Could You Stomach the Perfect Investment?

Suppose a mutual fund knew for sure which 10% of the largest U.S. companies would earn the highest returns over the next five years, over each upcoming five-year period. You’d invest in that fund and hang tight, right?

A research company called Alpha Architect, recently posed this as an interesting thought experiment. It divided all of the 500 largest U.S. stocks into deciles, and imagined that a hypothetical fund was investing in only the upper 10% returning stocks in the first five-year period, starting on January 1, 1927, and every five years it would switch the portfolio to the future top 10% of all stocks. (Hindsight makes it a lot easier to model what would happen if we were blessed with perfect foresight.)

Okay, so now you’re invested, and if you could have bought and held this magical fund, then at the end of the year 2009, you’d have earned just under 29% a year. What could be easier?

But, not knowing that this fund had a workable crystal ball, would you have held on while it was experiencing a 75.96% downturn during a particularly bad bear market starting in 1929? Or might you have been tempted to bail to safer bonds at some point during that catastrophe? This perfect fund fell more than 44% during a one-year period starting at the end of March, 1937, and overall it experienced drops of 20% or more nine times during your holding period—plus an additional 19% draw down that took it within a whisker of bear market territory.

Some of the times when you might have been sorely tempted to jump ship: the 2000-2001 downturn, when your marvelous fund lost 34% while the S&P 500 was only down 21%. Or a precipitous 22.11% downturn starting at the end of 1974, when the S&P 500 was gaining 19.94%. Or the 19.91% drop from the end of September through the end of November 2002, at a time when the S&P 500 was sailing along with a 15.28% positive return. The long-term returns were terrific, but it took a lot of stomach to hold on for the full ride.

The authors also looked at an even more marvelous manager, who not only bought only the 10% of stocks that would go up the most in the subsequent five years, but also shorted the 10% of stocks that would experience the worst 5-year performance (shorting means that you borrow and sell a stock first, hoping it goes down, then buy it back when it’s cheaper). The mechanics of this fund are a little more complicated, but the results were even more dramatic: the fund experienced enormous losses at times when the S&P 500 was experiencing gains—as you can see from the accompanying chart, which shows this perfect fund’s biggest losses compared with S&P 500 returns during the same period. You really had to be intrepid to hold on and claim the fund’s remarkable 39.74% annualized returns.

CA - 2016-2-5 - Perfect investment

The point? The authors say that even if God (who presumably has perfect foresight) were running a mutual fund, He would have lost a lot of investors who lost faith in his management skill during those times when the markets experienced rough patches. It’s fundamentally a lesson in humility and patience; great long-term track records are not immune from pullbacks, and our all-too-human tendency is to lose faith in the face of adversity.

What does this tell us? It indicates that investing is hard, because our psychological make-up tends to push us to do the wrong thing at the wrong time when it comes to our money. At the risk of sounding self-serving, having an advisor manage your assets can help put a barrier between your natural instincts and the markets. And who can’t use a little coaching and seasoned expertise …?

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch.

Source:

http://blog.alphaarchitect.com/2016/02/02/even-god-would-get-fired-as-an-active-investor/#.VrD5akrsaMY.twitter

The MoneyGeek thanks guest writer Bob Veres for his contribution to this post

 

Recovery—For How Long?

On Tuesday of this week, the U.S. stock markets (S&P 500 index) went up 2.39%, the highest one-day return in a month. Analysts attributed the rise to a variety of economic news that suggested that the American economy is not, after all, plunging into recession. The buoyant mood among investors may not last, but for many, it’s a welcome sign that things may not be as gloomy as they seemed just a month ago.

In fact, the S&P 500 only dropped about 12%, from 2078.36 at the end of December 2015 to the bottom of 1829.08 on February 11—despite widespread predictions of a 20% bear market. Since then, it has risen on shaky legs back to more than 1999, just 79 points from breaking even on the year. One more day like Tuesday would erase nearly all of the damage in 2016.

The good economic news involved construction spending, which reached its highest level since 2007. Oil prices were also gaining ground, although it’s hard to see why the average American would find reason to cheer about that. In addition, new orders and inventories stabilized in the manufacturing sector, after experiencing downturns in the last quarter of 2015.  On Friday, The February jobs report showed that the economy created 242,000 jobs and unemployment remains at a low 4.9%.  Other factors include the possibility that U.S. stock investors may finally have decided that declines in the Chinese markets are not going to directly affect the value of American-based businesses.

None of this means that we know what will happen next. Neither we nor any of the pundits you see on the financial news have any idea whether that long-awaited 20% decline will materialize, or the markets will continue to recover and we’ll all look back on February 11 prices as a great time to buy. But it’s worth reflecting on how unexpected this latest rally has been at a time when it seemed that all the news pointed to more pain and decline. Anybody who believed the pundits and fully retreated to the sidelines after the January selloff is now sitting on losses and wondering whether to jump in now and hope the gains continue, or wait and hope for another downturn, and risk losing even more ground if this turns out to be a long-term rally. This is not to say that hedging or taking some bull market profits off the table is still not a good idea. All-or-nothing investing is almost never a good idea.

We can never see the next turn in the market roller coaster, but long-term, the markets seem to operate under the opposite of the pull of gravity. You and I know with some degree of certainty in which direction the next 100% market move will be, even if we can’t pinpoint when or where.

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch.

Sources:

http://www.businessinsider.com/the-stock-market-is-over-china-2016-2

http://www.bloomberg.com/news/articles/2016-02-29/japan-futures-down-on-strong-yen-as-china-stimulus-buoys-aussie

http://finance.yahoo.com/news/wall-st-open-higher-oil-143344528.html

The MoneyGeek thanks guest writer Bob Veres for his contribution to this post

What’s Going on in the Markets January 18 2016

Wow! There’s no diplomatic way to say this: the global stock markets are in panic mode right now. In two weeks of trading, the U.S. S&P 500 index is down 8% on the year, which brings us close to correction territory (a 10% decline), and has some predicting a bear market (a 20% decline).

On top of that, we’ve been hearing a widely-publicized, rather alarming prediction from Royal Bank of Scotland analyst Andrew Roberts, saying that the global markets “look similar to 2008.” Mr. Roberts is also predicting that technology and automation are set to wipe out half of all jobs in the developed world. If you listen closely out the window, you can almost hear traders shouting “Sell! Head for the exits! We’re all gonna’ die!!!”

When you’re in the middle of so much panic, when people are stampeding in all directions, it’s hard to realize that there is no actual fire in the theater. Yes, oil prices are down around $30 a barrel, and could go lower, which is not exactly terrific news for oil companies and oil services concerns—particularly those who have invested in fracking production. But cheaper energy IS good news for manufacturers and consumers, which is sometimes forgotten in the gloomy forecasts. Chinese stocks and the Chinese economy are showing more signs of weakness, and there are legitimate concerns about the status of junk bonds—that is, high-yield bonds issued by riskier companies with high debt levels, and many developing nations. These bonds have stabilized in the past few weeks, but another Federal Reserve interest rate hike could destabilize them all over again, leading to forced selling and investors taking losses in the dicier corners of the bond market.

If you can think above the shouting and jostling toward the exists, you might take a moment to wonder about some of these panic triggers. Are oil prices going to continue going down forever, or are they near a logical bottom? Is this a time to be selling stocks, or, with prices this low, a better time to be buying? Are China’s recent struggles relevant to the health of your portfolio and the value of the stocks you own?

And what about the RBS analyst who is yelling “Fire!” in the crowded theater? A closer look at Mr. Roberts’ track record shows that he has been predicting disaster, with some regularity, for the past six years—rather incorrectly, as it turns out. In June 2010, when the markets were about to embark on a remarkable five year boom, he wrote that “We cannot stress enough how strongly we believe that a cliff-edge may be around the corner, for the global banking system (particularly in Europe) and for the global economy. Think the unthinkable,” he added, ominously.   (“The unthinkable,” whatever that meant, never happened.)

Again, in July 2012, his analyst report read, in part: “People talk about recovery, but to me we are in a much worse shape than the Great Depression.” Wow! Wasn’t it scary to have lived through, well, a 3.2% economic growth rate in the U.S. the following year? What Great Depression was he talking about?  Taking his advice in the past would have put you on the sidelines for some of the nicest gains in recent stock market history. And it’s interesting to note that one thing Mr. Roberts did NOT predict was the 2008 market meltdown.

Since 1950, the U.S. markets have experienced a decline of between 5% and 10% (the territory we’re in already) in 35.5% of all calendar years—which is another way of saying that this recent draw down is entirely normal. In fact, our markets spend about 55% of the time in this range (pulling back).  One in five years (22.6%) have experienced draw downs of 10-15%, and 17.7% of our last 56 stock market years have seen downturns, at some point in the year, above 20%.

Stocks periodically go on sale because people panic and sell them at just about any price they can get in their rush to the exits, and we are clearly experiencing one of those periods now. Whether this will be one of those 5-10% years or a 20% year, only time will tell. But it’s worth noting that, in the past, every one of those draw downs eventually ended with an even greater upturn and markets testing new record highs.

Many investors apparently believe this is going to be the first time in market history where that isn’t going to happen. The rest of us can stay in our seats and decline to join the panic.

Without a doubt the market picture looks dour, and it’s hard to see red on our screens and declines on our monthly statements. A disciplined approach that takes into account your goals, risk tolerance and time horizon remains the best way to approach when and how you’ll sell. There’s always a better day to sell since strength always returns to markets after a panic. Your patience is always rewarded in the markets, though I acknowledge that it’s easier said than done. If investing in the stock markets was easy, then returns would not be anywhere near as rewarding as they are.

In our client portfolios, we continue to look for opportunities to add to positions in good funds and companies at the appropriate time. We continue to maintain a healthy cash position, and have increased our hedges. While we may see additional selling to start the week (which starts on Tuesday due to the Martin Luther King, Jr. holiday), I suspect that the selling is somewhat exhausted in the short term, so I’m expecting a robust bounce as early as this week (I saw signs of selling exhaustion on Friday January 15). The quality and duration of that bounce will tell us more about what’s to come, and whether more defensive measures are warranted.

Nothing in this note should be construed as investment advice or a recommendation to buy or sell any security. If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch.

Sources:

http://finance.yahoo.com/news/why-the-heck-are-the-markets-tanking-165146322.html

http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/7857595/RBS-tells-clients-to-prepare-for-monster-money-printing-by-the-Federal-Reserve.html

http://www.publicfinanceinternational.org/news/2012/07/economic-crisis-%E2%80%98worse-great-depression%E2%80%99

http://blogs.spectator.co.uk/2016/01/the-author-of-the-rbs-sell-everything-note-has-been-predicting-disaster-for-the-last-five-years/

http://www.marquetteassociates.com/Research/Chart-of-the-Week-Posts/Chart-of-the-Week/ArticleID/140/Frequency-and-Magnitude-of-Stock-Market-Corrections

The MoneyGeek thanks guest writer Bob Veres for his contribution to this post

What’s Going on in the Markets January 7 2016

Have your long-term financial goals changed in the last four days?

Are American companies becoming less valuable because investors in China are panicking?

Is there any reason to think that because Chinese investors are panicking, that Chinese companies are less valuable today than they were a few days ago?

These are the kinds of questions to ponder as you watch the U.S. stock market catch a cold after China sneezed.  In each of the first four trading days of the year, China closed its markets due to a rapid fall in share prices—a move which may have made the panic worse, since it made investors fear being trapped in stocks that are seen as dropping in value.  It’s unclear exactly how or why, but the panic spread to global markets, with U.S. stocks falling 4.9% to mark the worst first-of-the-year drop in history.

For long-term investors, the result is much the same as if you went to the grocery store and discovered that the prices had fallen roughly 5% across the board.  At first, you might think this is a great bargain. But then you might wonder whether the prices will be even lower tomorrow or next week.  One thing you probably WOULDN’T worry about is whether prices will eventually go back up; you know they always have in the past after these sale events expire.

Will they?  The truth is, nobody knows—and if you see pundits on TV say with certainty that they know where the markets are going, your first impulse should be to laugh, and your second should be to check their track record for predicting the future.  Without a working crystal ball, it’s hard to know whether the markets are entering a correction phase which will make stocks even cheaper to buy, or whether people will wake up and realize that they don’t have to share the panic of Chinese investors on this side of the ocean.  The good news is there appears to be no major economic disruption like the Wall Street derivatives mess that triggered the 2008 downturn.  The best, sanest investors will once again watch the markets for entertainment purposes—or just turn the channel.

I overwhelmingly hear pundits predicting a bear market in 2016 (a bear market is defined as a 20% or more decline from the last market peak). “The bull market has gone on way too long, economic data is deteriorating, the Federal Reserve is raising interest rates, geopolitical events spell doom, we’re heading for a recession, oil is going to $1 per barrel” are all reasons our markets are headed for a tumble. Remind yourself that no one knows for sure what might happen, and while a bear market might assert itself in 2016, no one can reliably predict when it will come. All we know for certain is that it sets up opportunities

So what should you do? If you’ve enjoyed nice gains in your portfolio from this bull market, then you should consider cashing in some of those gains. It never hurts to take some money “off the table” and have some cash reserves to take advantage of better prices. Don’t panic sell–wait for the inevitable bounce that always comes after a multi-day selloff. You’ll be glad you did.

If you’d rather not tax the tax hit on your gains, there are ways to hedge your portfolio so you can at least sleep better at night. Speaking of that, if you’re up at night worrying about your portfolio, then you need to figure out whether you’ve taken on too much risk for your temperament and investing time horizon. You should first discuss all of this with your financial advisor/planner. Don’t have one? We’re glad to help.

As for our clients, we’ve been raising cash and doing some hedging ourselves over the past year. While there are some concerning recent economic trends and technical market anomalies, we don’t see signs of an impending recession on the horizon. We look for indications of a recession, because recessions usually lead to bear markets.

Nothing in this note should be construed as investment advice or a recommendation to buy or sell any security. If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch.

Sources:

http://www.ft.com/intl/cms/s/0/f248931e-b4e5-11e5-8358-9a82b43f6b2f.html#axzz3wc533ghn

http://www.ft.com/cms/s/0/bc8c0d60-b54d-11e5-b147-e5e5bba42e51.html?ftcamp=published_links%2Frss%2Fhome_us%2Ffeed%2F%2Fproduct#axzz3wc533ghn

The MoneyGeek thanks guest writer Bob Veres for his contribution to this post

The Association Factor

What’s the best way to be happy and successful? What do most happy and successful people have in common?

If you answered “money,” or anything to do with meditation or networking skills, you’re off the mark, according to Jason Butler, a former financial planner who is currently working as a motivational speaker. He says that after reading biographies of political, business, scientific and charity leaders, and hearing the personal stories of several hundred financial planning clients, one factor tends to be present in the happiest, most successful individuals, and it’s entirely in your control: who you surround yourself with. Call it your “association factor.”

There are several dimensions to this. If you’re an athlete who wants to improve your fitness or skill level, hanging out with (competing with) superior athletes will do more to help you ‘up your game’ than if you were associating with people you can beat without breaking a sweat. If you employ or work alongside people who have a diligent and service-oriented attitude, you can delegate work, avoid micromanaging, and feel confident that the workload will be shared fairly. If your social circle is full of people who are pessimistic, negative, defeatist or cynical, then it will pull you into pessimism or defeatism. We all know people who suck the life out of anybody they’re around. Why let it happen to you?

Butler says that cultivating meaningful personal relationships with the right types of people should be an essential priority for anyone who wants to live a meaningful, fulfilling, successful and happy life—which basically means all of us. You should consciously try to surround yourself with people who are optimistic, positive, capable and excited about the future.

The interesting thing about this advice is how few people seem to be intentional about their friendships. Most of us make friends by happenstance, because we shared an experience together or have something in common. Consciously creating a circle of friends, and constantly looking for business relationships that will be productive and supportive, is not often a priority.

But it can be, and the results could be dramatic.

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch.

I wish everyone a happy 2016 with many successful associations!

Sam

Source:

https://www.linkedin.com/pulse/one-thing-all-happy-successful-people-do-jason-butler?trk=prof-post&utm_content=bufferf8382&utm_medium=social&utm_source=twitter.com&utm_campaign=buffer

The MoneyGeek thanks guest writer Bob Veres for his contribution to this post

Rate Hike Hype

While I’m still a tad skeptical, we will almost surely see the U.S. Federal Reserve Board (Fed) start the long process of ending its intrusion into the interest rate markets, by allowing short-term rates to rise starting on Wednesday. It will be the first time the Fed has raised rates since 2006, and for some it will mark the beginning of the final chapter of the Great Recession.

Since 2008, as most of us know, returns on short-term bonds have been at or near zero percent, which is a consequence of the Fed keeping the Federal Funds rate—the rate at which it will lend banks virtually unlimited amounts of money, short-term—at 0.125%. The average Fed Funds rate has historically been 3.5% to 4.0%, so this is a considerable amount of stimulus.

At the same time, the Fed has purchased more than $3.5 trillion worth of Treasury securities and home mortgage pools as part of its quantitative easing (QE) programs, bidding aggressively against much smaller buyers, which is another way of saying: forcing the rates on these bonds down closer to zero.

Pulling back out of these interventions is going to be tricky, in part because shifts in interest rates have a direct impact on a still-fragile U.S. economy (higher rates mean higher borrowing costs, potentially less corporate investment and lower profits), and even trickier because we don’t know how investors will react. In the past, the markets have panicked at the mere mention of a cutback in Fed involvement, and (more recently) have also risen on the same news, presumably because people drew encouragement from the confidence the Fed was showing in the strength and resilience of the U.S. economy.

There are also some tricky mechanical problems. The central bank will try to control the extent that short-term rates rise and fall by raising the interest it pays to banks for the reserves held at the Fed, and also cautiously raising the amount it pays money market funds for short-term trades known as “reverse repurchase agreements.” The mechanics are highly technical and complicated—and still unproven, although there are reports that the Fed has been conducting tests for the past two years.

As the markets react, either upwards or downwards, there are a few things to keep in mind. First, despite the headlines soon to be blaring from every financial section of every newspaper in the country, the rate is expected to move very modestly from .125% to .375%—clearly a small first step in a long journey toward the long-term average. After each step—prominently including this one—the Fed will evaluate the consequences before deciding to make future changes. If the economy slows, or if there are signs that inflation is falling below the Fed’s 2% annual target, it could delay the next move by months or even years. That caution greatly reduces the danger of any kind of serious economic pullback.

It’s also worth noting that the Fed has announced no plans to sell the nearly $4.2 trillion worth of various bonds—including the aforementioned Treasuries and mortgages—that it owns. At the moment, the bank is simply rolling over the portfolio, meaning it reinvests $21 billion a month as bonds mature. Eventually, most observers expect the reinvestment to stop and the Fed to allow the huge bond holdings to mature and fall off of its balance sheet. The fact that this is not being done currently reflects the exquisite degree of caution among Fed policymakers, who don’t want to rock the boat too fast or too hard.

Finally, some have wondered about the future of mortgage interest rates as the Fed begins a cautious exit from the bond markets. Interestingly, recent history shows that mortgages haven’t been especially influenced by changes in the benchmark rate. The last time we saw extremely low interest rates, after the tech bubble burst in the early 2000’s, the Fed brought its Fed funds rate down to 1%. It began raising rates by 0.25% a quarter starting in the summer of 2004, but over the next four months, the 30-year fixed-rate mortgage actually fell from 6.3% to 5.58%. By the time of the last increase in the summer of 2006, mortgage rates were running at 6.68%, just a half-percent higher than they had been at the previous Fed funds rate low.

Nobody knows exactly what to expect when the announcement comes on Wednesday, but you can look for the investment markets to bounce around a bit more than usual, and economists—including the teams employed by the Fed—to examine every scrap of data about the impact on the economy over the next quarter. At that time, Fed policymakers will face another decision, and there is no reason to expect them to be less cautious than they have been recently. For many of us, the rate rise should be reason for celebration, a sign that the long recession and period of economic uncertainty is finally starting—carefully—to be put in our rear view mirror.

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch.

Sources:

https://www.washingtonpost.com/news/where-we-live/wp/2015/12/14/what-a-fed-rate-hike-could-mean-to-mortgage-borrowers/

https://www.washingtonpost.com/news/wonk/wp/2015/12/14/the-federal-reserve-will-likely-raise-interest-rates-this-week-this-is-what-happens-next/

http://www.usatoday.com/story/money/2015/12/14/this-week-december-13/77155714/

The MoneyGeek thanks guest writer Bob Veres for his contribution to this post

2015 Year-End Tax Planning Tips

As the end of the year approaches, it’s a good time to think of planning moves that will help lower your tax bill for this year and possibly the next. Factors that compound the challenge include turbulence in the stock market, overall economic uncertainty, and Congress’s failure to act on a number of important tax breaks that expired at the end of 2014. Some of these tax breaks ultimately may be retroactively reinstated and extended, as they were last year, but Congress may not decide the fate of these tax breaks until the very end of 2015 (or later).

These not yet extended breaks include for individuals: the option to deduct state and local sales and use taxes instead of state and local income taxes; the above-the-line-deduction for qualified higher education expenses; tax-free IRA distributions for charitable purposes by those age 70-1/2 or older; and the exclusion for up-to-$2 million of mortgage debt forgiveness on a principal residence. For businesses: tax breaks that expired at the end of last year and may be retroactively reinstated and extended including 50% bonus first-year depreciation for most new machinery, equipment and software; the $500,000 annual expensing limitation; the research tax credit; and the 15-year write-off for qualified leasehold improvements, qualified restaurant buildings and improvements, as well as qualified retail improvements.

Year-end tax planning is included on a complimentary basis for financial planning clients of our firm. Accordingly, clients will be receiving a separate e-mail from us requesting certain 2015 tax information so we can review and assess tax planning opportunities available to them.

Higher Income Earners

Higher-income earners have unique concerns to address when mapping out year-end plans. They must be wary of the 3.8% surtax on certain unearned income, and the additional 0.9% Medicare (hospital insurance, or HI) tax. The latter tax applies to individuals for whom the sum of their wages received with respect to employment and their self-employment income is in excess of an unindexed threshold amount ($250,000 for joint filers, $125,000 for married couples filing separately, and $200,000 in any other case).

The surtax is 3.8% of the lesser of: (1) net investment income (NII), or (2) the excess of modified adjusted gross income (MAGI) over an unindexed threshold amount ($250,000 for joint filers or surviving spouses, $125,000 for a married individual filing a separate return, and $200,000 in any other case). As year-end nears, a taxpayer’s approach to minimizing or eliminating the 3.8% surtax will depend on his estimated MAGI and NII for the year. Some taxpayers should consider ways to minimize (e.g., through deferral) additional NII for the balance of the year; others should try to see if they can reduce MAGI other than NII; and other individuals will need to consider ways to minimize both NII and other types of MAGI.

The 0.9% additional Medicare tax also may require year-end actions. Employers must withhold the additional Medicare tax from wages in excess of $200,000 regardless of filing status or other income. Self-employed persons must take it into account in figuring estimated tax. There could be situations where an employee may need to have more withheld toward the end of the year to cover the tax. For example, if an individual earns $200,000 from one employer during the first half of the year and a like amount from another employer during the balance of the year, he would owe the additional Medicare tax, but there would be no withholding by either employer for the additional Medicare tax since wages from each employer don’t exceed $200,000. Also, in determining whether they may need to make adjustments to avoid a penalty for underpayment of estimated tax, individuals also should be mindful that the additional Medicare tax may be over-withheld. This could occur, for example, where only one of two married spouses works and reaches the threshold for the employer to withhold, but the couple’s combined income won’t be high enough to actually cause the tax to be owed.

We have compiled a checklist of additional actions based on current tax rules that may help you save tax dollars if you act before year-end. Not all actions will apply in your particular situation, but you (or a family member or your business) will likely benefit from many of them. We can narrow down the specific actions that you can take once we discuss with you a particular plan. In the meantime, please review the following list and contact us at your earliest convenience so that we can advise you on which tax-saving moves to make.

Year-End Tax Planning Moves for Individuals

  • Recognize capital losses on stocks or funds while substantially preserving your investment position. There are several ways this can be done. For example, you can sell the original holding, then buy back the same securities at least 31 days later, or buy a similar security. It may be advisable for us to meet to discuss year-end trades you should consider making.
  • Postpone income until 2016, and accelerate deductions into 2015 to lower your 2015 tax bill. This strategy may enable you to claim larger deductions, credits, and other tax breaks for 2015 that are phased out over varying levels of adjusted gross income (AGI). These include child tax credits, higher education tax credits, and deductions for student loan interest. Postponing income also is desirable for those taxpayers who anticipate being in a lower tax bracket next year due to changed financial circumstances. Note, however, that in some cases, it may pay to actually accelerate income into 2015. For example, this may be the case where a person’s marginal tax rate is much lower this year than it will be next year, or where lower income in 2016 will result in a higher tax credit for an individual who plans to purchase health insurance on a health exchange and is eligible for a premium assistance credit. Being subject to the alternative minimum tax (AMT) may also change this recommendation, so it’s best to “run the numbers”.
  • If you believe that a tax-free Roth IRA is better than a traditional IRA, consider converting traditional-IRA money invested in beaten-down stocks (or mutual/exchange traded funds) into a Roth IRA if eligible to do so. Keep in mind, however, that such a conversion will increase your adjusted gross income for 2015.
  • If you converted assets in a traditional IRA to a Roth IRA earlier in the year, and the assets in the Roth IRA account have declined in value, you could wind up paying a higher tax than is necessary if you leave things as is. You can back out of the transaction by re-characterizing the conversion—that is, by transferring the converted amount (plus earnings, or minus losses) from the Roth IRA back to a traditional IRA via a trustee-to-trustee transfer. You can later re-convert to a Roth IRA.
  • It may be advantageous to try to arrange with your employer to defer, until 2016, a bonus that may be coming your way.
  • Consider using a credit card to pay deductible expenses before the end of the year. Doing so will increase your 2015 deductions even if you don’t pay your credit card bill until after the end of the year. Again, if the AMT applies to you, this strategy may not work.
  • If you expect to owe state and local income taxes when you file your return next year, consider asking your employer to increase withholding of state and local taxes (or pay estimated tax payments of state and local taxes) before year-end to pull the deduction of those taxes into 2015 if you won’t be subject to the AMT in 2015.
  • Consider taking an eligible rollover distribution from a qualified retirement plan before the end of 2015 if you are facing a penalty for underpayment of estimated tax, and having your employer increase your withholding is unavailable or won’t sufficiently address the problem. Income tax will be withheld from the distribution and will be applied toward the taxes owed for 2015. You can then timely roll over the gross amount of the distribution, i.e., the net amount you received plus the amount of withheld tax, to a traditional IRA. No part of the distribution will be includible in income for 2015, but the withheld tax will be applied pro rata over the full 2015 tax year to reduce previous quarterly underpayments of estimated tax.
  • Estimate the effect of any year-end planning moves on the AMT for 2015, keeping in mind that many tax breaks allowed for purposes of calculating regular taxes are disallowed for AMT purposes. These include the deduction for state property taxes on your residence, state income taxes, miscellaneous itemized deductions, and personal exemptions. Other deductions, such as for medical expenses of a taxpayer who is at least age 65, or whose spouse is at least 65 as of the close of the tax year, are calculated in a more restrictive way for AMT purposes than for regular tax purposes. If you are subject to the AMT for 2015, or suspect you might be, these types of deductions should not be accelerated.
  • You may be able to save taxes this year and next by applying a bunching strategy to “miscellaneous” itemized deductions, medical expenses and other itemized deductions. Check to see if deferring the payment of 2015 deductions until 2016 provides more benefit.
  • You may want to pay contested taxes to be able to deduct them this year while continuing to contest them next year. Check with your tax accountant before doing this.
  • You may want to settle an insurance or damage claim in order to maximize your casualty loss deduction this year.
  • Be sure to take required minimum distributions (RMDs) from your IRA or 401(k) plan (or other employer-sponsored retirement plan). RMDs from IRAs must begin by April 1 of the year following the year you reach age 70- 1/2. That start date also applies to company plans, but non-5% company owners who continue working may defer RMDs until April 1 following the year they retire. Failure to take a required withdrawal can result in a penalty of 50% of the amount of the RMD not withdrawn. If you turned age 70- 1/2 in 2015, you can delay the first required distribution to 2016, but if you do, you will have to take a double distribution in 2016—the amount required for 2015 plus the amount required for 2016. Think twice before delaying 2015 distributions to 2016, as bunching income into 2016 might push you into a higher tax bracket or have a detrimental impact on various income tax deductions that are reduced at higher income levels. However, it could be beneficial to take both distributions in 2016 if you will be in a substantially lower bracket in that year.
  • Increase the amount you set aside for next year in your employer’s health flexible spending account (FSA) if you set aside too little for this year. Estimate your expenses carefully since this is a “use it or lose it” type of deduction.
  • If you are, or can make yourself eligible to make health savings account (HSA) contributions by Dec. 1, 2015, you can make a full year’s worth of deductible HSA contributions for 2015.
  • Make gifts sheltered by the annual gift tax exclusion before the end of the year and thereby save gift and estate taxes. The exclusion applies to gifts of up to $14,000 made in 2015 to each of an unlimited number of individuals. Your spouse can give the same person up to $14,000 as well. Consider gifting appreciated stock or mutual/exchange traded funds to individuals with a lower tax bracket than you. You can’t carry over unused annual gift tax exclusions from one year to the next. The transfers also may save family income taxes where income-earning property is given to family members in lower income tax brackets (who are not subject to the kiddie tax.)

Year-End Tax-Planning Moves for Businesses & Business Owners

  • Businesses should buy machinery and equipment before year end and, under the generally applicable “half-year convention,” thereby secure a half-year’s worth of depreciation deductions in 2015. Be careful: a “mid-quarter convention” applies when the total depreciable basis of property that was placed in service during the last three months of the tax year is more than 40% of the total depreciable basis of all property that was placed in service throughout the entire year.
  • Although the business property expensing option is greatly reduced in 2015 (unless retroactively changed by legislation), making expenditures that qualify for this option can still get you thousands of dollars of current deductions that you wouldn’t otherwise get. For tax years beginning in 2015, the expensing limit is $25,000, and the investment-based reduction in the dollar limitation starts to take effect when property placed in service in the tax year exceeds $200,000.
  • Businesses may be able to take advantage of the “de-minimis safe harbor election” (also known as the book-tax conformity election) to expense the costs of inexpensive assets, materials and supplies, assuming the costs don’t have to be capitalized under the Code Sec. 263A uniform capitalization (UNICAP) rules. To qualify for the election, the cost of a unit of property can’t exceed $5,000 if the taxpayer has an applicable financial statement (AFS; e.g., a certified audited financial statement along with an independent CPA’s report). If there’s no AFS, the cost of a unit of property can’t exceed $500. Where the UNICAP rules aren’t an issue, purchase such qualifying items before the end of 2015.
  • A corporation should consider accelerating income from 2016 to 2015 if it will be in a higher bracket next year. Conversely, it should consider deferring income until 2016 if it will be in a higher bracket this year.
  • A corporation should consider deferring income until next year if doing so will preserve the corporation’s qualification for the small corporation AMT exemption for 2015. Note that there is never a reason to accelerate income for purposes of the small corporation AMT exemption because if a corporation doesn’t qualify for the exemption for any given tax year, it will not qualify for the exemption for any later tax year.
  • A corporation (other than a “large” corporation) that anticipates a small net operating loss (NOL) for 2015 (and substantial net income in 2016) may find it worthwhile to accelerate just enough of its 2016 income (or to defer just enough of its 2015 deductions) to create a small amount of net income for 2015. This will permit the corporation to base its 2016 estimated tax installments on the relatively small amount of income shown on its 2015 return, rather than having to pay estimated taxes based on 100% of its much larger 2016 taxable income.
  • If your business qualifies for the domestic production activities deduction (DPAD) for its 2015 tax year, consider whether the 50%-of-W-2 wages limitation on that deduction applies. If it does, consider ways to increase 2015 W-2 income, e.g., by bonuses to owner-shareholders whose compensation is allocable to domestic production gross receipts. Note that the limitation applies to amounts paid with respect to employment in calendar year 2015, even if the business has a fiscal year.
  • To reduce 2015 taxable income, if you are a debtor, consider deferring a debt-cancellation event until 2016.
  • To reduce 2015 taxable income, consider disposing of a passive activity in 2015 if doing so will allow you to deduct suspended passive activity losses.
  • If you own an interest in a partnership or S corporation, consider whether you need to increase your cost basis in the entity so you can deduct a loss from it for this year.

These are just some of the year-end steps that can be taken to save taxes. Again, by contacting us, we can tailor a particular plan that will work best for you. We also will need to stay in close touch in the event that Congress revives expired tax breaks to assure that you don’t miss out on any resuscitated tax-saving opportunities.

If you’d like to know more about tax planning or want to discuss other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.

Medicare Cost Increases

At the same time it was announcing that Social Security recipients wouldn’t receive any increases in their benefits, the government was announcing that certain Medicare participants would be paying dramatically higher premiums for Medicare Part B, the highest price jump in the program’s history. In general, the higher premiums will affect new enrollees in 2016, enrollees who don’t yet collect Social Security checks, enrollees with incomes above $85,000 (single) or $170,000 (married), and dual Medicare-Medicaid beneficiaries. In all, that represents 30% of 2016 Medicare beneficiaries—roughly 7 million Americans.

This jump in some recipients’ costs is, ironically, tied to a relative bargain for others. Under something called the “hold harmless” clause in Social Security, in years when there is no cost of living increase in Social Security payments, the government also has to keep Medicare Plan B the same for those receiving Social Security payments. Under current law, the government has to collect 25% of all expected Part B costs from recipients each year. As a result, this relative bargain for many retirees had to be paid for by others—meaning: those NOT receiving Social Security checks.

Medicare recipients who are not taking Social Security checks, who fall below the income thresholds, will see their monthly premiums go up from $104.90 to $123. Those whose income is above the threshold could see increases of $223 a month up to $509.80 a month for individuals whose family income exceeds $428,000 a year.

So next year will see some retirees make out better than expected on their Medicare costs, while others will lose big. There are proposals in Congress to fix this situation, but you shouldn’t expect any big reform in an election year. Should you take matters into your own hands and start collecting Social Security benefits—putting you in the protected class of Medicare recipients? Probably not. First, for those under age 70, it means locking in lower Social Security benefits. And second, if your income is above the $85,000 (single)/$170,000 (joint) thresholds, you will pay higher premiums anyway.

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch.

Sources:

http://www.aarp.org/health/medicare-insurance/info-2015/medicare-part-b-premiums-could-spike.html?intcmp=HP-FLXSLDR-SLIDE1-MAIN

https://www.medicare.gov/your-medicare-costs/part-b-costs/part-b-costs.html

The MoneyGeek thanks guest writer Bob Veres for his contribution to this post

No Social Security Benefit Increase This Year

You’ve probably heard by now that the 2016 cost of living (COLA) adjustment for Social Security benefits is zero—the third time this has happened in the last seven years. (2010 and 2011 were the other recent years.) In fact, Social Security benefit increases have stalled since the Great Recession; only once since 2008 have they risen by more than 2%.

For many retirees, this was surprising news. Anybody who has visited the grocery store lately knows that the price of food is rising. Every day, the papers tell us that housing costs are increasing and medical care costs are also rising.

You will undoubtedly see websites which blame the Obama Administration or Democrats generally for trying to balance the federal budget on the backs of people who have paid into the Social Security system, but in fact the annual COLA calculation is automatic and set by formula.

The formula is something called the Consumer Price Index for All Urban Wage Earners and Clerical Workers, known to economists as CPI-W, calculated by the government’s Bureau of Labor Statistics in an effort to make the purchasing power of Social Security as close as possible to the same each year. The CPI-W was attached to Social Security payments in 1972 and has never been replaced. There are many components, and indeed most of them rose in 2015. Food was calculated to be 1.6% more expensive than it was last year; shelter costs rose 3.2% and medical costs were up 2.4%. Ironically, the falling price of gasoline was the factor which drove the CPI-W back to zero; the index tells us that energy prices declined 18.4% this year.

Is this a fair way to calculate actual costs of living? Many believe it is not, for several reasons. First, the CPI-W is a weighted formula, based on the costs of urban workers, not retirees. Therefore, it presupposes, in the weightings, a very different lifestyle than most Social Security recipients are living. The price of gasoline, for example, is assumed to represent 20.1% of a retiree’s total expenditures, which may be true for somebody who commutes to work every day in one of America’s major cities, but doesn’t reflect the normal lifestyle of a retiree. Medical care is assumed to be 5.1% of a retiree’s annual expenditures. For a young office worker, that may be a slight overstatement. For a retiree over age 70, it is almost certainly a gross understatement.

Recreation is assumed to be 5.4% of expenditures, which again sounds about right for the office worker who brings home work on the weekends. But a retiree almost certainly spends more on travel and greens fees. (Amusingly, college tuition is assumed to be 1% of the average CPI-W person’s expenditures.)

Is there a way to fix the formula so it more accurately reflects the actual costs of living in retirement? The Bureau of Labor Statistics actually calculates, each year, something called the Consumer Price Index for the Elderly. In that index, transportation costs are assumed to make up a more realistic 14% of yearly expenditures, and medical care counts double the CPI-W figure: 10.9% of assumed expenditures. Curiously, the index assumes that retirees spend less money on recreation (4.4%) and food away from home (4.6%, compared with 6.4% for that urban worker). The Social Security Administration has calculated that if it had been using the CPI-E COLA each year, rather than the CPI-W, the result would have been significantly higher Social Security benefits, more than 15% higher than today’s payments.

So is it time to push for a switch? Alas, the proposals currently in Congress have nothing to do with the CPI-E. Our elected representatives want to switch the index tied to Social Security benefits to something called the “chain-weighted CPI,” which annually comes up with lower COLA figures—and would, indeed, help balance the budget on the backs of seniors. Instead of complaining, should we celebrate the fact that the cost of living calculation wasn’t negative for next year?

With the federal reserve holding interest rates at zero percent, and now no COLA increase for social security recipients, our senior citizens continue to see an erosion of their buying power and no return on their low-risk savings which they worked a lifetime to accumulate. It certainly doesn’t seem very fair, and makes the case for careful financial planning very clear.

If you would like to exchange thoughts about your social security benefits or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch.

Sources:

http://www.usatoday.com/story/money/personalfinance/2015/10/16/tips-social-security-recipients-worried-no-cola-2016/73993428/

http://www.nbcnews.com/business/retirement/social-security-benefits-remain-unchanged-next-year-n445066

http://www.socialsecurity.gov/policy/docs/ssb/v67n3/v67n3p73.html

The MoneyGeek thanks guest writer Bob Veres for his contribution to this post

Should You “Fix” Variable Rate Debt?

While investors are keeping a close watch on the Federal Reserve for indications of when it will start raising interest rates, the consensus among economists is that it will begin its credit-tightening cycle at some point this year.

Of course there are two sides to the interest rate coin: the investor and the borrower. Rising rates are generally good news for savers and investors, but they represent an expense for borrowers and increase the cost of taking out loans and mortgages.

In the current environment, individuals may be evaluating the potential benefits of converting variable-rate loans, including adjustable rate mortgages (ARMs), home equity lines of credit, and student loans, to a fixed rate.

Only One Way to Go

Interest rates are still at historic lows and are only likely to go up from here. Personal finance experts typically favor refinancing, when practical, to a fixed rate for the stability it provides the borrower. With a fixed-rate loan the borrower will not have to be concerned if there is a sudden spike in interest rates. What’s more, individuals with fixed-rate debt have much more control over their budget and can plan ahead with more confidence, as they have a clear, predictable picture of their monthly income and expenses.

While adjustable-rate loans may have lower initial interest rates than fixed-rate loans, the lower interest rate is only for a set period of time. At the end of the fixed period, the monthly loan amount “adjusts” based on the market rate or index. In this case, refinancing may be a smart choice if your ARM is adjusting to an interest rate that is higher than the current market rate.

How Low Are Rates?

Just how low are short-term rates now, historically speaking? Most lenders base their variable rates off a LIBOR rate, which stands for London Interbank Offered Rate and works as a benchmark rate for banks internationally.1 As the LIBOR changes, so does the variable rate. The LIBOR is low today, compared to its 10-year and 20-year averages (see table below), but once it begins to increase, borrowers holding adjustable rate loans will see an increase in their regular payments. While most variable rate loans will have an upper interest rate cap, it is important to know what that maximum rate is — and whether you could handle that potential debt load — before signing any documents.

LIBOR — Then and Now

10-year average 20-year average July 6, 2015
6-month LIBOR 1.95% 3.09% 0.44%
12-month LIBOR 2.17% 3.29% 0.76%

Source: Federal Reserve Economic Data (FRED). For the dates indicated. The 10-year and 20-year averages are for the period ended July 6, 2015.

Generally, a variable rate loan is a safe bet for individuals who plan to repay their loan quickly, or have a short time horizon for underlying property ownership. For example, if you plan to move within 3-5 years, refinancing to a fixed rate mortgage may not be worthwhile, when you take into account the cost of refinancing compared with your monthly potential payment (interest) savings. In general, you should be able to recoup your refinancing costs within two years to make it worthwhile in the short term.

While the Federal Reserve is expected to begin raising rates soon, it is likely to take a very measured, slow path, so there’s really no need to rush into a refinancing.

If you would like to review your current loans or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch.

Source:

1 U.S. News.com, “Fixed or Variable: Which Interest Rate Should You Choose?” July 14, 2015

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