Rising Capital Gains Tax Hurts Everyone (2010-09-27)

Rising Capital Gains Tax Hurts Everyone

(2010-09-27) by David John Marotta

Because of Obamacare and the failure of Congress to extend current tax rates, capital gains taxes will soon rise from 15% to 23.8%. Take note, take heed, and take action.

The tax increases will come in two stages, starting with a hike in 2011 from 15% to 20%. The 15% rate, established in the 2003 tax cuts, will expire at the end of this year. This is part of a more extensive rise in taxes taking effect January 1, 2011.

Another capital gains tax hike was part of the Democrats' health-care bill. It adds an additional 3.8% tax on long-term capital gains and dividends beginning in 2013.

Combined, these two tax increases enact a 59% increase in the capital gains tax rate. That's a huge tax increase, and taxes affect behavior.

The optimum rate for capital gains taxes is zero. Every economist worth his Ph.D. agrees that the correct rate for the capital gains tax is zero, zip, nada. Some have even suggested the optimum tax rate for capital gains is negative!

We should be rewarding saving and investing because it builds an enduring and robust economy. Saving is currently too low.

We need incentives to save and invest and thus create an economic environment that encourages the hard work and risk taking that pays everyone's salary. Investment is simply capital, and capital is simply deferred consumption. Why defer consumption if you are penalized for it?

Investment supports the factories, businesses and entrepreneurial ventures that actually make money. It stimulates the economy, which then creates jobs and produces real wealth.

The prospects for our Social Security system look bleak. There won't be enough money to support the number of retirees. Chances are only the worst off will receive anything significant from current funding. And now the political winds are blowing to make saving and investing for your own retirement much more difficult. It seems as though "fair" is being redefined to impoverish everyone and force them to rely on the government.

The new rate for capital gains will leave very little reason for anyone to take the risks associated with capital investments. With an average inflation rate of 4.5% and an average return of 11%, the return may not be worth the risk. Politicians are giving us no incentive to take care of ourselves. They are ensuring that government will need to save us.

For example, imagine you assume the risk and invest $100,000 in an equity venture. Let's suppose the investment pays off and appreciates 8%, or $8,000 in a year. Under the new rates, you would owe $1,904 in capital gains tax. And $4,500 of your remaining profit would simply be inflation on which you still have to pay taxes.

You would be left with only $1,596 of real return after inflation, a pitiful 1.6% gain over inflation. With such a small reward for taking risk in capital ventures, why not simply invest in municipal bonds with a guaranteed return and no taxes due?

Of course investing in municipal bonds may have its own risks. Downgrades or even defaults in muni bonds may make that category suffer its own poor returns. And if you lend money to spendthrift government entities, you may not even get your principal back.

The effect of higher capital gains taxes on investments is immediate and devastating. Capital investments make innovation and new businesses possible. Plans for such ventures include five-year return on investment projections that now have to take into account the headwind of a punitive government taxation environment.

Few will see these negative results because they are entrepreneurial plans that won't happen. People have a hard time seeing what doesn't happen. But the result will be that American-style 6.5% growth will slow to a more European-style 4% growth. Every 1% less you get on your investments over your career means you will have to work an additional seven years to attain the same lifestyle in retirement.

Big government politicians will ultimately blame all of these harmful effects on the markets themselves. They will use it as a populist excuse for higher taxes and more regulation. Their policies will have taken all the gains, and in the end they will try to take the credit for saving us.

Henry Hazlitt, in his well-known book "Economics in One Lesson," lamented, "The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups." Unfortunately, voters rarely pay attention long enough to connect the dots on the unintended consequences of economic policy.

In the meantime you should make some changes in your portfolio this year. Your retirement may depend on it.

First, if you are wealthy and haven't done Roth conversions yet, get them done before the end of the year. Pay as much tax as possible at the current tax rates and transfer your traditional IRA investments into a Roth account where the capital gains rate is zero.

Going forward, only investments in a Roth will have a tax rate that is most favorable to market risk and return.

Second, for your taxable investments, ensure your portfolio will be able to weather a long period of unfavorable capital gains taxation. If you have banked a large amount of capital losses, this may be sufficient. Otherwise you may want to cash in all your unrealized capital gains and pay the current 15% rate. Then order your portfolio so you won't have to make many significant changes over the next few years.

A well-structured portfolio may be able to avoid realizing any capital gains during the remainder of the Obama administration. Waiting for a more favorable administration is a wise strategy.

For taxable accounts, you need to be in control of when you realize capital gains. This is most easily accomplished when you are invested in exchange-traded funds (ETFs) rather than mutual funds that kick off capital gains as the fund manager makes trades in the underlying portfolio.

ETFs are very tax efficient. They seek to minimize capital gains by exchanging those stocks sold out of the index for those funds added to the index. Because buying and selling in the fund is done by means of like-kind exchanges, it is not a taxable event. Hence with ETFs no capital gains are owed until you decide to sell.

If you invest in individual stocks, there quickly comes a time when the company should be sold and your profit taken. By buying the right mix of ETFs, you will be able to hold the index indefinitely. And by structuring your portfolio across your taxable investments and your traditional and Roth accounts, you will be able to rebalance your portfolio outside of your taxable account.

A well-structured asset allocation should be able to weather a poorly run administration. And whenever voters realize they can't soak the rich without drying up the capital that drives prosperity, the capital gains rate will be lowered or, in the best case scenario, eliminated entirely.

from http://www.emarotta.com/article.php?ID=417

Hong Kong: An Ideal Place to Invest (2010-09-20)

Hong Kong: An Ideal Place to Invest

(2010-09-20) by David John Marotta

According to the Heritage Foundation's 2010 Index of Economic Freedom, Hong Kong has the most economic freedom. Freedom does matter. Hong Kong is the poster child for superior investment returns following free markets. Investments there have appreciated 71% more than the S&P 500 over the past decade.

Hong Kong has an incredibly low tax rate. Individuals are taxed at the lower of a progressive tax maxing at 17% of adjusted gross income or a flat tax of 15% of gross. Just as good is Hong Kong's 16.5% top corporate tax rate.

Hong Kong's government spending is equally low. In the most recent year of the Heritage Foundation's study, tax revenue was 14.2% of gross domestic product and government spending was 14.5%. Unlike the United States, Hong Kong tries to have a balanced budget every year.

Hong Kong's constitution is completely separate from the rest of China. Corruption is minimal, and it ranks above the United States for freedom from corruption in Transparency International's Corruption Perceptions Index. Of 179 countries, Hong Kong ranks 12th; the United States only ranks 18th. In the United States, the Troubled Asset Relief Program (TARP) and other bailout programs run by the Treasury and the Federal Reserve lack public accountability or transparency.

The value of the Hong Kong Index is 60% in financials, which includes real estate properties and stock exchanges as well as traditional banks.

It is understandable why Hong Kong has so many financial institutions. Today banks can be located in any country and still do business around the world. With current technology you can take a photo of a check with your iPhone, and then send the image and deposit the money electronically in seconds. Many banks allow you to use any ATM to withdraw funds and reimburse you for the transaction fee.

So imagine you are opening a bank and have the option to locate it in either Hong Kong or the United States. You can serve clients anywhere in the world. The only difference that your choice will make is which economic environment will bring the best value to your shareholders.

If you opt for Hong Kong, oversight and regulation are light and evenly applied by the independent Hong Kong Monetary Authority. As mentioned earlier, your profits are subject to a top corporate tax rate of only 16.5%.

In contrast, if you locate in the United States you are subject to the expensive and invasive 2002 Sarbanes-Oxley Act. The government subsidizes large firms competing with you that benefited from risky investments by allocating additional credit to them at below-market rates. And after the Frank-Dodd Regulatory Act of 2010, the government can decide to dismantle your company without judicial review because it considers what your company is doing to be a threat.

In the United States your profits are subject to a tax rate of 35%, second only to Japan. And in 2011 the U.S. top corporate rate will rise to 39.5% as Japan starts to lower its tax rate from 40%.

In which country would you choose to put your headquarters?

Investments to expand banks do not do as well in the United States as they do in Hong Kong. The United States is not a bank-friendly environment. We seem to be the last country to realize that high corporate tax rates only serve to move more and more businesses overseas.

In Hong Kong, however, banks like Hang Seng live up to their name, which means "ever-growing" in Chinese. Sun Hung Kai Properties is another financial company in Hong Kong. If being located in Hong Kong is lucrative, owning real estate in Hong Kong is equally so. Sun Hung Kai controls over 43 million square feet of real estate.

Hong Kong is only 426 square miles, less than 60% of the size of Albemarle County, Virginia. But its population is more than 7 million, making it one of the most densely populated places in the world.

There is an easy and simple way to participate in Hong Kong's equivalent of the S&P 500. A single exchange-traded fund, iShares Hong Kong Index (EWH), consists of 41 of the largest publicly traded companies there. The expense ratio is a low 0.55%. It has a five-year average return of 7.61% versus the S&P 500's five-year return of -0.91%. Earning 8.5% over the S&P 500 for the past five years will boost anyone's portfolio return. The 10-year return is also good, averaging 4.46% versus the S&P 500's -1.81%.

An annual 6.27% superior return adds up over 10 years. It is the difference between a cumulative 54.7% appreciation and a cumulative 16.7% loss. That means an impressive 71.4% more in your portfolio.

Economic freedom matters. And it makes you wonder why all the capitalists are in China and all the socialists are in Washington.

Mainland China could curb economic freedoms in Hong Kong at any time, but they choose not to. They are trying to move toward more of a market economy, and Hong Kong is their model of what that might look like. When Deng Xiaoping introduced market liberalization he remarked, "Let some grow rich first."

Hong Kong provides a place for free markets to work so they can compete in the global economic environment. Even though China knows that Hong Kong is a cash cow, every now and then they long to eat beef. It would be a grave mistake, but it is still a strong temptation.

The United States has started to eat meat, and we seem to be bewildered why the milk has stopped flowing. The answers are relatively simple, but until we figure them out politically, overweight your investments in Hong Kong and underweight your investments in the United States.

from http://www.emarotta.com/article.php?ID=415

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

The Very Last Chance for a Massive Roth Conversion

(2010-09-13) by David John Marotta

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

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

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

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

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

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

Traditional IRAs get you a tax deduction now, and you can delay paying taxes until after your investment has grown. With a Roth IRA there is no tax deduction when you deposit the money. But the investments grow tax free rather than tax deferred. Qualified distributions from Roth IRAs are not subject to any income taxes. Roth IRA accounts are to your advantage if your tax rate will be higher when you withdraw the money than it was when you contributed.

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

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

Recharacterizing a Roth conversion can be done any time before you file your taxes, including the filing extension. So you can change your mind any time before October 15 of year 2. And you can decide to recharacterize part or all of what you converted.

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

With a Roth IRA, you pay tax on the acorn. With a traditional IRA, you get a bigger acorn to start with, but you pay tax on the oak. Many families have actually lost money by investing in their traditional IRA when they were young and in a lower tax bracket, only to find themselves in a much higher bracket during their retirement. A year from now, we will all be in a higher tax bracket.

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

Even though this technique could boost your after-tax returns, be careful. Executing a Roth segregation account requires professional assistance. Such a technique should be just one small part of a larger comprehensive financial plan. And you should seek the guidance of a personal fee-only financial planner and certified public accountant (CPA) who have a legal obligation to act in your best interests. The laws are changing annually, and as a result so is the optimum path.

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

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

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

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

by David John Marotta

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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



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