefit plans. Along with that it is an opportune time to review your beneficiary designations in employer provided life insurance and retirement plans, but also in your IRA’s, Transfer on Death (TOD) assignments, non-qualified annuities and life insurance held that is not provided by the employer.

Why is it a big deal? Because beneficiary designations trump whatever is dictated in your will. It may not seem logical but relying on your will to carry out intended plans in these types of financial instruments can be a big mistake and is very often overlooked.

Imagine these scenarios:
-Having your ex-spouse receive your retirement assets or insurance proceeds
-Improperly designating beneficiaries in an IRA, as a result the eventual recipient of the funds will have to distribute them within a five year period after your death regardless if they needed the funds or not (and taxed on them if a regular IRA).
-Setting up trusts as beneficiaries with your estate planning attorney, but failing to implement this designation with the investment or life insurance custodian. That would be wasted planning.
-Still having your parents as beneficiaries, when your spouse and children are the ones that need the money. What if your parents and the in-law spouse don’t get along?
-Having a child who has special needs and loses government assistance if they directly receive these funds due to an improper beneficiary designation.
-What if you marry for a second time, want to leave your employer based retirement plan to your kids and you think a prenuptial agreement will take care of you – wrong! The person isn’t a spouse when they sign a prenuptial and once you marry, ERISA law recognizes the spouse and gives that spouse rights to the retirement plan at that time. Once married, the spouse then has to waive their rights in an updated beneficiary form that is acceptable by the plan.

I strongly recommend that you take some time to review your beneficiary designations and determine if these still reflect your intentions or if adjustments need to be made. In the end, it may only take a few minutes of your time, but it’s worth reviewing.