Roth Recharacterization 2011 (2011-01-31)

Roth Recharacterization 2011 (2011-01-31)

by David John Marotta

Last year was the year of the Roth conversion. Now it's time to consider how much of the conversion to keep. Although that decision depends on a hundred different factors, here is a simple rule of thumb to use as a starting point for discussions with your CPA.

Up until December 2010, it looked like a tax tsunami was coming. The higher your adjusted gross income, the closer you lived to the coast where the tsunami would hit. Now Congress has hit a two-year snooze button, but you should still safeguard your assets in a lifeboat and avoid getting swamped with future taxes.

At the end of 2012, 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 be reinstated at 55%. The capital gains tax will rise from 15% to 20% and then to 23.5%. Tax on dividends will swell from 15% to 39.5%.

Although the timing of this change has been pushed back, it should still factor into your tax management. Two years is a relatively small tax-planning window through which you should drive a Brink's truckload of savings.

The IRS allows you to change your mind. Last year I advocated converting more value to Roth IRAs than you intended to keep. Now you can decide the conversion wasn't worth it and 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. Filing an extension allows you to determine which accounts to keep, but you must still pay whatever tax is due by the normal tax filing day, which is April 18 this year. Then by October 15 you can recharacterize part or all of what you converted.

If you failed to convert anything last year, you missed an opportunity. If you converted much more than you probably wanted to, now you have to decide how much to keep. If you took our advice, you created five different accounts and invested them each in a different asset class (e.g., bonds, U.S. stock, foreign stock, emerging markets and hard asset stocks).

At this point the five accounts have appreciated differently, but the entire portfolio will be fairly well balanced. Now you must determine how many of the five accounts to keep and how many to recharacterize.

If you pay taxes in the highest marginal tax rate, you might as well keep all five. Even though the top marginal rate will continue to be low for another two years, the rate of taxes you pay if you convert in subsequent years won't be any lower. You might as well start growing the assets tax free in a Roth account as soon as possible.

If you pay taxes in the low 15% tax bracket, consider keeping just one of the five conversion accounts. You obviously will keep whichever account has appreciated the most. Recharacterize the other four accounts, moving the money back into a traditional IRA account. Then, after 31 days, you can convert the IRA to five new Roth accounts and begin another set of Roth Segregation accounts for 2011.

If you pay taxes in the middle tax brackets, you might hold on to two of the five conversion accounts. The goal is to try to convert the entire amount over three years while the tax rates are low but avoid pushing yourself into a higher tax bracket. After maintaining two this year, create five new Roth Segregation accounts for 2011 and plan on keeping three in 2012. Anticipate finishing your conversion in 2013 by retaining all five.

This general principle will keep 40% of the total amount the first year, 36% the second year and 24% the third and final year. The smaller percentages the second and third year would have had longer to grow, which helps equalize the converted amounts.

The information here is not intended to replace specific tax-planning advice. Don't try to fly solo about how much Roth conversion to keep and how much to recharacterize. Seek professional tax advice. This approximation will give you and your CPA a starting place for discussion.

The perfect tax-planning answer primarily depends on where you are in the progressive tax tables. Using your Roth conversion to increase your income to the top of your current tax bracket is a more refined answer to the question of how much to keep. Your accountant will be able to compute this amount as well for comparison.

The markets appreciated significantly in 2010, making it attractive to hold on to more of your conversion amount this year. And as soon as you have made that decision, recharacterize the remaining amount, wait 31 days and then start another set of five Roth Segregation accounts for 2011.



from http://www.emarotta.com/article.php?ID=437

2010 Non-U.S. Stock Lessons Learned (2011-01-24)

2010 Non-U.S. Stock Lessons Learned

(2011-01-24) by David John Marotta

Reviewing last year's investment returns provides a blueprint for where you should consider investing in the new year. Last week we looked at U.S. stocks and bonds. This week we broaden our horizons. Here are five principles to consider.

The United States isn't the only or even the best place to invest. Domestically, the markets enjoyed a great year, but the countries with more economic freedom and less debt did even better. Hong Kong was up 23.23%, Singapore up 22.14% and Canada up 20.45%. I would also add Australia to that list, even though its markets were only up 14.52%.

By comparison, the MSCI EAFE Foreign Index was up 7.75% for the year, recovering 24.18% in the last half of the year after dropping precipitously in the first half as Greek sovereign debt threatened the solvency of the European Union. A total of 61% of the EAFE index is invested in the so-called ring-of-fire countries with high debts. European countries with more government restraint did better, with Switzerland up 11.79%, Austria up 12.67% and Sweden up 33.75%.

Economic freedom and government restraint matter. All developed countries are not equally attractive places to invest. The United States has entered the ring of fire and expected to underperform in future years as a result. It is much easier to spend your way into deficits than it is to exercise austerity as a way into prosperity.

Emerging markets will continue to emerge. The MSCI Emerging Markets Index gained 18.88%. And this increase was not primarily from Brazil, Russia, India and China (the BRIC countries), which together were only up 9.57%. Mexico, in contrast, gained 27.45%, and Chile gained 47.13%.

Fighting the trend of globalization is not merely muddled economic thinking. It is socially evil. Poor workers in developing countries need employment even more than American workers. This is not a transfer of jobs from the United States overseas. It is a transfer of value from overseas to the United States. If we in the United States do what we do best and we let other countries do what they do best, both sides of the equation can gain. This is the most basic tenet of economics: Voluntary trade benefits both parties.

Hard asset stocks are an important inflation hedge. Hard asset investments include companies that own and produce an underlying natural resource. Examples include oil, natural gas, precious metals (particularly gold and silver), base metals such as copper and nickel and other resources such as diamonds, coal, lumber and even water.

Investing in hard asset stocks is not the same as investing directly in commodities. Buying gold bullion or a gold futures contract is an investment directly in raw commodities or their volatility, whereas buying a gold mining company is a hard asset stock investment.

Over time, dollars lose their buying power. The goods and services we buy cost more. Officially, inflation this past year was 1.1%. The government has a large incentive to underreport inflation. Unofficially, a barrel of oil went from $67 to $88 (up 31%) and an ounce of gold from $1,125 to $1,375 (up 22%).

Commodities as an asset class generally maintain their buying power in dollar terms. Stocks as an asset class generally appreciate over inflation after dividends are factored in. And recently, hard asset stocks have been appreciating nicely.

Hard asset stocks provide an inflation hedge. Due to the underlying value of the tangible commodity that natural resource companies produce, their earnings are tied to inflation. Their resources are worth more as the dollar declines in value. This situation can occur in times when the supply of money and credit is increased to fund government spending and budget deficits.

For 2010, the S&P North American Natural Resource Sector Index, which contains a portion of everything in the hard asset category, gained 23.88% for the year. Going forward we recommend deemphasizing gold and focusing on energy and real estate.

Stability should be truly stable. You don't put money on the stability side to make the most money. Therefore you shouldn't keep more money on the secure side than you need for the next five to seven years. Investors should consider what is and is not stable. For example, we recommend putting a portion into emerging market bond funds such as the Pimco Emerging Market Bond Fund (PEMDX/PEBIX), up 12.36% for the year. We continue to expect high volatility in the municipal bond markets due to economic strains in local and state governments. As a result, we don't recommend investing in municipal bonds at this time.

This review of 2010 can help provide an investment guide for the coming years. Analyze your portfolio against these observations to see where you should adjust your investment philosophy.

from http://www.emarotta.com/article.php?ID=436

2010 U.S. Stock and Bond Lessons Learned (2011-01-17)

2010 U.S. Stock and Bond Lessons Learned

(2011-01-17) by David John Marotta

Over the long term, stocks outperform bonds and bonds outperform cash, which was affirmed in 2010. Analyzing the breakdown of asset categories will help you craft portfolios that will perform best in this new year and beyond.

Fees matter. The S&P 500 finished up 15.06% for 2010. Your index fund probably underperformed this benchmark by whatever expenses the fund incurred. If your fund is very efficient, this amount was small. But if your funds fees are excessive, your performance was reduced even more.

For every additional 1% you earn over your working career, you can retire seven years earlier or 50% richer, a huge effect. In the financial world, a single percentage point is broken into hundredths of a percent. Each hundredth is called a "basis point," abbreviated "bps," and pronounced "bips" in financial parlance. Saving just 15 bps in expenses during your working career allows you to retire a year earlier, a dramatic advantage. That's how important fees are.

Compare your funds to the iShares S&P 500 Index ETF (IVV). It returned 14.97% with an expense ratio of only 0.09%. See if excessive fees are reducing your returns.

Stocks on average beat bonds, and bonds are more complex than stocks. Last year followed this trend. The Barclays Capital U.S. 1-3 Year Treasury Bond Index finished the year with a meager gain of 2.40%.

The expense ratio on iShares Barclays 1-3 Year Treasury Bond ETF (SHY) is 0.15%, which means you are charged more for investing in short-term bonds. Bond investing is more intricate than stock investing. Every share of Apple stock is exactly the same, but every bond's unique characteristics must be evaluated. No bond index fund can perfectly track the index, so they approximate the index and either over- or underperform. This year iShares SHY returned 2.22%, slightly underperforming its benchmark minus its expense ratio.

Setting the right benchmark matters. A fair benchmark for your portfolio is a combination of the S&P 500 for your equities and 1-3 year Treasury bonds for your fixed income. Blend these two indexes according to how much you have in appreciation and stability. For example, an investor with 70% of her portfolio in equities and 30% in fixed income would calculate her benchmark index as 0.7(15.06) + 0.3(2.40), or 11.26% for all of 2010. Knowing your benchmark return keeps you from being satisfied with an 8% return when at this level of risk you should have had an 11.26% return.

Risk is usually rewarded. For the past two years, appreciating assets have done better than stable fixed-income investments. In 2008, however, risk was punished severely. Equities return an average of 6.5% over inflation, and fixed-income returns 3% over inflation. So when inflation averages 4.5%, equities average 11% and bonds average 7.5%. In 2010 inflation was only about 1.1%.

Diversification means putting money in equity investments that ought to do better than the S&P 500 with reasonable risk and in fixed-income investments that are liable to do better than the 1-3 Treasuries with reasonable risk. Against these two benchmarks you can compare the plethora of other indexes.

Knowing which indexes are worth an allocation is critical. The thousands of different indexes each have their own return. The S&P 500, a large-cap U.S. stock index, is only one subsector of one of our six asset categories. Over the past decade, nearly every other subsector or asset class has done better than the S&P 500.

Let's begin by looking at subsectors with U.S. stocks. One way to divide U.S. stocks is using the style boxes popularized by Morningstar. The vertical axis on the 3 by 3 Morningstar grid represents size, from large cap at the top to small cap at the bottom. The horizontal axis represents value on the left to growth on the right.

Generally small-cap stocks do better than large-cap stocks. This year was no exception. The Russell 2000 Small Cap Index returned 26.85% versus the S&P 500's 15.06%. Your investments should include a healthy share of mid- and small-cap stocks even if they are more volatile.

Generally value stocks do better than growth stocks. This year that truism was mixed. Large-cap value beat large-cap growth. But in mid and small cap, growth performed better. Tilting value is recommended in every market except a roaring bull market. If your crystal ball doesn't forecast that clearly, we recommend maintaining a continuous value tilt.

In the United States, emphasize technology. Another method to divide the U.S. stock market is by sector of the economy. Information technology, the largest sector, comprises 18.4% of the economy. It includes Apple, Microsoft, IBM and Intel. The subsectors have all done well, with hardware up 23.36% and software up 22.64%.

This is what we do best. Our government now heavily regulates the financial, health and energy sectors. That's 39% of our economy. How can our banking industry compete globally with heavy regulation and a corporate tax rate of 35% when Hong Kong or Singapore has all the safeguards needed and a corporate tax rate of 10% or 17%, respectively? You don't want your investments dragged down by a lack of economic freedom. So overemphasize those sectors left free to innovate and compete on the global market.

Although technology historically is the highest performing sector of our economy, it also has the highest volatility. Interestingly enough, health care has been the second highest performing sector but with much less volatility. Not so this year. In 2010 health care was the second worst performing sector behind utilities, returning only 6.49%. The Patient Protection and Affordable Care Act, aka Obamacare, has begun to affect that sector of the economy negatively. Construction on doctor-owned hospitals has halted. Insurance rates are up. My own High Deductible Health Plan (HDHP) is no longer available to the public. My personal coverage will continue as long as I don't change any of the terms. So much for freedom and choice. In light of increased socialization, my standard advice to emphasize health care has to be reevaluated.

These eight observations should help you improve your U.S. stock returns. Next week we will look at the lesson to be learned from looking at last year's returns on foreign investments.

from http://www.emarotta.com/article.php?ID=435

A New Opportunity: Donating to Charity from Your IRA (2011-01-10)

A New Opportunity: Donating to Charity from Your IRA

(2011-01-10) by David John Marotta, Beth Anderson Nedelisky

Congress has reinstated the ability to donate to a charity directly from your IRA without any tax penalty. You may benefit from this provision if you fit the right criteria.

The IRS normally collects tax every time you withdraw funds from your IRA. For example, if you take $100,000, the amount increases your adjusted gross income (AGI). It can cause your deductions to phase out or trigger taxation of your Social Security benefits. In the past this was true even if you subsequently donated the entire amount to charity.

In addition, many retirees do not itemize. Thus they were taxed on their charitable giving without the benefit of a tax deduction if the gift was below their standard deduction. If the gift was a significant percentage of their AGI, much of the write-off had to be carried forward and realized in subsequent years.

Artificially inflating your AGI has other negative consequences. Medical expenses and miscellaneous deductions must exceed a percentage of your AGI. So increasing your AGI may mean you are no longer able to take these deductions.

But the tax law signed on December 17, 2010, is less restrictive. It allows taxpayers age 70 1/2 or older to donate up to $100,000 from their IRA directly to a charity. The amount of the charitable contribution is excluded from taxable income. Therefore it won't artificially inflate AGI and trigger an excessive tax burden.

You are normally required to withdraw a certain amount called the "required minimum distribution" (RMD) from your IRA account each year. Charitable contributions from your IRA can now satisfy this RMD requirement.

Because the law was passed so late in the year, you have until January 31, 2011, to make the transfers and still have them count for 2010.

You don't have to be a big donor to take advantage of this opportunity. Perhaps your 2011 RMD is only $10,000. But you don't need the money and normally give $5,000 to qualified charities. You can transfer half to charity. Only the other half will increase your AGI. This simple change could be enough to keep your Social Security from being taxed.

If your IRA contains both before-tax and after-tax dollars, you can save even more by giving. Qualified charitable distributions made from this type of IRA are taken from the portion of untaxed dollars first. This represents a radical departure from the typical IRA model that requires you to withdraw the pre-tax and after-tax dollars proportionately. Under the new act, you'll be able to give away the dollars that carry the highest tax liability. At the end of the day, you'll have a higher percentage of after-tax dollars left in your IRA.

All of these savings are liable to be small, perhaps only realizing about 5% of the value you give to charity. I've written previously about the benefits of giving appreciated securities in your taxable account. That technique is superior to this one in many ways, but not all. Giving appreciated securities adds the benefit of avoiding capital gains taxes that approaches an additional 15% benefit if the security is highly appreciated. But in some cases giving from your IRA would be the preferred method.

If you don't have a taxable account with appreciated securities, giving from your IRA is clearly the next best choice. And if you are older and not planning on selling any of the appreciated securities, your heirs will get a step up in cost basis and realize the capital gain without paying any tax. If you don't need the money for living expenses and already choose to do charitable giving, you might be the right candidate.

Transfers must be made directly to the charity or checks written made out to the charity. Each custodian has its own safeguards to ensure your transfer will qualify. No special forms are required. The IRS does not need to be notified. Your tax preparer will need to note the transfer on your taxes when you file.

Qualified charitable distributions are just one tax-planning tool that may save you money. We advise our clients to meet with their tax professional throughout the year long before the filing deadline. Tax planning is complex and time consuming but can be well worth the effort.

from http://www.emarotta.com/article.php?ID=434

Compute Your Net Worth Once a Year -2011 (2011-01-03)

Compute Your Net Worth Once a Year -2011

(2011-01-03) by David John Marotta

Since the end of last year the markets are up about 13%. Putting the last two years together the markets are up about 44%. Those are huge gains for two years. You may not have been on track for your goals two years ago, but now you should reevaluate again. The wave has propelled you miles toward your goal, and at least once a year you should measure your progress.

Everything in the financial markets has changed again: materials, emerging markets, real estate, foreign small cap, even the dollar. If you are within 20 years of retirement (age 45 to 65), it's critical to get your retirement planning updated. Computing your net worth annually is like taking a sextant reading to chart your course toward financial security.

Net worth gives you a snapshot of how much money would be left if you converted everything you owned into cash and paid off all your debts. Compute your net worth by creating four lists.

Liquid assets: An asset is something you own that has significant value. A liquid asset can be sold in a matter of days. Include personal bank accounts (checking, savings and money market), certificates of deposit, bonds, mutual funds, stocks and exchange-traded funds. Use values as of December 31 of the previous year so all of your amounts are calculated on the same day.

Nonliquid assets: Nonliquid assets are those things you own that incur a penalty when they are sold. Include the value of your retirement accounts (IRAs, 401ks, 403bs, SEPs, profit-sharing plans and pension plans). Add real estate investments as well as the market value of your home. Use the assessed value.

Other nonliquid assets may include proprietorships, partnerships or company stock in a firm that is not publicly traded. Add the cash value of any life (nonterm) insurance. Some people include jewelry, collectibles, cars and boats in this category. Although these items often have a high retail value, their true worth is often a small fraction of their initial cost. I do not recommend including personal property.

Immediate liabilities: List what you owe to creditors. Immediate liabilities include credit card debt, car loans, student loans, other loans and any bill or debt that must be paid within two years.

Long-term debt: For most people, long-term debt is primarily their home mortgage, but it may encompass other real estate or business loans.

The first time you gather all of this information will be challenging, but it gets much easier each subsequent year. By keeping an annual record of your net worth, you're creating a valuable financial planning tool.

Next compute three additional values. For your total assets, add your liquid and nonliquid categories; for your total liabilities, add your immediate liabilities and long-term debt; and finally, for your net worth, simply subtract your total liabilities from your total assets.

Use these net worth numbers to compute other values useful for reaching your financial goals. For example, your emergency reserve (liquid assets minus immediate liabilities) should be at least half your annual income. Any extra can be invested more aggressively for appreciation. Your debt load ratio (total liabilities divided by total assets) should be under 35%, with your home mortgage comprising most of your debt.

If you are trying hard to pay off your mortgage ahead of schedule instead of making a huge effort to save and invest, your attempts are laudable but mistaken. The quickest path to wealth includes holding a home mortgage you could pay off but you choose not to in order to take advantage of the tax benefits. The rich leverage wisely and invest.

A net worth statement helps you measure your progress toward retirement. At age 65 you can only withdraw 4.36% of your portfolio to maintain your lifestyle. In other words, to keep the same standard of living, you will need about 23 times what you spend annually.

Take your net worth and divide it by your annual take-home pay. The result shows you how many times your annual standard of living you have amassed in savings. If you are younger than 40, the number probably comes to less than five, which is adequate for now.

By age 45, you should be worth about seven times your annual spending. More sophisticated retirement planning includes the difference between taxable, tax-deferred and Roth accounts as well as Social Security guesses and defined benefit plans, but the method described here will approximate your progress. This table shows by what age you should have saved different multiples of your annual spending.

Age	Annual Spending Saved	Age	Annual Spending Saved
26	1	53	11
31	2	54	12
34	3	55	13
38	4	57	14
41	5	58	15
43	6	59	16
45	7	60	17
47	8	61	18
49	9	62	19
51	10	63	20

If your net worth is higher, congratulations! You may be able to retire earlier than 65. For every 1 unit you are over, you could consider retiring about a year earlier. Conversely, for every 1 unit you are under your age's benchmark, you may have to work an additional year beyond 65.

Between ages 40 and 50, your net worth should increase by 1 unit of your annual spending every two years. That means your current net worth divided by your take-home pay should be 1 unit greater than it was two years ago. And if you are between age 50 and 65, your net worth should have increased this year by 1 times your take-home pay.

Want to retire younger? Try lowering your standard of living. Most retirees spend about 70% of the gross salary they earned while working. If you can live off 50% of your take-home pay, it's not as essential to save as much.

Need to catch up? Save more than 15% of your take-home-pay. Determine how far you are behind and what additional percentage you can save each year. For example, at age 30, you should be worth 1.5 times your annual income. If your numbers don't match that ideal, an additional 0.3 times your annual income will help you get there. You could save an additional 10% of your income (for a total of 25%) for three years. If that's too much, try saving 20% (an additional 5%) for six years.

Money makes money. By the time you reach your 40s, you should have enough investments to be earning about half of your annual spending each year. Early in life what you save is most important for building wealth, but as you approach age 40 what you earn on your investments becomes critical. While you are young, the best advice a professional can offer is to "save." As you amass significant wealth, it is more pressing to "manage" well what you already have.

All financial planning begins with a clear understanding of your net worth. A PDF template on our website (www.emarotta.com/networth) can help you compute and keep track of your net worth each year. Contact us or visit our website to download a free copy.

from http://www.emarotta.com/article.php?ID=433