Tax Freedom Day 2008 (2008-04-21)

Tax Freedom Day 2008

(2008-04-21) by David John Marotta

This year we celebrate Tax Freedom Day on Wednesday, April 23. That's the day we stop working for the government and start working for ourselves. For average workers, all of our earnings for the first 113 days of the year go to pay federal, state and local taxes. Starting April 24, we are free--at last--to take care of our own family's needs.

The nonpartisan Tax Foundation based in Washington, D.C., measures the tax burden on Americans every year. According to its 2008 report, published in March, this year's federal Tax Freedom Day comes seven days later than it did in 2003. Interestingly, the day falls three days earlier than it did last year. This decrease in taxes is the result of the slowing economy and a onetime fiscal stimulus tax cut.

Because of our progressive tax system, Uncle Sam usually collects more taxes as inflation rises, owing to "bracket creep." As your income growth keeps up with inflation, your purchasing power remains unchanged. But as inflation drives you into a higher tax bracket you pay higher taxes.

On average, taxes take nearly 31% of a worker's gross income: 20% for federal taxes and 11% for state and local taxes. For every eight-hour day, 2 hours and 28 minutes of our labor is spent paying taxes. Without taxes, you could leave your job at 2:32 p.m.

Only since 1992 have Americans paid more for government programs than we spend on food, clothing and medical care combined. For the amount of money we pay in taxes, the federal government could provide universal health coverage and feed and clothe us as well.

At the state level, Tax Freedom Day varies depending on location. California has moved up from the 7th to the 4th highest level of state taxes with its Tax Freedom Day now delayed until April 30. Virginia has risen from 17th to 12th in the race for the highest state tax rate, even though its liberation day arrives on April 25, only two days later than the national average.

The Virginia tax rate continues to climb higher each year, despite claims of no new personal taxes because of both bracket creep and the significant increase in state business taxes. This situation reflects a national trend. Business tax receipts have risen sharply over the past two years.

Most non-economists vastly underestimate the negative impact of taxes on the U.S. economy. Taxes encourage every American to do things themselves, outside of the taxable economy, even if specializing and working together would mean greater productivity. If you add the costs of complying with the complex web of regulations, the federal government costs us Americans collectively more than 50% of our wealth.

Imagine three contractors who could build three houses if they worked separately. If they collaborated and combined their expertise, however, they could build six houses instead. It may seem incredible that these builders would not take the opportunity to double their productivity, but with any tax rate higher than 50% they have no incentive to choose the more productive partnership. Putting their production into the taxable economy means they have to pay more than three houses in taxes. A 50% tax rate halves their productivity. Envision the economic boom if the other half of workers' labor were set free!

Imagine a skilled surgeon who has a marginal tax rate over 50%. Everything she pays someone else to do costs her twice as much because she pays with after-tax dollars. From a societal point of view, it is inefficient and wasteful for her to mow her own lawn, change her own oil or paint her own house, but specifically because she is in a high tax bracket, she can save more money than the average American by doing those chores herself. Another way to look at it is that without taxes, she could afford to pay twice as much to those who provide her these services.

Economist Arthur Laffer recognized that the law of diminishing returns applies to tax rates as well. According to Laffer, at a certain point, increased taxation actually yields the collection of fewer tax dollars. As we near a 100% tax rate, we approach driving commerce into the ground and collecting no taxes.

Many economists believe we are still beyond the point of diminishing returns. In other words, tax cuts would actually result in increased economic growth and more taxes being collected.

Presidents Kennedy and Reagan understood the Laffer curve well. In 1964 Kennedy reduced the top marginal tax rate from 91% to 70% and, to many people's surprise, tax revenues increased. Seventeen years later, the Reagan tax cuts reduced the top marginal rate from 70% to 50%. Again, revenues soared. Between 1980 and 1997, the share of federal income taxes paid by the top 1% rose from 19% to 33%. The share of taxes paid by the top 25% increased from 73% to 82%.

The top 1% now pays 34% of the taxes in the United States. Do you know how to join the top 1% of taxpayers? Just sell a house in California. The top half of taxpayers pays almost 96% of the income taxes, meaning the bottom half pay just 4%. These two statistics have increased despite all the complaints that tax cuts favor the rich.

Economists understand that the optimum rate of taxation is zero. The second-most ideal is as low as possible. In contrast, many Americans seem to believe that tax rates should be increasingly punitive. One notable exception is Alaska, where Tax Freedom Day arrived weeks ago on March 29.

Low taxes should not be a political issue that divides us. Every American should agree with the goal of keeping taxes as low as possible. In 2011 all of the federal tax cuts enacted since 2001 are scheduled to expire. If this happens, Tax Freedom Day will move an entire week later. In the words of John F. Kennedy, "An economy hampered by restrictive tax rates will never produce enough revenues to balance our budget--just as it will never produce enough jobs or profits."

from http://www.emarotta.com/article.php?ID=280

529 Plans Help with Estate Planning (2008-04-14)

529 Plans Help with Estate Planning

(2008-04-14) by David John Marotta and Matthew Illian

While many parents are struggling to fund their retirements adequately, the size of some grandparents' estates are prompting them to look for ways they can avoid paying excessive taxes. One effective estate-planning technique is using a 529 account both to fund their grandchildren's college and also help them avoid significant tax liabilities.

Families are finding it increasingly difficult to save for college. Four years costs about $55,000 at a public in-state school. With college inflation averaging 6.2% in the past decade, new parents in 2008 can expect the bill to swell to $160,000 by the time their children graduate from high school at age 18. Private schools are about twice as expensive.

Imagine Grandma and Grandpa Smith. Having come of age during the Depression and World War II, they built great wealth through an entrepreneurial can-do spirit. They are reluctant to subsidize their grown children, who already spend more frivolously than they should. But they love their grandchildren and support giving them as much of a debt-free higher education as they can achieve. And, of course, saving on taxes is a welcome benefit as well. So funding a 529 plan for each of their three grandchildren is an easy choice for them.

Investing in a college 529 plan offers several layers of tax savings. Virginia allows residents to deduct $2,000 of contributions from their 2008 state taxes. If Grandma Smith opens an account for each of the three grandchildren and Grandpa Smith opens his own accounts for each one, they can deduct $12,000 (six accounts times $2,000). Any contributions over this limit can be carried forward for deductions in following years. In 2009 the limit goes up to $4,000 a year per account. That year the Smiths can deduct $24,000, saving them $1,380 at Virginia's 5.75% rate. Saving $690 in 2008 and $1,380 per year for 17 years gives them $24,150 in Virginia state tax savings.

The Smiths can also use 529 plans to reduce their large estate. Anyone can gift $12,000 per person without being subject to the gift tax consequences. With a 529 plan, you are allowed to give five years ($60,000) all at once to get the account started by filing tax form 709.

Great benefit accrues to gifting the entire $60,000 in the first year rather than gifting $12,000 a year for five years. By putting the entire gift upfront, all of the growth is compounding completely in the child's estate. Gifting $12,000 each year leaves the remaining $48,000 compounding in the grandparents' account, exacerbating their estate-planning problem.

But gifting the entire $60,000 in the first year puts over $16,000 in extra compounded growth out of the Smiths' estate by the end of the fifth year. This extra contribution will continue to compound in each grandchild's college account for further savings. Because both the Smiths have an account for each of the three grandchildren, the extra estate exclusion by funding them upfront is $96,000. At a 45% estate tax rate, they will avoid $43,000 in estate taxes by the end of the five years.

And the tax-free compounded growth continues to provide estate tax savings. Over the 18 years before the Smiths' grandchildren go to college, the compounded growth is both tax free and out of the Smiths' estate. After 18 years of growth at 10%, their initial $360,000 investment will have removed over $2 million from their taxable estate, for a total estate tax savings of $900,706.

There is also a savings from tax-free compounding. Had the investments remained in the Smiths' accounts, the growth would at least have been subject to a 15% capital gains tax, if not higher. Avoiding this additional tax saved another quarter of a million dollars.

And after 18 years, as if to add the cherry on the top to all of these tax savings, each account will be worth $333,595. Stanford, my alma mater, currently costs more than $60,000 for four years. Growing at 6.2%, after 18 years it should cost about $180,000. With two accounts each, the Smiths' grandchildren should only be limited by their drive and academic achievement.

You might wonder why Grandma and Grandpa Smith are overfunding their 529 plans with more money than their grandchildren will likely spend on college. Any unused money can be allocated for the college expenses of future generations. Beneficiaries can be changed to the children, stepchildren, grandchildren, parents, grandparents, aunts, uncles and first cousins. After the grandchildren have finished college and gone through graduate school, the beneficiary of any existing money can be changed to their own children. The Smiths could be starting an educational dynasty with generations of tax-free growth.

The Smiths retain full control of these assets, even though they have been removed from their estate. Typical estate-planning instruments would require the Smiths to make irrevocable gifts. But with 529 plans, they can switch the beneficiary, change owners or even withdraw money for their own use if they are willing to pay the taxes and the 10% penalty on earnings. They could even make themselves the beneficiaries and enroll in classes themselves. If one of their grandchildren receives an athletic or academic scholarship, the Smiths can receive a tax-free refund up to the amount of the scholarship. And with a grandparent as the owner, a 529 plan is not considered as a resource for financial aid.

Unlike 529 savings plans, we do not recommend prepaid college tuition plans. At best, they match college inflation, and if used at an out-of-state institution, returns may not even keep pace with inflation. Virginia has several different flavors of 529 college savings plans. VEST, the Virginia Education Savings Trust, is marketed directly to the public. Another, CollegeAmerica, is offered through financial advisors. It has different share classes, some of which have loads that make them unattractive. No-load shares are available through fee-only financial advisors. The advantage of CollegeAmerica is that it allows an advisor to create his or her own asset allocation mix from a few dozen different funds.

The plethora of choices can often paralyze parents and grandparents from doing anything. To help, Matthew Illian CFP® will discuss how to evaluate college savings options at the next nonprofit NAPFA Consumer Education Foundation meeting on Saturday, April 19, 2008, from noon to 1:30 p.m. at the Northside Library Meeting Room in the Albemarle Square Shopping Center. To learn more about the NAPFA Foundation, visit http://www.napfafoundation.org/NAPFAfoundation_Charlottesville.htm.

from http://www.emarotta.com/article.php?ID=279

Decide to Be Rich (2008-04-07)

Decide to Be Rich

(2008-04-07) by David John Marotta

It used to be that becoming a millionaire was regarded as a huge achievement. In today's dollars, however, it is fairly trivial. According to the Department of Labor's inflation calculator, $1 million today was worth only $183,285 in 1970. But $1 million in 1970 had the same buying power as $5,456,005 today.

That's the new rich: over $5 million.

Depending on your lifestyle, if you have amassed $1 million at age 65, you may not even have enough to retire. At age 65, you can withdraw only 4.36% of your assets each year to ensure you don't deplete your savings before you die. So if you are just a millionaire, you must be able to live on an annual income of $43,600. And if your lifestyle demands twice that amount, you don't have enough money to retire yet.

Many of our parents and grandparents were fortunate enough to have pension plans that continued to pay their salary in retirement. Even though they never had a large investment account, those guaranteed benefit plans were extremely valuable. A pension paying $43,600 a year starting at age 65 is worth $1 million in the bank. Our parents and grandparents were truly millionaires, although they didn't know it!

But the days of defined benefit plans are over. Most employers today provide defined contribution plans. They define the amount they contribute to your retirement, usually in the form of matching dollars, and you are responsible for saving a sufficient amount and investing it wisely. Thus employees must amass $1 million for every $43,600 they'll need when they retire.

Want a higher lifestyle? Save $1.5 million and you can spend $65,400 each year. Save $2 million and you can spend $87,200. At $2.5 million you can spend $109,000. So don't think people with a big income don't have to worry about money. Those accustomed to a high lifestyle can find it very difficult to save enough to retire.

All this information leads us to the most important lesson about wealth. You can live rich or you can be rich. Many people live as though saving and investing wealth is wrong. Yet consider the alternative: Is spending every dime you earn virtuous? Isn't it better to produce more than you consume? Isn't it preferable to consume less and therefore have more wealth that you can invest and put to work creating jobs and producing goods? After all, the economic definition of capital is deferred consumption. Can you put off spending or decline to consume long enough to create investment capital that creates factories, businesses and jobs so others can benefit?

Consider two families with identical incomes. Family A lives rich, buying high-definition TVs, indulging in luxurious vacations, dining out frequently, and so on. Family B chooses to save and invest instead. Which family is wasteful and addicted to wealth, the family that is living rich or the one that is growing rich?

Family B may live simply and modestly below their means during their entire working careers. Amazingly, for every $100 a month they save and invest at 10%, they will have $1 million more when they retire. The two families may have the same income, but Family A spends $250 each month on a richer lifestyle and Family B retires with $2.5 million in assets. Interestingly, one of them we encourage, help and support and one we envy, tax and ridicule.

The members of Family A who have lived rich will have no assets at retirement and will further strain the Social Security and Medicare systems. We perceive them as the truly needy when in fact they have lived life as the truly greedy. They could have taken care of themselves, but instead they burdened society simply by ignoring their retirement.

To add insult to real societal injury, these same people often claim they just don't care about money. They are above amassing wealth and instead just live to enjoy themselves. If they truly were indifferent about money, however, they would be able to live on 15% less than their take-home pay and save and invest the difference.

A couple we know just retired with $2.5 million after working and earning quite modest salaries. They lived simply and practiced frugality. Nothing was wasted. They waited a few years before purchasing the latest technological gadgets and then bid for them on eBay. They made do or did without. They grew rich by shopping at sales and avoiding impulse buying on credit.

Now that they have managed to save $2.5 million, however, some of the presidential candidates have suggested increasing the tax on investment gains to 28%, rather than taxing the consumption of those living rich. That will mean if your investment assets earn an 8% return, you will be unable to make any progress toward your goals. Five percent of your return will just keep up with inflation, and you will owe 2.24% for a 28% capital gains tax. You would only be left with a 0.76% real return after taxes and inflation.

We won't be able to help the truly needy until a majority of Americans realize they are part of the problem. People's failure to save for their retirement stresses our governmental programs with those who ought to be multimillionaires. Saving just a few hundred dollars a month over your working career makes the difference.

No matter what your income, a similar family is living off half of your salary and still saving more than 15% of their take-home pay. Another family is earning twice what you earn and struggling to make ends meet. Nearly every family we work with wishes they had an extra $10,000 a year to make life easier.

Because of inflation, the gap between the rich and the poor is growing. If $5 million today is less than $1 million in 1970, the absolute dollar difference between the rich and the poor has to be at least five times greater. The poor always have zero.

Greg Mankiw, a professor of economics at Harvard, offers an interesting analysis (gregmankiw.blogspot.com): "If we compare the incomes of the top and bottom fifths, we see a ratio of 15 to 1. If we turn to consumption, the gap declines to around 4 to 1. Let's take the adjustments one step further. Richer households are larger--an average of 3.1 people in the top fifth, compared with 2.5 people in the middle fifth and 1.7 in the bottom fifth. If we look at consumption per person, the difference between the richest and poorest households falls to just 2.1 to 1."

That's the difference. The richest 20% in America live 2.1 times more extravagantly per person than the poorest 20%.

Another study by Steven Landsburg shows that leisure used to be evenly divided among the classes, but it isn't any longer. Although Americans as a whole have an extra four to eight hours of leisure per week (or about seven extra weeks of leisure per year), this extra leisure has not been gained evenly. About 10% have no more leisure than they did in 1965. These hard workers, it turns out, are highly educated and have had the largest gains in income. At the other extreme, about 10% have gained 14 hours a week or more (over 18 extra weeks of leisure per year). These excessive gains in leisure have gone, oddly enough, to those who are the least skilled, least educated and have the most stagnant incomes.

It used to be the leisure rich or the idle rich. Now it is the working rich and the idle poor.

Many believe it is OK to redistribute income but would consider it absurd to redistribute leisure. It turns out there really is little difference.

Decide to be rich. Your retirement, and the country's welfare, depends on it.

from http://www.emarotta.com/article.php?ID=278

Ignore Daily Financial Noise (2008-03-31)

Ignore Daily Financial Noise

(2008-03-31) by David John Marotta

Investors are fickle. Investing should not be.

Even with a brilliant investment plan, it takes diligence to overcome emotional biases and avoid making investing mistakes. Naturally you love it when your portfolio values go up. But when they go down, even slightly, you may be tempted to make poor choices. Here are some reminders to help you resist succumbing to the fallacies of behavioral economics.

Psychologists suggest we feel a loss about 2.5 times as much as an equivalent gain. This "loss aversion" phenomenon means that even we see an equal number of ups and downs, we still feel miserable. Daily market movements are nearly always noise. Only 52% of daily movements are positive. Because the negatives feel worse, your average day could feel 68% negative. Quarterly odds of satisfaction are 62% but still feel 13% negative. But if you discipline yourself to look at annual numbers, you get 77% odds of happiness, and when you analyze 3-year, 5-year, or since-inception returns on your reports, it will make you even happier.

You may believe you have a high risk tolerance when the markets were going up, only to regret being in when they go down. You also remember your uneasy feelings just before the markets dropped and forget you had the same ones just before the markets went up. All this leads to a false confidence in your own ability to predict what will actually happen and possibly a weakening confidence in your financial advisor's skills to see the obvious.

Research repeatedly shows that jumping in and out of the markets reduces returns. But some people persist in believing that if they just had enough information, they could predict what, in reality, only seems obvious after the fact.

Remember to ignore daily financial information. Most so-called news is just noise; we call it financial pornography, which includes everything from CNBC to the nightly news.

The markets are inherently volatile, but until recently they have been well behaved. Between 2004 and 2006, the S&P 500 moved up or down by more than 2% on only two days. Since mid-2007, we have had 27 days over 2% and market volatility has returned to historical averages. Between 2004 and 2006, the S&P 500 moved a daily average of only 0.51% compared with a historical average of 0.75%. Since mid-2007, volatility has been slightly above average at 0.99%. You must remember that such volatility is normal.

Every January 1, sometime during the year we will have a foot of snow in a week, 6 inches of rain in another week, and a 5% to 10% market drop in one month. It is almost beyond commonplace. But the snow always melts, the rain dries up, and the equity market resumes its great long-term uptrend.

The markets are inherently volatile but also inherently profitable. It is prudent to diversify for safety and stay invested for long-term growth. So although we don't know the markets won't go lower (no one does), don't let your short-term emotions trump an effective long-term strategy. Remember that strong long-term investment returns do help, but the best way to achieve your financial goals is to moderate spending and stay on track with savings.

You can resist the temptation to overgeneralize or to succumb to the random noise with these two simple rules. First, a diversified asset allocation with a fiduciary financial advisor sitting on your side of the table ensures the best chance of meeting your goals. And second, don't forget to relax and enjoy life at least 364 days out of each year.

from http://www.emarotta.com/article.php?ID=277