Tax Changes for 2013

Here is a quick summary of the tax changes made effective at the beginning of the year:

• The two percentage point reduction in Social Security payroll tax was discontinued. This will probably have the widest impact as this will apply to everyone that is working.

• The exemption level for the alternative minimum tax has been made permanent and will be adjusted upward with inflation over time. Congress over the past few years would “patch” these exemptions at the last moment prior to year end.

• For those who earn over $200K if they are single and $250K if they are married will be subject to the 3.8% Medicare surtax on unearned income.

• Individuals with adjusted gross income of more than $250K and married couples with over $300K will be subject to phase outs of itemized deductions and personal exemptions. This is entirely phased out at $372,501 for individuals and $422,501 for married couples.

• Individuals with taxable income of over $400K and married couples with over $450K will be subject to the highest new tax rate established of 39.6%. Long term capital gains and qualified dividends will be taxed at 20% instead of 15% (add Medicare surcharge taxes and this increases to 23.8%).

• The $5M estate and gift tax exemption has been made permanent ($10M in total per couple), but the tax rate increases for amounts above the exemption from 35% to 40%.

There are some other smaller items that can be discussed at a later time, but these are the core changes. The biggest takeaways from this are individuals close to either the $200K or $400K threshold and couples close to the $250K or $450K level will want to intensify their tax planning to see if they can avoid these tax increases. Of course any strategies should be aligned with one’s goals, not for the sake of letting the tax tail wag the dog. The good news is that these tax codes are permanent in nature, which will help people plan for the long term without worrying about sunset clauses. The permanence of the alternative minimum tax exemption and estate tax code also takes away a great deal of uncertainty.

In the end, our tax code is still too complex and should be reformed. Although there is a sense of permanency here, just keep in mind that this can easily change when the next Presidential administration takes over in 2017.

Tax Planning: Better Plan for 2013 Now

Currently millions of taxpayers are trying to get their tax returns prepared. But if you are wise, I would take a look at what’s coming in 2013 and take action now to address it.

If the tax code remains as it currently stands, we will face the largest tax increase in history. The majority of this would come from the expiration of the Bush Era tax cuts. Current tax brackets would go from 10%, 15%, 25%, 28%, 33%, 35% to 15%, 28%, 31%, 36% and 39.6%. Capital gains rates would increase from 20% for those who are currently subject to the 15% rate and those eligible for the current 0% rate would be subject to the 10% rate. The most egregious taxes would be for qualified dividends. Rates would revert back and be taxed at ordinary rates. Those currently paying 0% in the 10% and 15% tax bracket would pay 15% and 28% next year. Those currently paying 15% could be pay either 31%, 36% or 39.6%. Dividend paying stocks have been in vogue these days, but this could quickly come to a halt. In addition, the phase-out of itemized deductions and exemptions would return affecting higher income households while the marriage penalty would return.

Outside of the expiration of the Bush Era tax code, there are a few other taxes coming into play for 2013. The payroll tax cut is set to expire at year. Also the 3.8% healthcare reform act surtax on investment income will start. For those who will be in the 39.6% tax bracket next year, their qualified dividend income will go from 15% to a whopping 43.4% which doesn’t take state income taxes into account.

Now there is periodic talk about extending or modifying these tax issues. But I’m not holding my breath. Election years tend to create standstill before the election. After the election, lame duck politicians are hard to rely on – especially if the power is split up between political parties within Congress and the Presidency. Rather than relying on politics and other things that we can’t control, I am advocating a more proactive approach. These are the things you may want to consider:

Tax Location: This strategy involves allocating your individual investments into accounts in a manner which optimizes the after tax efficiency of your overall portfolio. I like to call this tax account diversification as Roth IRA/401(k)’s are designed to be tax free, Traditional IRA/401(k)’s are tax deferred and then investors can also have regularly taxable accounts. You would want to be more cognizant of placing more of your tax efficient investments within taxable accounts. Low turnover stock funds and index funds and municipal bond funds (if they don’t have a great deal of private activity interest which is subject to the alternative minimum tax (AMT)) are very tax efficient in a taxable account. Roth IRA’s/401(k)’s are a great place to place the high growth portion of your portfolio. The greater the growth potential, the more potential dollars you should have for your needs over the long haul; all of this would be tax free. Mutual funds that invest in higher risk stock and commodities tend to be a good location for a Roth. Tax deferred vehicles such as Traditional IRA’s/regular 401(k)’s tend to be a great place for your slower growing diversifiers within the portfolio. Leaning slower growers in the tax deferred accounts means that less of your dollars will be subject to ordinary tax rates when withdrawn. Taxable bond funds and other high turnover/non-tax efficient strategies tend to fit well within the tax deferred account. If you have a mix of different accounts, you will find this strategy more powerful in the years to come.

Tax Gain Harvesting: Most of the time financial planners talk about tax loss harvesting. But given the higher future capital gain rates, one may want to consider taking capital gains now at the current lower rate rather than incurring a higher tax rate later in the future, especially if you were planning to incur a capital gain with an asset sale in the near future. If you find yourself in the tax bracket where you would be subject to the 0% capital gain rate, it may even make sense to incur a capital gain only to buy the holding back to create the higher cost basis for a later sale date. It may defy common logic, but sometimes the best financial strategies are counterintuitive in nature.

Roth Conversions: If you have a large portion of your portfolio in a Traditional IRA and enough funds outside of retirement accounts available to pay the tax (and if your taxable income will get hit the hardest by the tax increase), you may want to consider converting some or all of your Traditional IRA to a Roth IRA. In the future, I will discuss Roth conversions in greater detail.

Higher Funding of Tax Advantage Accounts: Higher future taxes increase the attractiveness of funding tax advantaged accounts whether they are IRA’s, employer provided retirement plans, health savings accounts, college funding vehicles and tax deferred annuities. You just want to make sure that you have accessible funds available for an emergency fund and future spending needs that aren’t subject to a tax penalty for early withdrawal. But it may make sense to keep your taxable accounts as small as possible.

Don’t Let the Tax Tail Wag the Dog: Be careful to make sure that the funding vehicle fits your goals and future needs. Often times I see people mistake tax efficiency for tax avoidance and they end up investing in areas that are a poor fit for their needs. For example I often times life insurance will be sold as an investment vehicle where a need for the actual insurance need should take precedent over the investment characteristics.

With some careful planning, there is a lot to benefit from if you think about your future tax circumstances right now. Before taking action, I would highly recommend working closely with your financial planner and tax accountant (and coordinate it so they are communication to each other as well) to see what actions make the most sense for you. With our current and projected federal budget deficits, it would suggest we will be more likely to face a higher tax environment in the future. Small tax efficient measures now could potentially make a big difference over the long term.

What If We Don’t Raise the Debt Ceiling?

This is the question that clients, friends and colleagues having been asking me over the past several weeks. Here is my take on the subject:

Will They Reach a Deal? At this point, I feel that the likelihood of a technical default is low and that some sort of reconciliation will be made prior to August 2nd. The one thing that I can count on is politicians wanting to stay employed. I suspect the only reason the politicians have been posturing so long is because the financial markets haven’t over-reacted to this point. There is a sense of caution out there, but it is definitely not panic. If Washington felt votes were on the line, this would be a done deal.

Will There Be Panic if Congress Fails to Make a Deal? There have been some catastrophic predictions of what would happen if we failed to raise the debt ceiling. Most notably, Bill Gross of the PIMCO funds in a recent letter stated: “default would still be a huge negative for the U.S. and global financial markets, introducing fear and unnecessary volatility into the economy and global trade. The market situation might resemble what happened after Lehman Brothers collapsed in 2008.” A post Lehman situation is always a possibility, but I would think it would take a combination of negative events like more trouble from the Euro zone or sudden weakness in China’s economy along with a technical default to set off a contagion like event. Just keep in mind that the probability of a “Black Swan” event is always a possibility and usually comes out of the blue from some combination of catalysts that nobody can foresee. Given there has been quite a bit of doomsday talk about what would happen here, I’m skeptical that contagion would be created solely from technical default; there would have to be more out there.

The Long Run: My main concern focuses on the long run implications of what will happen if we don’t get our financial house in order. The U.S. federal debt to GDP ratio is closing in on the 100% level. Once we go beyond this mark, it begins to have a detrimental effect on economic growth. If the confidence of buyers of U.S. debt wanes, this would erode our status as the reserve currency of the world. With more perceived risk in us meeting our obligations, this would result in higher interest rates, inflationary pressure and would undermine our ability to grow economically. Although it wouldn’t be pleasant, I would even accept some short term anxiety if action was taken to fix the problem in the long term. The days of kicking the can down the road should end.

The Reality of It All: Our problem is far from being unfixable. However it won’t be fixed overnight either so I think it’s absolutely silly for our politicians to be dangling the debt ceiling and deadlines as a bargaining chip. In the big picture the reality is that the plan will take years of gradual implementation to eventually right the ship, while not blowing up the economy in the process. Both sides are going to have to compromise. If a politician discusses deficit reductions without talking about entitlement reform, they will never fix the problem. The same thing goes for those that think that permanent changes in our tax system are not a necessity. Everyone will have to experience some pain in the form of paying more or getting less. It should not be “us versus them” in this debate. In reality it’s just us. I would rather be able to address the problem while it is still manageable, rather than creating a crisis that probably my kids would need to fix. Greece is now stuck and has no easy choices anymore. We don’t want Greece’s problem to be our problem as well.

Should You Retire with a Mortgage?

Does holding a mortgage into retirement make sense? Recently I was quoted in about this subject. In “Is Refinancing Before Retirement Wise” I made several points on the subject including:

-Those who have a long term steady stream of income such as a large Social Security and/or a pension benefit are more likely to be able to afford mortgage debt during retirement. The more you have to rely on the financial markets, the riskier this becomes.

-When you refinance, not only should you look at the breakeven time frame where the total monthly cost savings exceeds the cost of closing, but you should be very careful to also factor in the extra payments if you extend the term of the loan.

-Deductible interest isn’t usually as robust during retirement as during your working years because you are usually in a lower tax bracket. Also as the mortgage term continues in the future, less of the payment will be deductible interest and more will represent the principal of the loan as it amortizes.

-The decision can mean more than numbers. Sleeping well at night has value also.

Ultimately the optimal decision depends on the individuals circumstances. Most of the time, it is wise to eliminate your debt before your retire. However I have had several cases where holding a mortgage during retirement held little risk. If you are considering refinancing and are within ten years of retirement, I would highly suggest doing your due diligence and seeking expert guidance to see if this makes sense for you.

Is a Non-Deductible Traditional IRA Contribution Worth It?

Non-deductible contributions to a Traditional IRA usually aren’t the most exciting financial move one can make. But like every financial strategy, it has its place and can be effective for the right person under the right set of circumstances. Although not as exciting as a deductible IRA, earnings from the non-deductible IRA remain sheltered from income taxes until withdrawn.

Generally, deductible Traditional IRA contributions are limited if you or your spouse is covered by an employer provided retirement plan. Meanwhile, Roth IRA contributions are limited as well. These contribution limitations for these IRA’s are based on your modified adjusted gross income. As income hits certain levels, the contributions allowed gradually phase out. However, if you aren’t eligible for a deductible Traditional IRA or Roth IRA contribution, you still may be eligible for a non-deductible Traditional IRA contribution. The only stipulation with a non-deductible IRA contribution (or any IRA contribution in general) is that the taxable household needs to have earned income for the year the contribution is made. Earned income is income that is subject to Social Security taxes. So if you earned $4,000 in 2010 and are under age 50, then you can contribute up to $4,000, not the maximum contribution limit allowed of $5,000. But there are no upper income thresholds that limit how much one can contribute to a non-deductible IRA.

When does a non-deductible IRA contribution make sense and what to watch out for? Here are some considerations you should take:

• Before even considering a non-deductible IRA, you should be fully funding any employer based retirement plan first. Second, this is only attractive if you aren’t eligible for a deductible Traditional IRA or Roth IRA contribution. This should be a consideration once you exhausted these options.

• This can be an attractive alternative as compared to a variable annuity. Variable annuities have their place as well. For example, non-deductible IRA contributions are limited in the dollars you can deposit on an annual basis where there is no contribution limits to a variable annuity. But usually these products can become expensive as the benefit on the riders that you can buy on these investments usually don’t justify the underlying cost. In addition, some variable annuities have limited or less optimal investment choices. This is where you may want to put your next dollars into a non-deductible IRA before considering a variable annuity.

• For some people who want to invest in a Roth but can’t because of the income limitations, the non-deductible IRA offers a back door strategy. In 2010, the rules where lifted and now anyone regardless of income can now convert a Traditional IRA to a Roth IRA. So if you aren’t eligible for the Roth, one can now just contribute to a non-deductible IRA and then convert to a Roth. Only any appreciation between the contribution and conversion would be taxable as ordinary income (which could be a very small amount if the time frame on the investment has been short). And voila, you have a Roth IRA. This seems pretty simple, but I would offer some caution here. First, if you already have a Traditional IRA (whether in one or several separate accounts), you can’t just claim that you converted the non-deductible portion and left the other portion alone (even if this was kept in a separate account). Only the pro-rata proportion of your non-deductible contribution to your total contributions would convert tax free (the rest is taxable). So if you have significant money already in a Traditional IRA, this backdoor strategy wouldn’t pan out as well. Second, there is some grey area in how soon to convert after making the contribution. There is no clear guidance here from the IRS, but this appears to be an apparent and obvious loophole. If the conversion is made right after the contribution, I think it would be clear to everyone that the effort was made to skirt the Roth IRA contribution limit rules and it’s always the possibility that the IRS may decide this is a problem too. I’ve heard several well respected authorities say that doing this immediately is OK. Meanwhile I’ve seen others strongly advising to wait until the next tax year to convert and risk some capital appreciation and tax cost rather than taking the risk of this being deemed against the rules sometime in the future. So I would carefully consult your tax adviser if you are considering this.

• You also need to prepare and retain the proper paperwork with the IRS. If you make a non-deductible IRA contribution, remember to file a Form 8606 with your tax return. Failure to file this can result in a $50 penalty although the IRS sometimes will waive this if reasonable cause is shown. It’s pretty important as failure to file results in the IRS believing that future distributions are fully taxable whereas the proportion that represents earnings only should be taxed as ordinary income. Also make sure to keep this form in your permanent records as proof of the non-deductible contributions. This is a Form that could be easily lost or forgotten about after the years pass by; the big risk is paying taxes on dollars that should be tax free.

• This is an attractive strategy to shelter tax inefficient assets in the headwinds of a higher tax environment in the future. I’ve seen this to be attractive to the higher wage earner who is maximizing their employer provided plan contributions, but the ability to diversify within the employer based plan is limited. Most investments that are designed to offset the risk of a stock portfolio tend to be less tax efficient. A non-deductible IRA is a good way to shelter these tax inefficient assets and further diversify at the same time.

In the end, non-deductible IRA contributions aren’t for everyone, but they are another tool that can be attractive for the right person under the right circumstances.

(Tentative) Tax Deal Highlights:

Although the tax deal isn’t a done deal yet, I expect an accord to be reached prior to year end. The below is a brief synopsis of the tentative tax deal in place. Just keep in mind that this may be tweaked a bit depending on the political wrangling between now and when it is signed into law:

Tax Rates: Tax rates instituted during the Bush era will be extended for two years (through 2012). The big question over the past several weeks was whether these rates would be extended to all taxpayers or just the lower tax brackets.

Long term capital gain and dividend rates: Current long term capital gain and qualified dividend rates will be extended for two years (through 2012).

Alternative Minimum Tax Patch: The exemption within the AMT calculation will remain at similar levels in 2010 and 2011. This patch has been pushed through for several years now and has prevented millions of taxpayers from being subject to this tax. Over the past few years it has been the end of the year tax drama to see if the patch will be continued. So it’s nice to see that we won’t have to worry about this next year at this time.

Payroll Taxes: Amounts paid toward Social Security from employees will lower from 6.2% to 4.2% in 2011.

Estate and Gift Taxes: The top rate will be 35% (it was set to go to 55%) and an exemption of $5 Million per individual (where it would have reverted to $1 Million). This is the primary bone of contention within the political parties and may have a higher likelihood of change than other aspects of the legislation.

Extenders: These continue to allow for contributions directly out of an IRA for charity for those over age 70 ½, the state and local sales tax deduction as an itemized expense, the extra real estate tax deduction for those who do not itemize and the deduction for teacher’s expenses for 2010 and 2011.

Credits: The child credit of $1,000 is maintained for two years as well as higher education credits and expands the earned income tax credit.

Unemployment Benefits: These are extended at their current level for 13 additional months.

With all of this, I’m sure there will be additional minutia on this once the details come out. Over the course of the next few weeks I will be posting on my blog the planning implications of and how this will affect our economy over the short and long term as finality and details come in.

Should You Convert to a Roth?

There’s been a lot of buzz about the new rules which eliminate the restrictions on who can convert from an IRA to a Roth IRA. Prior to this year, your modified adjusted gross income (MAGI) needed 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 went 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 $177K or more. 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. 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.

Be Ready for Changes in Our Income Taxes

On January 1st, 2011 the largest tax hike in history will take place if Congress does nothing. This came into play because the tax legislation in 2001 and 2003 had the support to be enacted, but not permanently. Now Congress in a quandary; I’m sure they would love the tax revenue to reduce the federal deficit (hopefully). However raising taxes at the height of a growing anti-incumbent sentiment with mid-term elections coming up isn’t the best for job security. I suspect some sort of legislation will get passed that will at least temporarily extend the tax breaks for taxpayers in the lower tax brackets so our representatives have something to bring with them on the campaign trail. I also suspect some sort of permanent resolution to the federal estate tax code will occur by year end (although I’m surprised Congress let the estate tax die this year).

My primary concern is beyond the above. Raising taxes in a weak economic environment historically has been an effective recipe for economic slowdown. The powers that be have not declared that we ever exited the recession and raising taxes may create a rare double dip. Solely taxing the higher tax brackets isn’t a solution either. The problem is that many of the people who are in the higher tax brackets fall into the category of the small business owner. These are the people that are the engine for job growth in our country. With the entrepreneur already dealing with the anti-business political dialogue coupled with higher taxes from the healthcare legislation, increased tax hikes may further curtail job growth and Washington could be shooting themselves in the economic foot. Extending the current income tax rules for an intermediate time period (3-5 years) is much better economic stimulus than Congress can conjure up. A one year extension is not a solution; it will just prolong the uncertainty which means business will hold onto its wallet. It would be a gimmick like the rebate checks we got a few years back which did nothing to stimulate the economy.

Despite the uncertainty, these are the things that you can do now that will still be effective no matter what ends up happening in our tax world:

-Accelerate Income: Normally you don’t want to do this, but if you have the ability to accelerate your income into 2010 rather than waiting until 2011, you should be poised to take action if the current tax rules are not extended.

-Accelerate Deductions: If the tax rules are not extended and if your personal exemptions and deductions were phased out in the past, then it may be likely to see this come back into play in 2011. Some deductions are non-discretionary and the only thing you can do is accelerate moderate amounts (such as paying real estate taxes due in 2011 or paying your January mortgage or home equity payment in December). But if you are subject to the phase outs above and are charitably inclined, you may be better off accelerating donations this year

-Tax Gain Harvesting: Financial folks like to talk about accelerating losses, but I would be thinking about harvesting some gains, especially long term holdings that have very low cost basis that you were reluctant to sell because of the tax implications. If legislation isn’t extended, the capital gains rate goes from 0% to 10% for lower tax brackets and from 15% to 20% to higher tax brackets. It seems Washington would like to see the higher tax brackets even pay more if they could. Even if you have a holding you want to keep, you may want to sell at a gain and repurchase to step up the cost basis. If you are potentially subject to the healthcare tax surcharge, it may be wise to start working on this now before the tax becomes effective. You may want to consider gifting appreciated assets to your children and having your children sell and recognize the gain if they fall into the 0% tax bracket (just be aware of gift taxes).

-Roth Conversions: There are many reasons why a Roth conversion may make sense and when to avoid it that goes beyond the scope of this entry. But with potentially higher taxes in the future, it is something that should be considered. For those who have a lot of investment income from taxable investment holdings and appear to be subject to the healthcare surcharge in a few years, it may make sense to convert and pay the tax out of the taxable holdings. On the front end, converting and incurring the taxes when they are lower makes sense. On the back end, shrinking the taxable assets and the investment income created by it may help avoid or reduce your taxes subject to the future healthcare surcharge.

-Be Ready for Estate Planning: If you have a heightened concern about estate taxes, you should be ready to review your strategy once the federal estate tax legislation is passed and adjust if necessary. Also don’t forget about the estate taxes your state imposes. States usually react to what the federal government does so this should be addressed as well.

With the above, everyone has a unique set of tax circumstances. You will need to do your due diligence to see if this makes sense for you and get help if you aren’t an expert. Some tactics above may create unintended consequences as many deductions and credits can be subject to phase-outs; higher amounts of your Social Security benefits could be taxed. Also you have to be careful to avoid the alternative minimum tax (AMT), which is in legislative limbo as well. Also keep in mind that it’s not about avoiding taxes; often more problems occur by trying to avoid taxes. It’s about managing taxes efficiently. But by being proactive of your tax situation, you will be better off in the long run.

Municipal Financial Crisis?

For those who invest in municipal bonds, or for that matter are receiving a pension or expect to receive a pension from a municipality, you should pay attention what Warren Buffett has to say.

On Wednesday, Warren Buffett said at a hearing of the U.S Financial Crisis Inquiry Commission in New York said that there will be a “terrible problem” for municipal bonds and said, “Then the question becomes will the federal government help.”

There is no question that local governments are under pressure as the financial crisis lowered revenues that they receive in the form of income, real estate and sales taxes. Further compounding matters, many pension plans are underfunded due to the market losses suffered a few years ago coupled with the rosy return projections and lower funding that came beforehand. Yes, from a prohibitive perspective this can create a vicious cycle and quickly become a contagion similar to the fall of 2008.

What should you do? Now for those who are currently receiving a pension, the odds are quite low that your benefits will be reduced. But I wouldn’t make the assumption that they are perfectly safe either. For the current worker that expects to receive a pension in the future, I wouldn’t hang your retirement hat solely on your pension. I believe the same would be said of people solely relying on Social Security.

For people who invest in municipal bonds, I’d be very careful. Regardless of the potential risk addressed above, I’m not a big believer in buying individual muni bonds as for most people the dollar amount needed to buy an individual bond makes it very hard to diversify the risk. Unless you directly buy from the issuer, brokers make an awful lot of money on the spreads as muni’s are very thinly traded, which eats away at your yield. This lack of liquidity also makes it more difficult to sell an individual muni at a favorable price. If you do purchase municipals, it is best advised to use mutual funds to accomplish this; in particular funds that only buy bonds with high credit ratings. If you must buy individual muni bonds, focus on the one’s that are backed by the taxing authority of the entity rather than revenue bonds, which repayment is backed on a specific project. Because of this project risk, these types of bonds are more likely to default than ones that have the ability to tax to pay back the debt. If you are at risk of paying the Alternative Minimum Tax (AMT), you want to stick to funds or bonds that generate little private activity interest as this is an exception item for the AMT.

Finally, there are some scenarios where you should never buy municipals. It’s simply a waste of time to buy municipals in an IRA as the tax benefits are lost. And you really don’t get much benefit if you are in a low tax bracket.

In the end, just keep in mind that the risk of municipal default is quite real. And I wouldn’t bet against what Warren Buffett has to say.